Merit Medical Systems Inc (MMSI) 2016 Q2 法說會逐字稿

Good day ladies and gentlemen, and welcome to the MMSI second quarter 2016 earnings call. At this time all participant lines are in a listen only mode to reduce background noise, but later we'll be holding an question and answer session after the prepared remarks, and instructions will follow at that time. If anyone should require operator assistance during the program today, you may dial * then zero on your keypad at any time in order to speak with an operator. We'll be happy to assist you. As a reminder, today's conference call is being recorded.

I would now like to introduce the first speaker for today, Fred Lampropoulos, Chairman and CEO. You have the floor, sir.

Good afternoon, ladies and gentlemen, and thank you very much for taking the time to join us in toasty Salt Lake City today. We appreciate you taking the time. We know you're very busy.

We'll start our meeting today by having Brian Lloyd, our General Counsel, read our Safe Harbor provision. Brian?

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.

Our financial statements are prepared in accordance with accounting principles which are generally accepted in the United States. However, we believe certain non-GAAP financial measures provide investors with useful information regarding the underlying business trends and performance of our 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. Readers 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.

Thank you, Brian. And once again, good afternoon ladies and gentlemen. We are pleased to report our second quarter to you. As you can see from our press release, our revenues were approximately $151 million, and we're quite pleased with that. It's up 9.4%, and on a constant currency basis, about 9.9%. Our non-GAAP earnings per share were $0.26 per share. GAAP earnings per share were $0.16.

Margins improved for the quarter at 44.3% compared to a year ago period a couple of basis points. And I should point out -- or about 20 basis points -- but I should point out that sequentially from the first quarter, our gross margins also improved.

Let me give you some of the highlights, because as you know, it was a very, very busy quarter, and I'd like to go through some of the highlights of the quarter for you. I'd like to start out by discussing a business opportunity that Merit I think seized and has absolutely done a terrific job of moving forward, and that's specifically the Cook situation. Now, let me just temper that somewhat by saying that these are not pleasant things to befall a company like Cook, and I hold Cook in the highest regard.

That being said, our job is to meet the needs of our customers, and to be able to provide products that help save people's lives. In the quarter, we generated an additional $3.6 million of revenue on this situation, and you'll recall that this started in early April. Think about this for a just a moment. We had to ramp up, we had to go and get a lot of things in place to meet this demand. We hired over 50 people, and they had to be trained. We had to move up our supply chain so that we had adequate raw goods to build inventory. And I'm pleased to say that we did all of that, and in fact we've done some other things. That is that we've added substantial capacity going forward.

It is our belief that this opportunity is one that is going to be larger than I originally anticipated, and will last longer. The question always comes up as to, well is this short term or long term. From our point of view, and from input from the field and talking to customers personally, I believe that this is more of a long-term situation than short, the reason simply being is that Merit has great products; Merit has a breadth of products and has a sales force out there, and I think many hospitals want to make sure that they don't get caught in a position like this where they may have been sole sourced in the past.

I also believe that there is a second wave coming, and we're seeing that. We're seeing orders that are coming in now in increased quantities from China, Japan, Russia, in addition to the business that we have generated in the United States. We put into production approximately six new braiders, and we've increased, as I mentioned, our stocks, for instance platinum bands for our marker band catheters. And the second wave is being well received by our sales force, our customers are calling us, and we're visiting customers, and we expect this to continue.

Now, I'm not going to comment on what Cook's plan is and when they'll be back in the marketplace. The bottom line is, is we believe, based on our face-to-face conversations with customers, that this is going to continue to be a long-term opportunity for Merit.

Let me move on now and talk a little bit about Australia and Canada because part of what's driving this demand is the fact that we went direct in both of these countries, and we made them the priority because we were just starting up and we thought it would be a good opportunity, and that has more than paid off. In fact, we believe by the end of July, which is a few days from now, that we will have already met our entire forecast for our business in Australia. So I think that kind of tells you about how these opportunities are helping the company.

Now, that being said, there's also about 20 basis points that it cost us in this lower margin side of the business. And part of that is because of training, startup, scrap, the things that you do. And my expectation is, as we move forward, that we will overcome that. We will have higher yields, the training and experience will be in place. And then we're also going to see improved margins out of this business because of the mix as we expect that we will see a substantial increase in our marker band catheters as we move forward. Let me also remind you that Merit is fully integrated in this effort. We extrude, we braid, and we finish all of our catheters in-house, and I think that is a huge benefit and opportunity.

Let me move on now to the HeRO. As you all know, in early February we announced the acquisition from CryoLife of the HeRO product line. It has met every one of our expectations. I am particularly proud of the fact that within about a 90-day period, we were able to send a full team to Atlanta. We were able to have our people trained, and then we transferred the product back to Salt Lake City. The original estimates from my engineering staff is that we're going to be able to take an additional $2 million of cost. In other words, we're substantially more efficient in our facility in producing this product, which will take our original estimate of about a 55% gross margin, to somewhere around 70% gross margin. So we're very excited about this product line.

