Merit Medical Systems Inc (MMSI) 2013 Q2 法說會逐字稿

Good day, ladies and gentlemen, and thank you for standing by. Welcome to the Merit Medical Systems Incorporated Second Quarter 2013 earnings call. During today's' presentation, all parties will be in a listen-only mode. Following the presentation, the conference will be open for questions.

(Operator instructions)

I would now like to turn the conference over to Chairman and CEO, Fred Lampropoulos. Go ahead, sir.

Good afternoon, ladies and gentlemen. This is Fred Lampropoulos. We are assembled in Salt Lake City with our general staff. We appreciate you taking the time to visit with us today.

We have an exciting story to tell you, but prior to that we are going to let our Chief Counsel read a statement that you are all excited to hear. Rashelle?

Thank you, Fred. During our discussion today, reference may be made to projections, anticipated events or other information which is not clearly historical. Please be aware that statements made in this call which are not historical may be considered forward-looking statements. We caution you that all forward-looking statements of risks and anticipated events and uncertainties could cause our actual results to differ materially from those anticipated in such statements.

Many of these risks are discussed in our annual report on Form 10-K and other reports and filings with the Securities and Exchange Commission available on our website. Any forward-looking statements made in this call are made only as of today's date. And we do not assume any obligation to update such statements.

Although Merit's financial statements are prepared in accordance with accounting principles which are generally accepted in the United States, GAAP, Merit's management believes that certain non-GAAP financial measures provides investors with useful information regarding the underlying business trends and performance of Merit's ongoing operations.

The table included in our release, which will be discussed in this call, sets forth supplemental financial data and corresponding reconciliation to GAAP financial statements.

Investors should consider these non-GAAP measures in addition to, not as a substitute for, financial reporting measures prepared in accordance with GAAP. These non-GAAP financial measures exclude some items that affect net income.

Finally, these calculations may not be comparable with similarly titled measures of other companies.

Rashelle, thank you very much. And, again, ladies and gentlemen, thanks for joining us. We are pleased to be able to report today what I believe to be significant improvements and a further explanation of our profitability plan going forward.

One of the things that I will refer to most of my discussion and comments today will be in relationship with the results of the first quarter. And although we were required to compare quarter-to-quarter a year ago, I would remind all of you that there have been a lot of changes since that time.

We've had the introduction of the Affordable Care Act and the tax -- the 2.3% tax. Merit has made the largest acquisition in its history. We have shut down a facility. And we have started up a brand new facility.

And so most of my comments will be made as to the first quarter, comparing those, and then moving and talking about where we're going to go from here.

The first thing, of course, I would like to point out is the substantial improvement in gross margins. What we have discussed in the past is that we believe that Merit has an [opportunity] with the investments that we've made to be able to improve our gross margins approximately 60 basis points per quarter for the next six quarter, or year-and-a-half.

That's a very, very aggressive prediction, so to speak. That's 360 basis points that we should be operating at by the end of 2014.

Now, fortunately, this quarter we exceeded that. I would remind everybody that you shouldn't assume that we'll do 140 basis points, but that our plan is in place. And we believe that we should see those opportunities. It will have to do with increased market share, our product mix, and just an overall reduction of expenses and new product introductions.

Then we'd like to move down to the SG&A expense line. And once again, quarter-to-quarter from the first quarter, down 220 basis points. In just a moment I'll have Kent just briefly discuss some of the issues that may have been period-oriented like some of the expenses that were in SG&A that will now move to the gross margin side. But I'll just make a couple more comments and then have Kent kind of discuss that.

R&D expense was down 90 basis points compared to the first quarter. And I think we were able to do this, ladies and gentlemen, while reducing our inventory $3 million. So let me talk about that for just a second.

While we were moving, shutting down a facility and making sure that we had no disruption to our customers, we still reduced inventory $3 million. We continue to believe that as we get leaner, as our automation goes into place, that there's even more opportunity to reduce these inventories as we grow our company.

So it'll be one of the things in terms of cash management, obsolescence and other issues that we feel very comfortable about.

The other reason I think it's an important metric is that as we go back to last year and we looked at the third and fourth quarter where Merit was building inventories, actually, for most of the year, up until the third quarter. We disappointed shareholders when we had to slow production down because we had too much inventory. And we had those negative variances for the fourth quarter, some of which carried over into the first quarter. Those variances are essentially gone.

So, Kent, what I would like you to do is just briefly comment on variances, where we came from in the first quarter. And then maybe talk just briefly about the SG&A expenses and any adjustments that we could see as we've moved into the new building, and where they would be allocated. Will you comment on those, please?

Well, first of all, just following up on what you said about the variances. With the slowdown of production in the fourth quarter, and somewhat in the first couple of months of the first quarter -- January and February -- we were underutilizing our capacity. But as we've moved into March and the following months up through today, including this month of July, we're doing much better at meeting the standard costs of [applying] overhead and actually exceeding them in many places.

So that not only relieves the drag we've had on the negative variances, but we started to actually pick up some positive variances in some of our operations. And that's one of the biggest effects that were dragging us down -- now has been relieved.

The other things that are going on has to do with the move. There's some inefficiencies and lost productivity when you shut down a line, take those personnel and resources and move them into setting up and testing and re-qualifying a production line. And that, while it's non-productive, gets reclassified as an SG&A cost if it's not being used to build products.

So for a short time here we've had some outside costs of $200,000 or so of actual moving people and the logistics of that. And second, we had a reclassification of $400,000 or $500,000 in the SG&A which will now be back in the cost of sales when you see the third quarter numbers.

