Integer Holdings Corp (ITGR) 2005 Q2 法說會逐字稿

Welcome, everyone, to the second quarter Greatbatch Incorporated conference call. Before we begin, I would like to read the Safe Harbor statement.

This presentation and our press release contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 and involve a number of risks and uncertainties. These risks and uncertainties are described in the Company's Annual Report and Form 10-K.

These statements are based upon Greatbatch Incorporated's current expectations and actual results could to differ materially from those stated or implied. The Company assumes no obligation to update forward-looking information included in this conference call to reflect changed assumptions, the occurrence of unanticipated events or changes in future operating results, financial conditions or prospects.

I would like to now turn the call over to today's host, Treasurer and Director of Investor Relations, Tony Borowicz. Please proceed, sir.

Thank you and welcome to the second quarter Greatbatch Incorporated earnings conference call.

On the call today are Ed Voboril, our Chairman and Chief Executive Officer, Tom Hook, President and Chief Operating Officer, and Tom Mazza, our newly appointed Senior Vice President and Chief Financial Officer.

In terms of the format for today's call, Ed will start by reviewing our financial highlights for the quarter. Tom Hook will follow with an update on the business and strategic initiatives and Tom Mazza will conclude with the detailed review of our financial results. At that point we will open up the call for the customary Q&A.

Let me remind you that we are providing slide visuals of this call which can be accessed at our Web site at greatbatch.com.

Let me now turn the call over to Ed Voboril.

Thanks Tony. Good afternoon, folks.

I'm very pleased to report on our second consecutive record quarterly sales performance, achieving $63.5 million in sales, a 20% increase versus the same period a year ago. We also demonstrated significant operating leverage earning $0.23 a share which exceeded both internal and external expectations.

The earnings of $0.23 a share are inclusive of $0.11 a share in selected charges. These charges include $0.05 a share in consolidation costs for Greatbatch Mexico and our Alden facility.

The balance of the charges was primarily due to costs associated with the discontinuation of a drug development agreement during the quarter. Excluding these charges, we achieved an operating profit margin of 19% in the quarter.

We believe that as we achieve greater capacity utilization at the Alden and Tijuana facilities, we will have the ability to leverage our infrastructure even further.

Let me touch on some of the key factors that contributed to the positive results.

First, it was clear that we did receive some benefit from the CRM product field actions in the marketplace. Let me point out, though, that none of these field actions were related to a component parts manufactured by Greatbatch.

Trying to determine how much benefit we received is difficult. We did see a quarterly sequential increase in CRM-related sales in the range of $5 million.

We do not have granularity into the nature of the order and can only assume that some percentage of the increase relates to the CRM field actions in the marketplace. It is very conceivable that our sales will continue to be favorably affected by these field issues into the second half of the year.

The increase in demand is not isolated to any one customer. I want to emphasize that we are seeing strength across all of our products and throughout our entire customer base.

We believe that the CRM market continues to exhibit strong underlying growth fundamentals and that we are well positioned to participate in this market growth.

There are a number of factors both short-term and long-term related to recent field actions that may impact our results. In the short-term if product has to be replaced or customer inventory levels have to be restored, this could result in increased demand for Greatbatch components.

Also, changing customer order patterns due to market share shifts or accelerated device replacement may have a positive impact on our sales results in the near-term. These same factors may have longer term implications as well.

Customer levels may have to be rebalanced to match demand. These dynamics should be clarified in early 2006 and will have to be carefully considered when we provide our 2006 outlook.

It is important to understand that we have been extremely responsive in meeting this accelerated customer demand, which is the result of the hard work and commitment of our employees and the disciplined processes that we have in place.

Turning to the Commercial business, we've posted our second consecutive sales record with second quarter sales of $8.7 million, a 30% increase over the second quarter of 2004. The sales growth has been driven by a number of factors.

First, we have expanded our Commercial sales and marketing force in the first half of the year. We are aggressively pursuing new business opportunities and have been successful on many of these fronts.

Second, we have significantly reduced our manufacturing lead times at our Canton Commercial battery manufacturing facility allowing us to increase shipments in the current year. We will continue to expand on these efforts from various lean manufacturing initiatives that are underway in this facility and throughout the Company.

The third factor that has contributed to our positive Commercial results have been favorable market dynamics in oil and gas, seismic, and oceanographic market segments. The continued strength in oil and gas explorations results in increased demand for power sources used in pipeline inspections, pressure monitoring, and measurement while drilling applications.

In addition, we have seen an increase in demand for batteries used in oceanographic monitoring and seismic recordings due to heightened tsunami-related concerns mainly in the international markets.

In summary, we are very pleased with the many significant accomplishments in the quarter. We continue to believe that we are the leading provider of the most highly reliable and technologically advanced products serving both medical and commercial markets.

Furthermore, we are very well positioned to build on our leadership position in offering the best technology solutions for all of our customers.

Now I'll turn the call over to Tom Hook who can update you on the progress of our key performance drivers.

Thank you very much, Ed.

First, let me provide an update on our manufacturing facility move initiatives. Last quarter we announced that we were in the process of moving our medical battery operations to Alden and were in the planning stages for our capacitor move.

