Merit Medical Systems Inc (MMSI) 2014 Q2 法說會逐字稿

Ladies and gentlemen, welcome to MMSI's Second Quarter 2014 Earnings Conference. At this time, I would like to hand things over to Mr. Fred Lampropoulos. Please go ahead, sir.

Thank you, and good afternoon, ladies and gentlemen. We are broadcasting from a rainy and thundery Salt Lake City this afternoon. We'll start the meeting out today by having Anne Marie Wright read our Safe Harbor provision. Anne Marie?

Thank you. During our discussion today, reference may be made to projections, anticipated events, or other information which is not purely historical. Please be aware that statements made in this call which are not purely historical may be considered forward-looking statements. We caution you that all forward-looking statements involve risks, unanticipated events, and uncertainties that 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 any 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 provide investors with useful information regarding the underlying business trends and performance of Merit's ongoing operations and can be useful for period-over-period comparisons of such operations. The table included in our release and discussed on this call sets forth supplemental financial data and corresponding reconciliations 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, but not all, items that affect net income. Finally, these calculations may not be comparable with similarly titled measures of other companies.

Thank you, Anne Marie, and good afternoon, ladies and gentlemen. Well, we are going to have an interesting conversation today. As you can read from our release this afternoon, we reported our earnings for the quarter as well as our revenues. Let me start out with the revenues first. As you can see, revenues were a record $248 million. That is an increase of 17% over the year-ago quarter. Just a quick note that the core growth was 15%, and that difference is really from the -- which will be a quarter in which the Mackay acquisition will be included in the second quarter and the third quarter, and then it will be apples-to-apples going forward in the fourth quarter.

I think you would all agree that that is an outstanding effort in terms of the revenue side of things. You will also note on page -- on the final part of our press release that we are increasing our revenue expectations and guidance from the $495 million to $498 million range up to $511 million to $515 million, a pretty substantial increase, which includes -- then works out to be on an annual basis about 14% to 15% overall.

Now, you will also notice that that's a little bit lower than the first quarter, but you remember last year we had a stellar third and fourth quarter. We had very, very good numbers on the sales side last year. And the good news of all of this -- I recognize that today that there is maybe substantial disappointment on the earnings side. But I think if you will indulge us for a few minutes, we will, I think, talk you through that. But the good news is, we expect to see substantial growth going forward. The investments that we have made in distribution and our systems, whether they be in China, Brazil, India, Europe, Russia, and so on and so forth, are paying off and will continue to pay off, I think big time.

So, we expect, as we look forward to the balance of this year, and very candidly, looking into the next couple of years, we're going to see growth that is going to be extraordinary. And you can compare it against other companies and come to your own conclusions on it. But we think that our product pipeline -- we think that a number of products that have already been approved in Europe, that are just getting started there, that we expect it will be approved in the United States later on this year, in the late third, early fourth quarter, really set the stage for an extraordinary year, as well as going forward to the next couple of years.

A little bit later on in the call today we're going to talk to you about some new products and some really different things for the Company that we have not had discussion about nor are they in this particular press release. But we'll talk a little bit about some other products that we think down the road are going to bring substantial opportunities to the Company, and they are a little bit of a departure from Merit's business as you have known it in the past.

Now let's go to the earnings side, because that is where most of you and we're spending a lot of our attention in trying to look at the earnings. We missed, I think, the Street consensus by a couple of cents, but maybe more importantly, what we've done as we've looked at the business, there are a couple of events that are taking a little more time and a little more money than we expected. Let me talk about the split of the sales force.

I think we're getting exactly what we had hoped for. We're getting a deeper sell into our back. We're getting more focus from our sales reps, and that is part of what we invested in and what we had hoped for. I think at this particular point, both of the domestic groups have exceeded our expectations. We had had discussions that we would see this thing start to kick into place about six months following the implementation, but we've seen it in the numbers that has taken place sooner than that. That being said, the other side of that coin is the expenses associated with that in the subsidies. Let me just very briefly explain the subsidies to you

What we've done is when we split this sales force and split along product lines, where there were some areas where people had a full bag and now they were going to a substantially smaller bag. And so what we did is we wanted to hold those individuals harmless and wanted to make sure that we were able to maintain the sales force. I think short of one performance termination we have essentially kept our entire sales force intact. And I think when you go through a transition like this, that that's an extraordinary accomplishment. I do think, however, that there were some things that we underestimated, and that is some of the travel, because now we have much larger sales territories and more expenses in those areas. That being said, we are committed. We believe it was the right thing to do. We think you are seeing the results of that, and we believe you will see that going forward. So, we do not have any second thoughts on this, although you will have this short-term for about another -- this thing kind of trails off over the next 18 months from here. We're in the first six months of it. Kent, I'm going to let you comment on that.

Yes, I would like to add to that. The sales increases of costs have bumped up both for reasons of leveling it out and making it fair, that Fred has mentioned in the travel and so forth, larger territories. We have also seen some increases in some of the bonuses and things that we're doing to incentivize them, to focus them in the products we want, and that focus is working. But most of it is going to be fixed. So, I believe there is leverage coming. As the sales grow, it should grow faster than the SG&A costs associated with the split sales force, although it doesn?t look like it right now at the beginning. I believe that is in the future.

Yes. And, again, the good news is, we're getting the result we had hoped for. Now, let's talk about the gross margins going forward, because I think that is one of the areas that as a business we're concerned about. As you know, if we were to go back 18 months to two years, we set out a plan to growth the gross margins from 41% and add 360 basis points. And most of that we have accomplished. The challenge is in this market environment that we're faced with we are seeing more expenses in the areas of freight. Simply put, with national accounts, the various things that we signed up for with our international operations, we have seen higher costs in some of those areas, which we are monitoring and evaluating, but we have seen some higher costs in those areas. We see some price pressure. I think that anybody that is in the device area across-the-board is seeing more and more hospitals, more players looking and wanting to have discounts and lower prices and more competition. So, we see some of that.

