Integra Lifesciences Holdings Corp (IART) 2008 Q2 法說會逐字稿

Good day, everyone and welcome to the Integra LifeSciences Q2 financial reporting conference call. As a reminder, today's call is being recorded. At this time, I would like to turn the call over to Mr. Stuart Essig, President and Chief Executive Officer. Please go ahead, sir.

Thank you. Good morning, everyone, and thank you for joining us for the Integra LifeSciences second-quarter 2008 earnings release conference call. I am Stuart Essig, President and Chief Executive Officer of Integra LifeSciences Holdings Corporation. Gerry Carlozzi, Chief Operating Officer, and Jack Henneman, Chief Financial Officer, join me today.

During this call, we will review our financial results for the second quarter of 2008, which we released last night and update our forward-looking statements for the rest of the year. We will also take a few minutes later in the call to discuss the acquisition of the Theken companies.

At the conclusion of our prepared remarks, we will take questions from members of the telephonic audience. Before we begin, Jack 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 webcast. A replay of the conference call will be accessible starting one hour after the conclusion of the live event. Access to the replay is available through August 26, 2008 by dialing 719-457-0820, access code 5425710, or through the webcast accessible on the Investor Relations page of our website.

Today's call is a proprietary presentation of Integra LifeSciences Holdings Corporation and is being recorded by Integra. No recording, reproduction, transcript 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, August 12, 2008. Unless otherwise posted or announced by Integra, the information in this call should not be relied upon beyond August 26, 2008, 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 others, statements concerning management's expectations of future financial results, new product launches and regulatory approval 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 Item 1A of Integra's annual report on Form 10-K for the year ended December 31, 2007 and the 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.

Certain non-GAAP financial measures are disclosed in this presentation. A reconciliation of these non-GAAP financial measures to the most comparable GAAP measures is provided in the press release we issued last night, which is available on our website in the Press Release section under Investor Relations.

Additionally, in this press release and in the current report on form 8-K that we filed yesterday, we provide explanations for why management believes that presentation of these non-GAAP financial measures provides useful information to investors regarding Integra's financial condition and results of operations and the reasons for which Integra's management uses the non-GAAP financial measures. I will now turn the call over to Stuart to review the highlights of the quarter.

Thank you, Jack. The business delivered another strong performance. Total revenues in the second quarter of 2008 increased by $22 million to $157 million or a 17% increase over revenues of $135 million in the second quarter of 2007. This is in line with our expectations.

Importantly, for the first half of 2008, our revenues came in right within the range that we projected nine months ago when we gave our guidance after the IsoTis acquisition. While organic growth calculated and the way we have done so historically was 7%, remember that we anticipated a difficult comparison in the first half of 2008. The reasons are unchanged from the prior quarter -- underperformance in our ultrasonic aspirator business and the planned rationalization of certain of our Medical Surgical productlines.

As we said last quarter, we anticipated improvement in our core growth rates both in the Medical Surgical products and overall in the second half of the year. Our Neuro Ortho Implant revenues in the second quarter increased over the prior period by 37%. Organic growth in this category exceeded 16%. Extremity reconstruction implants grew in excess of 35% this quarter with strong growth from both metal and collagen-based implants.

Revenues from our Medical Surgical Equipment productlines increased over the prior year period by 5%. Excluding acquisitions, sales of products in the Medical Surgical Equipment category were slightly up over the prior year period. International sales were 27% of total sales this quarter compared to 24% of revenue in the full year 2007. Foreign exchange had a favorable impact on revenues of $3.7 million.

Over the past year, our company has changed rather significantly. Our goal is to build Integra into one of the top multi-division medical device companies. We continue to strive to do so in four ways. First, we will innovate new products. Second, we will start new businesses from scratch. Third, we will grow through acquisitions and business development. And finally, we will grow through entering new markets both domestically and internationally.

Last year, we launched more than 35 new products. We are well on our way to launching a similar number this year. We continue to invest in our core tissue engineering technology. Our collagen-based products have grown over 25% annually over the past 10 years and we continue to add new products. In addition to our DuraGen adhesion barrier trial, we are planning on kicking off two new multicenter clinical trials in the next 12 months. The first to expand our indications for our Integra Dermal Regeneration Template and the second to gain US approval of our Integra Total Ankle.

Over the last several years, we have started three new businesses. First, we built our extremities orthopedics business. Next, we created an OrthoBiologics salesforce to detail Integra MOZAIK to the orthopedic surgeon. And finally, we built the best-of-breed hybrid distribution organization for surgical instruments and lighting.

Over the past 10 years, we have completed over 30 acquisitions. These acquisitions have been done for a number of different reasons. Some to add sales infrastructure and increase our distribution, some to add productlines to fill holes in our portfolio and others to add completely new lines of business where we can sell our internally-generated products based on our collagen technology.

Over the past several years, we have significantly expanded the number of direct sales representatives we have both inside the United States and around the world. We have been recruiting and will continue to recruit more representatives in those North American and Western European countries where we are direct and we will add distributor partners elsewhere around the world. We are also moving to direct distribution in additional countries as opportunities present themselves either by going direct or acquiring our established dealers.

Last week, the Board of Directors of Integra chose to renew my employment agreement through the end of 2011. After more than 10 years as CEO of the company, I am more excited than ever about the prospects for our business and our associates. We have great technology, boundless enthusiasm for the business and we have wonderful customers. It has been a great honor to serve these constituents as the company's President and I look forward to guiding the company to even greater opportunities. I appreciate the Board's vote of confidence in our growth strategy and my continued leadership.

Before Jack provides more information regarding our financial results, I would like to turn the call over to Gerry Carlozzi to discuss our acquisition of the Theken companies.

Thank you, Stuart. The Theken acquisition represents an excellent strategic fit for Integra. It provides us direct access to the spine market and significant growth opportunities for us to leverage our OrthoBiologics technology platform, allowing us to take marketshare in the attractive spine market. As you may know, we have been talking for a number of years about our desire to enter the spine market. We are pleased that we are able to find a well-run company that fits well with Integra's culture.

For those of you who don't know Theken, we purchased three companies from Randy Theken and his investors. These include because Theken Spine, Therics and Theken Disc. Theken Spine was founded in Akron, Ohio in 1998 and designs, develops, manufactures and distributes a full range of spinal fixation products. Theken Spine's products include cervical plates, medical screws, spacers and trauma devices for the treatment of degenerative spine and spinal deformities.