I'm pleased to report that we have completed the battery move ahead of schedule and are now manufacturing all our medical batteries at the new Alden facility. Furthermore, we have started moving our capacitor operations and expect to complete this move in the fourth quarter as scheduled.

These moves have been closely coordinated with our customers and they too are pleased with the smooth transition.

The same can be said for the assembly equipment moves into our Greatbatch Mexico facility. We continue to move the equipment in various stages which remains on schedule for completion in the fourth quarter.

We have also started the planning and infrastructure build for the consolidation of our Carson City operations in Tijuana. We expect this consolidation effort to be completed in the first quarter of 2006.

This world-class facility will be a key ingredient in our strategic direction providing us with additional manufacturing capabilities and the opportunity to extend our product line offerings.

The second strategic initiative that Ed touched on earlier is the expansion of our sales force.

We have significantly added to our commercial sales force and marketing capabilities which have resulted in increased sales volume. We expect to continue to increase our sales and marketing efforts and increase our market penetration.

On the Medical side of the business we added two new account managers in the second quarter. Their role will be to focus on strengthening our customer relationships and also to expand our customer interface by addressing new product opportunities.

Turning to our product development activities, we are extremely active on new product development programs. We currently have 52 active development programs in place covering our entire product offering.

We anticipate adding to our engineering and development staff in the second half to meet the increased product development requirements.

Our most exciting new technology is our Q-Series battery. Customer interest remains very high and as discussed last quarter, we have begun shipping qualified cells to two customers in the first quarter.

We are in the process of implementing a majority of the new Q technology process automation equipment and are currently gearing up for a fourth quarter ramp in production. We also have multiple development agreements in place for our Q Medium Rate cell which can be used in various neurostimulation applications.

Regarding longer term development plans, we remain on track with our IRM development efforts and continue to meet all our major milestones.

We are also very focused on developing a higher voltage ICD capacitor. At this point, we could have a qualified high-voltage capacitor in place by the end of 2006 for customer evaluation.

Finally, let me touch briefly on emerging market areas, emerging product areas. A key market area for us is the growing neurostimulation market segment.

As we discussed earlier, our new Q Medium Rate battery could represent a significant upgrade in primary cell performance for neurostim applications. We are currently working on improving our rechargeable battery offering and fully expect to have a leading technology in place within the near future.

The neurostimulation opportunity looks very attractive and could represent a significant revenue opportunity long-term. We have had related discussions with numerous customers regarding the use of our technology for the treatment of depression, hypertension, emotion disorder, stroke, gastric stimulation and control, urinary incontinence and obesity.

In the non-medical area the [telemetics] market represents an attractive market for batteries and related assemblies used in fleet and asset management applications. The product development of these emerging markets is ongoing and their impact to our business will increase in significance over time.

In summary, we remain committed to advancing our technology leadership to drive organic growth in existing and emerging markets. At the same time we will look to diversify our customer base through inorganic means.

Now let me turn the call over to Tom Mazza to provide a detailed review of our financial results.

Thank you, Tom.

I will address four primary topics in my review of the financial results. First I will provide additional insight into what drove the quarterly sales and earnings increase. I will specifically address the details into the costs that were incurred in the quarter for excess manufacturing capacity and for the other operating costs.

Third, I will provide a brief review of our balance sheet and will conclude with a discussion of our 2005 full-year guidance.

First turning to sales.

We reported a 20% increase in sales compared to the same quarter last year. By segment, Implantable Medical Component sales increased by 19% and Electrochem Commercial Power sales increased by 30% compared to last year.

We saw a significant increase in all of our Implantable Medical Components compared to last year with the exception of capacitors, which declined by 5%. What is more relevant for the capacitor product line is the 39% sequential growth which reflects increasing customer demand for this product.

Commercial sales increased were 30%, came on the heels of a 17% increase in the first quarter. Expansion of the sales force, coupled with the strong market dynamics in the oil and gas exploration and seismic and oceanographic monitoring, continues to fuel the growth.

Moving on to gross margin.

We achieved a 39.5% growth margin in Q2 versus a gross margin of 45% compared to last year. In the current quarter, we incurred approximately 1.8 million in excess capacity costs at our existing capacitor and Greatbatch Mexico facilities.

We anticipate eliminating the excess capacity costs at our existing capacitor facility by the end of 2005 when the move into Alden is complete and we terminate the existing facility lease.

The Tijuana excess capacity is expected to continue into 2006. The factors that will reduce this excess capacity will be the successful consolidation of the Carson City facility into Tijuana, and our ability to increase the production of new products and assemblies.

We expect that this excess capacity will be reduced by mid-2006 as the Tijuana production facility ramps up.

The excess capacity costs contributed to 2.9% point decline in gross margin in the current quarter. The remaining decline compared to last year is primarily due to lower medical selling prices, increased incentive compensation and profit sharing, as well as higher [platinum] and material costs.

On the operating expenses.

Our SG&A expense increased by 33% from last year. Of this, $2 million was due to increased incentive compensation.