So, what we're not seeing is the leverage going forward on the gross margin side, at least as it is presently constituted. And by that I mean we have a lot of new products. They are very high margin products, but whenever you're starting this projects up, you're going to have just a startup cost, the launch packages, the training and all the expenses associated with that. So, if we look at labor, we are also at a very, very, very tight labor market here, at least in Utah, although interestingly enough, labor isn't the issue. It is in the overhead and in the sales prices, so here is what we're doing.

First of all, as we have mentioned previously, we have essentially frozen hiring in our businesses. So, other than replacements that we think are necessary, we have essentially frozen hiring, and I think that will have an effect as we go forward.

The other thing that we are doing is we are asking our research and development and our marketing department, our sales department, to be able to operate short of ancillary or expenses associated with sales. In other words, if they sell something, there is a commission to be paid, but we are not going to expand our sales force beyond where it is. We have plenty -- I wish we had more, but we're simply not going to do it. We are not hiring more people, and we are holding the budget on the research and development side going forward to the same expense dollars of this year. So, even though we would expect, and this is a ballpark number, that as we look forward to next year that we could see revenues grow. This is just, please, we'll get you a formal forecast in the future, but let's just say it went up 50% -- excuse me, $50 million. Generally, we would take about 8% of that, 7% to 8%, and we would allocate that for research and development expenses going forward as a percentage of sales. Well, where we are today is that we are going to freeze and have in fact frozen research and development expenses and these others areas to their current spend levels. So, other than the cost of insurance and commissions, it's essentially going to be flat. So, that is going to give us substantial opportunity going forward.

We thought it was time, as we looked at situations with our buildings, which I'll have Kent explain to you now, and some of those issues, that it would be important to kind of reset the number to -- at the same time we're still very optimistic about the revenue numbers, as you can see. I suppose the criticism will be great sales numbers, why can't you leverage it? Ken, I'm going to let you comment a little bit on some of the factors that are affecting that lack of leverage that we're getting and that we see for most of -- the rest of this year, as we look to the startup of some these other facilities and the absorption levels, please.

Well, starting with the cost of sales, you have covered many of them. One of them you haven't mentioned is that the amount of capacity we have added recently and the overheads that go with that. So, both here in Salt Lake, as well as the parent Texas facility, and Ireland not very long ago we added some new businesses over there, are startups still, and they have facility costs to them and overhead that aren't being absorbed yet. So, you have the necessity to absorb fixed overhead costs that we have loaded into it, and that is flowing down. And as part of that we have the transition we've spoken of before, where right now, in the first and second quarter, we've had heavy load, nearly $1 million a quarter, of costs involved with a facility that isn't in production yet. And I'm talking about the new one in Pearland, as well as transitioning out of the old one in Angleton. So, those have been SG&A costs that are going to transition to cost of sales and therefore they are going to add overhead to the cost of sales margins that we've been concerned about, as Fred was mentioning.

So, as we look at that we will get some help in the SG&A area. But the other areas that we're looking at has to do with just mostly the split sales force, has to do with some of the increased costs, like the 401(k) plan that we put back into place through all the departments, the higher healthcare increases, the legal costs. Now, those will be suspended a little bit, because it's been delayed (inaudible) --

The trial (inaudible) is going to be in January.

So, we're going to be able to see those slow down a little bit. But we have had some of those increases that are behind us or they are fixed. And so we believe we can start moving it forward and leveraging it. It's just been a little delayed more than we expected. We underestimated some of those costs in the transition periods and how long it would take.

Let me go on to some of the newer products and talk about what effect we think they will have. We alluded to the fact that we -- and have talked previously that we have introduced a number of new products. One of the big successes that we believe that we will see -- so, I suppose maybe that is somewhat premature, but we're just launched our PreludeEASE. It is a hydrophilic sheath which is used not only in radial procedures but in femoral as well. And this particular product in its first week, we were able to convert one of the largest accounts in Great Britain. We believe that in the next week we will convert another, even larger account in Britain. So, just so you'll know what these things mean.

These two accounts could account for up to 20% to 25% of our existing capacity on this product line. That is how large they are. It's not approved in the United States at this point. This is the PreludeEASE. But we expect that by the end of the year, we have received notice from the FDA, they have comments, we will respond back to them. But what I'm trying to say to you is we have great products and great growth opportunities, and this absorption that Kent is talking about at these facilities will take place because we are going to see substantial growth in these products that have [those kinds of] margins.

We are also going to redirect our thinking in terms of how we compensate our sales force and what products. I think that's another thing. Even though we do that to some extent, there will be a greater emphasis going forward about making sure that the efforts of our sales force will be in the products in the areas where we simply can make more money. So, there will be some restrategizing of that particular -- of the current strategy.

So, we have great products and we have a great opportunity. Now, if we didn't have the growth, my goodness, it would be a tough conversation. So, I know many of you are inpatient and some of you are saying, well, we've heard this story before, and perhaps you have. But I think as we look at our business today and say we have capacity, we don't have to make any major capital expenditures. We have this absorption, as Kent pointed out, of Angelton, some startup stuff in Ireland, and very candidly still the absorption of the new facilities we have here. We are very optimistic about the future.

So, although we will have some disappointment for the near term, let me assure you that we haven't given up; in fact, quite to the contrary. We believe that this is a great opportunity for the Company to go forward. Let me hit another couple of other points that I hope will be of interest to you.

One of the other things that we have done in our research and development is that we have been transitioning the Company for some time. I say some time, over the last couple of years, to take a look about where is this Company going to be five years from now? And we have also started and directed some research and development projects that are longer-term projects. I am pleased to report to you today that Merit is developing a central venous, what we call a CVO stent. This is a vascular stent that is used in the upper extremities of these veins which are essentially destroyed or malfunctioning due to various types of interventions. It comes from using PICC lines, putting in central lines, or putting in dialysis catheters. And it is something that is a major problem and there is not currently a product on the market that we're aware of that is approved for these types of procedures.

