Integra Lifesciences Holdings Corp (IART) 2013 Q1 法說會逐字稿

Good day, everyone, and welcome to the Integra LifeSciences first quarter financial reporting conference call. As a reminder today's call is being recorded. At this time I would like to turn the conference over to Ms. Angela Steinway, Head of Investor Relations. Please go ahead.

Good morning, and thank you for joining us for the Integra LifeSciences first quarter 2013 earnings results conference call. Joining me today are Peter Arduini, President and Chief Executive Officer, and Jack Henneman, Chief Financial Officer. Earlier this morning we issued a press release announcing our financial results for the first quarter of 2013 and revising our full year guidance.

Certain statements made during this call are forward-looking and actual results might differ materially from those projected in any forward-looking statements. Additional information concerning factors that could cause actual results to differ is contained in our periodic reports filed with the SEC. The forward-looking statements are made only as of the date hereof, and the Company undertakes no obligation to update or revise the forward-looking statements.

Certain non-GAAP financial measures are disclosed in this presentation. A reconciliation of these non-GAAP financial measures is available on the investor section of our website at integralife.com. As we aim to keep our prepared remarks short, we will reference the financial results in the press release and will not restate the individual numbers. As a result you may want to keep a copy of the release handy during the call.

I will now you turn the call over to Pete.

Thank you, Angela. As we indicated in our April 10 press release and Form 8-K, the voluntary recall we announced three weeks ago overtook our momentum for what otherwise would have been an on target quarter for revenues and earnings. The recall is well defined and bounded. Today we are producing and releasing products from Anasco, but it will be several months before we reach adequate supply levels.

That said, the recall's impact on both the first quarter's results and on our expectations for the balance of the year was significant. For the first quarter the recall product returns reduced revenues by $2.9 million, which falls within the range of $2 million to $4 million that we estimated on April 10.

We also estimate that recall-related shortages reduced revenues during the quarter by an additional $6 million to $7 million. The product shortage primarily affected sales of DuraGen and select products in our private label business. But for the effect of the recall, we would have met expectations on the top line.

Further, the recall and related supply issues have a disproportionate impact on ourprofitability. The regenerative medicine products, our highest gross margin products, saw an unexpected reduction in sales of those products translates rather directly to the bottom line. In addition, we are incurring significant incremental expense, mostly recorded in cost of good sales -- cost of goods to respond to the warning letter in Anasco. We will discuss these and other unplanned variances in our manufacturing operations a bit later in the call.

Because of the recall, our biggest challenge and highest priority today is to build enough product to meet the requirements of our customers. We are executing a plan to increase capacity in both of our regenerative medicine facilities and have reprioritized production in favor of the highest value and most strategically important products. Both of these priorities have the potential to drive results towards the higher -- the high end of guidance.

However, we are operating with the highest degree of compliance vigilance and are anticipating that we may have interruptions for product production modifications that could lengthen the time to meet our inventory targets. We expect that our plans will enable us to regain the profitability levels we had in 2012 as we exit this year, even after absorbing the impact of the medical device tax and additional expense embedded in our P&L.

Turning to the top line results from the first quarter. Our strongest growth continues to come from extremities, particularly in the United States. Our US Extremities business, which was largely unaffected by the recall, grew 18% in the period. Our regenerative medicine and foot and ankle product lines drove most of the increase, and all product franchises performed well, posting double-digit increases.

US Spine and Other, which includes our spine and private label products, decreased 3%. Our spine hardware product sales declined, resulting from continued pricing pressure in a challenging market. Orthobiologic sales grew, led by a strong demand for Evo3 products.

Sales of our private label products were down from the prior year period due to the recall. The reprioritization of production in Anasco will adversely affect our private label business and therefore the results of the US Spine and Other segment for the balance of the year.

US Neurosurgery revenue decreased 3% over the first quarter of 2012. The recall related product returns and resulting product shortages directly caused the revenue short fall in our Dural Repair sales. Sales of our capital products in critical care, tissue ablation and cranial stabilization increased mid-single digits.

US Instruments revenue decreased 3% versus prior year. In the quarter lower sales of our Xenon lighting and alternate site products drove the decline. Sales of retractors, instruments and LED lighting head lamps to hospitals partially offset those declines. Generally we have seen a slight lengthening of the capital sales cycle, specifically in our lighting franchise.

International revenue declined 2% from prior year. The recall related product returns and product shortages negatively affected our sales around the world and drove more than the entire decline. Foreign currency had a small unfavorable impact on our sales as well.

In the rest of our International product portfolio we saw growth in our spine implants and dermal and wound franchises, with several new products and increased sales coverage in select markets.

Now I will turn the call over to Jack to discuss the financial results in more detail and provide an update to our 2013 outlook. Jack?

Thank you, Pete. The recall and related product shortages have the effect of reducing the revenue of our most profitable products, disproportionately affecting the bottom line. In particular our gross margin was and will be lower as a result of the unfavorable product mix, higher costs required to remediate our quality systems, and other unplanned expenses affecting COGS, including higher reserves for excess and obsolete inventory. Further, our selling costs on the margin will increase because we are revising our commission plans to motivate our sales force while we are managing the supply of affected products.