Therics designs, develops and manufactures a variety of synthetic bone graft substitute products. The Beta-Tricalcium Phosphate technology known as Theriform will add to our portfolio of OrthoBiologics technologies.

Theken Disc is a research stage company that is developing the revolutionary eDISC, a microelectronic, artificial spinal disc replacement. We are very excited about the opportunities that this combination presents in both the United States and the rest of the world where Integra has an established network of direct and distributor reps calling on the neuro spine market. In the United States, we will maintain existing distribution network for the sale of Theken's products, typically from Integra OrthoBiologics and neurosciences.

Theken companies are profitable and well run by the current management team, which is staying in place. However, Theken will now have the resources and experiences of a much larger company behind it. We anticipate that the combination will help Theken continue its track record for success.

For modeling purposes, you may wish to note that the revenue growth rate and gross margin for Theken is above our corporate average. However, so are the percentages of revenue spent on R&D and sales. We are modeling growth for the Theken companies at about 15% going forward. Although we are optimistic that we will do better.

We paid $75 million in cash at closing and expect to pay two additional earnout payments. Each earnout payment will be equal to 2.5 times the prior four quarters of revenue ending on September 30, 2009 and 2010 respectively. Plus all previous payments made, including the initial $75 million. The maximum total consideration will be $200 million. I will now turn the presentation over to Jack for a further discussion of our financial results.

Thank you, Gerry. Before I get into the details of the financials, I wanted to comment that I am pleased with the progress made in the accounting group this quarter. As you saw, we filed our 10-Q on time. We continue to improve the people, processes and systems in our finance department.

Now to the financials. Gross margin on total revenues in the second quarter of 2008 was 63%. This is a significant improvement over prior year reflecting the faster growth in higher-margin implant products. Research and development expense increased by $1.6 million to $7.8 million. In the quarter, we spent approximately 5% of revenues, which is in line with our guidance. Selling, general and administrative expense increased by $8.5 million to $63.5 million or 40% of revenue. This increase in SG&A expense over last year was primarily a result of the larger size of our sales and G&A organizations and the impact of the acquisition of IsoTis. I am pleased we saw the expected increased leverage in SG&A. In the second half of the year, we expect to spend 38% to 40% of sales on SG&A and 5.5% of sales on R&D, excluding special charges.

Operating income was $24.8 million for the second quarter, up $7.9 million from the second quarter of 2007. Our expense for the amortization of intangible assets was $4.1 million in the quarter, of which $1.1 million is included in cost of product revenues. We expect total amortization expense to be approximately $5 million per quarter through the end of 2008, of which approximately $1.5 million per quarter will be reported in cost of product revenue.

In the second quarter of 2008, we recorded $3.8 million of net interest expense. Our effective income tax rate was 33% for the quarter. We anticipate a full year tax rate of 35%, down from last quarter's estimate. Our projected tax rate continues to fluctuate a bit reflecting our changing mix of revenues and profits.

Before I discuss earnings, I would like to remind you that we are not adjusting our earnings for the effects of FAS 123(R). We reported net income of $13.8 million or $0.48 per diluted share for the second quarter of 2008. When adjusted for certain restructuring-related expenses and other charges, net income for the second quarter of 2008 was $14.1 million or $0.49 per diluted share. For comparison, our second-quarter 2007 adjusted earnings per share were $0.41. Adjusted earnings per share exceeded the high end of our guidance for the quarter.

The weighted average common shares outstanding used in the calculation of diluted earnings per share in the second quarter of 2008 were approximately 28.6 million shares. At the end of June, our cash totaled $77.3 million and we had outstanding borrowings of $120 million under our $300 million credit facility. Note that early in the third quarter, we borrowed an additional $80 million to fund the acquisition of Theken. Now let me turn the presentation back over to Stuart.

Thanks, Jack. Our management team continues to seek out external opportunities for growth and future acquisitions could affect our results going forward. However, the forward-looking guidance that we are providing does not reflect the impact of acquisitions or other strategic corporate transactions that have not yet closed. We have updated our 2008 annual revenue and adjusted earnings per share guidance to reflect first-half actual results and the acquisition of the Theken companies. Excluding special charges, the Theken acquisition is expected to be approximately $0.03 dilutive in the third quarter. Thereafter, we are not modeling any dilution from the transaction.

Overall, our upwardly revised ranges for annual revenue and adjusted earnings per share guidance reflect the strength of our business in the first half of 2008 and the positive expected impact of Theken. While we will likely have quarterly fluctuations in our performance versus our expectations, we believe that our annual guidance remains the appropriate benchmark for our business. Longer term, we intend to drive internal revenue growth consistent with our target of 10% to 12%.

We have also adjusted our GAAP guidance to reflect the special charges that we anticipate occurring over the balance of the year. In the third quarter, we expect a non-cash, after-tax charge of approximately $23 million in connection with an in-process research and development charge related to the Theken acquisition and the accounting for the non-cash restricted stock unit grant pursuant to the renewal of my employment agreement in August.

We no longer adjust earnings per share for the effects of FAS 123(R). For those of you who're still tracking the impact of FAS 123(R), we expect the quarterly impact of share-based compensation expense to be approximately $0.09 per diluted share for each quarter during 2008.

As a management team, we look forward to continuing to meet with our investors. Gerry Carlozzi will be presenting at the Canaccord conference tomorrow. Now, we will be happy to answer all of your questions. Operator, you may turn the call over to our participants.

(Operator Instructions). Tao Levy, Deutsche Bank.

Good morning. So just a few clarifications on my end. The Theken -- when you guys have to start paying some of the future payments, are you going to be recording sort of on a quarterly basis as we go through 2009, 2010, future payments on that, the 2.5 times?

No, that is not the way the transaction is accounted for like the one we are doing. So no, we will pay the additional purchase price after the first year of results are reported and then those will simply go up on the balance sheet as additional goodwill and cash will be removed from our cash account.

Got you. Will that -- Stu, when you mentioned that it wasn't going to be dilutive thereafter, you are not including those payments down the road?