We started working on this about two years ago. We call it our Spider project, and it is a project that we believe could generate $50 million to $100 million a year in revenues. It's an exciting opportunity. Just this week we finished our animal work in which we had results which were stellar. We had no inflammation, we had full patency of these implantations, and had great results. And so now we will start moving down the road, and this is a five-year project.

I announce it to you today so that you can see that as we view the future of the Company , it's not a company that is necessarily selling stopcocks and tubing and kits, although they will continue to be part of our business. Merit is still transitioning to what we believe are higher need, higher opportunity projects. And I would also say with that goes higher risk because it has more effort and it has more regulatory scrutiny.

Another thing I think is a highlight and it's just kind of getting started, too, and it will affect us positively, is our embolic business. Now, if we take a look at various regions of the world and particularly Asia and Europe, we are just doing a great job. In fact, one of the challenges we're having is in some ways keeping up with the growth. We probably could have added another $500,000 to $750,000 of revenues if we could have shipped all the product that was on order that we had hoped to ship for this quarter in the embolic business with higher margins. And we are just simply -- I don't want to use the word struggling because that's not maybe appropriately -- but we are catching up. We have almost doubled our workforce in France to keep up with the capacity, and the demand that is coming out of Japan and China, coming out of the Middle East, coming out of Russia and other places for the demand for our embolic products, which have very high margin. But we have, again, had to hire and staff up to be able to meet that demand.

So, as you look at our business, there are a lot of positives on the side -- but, again, it depends on -- I suppose we can talk about the -- continue to talk about the disappointments on the earnings side. The issue of the containment of expenses is the subject of topic here. Programs are in place and there are more to come. We had, just before this call we talked about more of the discretionary expenses and some of those things, and we'll do more of that.

So, the bottom line is, we have a good business, we have a business that is growing and will continue to grow, but we've got to work through the next six months or so of absorption and getting moved into the Texas facility. And I will say one other thing, too, that I think that you can expect in the future, and that is we think that our consolidation of our facilities from 45th South, which is here in Utah, to this facility was very positive. And we would expect to look at how we can consolidate other facilities and be able to get some financial advantage from that going forward. So, it's a little too early to talk about that today, but it's on the horizon.

Another thing that we expect to do is to take a look at how we can expand our low cost environment, to be able to put more products in an environment in which we can see lower cost. So, a lot of things going on here, but we thought it would be appropriate -- and isn't it a paradox? Isn't it interesting? We're sitting here raising this forecast by almost $15 million, and yet we're not getting the financial performance. But I think if you look beyond where we are today, I think you can see -- I hope you'll see where the opportunity lies, and that is in this ability for us to be able to take and control these expenses and get the kinds of returns. We probably haven't done that to this point, but I'm not going to linger on it any longer than I -- it speaks for itself. Everybody in the room here, and there are 40 people sitting here with me today, our staff, understand what we need to do. And I know you've heard it before. And so what's the old saying, that it's always darkest just before the storm? I think the storm has passed. We have some -- we have a lot of work to do, but there is a lot of opportunity. So, Kent, you want to comment?

Yes. I mean, I do want to focus on a few things that I think are strengths and momentums for the future, not only just the total revenue gains across some of these, but our international business has grown amazingly. We talk about China all the time and it's still at 37%. Europe is at 30%, both distributors and -- we've moved to, what, the month was 40%, now is international 39% for the quarter is the ratio. And a lot of the things that we're trying to focus on most are the ones growing the fastest. So, you look at the embolics, both the drug carrying QuadraSphere, as well as the Embospheres are growing, some of our top products, along with the radial projects.

So, we are seeing the things -- inflation devices have reinvigorated, both Kyphon coming on stronger, but also our basics is reinvigorated, too. So, it's nice to see these higher margin products starting to kick in, or we'd be having more problems with our gross margin.

So, the momentum in some of those areas is encouraging, the total revenues. And so most of the stuff we're concerned about are pretty fixed. So, I think there is a chance, as we said, we predicted it all along in the year, it is just being a little slower. I think we're seeing still through the rest of the year we're going to see sequential momentum coming into the financial statements, into our cash flows, and it bodes well for the future.

Yes. And I think as we look at the numbers, again, this is on an internal forecast, but sequentially the earnings go up quarter-by-quarter in terms of -- and they are sequential improvement in each. But there was a pretty high bar to reach in the second half of the year. The programs are in place.

Let me just finalize by, and summarize by saying that we expect to be in our Pearland facility and essentially fully buttoned up other than a few little minor details by the first of September. That is significant. It will also cause a move from the SG&A into the cost of goods. SG&A will go down, cost of goods will be affected like that, but hopefully then again the volumes and the consolidation and efficiencies being there will start to come into effect.

Plenty of products. I think the good news is that even with R&D flattening out in terms of this year's expenditures, we are loaded; we have everything we need. So, there are no needs, we're full, and we have a lot of new projects.

On the acquisition side, we have absolutely no appetite for it. We are too busy with the things that we have. We don't see any need for it and we don't have any money to do it, so it kind of solves the problem all in one. It's not the time to do those things until we can get into a better position in the future. But we don't foresee any of those expenditures or disruptions. I will say, by the way, that on the radial side, when we did the Mackay deal last October, that it absolutely fit in perfectly. It has been fully integrated, as I mentioned in my previous calls, seamlessly. And the good news there is that as this PreludeEASE, this new project, this new hydrophilic sheath comes onto the market worldwide, you are going to see that business improve business across-the-board.