Kent, thank you very much for that explanation. Let's talk a little bit more about some ongoing expenses that we will have. In shutting down of the facility, we have essentially one more month of rent. And that'll be the month of August. After that point, there will be a reduction of expenses of approximately $90,000 a month going forward that will, of course, help to offset the increase costs of our new facility.

Kent, you want to comment on that?

We are already seeing some of those cost reductions by not having to do the security level, the cleaning, the maintenance. Utilities are already dropping before the rent end, because we're out.

Okay. So that will give us more momentum moving forward in terms of costs.

We have a number of new systems. Some of you have been here and have seen of the new automation systems where we don't have to truck materials. They go directly from the molding area and other players to the replenishment center and right into production.

We expect that we're going to see dramatic increases in productivity in our business. And that we will see substantial returns in the future as we move forward.

It is not going to happen overnight. The third quarter will still have some of the drag of this expense that Kent just discussed that was in the second quarter for the full quarter. Some of that will be relieved and be totally gone by the fourth quarter.

We're also bringing this new fulfillment center online on or about August 15. And so we will have almost a quarter-and-a-half of that expense and not the productivity. And it will take us some time to be able to work out the wrinkles there.

But by the time we get into the fourth quarter, then those should be pretty well worked out. And then we'll start to see substantial increases, we think, in that productivity and the movement. And, candidly, a lower headcount because we won't need the people that have been doing the things in the past. That part will have been automated.

So we're, I think, enthused about the campus and how we've been able to consolidate. And let me just say that it wasn't easy. We've been trying to move from our 45th facility where we started 20 years ago.

But I want to commend this staff for the work that they did. Literally, we came in about $500,000 under budget. We came in five weeks earlier. And we had no disruptions for customers. That's a big deal. And I want to express again my appreciation to the staff.

Now let's mover over if we could for a second to the sales side. I suppose if there could be a criticism it would be on the sales. If you take a look at our business, we had 9% business overall. And we had some uptakes and some downtakes -- downdrafts, so to speak.

I'm going to have Kent go through some of the ups and some of the downs. And then I will comment on the specifics of those. Kent, you want to go ahead and discuss that?

Yes. I mean, some of the strong things we've got -- we can look at it as products or as geography.

I would like to look at the departments that you and I looked at earlier on that --

So we've seen really strong growth in the international areas, for both the European distribution, as well as some of the Pacific Rim and those areas. We've seen growth rates -- I'm just looking for them here. Oh, there we go.

So we've got growth rates outside the US For example, the Pacific Rim type dealers are 18% growth. Japan's at 10%. China, our direct sales, is 28% growth. And as well as the European distributors are up in double digits -- 25%.

So the problem this summer is we've had some downers as far as some of our core OEM business is off. The [kyphon] business is down significantly. It's off 84%. So that one, we've been telling people --

And just to interject, that's something that we expect to essentially go away.

That's right.

But I would also say that we also provide for the products they are building -- sensors and other products -- on that site. So just finish up with a couple more, Kent.

So, anyway, those kinds of things that reduce and offset some our growth. And so we've ended up with a slower than expected growth rate in the core business.

Yes.

Although we've got some products, both acquired and coming on, that have been strong and look good in the future.

And we have some very hot products. Our hydrophilic guide wire. Our Laureate is up substantially.

269%.

269%. And I think at the quarter, we were up $1.2 million in new growth -- our micro catheters. All of these are relatively good margin products. A number of products -- our radial access products as we start to see that shift.

So we are confident that what you're seeing is a temporary. We'll see probably the same type of performance on the core business, mostly coming out of the United States, which is the slowest area. And be reminded that as we move into this third quarter, it is our slowest quarter of the year because of the seasonality, particularly the seasonality in the areas that have been the highest performers for us.

But we will see that typical slowdown that we've reported for 25 years in that seasonality. And then it'll start to accelerate in the fourth quarter and going forward.

Let me talk about another point, though, that I think is very, very significant. So part of what we did -- many of you will recall that we had downfall of revenues in the first quarter based on the fact that we did not receive any orders from a large OEM customer, out of Thomas Medical. We received and order and shipped one in late December. And then we didn't really see anything after that. And that was a surprise to us.

However, I am pleased to say that from that customer we actually recently received an order. And although I don't believe that we're going to go back to those levels, at least tells me that there's still interest in that product and opportunity.

And I will also tell you that we are in the final throes of negotiating what we think is a major opportunity for one of our products on an OEM basis and which we have a forecast of about $4.5 million. This is coming out of our Thomas Medical.

Now, hold onto that $4.5 million for just a second. In addition to that, during the first six months of the year, and on a basis that each month improving sequentially -- January, February, March -- and each number going up -- we've been able, on an annualized ramp basis through the first six month produce about $3 million of ramp sales that were in our stand-alone [sheet] formerly OEM.

We believe that that will accelerate on an annual ramp basis to about $6 million by the end of the year.

If we take that $6 million that we believe will now be direct at higher margins and add to it this new opportunity that will be in 2014 for another $4 million, it is my belief that the $10 million that we lost will be made up. And on a ramp basis going forward into 2014, we will have made that up.

In addition, a number of the Thomas products have been now private labeled. And when I say private labeled -- Merit labeled. So our transseptal needle, our coronary sinus guides, and we expect sometime in the very near future -- in the next 30 days or so, I hope -- receive approval -- a second approval from the FDA. We've already received one on one of our steerable sheaths. But some modifications were made. We filed a special 5-10K. And we hope and we believe, to some extent, that in the next 30 days we'll have that approved.

There is a lot of momentum in the Thomas Medical. And although we hiccupped, we took some steps back, it's my absolute believe that as we move into the balance of this year you'll see that ramp rate, which is right now around $30 million, based on about $2.5 million a month with these other opportunities and this continued focus on the direct effort by our US sales force, we'll see that move back up into the areas that we had previously forecasted.