The balance of the increase was primarily due to sales and marketing costs pertaining to the expansion of the Medical and Commercial sales forces previously discussed by Tom.

RD&E expenses net of development costs reimbursed decreased by 36% compared to last year. In terms of the net expense breakdown, gross R&D spending of 5.3 million declined by 12% versus last year.

A significant portion of this decrease is due to the QHR product line moving from the development stage into productions.

Reimbursement for development costs billed, which are netted against gross RD&E, increased by 1.3 million compared to last year. The timing of the achievement of these reimbursement milestones was the primary reason for the reduction in the net RD&E expenses.

We expect that RD&E costs will increase in the second half due to the increase investment in future development programs and the timing of achievement of development milestones.

Shifting to other operating expenses.

We incurred pre-tax expenses of $4 million consisting of 1.8 million for the Alden and Tijuana consolidations, 1.2 million for the discontinuation of a drug pump development agreement, and $1 million in various other write-downs.

For the full-year 2005, we expect our operating expenses to be approximately 14 to 14.5 million, up from the $12 million we guided to in Q1. The increase of $2 million pertains to the additional $2 million that was recorded in the current quarter of the discontinuation of the drug pump development agreement and for the other asset write-downs.

Turning to the balance sheet.

Our cash and short-term investments were 88 million at June 30th, an increase of $2 million from the $86 million we reported as of March 31, 2005. Due to the significant sales increase in the quarter, our receivables balance increased by $6 million, inventories increased by $2 million from last quarters, with turns remaining constant at $3.9 million -- times cost of sales. 3.9 times cost of sales.

We spent $7.5 million on capital projects in the quarter bringing our total capital spending to $16 million for the year. The majority of this investment is due to the spending on the new Alden and Greatbatch Mexico facilities which we expect to complete by year-end.

I'd like to now provide you with an update of our 2005 full-year financial guidance.

For the full-year we are increasing our sales guidance to be in the range of 220 to 235 million, an increase of 10 million from the previous guidance range of 210 to 225. As discussed earlier, we did receive some benefit from the marketplace CRM field actions.

Our best guess, based on our recent sales run rates, is that approximately half of the $10 million increase in our sales guidance relates to the CRM product field actions. The balance of the increase is due to underlying strength in both Medical and Commercial markets.

Full-year 2005 EPS is expected to be in the range of $0.20 to $0.34 compared to the 12 to $0.20 previously announced. As mentioned earlier, this includes $14.4 million of pre-tax selected charges or approximately 45 to $0.47 per share after tax.

We are reaffirming our capital spending plan of between 30 to 35 million for the year 2005.

In summary, we are very encouraged about the momentum heading into the second half of the year. We have recorded all-time record first-half sales, and let me reiterate that we are seeing strong demand across all of our product lines and customers in both the Medical and Commercial markets heading into the second half.

We are extremely pleased with the progress on the plant consolidations which should provide the catalyst to improve our manufacturing efficiencies even further.

Moderator, this concludes our prepared remarks. Let me turn it back over to you for Q&A.

[OPERATOR INSTRUCTIONS] We'll take our first question from the line of Bob Hopkins of Lehman Brothers. Please proceed.

Thanks very much and good afternoon. A couple quick questions. On your best guess in terms of the benefit from the field actions, could you just walk us through how you kind of arrive at that estimate and the way you thought through the process?

How are we doing? Bob, primarily we're seeing it as based on the comparison of the second quarter run rate compared with the first quarter run rate for the CRM markets. We saw that increase about $5 million during the quarter and we believe some significant portion of that was due to the field actions, approximately half of it. So we're estimating that for the year we're going to see approximately $5 million worth of additional sales.

And is that 50%, or that half benefit, half real thought applied to what you saw earlier as well? Because I think relative to the beginning of the guidance that you gave at the beginning of the year, you're now about $15 million higher and so is, you know, the benefit 7 or 8 million or 5 million relative to that original guidance?

Well, Bob, this is Ed. Let me respond and then I'll give it back to Tom for a minute.

There's obviously a lot of moving pieces here, Bob. We know there's some inventory builds, we know there's a one-time affect in there to a certain level for the field actions but we're also seeing, I want to re-emphasize, we're also seeing very strong underlying growth in the entire CRM market.

All of our CRM customers worldwide are showing strong growth in all product areas are growing. So there are some one-time affects but it's on top of a very strong underlying base.

Okay. Thank you. Do you get any help from your customers in guessing at what field's action related and what's underlying demand?

Very little.

No. We don't, Bob, this is Tom Hook talking. We don't ask for that. Obviously what we do is just respond to the product folds as they need them and we don't really get any visibility or granularity on what they're for.

Okay. And Tom Hook while I've got you, you mentioned high-volt cap potentially by the end of '06, could you define high volt?

The, you know, north of 360 volts, operating volts.

Okay. Would that, is that enough to get you through a true two-cap per system design?

Well, obviously we're going to develop base technology from their customers would decide how to deploy it. Different applications for different customers. They'd make the decision on how they want to deploy it two-cap system.

We think, you know, as long as we're north of 360 volts for operating voltage that that's going to make a two-cap system feasible. And then obviously we have to work once we have that technology development done on a specific customer program but that's the intent, is a two-capacitor high energy density technology.

