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Edited Transcript of CRY earnings conference call or presentation 14-Feb-19 1:30pm GMT

Q4 2018 CryoLife Inc Earnings Call

KENNESAW Feb 20, 2019 (Thomson StreetEvents) -- Edited Transcript of CryoLife Inc earnings conference call or presentation Thursday, February 14, 2019 at 1:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* David Ashley Lee

CryoLife, Inc. - Executive VP, COO & CFO

* James Patrick MacKin

CryoLife, Inc. - Chairman, President & CEO

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Conference Call Participants

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* Brooks Gregory O'Neil

Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst

* Jason Richard Mills

Canaccord Genuity Limited, Research Division - MD of Research & Analyst

* Joseph P. Munda

First Analysis Corporation - Analyst

* Suraj Kalia

Northland Capital Markets, Research Division - MD & Senior Research Analyst

* Lynn Pieper Lewis

Gilmartin Group LLC - Founder & CEO

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Presentation

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Operator [1]

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Greetings, and welcome to the CryoLife Fourth Quarter and Year-End 2018 Financial Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Lynn Lewis of the Gilmartin Group. Thank you. You may proceed.

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Lynn Pieper Lewis, Gilmartin Group LLC - Founder & CEO [2]

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Good morning. This is Lynn from the Gilmartin Group. Thanks for joining the call today. Joining me from CryoLife's management team are Pat MacKin, CEO; and Ashley Lee, CFO.

Before we begin, I'd like to make the following statements to comply with the safe harbor requirements of the Private Securities Litigation Reform Act of 1995. Comments made on this call that look forward in time involve risks and uncertainties and are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The forward-looking statements include statements made as to the company's or management's intentions, hopes, beliefs, expectations or predictions of the future. These forward-looking statements are subject to a number of risks, uncertainties, estimates and assumptions that may cause actual results to differ materially from those forward-looking statements. Additional information concerning certain risks and uncertainties that may impact these forward-looking statements is contained from time to time in the company's SEC filings and in the press release that we issued last night.

With that, I'll now turn the call over to CryoLife CEO, Pat MacKin.

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [3]

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Thanks, Lynn, and good morning, everyone, and thank you for joining us.

As we're going to hear today, 2018 was a highly successful year for CryoLife as we made meaningful progress toward becoming the leading provider of solutions for people suffering from aortic disease. We now operate from a position of strength due to the quality and breadth of products, our experienced sales team and adept customer support.

This morning, I will outline why we expect CryoLife will be even more -- in an even stronger position in the coming years without needing to make a single acquisition. Simply put, we believe our story will keep getting better as we advance our pipeline and execute our strategy. We expect our steady growth to continue and our addressable market to increase by over $1.5 billion due to anticipated regulatory approvals and from geographic expansion we aim to deliver.

As we reflect on 2018, our team made significant progress towards the goals we set for our year. We generated top line growth of 11% for the full year 2018 versus 2017 on a non-GAAP basis, and 10% on a constant currency basis. We completed the integration of JOTEC, we leveraged our global commercial organization, we enhanced our commercial leadership team in Latin America and Asia-Pacific and we advanced both our product pipeline and our clinical programs meaningfully.

Turning to our operating performance in the fourth quarter. CryoLife closed 2018 like it began with solid revenue performance led by double-digit organic growth from our JOTEC and On-X product lines. Revenue in the fourth quarter was $67.8 million, up 8% on a non-GAAP basis and constant currency basis.

Despite revenue exceeding our expectations, our operating expenses were more than anticipated in the fourth quarter due to the acceleration of spending on our product pipeline and increase related to international growth. Ashley will review our first quarter financial performance and 2019 outlook in more detail later in the call.

Now I'll take a few minutes to summarize the progress we've made toward our 2018 initiatives and then talk about our strategic priorities for 2019, including milestones and goals that we anticipate will drive both near- and long-term revenue growth and improved earnings performance.

In 2018, we posted strong organic revenue growth driven by On-X and JOTEC product lines. In both instances, we continue to take market share through an experienced and well-trained team of dedicated sales professionals and a highly differentiated product portfolio, backed by significant clinical experience and strong clinical data.

We grew JOTEC non-GAAP revenue by 25% for the full year 2018 versus 2017, while integrating its products and employees into CryoLife. Our best-in-class family of mechanical valves, On-X, posted revenue growth of 21% in 2018 versus 2017 as we continue to demonstrate the clinical advantages of our technology compared to our competitors.

Finally, we transitioned a large portion of our European markets to direct sales from distributors and we're already starting to enjoy the benefits of that decision.

We also achieved our second key initiative, completing the integration of JOTEC and delivering double-digit non-GAAP revenue growth in 2018. We estimate that the international market for which our JOTEC portfolio competes is growing in the low single digits.