So we would have been a year off. But I think we've made a lot of ground. Now the reason I'm saying this is we like this business. We think it has great opportunities for Merit. And we also like having a little less exposure and having more control in terms of having some of those products go direct. And we think that we're on good track for that.

Our sales force -- and this is the point, after all this stuff that I'm really trying to make -- our domestic sales force spent a substantial amount of time in the second quarter, which I think is evidenced by the month-to-month increase in orders in working on transferring that business directly to Merit. And they'll continue to do that at higher margins.

So one might look and say, "Well, you would have been at this number core," most of which was taken down because of OEM and slow domestic sales and [kython]. But if you look at the other markets that don't have the device tax, we are doing substantially better in the Middle East, Russia, China, Central and South America. And, unfortunately, we have those going up and these other ones are detracting. But we think that there's opportunity to move this forward.

The point is the US sales force spent substantial time promoting that product under our direct sales. And I hope you will not just separate the core and the overall growth of 9% because it's probably somewhere in the middle if you add that extra ramp basis they've come up with.

And that's how we've constructed that because we thought those were the sales that we wanted to kind of bring home and make sure we could make up that difference from the shortfall.

Kent, you want to comment?

I was going to comment on the strength of the international businesses moving now to 37%. In fact, for the month of June, it was 45% of our revenues were international. Part of that is quarter-end shipments. But it's still interesting to see how strong that is.

I didn't realize that, Kent, that it was 45%. I figured it was 39% or 40%. But that is extraordinary. I think that gives us an advantage going forward. And we're doing better and better in these locations.

We're also, over the next few quarters, we will be opening up with a modified model in Turkey. Also, probably for early next year, in Switzerland. And some of these models that we have used in China, Brazil, in Russia, India and the UAE have worked out very well. And those decisions, which did have a cost to them, are now paying what we think are very, very handsome dividends.

Let me move on to some of the new products and discuss those because I think those are also important in terms of the momentum that we see coming.

One of the products that you've heard me talk about is our basixTOUCH. And there's no doubt that, in my mind and I think in minds of a number of new customers, that it is the best inflation device in the world. Now why is one device something that we talk so much about?

Well, the fact of the matter is Merit is the world leader. Merit has well over $125 million in various forms or another coming out of this product line, whether it be for esophageal dilatation, whether it be for coronaries or peripherals with several different product platforms. We spent a good 18 months and substantial resources to develop basixTOUCH.

Because of the success that we've seen in Europe, and the distribution, we are seeing substantial take-up of this product to the extent that we are essentially selling everything we can build. Everything we can build in this product is being sold in Europe, in the Middle East and Eastern Europe today. We've even received orders from Japan. We've received orders from Mexico. It's just getting started.

Now what are we doing about it? We have a second production line that will be up and running, I think, in the next 60 days. Guys, is that about right? About 60 days? Okay. And then we have the ability at that point to go a night shift. We'll be able to produce about 40,000 a month when we're fully staffed up on this. That will generate somewhere around $15 million in revenues.

This is a hot ticket. It's a great product. There's nothing better. And when we combine that product along with our hemostatic valves -- and, in fact, a new hemostatic valve called a PHD -- we expect that we're going to see substantial growth.

I will also say it's kind of just in time. And that is we've seen kind of a flattening of our inflation device business and this is the perfect time to regain the momentum, particularly when our competitors really aren't introducing any new products that we're aware of. So that's one product that you'll be hearing a lot of along with some of the others.

Additionally, we expect to introduce, sometime late this year, possibly early next year, our PreludeEASE Hydrophilic Radial Sheath.

Now, as many of you know, years ago there was very little discussion about radial procedures. To go to Europe, Japan, Scandinavia -- any of these areas -- the procedural rate will run anywhere from 40% to 80%. There's, I think, ample data to support that there's better mobility, no more morbidity, and certainly no more mortality. It is a product whose time has come.

Merit has grown that business. It's well over 100% growth this year. It was over 100% last year in terms of our current product line. But this is a hydrophilic product. And we're very excited about its introduction. Particularly where the United States has gone from that 3% that we discussed to somewhere around 16%.

There are some who say that it will be 40% to 50% in the next five years. Think about that. Think about essentially half of the femoral procedures or approaches in the United States going to these products.

In addition to the sheath there are all the other products like the wires, catheters, guide catheters and other products that Merit makes that will, I think, also see substantial opportunity.

And of course, along with that, once you have that presence with inflation devices and sheaths and guide catheters, then you also see the kits, the trays and all the rest of the business come along with it. So we think that's a great opportunity.

We also will introduce -- hopefully later on this year in the fourth quarter -- our ASAP LP catheter, which is an Aspiration Catheter. We're very excited about this. We're doing very well with our ASAP. We think the LP will have to enhance -- in fact, we would expect a substantial -- almost a doubling of revenues in that whole product line the first year based on this new product. And so we're very excited about ASAP. Kent?

Yes. This first quarter -- I mean the second quarter was up 121%, added $645,000 in revenue.

Yes. So we're excited about it. I'm telling you stuff, folks, because, although it's slow, I believe that once we come through this third quarter, which will be the slowest time of the year, you're going to see growth resume at very high levels -- I would say higher levels -- let me say that -- as well as the resumption of sales that we'll see.

So although you might look at these things and see something differently, I think that as we look at the staff, we can take a look at the products, the distribution. And there are many others. There's another five or six products that will be coming out. And we could go through all of those. But we have a full pipeline that we've talked about. But I think we've hit the highlights of the ones that we think that will have the biggest opportunity.