We're introducing two new products in the HeRO line in the first week and second week of August. So we believe that we'll have more momentum going in this particular area. In addition, in the end of August, August 25th and 26th, we are starting our first Think HeRO program. Now, many of you know that we've been very successful with our ThinkRadial program where we're training both cardiologists and interventional radiologists, and we're bringing on now this program where we have a full capacity of 12 physicians that are coming in to our facilities to be trained. And we're excited about that opportunity, that physicians will be doing the training, and they'll have an opportunity of course to be in our facilities here in Salt Lake City.

Now, in the second quarter, there was a little bit of a drag because of the extra expense of having people in Atlanta. A little bit of expense in terms of the inventory markups. But all of that should wash through here in the very near term, and a good portion of that already expensed in the second quarter. And we believe this will be a nice contributor to gross margins moving forward. And as I mentioned, I think this Think HeRO program has substantial opportunity for Merit.

Let me move on now and talk to you about DFINE. And I also want to take a few minutes and make sure that I clarify, for the benefit of our analysts and shareholders, why we think this fits. So we have had conference calls on this, but want to just make sure everybody understands that business.

First of all, it is a vertebral spine business where we're dealing in kyphoplasty and vertebroplasty. We believe that we have the best cement in the business. We have the longest pot life, which allows physicians to complete their procedures without having to go to another kit or source and expense. We also have articulating osteotomes that allow us to be able to create the space that's needed. So we continue to believe that this is going to be a great opportunity for Merit.

Then there is the oncology side of this where we have the Star product line, and that product line is used to ablate vertebral metastases. And then, if there's a fracture present, you can then also follow that up with the use of cement and a kyphoplasty. In most cases, this is the very same call point, not always the same physician, but the same call point that a good portion of our peripheral, and now our new interventional and oncology spine sales force is calling on.

And then let me remind you about the sales force reconfiguration. We talked briefly about the HeRO. If you have just one group of people selling all of these products, it's very difficult to get all of that work done, so we've pulled the DFINE products, our embolic products, our micro catheters and some other products into this IOS group. And that leaves more time for the peripheral guys to sell the HeRO and all of the products that are in that particular product area. So we think that having additional sales people, having additional bandwidth, is going to be very, very beneficial to the entire company, not just the DFINE part of the business or the IOS group.

We've had our sales meeting, the entire sales force, and those who were invited from DFINE. We did training for over a week where we had -- it was cross functional. We did didactic. We did hands on. And we're very excited about this opportunity.

On the business side, we are integrating the business, and there's a lot of work to be done here. As you will recall, we had a plan in which we say that we are going to be flat on the earnings side in terms of the expenses for the last half of the year. And we're going to ask you to be patient because some events in the third and fourth quarter and how they'll match up.

So, Bernard, I'm going to ask you now, if you just kind of explain this so that we can make sure that everybody understands how we hope to stick to our plan, our three year plan, and yet how this next six months will play out for the benefit of our shareholders and analysts.

(Inaudible) what we're going to see is that we will have expenses in Q3 in relation to the transition of DFINE and incorporating that into Merit's business. So we may see some adjustments on our earnings within that period, and if there is any adoption in Q3 we expect to take that off in Q4. So over the next six months the effect will be neutral on earnings as we've already guided, but there may be some timing differences within the two quarters, so just for people to be aware of that.

Okay, Bernard, and thank you very much. We'll have you come back in a few minutes and talk about some other things. Again, I think all in all, we believe it's a perfect fit. We're already working and integrating new research and development projects and prioritizing those into the queue, if you will. And we believe in our sales force, and I think it doesn't really make any difference what I think, I think it's what the sales force thinks. Those are the guys that have to make the calls. And all of my input from that has been positive.

(Inaudible), just as a point of interest, one of the things that we found out at our sales meeting is that about 75% of the new DFINE sales folks who are now Merit sales folks, have had experience in selling embolics. And I think that's a big plus that we didn't anticipate, but there's a lot of experience out there.

And the other thing we found in this group, and it's something that we looked at in our due diligence, and that is that this sales group is much more -- what's the word I want to use -- clinically trained, and they come from that clinical background. We think when you're talking about embolics and oncology, and with our new biopsy product line, which is releasing here in the next week into that group, we think that it gives us great opportunity. At the same time, the other groups are, I think, going to do well as well.

So, we've talked about now the Cook situation. We've talked about DFINE. One of the things that I have to mention is just how much work everybody has put in. Now, I know that that's what we get paid to do, but during this last quarter we were dealing with the Cook opportunity, we were doing due diligence with the DFINE situation, we were ramping up in Australia and in Canada, and we were transferring the HeRO product. And when you really think about how monumental that was, and the effect that it will have on the business going forward in terms of gross margins, in terms of profits, now I just want to make sure that I'm -- how appreciative I am of my staff. Now, you get a few pats on the back and well done and all this sort of thing, but I really need to acknowledge the efforts by our engineers and people who travelled out of town, and stayed out of town in some cases for up to five weeks to get this product transferred. And so again, I wanted to make sure that I made comments about that.

I want to go a little bit to the mix for a second. One of the things that you'll notice on our charts when it breaks down the sales categories, you'll notice that custom kits and procedure trays are flat. I think this is exactly what we had hoped for, and I think this is what we've been driving for, that although we think it's an important part of the business, and particularly after we get the install basis on our kyphoplasty and oncology products, other things that we can sell the lab, the focus has been on these other product areas that have higher margins. And so we've not abandoned the Business. We still think it's an important part of the business in the long run, but I think it's important that you see that we had essentially flat, which is exactly what we were planning and what we were driving to do.