Now, I will walk through the P&L results and our revised expectations for the full year in a little more detail. In the first quarter GAAP gross margin declined 3 points to 59% versus the prior year period, primarily as a result of $3 million of revenue reversals from returned product, $1 million of scrap expense due to the recall, unfavorable product mix driven by supply shortages of high margin products, and a $2 million increase over prior year in excess and obsolete inventory write-offs.

Finally, the results in the quarter reflect the medical device excise tax, which had a slightly negative impact on both our GAAP and adjusted gross margins as compared to a year ago. We calculated adjusted gross margin by backing out the adjustments to cost of goods sold detailed in column A in the adjustments table in our press release. During the first quarter our adjusted gross margin of 62.3% was down 3 points from the comparable measure in the first quarter of 2012.

For 2013 we now expect reported gross margin to be between 60% and 61% and adjusted gross margin to be between 63% and 64%. We expect to finish the year with adjusted gross margin in the fourth quarter at our 2012 level of 65%.

In the first quarter R&D expenses increased $1 million versus the prior year to 6.5% of sales. Extremities product development activities drove most of the increase. We now expect R&D spending to increase over 2012 and to be around 6.5% of sales for the full year.

GAAP SG&A during the first quarter increased significantly versus a year ago, resulting from higher spending across the board in anticipation of increasing sales, including greater spending on our European implementation, higher head count and higher commissions, particularly in extremities. SG&A adjusted for about $9 million of special charges as detailed in our press release was 46.4% of revenues up 4 points versus the prior year.

Selling expense increased over the prior year because of higher commissions in the Extremities segment and higher head count in general and administrative functions. For 2013, we expect reported SG&A to be approximately 46.5% of revenues and after adjustments to be around 44% of revenue. We expect to finish the fourth quarter with adjusted SG&A in our longer term guidance range below 42% of revenues.

In the first quarter our adjusted EBITDA margin was 12%, down significantly from the prior year period. We expect adjusted EBITDA margin to rise during the balance of the year and reach our 2012 level of 20% in Q4. For 2013 we suggest modeling approximately $7 million in depreciation expense per quarter and approximately $4.5 million in intangible asset amortization, $1.5 million of which will be reported in COGS.

Cash interest expense net of interest income is $3.1 million in the quarter. For 2013 we recommend modeling approximately $5 million per quarter in total interest expense.

During the first quarter we recorded $900,000 of other expense. We recommend modeling this line item as zero going forward.

We ended the first quarter with an effective tax rate of 29.6% and an adjusted tax rate of 24.6%. The full year of 2013 we expect our reported tax rate to be about 1% and our adjusted tax rate to remain around 24.5%.

We generated $8 million of cash from operations during the first quarter, and we invested $11 million in capital expenditures. During 2013 we expect to spend between $55 million and $65 million on capital expenditures.

I will now provide some color on the revised 2013 guidance that we provided in the press release this morning. Full year we now expect revenues to increase 1% to 2.5%. Within that guidance we expect US Neurosurgery revenues to be flat to up mid single digits, US Instruments revenues to be flat to down low single digits, US Extremities revenues to increase mid teens, US Spine and Other revenues to be down mid to upper single digits, and International revenues to increase mid single digits.

We expect our year-over-year revenue growth during 2013 to increase in the second half of the year. As we indicated in our April 10 release, we expect our revenues in the second quarter to be between $205 million and $211 million and for year-over-year comparisons to improve significantly in the second half of the year.

The biggest impact on earnings is in the unfavorable gross margin, driven by forecasted back orders in regenerative medicine products. We do, however, expect other expenses to drive the disproportionately lower earnings described in the guidance, including higher selling expenses to motivate our sales reps, expenses elsewhere in the supply chain, particularly in orthopedics products.

Despite the significant head winds driving down our profitability in the first three quarters of the year, we expect Q4 to include some benefit of supply catch-up from prior quarters and therefore to have profit margins essentially the same as 2012, with adjusted EPS growth above our longer term objectives. Our underlying business has good momentum. We do have a near term setback in our plans, but the core of our strategy and business remains intact.

Now I will hand call over to Pete.

Thanks, Jack. Our number one priority now is returning our inventory of regenerative medicine products to normal levels so that we can meet the needs of our customers and the expectations of our investors. To do that we are focusing on the quality systems and operations at both the Plainsboro and Anasco facilities, with the twin goals of recovering supply and having successful inspections when FDA returns to those facilities later this year.

Joseph Vinhais, head of Global Quality, and John Mooradian, head of our worldwide operations, have each been here just over six months, and their organizations are hard at work, but the effort goes far beyond them. We have strengthened the teams reporting to them and have shared our plans with the FDA in detail. We met with the FDA's Office of Compliance at the Center for Devices and Radiological Health in March to present our plans for the entire Company, and with the San Juan district office in early April to discuss our plans for immediate remediation of their finding in Anasco and the scope and boundaries of the recall.

In addition, we've used and are continuing to use pre-inspection audits by some third-party ex-FDA consultants to benchmark our progress and help identify areas for further work. We believe we have the right team and the right plans in place.

While our near term focus is on addressing the quality and supply issues, we remain committed to our longer term margin improvement and growth acceleration targets. We continue to make progress towards optimizing the Company through our ERP implementation and our plans to streamline our manufacturing and distribution footprint. We are anticipating our new product launches and international product registrations to be on track for 2013, which will lay the groundwork for accelerating growth in 2014 and the years to come.