Well, when you look out a year -- so fast forward and assume we pay out a certain number, then that additional interest expense on the cash that was paid to Theken and investors would then hit the P&L, but the profitability of the business we would more than expect to offset the additional interest expense. There will be no additional intangible amortization due to the second or the third payment. It all goes into non-amortizable goodwill.

Got you. Okay. That's helpful. And also do you mind walking me through the organic growth. You guys did really well again in the Neuro and Orthopedic Implant segment. What is the dollar number that I should be using in terms of sort of acquired dollars?

We will search for the answer to the question, but let me try to answer it qualitatively. We had about a 16% internal growth in the implant business and Jack is showing me $10 million of acquired growth in that category. So you can subtract that from the total reported to get the organic number. And then the MedSurg business was essentially flat and when you take the two together, you end up with about a 7% organic growth rate based on the way we have traditionally presented it to investors.

Now, if you look at expectations for the quarter, in our forward-looking guidance of $157 million to 1 -- I think it was $161 million or $162 million -- implicit in that forward guidance was about 7% to 10% organic growth. So we were at the light and of our organic growth calculation.

That being said, remember, we are trying to run the company for multiple targets and this quarter and many quarters, we have been trying to drive gross margin, operating profit, revenue growth and a number of other statistics and this quarter, we were very successful on gross margin, beating our own expectation by one percentage point. We were very successful on operating profit, finally getting back into the 16% operating profit range, which was frankly our objective for the year. And then -- but a little light on the organic growth calculation. That was on the one hand planned for. We have been selectively going through a number of our MedSurg productlines, in particular instrument lines and rationalizing them and if they are not providing the appropriate return on our investment, i.e., delivering the bottom line, we are deemphasizing them or discontinuing them.

And then the part that was not planned for is we continue to see some softness in our ultrasonic aspirator line and it is really, in my own view, our own fault. To some extent, the quality of the integration internationally of the CUSA business; to some extent, delays in launching some of the new products in ultrasonic aspiration; and to some extent, cannibalization of our Selector line by the CUSA.

Anything on competition? Sorry about that, Stu.

Well, it's pretty interesting. We have one publicly traded competitor and they have not shown better numbers than us. We talk to our sales people and they say we are not losing business, but I guess we are not provoking enough business. I expect it to turn around and -- I don't expect a rapid turnaround, but over the next 12 months, I expect that to turn around and we have seen that business go up and down. So I would say one knock on us for not delivering on ultrasonic aspiration growth, but on the other hand, quite deliberate in terms of trying to rationalize our instrument productline.

And I just have two additional ones. Does the 7% to 10%, is that still in effect then going forward? Is that how we should think about it?

No, long term -- remember what we try to do. We give you quarterly and annual guidance. So the thing you should hang your hat on and the thing we are trying to achieve is the annual revenue guidance and then we have adjusted it up for our expected impact of the Theken acquisition. Now because a number of our analysts like to calculate the internal growth of our businesses, one of the ways to evaluate our performance, we give this year and prior year acquired revenue information.

That being said, it is not an exclusive or critical measure for us. It is one of the measures that we are particularly focused on long term. So our long-term expectation, and when I say long term, I am talking about three-year guidance or -- it is not really guidance, but three-year objective of 10% to 12%, said differently, double-digit growth without the acquisitions. If you look at the last 10 years, we have put up well in excess of those numbers and then over and above that, the impact of the acquisitions. But to focus exclusively on the internal growth I think is missing indeed the impact of growth that we see in the things that we buy and the synergy of putting all of the different pieces together.

So if you look at the back half of the year, all you need to do is take our revenue guidance for Q3 and Q4, compare it to prior year and you will come up with a implicit organic growth rate. The implicit organic growth rate for 2008 has been and will continue to be 10%.

Okay. That's helpful.

I made the point of trying to get across that we have delivered on what we said for the first half of the year, hitting the number exactly in the middle of our initial guidance range that we introduced nine months ago after the IsoTis acquisition.

Okay. And then just lastly on the Theken acquisition, strategically how should we think about the opportunities? First quarter seemed tremendous and sort of being leveraged different, the OrthoBiologics that you have, the MOZAIK and now the implant, but you've mentioned that you are going to keep the salesforces separate, but is there going to be some crossover of what each of the distribution salesforces can sell? So can the OrthoBiologics folks leverage their relationships with their spine surgeons, neurosurgeons and bring in some of the Theken and also vice versa?

Critical point. In the orthopedics business, you are only as good as your salespeople. And we value the distributor network that we acquired when we acquired IsoTis and we value the distributor network that we acquired when we bought Theken. So our plan is to invest in those two separate distributor networks and take what is a relatively small OrthoBiologics business -- as you know, we acquired something with about $40 million of revenues -- and what is a relatively small spine business -- as you know, we acquired plus or minus $35 million of revenues -- and tried to drive those in a separate, but synergistic way.

I will give you, for example, a couple points. First of all, if you look at the OrthoBiologics business, we already introduced a range of demineralized bone matrix products, as well as a version of the MOZAIK productline and are selling that through our Extremity salesforce. So we are able to take the acquisition of IsoTis and drive it through a completely new distribution channel.

Separately, a number of the Theken dealers are IsoTis dealers already. Now known as Integra OrthoBiologics dealers. So the art in this will be to not force synergies, but to allow people to take advantage of the synergies. What we wouldn't want to do is try to, for example, drive IsoTis through the Theken dealer network and in some way alienate those dealers or make them sell something they wouldn't want to sell and vice versa. But to the extent that one dealer sees some synergies in approaching IsoTis, then that is a neat opportunity for upside.

So what I would say is it is all about revenue growth and not about cost savings. We already squeezed the costs out of IsoTis like we promised we would do and now it is all about revenue growth.

Great. Thanks a lot.

Amit Bhalla, Citi.

Hi, good morning. I wanted to continue on the lines of the MedSurg business and get a performance update on Jarit. You said last quarter you were expecting a substantial increase in the growth rate in the back half of the year. So could you give us an update there and then I have a couple of other follow-ups?

Yes, so if you recall, one of our opportunities last year was the acquisition of LXU and that opportunity comes with both upside and restructuring. The upside is we ended up, post-acquisition, with approximately 50 direct salespeople or half the country covered with direct salespeople. Those folks are all now selling Jarit. Those folks are all selling the Luxtec lighting systems, but on the other hand, we have discontinued a significant number of the productlines that Luxtec LXU carried a behalf of what was essentially a much smaller company.