Okay. Great. And then last question. Relative to feed-throughs and the progress that you're making there with Medtronic, would you say that the program where you're manufacturing feed-throughs for Medtronic is at your, what you expected earlier on, above or below expectations?

You know, Bob, I know you get sick of me saying that we won't comment on specific customer programs, so I won't comment there but obviously we are not looking beyond any opportunity with any customer and we're pursuing every one very aggressively, whether they're in the CRM market or outside the CRM market. So in our, my intention is still to kind of maintain consistency of not talking about individual programs but obviously just, you know, pursuing the overall product portfolio very aggressively with all customers.

Okay. Thanks very much.

And your next question will come from the line of Keay Nakae of Unterberg. Please proceed.

Yes, your pacemaker battery sales increased quite significantly. Can you talk about that a little bit?

Well, this is Tom Hook talking. We saw the, pretty much healthy demand across the bradycardia segment. Obviously we have a long history in those product lines and put a lot of focus not only just on the reliability and the performance of the product, but also with the lean and the manufacturing initiatives we have in our Alden facility to make sure products can be delivered with close delivery times.

We don't really get the granularity from the customers specifically on the pulls in terms of the market demand. We've just basically done a very good job of when they're demanding a volume of actually operationally backing it up and delivering it, the Medical power business in particular did a very nice job of capitalizing on that for the first half of the year.

The underlying drivers are, it's tough to comment on because it's across the board of all customers and really all product lines in the bradycardia side.

How about for the CFX batteries? Did you see a significant step up there sequentially?

Slight one for the quarter.

It, yeah, obviously the number's dramatically lower. There is one relative to the quarter but the, you know, obviously the numbers kind of get washed relative to the size of, you know, in particular the lithium iodine products.

Okay. And on the drug pump action, I assume that's MRG that you've now phased out of that?

You know, we don't really comment on the specific customers but we've obviously made a decision on the focus on Power Systems including drug pumps, maintain the customer relationships we have there but transfer out of the technology for the actual pump mechanisms and pump drives themselves. So we're not going to get into motor drives and stay in so solenoid drives or pumping mechanisms but we're going to maintain our presence, our strong presence, in the actual pump power supplies themselves and other associated components that we provide to those customers.

So it's, we're basically exiting some technology areas that we don't want to continue to invest in and get that technology transferred over to the current customers.

With respect to the sub-assembly business, you did have some revenue in Q2 and how rapidly should we expect to see that accelerate in the back half of the year here?

We'll see it continue, we're obviously in the process right now of doing a staged moving process for the ramp up in Tijuana and so you should expect to see that that ramp continues throughout the remainder of the year. Really it goes month-by-month but you'll see it quarter-by-quarter.

And I think we're really about where we thought we would be for the ramp of that business. We're on our mile, within 30 days of all the milestone accomplishments that we needed to have and I don't see any schedule changes at all.

Okay. Thank you.

And your next question will come from the line of Glenn Reicin of Morgan Stanley. Please proceed.

Hi, folks. A couple questions. Can you explain the growth in the core pacemaker business?

This is Ed, Glenn. Tom talked to that. Again, it's stronger across the board with all customers.

The market's not growing, so --

Some of our customers have differences in their inventory management practices. There's a possibility that there was some market share shift one way or the other, but it's just one of those time frames where we're seeing a historically important product line snap back with more growth than we anticipated.

Okay. And then on the, can you give us an idea of what sub-assembly revenues were in the quarter?

Less than a million dollars.

Okay. So are you going to make your targets for the year from the sub-assembly business?

We're pretty close.

Yeah. We're very close. I mean, Glenn, this is Tom Hook talking again.

You know, we have just a general business variable of being able to bring in that business but also we have the added, we still obviously have a ramp up start-up stuff to do in Tijuana. So we feel we're on schedule right now and we think we're managing that start-up very well. And as long as we maintain that time line, we will hit our targets and be right where we expect to be for the year.

And you're still committed to the strategy?

Yes.

Yeah. We're still committed to the strategy overall down for the Greatbatch Mexico business.

Okay. Just a couple of other questions. When I'm working through my margins for the year, I'm coming out with like a 36, 36.5% gross margin assuming you have a fall off in volume in the back half. Can you endorse that number at all? That's inclusive of the excess overhead but exclusive of any one-time charges.

That's probably in the range.

Okay. And at this point I guess '06 is really unknown, just given the volume outlook for '06?

That's correct.

Okay. Can you explain, two other questions. Can you explain this other write-down what that is, net asset write-down?

Yeah. Actually, we had a, we basically go through on a quarterly basis, Glenn, all of our assets and look for the ones underachieving. Basically had a non-cash write-down during a period of time and we don't expect any continuation of this into the --

What is that, though? What is that asset?

The granularity.

Can --

He wants granularity.

Granularity on it. It's a series of, it's basically some fixed assets that we wrote down.

Fixed assets. Was that like a facility or something?

Equipment, equipment.