In summary, we are doing better. We're just getting started. We realize that we have been laggards in terms of operating profits and creating shareholder value. We have restructured the Company in many ways so that our attention is on efficiency, reducing costs, introducing new products and really getting our operating margins well above 10%.

You saw the substantial improvement just between the first and second. And although I know one month does not a trend make, in the month of June our operating margin was around 9.2%.

So as we think as these expenses come off, we absorb more, we introduce these products and move through this third quarter that we're going to start to see the kinds of returns that I think all of you are interested, and certainly we are in terms of establishing shareholder value.

So I think that's pretty well it for me. I think you're probably tired of listening to me. But we do have a plan. We don't want to just be in here just jabbering and just talking about how wonderful we are.

We're not performing at the level that we're capable. We have a plan in place. We're focused to those efforts. We have the investments in place. We have the products in place. And we want to make you money. We want to make money. We want everybody to do better. And we're committed to do that. I know the staff is. And we have a plan in place to do it.

So talk is cheap. The real issue is I think we've done exactly what we said we would do between the first and second. And even though we were a little disappointed on the sales side, going forward, we have the products, the distribution system and the capability to manufacture.

So with that said, I think we will go ahead and turn -- Kent, do you want to comment at all on anything?

Just summarizing the high points. I was pleased with the inventory dropping $3 million since the beginning of the year. You mentioned the gross margin improvement. The SG&A drop is ahead of schedule now as far as we move forward. And we've seen a drop in R&D we didn't mention. So there's 90 bps there that we've also accomplished. And all that comes into this operating margin you've been talking about. So those are the things that I think are really good accomplishments for this quarter.

Okay. All right. Well then I think it's Chad. Chad, if you're out there, let's go ahead and turn it over and line them up.

Thank you, sir. And we will now begin the question and answer session. (Operator instructions). And our first question comes from the line of Tom Gunderson with Piper Jaffray. Please go ahead.

Hi. Good afternoon, everybody.

Hi, Tommy.

So just -- Kent, maybe just to start off, maybe we could -- if you said it or had it in the news release -- could you just break out overall revenues for Q2 between US and OUS and the organic growth rate for the US and the growth rate for the OUS?

The overall revenues for domestic is $69 million -- and 69.0. And the international is $40.8 million. And that percentage -- I'll calculate quick. I just don't have it handy. I know what the split is. It's 37% (inaudible) the international. Let me get the growth rate for it. Just a second. You can ask another question if you want and I'll come back to you.

Okay. And then, Fred, last quarter -- Q1, I believe, was the first quarter that [Endotech] was profitable. I noted in your press release that the sales were' up nearly as much. But I'm wondering about the profitability for that was in Q2?

Tom, thanks for the question. And I'm happy to answer it because just prior to this call we had the discussion. If we were looking for the six months -- and we'll just talk through the six and we'll talk for the quarter -- but I'm going to do the quarter and the six.

The profitability on lower than expected sales. I was say that was one of the areas that was a little bit slower. For the three months was about $129,000 versus a loss of $250,000 last year. For the six month period, the profits were approximately $255,000 versus a loss of $592,000.

Now one of the other things, Tom, that you'll see we are just now starting to utilize those lower cost stents. As you'll recall from our conversation previously, we changed vendors. And it was a savings of somewhere between $1 million and $2 million, depending on the mix. And since the sales have been a little bit slower, we didn't use it as quickly as possible.

But as we move from this point out, by the time we get in, I think, the fourth quarter -- which is not very far away -- we will have utilized, essentially, all of those stents through the end of the year. And then the lower cost. So the margins will kick up pretty substantially and the profits will continue to improve in this division.

We also, just as a point of interest, have filed for our IDE on our Endomax [DVT]. This is our valve esophageal stent. This is a significant product. We expect to have the CE mark on that product by September of October, and we'll start selling that product in Europe at that time. It's going to require a small study and a 5-10K with the study in the US.

We also will be launching later on this year our pulmonary dilation balloons that go along with our [Big 60]. And then we'll be ramping up other balloon products in that product line through 2014. So we do have a product pipeline. And we have made, I think, substantial improvement.

The growth rate for international business was 12.2% for the quarter, and domestic was 7.6%.

Got it. Thank you.

That includes Malvern, of course, in there. In the domestics primarily.

Right. And then on -- not much on international, right, for Malvern?

Very little.

Got it. Last question and I'll let some others get in here. And that is can you give us an update on headcount. Q1 there were some reductions. I don't know if that -- if you did it all at once or whether it's going to continue through the year. But can you give us an update where you are at the halfway point?

Yes. We have not reduced headcount. In fact, just the opposite as we built some of these production lines and we include the automation -- remember, we've been in the new building about -- let's see here -- maybe less than 45 or 60 days.

Now with the new automation coming on line on or about August 15, that's when we will start to see a trimming of the sails through then and the balance of the year. So that's when we'll start to see it.

At this point, we've had people moving, extra people setting things up, staffing these production lines that we've said. And then now with the stuff coming in now comes what I would say is the most difficult part. But it's less than 30 days away as we start to trim.

Got it. Okay. Thank you.

Thank you, sir.

And our next question comes from the line of Jim Sidoti with Sidoti and Company. Please go ahead.

Good afternoon. Can you hear me?

We can, Jim. Good to hear your voice.

Great. Can you break out any one-time costs in the quarter, start-up costs related to the new facility? I guess there was no severance if you didn't do any reductions. And what the inventory step-up charges were?

Yes. There was very little in the inventory step-up charges. We've had some moving costs. Let me go over a few of those for you.

There was severance in the quarter of $266,000. And a little bit of an acquisition cost for $27,000. And we've had -- wasn't it about $700,000 in moving costs? Those were probably reallocated. But they're not long time charges like I think he's referring to.