So we have literally, and I am going to guess at the number, discontinued probably 50 different distributed productlines that the LXU company carried because they were getting small distributor margins and we are not a distributor. We have now gone through the process of training the salespeople of LXU to sell both the Jarit products and the LXU lighting products. So the point is that this direct salesforce is now responsible for a much broader set of products, but they are all self-manufactured as opposed to distributed.

In terms of the revenue for Jarit, we don't break out the specific numbers, but I will say that Jarit was up, it was up single digits, high single digits from prior year and we expect in the back half of the year it to be up at least single digits, if not double digits for Q3 and Q4. So it is indeed delivering on what it was expected to do.

I'll give you an example of one that is down and that would be our spinal specialties productline, which we have now essentially integrated into Physician Industries, but the impact of the integration was to again delete and remove on the order of 40 to 100 unprofitable customers that we simply either offered a Physician Industries' product to or discontinued selling to.

Okay, thank you. Just two other quick follow-ups. Can you quantify in dollars the products that you have rationalized out of MedSurg? And then cash flow from operations, it was negative in the quarter. Help us with the target for the full year on cash flow from ops.

Okay, for discontinued products, I really don't have the statistic I can give you. So I don't really have a follow-up for that. In terms of cash flow, cash flow in Q1 was actually pretty spectacular. And if you recall, I believe it was well north of $20 million, well above our expectations. Cash flow in Q2 was well below the expectations, but I would make a point. We paid well over $20 million of cash taxes in Q2 either as payments for the contingent interest part of the convertible bond or pre-payments for our expected tax rate going forward. So most of the chewing up of cash in Q2 reflects either a one-time event, which was settling up the convertible bond, or pre-payment of taxes that we will then not have to have flows of cash flow out for in Q3 in particular.

And if it is not obvious, our tax rate has bounced around. Why has our tax rate bounced around? We went from being a company using NOLs about two years ago to using them up in 2007 to estimating what our tax rate will be for 2008. And when you are dealing with governments, it is better to pay and then go get your money back than not pay and get fined. And so we have made substantial prepayments in taxes in anticipation of a higher tax rate.

Indeed, if you look at the second quarter, we had a very perverse thing happen. We made IsoTis profitable and one of the interesting things about having made IsoTis show a profit for the first time in its recent history was it actually lowered our GAAP tax rate [10]% to 35% for the year compared to the Q1 of 37.5%. So I am hoping by the time we are done with 2008 and into 2009, we will stop seeing our estimated tax rate bounce around. We will settle in at a reasonable number, which right now we think is 35% and the cash taxes will start to approximate the GAAP taxes.

In the back half of the year, we expect to spend about $10 million a quarter on cash taxes and if you look at the first half of the year, if you average out what we have been doing, it is much more in line to a 35% cash tax rate.

So what is the full-year target for cash flow from operations?

I don't have a specific number. You would have to back into it.

Okay, thanks. I will jump back.

Taylor Harris, JPMorgan.

Thanks a lot. Just to follow up on some of the product rationalizations you are doing in the MedSurg reporting category. Did that accelerate at all in the second quarter or do you think you are at a steady state that either stays the same or improves from here?

We are modeling in the back half of the year an improvement in the performance of the MedSurg business as a whole, which implies an improvement in the organic growth rate. Now we are not modeling it based on wishful thinking; we are modeling it based on anniversarying certain performance and it is not just the rationalization; it is the performance of the ultrasonic aspirator business.

I will say the answer differently because I am not sure that was a satisfying response. We have identified and acted upon all of the restructuring activities that we anticipate in the MedSurg business and now it just needs to play itself out over the coming quarters. There is not going to be new things that we are discontinuing in Q3 and Q4. Much of this activity was done several quarters ago and you are now seeing the results of it.

Okay, great. And then on the IsoTis business, you have settled in here at around $10 million a quarter, which I think is a little better than you had thought you would do at the time of the deal. What are you seeing I guess beneath the surface in the IsoTis acquired business in terms of potential for growth as we look out into 2009 and beyond?

I will give you a couple thoughts. First of all, there are three major components in the IsoTis business and each one is worth thinking about separately. IsoTis had great products, but was struggling operationally, mostly due to lack of cash, but also because it was trying to do too many things at once. Indeed, when we acquired it, the US distribution was faltering, revenues inside the United States were shrinking and indeed, we anticipated a more substantial decrease in the first couple of quarters than we actually achieved.

We reached out with both the existing IsoTis dealer managers. We met with all the major dealer principals. We showed them a business plan to grow the domestic business and we integrated our MOZAIK productline with the IsoTis productlines so that now Integra as a biologics carries both sets of products.

That relationship-building activity, that focus and sense that the business was going to grow, has turned around the domestic business so that, in Q2, for the first quarter in recent memory, it grew as opposed to shrinking. So we are still in a turnaround of the domestic business and we are well on our way to growing it.

All right. Part two and part three are the international business of IsoTis and the OEM business. The international business of IsoTis was essentially unaffected by the acquisition. There was some synergy in us not needing to the IsoTis international dealer -- excuse me -- the IsoTis international dealer management, so the employed people, and so we turned that business over to our European and international sales and marketing groups and we have a lot more people to manage dealers.

So there is a very positive reaction to the international side of IsoTis because of our footprint that we have worldwide and the fact that we are focused. Keep in mind, in Europe, we are very much perceived as an orthopedic company because of the acquisition of Newdeal and so IsoTis came very naturally to our European sales and marketing organization.

Finally, there is an OEM business and the OEM is of various relationships with companies where we make a demineralized bone matrix that they then essentially sell in markets under their name. And we have a dedicated team focused to growing the OEM business. We have been out now helping train the salesforces for the OEM customers and again, I think we have stabilized that business. I am not sure it has really started to grow yet.

So I continue to anticipate that business running at about $10 million a quarter and then as we get into 2009, it will start to grow as I hope all of those different pieces start to click in. Gerry is going to add something.

Yes, I think an additional to the IsoTis base businesses that we acquired, it also provided us a launching platform to really penetrate the market with our MOZAIK OrthoBiologics, which has also provided additional growth opportunities at a faster pace than we would have had otherwise. So I think the combination of having a comprehensive productline of the IsoTis products and we continue to invest in new product launches and configurations of the product, we are also being able to add configurations of MOZAIK to the same distribution channel, which gives us much greater penetration and market coverage for that product to enhance our growth opportunities in the overall OrthoBiologics business. So I think just having the ability to manage a total OrthoBiologics business with a complete portfolio of products will provide us stronger growth opportunities going forward.