So, on the revenue side we see great things. On the earnings side you will see sequential improvement; it just didn't move as quickly as we had hoped and thought it would, and that's what we're here to report to you today. So, I think, Kent, unless you have any thoughts you want to add, I think we'll go ahead and turn it back over to the operator and we will take your questions.

(Operator Instructions) Our first question comes from Mike Petusky, Noble Financial.

When you were talking about the split of the sales force and some of the incremental costs associated with that, is there any way you guys could quantify the subsidy, the travel, the bonuses? I mean, what are we talking about, either if you could break those out by those three different factors that you identified or in total? Anything there would help.

Let me try to answer all of those, and let me explain it. When we talk about the subsidies, let's say we had a sales guy that was making $200,000 a year, and that salesperson was going to the division that had less products and there was a gap there. What we've done, since we certainly didn't want to lose that salesperson and take the risk of hiring somebody else, we essentially said to them that you will make no less than what you made during that period. And we'll do this and we will (inaudible) and it will decline. So, you're talking about $400,000 a year or so, -- Marty, am I right? I'm just talking about the subsidy -- or so, that you would have that would be to make up for those.

Then you would have the -- we hired some additional salespeople, I think there were four, and we added, I think, one or two clinicals. So, we hired about six people. And the reason that we did that, there were some big gaps as we looked at these particular areas. So, if you can take six people, I'm just going to just take -- and two managers. So, you're going to add maybe a total of eight people. I'm just going to take a number fully burdened of $200,000, just for the sake of the discussion, and that's $1.6 million plus the $400,000. So, now we're at about $2 million a year.

Then on top of that, since they have larger territories, you're going to have a bump up in the expenses to travel into those particular areas. And so I would add probably another $200,000 to $300,000 a year of additional expense. So, about $2.3 million to be able to put all of that in place. And that will eventually -- I mean, the subsidies will go away. The travel won't go away. I mean, they're still going to have to travel to various locations and that sort of thing.

Now, that being said if you take a look at the sales side of it, the reward side -- that's the expense side, Mike, what you're seeing is -- and I should say just the beginning. So, I think that's another really important point, that from a sales point of view, the ability to focus on less products in these various groups has already made a difference, but it's just getting started. You have to remember, we're only six months into the year and some of these people are still learning and getting comfortable with the new products. Ken?

Yes, in support of that, the sales in the US direct group was up 13.2% in the quarter, in the second quarter. And you know the history. That's a lot of expansion; it's an acceleration. It's 11% basically for the year-to-date, so it's definitely making -- it has to be part of the difference if not most of it that we're seeing better focus. And then when you drill down, a lot of the products that are growing the most are the ones we want to focus on, so it's nice that way.

So, anyway, that was a conscious decision simply because as we developed more products, our sales force through just kind of the natural way things are would focus on the new products. But there are a lot of really good products and some of them very technical. If you take a look at our Worley Coronary Sinus Guides, if you take a look at our peritoneal dialysis catheters and those catheter systems, these are complicated products that take more time and more understanding and more clinical support. And those are some of the very same areas now that are growing the fastest, along with embolics.

I mean, Kent makes a very good point. Selling -- Mike, I'm sorry it's a long answer. But when you look at these embolics, you're sitting in there in an account -- Merit has three embolic products that can be sold and a fourth one that is being developed as we speak that we'll release next year. And it takes a lot of time to do these things. We just weren't getting the time that we needed and we felt to grow the business. Well, I don't think there is any question that we were correct in our assessment of these opportunities.

So, the answer to your question about those are the buckets, that's a ballpark, but about $2.4 million was the additional incremental cost. A little bit higher than we thought. It's a little bit higher than we actually had thought it would be initially. But that being said, we are also getting the sales results that we want.

Okay. In terms of -- just a real quick follow-up on that. In terms of the subsidies, then, you seem to indicate that that would trail off. Does that go down on a quarter-by-quarter basis or does that just kind of go down at some point late '15?

Yes. It goes down each year; a portion of it falls off. And at the end of 2015, is it Marty? When does it totally go away? So, about 18 months or so, that subsidy will be gone totally.

Okay, okay. And then I just want to make sure I understand. So, the R&D this quarter was, on a dollar figure, I think about $9.7 million. Are you guys essentially, and maybe I'm misunderstanding, but are you essentially saying that that dollar figure, no matter what the sales do, that dollar figure of $9.7 million, $9.8 million-ish, roughly, won't go up, and so essentially next year's R&D will be $40 million or a little bit under $40 million. Is that -- no matter what sales does. I mean, is that fair or --

No, that's correct except for two items. One will be if there are healthcare increases, we don't know what that is. We will be working on that. But let's say in the R&D department we had $250,000 worth of healthcare increase, that would be -- we would allow that expenditure to be there. But we are not going to go out and spend more money. So, you're short of a couple little issues, and I mean little. I'm talking about $250,000 on a relatively large number. But short of that we are going to freeze R&D spending at its current -- it is not we're going to; it is done. That is already the directive that's already in place as we speak.

So, as a percentage of sales, you would see, if we add it again, I'll just use this as the example. If you added $50 million worth of new revenues next year, then what you would do is if we were to spend, let's say, 8%, that would be $4 million. Then what we'll do is whatever that healthcare, those costs which they can't control, we'll give them an allowance for that, but short of that, that is their expenditures for the year.

Now, if I could just add, we still will release, even with that slowdown, we will still release at least 10 new products next year or more. So, it will not affect -- we still have a huge pipeline of products and we will still essentially release the same amount of new products and enter some new markets -- when I say new markets, within our call points. So, yes, that is correct. So, we will freeze that amount. It is currently frozen and it's in place as we speak today.

Okay, all right, great. And just last one. So, Kent, what I'm hearing you say on the gross margin, to me it sounds like gross margin could actually back up even a little bit more, even though SG&A and R&D will be coming down as a percentage. But it sounds like gross margin could actually, probably even come in a little bit further before maybe it firms up. I mean, is that a fair way to look at it?