It's basically equipment, Glenn, that we're not using that, as we're doing our consolidations and our moves and other things we're just taking a fine-tooth comb to the business and looking at what's being used and what's not and reflecting the value of the assets appropriately.

Okay. Last question and this is a follow-up to report we put out this morning, just a general industry outlook. And when I work through my numbers, I was sort of stunned to notice that right now your return on invested capital does not cover your cost of capital, your return on invested capital right now is like 5%, 5.5% and it doesn't get much better in the outer years even with margin improvement.

Is there an inflection point in terms of revenues that you've determined that you actually can't cover your costs to capital, have you looked at the business that way?

Glenn, it's Ed.

There's no question that we've been in a heavy investment mode certainly with the facility in Alden, with Tijuana. And we're in the midst of our updating our strategic plan but I think I mentioned before that we expect our Tijuana facility to be fully utilized by the end of '07. And with the growth that we see in the industry, we believe that Alden was a very good investment.

Now in terms of how that balances out, ROIC versus cost to capital, that's an ongoing analysis and part of it really depends on also gaining additional manufacturing efficiencies through implementation of both automation and leans at the Alden facility. We've got to grow the top line.

Yeah. I mean but I gave you credit for margin improvement based on volume. I have a sneaking suspicion, and tell me that I'm wrong, I hope I'm wrong, that the way you're going to get your returns up is to write-down additional assets so the denominator is in fact smaller relative to your returns.

I don't believe that that's our plan.

We certainly don't contemplate any significant asset write-downs.

No.

Hmm, okay. So --

We're looking to, you know, over the long run we're seeing it go into the mid-teens over the long run, which is our stated objective. And I think a big factor in that is achieving the 20% operating margin which we're looking to get to in the short-term.

20%. Okay. In the short-term. What is that, what is short-term defined as?

Over the strategic planning two to three-year period of time.

Yeah, I still don't get to double digits, but okay, we can connect offline on that one. Thank you.

And your next question will come from the line of Tim Nelson of Piper Jaffray. Please proceed.

Hi. Just to pursue the pacemaker category a little bit more. It also includes other batteries. Were other, any part of the outperformance category this quarter?

There are, the product lines, you know, across, even the other batteries showed a favorable trend but because the overall units, Tim, are small, they get washed out in the main running product line. So the effect there is not that large from a gross perspective.

Driver was --

Is that where neurostim batteries are booked?

That's correct. We show them in other category.

Okay. Great. And is the outlook for the neurostim business the rest of the year more or less, what part of your guidance is that as you look through the rest of the year?

Well, I'll tell you, there are a couple of elements, Tim. This is Ed. First of all of course, you've got a couple of larger customers, Cyberonics being one of them that, as you know, has some new indications so there could certainly be some growth attended to that. But a large number of the customers in the neurostim category that we're dealing with are very early stage companies.

Uh-huh.

So I mean our philosophy, our strategy's always been get design in early and we'll enjoy the benefits longer term of being the key supplier. The timing of that, of course, is largely dependent on when our customers can successfully bring their products to market, but we, I mean that's the business model that we've used successfully for 35 years and we're continuing to use that same model.

Sure you're going to be successful. As we think about the, you know, the temporary influences on the revenue in the quarter, it's clear that most of the CRM industry is trying to be opportunistic about the field actions. Is there a possibility that they have doubled up on inventory and there could be a slowdown in the second half of the year as everybody gets their piece of --

Yeah, Tim, I think I mentioned in my remarks that there well could be some inventory adjustments and I think it'll probably take us until early next year to really determine how much inventory overhang there is. But we believe that positioned against the overall strength in the industry that we're seeing, while there's a possibility it might have some impact, it's against a backdrop of a very strong base underlying growth business that we have.

But internally that's a little hard to figure out given all these --

There is a lot of moving pieces and it is difficult to figure out which of the pieces are going which way.

But last question. Has there been any change other than the drug pump program in this asset write-down in the one-time charges on a go-forward basis, any forecast for the rest of the year?

No. It's only the changes for the quarter. We're going from the $12 million originally forecasted to 14.

Okay. And that's the drug pump and the other asset write-down?

That's correct.

And on excess capacity, is there any change there for the rest of the year?

It's going pretty much according to budget.

Okay.

7 million.

Thanks.

And your next question will come from the line of Jason Mills of First Albany Capital. Please proceed.

Thanks, guys. Ed, Tom and Tom congratulations on a very good quarter.

Thank you, Jason.

Thanks, Jason.

Sure. Just exploring, at [inaudible] you're guidance for the second half of the year, so part of that seems to be organic, but incrementally, as I look at it, it was a couple of million dollars, which is fine, I'm just sort of wanting to understand your perspective from a customer standpoint.

Does this imply that you're modeling some of the guidance share loss which certainly I think we all realized there was some that occurred to Medtronic? I don't think it's brain surgery to suggest that that happened as well. Does it imply that some of that share shift to Medtronic vis-a-vis the recall sticks?

Honestly, we haven't tried to figure out anything regarding share movement. We've just looked at underlying demand where we're seeing a business forecasted out by the customers. As to why one or the other thing is happening we don't know.