For a lot of these companies that we acquired, they tend to have good products, but not have the footprint that we do. And so there is a real halo effect of being part of the Integra organization, whether it be showing up at NAS and having a 40X40 booth as opposed to a 10X10 booth, whether it be having 50 or 60 people at the shows, whether it be leveraging our dealer management organization or customer service organization or just the fact that we are providing some sense of stability.

If you think about both IsoTis and Theken, it was sort of inevitable that they would be acquired and that always adds uncertainty in your relationships with the dealers. There is nothing better than it being done with and being able to stare the acquirer in the eye and say are we working together or not, and I think we have a good track record of working with the salespeople and distributors who we acquire and showing them how to grow the business profitably. So I think there has been a very positive reaction to both of those acquisitions in the dealer and customer organizations.

So do you think maybe for both IsoTis -- well, for IsoTis outside of putting MOZAIK through the channel, etc., is that a double-digit grower in '09?

Yes.

Okay. And then last question on gross margin. Jack, did you update the gross margin guidance for the year? I just missed that.

No, we did not update the gross margin guidance for the year. Obviously, this quarter was very strong on gross margin. That was driven by a very attractive mix primarily. We continue to expect 62% to 63% for the year. We have also said I think that the MedSurg products we hope to show improvement in the back half. That has been something we have been saying for a couple of quarters, try to describe the year going forward. So that will probably slightly alter the mix. But we have not changed the guidance. I think you should stick with what you have got.

Okay, well, at 62% to 63%, that is not a ton of improvement over '07 and it feels like you have been running above the 63% level, at least in the second quarter. So is there something that is making this a tough comparison this year, in the back half of this year?

No. I think our view is 62% to 63%. The odds are reasonably high we will be at the high end of the range. We want to keep the model where it is until it changes, but I think the 62% to 63% should be a conservative estimate. I think the concern is if we are lucky and the business does what we expect it to do that the MedSurg business will pick up a little bit and we don't want to hear criticism that, oops, the gross margin went down a quarter or a half a point when we outperform organically on our MedSurg business. So I think we are trying to be balanced because we can't always predict exactly the implication of one set of revenue lines on the overall gross margin mix. Suffice it to say, adding Theken to the mix should also drive the gross margin up and depending upon how much Theken we get into the quarter, that will help the gross margin reasonably significantly.

Yep, got it. Okay, thank you.

Matt Miksic, Piper Jaffray.

Hey, good morning. Thanks for taking the question. Just a clarification on your comment earlier about Jarit and the growth trends in the quarter and the back half of the year. Is that speaking both for Jarit and Miltex or just Jarit?

Actually just Jarit. Miltex will be flat.

Okay, so Miltex flat, also kind of in the second quarter?

My recollection was Miltex was flat quarter-over-quarter versus prior year roughly.

Okay, roughly is helpful.

I am trying to find it.

Okay.

I will try to get you an answer. Flat as a pancake, Matt.

Okay. And any prospect for picking that up in the back half or is that the way we should think about it for the rest of the year?

It will grow in the back half sequentially. Traditionally, Miltex has much stronger back half than front half of the year, so it will grow sequentially, but then again the comparison versus prior year is relatively tough. So 2008, tough year for Miltex. 2009, we expect to improve. And keep in mind, Miltex has a number of high-margin acquisitions that we tucked in, including [Precise Precision] and some other things going on, that are helping drive profitability.

And recall we bought Miltex not necessarily for driving high revenue growth. I think we said we expected it to be mid-single-digit revenue growth, but boy does Miltex deliver the bottom line and help us reinvest in the rest of the business. So we are telling the Miltex people we expect you guys to deliver a strong EBITDA and we are going to take that EBITDA and certainly invest in acquisitions for Miltex, but also invest in things like growing our spine sales organization, growing our OrthoBiologics sales organization.

It is our objective, Matt, to have a balanced business and very rationally take businesses that tend to be relatively low growers and redeploy their profits in the high-growth parts of the business and we do that I think very pragmatically. But to answer your question, Miltex should be flat roughly year-over-year this year and then we would expect it to be mid single digits 2009.

Fair enough. And so if you take your sort of handheld instruments altogether, looking at them together, is that sort of a mid to upper single-digit grower in the sort of back half of the year or is it a mid-single-digit business for you?

I would say, again, it is probably a level of detail I don't have handy, but I know you are trying to do some thinking about it. And I would say mid to high single digits for the two together recognizing that Jarit and Miltex are roughly the same size and Jarit surprises us sometimes. The ability to take share, the significant turmoil amongst Jarit's competitors, I see Jarit with the potential, as we go over the next 12 months, to be back in the double-digit growth range as we are done with our restructuring activity and have a much larger sales organization and almost every one of our major competitors for Jarit in turmoil.

Okay, that's helpful. On some of the other businesses in MedSurg, I am wondering and maybe in your implant business as well, but if you could talk about what kind of impact you have seen or if you have seen any impact of slower procedure growth in general, surgical procedures in the quarter or is that not affecting your businesses?

I don't believe we have the data to give you any useful insight into it. Because our business is so diversified, we have so many SKUs, I tend to take responsibility for the underperformance, for example, of the MedSurg, having a lot more to do with the actions that we initiated than procedure growth. There is a certain amount of our business, in particular in the foot and ankle, which is elective, but candidly, it is one of our best performing businesses. So I don't know that I could put my finger on procedure growth and say that is impacting our business one way or the other.

Sure.

Same thing with the economy. We try to look for trends in the economy and say is it hurting our business and I am not sure we really have any insight there to say yes or no. It is kind of doing what we expected it to do -- the business.

Okay. So if I were to think about this, it sounds like some of the extremities procedures are maybe most vulnerable if we think about discretionary versus nondiscretionary, but because it is I guess -- I don't know how to think about it. Maybe because you are taking share in those businesses, potentially it is just not something you are seeing?

Gerry, you can try to take that.