Overall, we view the recent product recall and related product shortages as a four to six month delay in our near term activities, but manageable in the medium to long run, as we fully expect to recover the momentum we had at the beginning of this year towards achieving our five year objectives. Our strategy to achieve those is unchanged. And our potential for growth and margin improvement over the horizon of our plan is undiminished, because our franchises are strong and diversified.

Now, taking a broader view of the Company, we see strong momentum in US Neurosurgery, which has the largest direct sales force calling on cranial neurosurgeons, the biggest selections of products, and a robust pipeline of new offerings that will support growth in the coming years.

Our Extremities business grew 18% in the first quarter, as I mentioned, demonstrating that it can deliver an exciting result, even when other parts of the Company are extracted. US Instruments is one of the top two players in its markets and has reach in its sales to half of the hospitals in the United States and therefore touches many of our core customers.

Our Spine business is young, with a unique breadth of orthobiologics and an opportunity to exploit the turmoil in the market. Internationally we have a great opportunity, and we are putting the foundations in place to grow our business worldwide. Finally, we are proud of the team at Integra and the progress we are making behind the scenes that positions the Company for future success.

Now we will be happy to answer any questions that you have. In an effort to accommodate a large number of requests, please do limit yourself to one question and one follow-up. You may rejoin the queue if you have additional questions. Operator, we would now like to open up the call for participants.

Thank you. (Operator Instructions). We will take our first question from Matt Miksic of Piper Jaffrey.

Good morning, Matt.

Good morning. Can you hear me?

We can hear you very well.

Thanks. So first question, just on -- and I apologize if you went through it, but just to be clear, I guess one of the questions coming out of the recall announcement was when you think you are going to be able to get back up to supply? Supply into your channel and to your customers for the products coming out of Puerto Rico. And is it your four to six month delay comment that we should use to measure that? Is it sometime in, what, the end of Q3 that we should expect that?

Matt, I think my four to six comment is really about the total year. So including Q1. But you when you think about supply, realistically Q2 is obviously the biggest impact, as we are really rebuilding back our inventory supply.

And as we mentioned when we did our pre-announcement discussions, we take down three to four months of supply. We were tight on inventory to begin with. It takes three to four months to regain that. So we have impact in Q2 and also in early Q3. How well we ramp up our third shift, get our yields to where we need to maintain that, we will either shorten or lengthen that window.

But at this point in time we have been able to manage through customers by substituting different product codes, managing through that. We've clearly had some shortages, particularly to specific customers. We've obviously tried to do what we can do to manage and take care of our top customers in that mix, but we are tight on supply here and will be through Q2 into early Q3.

This is Jack. The one thing I would reinforce is the point we made in the prepared remarks, we have replanned our production, as we said we would do on April 10, to reprioritize it in favor of our strategically most significant products and our highest margin products so that the economic -- we will work our way through the lion's share of the economic impact sooner than we are completely out of back order on all of our products. We will have lingering back orders into the second half, but we are hoping that we will diminish the impact of them through rethinking the order in which we produce products.

That's great. Very helpful. And the one follow-up I guess I would have is just around the guidance for the full year. Particularly in neurosurgery.

Just to be crystal clear, is the entirety of that change around DuraGen -- and I assume it is just primarily DuraGen into that line item -- or is there any other the procedural adjustments that you are making to what you are expecting out of that business in the year?

Matt, as it relates to Neurosurgery, it is really all attributed to the effects on DuraGen and then our time to really ramp up in the second half of the overall year. Jack, I don't know if you want to add any particular comments?

No, I think that pretty much captures it. The planning question for us is whether the amount of attention that the reps will devote to maintaining the DuraGen business -- they'll have to do a lot of moving around and substituting SKUs, that kind of thing -- whether that will take away from their selling efforts in other lines, but right now as we assess it the impact is fundamentally around DuraGen.

Great. Thanks so much.

We will take our next question from David Lewis of Morgan Stanley.

Good morning. Hello, this is actually Jon -- good morning. This is actually Jon Demchick in for David.

Hi, Jon.

I had a quick question, I guess concerning EPS in the quarter, and it was probably about $0.30 lighter than I guess the initial expectations, and obviously the lion's share if not all of that is related to the recalls. But as I kind of run through about $10 million through the income statement, even at very high margins I still come to probably short of $0.25 of that. And I guess I was curious how much of the delta there is just increased costs that were associated with the recall, and if those are going to also carry forward over the next few quarters?

Yes, certainly a good chunk of it is costs, whether associated with the recall or associated with remediation in Anasco or things we are doing to improve production. We are also spending more money on selling expense as a proportion of revenue than we would expect to do, because we have got to motivate our sales force through this. They can't afford to take a big hit to their own personal income because we can't deliver product, so we made some adjustments to their commissioning that will have an impact.

And there are also a couple of other things going on about in the supply chain that are less significant. We've had higher E&O than we forecast because of changes in the rate at which we are selling certain product lines, and probably the acquisition of more inventory in certain areas than we needed. Transitions in the Extremities distribution system, a whole series of different things have had a somewhat greater impact on E&O. But those are the main considerations.

Thank you. Very helpful. And also had a quick follow-up on I guess just ERP and broader restructuring. There appears to have been a step up in some of the expected spending this year for the ERP implementation, and I was just wondering if the costs are going higher because of anything unexpected or if you may be accelerating the timeline? Just trying to kind of gauge the process if the recall has changed any plans -- any of the future plans of the Company and the broader restructuring?