I'm going to reiterate. Every customer is showing growth in every product line across the board. It is not isolated and isolated from one customer versus the other.

That's acute to this quarter, correct? Because as we look at the market, the pacemaker market's clearly not growing and for some companies it's down year-over-year. So you mentioned that lean manufacturing, the initiatives there have definitely helped your lead times and your order of, being able to place the orders in sort of on an as demanded basis.

So if we kind of look at when the recalls happened from guiding in the quarter, they actually happened after the quarter ended, but presumably people knew about it before the June quarter ended. Did that have any impact, you know, sort of in June as we sort of exited the quarter?

We don't know.

Okay.

We can't tell.

Okay.

I think what we're just, Jason, focused on is just being very responsive to the customer requirements and performing and exceeding those expectations and --

Right.

Not only just in the product, just in the operating efficiencies of delivering it to them when they need it.

I think we can appreciate the difficulty, Tom. I just, what I fear is that, you know, with, you know, it's difficult for you guys to model however, you know, if you've got, you know, somebody modeling continuation of 20% year-over-year growth in pacemakers in their models and that just doesn't seem to be realistic and you come back to earth a little bit in the back half that possibly someone may beat you up for that, without it being really appropriate to do so.

Yeah. Well, we're obviously grounding ourselves in the market as well when we do these things. We obviously have fluctuations quarter-to-quarter because there's other variables. So we, but we do recognize the point you're making and obviously factor that in so that we're not overheating ourselves.

Okay. And just a couple quick ones then I'll get back in queue. As we all know you anniversaried the Guidant order reduction this quarter. Sort of excluding if you can for a second some of the moving pieces with respect to the field actions, would you expect sort of on a normalized basis the ICD capacitor business to sort of return to, you know, whatever you model for ICD unit expectations going forward? Growth expectations in ICDs?

Wow, that's a very involved question there. I think we are confident in the product technology to put us back in a strong position and having compelling technology that all customers will want to evaluate, obviously we think if we continue to hit the operating effect of a milestone it will be very compelling for our customer base.

So given that, yes, we think we can do very well in the marketplace relative to the general ICD market growth and be very successful with capacitor product line.

Okay. So again, we would be thinking about returning to somewhere in the high teens type growth given that that's at least what the industry's going on a unit basis?

Probably will be a difficult one to comment on but I understand what you're asking but I just couldn't comment on it.

Okay. Because of the field actions and the moving pieces.

There's too many variables.

Exactly.

Okay. And just a couple of housekeeping. The expectations for extraordinary charges you had roughly 6.4 million in the first half so that implies somewhere around 8 million in the back half, is that pretty much pro rata per quarter?

Pretty much. Probably more towards the back end.

And more in the fourth quarter?

We're confirming the 8 million for the balance of the year though.

Okay. Sounds good. And then lastly, the R&D, explain why it was lower. You said it would increase in the second half, could you quantify the increases and what we should expect on a run rate going forward? I think you've said in the past you expect sort of right around that 10% as a percentage of sales level. Would that be the case in the second half?

Yeah. I'm going to let Tom answer that in a minute but one thing you must remember, Jason, and we commented on it, the R&D number is a net number to the extent that we're successful in negotiating non-recurring enduring charges and program charges, they can net out at different points in the year depending on completion. So it's a little difficult to hang a percentage number out there because it is affected by when we get these --

Milestones.

You know, cash payments that we don't record as revenues but are significant in terms of impacting the net amount of R&D in any quarter.

So Ed, we should look at, we should add back that reimbursement and assume that's what your, sort of the organic R&D was in the quarter?

That's correct. Right. Okay.

We're expecting Jason, we are, you know, gearing up for additional product developments in the second half and we're expecting the net increase to be between 2 and 4 for the back half over the first half.

For the second half '05 up 2 to 4 versus the first half.

Right.

Okay. I'll hop back in queue. Thanks, guys.

And your next question will come from the line of Mark Landy of Susquehanna Financial Group. Please proceed.

Evening, folks.

Hi, Mark.

Mark.

Hi, guys. Just a housekeeping note. What is the fully diluted share count in the quarter? I don't know if I caught that.

The fully diluted shares in the quarter were something a little over 26 million. The contingent converts come into play.

Okay. Great.

About 4.2 million.

Excellent. Would you have any reconciliation on your Web site from this quarter?

Are we going to post the reconciliation for the quarter on the Web site?

Of the other charges?

Of, yeah, the charges and the convert.

Yes, converts will be attached to the Q which will go out tomorrow.

Okay. Great. Just kind of going back to the neurostim market. A number of the start-ups are co-operating with existing market participants to act as stimulators. Is it fair to assume that your contracts with the manufacturers of stimulators would include OEM manufacturing agreements with third parties?

Um, no, not necessarily. You mean if they have contracted with someone else for manufacturing the product would we have a contract with that company?

No. The simple terms, the young guys are buying stimulators from the existing participant. So, does your contract with the existing participant, would that include stimulators that they would then sell to the younger companies?

Are you asking are we manufacturing the full device?

No, no, no, you're manufacturing parts of it, correct.

Correct.