Oh. Okay.

And then we had a little bit of debt issuance charges long term that we've --

Anything else --

-- $250,000 --

It's not a lot, Jim.

So maybe about a $500,000

Yes. Those adjustments in our non-GAAP. Yes.

Okay. And I just want to be clear now. It sounds like you continue to have some of these transitional costs in the third quarter as you shut down the one plant and start up the other.

Now, starting, as we get into the fourth quarter, those costs should be gone. Will there be any new costs that will enter the equation now once that plant has started up?

Well, let me come back to the first one. The reason there are some costs in this quarter, even though we've moved, we had a notice of six months. We gave that as we were engaged in the time. We now have moved. And as I mentioned, we are five weeks early. And we're in the building. So those costs will come off starting the first of September -- the majority of the costs of the other building.

The only other thing I can think of that we'll have to think about is we do have this new fulfillment -- the [domatic] system in our facility. As that comes into play, that's going to go on the depreciation schedule. So we will go from the development to depreciation, which will be some costs associated with that.

But that's amortized over 15 or 20 years. I don't want to say in the noise. But there's about $6 million or $8 million of that. So we haven't looked at the cost that'll add, Jim. But that'll be some expense, probably almost over 20 years. And there'll be both the book and, of course, the tax issues on that.

But that will be one cost we'll add. I think all the other costs are in place. And I think, if anything, we should see those counts and there's sufficiency that where the biggest opportunity for us is to reduce costs, now that everybody is here.

Okay.

And you know -- And I don't -- Jim, I just want to say that -- again, maybe I'm overstating this. But, you know, it's like playing baseball without making an error. You know, we made a lot of mistakes. And we've done various things in our business careers. But we executed with almost perfection the movement of that facility.

Remember, this is automation equipment, 85,000 square feet and 150 employees. And, again, we did extraordinarily well. Kent?

Actually, more than that, because we moved almost everything from this building over, too. It had to be taken down and reset up. So it was a big operation.

We did a great deal. And we did all that in this quarter. And so we're pleased with that. Other questions, Jim?

But you're saying that that cost -- all that cost is about a half a million dollars, all in?

Yes. For the quarter. There were other costs associated with moving and rigging in the first quarter, and stuff like that, as we were bringing it over and setting things up, and qualifying. Remember, these things all have to go through the whole process of certification once you move them. So rigging them up. So those costs, I think, in the first and second quarter we're probably talking about --

About $800,000 total.

About $800,000 in the first six months that won't be there going forward. Plus the additional offset of the rents, which were about $100,000. So that's another thing that will drop off and help to offset some of the higher costs of depreciation of the building that are already in the results that you see.

Okay. So the third quarter will probably still be a little messy because it sounds like that's when you'll start -- you'll have some more severance expense and you'll finish your transition. And then the fourth quarter, I guess, will be our first look at what -- the new Merit is going to look like with just this one facility running. Does that sound right?

Yes. If you want to call that the new Merit, I think it's fine. But I think, Jim, I hope you'll give us some credit for this quarter and where we came from the first quarter. And in these improvements in these margins. They don't happen magically. They happen because we focused on the expenses and all sorts of things.

But if you're talking about that fourth quarter, you're right. All of this stuff will be off. The thing will be through the summer slow-down. The systems will be up and running. And then you'll start to see a reinvigorated, a leaner, a trimmer Merit as we move through with these new product introductions and with these new facilities. So, yes. Yours is probably a fair statement. I'd just like the way I said it better than you.

All right. So then if we look at the fourth quarter -- and that's typically your best revenue quarter -- do you think you'll get back to a double digit operating margin?

That's our goal.

Okay.

That's our goal. Like I said, in June we did 9.2%. That's our goal. That's a very steep goal to go from 5.7% or 5.6% this quarter and double that.

But I will say that you will see sequential improvements in our operating profits. And we believe that we have the capability to do double digit. Whether it all happens in the fourth quarter as we're launching these new products and those sorts of things -- and they're launching in a big way. I don't know that I'm willing to stick my neck out, but it'll be better, in my view, than what we saw this quarter. And the next quarter will be better than that.

So we will continue to make improvements quarter-by-quarter gross margins, operating profits and the things that affect those profits -- SG&A, R&D, and so on and so forth.

Incidentally, one thing that you did say that I want to correct you. We're going to do as much as we can in terms of attrition and other types of things rather than having large amounts of expenses with trimming.

Okay.

So we had some pretty big expenses in the first quarter -- some of those -and in the fourth quarter. And some of those were management changes. They will be substantially more modest going forward.

Okay. How is the size of the sales force been affected, you know, from the recent challenges you had in the first and second quarter? Have you maintained the same size sales force that you had at the end of last year?

We're down one.

Okay. So that includes the additional people with Thomas?

Yes. I mean, they only had one sales guy.

Okay.

So remember, they only had one sales buy. And it was all OEM. But we are down one sales person. And that's almost -- and that's just transitional stuff. That's the essence of it. It didn't have an effect.

Do you think that you'll be ready to start adding again by the fourth quarter? Or do you think you're going to stay at this level for a while?

You know, I think it would be disingenuous to say that we're go out and grow the business at substantially higher levels without adding some sales force. But I can say that we can do that and still maintain a lower SG&A expense as a percentage of sales. So I can say that. But we will start adding some.

We do not have a plan that goes out and adds substantial amounts of sales force or anything like that, other than one or two here or there. Or three or four. But it's a percentage of sales. We'll still be able to get that leverage.