So, the ERP system had a successful pilot in Q1, so it is up and running really darn close to glitch free, in a good chunk of our instruments business right now. We are to some degree rethinking the order in which we do certain of the implementations going forward, and the mix of cost and capital and a whole series of other things around that to frankly make it as cost-effective as we can over the long-term. And that will have some impact on the timing of various expenses and so forth.

As far as the other restructuring goes, our plans are very much intact. However, our focus, as Pete said and he can elaborate, is on frankly getting supply of our collagen products and so forth back to where it needs to be. So the OPS team is very much devoted to that over the next -- call it next quarter.

Yes, I think it is important for everyone to understand. I mean, our plans we laid out in November, the focus on the optimization plans; we made a lot of great progress, continue to make a lot of great progress, and expect to hear from us later this year about more of those items as we are ready to roll those out. But I feel good about that progress, and we have been able to separate individuals working on those items from any of the other areas associated with the recall.

That being said, as Jack commented, in the short-term here in the next 90 days we've got obviously a big focus on customers in our field organizations to take care of our key customers, which is extremely important. Our focus on supply and our focus on our broader quality components to make sure, candidly, that we get everything done we need to get done on our three warning letter sites, as we expect -- as I commented -- the FDA is going to be coming back in this year, and we want to be ready and be able to kind of move forward.

So that it our short-term focus, but again I think with the bandwidth we have in the organization, it doesn't really affect our long-term strategy plans that we've laid out.

Thank you. Very helpful.

We will take our next question from Bob Hopkins from Bank of America.

Good morning, Bob.

Thanks. Good morning, guys. I appreciate the time. I have two questions. The first one is focused on the reduction in guidance for the year from an EPS perspective. It's roughly $0.60, $0.65 from the original guidance. Could you put that into as many buckets as you can, relative to how much of this is related to all of the different factors that you laid out at the beginning of the call?

Sure. So revenue reduction is a big part of it. If you really look at the midpoint of our new range, it is around a $30 million reduction from the original number for the year. On that order. A very high margin product. So start with that. And that accounts for the vast majority of the earnings reduction.

Then, if you look at on top of that essentially incremental expense to contend with that from the selling expense perspective -- that is, selling expense isn't rising per se, but it is not declining in proportion to the revenue decline, because we have to pay our reps. And then if you add to that some incremental expense for remediation efforts, QA to get everything we need to get, that basically gets you there. There are some small additional costs in COGS, which we detailed, principally somewhat higher E&O charges, which amounts to a couple of million dollars in the total, but that impact is the vast majority of it.

Okay. And then the other thing I think a lot of people on the call are going to be trying to figure out is what all this means for 2014. And I know you are not nearly ready to give 2014 guidance, but two questions in that regard. One is how much of what is going on this year creeps into 2014 in terms of incremental remediation spend or whatever, and just what is the right base level of earnings that we should be thinking about in 2013 to grow from? Obviously it is not the $2.55. A lot of this is one-time. I'm thinking the midpoint.

And is it as -- and I assume it is not as simple as just taking the old range -- or taking the new range and adding back $0.62 and growing from that. So if you could give us is any help there, that would be very -- that would be much appreciated.

Sure. So I would say you're correct, we are not ready to give 2014 guidance, and ordinarily we wouldn't give it until next February. At the beginning of the year in effect. In any case, I would point you to two or three things that we are thinking about ourselves, for those of you developing a view of 2014.

First is we do expect a pretty strong and pretty profitable Q4 this year, but as we said in the prepared remarks, we view part of that as reflecting the potential for call it snap back purchases. Inventory on hospital shelves will be pretty thin by the post-Labor Day period when we are really in a position to restock, and that should have an impact in the back half. I wouldn't assume that momentum will fully sustain itself into 2014.

So if I were going to think about it, I would essentially use a good -- I think the 2013 results are not a bad place to start, reflecting fourth quarter momentum to some degree but not totally, and then building some growth off of that into 2014.

You mean the new you guidance of $2.55 as a midpoint is not a good -- that is a good place to start? Is that what you are saying?

I'm speaking primarily in terms of revenue. I would say from an expenses point of view we are a long way from being able to give you any guidance on that. So that's -- it's a good -- your clarification is a good one. I think I'm only right now prepared to talk about the top line and our thinking about that.

I think, Bob -- it is Pete. I mean, as Jack was commenting on, we clearly see strength picking up in the second half of the year because of this recovery in 2013 with the supply. We don't see that as the steady run rate that is just going to fold into next year.

We don't have a definitive opinion on that at this point, but I think the fact is our long-term guidance of 5% to 7% is intact. And at this point I think what Jack is pointing to is that we are probably on the lower end of what that guidance is at this point in time. And again, from my standpoint I think it is just prudent where we are. We have to get through a couple of FDA audits.

We have high confidence we can ramp up our third shifts and take care of that supply, but at this point in time I think that is how we are kind of look at how second half of 2013 and how that may parlay into 2014. If things align and we are successful and we can ramp up at a higher level, obviously we could move up higher in our overall revenue range.

That is great. I was -- really just one quick comment maybe from you guys would be helpful on the degree to which you think some of these remediation expenses will -- or other expenses will continue beyond this year?