For example Cyberonics has agreements with third parties to provide stimulators, so does Medtronics. I'm assuming if you signed an agreement with Cyberonics or Medtronics, that would include additional stimulators that they would manufacture to provide other participants.

Yeah, for other indications.

Yeah. That's right. And Mark, no, we don't specify that in our agreements. We just basically have the ones with our core customers and obviously it's, they go out and do third party extensions of their product lines. We enjoy the benefit of that though our current customer base.

Okay. Sure. I thought that would be the case, but I just didn't want to make any assumptions.

And then with respect to the batteries, guys. Is there a materially different drawdown on a battery if that battery is activated sitting on the shelf versus implanted in a patient, activated and implanted in a patient?

Well, obviously on the shelf there's a lower temperature than when it's implanted in the body so the discharge is slightly affected by temperature. You know, the, it's highly technical differences between different battery chemistries as to how they behave under partial discharge or undischarged conditions over time. But it's variable but there are normally very slight affects, you know. 1% to 2% type affects.

Not a meaningful difference.

Yeah. There's really not a big meaningful difference.

The batteries we manufacture are meant for demanding environments, obviously implants, you know, or long storage terms or long times with inconsistent discharges. That's what they're meant to perform for well beyond the specifications under those scenarios. So they're designed to do that.

So kind of the follow-up to that question and if you can share it with us we'd appreciate it. A number of your customers actually do not seal product until pretty close to shipping out. Do you know on average how soon before shipping the industry actually seals product?

I just couldn't comment. I just don't have an answer for that at all. That's just a question we don't have information on.

And then would I be correct in assuming that once something's sealed its salvage value is pretty low, if any, and if it's unsealed is quite a high salvage value of product?

Yeah. That's probably a good characterization. Yeah. That's fair, Mark.

Okay. Thanks very much guys.

Thanks, Mark.

Thanks, Mark.

And your next question will come from the line of Alex Arrow of Lazard Capital Markets. Please proceed.

Thank you. And I'll add my congratulations. I'd like to spend my question on the non-Medical side of the business, the oil and pipeline gas exploration and other businesses.

I'll start out by asking the Oil and Gas Pipeline Safety Act of 2002, which I believe is the piece of legislation that has lead to the increase in the frequency of testing pipelines, is that the factor that is leading to the, is that one of the most important factor leading to the outperformance or is it the exploration of new sites?

It's a, I think obviously markets like this are complicated, Alex. It is a favorable factor but obviously we've made a lot of focus commercially in the marketplace with the reinvigorated sales and marketing initiatives.

I think that's where we're getting the near-term affect and obviously in the marketplace we have other favorable variables such as the increased requirements for pipeline inspection that drives both short and long-run pipeline inspection business. So we do notice that in that marketplace that's a variable.

But again, you look at other segments beyond just oil and gas into seismic and oceanographic and we also see those increasing because we're making the investment in the sales and marketing presence in the marketplace.

Can you be any more specific about what those new marketing initiatives are?

You know, I think we've increased, I'll give you the simple ones. We've put a lot of focus on, you know, increasing our presence of sales representation in the field. We have direct sales, an increase in terms of the headcount internally.

We've initiated market initiatives to more actively call on customers and drive programs and value drivers for them in doing business with us. There's more customers in the Commercial side than there is in the Medical side so there's a broader landscape. We've been very active into the marketplace selling our value and our services.

Can you say what the headcount was before and what it's gone to?

There's been a net increase. We went, you know, in the Commercial Power business to about five or six direct people and then we're in the process of engaging our value-added resellers as well as representation in the field to extend our sales and marketing coverage.

And then also we're using management and executive time to actually go out and visit customers and look for creative ways to expand business with them. So it's more than just a head count of the sales itself, it's really broad scope.

Okay. That's helpful. And the five to six was up from none before or from one or two before?

It was a couple of people in that row before but we've not only increased the headcount we've also increased the resource allocation and obviously the expectation for it as well.

Okay. And then as far as the compliance with the Pipeline Gas Act of 2002, is that a process where we're part of the way up to compliance and there's still more compliance updating that the customers have to do, or at this point are we pretty much in compliance and now it's more of a steady state?

[Inaudible] the level of compliance at the industry in general other than, you know, clearly there's been a change in the number of inspections. The tough thing to deconvolute, Alex, is that there's a short-run market and a long-run market in pipeline inspection.

We're very focused on the long-run market and we think there's a lot of opportunity for us in the short-run. There's a lot of customers we still can actually go out and sell our technology to. So we take the opportunity beyond just what the industry's going to do is just good for us in general.

And of course when Tom says long-run versus short-run, he's talking about the length of the inspection as in miles or kilometers, not in a time frame viewpoint.

Ah. See that's something that at least I have absolutely no background in. How many miles does it take before it becomes a long-run type of --

Probably more than a couple hundred miles.

Yeah, it --

Obviously we're talking about inspections that can cover hundreds of miles in total.

And this is a pipeline inspection gauge, the PIG product?

It's --

That's correct.