In the fourth quarter, the JOTEC portfolio recorded non-GAAP revenue growth of 17% and 19% on a constant currency basis. This is implying meaningful share gains. We believe this is driven by the combined effect of our experienced direct sales teams selling the best and broadest portfolio of branched stent grafts on the market.

Turning to On-X. Our fourth quarter for On-X was up 13% as reported and 14% on a constant currency basis. North American On-X revenue grew over 13% in the quarter, while our European, Middle East and Africa business grew over 22%. We expect On-X revenues will remain solid as it is the only mechanical aortic valve in the world that carries the FDA label, allowing patients to be managed starting 3 months after their surgery at an INR level of 1.5 to 2.0, and that difference gives us a tremendous competitive advantage.

Another key initiative for 2018 was to expand our addressable market opportunity through investment in our R&D product pipeline and we made meaningful progress towards advancing our clinical programs as well.

And finally, we also achieved an important initiative completing the transition to direct sales channels for our legacy CryoLife products in Spain, Italy and Poland. I'm proud of all we have accomplished in 2018, and as you'll hear, we have an equally ambitious 2019.

For 2019, we expect to achieve high single-digit growth in total revenues and double-digit growth in our JOTEC and On-X product lines. We anticipate performance this year will be driven by further market share gains from existing products and new product introductions via our direct sales force.

We also have several catalysts in 2019 to fuel our continued top line growth. First, we expect to introduce 3 next-generation JOTEC products into select international markets in 2019. These include our next-generation Frozen Elephant Trunk called the E-vita Open Neo, our second-generation thoracic stent graft called E-nya and the first-ever off-the-shelf branched thoracoabdominal device called E-nside.

Second, we're continuing to advance our regulatory approvals. As you'll recall, we completed the enrollment of our clinical trial for BioGlue China in 2018, and we remain on track for regulatory submission in the first quarter this year.

Third, we also recently completed the enrollment of the PerClot study in the United States, setting us up for a PMA submission to the FDA in early 2020. This is delayed compared to our previous guidance due to work established -- to establish our large-scale manufacturing process and the related verification and validation work, including shelf life studies to support the anticipated launch postapproval.

Fourth, we're excited about the upcoming Ross master class at the upcoming AATS meeting in May. Dr. Paul Stelzer from Mount Sinai, New York, will be presenting a subset of his 600-plus Ross procedures with up to 20-year follow-up. The Stelzer series, when combined with the recent JACC publication by Mazine and coworkers, provides a retrospective look at more than 4,600 patients from 10 different literature reports that underwent the Ross procedure. For those who are unfamiliar with the Ross procedure, it is a double valve procedure where pulmonary allografts are used to replace the patient's native pulmonary valve, which has been moved into the aortic position. We've seen an uptick in the Ross procedure over the last couple of years and it has helped to drive our cardiac tissue revenues. The data shows that the Ross procedure restores normal life expectancy to patients, and it appears to be the best option for young- to middle-aged patients with a diseased aortic valve. The symposium will highlight the very compelling long-term efficacy data for the procedure and should be a clear positive for our cardiac tissue business.

Fifth, we are investing in the development of our distribution channels in Asia-Pacific and Latin America. Last year, we strengthened our commercial leadership team with the addition of 2 seasoned sales professionals to lead our commercial efforts in these geographies. We will begin migrating to a direct sales model in the second quarter in Brazil with our legacy CryoLife products.

And sixth, we will enhance our sales channel across Asia-Pacific with a focus on China where we expect to have new distributors in place by mid-year.

We expect these initiatives to deliver high single-digit revenue growth in each of the next 5 years. And with that, we're providing 2019 revenue expectations between $280 million and $284 million.

In addition to these near-term catalysts just described, we have a rich long-term pipeline filled with opportunities that we believe will increase our addressable markets. I would like to highlight several important opportunities in our pipeline. First, we have submitted our IND for the PROACT 10A trial and are hoping to begin enrolling patients in the first half of this year. We held an investigators' meeting in late January at the Society of Thoracic Surgeons Meeting and there is significant enthusiasm for the trial and great anticipation for the commencement of the study. Through this trial, we will seek to obtain FDA approval with the On-X aortic valves using Eliquis rather than Coumadin as the blood thinner. We look forward to working with the FDA and will provide more details as they become available.

Second, we will file a regulatory approval for BioGlue in China in the first quarter of this year and for PerClot in the U.S. in early 2020. We could potentially have both of those products in the market in 2020.

Third, in 2021, we expect to have the E-ventus SX, our self-expanding peripheral stent, in the market in Europe, and expect our On-X mitral valve to receive regulatory approval for a lower INR similar to the On-X aortic valve in both the U.S. and Europe. That valve would offer doctors and patients the same low INR profile found with our aortic valves.