So our great hope is that our outside remediate -- call it extraordinary remediation expenses, whether or not reflected in special charges, that we will get beyond that this year. That is obviously our great hope. However, we are out of the business of handicapping the timeline here beyond the near term and what we can tell you, because it has become -- we have been sadly wrong enough on some of this stuff in the last couple of quarters that we don't want to go there.

But this is our great hope is that we will get these warning letters lifted this year. I will say we do have higher QA costs embedded in our processes in our plants that will continue compared to, say, the levels of a couple of years ago. So we have a permanent higher investment in QA that I do not expect to go away versus, say, a couple of years ago.

Okay. Thanks, guys.

And we will take our next question from Glenn Novarro from RBC Capital Markets.

Good morning, Glenn.

Hi, good morning, guys. Good morning. Pete, I wonder if you can just take a moment and go through the competitive landscape for your regenerative products? The reason I'm asking, it just sounds like to me once you get supply back, your customers are going to immediately buy. And I'm just wondering in the interim are there any competitors or competitive products that the customer can move to? So that is question number one.

Sure, Glenn. I mean, keep in mind, I mean, the recall, as you guys have all seen, touched a lot of different products, but it really only had probably a more profound effect on the DuraGen product family specifically. It touched some of our private label partner products, but in many cases because of supply that was maintained it wasn't a part of the recall. From a competitive standpoint they should be fine.

So I will focus on the DuraGen product. And again I will also make a point that products like our skin product and things like that really weren't involved in this at all, so there is no impact. Around DuraGen it is the guys that from the J&J, Codman, Medtronic; Stryker plays in the role, and some individual independent players that support other folks.

We've gained and have been growing our share quite successfully. As I mentioned, our momentum in the first quarter and really coming out of Q4 we were on track for a strong quarter if it wasn't for the recall. A lot of that was driven by our ability to gain share and grow within our DuraGen franchise. And the reason being is the combination of the breadth of the product line -- its appliability, which we have in recent years been able to differentiate versus other products that are out there.

Now that being said, surgeons have the ability not to use a dural onlay and actually suture. They could use products from any of the three or four folks that I had mentioned. But we believe, from a standpoint of being able to take care of our primary surgeons, our thought leaders and our biggest institutions, that we will be able to manage through some of that supply. But we aren't going to be able to meet the run rates that we are at really here through Q2.

And in the meantime we will probably lose or have some accounts switch over to some of those folks, and we have plans in place already to take a look at how we can incentivize customers to come back and stay with us. Our focus -- and it's really why we have been taking care of our sales team with compensation -- is everybody goes through tough times like this, and we want our sales teams engaged with our customers side by side.

As you know, we have a lot more than DuraGen products. We're in the neurocritical care many, many of the products used within the whole cranial access area. So we have our reps out there taking care of customers, and as we increase our supply our hope is that this one critical product that is part of this extended offering we have, customers will come back to us because of the level of service that we provide them.

Okay, but just to clarify within the guidance maybe there is some assumption that you lose a little bit of market share. There is within guidance the assumption that maybe you have to discount a little bit to get market share back. Is that fair?

I think that is a fair assumption, Glenn.

Okay. One more question, and this a head-out question on Extremities. Is this a type of product that is contract-based? In other words, are there any contracts coming up that may impact your ability to bid successfully because of the DuraGen issues?

There is some level of contract base, but it is probably more pronounced outside of the United States relative to tenders. In the United States we think that most of any of the type of bids or GPO agreements that we go into that we won't have any specific issues.

Okay. And lastly on the Extremities line -- so a good Extremities number. Is there any way you can break out the growth between, shoulders, foot/ankle, hand/wrist?

All of the areas were up. Shoulder is very small and would not at this point -- until we get the reverse out and so forth, we are not going to have a meaningful impact on shoulder. But the Extremities group was not affected by the recall. The skin was not on the recall.

It was a pretty successful mix across the board, Glenn, of lower, upper and regenerative, and as Jack said, there isn't a surge of shoulder in there that drew revenues a lot higher. It was a lot of our core business doing well. I think our sales teams are quite comfortable now with our product lines.

We have been able to actually keep our sales levels and our territories filled. I have done a lot of additional training actually in Q4 that we think is starting to actually benefit us as well, so good execution is helping there.

And we are on track to our plans here for our reverse shoulder with our whole offering, and we are hoping that then later in the second half of the year we will be on track to be able to roll out that whole complete offering, which again as we mentioned, will help us bring in some larger distributors and such as that is a distributed product for us.

Thanks. I will let others jump in now.

Yes, we squeezed an extra question in there for you, Glenn. Thank you.

We will take the next question from Amit Bhalla of Citi.

This is actually [Adam] in for Amit today.

Good morning, Adam.

Good morning. So first question is on the OUS guidance. So I believe that came down from up mid to high single digits? Can you talk a little bit about what is happening there? I mean, is this related more to the new product rollout strategy that we are supposed to be seeing in the second half? Or what else is going on there?

Adam, the main component of that, if you think about our OUS business, really over half of our business outside of the United States is still within our neurosurgery franchise, and within neurosurgery DuraGen is a large component. So the biggest change item that affected the whole point, as I commented in the opening remarks, was the DuraGen recall, and then obviously the time to actually replenish and build that up.

It has a little bit more of a sharper challenge outside the United States than it does in the US. To the previous comment I made to Glenn's question, where there's the tenders and such, that the timing of tenders and how we build that up has a little deeper effect. But primarily all tied with the recall itself, which we are still in the midst of obviously executing outside the United States.