We're going to have to -- you know, if you get those sales going up on these new products, it becomes harder and harder. And more and more opportunity. If we don't do it, we'll lose opportunity. So we just have to manage that. Kent, you want to --

I'd say most of the increases in headcount by numbers are actually internationally. Unfortunately, in many of those markets -- India and Brazil and some places -- it's less costly per (inaudible), and China, as well. So those are where we've added some more, I think, in international more than anything this year. And probably next year.

And listen, the international markets for Merit products is hot. And, you know, whether it be the UAE, Russia, China, India -- I think we're up 150% when we put this new model in. And that will continue to grow. So I think we're positioned very nicely in what I would say most people say is a pretty tough market.

So I think this basixTOUCH, some of these products that we're talking about, looking at these radial procedures, which is one of those areas in interventional cardiology that's growing very, very nicely. I think we're in the right areas. And I think we -- you know -- EP. EP is still growing in the low double-digits. And with our products, it's part of what's driving this order this transseptal needle and some of these other products. So I think we're in the right place, Jim, in terms of the product mix that we have.

Okay. Then the last question. Specifically in China, can you just give us an update on how your sales are doing there? And how many products do you have approved at this point? And what direction that's going?

Yes. I'm going to comment just a bit and then I'll ask Joe Wright who has responsibility.

I will say that our direct sales force, direct sales in China are up around 28%, give or take. We have seen, when we went through this transition, we did have some OEM customers, our large distributors, those have dropped dramatically. (Audio gap) Merit's direct business has improved.

There are two significant things. I'm glad you mentioned this, Jim, because I failed to mention them in the press release. We did send another separate press release a couple of weeks ago.

You know, we have approval for [EmboSphere] and our QuadraSphere in Japan. That's significant. We received our first order of $1.6 million for that account. We just received approval for the EmboSphere in China. And we've received in in Colombia and a number of other places.

But that's good because that's kind of -- the embolic business has been a little bit slow and some of these procedure rates have fallen off.

The [boss] introduced PVA. So we have a new embolic on the market. And we expect that by early next year or mid next year, we'll have at least one, and maybe two, new embolic products on the market.

So that's the best way -- and I hadn't mentioned those in this presentation. I think those are important to know that with these two areas, which are the two largest areas for usage of this kind of product, are pretty significant.

Joe, you want to add anything. Anything to dangle over India, China. Joe Wright.

We have about 250 distributors now in China so we continue to add field people to support that business. We've grown in the tier one cities -- Beijing, Shanghai, et cetera. We're now expanding into the tier two cities and we'll continue to do that over the next couple of years.

In terms of new products, regulatory in terms of approval products, [John Norff], our Chief Regulatory Officer, how many products -- ball park, John -- do we have approved? If you can give me a quick answer. I know that's kind of asking you to shoot from the hip. But it's pretty substantial.

John, are you going to speak? Or I'll speak for you.

Well, just this year, Fred, we've had, I think, several submissions in China. We've got three that are currently pending. We had, in terms of approvals this year, seven approvals.

So, year to date, we have seven new approvals. We have three more that are pending and a number that are being prepared. We're probably selling 20, 25 product lines there, give or take versus three or four years ago as we were starting to ramp this, we were selling five or six.

One of the other things that I think that's important, Jim, is that cardiology has been a big part of that. We think it's an emerging opportunity in interventional radiology there -- peripheral, embolic, drainage. A number of other products that we're starting to focus on. And we hope to be able to get another group of distributors.

And that's the beauty of our model there is we can pick and choose the cites and the specialties. And, again, we've been very successful, I think. I would put up our model and our success in China with anybody. At least relative to size. I think we've done a great job there.

All right. Thank you.

You bet, Jim.

And our next question comes from the line of Jayson Bedford with Raymond James. Please go ahead.

Hi guys, this is [Mike Holman] for Jayson. Can you hear me?

Mike, how are you?

Okay. Great. Thanks for taking the question. First, when you look at the Thomas Medical business, what's the -- you talk about going direct more in the quarter. What's the current mix? Where do you expect that to go over time? And how confident are you that you can increase that mix without de-emphasizing the organic business?

Well, as I mentioned in my previous comments, we're on a ramp rate right now through the quarter of about $3 million of selling our classic sheath. That was essentially zero at the end of the year. We think by the end of the year, our goal would be at about $6 million.

We are developing a new product that we think will be best-in-class. And that will be out in about a year to 18 months.

We have also introduced the Worley coronary sinus guide product. We are now introducing -- these are things that are coming as we're speaking. Our transseptal needle under the Merit label. Previously, these have all been sold to other players.

And, remember, that whenever we sell any of these products that there's $2,000 or $3,000 of additional products that are used in these EP procedures and these implant procedures. So there's a lot of pull-through.

And I'll also say we will provide needs for our customers. We will meet the needs that they have. But at the same time, Merit's goal long term has always been to be able to have and control the point of sale. I mean, that's what we've always done. And we have an almost $80 million -- give or take -- OEM business. And a lot of that stuff is stuff that does not compete with us.

But I would say we have a new steerable sheath. We're going to go out and sell that exclusively under the Merit name. That's a $1,200, $1500 catheter used in EP procedures.

We could go on the OEM basis. That's not going to be the way that we're going to do it. We're going to sell it, along with our sheaths, our transseptal needles, the coronary sinus guides. And then we have other products that we are now developing to build that portfolio in electrophysiology and CRM.

Okay. Okay. Great. You've talked about in the past expanding Thomas Medical internationally. I know you said it wasn't much in the quarter. But any timeframe for getting that business outside the US?

Yes. We have just started selling the sheaths in the overseas markets. Many of the customers that are over there are on OEM. But because the sales force has been so busy with the basixTOUCH and these other products, our focus has not been the Thomas Medical products.