If you look at our capital market you can see that that is just doing terrific. And just another point that I want to bring out to you. You'll notice in the endoscopy division that that was only about 5%. We still expect for the year that this division is going to produce 20% to 25% growth. What happened in this particular quarter is there were some large OEM orders last year for some of our bipolar probes, and we just didn't have those orders this year. But we're running substantially hotter moving forward with our new products, and have launched a couple of new products in the endoscopy line. We have our 510(k) in, we've received comments, and we hope that very soon that we will have our approval for our pulmonary balloons. I will tell you the Elation balloons, as part of Endotek, we're literally making those as fast as we can. I'm very pleased with the efforts of that product and what it means going forward as well.

So, those are my comments. On inflation devices, just another point of interest, Merit launched this day our new basixTOUCH40. So we've had a competitive product that came out from (inaudible), and it hasn't been out there very long but it did take some business away, but we now have that product that is online and is now in the hands of our sales force, so we're very excited about that.

I think what I'll do now is, Bernard, maybe just turn a little time over to you to talk about some of the highlights and some of your thoughts on some of the financial issues. Bernard?

Thank you, Fred. And just a quick recap on gross margin on a non-GAAP basis and gross margin for the quarter was 46.4% compared to 46.1% for Q2 2015. We see margin improvements of 30 basis points when we compare the two periods. And there were two areas that we should note that affected gross margin. One is, we've already mentioned, is on (inaudible) products and the increased catheter sales, it's affected by about 20 basis points. And also we've seen an FX impact, particularly coming from our Chinese operation, which was about 30 basis points in the period.

On SG&A and R&D, (inaudible) SG&A was 26.8% of revenues in Q2 and 27.5% on a year-to-date basis. R&D, which includes regulatory and clinical, was 7.6% both for the quarter and year-to-date. And just also to note on our CapEx expenditure, that again we've seen a reduction in that amount in Q2 2016, so we've seen our CapEx reduced quarter-on-quarter since Q2 2015. And so again, we're really paying a lot of attention to that level of expenditure and controlling our expenses, and at the same time it's driving higher revenues. And again, we understand the focus on margins and that it gets a lot of our attention and we believe we will see that margin improve through Q3 and Q4, as we've already talked about.

Well, and I think, Bernard, that's five consecutive quarters of lower CapEx expense. And I think, as you all know, we put a lot of capacity in place and we don't have to spend that money, and we should be able to grow the money with just generally -- and there will be some expenses, but just basically with maintenance and new projects and that sort of thing. And that I think was exactly our plan.

Let me just briefly, if I could, move to Mexico for a moment. So, Mexico continues to operate in positive variances. They're still, of course, absorbing a lot of growth down there. We have about 500 employees in Mexico today. We are now going through and looking at various facilities and products, and taking a look as to what our next moves will be. We have a lot of capacity down there and we'll continue to evaluate. And I think we'll probably move a few more product lines before the end of the year. So that's what's going on in Mexico.

And I want to again -- and not to offend anybody, but you look at numbers and you have words and so on and so forth, it's the efforts. You think about the efforts of the new facilities in Canada and Australia and an acquisition and a movement of a product, I couldn't be prouder. But I think at the end of the day, you can have all of these events, but they have to be meaningful. And the meaning is growth, improvement in margins and profits. And so I think we're online for meeting that three year plan. This will be incremental. Our sales, and as Bernard pointed out, we're going to be flat for the next six months as we integrate the DFINE business.

And incidentally, there's a lot of work to be done there still. We've moved now customer service and inventory to Salt Lake City. We've pared the business down in a number of ways, I don't want to go into a lot of detail on that, and there's more paring to do. And we will do the job that we committed to do, and I think it will have great benefit to Merit shareholders in the intermediate term once we get through this restructuring part of the business.

Well, I think ladies and gentlemen, that pretty well covers it. I think a quarter that I'm pleased with. There's always more that we can do, but we've been very busy here and I think we accomplished a lot. We're looking forward because, as we look into this third quarter, we'll be able to talk to you about the integration plan. We'll be able to talk to you further about and the accomplishments of that. We'll be able to talk to you about a number of new products that will be coming on and driving growth in the future. But I think I've said enough for today to give you kind of an overview of both our earnings, our sales momentum, and all the things that are going on here at Merit.

So, I think at that point, back to our administrator. We'll go back now and we'll take questions regarding our results and aspects of the business. So we'll turn the time back over to our administrator.

(Operator instructions) Our first question comes from the line of Brooks West from Piper Jaffray. Your line is open.

Thanks. Fred, can you hear me?

I can, sir. Thank you.

Great. Good to hear your voice and congratulations on a nice quarter.

Thank you, sir.

I wanted to start with guidance. You didn't say anything about guidance. I'm looking at, I guess it's slide 9 in the webcast, and it looks like you did take revenue guidance up a bit for the year, but it looks like margins and EPS are unchanged. Am I reading that correctly?

Yes, I'm going to let Bernard just speak to that for a second. So, Bernard, this is something we hoped to clarify, and clearly we need to give a little more details, so (inaudible) Bernard?