Yes, I think if you look at the extremity business in particular, what we are finding is more surgeons are doing some of the procedures that we are actively involved with because we are dealing with mostly degenerative diseases where patients have a real poor quality of life. They experience a lot of pain as a result of deterioration of the joints. And so it is not just an elective type procedure or cosmetic type procedure; it is more of a reconstruction of the joint to improve the quality of life for the patient.

What we're finding is, as new products are introduced in this space, more surgeons are actively doing procedures that they would not have otherwise done where historically they would have done a fusion and now they are looking at how to reconstruct a joint to get a better outcome for their patient. We are also seeing increased marketshare capture as we expand our sales organization and get better coverage in the United States and outside the United States.

So I think it is a combination of numbers of surgeons doing more of these procedures as they get more comfortable with the new surgical techniques and greater coverage in the marketplace allows them to get better penetration in marketshare capture.

Okay, so if I read that back here just to make sure I am hearing you right, it sounds like maybe market expansion and marketshare gains offset whatever might be happening systemically in the market in terms of procedure growth?

Yes, I would agree with that.

Okay. A question on -- I know you don't get into the productline detail, Stu, but Radionics, I'm just trying to figure out if that business is -- is it kind of going sideways sequentially, is it growing, is there any fluctuations that are worth noting in that business?

Overall, the Radionics business is -- well, it is broken into two parts -- the ultrasonic aspirator business and then the image-guided radiation therapy and fixation parts of the business. And as we have pointed out already, the ultrasonic aspiration has been the culprit for the last couple quarters in terms of underperformance in that business. And that, I think I have outlined the rationale for it. The rest of the business is essentially on the one hand not a big contributor one way or the other, but has been growing because of the additional attention that we have given it and the fact that our neurosurgeon customers are users of these different productlines. So net net, since we acquired Radionics, both parts of the business have grown and we would expect that to continue going forward.

And just one last question here on the P&L. We talked about improving SG&A as a percentage of revenues in the back half of the year. Could you quantify how much of that is from some of these expenses related to the work you are doing in the finance area rolling off? I am assuming that they are rolling off now in the back half and that's -- I will just hop off.

I don't know that we are inclined to quantify it, but I can tell you that we have been systematically replacing consultants and high-priced temporary help, which came on board more than a year ago at this point with permanent employees that are both more productive and less expensive. And that has been going on really since I would say November and that process is I'd say 80% complete.

We are, as we go along, making decisions about I would say deeper investment in systems and that will entail consulting expense as we go along and so forth. But I would say, thematically, we are making steady and systematic progress in both the expenses and the result, particularly as a percentage of revenue, which is how we have been thinking about this. Remember that there is a certain amount of structural noise in this expense in so far as the company continues to grow and we have to, in the financial organization, respond to that growth with more staff, more investment systems and so forth in the ordinary course. But I would say, thematically, we are making progress. I was very pleased with how the last few months have gone frankly and I expect that we will be able to hit our objectives on SG&A this year.

What I would add is the biggest impact in Q1 and Q2 for getting SG&A in line was all the cost reductions we took out of IsoTis. So Jack is right, but to some extent, we are investing in building out the organizations, so lower consulting, but more people. The biggest numbers come from a substantial reduction in G&A at IsoTis.

Okay. Well, thanks again for taking the questions.

Amit Hazan, Oppenheimer.

Good morning. Can you hear me okay?

We can.

Okay. Just one question on MedSurg I promise, which is kind of just making sure maybe we can summarize all the questions that have been asked. As I am taking notes here, I am seeing that if there was any weakness, we could attribute it either to ultrasonic aspiration, perhaps to spinal specialty productline being down. I am wondering if you can just comment on whether there are any other product segments in MedSurg that were down this quarter that we need to know of.

I can't think of anything in particular worth pointing out, except a whole host of unnamed products from LXU that have been discontinued that we probably never talked about, but are gone. And I talked about those already.

But were those sold this quarter last year?

Yes.

This is Jack. We closed that acquisition at the beginning of May, so there was approximately two months of revenues, seven weeks or so of revenue from that acquisition in the second quarter of last year.

Yes and it doesn't go into your organic growth calculation, but it goes into our reported revenue. So that is maybe the distinction.

But silly question I suppose, but the discontinued products were sold in the second quarter of last year?

Correct. And we reported them in our reported revenues, but you would not have used them in your calculation of organic growth because we exclude anything that was acquired in the quarter if it is not a full quarter if you recall.

Okay. And then on MOZAIK, in the press release, you make some very strong comments on it having doubled. I am wondering if we can get a little bit more granularity there. Maybe just thinking about it quarter-over-quarter. It sounded like last quarter, even though it was strong, it may have been impacted a little bit by the IsoTis integration. It sounds like it was very strong this quarter. Where are we with that productline? The fact that it doubled seems great. We just are trying to get a handle on what that really means in terms of doubling. Where are we as far as kind of an annualized run rate or anything you can help us with.

Well, we have specifically avoided giving out the data because it is competitive. As you might imagine, there is a lot of people in this market competing and so we have tried not to break out the data. What I can tell you is the impact of the IsoTis and MOZAIK integration in Q4 and Q1 is pretty much gone and we have seen a resumption of sequential quarterly growth. And I expect next year that MOZAIK will be a reasonably significant contributor, but more than that, I really don't want to break out. Needless to say, it is an important part of the business and a fast-growing part of the business. So I realize that wasn't very helpful, but I don't want to give you more information.

Okay. All right. And then the last one I think is it for me, on Theken, I am just wondering if you can give us a little bit more information on how you are planning to launch that product internationally, when you are planning to do so and what channels you are going to sell it through. Thanks.

Gerry, will comment. Just one point. Theken is not a product. Theken is a full range of products. I think it is something like 15 different sets that take you up and down the spine and one of the critical points of the Theken acquisition was a desire to buy a well-rounded, fully integrated company that is selling into most of the different parts of spine, even having a project to develop an artificial disc. So the right way to think of Theken, as far as I am concerned, is as a platform and we can grow it in a variety of ways.

Candidly, the most important thing we can do in the short term is help them grow domestically by adding additional sales, marketing and clinical support. They have been somewhat constrained simply by being a private company and funded with their own cash and so the key priorities in the short term are the US market. Gerry?