No, we're just saying it's not going to grow as fast as we had hoped. We think it's still going to improve sequentially. It has some headwinds, for example, the Texas facility coming into cost of sales, but, no, it's just we're not going to be able to do what we hoped for this year in the second half of the year because we've see it slow down in this quarter.

You actually are internally modeling that slightly up then in the third quarter? Because, to me, it seems like --

Yeah, we are thinking it can still grow sequentially, but just not a lot. And so it's going to be ramped down from what the expectations in most of the models out there. So, we're trying to manage those expectations and say even in spite of our increased sales and production levels, we need to be conservative a little bit in what those gross margin potentials are. And I think there is still some upside depending on how the product mix goes, how our overhead management levels are and so forth. But, yeah, we're trying to be conservative. I wouldn't say -- I mean, these are interesting. It's the hardest part of our statements to forecast. There are so many moving parts to it that can vary on you. But we are seeing some momentum, for example, in our variances, at least in the US production facilities. So, we think we can start to see some improvement. But it's going to be slow.

But based on our model, it improves, I think, 60 basis points for the next quarter and then another 80 basis points on our internal model -- no, another -- excuse me, not quite that much. It would go about 60 basis points in the third quarter, and then just because we didn't want to get too far ahead of ourselves in terms of this, another 20 basis points. So, almost 100, or 80 basis points improvement for the balance of the year. Now, this is in addition -- so, this is where I think it's positive and, Mike, we appreciate the question. This is even though the cost of Texas is currently in SG&A, it will move up into the gross margin side of things.

Right. Well, that's why I actually thought you would back up a little bit. That's where that question was coming from.

Yes.

Yes, we'll see. There is some risk of it being slower like that, but we think it's going to still -- because of this volume of sales we expect, we think it's going to be absorbing overhead and improving somewhat.

All right, great. Thanks. I'll let somebody else get in. Thank you.

Next we'll hear from Jayson Bedford, Raymond James.

Just, I guess, to tag on the last question on gross margin. A little surprised, you said that most of the growth is coming from higher margin products, yet the gross margin is coming down. Again, a couple questions on that. One, can you just quantify the impact of price? And, two, are there redundant costs, I guess meaningfully redundant costs associated with the Pearland facility in just kind of trekking product back and forth from Angleton to Pearland?

I'm going to let Kent comment on that. Go ahead, Ken.

Yes, we are right now. Not only are we having a lot of overhead, like utilities and things duplicated and running cleaners in both locations that we can slow down somewhat, we do have that transportation issue and packaging. We had to haul them back and forth. We had to buy a truck and we've got people involved in it. So, yes, that's part of it. And I think those are significant. In the big, big picture, the entire global operation, it's still small BPS, but it does hurt. So, we do have some upside by the fourth quarter of shedding some of those costs. So, that was -- what else did you want to know?

I think the other question he had and it's a really good one, and that's the issue of, we've commented that we're seeing growth in the embolics and in those areas, and the question is why aren't we seeing more of a response in our gross margins due to those? Let me comment a little bit. I'll go to our European situation, particularly in France.

As you know, Jayson, we received approvals in China and approvals in Japan. We have also, by the way, received approvals in some other key areas just recently, but I'm going to reserve comment on those. And the problem is essentially that business has doubled. If we take a look at the amount more than doubled in terms of some of these areas, and so we've had to staff up. And very candidly it's been a little bit of a struggle for us in our French facility to be able to respond. I mean, that's just -- those are the facts.

We have had to send a substantial amount of folks from here and from Ireland, and we've just had to kind of come to the rescue there because they simply were not prepared to be able to meet that demand. And so those expenses and those costs and that training, again, they were just simply ill equipped. And it's just something we missed. We thought they could respond and they couldn't, and to the extent that we couldn't even ship all those products. Like I said, we probably had $500,000 or $750,000 that we've had orders for for a month or two that we couldn't ship, and we have more in the future. So, the pipeline is full there. But we have to kind of reinforce quite a bit of effort in France to be able to meet that demand going forward.

So, we had the expenses, we couldn't ship all the product, and that's just one of the issues. However, I think that's a short-term issue. We've put the resources there and we expect that that will smooth out, if not -- I mean, there are still some issues. I don't want to understate the issue there, because whenever you have to double your business -- and then we also had some problems with some vendors, so the vendors couldn't respond. That created a number of other issues. Kent, you want to answer?

Yes, I wanted to add some things to the question you asked about why isn't that enough to make more of a difference. We've seen some increases. One of our top growing product is our trays, which is lower margin. We haven't mentioned that. That dilutes it a little bit in the other direction. The other thing is that we are having some -- I mentioned it in the call earlier, but we have some startup businesses in Ireland that are running negative for variances, both the [pack] business and the Hypotube. So, we're seeing those negative variances be pretty high for, like I say, dragging that down a little bit. It's about $900,000 so far this year. So, those are kind of countering, if you will, the benefits you referred to on our mix.

So, to be a little more specific, we started up a kit business, a tray business, that's been operating now just a little over a year, and it's a business that we felt strategically to be able to meet needs for products in the Middle East. And very candidly, Jayson, to be able to offset competitive pressures of people that would replace our products that weren't in a kit or tray. That was a business that we worked on for about a year, a business segment. That's up and operating. And, incidentally, it will do about $5 million or so worth of business this year and it's business that we think strategically in Europe was necessary.

But we've got that new building and we've got large clean rooms and areas, and it's taking a portion of that, but we have the overhead associated with that, the building. And I think it's good to remember this. So, you have Angleton -- excuse me -- Pearland, you've got Salt Lake's facility that has only been up now and operating for a year. You've got the facility in Maastricht in which we added warehouse space so we could accept these products. We were running out of space to be able to ship these products. And then you have -- let's see, did I miss one? And Ireland. So, we have all of this, these expenses. At the same time, the good news is, they're all in there, they're in these numbers, and if we didn't have them, we couldn't meet this demand and this opportunity that we see in front of us.