Yes, so we adjusted the revenue guidance based on the addition of the DFINE products for the remainder of the year. And as we had already guided on earnings, that would remain flat for the year.

Okay.

Just let me make that -- so there's going to be about I think [16.5] of additional revenues. And of course we'll have increased gross margins that go along with that. We discussed that. I think we said about 80 basis points. It could be --

Yes (multiple speakers).

It could be higher than that.

That's still within the range.

Yes.

That's where we are (multiple speakers)

And that's within the range. But what we want to make clear is that there are these restructuring charges that are going to be part of what we'll have to finish out through the balance of the year, and that's why we've said all along that it would be -- earnings would be flat. When I say flat, they'll be above -- they'll be our original numbers until we get through this six months, and then from that time forth we'll have the restructuring completed.

Let me tell you what that restructuring is so I'm perfectly clear. We have facilities to shut down. We have to trim the workforce. We're going to be moving customer service and inventory and shipping, all those sorts of things. And so there's a lot of work, and I would say that right now we have completed, as of our discussion this moment, about a third of that. So we've already in a very short period of time accomplished about a third of what needs to be done. And then over the next -- the balance of the year, we'll finish the other two-thirds. And by the time we get of 1 January, everything will be squared and then everything will flow down, and then of course we will guide both earnings and revenues going forward from there for next year.

Got it. Okay. And when does the DFINE transaction close?

It closed on July -- was it the 6th? July 6th.

July 6.

We tried to get it as close as we could to the end of the quarter so we wouldn't have stub periods, but because of the holiday and everything, it got pretty complicated. But anyway, we finished it up on July 6th. And by the way, I should say that there are always issues with integration, but I think what was really pleasing was when you see the revenues, you see the customers, you see the sales force, and we're starting to already see that the former DFINE, now Merit sales people, are selling the Merit products and the Merit people are selling the DFINE products. So it's already starting to come together. It will take some time and additional training to get this thing all in synch, but I think we're moving exactly as planned.

Okay, great. Okay, so I guess, Fred, I'm a little surprised, you know the business has been performing above expectations in the first half. You've got this Cook opportunity. It sounds like HeRO is trending a little bit better than planned. I'm a little bit surprised you aren't taking up numbers for the base business. Can you just speak to that?

Well, yes. I mean one of the things that you have is that when you have all of the effort, you think about the amount of business that we picked up on the Cook situation, that takes away from a lot of other things that we could be selling. So, I just think with all that's going on, we just thought it would be better to -- especially going into the summer -- we just thought we'd just stay pat. We're going to see a continued growth. And, again as I mentioned, in the third quarter of the summer, with all the things that are going on in Europe, we just felt we'd like to stay conservative, and we would bring in this capacity on as well.

So I think, Brooks, more than anything, it was just not to get expectations ahead of where they ought to be and just trying to manage these things properly. And then, as the old saying goes, you know this, you've taught it to me, you know under promise and over perform. So I mean I don't know that we're necessarily under promising as much as we're saying, there's a lot of work to do, a lot of things to be accomplished, but I think that what we've done, for instance as I mentioned on the catheter situation, we're going to have a huge opportunity here. But, I've still got the six braiders to bring online. Some of them are already online, so I think that's part of it.

I think whenever you have a transition and you're training people, and you've got people that -- even though I think they -- we feel pretty comfortable about this, we've only been into this three weeks. But I think rather than trying to get the best outcome, I think we said let's stick with this and then let's prove what we can do instead of going out and, here you go, we're all excited, because we are, we're very excited. But I don't want to be apologizing for anything either. So I think it's just trying to stay conservative and not get things in front of us, that's all.

Okay, okay. And then I guess last question for me, you said the Cook situation was about $3.6 million in the quarter. If we annualize that number, you know call it $14 million, $15 million on an annual [basis], is that about the right way to think about it, or are you still ramping there? Is the opportunity actually bigger than that? Thanks.

I think going with what I just said in terms of trying to keep things, I think that that's a fair comment. What I feel strongly about is that as -- I don't know what others were doing, but as we made an assessment of the situation, we immediately made decisions to add capacity, because we have new facility in Texas, we had to add some machinery. We also made plans with vendors that more than triple our market (inaudible) capacity and availability. That's the high margin product, as well as some (inaudible). That capacity is now coming online. In fact it is online, not fully, but over the next 30 days, we will more than double or triple. That double or triple was not in this quarter.

And so I'm going to stick with kind of the ramp that you indicated. Is there upside to that? Yes, but we have to come online and get that product sold. I also think, as we mentioned, it will have higher gross margins it will absorb. And I think this business is going to stick. And I have a lot of reasons to believe. And listen, our customers are telling us they like our product. They don't want to get caught by any vendor without having availability. And very candidly, some of our competitors that are also doing this are starting to go into backorder, and Merit is now, with that increased capacity, is going to have the advantage. So we're very aggressive on this.