And fourth, beginning in 2023, we look to leverage our JOTEC product line, which is currently not approved for sale in the United States. We plan to conduct clinical trials in the United States with the 3 next-generation JOTEC products that are slated for launch in Europe this year with the goal of obtaining FDA approval for each product.

With that, I will now turn the call over to Ashley.

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David Ashley Lee, CryoLife, Inc. - Executive VP, COO & CFO [4]

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Thanks, Pat. I'll now review our results for the fourth quarter as well as our financial outlook. Total company revenues increased 28% to $67.8 million when compared to the fourth quarter of the prior year.

Q4 total revenues grew 8% on a non-GAAP and constant currency basis compared to the fourth quarter of 2017. Q4 North American revenues were $37.9 million, an increase of 5% year-over-year. The increase was driven by a 13% increase in On-X and a 6% increase in tissue processing.

Q4 revenues from our EMEA region, Europe, Middle East and Africa, were $23 million, an increase of 11% and 13% on a non-GAAP basis compared to the prior year.

Revenues from Asia-Pacific and Latin America were $6.9 million for the fourth quarter, an increase of 28% and an increase of 9% on a non-GAAP basis compared to the prior year.

Looking at individual product lines. On-X revenues for the fourth quarter were $11.3 million, an increase of 13% over the fourth quarter of 2017. Q4 On-X revenues increased 14% on a constant currency basis compared to the fourth quarter of 2017.

JOTEC revenues for the fourth quarter were $16.7 million. Non-GAAP JOTEC revenues increased 17% compared to the fourth quarter of 2017 and 19% period-over-period on a constant currency basis.

BioGlue revenues in the fourth quarter increased 1% year-over-year to $17.9 million. North American BioGlue revenues were $9.4 million. OUS BioGlue revenues increased 3% year-over-year to $8.5 million. BioGlue revenues for the fourth quarter of 2018 increased 7% in the Europe, Middle East and Africa region and decreased 1% year-over-year in Asia-Pacific and Latin America.

Tissue processing revenues for the fourth quarter were $18.5 million, an increase of 4% compared to the fourth quarter of 2017. During the fourth quarter, vascular revenues and cardiac tissue processing revenues increased 4% and 5% year-over-year, respectively.

Our gross margins were 66.7% for the fourth quarter and 65.8% for the full year. Our pro forma gross margins, excluding JOTEC purchase accounting adjustments, were 66.7% for the quarter and 66.9% for the full year of 2018.

SG&A expenses during the fourth quarter were $35.6 million, which includes $1.4 million in integration and business development-related expenses. These charges include ongoing expenses related to the JOTEC integration, which primarily relates to SOX implementation. Our operating expenses, however, were more than anticipated in the fourth quarter due to the acceleration of spending on our product pipeline and increased costs related to international growth.

On the bottom line, we reported GAAP net loss of $1.7 million or $0.05 per fully diluted share in the fourth quarter of 2018 and non-GAAP net income was $1.9 million or $0.05 per share for Q4. Our non-GAAP EPS was adversely affected by the items I previously mentioned.

Please refer to our press release for additional information about our non-GAAP results, including a reconciliation of those results to our GAAP results. Also, our reported financial results are preliminary, pending the completion of our audit and the filing of our Form 10-K, which we expect to file next week.

As of February 11, 2019, we had approximately $46 million in cash, cash equivalents and restricted securities. We had approximately $223 million outstanding under our term loan B. And based on our credit documents, our current gross leverage stood at approximately 4x and our net leverage was approximately 3.5x. We expect our net leverage to be around 3x adjusted EBITDA by the end of the year. We can comfortably service our debt and have no financing needs to support our current business model.

Now turning to our outlook for 2019. We expect full year revenues in 2019 will be in the range of between $280 million and $284 million. We expect first quarter revenues of between $66 million and $67 million. We expect non-GAAP EPS to be between $0.28 and $0.32 per share. This includes approximately $3 million in nonrecurring cost associated with work necessary to comply with the new Medical Device Regulation in Europe, which is scheduled to go into effect in 2020. Compared to the current Medical Device Directive framework, the new regulations had increased the requirements and costs to get existing product certification renewals and new product approvals. These new regulations have essentially moved Europe closer to what is required by the U.S. FDA. The costs I have referred to earlier primarily relate to costs for certifications of products already on the market in Europe. The bottom line also reflects approximately a $2 million investment in the acceleration of our channel development in Asia-Pacific and Latin America.

That concludes my comments and now I'll turn it back over to Pat.

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [5]

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Thanks, Ashley. So in closing, we had an exceptional 2018 in which we achieved many product development and regulatory milestones and delivered strong financial performance. I would like to thank all those at the company who made 2018 such a success. Your hard work literally improves the lives of people every day around the world. Our mission is straightforward. If we execute on the goals and objectives I've outlined today, we expect to be a significantly larger company with a stronger leadership presence in the markets we serve.