I don't know if you saw the old James Bond movie a few years ago but it's literally a thing that looks like a space capsule and some of them are quite large. And historically on the long-run, which again is, can be hundreds of miles, we've been pretty much the market share leader as in very high market share, 80% plus.

And on the shorter run, some other types of technologies have been used but we are more closely matching up some of our newer product initiatives with those requirements as well. So we do, even though we've already had very high market share in the longer run, as in length of run, we do have an opportunity to gain share in the shorter length of run market as well.

How many inspections occur before a battery, before your device needs to be rebought and do they use it over and over again for --

It's really highly variable. It depends on the user, it depends if they want to deplete the battery fully or if they only want to do a partial depletion.

So it's, the length of the runs are variable, the measurements that are taken during the runs are variable. So it's, you only can do general trends, not, you know, because the specifics are too variable.

This is one of these types of markets that we really like because relatively speaking, the costs of the battery is a very small part of the total cost of providing the service and the cost of failure is very high. So that means that people are willing to pay a premium price for the best and most reliable product, which happens to be ours.

Okay. And the fact you've calculated 80% market share, that means you have a calculation of how many total long-run pipes there are in the country or --

Well, we think we know how much battery purchasing there is worldwide and so that's, we're going on it on that basis, on a revenue basis when we talk about market share.

Have you said or would you say what your ASP is roughly for each of these batteries?

Again because it's all over the map, Alex. These are battery packs and some end up, you know, the system, depending on the system, it can, the number of individual cells that go into the battery pack can vary dramatically.

They're all customized products.

Yeah. And it's all customized.

Okay. Great. Thanks for that primer on batteries.

And your next question will come from the line of Aaron Lindberg of William Smith. Please proceed.

Hi. Just a couple quick questions. Have you commercially shipped any QMR or QHR product or only qualified cells?

We have QMR products in qualification with the customers right now but we have, the QHR cells are shipping commercially. QMR cells are in customer qualification but not shipping commercially.

Okay. And is there currently a backlog in Commercial orders?

Yes.

And will you comment on how long that might be?

No.

Are there any backlogs on the Medical side of the business?

Is there backlog.

Yes, yes, there is.

And across customers and products?

Yeah.

Yes. It's very --

It's broad.

Okay. I appreciate it. Congratulations.

Thank you.

Thank you.

Your next question will come from the line of Keay Nakae of Unterberg. Please proceed.

Just wanted to follow-up on a comment you've made at least twice on the call, Ed. That's your comments about the inventory levels and your belief that we'll see perhaps a normalization of that in '06. What gives you the confidence we won't see that perhaps as early as Q4?

I didn't say I didn't think we would. There's a possibility we could see some corrections in Q4. [Inaudible] there's some possibilities that could happen, but we don't have any visibility on that right now.

Okay. So other than you're rolling 12-month forward plans that you get from your customers, no particular insight of where that inventory normalization might occur?

No. We cannot tell right now.

Yeah.

And to what extent it might have.

Yeah. It'll be an unknown until 2006.

Okay. Great. Thanks.

And your next question will come from the line of Glenn Reicin of Morgan Stanley. Please proceed.

Hi, guys. Just some clarification. Two things. On the SG&A line you mentioned some sort of an incentive compensation impact in the quarter. How does it, I didn't know you had quarterly bonuses.

That's not it, Glenn. We true up our estimates with the full-year on a quarterly basis.

Okay. So can you give us an idea for the full-year how much incrementally you're going to be spending on this?

We're not going to guide to individual line items, Glenn.

Okay. Then for SG&A for the year what are you thinking in terms of total spending?

I don't think we can guide on that line item.

Okay. Secondly, you mentioned about your guidance in the third quarter and the back half of the year you're, it sounds like you're being relatively cautious because you just don't know about the whole issue of stocking but the real, it strikes me that the real impact from guidance should begin in the third quarter, you know, thinking that they didn't really, you know, in terms of the building, the building of inventory and the like, I would assume you could not have turned around. If they pulled the product, renewal three and four, if they pulled the product in late June, like June 17th, you would not be seeing the rebuild orders until July and August.

Yeah. It, you know, we understand the logic, Glenn, but just don't have any information on the granularity, you know, to that.

Hmm, okay. And do you have any sense whether some of your customers may have built cushion inventory knowing that the Alden move was taking place or knowing that you have a, you know, several moves both on capacitors and on enclosures?

Well, I think through logical deduction we can draw that but, you know, because it's inter-mixed with just the general flow of business, you know, we really don't have information on what piece represents what.

Right.

And the most we can look at is just quarter-to-quarter, what's changing and try to draw conclusion from it and that's, you know, really the limit of what we have.

Okay. All right. Gave it a shot. Thank you.

And that does conclude today's question-and-answer session. I'd like to turn the call back over to Tony Borowicz for closing remarks.

Great. Thank you. I know we had a number of calls still in the queue but we ran out of time.

Thanks, everyone, for your participation and we'd like to remind you that the audio portion of this call and the slide visuals will be archived on our Web site at greatbatch.com. Thanks, everyone, for joining us.

Ladies and gentlemen, we thank you for your participation in today's conference. This concludes the presentation and you may now disconnect. Have a great day.