And again, in the long term, we've been through these before, Brooks, and it comes and it goes. This isn't going to go, in my view. I think this is going to stick. And of course, as we build that, particularly with this oncology business, remember it's the same call point. So we think that this bodes well. And listen, we've seen what it's done for us in Australia and Canada, in Europe, and it's still coming. And that's the thing I tried to get across, was that orders from India, Japan, Russia, Turkey, some of this stuff is still percolating. And you take that along with now reorders and more capacity, it's going to be a very big deal. I mean it just is. I'm sorry that somebody's -- to someone's disadvantage, but it's a very, very big deal.

Great. Thanks, Fred. I appreciate the comment.

Thanks, Brooks.

Our next question comes from the line of Jason Mills from Canaccord Genuity. Your line is open.

Great, thanks, Fred. Can you hear me okay?

I can, Jason. Good to hear your voice.

Thank you, you too, Fred. And grats (sic) on a solid quarter. I wanted to start with the gross margin. It was nicely up sequentially. Obviously you have a lot of things going on in the second half of the year, it seems like most of them favorable. So could you talk a little bit about gross margin trends quarter-to-quarter as you look into Q3 and Q4 and where in your range you sort of feel most comfortable?

Yes, I think the way I'd rather handle this is to say that we talked about the beginning year 100 to 150 basis points would be our goal. And I think that we're online with that, and we believe that will be the case. And then of course you'll have that incremental gross margin that we'll pick up from the DFINE business that we indicated that would be 80. There is some upside potential there, but that's kind of what our numbers are for planning.

Is there additional opportunity for gross margin? The answer is, yes, but it all comes down to execution. It all comes down to training and how quickly the sales force. So I would rather hold and see what we do in the summer quarter before we have any sort of (inaudible). I just don't want to get too far in front of myself here, Jason. I want to hit my numbers, and again my goal is to exceed them all the time. But I get pretty excited about this stuff and I'm going to try to damper my enthusiasm. So the answer is, 100 to 150 on the base business for the year, plus the incremental improvement that we'll get from DFINE, and all the other things that we can do.

We're also starting up some projects, new things, for instance our Corvocet. We've done about 75 cases with Corvocet, all approved, in Canada, in US, and in Europe. It has the opportunity to be an extraordinary product. And it's right in this IOS area that we've talked about. But anytime you start up a new product, it's not as efficient as we're going to be six months from now. And so that has very nice gross margins, along with other products that we're releasing. So again, I'm sorry to -- I'm not trying to avoid your question in any way, I'm going to say it's the 100 to 150 plus the DFINE, and hopefully we can deliver more.

That's helpful, Fred. Just a follow up on the gross margin side. So the baseline that you're coming up from, 100 to 150 plus the 80 in DFINE and the potential for more, although that's not something you're commenting on right now, would be sort of in that 45.5 range last year. So that implies the second half of the year sort of run rating in the mid-47s?

I'll just look, think about. The answer --

Yes, so we guided 46.5 to 47.5. Currently we're at 46.1 for the year. And so yes, there is some room for upside in the second half of the year. And that's what we had spoken with people about, that as we transferred more products to Mexico, and actually the variance was reduced from that facility, we introduced cost saving projects within our operation and introduced higher margin products that we would see an uptick in gross margin in the second half of the year.

Perfect. That's helpful, and I think important. Secondly, Fred, I just want to make sure I understood your commentary with respect to the quarter-to-quarter variances on the earnings given the expenses that you talked about and the timing of those expenses here in the second half of the year. So I know you don't give quarterly guidance, but just to make sure that we're all calibrated consistent with how the business should track given those expenses and the timing of them. Could you talk about maybe this time around, a little bit more granularity with respect to your pro forma earnings expectations for the third and the fourth?

Well, let me answer it this way, Jason. What we commented on was that we know what our expenses and what our plan is on the DFINE business, and our goal is, is to have a good portion of that, if not all of it, completed by the end of the year. And I think what Bernard was alluding to was the issue of timing, and could you have a little bit -- you know, even though we're getting that higher gross margin, will you have more of it fall in this quarter than you will in the fourth quarter. And what we were trying to say is there could be that. Some of that, maybe have Bernard give a little bit more of a granular (multiple speakers).

So there's a couple of things that we've taken into consideration and costs that we will see in Q3. So, we had a sales meeting expense, a big sales meeting that took place in July, so that was an additional expense. We will have it in Q3; we will not have it in Q4. Timing of synergy, so we're working through the synergies, and again, we will realize some of them in Q3, but there will be more of them in Q4 as we kind of restructure that business. And then as we're transitioning the business to Merit, we have DFINE people there helping us to do that within the next three months. And then again, they will, as part of the synergies, they will not be there in Q4. So there will be a level of expense in Q3 that it will just be for that period, about $1 million to $1.5 million. So it's a (multiple speakers).

Okay, got it.

That's the kind of figure we're talking about.

Yes, and I appreciate the question because we were concerned. We want to make sure everybody understands that it doesn't change our plan at all, it's about the issue of timing. And at the end of the day, Jason, we'll have this business. We have our business development leaders and those folks, and their compensation and everything that we're working on is to get this thing aligned properly, and we'll have that work done. And then again, as we get so -- we'll make our goals this year. We'll improve those margins. And then it really sets the stage for 2017 as well. We'll have a good year and we'll do the things we said we're going to do, but it helps us to complete the business. And then as we look at it and get that work done, as we give our forecast out into 2017, I think we had talked about 8% growth before, but we'll update all of these things as we come down the road.