Fortunately, we have all the pieces in place, including a strong leadership team, to drive the process. We enter 2019 well positioned to continue delivering solid and sustainable financial performance. So given all the opportunities for growth I've outlined this morning, it's easy to understand why we're so optimistic about our future days.

With that, we will now open the line to questions. Operator, please proceed.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question is from the line of Jason Mills with Canaccord Genuity.

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Jason Richard Mills, Canaccord Genuity Limited, Research Division - MD of Research & Analyst [2]

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Can you hear me okay?

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [3]

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Yes.

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Jason Richard Mills, Canaccord Genuity Limited, Research Division - MD of Research & Analyst [4]

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Great. So Ashley, you sort of got into the first line of questioning I'd like to get into, which is sort of the earnings profile of the company. And we all knew because you guys had been talking about the MDR mandate and the necessary spending there, we just didn't know how much it was going to be. So maybe run through more broadly, Pat, the operating expectations, earnings expectations for the company on a pro forma basis. It looks like that $3 million if I tax it with the tax rate I had in my model is fairly meaningful, 10, 10-ish, give or take, depending on how you calculate it. But generally speaking, looks like the earnings profile of the company could be quite a bit higher without it. And I'm wondering just as we look into 2020, if that's sort of the baseline we should be thinking about excluding that $3 million and sort of assuming the midpoint of your range.

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [5]

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Yes, let me take the macro question because I think this is a really important one, and I think for investors -- and I'll have Ashley -- if this follows, I will have Ashley, maybe he can get into more specifics. So when I look at the company today and I go back, when I got here, we had 10 reps in Europe and a $20 million business. And through the acquisition of JOTEC and going direct and all the things that we've done over the last 4 years, we now have 80 direct reps and $100 million business. And it required investment along the way to get there, but basically, the European infrastructure is now set for us to leverage with our pipeline. The same could be said about the U.S. When we acquired On-X, we merged sales forces, we built those sales forces. So what we've basically been doing is a step-by-step approach to investing in our channels. So our U.S. is pretty solid and fixed, Europe is pretty solid and fixed. We have basically wide-open markets in Asia-Pacific and Latin America. We're choosing to invest a couple of million dollars to build out those channels. But once those are built out, we basically have a global infrastructure that is somewhat fixed, and that comes to the next point, which is the pipeline. We have 13 products in our pipeline that are going to add $1.5 billion to our total addressable market. And as those channels get fixed in Asia-Pacific and Latin America over the next 12 to 24 months, the entire global footprint can then be leveraged on every single one of those 13 new products that we launch.

So I think, what you're going to see, and again, this goes back to kind of our 5-year goals as a company, we're building a company here. And I think we've done a nice job in the last 4, but we've got a lot more to do, and I think the opportunities are great. So we think we can deliver a high single-digit 7% or 9% growth to investors in revenue over the next 5 years. Our gross margin is at 67% this year. We're going to try to add 1 point of gross margin per year over the next 5 years. And because those channels are mostly going to be fixed in the next 18 months, I would say, the ability to leverage the operating margin of this company as the 13 new products come out is going to escalate quite quickly as we get that infrastructure set up moving towards a 20% operating margin, which is our 5-year goal. So this -- we're building a company. We are investing in channels, we are investing in the pipeline. And we obviously had to deal with this MDR issue, which is kind of a onetime thing, but at the end of the today, we are still committed to our 5-year goals, and I think we are very well positioned to do that.

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Jason Richard Mills, Canaccord Genuity Limited, Research Division - MD of Research & Analyst [6]

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Terrific. That's very helpful color around sort of the longer-term expectations as you operate the business to build it. Wanted to move to JOTEC. Obviously -- and you mentioned it in those remarks, the importance of JOTEC not only from the standpoint of having products that you like in there growing but also the offerings and the business strength that you have in Europe relative to where it was when you came on board. So maybe spend a minute and level set us on the JOTEC business in light of the fact that you have several new products coming in 2019. You are now starting to talk about your regulatory plans and strategy for the U.S., which is obviously a couple of years away, but it's getting closer. And maybe just talk about the trends across your product line, buckets within JOTEC. What you are seeing not only from a volume perspective but an ASP perspective and a competitive perspective? As you start to get into these new markets, how do you expect JOTEC to contribute to Latin America and Asia-Pacific? Just trying to get a sense for whether or not on a go-forward basis, and you obviously talked about '19, but over that 5-year period time, what sort of contributions do you expect from a growth perspective from JOTEC. I think it is an important part of your business.