So, we're not out there selling product at any price; we're out there, though, with these expenses. But the good news is, Jayson, is that there's a lot of demand for Merit products all over the world, and it won't take us very long to absorb these up. So, particularly when we take a look at -- you can see just see what the numbers are this year. And, again, I don't want to get into forecasting for next year, but I would expect that we would see something either similar to what we see this year or more on a going-forward basis. So, there's a lot of stuff out there and we're kind of loaded up.

Just a couple other quick ones here. What was US direct sales in the quarter? I just want to be clear that these are sales generated by those 120 US reps.

That is correct. Ken?

So, for the three months it was just $59.1 million. Is that what you want, the quarter?

Yes.

Up 13% over $52 million a year ago.

Okay. So, it seems like those reps are very productive.

Yes, I think, Jayson, as we look at -- again, I've said this earlier, but if we look at the split and then take a look at both divisions and how we split it out, they are all operating well above their forecast. So, they are beating the internal forecast that we had, which leads us to believe that those products that weren't getting attention -- in fact, I think this is fair. Marty, you'll have to comment, Kevin. I believe the Interventional division as a percentage is actually outperforming the Diagnostic, isn't that correct? So, the Interventional, these are snares, these are electrophysiology, this is embolics, this is peritoneal dialysis. These are very complicated area is operating at 126% of forecast. So, we're getting the result we want and I think we're doing a little earlier. But, again, I don't want to -- we to understand that there is costs associated with getting that training up, getting these things going. But I'm not disappointed in any way with the sales effort. I mean, these guys are out there doing a terrific job.

And along with that, they have actually exceeded our expectations as they sell more in the compensation they receive. So, that's part of that expense. It's a tradeoff I guess you get for that. Not only commissions, but their bonuses. If everyone -- we didn't expect everyone to make their bonus, and that's what's happened.

Right. But it just -- it frankly just helps to understand the costs and it seems like the cost of the business is not being weighed down by the sales force. I guess just lastly for me and then I'll drop. Just given the erosion in earnings, can you talk about the impact on our debt covenants?

Our ratio right now is 3.36 and it's well below the 3.75 level, so we're good right now.

Okay, no impact.

No.

All right, thanks. I'll get back in queue.

Up next you'll hear from Tom Gunderson, Piper Jaffray.

Hi. So, Fred, you've been doing this longer than I have, and so I want to get into some of the delta here. I think you captured the paradox, as you called it, with the higher revenues and the higher expenses, lower earnings. But if we look, you went through in quite a bit of detail on the first questioner with the subsidies and travel with larger territories, but I didn't hear anything -- this is hindsight -- but I didn't hear anything that wasn't predictable. The subsidies you probably knew in late April when you were talking to us. The travel in a bigger territory seems obvious once you hear it. The gross margin on the variances, pricing pressure isn't a surprise to you from your customers. Maybe some freight thrown in there a little bit. And the variances, I think, would have been mollified by the higher revenues. And also on the last question -- I realize this is multi-level but you get my basic question here -- on the last question you want your sales guys to beat forecast, don't you? And you don't want that to be -- you know, I would hope that if they all get paid bonuses that you make even more money to the bottom line than you expected because you got so much higher revenue. So, all that together, the short question is, what was the surprise in the last three months? What was something that fogged the visibility?

I think it was the gross margins. I mean, if we take a look, that was the area that was the biggest surprise to us is the costs, you know, labor, materials and overhead. So, we're seeing some inflationary costs in materials. There are some FX effect in some of this that affected us. But, I mean, there are a lot of factors, but it was clearly in the gross margins that -- and there are some on that SG&A side, too. You can talk about splitting the sales force, and you can talk about that, but the reality of the travel and some of those things are not things that you can clearly anticipate because you can't anticipate, I think, clearly enough, Tom, where they're going to go.

I'll give you an example. This is one of the interesting downsides to the split. I talked about how positive it is. We've got some territories that have become so large that some people can't get -- and I don't want to disclose where they are, but let me just say that there are two or three areas in which some people are covering three or four states. And we've not had that in the past. They are so busy in some areas, and you would say, well, that would offset expense. But we've got some holes and some various things in adjustment [we need to do.] So, I would say, to answer your question, there are some areas, and clearly the gross margins -- some new things that we didn't see, we had some national accounts. We saw some take-up, for instance, on part of what's giving us the sales growth, you've got a 3%, and then you've got to go and you're also providing -- on these national accounts you're providing shipping. So, you've got those higher costs. You get the higher cost, and as Kent pointed out, we had growth in some of these areas. In fact, they were still the fastest growing areas of the business.

So, I think -- I didn't anticipate, or we didn't anticipate, because we all look at these numbers -- we didn't anticipate some of those expenses, and I don't think we anticipated the gross margins would be. I thought they would be -- very candidly, I thought they would be 100 basis points higher, but they weren't. Kent?

So, just on the point -- I think we did underestimate. We expected the travel expenses to go up, but they were almost twice the growth rate, nearly 45% or 50% they're running at instead of the 25% we forecasted. It's not that huge, but it all adds up. The other part of it is really, as Fred said, over in the gross margin issues. And there is pricing in there, and it's a mixed bag worldwide, in fact, on pricing issues and declines. Some of the product lines are more impacted than others. So, that, of course -- price effects gross margin as well.

Got it, thanks. And then I'll ask what I think is a short question, and that is on the embolics, where you could have sold more but you didn't have it, is that a capacity problem? Are you going to have issues a year from now selling 10%, 15%, 20% more than you're selling now, or how does that get resolved and can you raise price?