And, if we get to a point in this third quarter where we have, I don't want to say a surprise, but if we are up on the higher end of things, then we'll look even at the fourth quarter if necessary. But we've got to get the work don't first. And it's a summer quarter and I always -- you know, things slow down in Europe and parts of the US as well, so. But it think, again, the bottom line is we'll do the plan we said we would do, and we do have an awful lot of wind at our back, and that's nice.

Got it. The last question for me. I'll get back in queue. Fred, you talked about the endoscopy division you're still fairly bullish about. Well, you said growth there over 20%, obviously that would require a pretty big step up here in the second half of the year. Maybe comment on what gives you confidence there.

Well, because I'm already seeing it. I mean I'm commenting on it because we've already seen that improvement as we're going forward. And I alluded to it, but to clarify, Merit is the leader in the pulmonary stent market. And our line of pulmonary balloons, we've received comments from the FDA, I believe, at least it's my hope, that within 30 days we'll have that approval 510(k) there. So if we see that, along with the acceleration that we're seeing in the Elation balloons for the esophageal balloons, and the stents go right along with it, so all of that is in place. That's a 75% gross margin business. And we're seeing those indicators in place as we're speaking.

And in fact, interestingly enough, even though we did not see some of those orders on the bipolar probes that I've talked about, those orders have returned now, and those will be delivered in the third and fourth quarter as well. So you take all of the things and add them up, and it's going to bring us back to those growth levels that we've talked about.

Perfect. Thanks, Fred and Bernard. Get back in queue.

Jason, good to have you onboard.

Thank you. Our next question comes from the line of Jayson Bedford from Raymond James. Your line is open.

Good afternoon, and thanks for taking the questions. I just have a couple. Somewhere in the commentary you mentioned a 20 basis impact on -- a 20 basis point impact on gross margin, and I thought it was related to kind of the Cook related recall, meaning the additional 50 folks. So first I guess, is that correct?

Yes.

Okay.

So what we said is it [negatively] affected us by 20 basis points in the quarter. Generally on those catheters, they are lower margin, but on top of that we hired people, you train people, you had higher scrap. And just because -- think about it. I mean we quadrupled our business in 90 days, so all of that had some expense to it.

Now, those people are trained. We have the supplies. We're becoming more efficient. And it's our expectation that that will be erased. And then (inaudible) the mix part of that. So most of this was the diagnostic catheters, but the other part that comes with this, Jayson, is the hydrothermal catheters, the vascular access, the non-vascular access product. It's a product we call the MAK-NV. And then on top of that, the big push that I think is coming in this third and fourth quarter is on our marker band catheters.

And so we had a big improvement there, but the problem was, I mean over last year, just to give you an idea, on [vessel size] and catheters, we were up at about 58%. But if you take a look at the diagnostic catheters, we were up 200 percent over the year ago period. Well there's a big disparity there, and that was nobody had the supply of the marker bands. Well, Merit stepped in very quickly and we've more than tripled -- and I will tell you, the market availability is there. The production is now actually coming online. When I say coming online, there's product on our shelf that is an increased amount from what we had just three weeks ago, and that will continue to ramp over the next month and a half to two months. And so we're going to take a lot of this business, and this is the highest margin part of it.

So, this is still ramping up. We did it early. We did it aggressively. And it was the right decision. The 20 basis points was the lower margin and kind of the startup cost of getting all this work done. I mean we were working 60 hours a week, overtime and this and that. Now we've hired and trained, and so we're going to become more profitable, and we're certainly more efficient today than we were two months ago.

Okay, thanks, Fred. In terms of Mexico, is that adding or detracting to gross margin?

It is now adding. We were $138,000 positive I think it was just last month. Is that right, guys? Yes. Just last month. And you remember what we said, that we would be at the breakeven point by the end of the first quarter. So now that is incrementally adding to gross margins going forward.

Okay. And then in terms of you mentioned a second wave, and I was just a little unclear as to what that meant. Is that just --

Yes.

-- you're seeing new orders from new countries? Is that what you mean by that comment?

Well, that's part of it. Thank you again for allowing me to clarify that. So, there was this initial wave that came out of this unfortunate situation. And I mean there were orders coming from a lot of places, and there were fives and there were tens, and a lot of customers, and we were able to fill a portion of that. But in some cases you just can't turn on and go up 200% overnight. But we filled that as well as we could, and had a little bit of a backorder. At one time it was up to about $1 million. That's dropped dramatically, but what we're seeing now is that our competitors, those other companies who were also participating in this, we're starting to have customers tell us they can't get supplies from them.

At the same time, I now have the increased capacity. I hired the people. I made the investments. Better yet, we made those investments. And so we're seeing orders coming from large hospitals. We had one the other day of over 200 catheters, and it wasn't part of the first wave, that first (inaudible). We had another one that was 170. We had an order from Russia for over 1,000 catheters. So some of those were filled by the other companies. But it at least appeared from us, and anecdotally the evidence that I'm receiving is that they can't meet those orders.