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [7]

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Yes. No, absolutely. And I couldn't be more pleased, to be honest with you. And I've done a number of acquisitions in my carrier, and as you well know having watched a number, there's always kind of trips and kind of stutter steps because of things you didn't know about or just things that happen. A year after we acquired JOTEC on December 7 of last year, so we've had it for a full year now plus a month or so, I mean, it's been -- it's frankly been flawless. We delivered 25% top line growth. We've had no turnover of the executive team. We've had no turnover in the field, and the pipeline is very robust. And so I think there's probably 3 things that I would watch with JOTEC. Number one, starting this year, we've got 3 new products coming. We have a next-generation Frozen Elephant Trunk, we have a next-generation thoracic stent graft and we have a next-generation -- actually, the first-ever off-the-shelf branched cervical abdominal device, which we think is going to be kind of a game changer. Those are all planning on being launched this year. Two of those products are being submitted to the CE Mark this month, and the other one will be submitted, I think, in Q2.

So the first thing you're going to see is those 3 products as they get into the European channels, which is an 80-person channel now, you're going to start to see the impact that, that fixed kind of footprint has on -- with those new products. The second thing you will see with JOTEC is our investment in Asia-Pacific and Latin America. We've a tremendous opportunity in China. We already have JOTEC products approved in China. We have JOTEC products approved in many markets in Asia-Pacific and Latin America. The addition is, there is a bunch of markets where we can actually -- all we got to do is get the regulatory approvals in those places and we can sell the products. So I think the second kind of vector you're going to see for JOTEC is the expansion into Asia-Pacific and Latin America as we build out those channels. The third is we are already starting the testing for the U.S. PMA clinical trials. We're going to take those 3 new products that we talked about that are coming into Europe and we're going to trial those in the U.S. Now obviously, that takes a long period of time, but the total addressable market for those 3 products that are launching in Europe this year, it is probably in the $700 million range. And the margins are higher and we think we have very competitive offerings in those spaces.

And then the last thing I would say is, a product we have not talked a lot about from JOTEC is their ePTFE coverage stent called E-ventus SX. That's a $500 million market if we choose to take that to the periphery, and we haven't even talked about it. So I guess to -- kind of to summarize the JOTEC, the entire -- every product line was growing double digits last year. The whole business grew 25%. We're getting ready to launch 3 new products in Europe. We're building out our channels in Asia-Pacific and Latin America which are going to leverage that, and that we've got this U.S. pipeline kind of in the wings that the work is already being started there. So we -- as we said when we acquired the company, we see JOTEC as a double-digit grower for a long period of time.

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Operator [8]

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Our next question is coming from the line of Brooks O'Neil with Lake Street Capital Markets.

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Brooks Gregory O'Neil, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst [9]

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I was just curious if you could describe kind of when you made the decisions to accelerate your spending during the fourth quarter. And would you describe those decisions as sort of strategic opportunities that you found that you just decided to make the investment in? Or was it something different than that?

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [10]

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Yes, I would say the -- I'll talk about kind of '19 and then I'll come back to Q4. So we had a meeting with our board in October where we talked about the 2019 plan. And we obviously knew where kind of The Street was with EPS and we saw the opportunities in front of us. And we feel in the long-term value creation for our shareholders, the return on investment is just too great with these channel investments in the R&D pipeline to -- we could be much more profitable. We could kind of constrain our R&D pipeline, we could not invest in Asia-Pacific and Latin America, we could deliver way higher EPS. Working with the board and we all felt with management that for long-term shareholder value creation, this company has got so many opportunities. I mean, no company of this size has 13 products in their pipeline and it's a low-risk pipeline and a high-return pipeline. And like I said, we have nascent commercial markets in Latin America and Asia-Pacific. We have a handful of people. So with the support of the board, they fully agreed that we needed to invest long-term in the company and this is a building year for us. And as I said earlier in my first comments with Jason, we are still committed to the financial metrics we talked about of delivering high single-digit growth. As the pipeline comes forward, we think that will accelerate. We think we can get gross margin expansion of 1 point per year. And we think because this infrastructure once in place is largely fixed that as those pipeline products come out, you're going to start to see the operating margin of the company accelerate through the 5-year period. So if I come back to Q4, it is fair to say we didn't sit down and have a conscious plan. I mean, the biggest overspend was the pipeline. We were pushing hard to enroll the PerClot trial to wrap up the BioGlue China trial. So once -- for those who have been involved with R&D and clinical trials, I think every quarter, we were behind on our enrollment and we are pushing hard to get it done, and obviously that was a big part of the overspend. So, I mean, to me, that was -- it's good news. We actually were under our R&D budget for the year, this was over in the fourth quarter. So I'm not that disappointed because we're pleased to have the trial enrolled. A second piece is, as we talked about, we've invested in the bringing on of new leadership and we are starting to put plans in place. We've got BioGlue getting ready to come to China. We've got going direct with the BioGlue in Brazil. So those things started unfolding. And then the third piece there I'd say is we actually had a commission kind of accrual issue in JOTEC and it was probably one of the only things, I'd say, that there was a negative that we just kind of missed on our earlier commission accrual, but that's not going to happen again. So again, it was kind of a onetime thing. So again, I'm pleased with the direction that we are going and I think that the EPS goals we've set out there are going to allow this company to continue to build the channels in Asia-Pacific and Latin America, to invest in this pipeline, and you're going to see the financial metrics start to accelerate here on all 3 fronts.