Okay. And then maybe can you provide any updates on where you stand with the FDA on your outstanding warning letters? And I believe the last time we talked you had mentioned submitting a first 30 day response letter back to the FDA, and that was supposed to be happening soon. Can you talk about that?

Yes, so just to it kind of recap. Myself, with our quality leader and some others, actually were out at CDRH, as I commented in the opening prepared comments, and laid out our broader plan across the Company. Part of that was to make sure that they understand how seriously we take the plans, the investments we are making, and really our overall approach. And I'd characterize that as a meeting that was on track to our expectations of what we wanted to accomplish.

We've talked to all of our districts that we have ongoing inspections or plans with. I mean, for example, Parsippany, New Jersey, we do a monthly update, and we are in regular contact with them as well as other locations. We were actually just in Anasco, and that was a part of what we had communicated to get clarity around the recall, as well as to make sure that we have got the right approach on what we are doing for remediation of the warning letter.

Yes, we have been updating the districts and such on a regular basis. Even with the recall itself we've made very good progress already throughout the United States and the world getting product back, working with customers, and so we have been able to communicate that back to the agency so that they understand how well we are moving along.

I think the other aspects are there is obviously always inspections going on. We have a large footprint, as we've commented on before. One of our desired states is to obviously reduce some of that and increase the size of our facilities.

Recently we just actually had an audit out in our Salt Lake City facility, which hadn't been audited since 2010. That audit just completed and had no 483 observations. So that is one of the sites as well that we have been putting a lot of work into as well as other locations.

Those are how we are currently at the agency. I think Jack commented before, our focus around the three warning letter sites is really our biggest focus. We believe that the agency will be coming back in to audit in particular Plainsboro as well as Anasco. Probably before Labor Day would be how we are thinking about things, and so all our efforts have been focused around making sure that we are ready for whenever they come in. Obviously they could come in tomorrow if they wanted to, but our belief is that sometime in the next few months we will be seeing follow-up inspections.

Okay. All right. Thank you very much.

And we will take our next question from Chris Pasquale of JPMorgan.

Thanks, guys.

Hey, Chris.

Hey. To start, can you quantify the decline in the private label ortho business this quarter so we can better gauge how the base business performed there?

Want to take a shot at it, Jack?

Yes, the -- let me just see how I want to look at. The total private label business, which is -- for everybody to get on the same page, in the US Spine and Other segment that we report, was in fact down a little bit. Call it low single digits.

The reduction in that segment is about -- in the guidance for that segment in the year going forward is about half in the proprietary products and about half on the private label side. So that is how we are thinking about it for the year going forward. The private label business has lots of different customers, some of which are specifically orthopedics and some of which are -- do other things, and we are not going to get into the business of breaking out the impact, partly because they are each in different situations.

We are very focused on giving them the support they need through this, and I don't want to direct a lot of thinking around where that is going to go, both for our purpose and also because for us it is a confidential business arrangement. So that is all we are going to say on that point.

And the change in outlook to the proprietary piece of that business, that was all recall related, or were there other factors?

There were other factors. The spine hardware component, we have brought down to some degree our expectations for the year, around price mostly, and that is factored into the guidance adjustment there. There is recall-related impact as well on that.

But it should be worth saying that our spine hardware business, which is embedded in that segment, was down less in Q1 than the other famously reported numbers that have come out more recently. We just -- we want to be conservative until we see some secular improvement in that market.

Okay. And then one on R&D spending and how you are approaching that. So you're guiding to the low end of your prior range, but that is against a lower overall top line, so that would suggest that you are pushing off some investment that you had previously planned to do. So was there anything specific that fell out of the budget, and how are you balancing the desire to maintain near term margins as best you can while still investing for future growth?

That's an excellent question. It hits more than R&D actually, and it is a worthy subject.

If you look at the P&L, our expenses are higher than they were a year ago, in no small part because we planned for significantly higher revenues than we are now going to have. And therefore one of the exercises we are going through is a reexamination of expenditures that we can defer without significant consequences for any of our key priorities.

So we are -- to look at R&D, we are continuing to focus on the DFU trial, which is very important are to us. We are continuing to focus on getting out the shoulder set where it needs to be. But at the same time there are longer term programs in our budget that we can defer a little bit. And that same general thinking flows through other parts of the P&L.

We are not going to cut our expenses to the level to fully, in effect, recover from the recall by any means, because that would be hurting our future for what is a short-term and specific issue. But at the same time it is only wise for us to take a careful look at how we are spending our money and be as careful as we can be. So that exercise has been going on and will continue to go on, certainly for the next couple of quarters.

Great. Thanks, Jack.

We will take our next question from Robert Goldman with CL King.

Good morning. Just a couple of quick financial things. Jack, I might have missed it in your prepared remarks, but did you or could you give us a projection for free cash flow in 2013?

We did not give a projection for free cash flow or operating cash flow. We did say CapEx would be $55 million to $65 million. Obviously cash flow is not going to perform as well as we had hoped, because it is highly correlated to earnings, and our earnings are going to be down. So we have not given that number for 2013.

And you are not able to give it?

We are not inclined to give it. There is obviously a wide range in that number, because however it plays out, the difference between our -- we have got a bunch of delta in our CapEx, and we have a bunch of delta in our earnings, and we are not walking through all of that. So we want to see how you how this goes, and you will see our cash flow numbers as the year progresses.