Yes, I think we have sort of tried to look at it from that point of view where, in the short term, focus on the US side of the business and provide the support that is required. So Randy Theken can lead his team and develop that business to achieve a much stronger position in the US market. And as we look outside the US, currently, there are no product sales outside the US. So we are looking at opportunities in the various European countries where we have direct distribution or direct salespeople and where we have some distributor networks that a spine offering would provide a very nice complement to the OrthoBiologics products that they currently sell for us, as well as other orthopedic productlines that they distribute.

We haven't solidified our plans on expansion outside the US at this stage. We just completed the acquisition a couple weeks ago, so we are still working that through with our European management team and Randy and over the course of time, certainly probably not before the end of the year, we will be expanding outside the US, but as we look into 2009, I am sure we have plans to look at how can we take advantage of the opportunities that lie outside the US and initiate some distribution strategies.

The critical point to remember is Integra in Europe is perceived as an orthopedic company. Next question please.

William Plovanic, Canaccord Adams.

Good morning, Stu. This is actually [Anewt] for Bill. I just wanted a couple of questions. First, I realize that you are saying that organic growth is not a primary driver for the business or primary metric, but as you look forward, what are some of the areas where you are finding opportunities for organic growth via leveraging the IsoTis acquisition or those types of things? Where do you think you're going to get that extra organic growth from?

Well, let me go back to first principles, which is our neuro business we expect to grow over the indefinite planning range, so three to five years, at approximately 15% a year. We expect our instrument productlines to grow in the high single digits. We expect our Extremity productlines to grow well in excess of 25% a year and we expect the new acquisitions -- IsoTis, Theken in particular -- to grow well in excess of 15% a year. So if you add that all up, the Theken, IsoTis, neuro will on average drive the growth rate to at or above the 10% to 12% organic growth target that we have given.

So if you look at it by franchise, we expect to continue to drive that substantial growth and we are quite confident of our ability to do it. To get into individual products, it is worth pointing out that DuraGen is back up and growing again. Integra [Skin], which is not a small franchise, is growing again -- it's not growing again, is growing very quickly. The Newdeal productline in the United States in particular are growing very quickly. That is the Extremity franchise. MOZAIK and IsoTis together will drive outsized growth for the company. And keep in mind, we are modeling Theken conservatively and we certainly have ambitions, as does Randy, to do a lot better than the 15% guidance that we are providing.

Okay and then the next question would be, in terms of your distribution, has there been any significant change over the last quarter in any of the either direct or distributor networks?

Not really, no. We put a lot of things into place at the end of last year, but no, we're pretty much just executing and there is not a big change in really anything we are doing structurally from Q1 to Q2, so other than obviously bolting on Theken now.

All right. Thank you very much and we will see you at the conference.

Thanks.

Jayson Bedford, Raymond James.

Hi, good morning, guys. I just have a couple of questions. Just on the SG&A line, you showed some nice leverage there. Is there anything left to integrate or are there any other big projects that could provide additional leverage?

There is still plenty going on and plenty of opportunity to take costs out of sales, marketing and G&A. I think as you go into the back half of the year, you will see the percentage increase -- sorry -- you will see the percentage go down, but that will be principally driven by revenues going up. So we are not expecting reductions in the absolute value of SG&A, but rather SG&A should not grow in proportion with the revenue growth that we are expecting in the back half of the year. So I hope that answered the question.

That's fair. Just switching over, and I know we have kind of beaten this to death here, but just on organic growth, your third-quarter guidance implies, by my math, a high single digit organic growth rate and I am just, given the easier comp, I thought it would have been a little higher. So either, one, you are being conservative here or there is something new in the business. And I am just wondering if you could comment on that. Thanks.

I think our revenue guidance is our revenue guidance. There is nothing new that we are pointing to. We basically -- we are pointing toward approximately 10% organic growth year-over-year and we haven't changed anything really in our forward-looking guidance this quarter other than rolling in the impact of the first half of the year. So no.

Okay and then just international opportunity for Theken, do the products have CE Mark?

Some of the products have CE Mark currently. A few of the products do not, some of the newer ones. But that is sort of more of a product registration issue and just following through on the regulatory requirements to get them registered for CE distribution. So that is why I said earlier, as we look at our plan to expand this internationally, we will take over the next few months to identify which products are the right products to bring into the international market outside the US and also looking at timing in terms of -- just in terms of when is the right time to introduce a new product into the European market. Right now is not a good time because you are in the summer months and it is a slow period for the European market. And as we get into the fourth quarter, we try not to get our people be distracted with launching and trying to set up new product evaluations. Usually we try to look at everything from a January forward into the year as far as a launching point for the international market allows us to get a much better training program and focus in place to have a successful launch.

One point, which I am sure is obvious to you, but I will make in any event. Integra is a regulatory approval machine. While for a small company, the question of [are you] CE Mark is a big challenge. Integra's got something on the order of 25 to 30 PMAs and PMA supplements, well over 500 510(k) products. We have probably got, and I think I am not exaggerating, thousands of products CE Marked and we have a full European regulatory and quality team that does their own work both on doing FDA approvals and CE Marking. So it is not a challenge at all to work with Randy to get his products CE Marked. It is really just a question of priority and where do we want to spend the time to get the best bang for the buck.

Sure. That's fair. Just lastly, inventory levels crept up in the quarter. Obviously, that is having a big impact on the cash flow. I am just wondering what does it take to get the inventory levels down.

A couple points. First, not a big impact on the cash flow. It is about $5 million and I would also point out, to some extent, it is foreign exchange because a fair amount of the products are European and we mark them up because of the increase in foreign exchange rate. So that being said, no pat on the back for anybody at Integra on inventory control and it will still be a focus as we go into the back half of the year to get the numbers down absolutely or in other words, on an absolute basis.

We have a number of programs in place, including trying to do a better job with forecasting, trying to put goals and objectives in place for each of the manufacturing sites and the truth is, if you look at the increase from Q1 to Q2, I wish I could blame it on one place or the other, but it is lots of little things. And we have done a good job in the last 12 months of getting AR where we want it to be and we will give the same focus as we go into the next six to 12 months on getting inventories. It is not lost on us that that is an important part of managing our business.

Keep in mind, to some extent, days tick up as we get more and more into the orthopedics world. So when we bring Theken in, that is going to increase the number of days of inventory we have outstanding. But we clearly know in other parts of the business it is just a need on our part to manage better. But do not read Q2 as chewing up cash going into inventory. It is virtually all prepaid and tax-related and inventory represents only a $5 million change quarter-to-quarter, including the impact of ForEx, which means some of it is not even cash.