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Brooks Gregory O'Neil, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst [11]

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I think that's great. My own personal view is investors should be looking to you as a growth business and one that demands and will value the investments. So keep it up.

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [12]

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Thank you.

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Operator [13]

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The next question is from the line of Suraj Kalia with Northland Securities.

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Suraj Kalia, Northland Capital Markets, Research Division - MD & Senior Research Analyst [14]

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Pardon the background noise if any. So Pat, 3 buckets of questions. First and foremost, can you quantify for us the cross-selling efforts and the results for CryoLife and JOTEC in Europe? Also, can you help us quantify the cross-selling between CryoLife and On-X in the U.S.?

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [15]

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Yes. So one of the things -- I actually just -- I was at the -- we had an international sales meeting back in January, so I was actually with the team in Europe. And one of the things that's interesting, if you think about it, trying to capture cross-selling in the first year is difficult because you didn't have a prior year comparator with your new structure. We now have kind of a prior year comparator to the existing structure. We'll be able to better manage that or tell you this year. I will tell you BioGlue as an example. So we -- one of the cross-selling opportunities between JOTEC and CryoLife was BioGlue. And we grew BioGlue 8% in Europe this year or in 2018. That was probably twice the growth rate of the prior year. So I would tell you that adding that additional channel clearly benefited, there was a benefit from cross-selling. That's also an easier product from a training requirement standpoint. We had the full vascular team trained a year ago.

I think the second opportunity was kind of going the other way, which is the legacy CryoLife cardiac surgery reps started selling the Frozen Elephant Trunk from JOTEC. And we've also seen a pickup there, although that's a much more difficult kind of -- from a training requirement standpoint. So I think we'll actually -- until we get the new product, I think we are going to see that accelerate rapidly. We're probably a little behind on the technology there. So I think you're going to see the benefit of that once we start to sell our new Frozen Elephant Trunk.

As far as the U.S. kind of the On-X kind of CryoLife cross-selling, I would tell you that the 2 things I would look at, 2 metrics I would look at is we grew On-X 20% this year, year-over-year. Number two, we grew cardiac tissue valves 10%. And again, I'm talking about 2018. Those 2 metrics, I would tell you, would tell me that there is some serious cross-selling going on. I also think that as the data continues to come out on the Ross procedure and as we start this PROACT 10A trial, CryoLife is extremely well positioned to be the market leader in patients' undergoing aortic valve surgery under the age of 70. So we think there is a lot of synergy between the SynerGraft Ross procedure and the On-X aortic valve with the PROACT 10A trial to literally we have, we think, is what is the best offering for a patient under 70 years old for getting aortic valve replacement.

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Suraj Kalia, Northland Capital Markets, Research Division - MD & Senior Research Analyst [16]

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Got it. And, Pat, forgive me if this is an unfair question. In my experience over the last 2, 3 years, you guys -- unlike others, you guys don't throw around flashy words. You guys get down to brass action of building a biz. That having said, we know in a couple of months PARTNER III results are going to come out. We know the age delta between mechanical and the transcatheter valves. Do you think any change in messaging is required by the On-X sales force, if any? And at the same time, have you all factored any impact whatsoever from PARTNER III? Obviously, the trial is enrolled, although approval is not going to come till next year, just curious how you all are thinking about more of messaging impact, if any.

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [17]

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Yes, I mean, again, we've talked a lot about this on previous calls as well. I mean, this is a call that Ashley and I are -- a question we get with investors often. And trying to predict the future, I mean, it's -- people have different opinions of what's going to happen, what the data is going to be. And I just think there is such a gap between the average age of a TAVR patient and the average age of an On-X aortic valve patient that even with that data. I have a -- so the average age of an On-X aortic valve is 58. The average age of a current TAVR patient, I think, is 78, maybe higher. You probably know the data better than I do on that. So you got a 20-year gap. It is not just the age, right? So let's say, the PARTNER III data comes out and the age starts creeping down, the problem is, you don't have long-term data for TAVR. And so, every year, you go lower, you're making a bet for that patient that, that valve is going to last. So you're telling me a 58-year-old is going to get a TAVR valve. How long is that valve is going to last? And then what do they do on the next operation? So I just think, again, we'll see what the data looks like. It's hard to comment because I haven't seen the data. But then I also say, you're asking the question in the backdrop of a PROACT 10A trial that's about to start where we can offer a patient under the age of 70 one operation in Eliquis for the rest of their life. I'd love to hear about what the TAVR companies are saying about this -- the data coming out on the requirement to actually anticoagulate the TAVR valves. So if you're going to have put people on Eliquis or some anticoagulant, why are you getting a percutaneous valve when you get a 1 operation and if you're going to be on it for the rest of your life? So again, the way to frame this in my mind is, the target is moving for TAVR because maybe it is moving lower. The target is moving for On-X and we're going older because of PROACT 10A.