And then I did see that in the quarter your intangible amortization expenses became less negative, and I'm just curious why that happened. Did you write down some business or why?

We reached the end of the useful life on some intangibles that came along from acquisitions years ago, and they rolled off. And we haven't -- we actually haven't, as you know, done new acquisitions. We haven't done an acquisition since September of 2011, apart from the small orthopedics deal we did -- the very small orthopedics deal we did in Q1.

So we had -- that is basically what is going on. And that happens in our business as time goes by. It then goes up when we do an acquisition and we pick up new assets to amortize.

So on that number should we just kind of use the first quarter number and run that through you for the year every quarter?

I said something in the prepared remarks about how to deal with that. Here it is. We have -- we estimate about $4.5 million a quarter -- well, $4.5 million a quarter in intangible asset amortization, about $1.5 million of which is in COGS and obviously $3 million of which is in operating expense.

Okay, great. Thank you, Jack.

We will take our next question from Steven Lichtman of Oppenheimer & Company.

Good morning, Steve.

Thank you. Good. Hi, guys. Just two P&L questions. One, just to build on Bob's question relative to 2014. Certainly the -- you'll be building off on the top line off of the base on 2013, but as we think about, say, first half 2014 versus first half 2013, the P&L is obviously going to look a heck of a lot different when we look gross margin and SG&A relative to top line impact you're having here as well as some of the incentives on the sales force, right? So the drop through is going to look a lot different as we look at the bottom line in the first half of 2014 versus the first half of 2013. Is that not fair?

Yes, that's fair.

Okay. So we are not building -- go ahead.

[But I think your basic] -- I'm sorry, I think your basic view, which was helpful, is I think people should look for growth off essentially on the rev -- on top line we should be looking for growth off of the number we report in 2013. I think assuming that we will have a full snap back is too aggressive.

Right. But I think relative to the bottom line, I just want to make -- clarify in terms of the base for 2013, you were talking about the top line. Because the bottom line is a different animal given some of the pressures on the gross margin and SG&A that you are particularly feeling here in the first half, is that correct?

We agree.

Okay. And then just relative to this year, obviously a little wider range now on the bottom line. Is it just -- obviously the top line hits the bottom line particularly hard with you guys because of the low share count. Is it just the variability on the top line that is the variables on the bottom end of the EPS guidance versus the top end or, anything else we should be thinking about that would drive you to the lower end versus the upper end on the EPS side particularly this year?

It is pretty much the delta on the top line, which is in our estimation overwhelmingly our highest margin product. So that increases the leverage, if you will, on the bottom line.

Right.

Okay. Makes sense. Thanks, guys.

And we will take our next question from Spencer Nam of Janney Capital.

Hey, thanks for taking my questions. Just a couple of quick question. First one is on the EPS guidance. If I remember correctly, your previous guidance was -- I think had a $0.20 margin between the low end and the top end. Now we have $0.30 after one quarter. Was curious kind of how -- what kind of scenario would lead to the EPS coming at the low end of the range versus the high end of the range?

If we had lower -- if revenues were toward the lower end, if the revenue miss were higher-margin products, and if expenses were greater than anticipated for whatever reason, that certainly would drive an earnings result toward the lower end.

I mean, Spencer, it is heavily tied to what Steve's prior question was about revenue. It's the volatility. We've got -- obviously we've got the FDA coming back for inspections. We've got ramp up of third shifts to actually be able to meet that capacity, and so that -- and obviously tied to the fact it is our highest margin products, that's why the wider range.

Okay. So basically it is pretty much tied to the revenue outcome? That is how I should think about it overall?

Yes.

It overwhelms everything else.

Correct.

Okay. Got it. And then just a quick follow-up. In terms of this backlog, if you will, or the shortage of supplies, is there a potential risk of competitors coming in and taking share away from you guys through you this process?

Look, the truthful answer is, yes. I mean, I think are we going to lose some accounts? Yes. But we believe in this franchise that we do have some differentiation. We have some very long time thoughtful users that like the feel and the utility of the product, so we have confidence that we can bring that back.

But the fact is if we gap some customers, are there some we are going to lose? Yes, and we've factored some of that into our thinking.

Okay. Thank you.

Yes.

(Operator Instructions). We go next to Amit Hazan from SunTrust.

Good morning, guys.

Good morning, Amit. How are you doing?

Very good. Just want to go back to Anasco for a moment, and I want to ask about the chronology of events, which I think is a little bit concerning, given that their remediation began in 2011, and then kind of fast-forward, we had the third party validation in February. And you guys stated fairly clearly that you've completed substantially all of the corrective and preventative actions in the warning letter on the 4Q earnings call. And then we had the April recall over one month later.

So I'm kind of trying to understand who takes responsibility for this on the ground, and what changes have happened in management on the ground in Anasco that can give us some confidence that it is resolved -- there is kind of visibility that this is substantially resolved at this point?

Yes, so look, let's kind of frame it up. When you get the warning letter, you have the 483s, there is obviously the focus in the work on getting the actual observations closed out and cleaned up. And that has been obviously your first priority item that one goes after, and we have been focused on that.