Okay, fair enough. Thanks, guys.

Bruce Jackson, RBC Capital Markets.

Just going back to the productline rationalization that took place, I think we have covered that topic pretty well. Do you have any plans in the future to look at additional productline rationalization?

Well given the enthusiastic response we've gotten from investors, I ought to say no, but we are running a business and the point is we are going to drive in the medium term cash flow and earnings. And that means sometimes having to do the tough thing that is not that popular in any short-term period. It is the right thing to do given the appropriate focus to our sales and marketing organizations. It is driving the gross margin. You saw it in the quarter. The fact that we are focusing our salespeople on selling the implants is clearly going to help drive gross margin.

That being said, no, I think the bulk of the pain is behind us in terms of new decisions to integrate or discontinue businesses and indeed -- not discontinue businesses, but discontinue particular productlines. And so I think the answer is most of the decisions are behind us now.

Okay. And then looking at the gross margins going forward, the main determinant of where we end up in that range is going to be the product mix between MedSurg and the implants, is that right?

That has always been the biggest impact is the mix, yes. Certainly our sites have objectives in terms of taking costs out. Certainly we are trying to do things to operationally improve the gross margin, but the biggest single influence on gross margin is the mix between, in particular, the collagen and metal implants and the instrument productlines and the other MedSurg productlines.

Okay. And lastly, with the impact of the Theken acquisition, I think Jack said that the R&D was going to go up a little bit. Is that just in absolute dollars or as a percent of revenue?

Well, in our forward-looking guidance, we essentially left the gross margin at 62% to 63%. We left the SG&A at 38% to 40%, but we upped the R&D to 5.5% from 5%. So that is really the only change in the model. Obviously, as the businesses roll in, it may drive I hope gross margin up a bit and it will impact SG&A, but the only real change from our previous modeling guidance was 5.5% on R&D. And that is all good. I mean we have been wanting to spend more on R&D and we think they are a good machine to do that for us.

All right. Thank you.

David Toung, Argus Research.

Yes, good morning. I think some of your voices dropped off a bit, so excuse me if I am asking questions that have been answered before. I just wanted to go back and get a little more directional color on your gross margin and your SG&A.

Okay. So SG&A came in at about 40%, which was where we had hoped it would come in. We hope, over the next two quarters, to bring it down a bit from the high end of our range of 38% to 40% to something lower than that.

In terms of gross margin, we came in at 63%, which was above our previous guidance for the quarter and in line with the 62% to 63% forward-looking modeling guidance. And then R&D at 5%, we hope as we roll Theken into our numbers, to increase to 5.5%. Keep in mind, while the R&D number for Integra seems somewhat low, a good $100 million to $150 million of our revenues, in particular the surgical instruments, use zero R&D. And so I think if you back out those numbers, we are closer to 7% or 8% R&D for the products that use R&D, which puts us in line with many other companies that we are comparable to.

Okay, great. Thank you.

(Operator Instructions). Taylor Harris, JPMorgan.

Just wanted to follow up really quickly on some of the neuro productlines and would you mind helping us out on growth rates either in the quarter or just trends in the first half of the year for DuraGen, NeuraGen, Integra Skin?

Yes, again, we are a little bit loath to get into too much detail. What I would say is we gave some numbers on Integra Skin and Newdeal together and we said they were growing well in excess of 30%. It may have even been 35%.

In terms of DuraGen, we are back into the high single digits on DuraGen, which is good compared to where we were a year or two ago and then we said we doubled MOZAIK and I think I answered -- and then Neuragen is, again, sort of lumped into the others, but we are still in the very high teens.

Got it. Okay, that helps. Thank you very much.

Dave Turkaly, SIG.

Good morning. Just one strategic one. First, congrats on the new employment deal. When you are looking -- historically some of the things you guys have brought in-house neuro side, now we are into spine where some of the multiples are a little higher, has anything changed in terms of what things you guys are targeting to add to kind of the base Integra business now? Would you consider using equity in any acquisitions as they get larger and is it really -- would spine now be kind of your main focal point? Thanks.

Well, a couple points. First, thanks for saying that the multiples are higher and with about $200 million of orthopedic revenues at Integra, I hope you guys will drive our multiple higher. I think there is people missing the story that Integra is about half an orthopedic company and we still trade as a surgical supply company. So indeed, we did pay up for Theken, but in a very responsible way.

If you look at the upfront payment and then the upside, it is a good balance between on the one hand not overextending ourselves and on the other hand rewarding the Theken team for delivering on outsized revenue. If we are lucky enough to pay out the full purchase price, that will have a really spectacular impact on our growth rate going forward and on the drop down to profitability.

So no, I don't intend to lead the company to go buy some big spine company and pay a huge multiple. Not very interested in that. On the other hand, investing in Theken and growing it in a responsible and organized way in profitable parts of the spine business is very much the strategy.

No, we are not remaking the company into a spine company at all. On the other hand, we are following our traditional strategy of investing in niche markets where we can be a fast-growing market leader and leverage our core tissue engineering technology like MOZAIK, like now the tissue engineering technology required in the acquisition of IsoTis.

So I view the Theken acquisition, and I know this may sound funny, as very much a stick to our knitting type acquisition in the same way IsoTis was and in the same way Newdeal was and I am proud that we built an Extremities franchise that now is on the order of $100 million of revenue essentially from scratch. Certainly we had the benefit of the Newdeal team, but virtually all of the growth that we have gotten there has been driven by our US and European Extremities team. It hadn't been bought, it is all organic and similarly, I expect IsoTis and Theken to deliver on the same results.

So I think, although from time to time we are criticized because we have a tough organic growth comparable or we have too much SG&A in any given quarter, on average, we have been able to drive margins, we have been able to drive top-line growth over the last 10 years, compound annual growth rate to 44% for the overall company.

Great. Thanks a lot.

It appears we have no further questions. At this time, I would like to turn the conference back over to Mr. Essig for any additional or closing remarks.

Well, I certainly appreciate all of your interest in Integra and we look forward to reporting to you next quarter. Thank you.

Thank you. That does conclude today's conference. You may disconnect at this time.