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Suraj Kalia, Northland Capital Markets, Research Division - MD & Senior Research Analyst [18]

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Pat, I love the enthusiasm and the passion. It will be fun watching this battle. One final question and maybe I got my numbers wrong and maybe Ashley can chime in. Pat, you said 5-year target, 20% operating margins, okay? There was some mention about 100 bps per year improvement in gross margins. Can you quantify for us how much do you see is the improvement or what percent contribution from the channel, what percent contribution from product mix, what's from new markets? Just kind of frame it how you all are thinking this 5-year outlook?

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [19]

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Yes, so we -- when we put together our 5-year strategic plan, we look at all these considerations. And so again, one of the things, I think, we've shown and you would agree that as we kind of solidify a market like the U.S. once we acquired On-X, we have not really invested. In fact, their year-over-year spending increase from '18 to '19 was like 0. We don't have to add investment into the U.S. channel. We're still -- we're 1 year into JOTEC, and so we just went direct in a bunch of countries, we're still rounding that out. But that infrastructure will be fixed in 2019. So in 2020, I don't see a big increased investment in the JOTEC channel in Europe. So those 2 are fixed. We just told you we're investing $2 million in Asia-Pacific and Latin America. Those will be fixed probably at the end of '19 as you get to a full year '20 once they annualize on themselves. So when you finish '20, your global channels are fixed. I then back that up with 13 new products that are coming out around the world and I don't have to add any new reps. So it doesn't take a lot of math to figure out how you get to the operating margin of 20% just by leveraging your channels with 13 new products.

As it relates to gross margin, we have a goal. We're not going to break out where it all comes from, but we are looking particularly on the cost downside. I hired a former operations executive that I worked with at Medtronic, He ran the global supply chain at Baxter. CryoLife, legacy CryoLife kind of On-X and JOTEC have done 0 cost down in the last 5 years. It just wasn't something they focused on, right? We have got the pieces in place just on the cost down side to get 1 point per year over the next 5 years. It's not easy. We'll be using all kinds of employing things like lean, like design for reliability, like purchase price reduction from our suppliers, but not even getting into kind of mix and new products and all these kinds of things. We're working to get to the 1% cost down on -- frankly on the -- basically on COGS reduction, something we have very high control over.

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Operator [20]

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Our next question is from the line of Joe Munda with First Analysis.

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Joseph P. Munda, First Analysis Corporation - Analyst [21]

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Can you hear me okay?

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David Ashley Lee, CryoLife, Inc. - Executive VP, COO & CFO [22]

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Yes.

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Joseph P. Munda, First Analysis Corporation - Analyst [23]

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So first off, I just wanted to touch on the pipeline. A lot of moving pieces here, a lot of excitement. I just wanted to get some clarity maybe on the cadence of R&D going forward. Obviously, probably ticking up, but I was wondering if you could give us your thoughts as well as what to expect in regards to the $3 million related to the Med Device framework in Europe, how that will play out over the year.

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [24]

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Yes, so -- I think one of the things that -- for investors, that's a real positive is that -- those 13 products that I mentioned, right, so I'm not going to go back to the laundry list, but we've got 13 products in the pipeline. We are able to fund that pipeline, and again, I'm talking about over a 5-year period, and roughly keep our R&D spending around 10%. I think that's a big deal. I mean, that pipeline is about $150 million investment over the 5 years, but we get access to a $1.5 billion opportunity. So we're not spending crazy percentages on our R&D because of our top line continues to grow. We're able to fund our R&D pipeline this year actually under a 10% R&D spend. And I think again, some years, it may go up a little bit, it may go down a little bit, but that's another piece of the income statement we're going to leverage over time because as we continue to build this business and grow this top line, our R&D spending can also come down, which will contribute to the 20% operating margin. So again, that pipeline is affordable because of the size of our business and even keeping it at 10% or a little bit lower. As far as the MDR throughout the year, I mean, I don't know that we've given kind of breakouts of that.