The second area, though, is once you have a warning letter, as you well know, it basically means anything you have got on any product in that facility is open for obviously discussion with the agency. And so a big part of the supplemental remediation and focus is going back through all of our products to make sure that we are air tight, as well as, since this is a sister plant to Plainsboro, the two of those are well connected on approach and process, which we have been focused on. So that is at a larger level of saying how we think about the stages of those items.

The other aspect is we have a new plant manager, a new head of quality within the facility. Really less than probably about seven months in the role. We brought in some top talent, both as employees but also as some consulting help that is literally helping us get ready. Our head of quality, Joseph and John working tightly together, literally have a control room where they are daily getting updates interacting with the team, where they're reporting out the multiple times a week, giving direction, making sure that we have the right coordination.

So when I talk about this focus over the next 120 days around making sure we get these items closed out, having the right people in the right roles, that is exactly what we are doing. And so from the certification, the certification was successful. It allows us to manufacture products going forward, saying that what is coming off the lines in Anasco is high quality product and it's following all of our procedures and capabilities. We reviewed that with the FDA in Puerto Rico, and obviously we are continuing to manufacture because of that.

That is different than the observations that came up in the items that we found within the recall where we found some deviations even a couple of years ago, and how we reacted to those. So I think we are making good progress, and again, not acting like just because you get the observations fixed you are done. We are taking a very comprehensive look everywhere, because we view that is the new world order and how the FDA expects us to think about when you are under a warning letter.

If I may -- Amit, if I may help a little bit with the specific timing question you asked, yes, we have been working on that plan a long team, and it is immeasurable tighter than it was, say, a year ago. That's point one. Point two, yes, it remains the case that the products coming out of that plant are coming out, as Pete said, according to fully validated processes. What we found though, between say the February call and the announcement of the recall, was in the preparation of our detailed response to the FDA around the warning letter, we went back and, as Pete said, we looked at everything.

And we found that in our judgment a couple of the CAPAs -- corrective and preventative actions -- that we had historically, one quite a while ago, the other more recently in December, we felt that in retrospect they hadn't been closed out tightly enough in effect. And that given in a situation like this all decisions are subject to post hoc assessment by the FDA in a subsequent inspection, we decided to approach this question with I would say a great deal of professionalism and care.

The consequences turned out to be financially quite significant, and we obviously regret that. But we are doing the right thing from a timing -- or from a remediation perspective and response perspective. The timing is uncomfortable, but it is essentially a lagging indicator.

So maybe given those comments and your comments on what's coming up before Labor Day with the additional inspections, how should we think about where you are and kind of what you are probably doing in your Plainsboro facility -- similar process -- and the risk there might be there, whether it's with the endotoxin issue or otherwise, of you having product issues in that facility as well? Or finding some issue that you want to take a very safe stance on before the inspection?

Well, we have been taking a very conservative approach in Plainsboro all along since the warning letter, so the key is that we are reconciling anything that has come up in Puerto Rico and making sure we are reconciled with New Jersey. That is part of what the leadership team does, is we make sure that we implement our plans. I mean, I will tell you that we have been, again, updating New Jersey FDA office in Parsippany on a monthly basis.

Substantially all of our items that we really committed to are well on their way and completed. But, again, what we embarked on as well with Plainsboro is looking at every product we make. How we think about the products. How we think about all of the aspects associated with making those. Because again we know and expect when the FDA comes back in that they are going to look broad and wide.

And I feel quite good about the progress that we've made. The leadership team that we have there is very good -- the capabilities of that team. And they are getting ready for if the agency comes in tomorrow or whether it is six months from now. But as we expect, we think that it is probably going to be here sometime in summer time to late spring here.

All right. Thanks very much, guys.

Yes.

We will take our next question from Michael Rich of Raymond James.

Hey, guys. This is Michael. I'm in for Jason.

Good morning.

Can you hear me okay?

Yes.

Okay, great. Thanks for take my question. Just kind of in the same vein, I was wondering if you could give us an update on the new you Plainsboro facility? Maybe, when do you expect to begin transitioning meaningful volumes from either Anasco or the current Plainsboro plant to the new one?

In our new facility we have made a lot of good progress on the core of it. The facility is going to be a state of the art capable facility to do really everything we need, and ultimately again just to remind everyone, it is right across the street from our -- what we call our 105 facility. Between the three locations then we will be shifting and managing the balance of our production. Part of that is in -- why do we need the added capacity. Obviously we think we have more expanded capabilities, things such as tied with DFU and all that growth. So that is the backdrop of it.

Relative to bringing it up in capacity, at this point in time we see that being a 2014 event, primarily tied to the fact that the processes and procedures that we will utilize to make the products are the exact same ones we will make in 105. And so obviously getting a thumbs up from the FDA on that is an important aspect of it, and so in some ways those two are correlated.

We would expect when we are going to turn on that facility that the FDA will want to have to do a pre-inspection as they normally do on a new site, particularly when there is PMA products. And so that is the correlation of how those two tie together, and at this point I would say we will start bringing that up in 2014. But we haven't slowed down getting the site ready, all of those things that we need to be able to manufacture and get that ready for full capacity.

Okay, great. Thanks. That's it for me.

Okay. Thank you.

And we have no further questions at this time. I would like to turn the conference back over to the management team for additional or closing remarks.

All right. Thank you all for dialing in, and we look forward to speaking to you again next quarter.

And this concludes today's presentation. Thank you for joining, and have a nice day.