Over time, we will do the same things there that we've done in the United States. But as you can see from the growth, whether it be from the Laureate, which is very hot, to our Maestro micro catheters, to our basixTOUCH, to PVA, to other things that we're doing in Europe, we're growing there with our dealers at the rate of somewhere around 15% with our dealers -- 20%. And our direct sales force at about 9%.

So we're focusing on that area as we fill out this product line and the steerable sheath. I think once we have that broader portfolio of products, which we will have, hopefully, by the end of the year, then we'll start looking at that opportunity.

But the basixTOUCH is so hot. And we have a new product called the PHD, which is a hemostatic valve. These are very high margin products. There's a lot of pull-through.

I don't think it's an immediate issue of focus until probably some time -- I'm going to say early next year, mid next year. We have a lot of other -- I mean, the fish are jumping. And we're going to go fishing with the stuff we have for right now.

But the good news is we'll have new products. And we have these things -- I don't want to say waiting in the wings. But we have plenty to sell. That's the good news.

And they're all approved. So these are essentially -- everything we have is CE marked and approved and ready to go. So that's the good news. We don't have regulatory confinements generally.

Okay. Very helpful. And then lastly for me, it may too early to answer this. But you mentioned that the large customer that you lost in the first quarter has come back to some extent. Is there visibility there for recurring orders? Or is it too early to tell?

Well, I think it's too early to tell. And it was a relatively modest -- $200,000 order. But I will say this. And you're going to have to kind of read between the lines here. It's interesting to note that this large other order that I talked about is with that very same customer.

So, interestingly enough, we are, I think, hopefully back in the good graces. And again, part of the reason that that situation fell out had nothing to do with Merit. It had to do with some history and some brewing and a whole bunch of things that we weren't responsible for.

So we believe, over time, there's an opportunity to bring all of that home. In the meantime, we're not counting on it. We're going to go out and we're going to develop our markets in our products.

If it comes, fine. If it doesn't, very candidly and without sounding arrogant and puffy, we candidly don't need it.

What we do need is control of the point of sale. And that's always been Merit's mode. And the other stuff is more ancillary and supportive rather than our primary goal.

Okay. Great. Thanks again.

You bet.

And our next question comes from the line Chris Cooley with Stephens Incorporated. Please go ahead.

Hi, Chris.

Hey, guys. It's actually [Carosh] on for Chris. Just have one quick question. Fred, I think you talked about the third quarter being the weakest quarter. But you also talked about kind of sales being adversely affected this quarter. Are we still looking for sequential decline for the 2Q in the third quarter?

I would just say, generally, if you look historically you're aware of the issues in Europe. It started this week. The races are on in Ireland. People are heading to the beaches. Germany shuts down. And we have seen, historically, a sequential decline of about 2% to 3% in revenues during the quarter historically.

Now, on the positive side, some of these new products are going to get a lot of take-up and we believe that as we move into the fourth quarter, there's going to be a substantial take-up in growth. And I think possibly even to double digits in our direct sales force. And, certainly, it's already in double digits with our distributors in Europe.

So this is a phenomenon that we see every year. So I don't see any reason why it would be any different this year.

Okay. Thanks.

Okay.

And our next question comes from the line of Gregory Macosco with Lord Abbett. Please go ahead.

Hi, Fred.

Hi, Greg. I'm watching you.

I'm watching you too, Fred. I'm watching you as well. And I'm watching the gross margin.

I just want to understand that 360 basis points increase. I'm assuming that 360 basis points for the six quarters is some kind of low point of what -- 40, 44, 45?

Well, we -- go ahead, Kent.

The low point of 41.4 if you're looking at it on a GAAP basis.

All right. I don't know.

To clarify, it's the first quarter. Which either one you use, it's the first quarter we're counting from.

Okay. So that was -- so the point is we're going to go from about -- what -- 45 to 48.5, or something like that? Is that the idea? When we get normalized? Or what is it? What are the numbers we're looking at for that fourth quarter, first quarter next year, the normalized level?

Like I said, I've got 41.4 on a GAAP basis. So you'd be looking at --

360 on top of that.

-- about 45 almost.

All right. 45. Sorry. All right. And if I look at the pieces of that, some of that is obviously from -- you know -- it was depressed because of the slowdown and all of the things there. It sounds like you're adding, maybe, sort of on a normalized basis, you expect to add maybe 150 -- 200 basis points in total?

You know, I don't understand the question -- 150 and 200 of what?

Basis points. In other words, the increase in the gorses margin from a historic normalized level to a future normalized level. What will that level be, I guess, on a GAAP basis or an adjusted basis? However you want to look at it.

You know, I haven't broken that down to analyze that, Greg. The only thing we've looked at is we hit this bottom point. There's going to be some take-up time and absorption of the building. We have some vacant space here for growth. So we're not operating at capacity.

But as we move down the road, we can see and believe that we should be able to do this over this 18-month period. And very candidly, we should do better than that and continue to do that beyond there.

But at this point, that's as far as I want to kind of talk about what our goals are. I can't have goals out so far that people lose focus of what we need to do today. But there will be opportunities beyond 18 months for continued improvement.

I understand.

Substantially.

Yes. Okay. And would you just help me with the bioSphere? You said that was down in the quarter. What's driving that? What are the changes there? And what are your expectations around bioSphere?

You know, it's interesting that as we look at the bioSphere business and look at our top 50 customers, we haven't lost any of them. But what we're seeing is lower procedural growth. So part of it is just a sign of the phenomena we're seeing in the United States on the various procedures and so on and so forth.

Now, we think that with these new approvals in Asia, that will help enhance it. We have a number of new -- and we'll call them embolics -- that will help to support and enhance those sales. And, of course, we're continuing on with the trial that we're involved in, which we think is going to give us an opportunity in the future.