You know, you always ask the really good questions, Tom. One of the things that we're doing in France is, in order to meet this demand and also a new product that is going to be coming online that is in research right now but should roll out sometime in the first -- late first, early second next year is in our facility in France. What we've done is we've taken some additional space right next-door to us. So, we don't own those buildings, we lease those buildings, but in order to meet this demand, there are two things we've done. We've taken the additional space and we've added an additional sterilizer. So, in order to meet the demand, we are having to put some more capacity in place to be able to meet that demand. So, you hit the nail right on the head. You can't do it in the same space. We've been in, I think -- how many square feet is it, like -- how big is that facility, George? How much? So, we're 19,000 square feet, and we're going to be adding, I think, another 10,000, 15,000 square feet for the demand that we see coming forward.

And one other thing I should say. I want to be careful how I say this. But one of the most difficult areas to sell to in the world because of the very high standards are some of the Asian countries. And that's another thing I think that has been -- and as I said that, a bunch of eyes rolled in the room. But about 80% of our product complaints come from about 5% of our sales. And that's just a cultural issue. It is something that we've been dealing with, and all medical device companies that are in certain Asian countries have to deal with.

So, one of the issues on this startup, and we didn't address that, so I'm glad you asked this question. I would say that our input and our rework, and all the work we put in to getting up to those demands was substantial. I would say we put in two to three times more effort than we would have. And, of course, the question is, why isn't all the product that way? There are just some places that have higher requirements, I mean, to and including a label, a box. These are things that -- so, I don't want to maybe overdo this, but I will tell you that it has been a struggle. We sent and hired some new production management. We've sent teams to support this and to be able to meet this demand, and maybe the more important question is the demand is there and we expect it to continue to grow. You can see the numbers in here. We expect growth rates to continue at this or higher going forward in this business.

Got it.

And, Tom, going back to anticipation, I don't know that we anticipated all that. I don't think -- I mean, as I mentioned earlier in the call, we thought our guys could handle it and we had to send in the cavalry.

Thanks, Fred.

Next up we'll hear from Jim Sidoti, Sidoti & Company.

If we go back about a year or maybe five quarters ago, after Thomas lost that major customer, you had a big cutback on selling expenses, trade shows and that kind of thing. Based on what we've heard today, should we assume that you kind of reversed that and it's kind of full speed ahead with all those expenditures?

No, I don't think you can. In fact, one of the things that we did, Jim, is that we pulled back the size of almost every one of our major shows. However, when we added the Thomas deal, there were a couple of shows that came on, like the Heart Rhythm show, and some of the other things that we felt that we needed to go to to be able to show our products. Incidentally, since you've asked, we have another major product introduction that we expect in the late first quarter in this particular area.

So, this is the debate we're having, and this debate is, we've cut down dramatically on the people that go to these shows, the size of the booths at these shows. But on a discretionary basis, these are things that we spent at least an hour today or longer talking about what shows do we go to? Do we not go to these shows? And there are so many things that happen at them. So, I would say that from 18 months ago we're doing less in terms of size and people, but we're doing a couple more shows.

But let me give you an example of something we did this year at MD&M. This is a big OEM meeting. Normally, we would go to the trade show, which is at the Javits Center in New York. What we did this year is we met with our customers at a -- I'm going to call it like a rooftop type of social -- not dinner, but a social, and it cut the cost of that show by $150,000. And so we're looking at different ways to do things, Jim, that are less expensive but still allow us to have the visibility with our customers without maybe having those huge expenditures that you would have by attending and having people on the floor and shipping booths. And I think that was an example of, I think, thinking out of the box and it was very, very successful.

So, I think as we go forward, we will look at alternate ways to have a presence, to be visible, but to look at how do we take -- so, it may be a hospitality suite versus a booth, or something like this. So, we can still meet with customers, we can still be on the floor of the conventions, but that we would look in how we could cut costs. And I think that's the best way to answer it. That's a real live case of something that we did that cut costs dramatically.

Another thing, I'll give you another one, since you brought it up. Next year, the decision is already made that we will not attend the PCR, so we are not going to go to the PCR meeting in France next year. That is $250,000. That decision has already been made. We've cut that show. So, I think your comment is, if we made it sound like it's full speed ahead and that we're back on, the answer is that's not the case whatsoever.

All right. And then you talked about the sales force quite a bit, but I'm not sure if you actually gave hard numbers. What was the headcount at the beginning of 2014 and where do you think it will be at the end of '14?

And you're talking about the sales force?

Right.

So, Marty, do you want to go ahead and just -- just in the US, and then we'll move -- the US.

Well, there is only a difference, as Fred explained, we had four reps, two managers, a clinical specialist and an IDN person. So, we had, what's that, eight or nine people could have been added over the end of last year. It's about 125, and that includes all of our clinical specialists and managers and others.

So you had about --

Go ahead, Jim.

Okay, so it sounds like you went from around 115 at the beginning of the year and you'll end around 125?

Give or take, yes.

Okay. And outside the US, I mean, can you give us some rough numbers on where you started and (inaudible)?

Yes, I can give you exact numbers. For the six months for all positions in sales and marketing, national accounts, customer service, that's China, everywhere in the world, is 42 people with increase, 11% in accounts. It's gone from 380 to 422.

And that's a worldwide number?

That is worldwide.

There's people in Brazil, there's people in China, there's people in Russia, there's people in the Middle East, Turkey, and Australia. We added one person in Australia.

All right. That includes the 125 people in the US?

That includes the extra 10 or so. Yeah, the 422, obviously, includes everybody, including the US people. The 42 increase includes the ones Marty has been talking about, yes.

Okay. All right.