Now, I don't know what they did, Jayson. I don't know if they -- you know, it's selective, or they didn't ramp up, they didn't -- or they've reached their capacity. I simply know I'm seeing new orders. I'm seeing old orders, and I now have the capacity. And we're calling it the second wave here. And we're seeing order levels above where this thing originally started and broad. So it's our belief, based on what we're seeing, that this is going to continue. We believe it's going to stick. We're talking to customers. And you're going to hear the opposite from others. The fact of the matter is, is we have as good or better product. My belief is it's better. Customers don't want to be held at risk. They want to make sure -- and this creates a lot of other opportunities for Merit to sell other products. So that's what I'm talking about, the second wave. That's added on top of the initial business that we've seen.

Okay, thanks. I'll jump back in queue and let others jump in.

(Inaudible). Hey, thanks so much.

Thank you. Our next question comes from the line of Jim Sidoti from Sidoti & Company. Your line is open.

Good morning, Fred. Can you hear me?

Hey, Jim, I can. It's good to hear your voice.

Great. Great. First question is, what are you doing to keep this business so that when Cook comes back online that you can keep some of this business?

Yes, the answer is this, Jim, is first of all, I heard various stories about, you know they'll be on in six months, they'll be on in one year, they're replacing with other catheters. You know, I hear all those stories and that's the thing. But here's what our customers are telling us. Now first of all, we have probably the broadest line. If you take a look at our catalogue, and there's two lines, we have the Impress line radiology catheters, and we have the Performa line of radiology catheters. That was part of our original acquisition when we bought the (inaudible) catheter line. Merit then developed its own catheters called the Impress.

And so it's the broadness of the product offering. It's the fact that unfortunately I think customers, like anybody, if you don't meet those needs, or these things go on too long, or they happen more than once, you know they're just going to lose faith. And you have a good product, you have a presence, you have a broad line of other products to sell, and it's not like we're new at this. We've been around here for a long time. So I think it's the mix. I think it's the quality. And I think it's the ability simply, I mean at the end of the day, to provide the product.

So, you know, I don't want to comment, I have a lot of things, but I don't want to comment on somebody's misfortune. It's just very unfortunate. But, if you're prepared, if you have the capacity and you have the breadth of product, and you can deliver that to your customer, you're going to win. And I just believe this is unlike other ones we've seen, and listen I've got my sales guys sitting in a row here. They're all within an arm's length of me so I can belt them one if they don't sell something. But we all believe that. I mean I've got Justin, and I've got Don, and I've got Munroe, and I've got others in here, Jesse, all the guys that are responsible for this are saying, you know we're all on the same page. We're not making it up. We're seeing it and our customers are telling us this. And we're not just coming up with it. It's not a hope, it's what we're seeing in the field every day.

All right. And my second question is regarding your R&D spend in the quarter. It's up about $2 million year-over-year. Is that people or trials or can you just give us some color on what that is?

Yes, I'm going to let Bernard comment on this. Bernard?

It's following on from the additions that we made to our R&D group in Q3 and Q4 of 2016, or sorry, 2015. And the spend is actually in line with what we had guided at the start of the year. We have a number of projects that are -- that we need to complete. There's new products to be launched in the back half of 2016, so there's a big effort on there and we felt that we needed to make that investment in head counts and at the back end of last year to deliver on those projects.

I think there's some additional expenses in there for the trials too. There's some expense for that as well. And, and very candid, as you know we put some of the regulatory expenses that are in the R&D budget and we've placed the things that we've been doing in Canada and in Australia. So there's several places, but I think the key takeaway is, it's essentially on our budget line. Is that correct, Bernard?

Yes, it's in line with where we would have forecast. So for the full year of 2015, we were about at 7.5% and we're tracking at about 7.6% of revenues right now.

Okay, thank you.

Okay.

Thank you. And our next question comes from the line of Marco Rodriguez from [Merit]. Your line is open.

Good afternoon, guys. Thank you for taking my questions. One real quick clarification on a prior question with kind of the volatility you might expect in the second half of the year based on the integration aspect. You threw a number of $1 million to $1.5 million. I just wanted to make sure that that number is actually going to be stripped out of your pro forma EPS number. Is that correct or is that going to be part of it?

It's part of it. Now, we had forecast this in our model that actually got us to neutral on an earnings basis when we actually spoke about DFINE initially. But it's just the timing of those expenses, so again, as I said, it's sales meeting expenses, it's having people help us transition the business from DFINE into Merit. So you're going to see slightly higher level of expense in Q3 for that rather than in Q4. But overall, it will be neutral on an earnings basis for 2016.

And so that I could also make it clear, so no one misunderstands. We're restructuring this business. We're paring employees, services. We're consolidating that duplication into Salt Lake City, and all of those sorts of things. And we figure in our plan, as we put it together, that would take us about six months. Maybe some of it will fall out. Some of it's a little early, some of will be a little late. But all in all, we should have all of that taken care of over the next six months. And then as we start the next year, we will have that, essentially that business in line with what Merit expenses are. And then we'll have the benefit of the gross margins, and by that time we'll also see acceleration on the revenue side because of the more sales people, a broader international footprint, and the [bag] in which there's complementary products.

And going back to the DFINE guys, you know they have a great product line. I think, by the way, that's been confirmed over and over to me as I've talked to physicians, and some of the best tertiary care centers in this country use this product. The problem is that those guys didn't have enough products to sell. They had a couple product lines. And so what we've done now is put this group of products, that are all complementary to each other. And we think that with that, and with the Corvocet, which is the biopsy product going to the same point of sale, we think this is going to be the fastest growing division in the company for quite some time.