We grew it very nice over the last couple of years. But we've just seen this slowdown. With Asia, with the PVA and other products and others that we're coming with, we expect that we've kind of seen -- at least my expectation is we've kind of seen the bottom of that. We'll probably be in this quarter again because this is the slowest quarter of the year. And we'll start to see that move forward.

We do have some initiatives. We do have some plans. But I also would like to point out -- because I think that there's some correlation here. The one thing that we've been able to do and one of the arguments that we made for the bioSphere transaction was the pull through. And one of the things that we're starting to do, we saw in terms of our micro catheters growth this quarter, I think was about $600,000 of incremental growth in the quarter, Kent?

Yes. $560,000.

Yes. So about $600,000.

(inaudible) percent.

Now, here's the good news, Greg. We're going to start to produce that product at about half the price that we're currently paying for and produce that in-house starting in the middle of October. And that is a very, very hot product for us.

What that tells me is that we're able to go out and use that product not only with our existing embolics, but we're taking market share from our competitors. And it gives us a tremendous tool to take and bundle our micro catheters, which are about $350 a pop, along with these embolics.

So we're not -- we're disappointed that it slowed down, that we've seen a slowdown this year over last year. But we haven't given up by any means. In fact, we're developing strategies to reignite those opportunities.

And then the last question. You mentioned the study you're doing there for the trial stuff that you're doing in bioSphere. How is that going? And has that -- I assume that a good piece of the R&D budget went up because of that. Have we kind of stabilized here? Or is there more increase coming, particularly from the bioSphere or anything else? Give me some color on the R&D?

Yes. We are going to spend this year probably $2 million -- $2.5 million on our study, give or take.

(Inaudible).

We have, I think, 125 or 100 or so patients enrolled. We still have a long ways to go. But there's a lot more that goes with the study than just the cost. And that is the opportunities to sell other products like these micro catheters.

So we are trudging on down the road. The payday for this is still three to four years away. But at that point, we believe that we will be the only company with an approved indication for these products.

So we believe this gives us a lot of credibility with the customers. And we believe there's good science. And I know a number of people said, "Well, why don't you just stop doing this?"

And the answer is we've sat and surveyed that and talked about that in circles. We just don't think it's the right thing to do, and that the longer term opportunity here will more than pay for the expenses of the study. So that continues to be our position.

Thank you, Fred.

Thank you, Greg. Good to hear your voice.

(Operator instructions). Our next question comes from the line Dale Dutile with the Boston Company. Please go ahead.

My question was answered. But while I'm here I'll just ask the 10% goal you set, Fred, I'm assuming that's GAAP, not the adjusted weight?

That's correct.

Okay.

That's correct. And, again, that's not the end game. That's something, I think, that given over the next 18 to 24 months we will see that we can operate at that level. I think that's the first train stop we want. We will have to climb to that. And it's a big climb.

But when we start to see things like 9.2% in June without these efficiencies, without -- and with some of these additional expenses and so on and so forth, it gives us reason to believe that it's an attainable goal. And that there's more beyond that. Particularly when we're only utilizing a portion of these new facilities.

Without trying to pin things down too precisely, I can look back at your margins -- I believe it's on a GAAP basis -- '07, '08, '09 -- I mean, is there something structurally different outside of the medical device tax, which I understand -- is there something structurally different that would make those historical margin levels either unattainable or irrelevant to the current state of the business?

Well, you know there are a lot of things going on in the business, as you know. There's price pressure. There's all kinds of issues. It's a tough business.

Listen, you've got rep check. You've got buying groups. You've got the government. Listen, it's tough for everybody. I think it's one of the reasons why the investments that we've made outside the US are ones that will pay handsomely. You can see it in our growth. You'll see it in our profitability.

So I think we hit a low point a number of years ago at about 43.3% or 43.1% -- No. Actually. It was 38.3%. And we talked about moving up 150 basis points per year. We were able to do that. And then we took a step back. And we've added some of this overhead.

But, again, as we absorb this, we have higher margin products. And I will tell you that we are spending a tremendous amount of time, both in terms of lean manufacturing efficiencies, automation. And I think we will exceed, even with the device tax, the previous levels that we've hit with markets.

We will absolutely do that. It won't happen overnight. But over the next two to three years, we will meet and exceed. And we will approach that 50%. And we will have our operating profit sitting in the double digits.

So we'll get there. We've got the plan. We've got the people committed to it. And we'll get there. It won't happen overnight. But it's moving n that direction, as you can see form this quarter. And you'll see it sequentially quarter-by-quarter.

Thank you.

Okay.

And I'm showing no further questions at this time, sir. Please continue.

Okay. Well, listen I think we've tried to explain to the best of our abilities the opportunities, the challenges. At the same time, I am reasonably pleased with what we've accomplished. But I am very optimistic about where we can go from here.

We've built these facilities. We needed more capacity. We're out of the building business. We have a few things to wrap up and finish up. But we're out of the building business. We're into the manufacturing business, the lean business, the efficiency business, and the profit business.

And, as I've said to all of you guys, I want to make some money. I don't want [stock]. And I want to make some money. And I want you to make some money. And I think we can make some money together.

We appreciate your interest. Kent and I will be available for the next couple of hours to answer questions and drill down to whatever we can do under the requirements of the update. We appreciate, again. Look forward to reporting to you in the future.

And we'll go ahead at this moment now and sign off in Salt Lake City, wishing you and the Boston Red Sox great success this season. Good night.

Ladies and gentlemen, this concludes the Merit Medical Systems, Incorporated, second quarter 2013 earnings conference call. Thank you for your participation. You may now disconnect.