This is as a point of interest, though, if I could. When we're talking about adding, let's say, somebody in China, you'd be talking about a cost that is probably, I'm going to say a third or 25%, Joe? Yes, it would be about $50,000 a year versus, let's say, someone in the US about $200,000 a year. So, I think that's important to note. And that's where a lot -- how many people did we add there, Kent?

Joe just gave me that.

Okay, so we added four or five salespeople. So, go ahead, Kent.

Yes, four salespeople, three more in Hong Kong, one in Brazil and one in Australia.

So, on the international side, we've added 9 or 10, so this would be Asia -- and again now, remember, these are areas that are growing at 36% and that sort of thing. So, at much lower cost than you would see if you added a US sales guy. And one other thing I think Marty pointed out, Marty Stephens, our Vice President of Sales in the US and Marketing is that we added an IDN guy. One of the things that -- these are small selling groups. You know, we have a national accounts group here, Jim, in which we are calling more on administration and that sort of thing. So, we've added three people there in the US to support the sales force. And, by the way, that's another reason we get sales growth is because we have people that negotiate these contracts with hospital selling groups or buying groups.

Great. And then can you just touch a little bit about what you are targeting for cash flow for this year and maybe next, and how long you think it will be before you can pay down a significant portion of the debt?

Well, we did $21 million just historically now for cash flow from operations, and we actually had positive cash flow we haven't seen for a while of $1.4 million, and that should now accelerate somewhat as our earnings increase as we forecasted. So, I don't have a 2015 number for you off the top of my head, but we should see some increases in the cash flow from operations and that's how we'll direct it, is to paying down debt. Then we need to accomplish both EBITDA ratio for earnings-to-debt.

And have any flexibility and opportunity in the future. So, it's something that we know we need to do and we will. And I think the other point, Jim, is that short of some of these smaller projects, we don't really have -- other than maintenance and bringing on new products and stuff, we don't have any major projects ongoing that we've had in the last three or four years.

Okay. And the expansion in France, is that relatively immaterial?

Yes, it's a lease. It's a lease, so it is immaterial, yes.

Okay. All right, thank you.

Our next question is Chris Cooley, Stephens.

Just two quick ones for me at this point in the call. I apologize, but could you go over the sequential gross margin expansion that you expect the second half of the year? And then, secondly, you talked about the changes to the sales force compensation structure. Just a little but curious there when that will be implemented. I realize that they effectively have their guarantees here that trail off over the next 18 months, but help me think about when the new sales structure on the (inaudible) sales cost system goes into place? And one other quick last one, kind of a housekeeping item. Just in terms of the pricing pressure that you saw during the quarter, was that -- was it across-the-board or were there select products that really kind of bore the brunt of that? Thanks so much.

Chris, let me answer the first one on pricing pressure. You know, interestingly enough, on some of our products, like the -- some of our snares and some of those products, we actually saw the average sales price go up. Where we see the most pressure are actually in the lower margin products interestingly enough. If you take a look at kits, you take a look at some of those kinds of areas, areas where people can compete with you, those are the areas where we're seeing most of the price pressure. Greg, is that a fair statement or do you want to add that? Okay, so in catheters. But basically in those areas. And I don't have a number, but as Kent pointed out earlier, our inflation device business is growing at the highest levels we've seen in years. And so that's been fine. In terms -- on the gross margins, I'll let Kent address that one. Kent, go ahead.

Yes. So, we're talking about 0.5% in growth the next quarter, total of 80 BPS we're hoping sequentially when you look at it by quarters. So, it will average it somewhere in the upper 43s, 43.7, something like that. Is that what you wanted to know?

Yes, thank you.

Okay. And then let me go to the issue of the sales force thing, and this is a little bit, as you can imagine, a little sensitive, but let me, I think, frame it this way. First of all, we wouldn't do anything this year in the middle of a sales year. We have programs out there, we have the incentives, we do -- all those things are in place. We don't think it's wise to ever switch people in the middle of a year and change the rules.

So, what I will say is that going forward, and I'm actually very pleased to say this. I think what we will look at is how to better align the interest of the Company and the sales force so that it's just not about sales numbers, it's about something in which we make money, the sales guys make money. We have to better align the interests of the Company in the sales force to get the result that we want, and so that's the best way to say that. And I think that's what everybody wants to do is align the interests so that both parties -- it's not just a matter of how many dollars you can add and what your commission is; it is how many dollars that you can add that add benefit to the Company and to the salesperson. So, I think philosophically it's very easy to say that, and that's what we need to do, and we need to do a better job of it than we had done in the past.

So, I think that's the best way to answer that one is that that realignment will be done to make sure that our interests are aligned and that there are more factors in that compensation that have a benefit to the Company.

So, the essence of it is we want to incent those higher margin products, those higher things that give us a better benefit and not just go and do it in terms of sales dollars themselves. So, I mean, I think that's what every company wants to do. At the same time, the good news, Chris, is we have the products and we have the things to do that. And I think with this split that we put in place at the beginning of the year, we get the opportunity, because people can spend more time and have better training and we put more support to support those sales. So, as I mentioned, PD catheters and in the CMR area, when you're taking a look at coronary guides and things like that, those things are complicated products. Kent, you wanted to add?

I just wanted to make clarify on the (inaudible) question. That is a GAAP basis, by the way, Chris.

I'm sorry, could you repeat that?

I don't want confusion on that.

So those GAAP numbers and gross margins are GAAP.

Non-GAAP are roughly 2% higher.

Got it. Thank you very much.

And at this time there are no further questions. I'll hand the conference back over for any additional or closing remarks.

Well, ladies and gentlemen, we certainly appreciate you indulging us and taking the time to ask what I think were great questions, and Kent and I will be here for the next hour so to take your questions or clarify other things that you may need. We appreciate you taking the time to visit with us today and we will then now sign off from Salt Lake City, wishing you all a very good evening. Goodbye.

And, ladies and gentlemen, that does conclude today's conference. Thank you all for your participation.