Got you. Very helpful. Then, last question I have here. On the inventory side on your balance sheet, have you guys been building any inventory to kind of capitalize on this Cook situation or is there other drivers there?

Well, a lot of it has been that the raw materials that you have to build for the Cook situation, we've also launched the basixTOUCH40. We've got the inventories that we're building for the Corvocet, the pulmonary balloons. I mean we've been building the stock to launch these products, and some we've launched and others we're building. But, Ron, do you want to add anything? Ron Frost is our Chief Operating Officer. Ron, do you want to add anything to that?

Sure, Fred. We do have inventory in Canada and Australia that we had stoked up, as well as Russia. So that is on the books so we can meet the increasing sales in those territories.

Yes, and that's a very good point, Ron, thanks for mentioning that. So, in the past, when we worked with a distributor, we would just fill those orders. In Canada, by the way, just as a point of interest, some of those orders were delivered in three weeks, and that was the standard. So we have warehouses and customer service in both of those areas, and we deliver on demand, and that's what you need to do. And that's why I mentioned that in our -- at least in our Australian business, that we've already hit the forecast for this year. And in the Canadian -- both of these businesses, by the way, are profitable and making money, and that's kind of an interesting thing when you can start up -- and we're getting higher prices. So as that business comes down the road and offsets those additional expenses of distribution we have, we're going to see pretty -- very nice comparisons in terms of gross margins and contribution there.

But what we had to do is we've got a warehouse there, and it's not kind of get it there when they order it. We've stocked it up and we have to [send] a long ways. And I think one of the reasons why we're already at that point is because we have the product. It's on the shelf. The customers can order it. So yes, the Cook was part of that, but the other thing is just having availability. And I'd say that's, in Toronto, or in Melbourne, we have our own warehouses, product down there, and it's more than it would have been if it was the distributor. So that's part of it.

Our inventory turns are also consistent. We're not seeing any spike in inventory turns and month over month, even when we compare it to 2015. So it's something that is managed very closely. As we said, there is inventory sitting in other warehouses but we're turning this at the same rate that we've turning it for the last probably six to nine months.

Appreciate it, guys.

Okay.

Thank you. (Operator instructions) We will hold for one more moment for questions.

There's just one thing I would like to comment on before we finish. (Inaudible) DFINE acquisition will be neutral on a non-GAAP basis from an earnings perspective. From a GAAP perspective, there will be an effect there based on all of the reorganization costs, and that's approximately $0.24, and that's not reflected in the document that we issued. So I just want to make sure that people are clear on that.

So we'll have those expenses (multiple speakers) expenses, the GAAP expense.

It's just purely GAAP.

Onetime expense.

Yes.

Those were added back in for non-GAAP.

Yes.

And then we're done with them. So, okay, I appreciate that clarification. Well listen, it looks like that's the end of the questions. We've kept you on here for an hour, and one of the commitments we made is to try to keep it shorter, and we haven't been able to do that. A lot to talk about. I think if we look again in summary at what we've accomplished in this quarter, and the stage that it sets for continued growth, improvement in margins and profitability, clearly we're engaged. We're focused. And we haven't lost sight of that three year plan. As we look at it, everything we look at and everything we talk about, is this consistent with the ability to deliver that three plan, and are these other incremental things there to help improve the performance of the company.

So, we've got a lot to do. There's a lot of exciting new products and that sort of thing coming forward I think. I think we're going to see a lot of good things coming out of this restructuring. As I mentioned, you know the guys in the different divisions can focus on the various products (inaudible) I have a broader [bag] and I think a net/net of about 25 to 30 sales people. So, that's another thing I want to make clear is that that sales number has gone up. And then that, as we take this into the international markets, that was the thing that was I think very interesting to us is there was a very, very narrow footprint that DFINE had in terms of -- you know, Europe essentially just being in -- a little bit in the United Kingdom and Austria, and the bulk of their business. But there are all of those other footprints that Merit has, and the DFINE stability products are also approved in Canada. So as part of our sales meeting, we brought the Canadians down there as well.

So, listen, there's a lot of work to do. There's a lot of momentum in the business. And then you get these things, like you have this situation that Cook that certainly is going to be a bigger opportunity. You know, we were very I think conservative in the comments at the end of the first quarter, and we said we'd see how it would go, and we would come back and tell you after we'd been out on the battlefield for a while. And the report is, we're winning the battle, and there's great opportunity going forward, and we're going to retain the ground that we've captured.

So, ladies and gentlemen, that's my report. Bernard and I will be here for a couple of hours if there's clarification and things that we can help with. We'll be happy to answer questions. We appreciate your interest. We appreciate you taking your time. I know it's a busy earnings season. So, at 105 degrees in Salt Lake City, we'll go ahead and sign off, but we'll be here to answer questions for you. Thank you again for taking the time. We'll sign off now. Wishing you a good evening from Salt Lake City. Good night.

Ladies and gentlemen, thank you again for your participation in today's conference. This now concludes the program and you may all disconnect at this time. Everyone have a great day.