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David Ashley Lee, CryoLife, Inc. - Executive VP, COO & CFO [25]

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Yes, I mean, I think we expect R&D expense to be somewhat level quarterly throughout the year with the exception of -- with the final work that we're doing to get the BioGlue China submission in and the work that we're doing on the PerClot PMA submission. The first and second quarters could be a little bit higher from an R&D standpoint than the last 2. But overall, as Pat mentioned, we're estimating high single digits up to 10% of revenue for R&D in 2019.

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [26]

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Yes, and I think also, Joe, the other thing that is really important for investors is, we don't have to do another acquisition. We don't need to raise money, we don't need to issue shares, we don't need do another acquisition, okay? I'm not saying that we're not going to, I'm just saying we don't need to. You could look at our pipeline as an acquisition. It's a $150 million investment over 5 years, but I can keep my R&D spend under 10% and probably decelerating over the 5 years, which will contribute to the operating margin. But we've got 13 products that -- by the way, it's a very low-risk pipeline. Lots of these products are either approved in other markets, it's just doing the trials and getting them moved to new regions or new geographies. So we feel very confident with this pipeline. And as I said before, as this channel investment solidifies in '19 and '20, particularly in Asia-Pacific and Latin America, we don't have to really increase our channels after 2020, and that's when all the products start hitting. It will drive margin, it will drive operating margin. So again, we're building the company and I think we've shown what we've done with On-X in the U.S., JOTEC in Europe. This is the next piece of the puzzle and this thing is very well put together in the next 24 months.

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Joseph P. Munda, First Analysis Corporation - Analyst [27]

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Okay. That makes sense. The other -- 2 other questions I had here, based on the first quarter guidance that you're giving, from my model, it looks like expecting a strong ramp in the second half of '19. And that's I'm assuming as a result of the new product launches, but is there anything else there maybe in regards to tissue? Tissue had a strong year this year, you're talking about a lot of excitement around Ross procedures. Maybe a little bit of clarity. Are you expecting a ramp in the growth in the second half of this year? I'm just looking for clarity there.

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [28]

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Yes, so if you go back, and I know I went through it quickly, but if you look at the catalysts for '19, so we've got like 7 or 8 catalysts for 2019. The first 3 are the new JOTEC products and those are hitting in the second half. So clearly, those are going to start as soon as those get approved and we get them rolled out in the market. So the back half of '19, we will start to see accelerated growth with JOTEC with those 3 new products. We're starting to go direct with BioGlue in Brazil in the second quarter. We have the new distributors in China for both -- for our JOTEC portfolio and our On-X portfolio in the second half of the year. So we clearly have -- we've got the PROACT 10A trial starting kind of in the first half, but starting to get momentum in the second half. So clearly, a lot of these catalysts are starting to hit kind of midpoint of the year. So clearly, I think the back half, just inherently, because of all those catalysts kind of coming to fruition, are going to drive the back half.

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Joseph P. Munda, First Analysis Corporation - Analyst [29]

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Okay. And then I guess on the tissue business, you had been forecasting in the past mid-single-digit growth, but it appears cardiac is really taking hold. Is this something -- is this a trend we are going to expect it to continue in 2019 and going forward?

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [30]

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Yes, so again, I think we were pretty transparent on the tissue. We basically said, we thought it would grow kind of mid-single digit. And so we had internal goals like, I will say call it, 5%, and we grew almost 8%. I was very pleased to see the cardiac tissue business up 10% last year. I made some comments earlier about the Ross data. There is a big paper and symposium at the AATS Meeting in May, 600 patients with 20 years follow-up. There is a resurgence of the Ross, and we are the market leader in that segment. So I think that -- if that -- how that data is received could be another positive for the pulmonary valve segment of our business. The second is, and we mentioned this over the calls over the years, we've got a 2,000-patient trial going on at the Cleveland Clinic for our aortic tissue valve. That data should be coming out this year. So those 2 things could not only be -- kind of keep us in the mid-single, that could actually bump us up. And we will see how that unfolds, but we are actually very encouraged by what we're hearing about some of the data coming out on our tissue valves.

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Operator [31]

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It appears we have no further questions at this time. So I'd like to pass the floor back over to management for any additional concluding comments.

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James Patrick MacKin, CryoLife, Inc. - Chairman, President & CEO [32]

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Well, listen, I want to thank all of the -- everyone who joined the call this morning and as, hopefully, you can hear from our enthusiasm that we are excited about what we're doing with the company. I think if you've been with us for the last 4 years, this company has transformed. And I think probably the best -- the most important takeaway message is that we have made the decision to invest in our pipeline and we don't need to do M&A, we don't need to issue new shares, we don't need to issue new debt. Our debt is coming down, and we are investing in 2 things. We're kind of fixing our international channels outside of Europe and the U.S. So Latin America and Asia-Pacific is requiring some investment. As those things take hold, those will be fixed in our income statement without a lot of need for additional investment as those annualize in 2020. And we've got a pipeline of 13 products with a market -- total addressable market of $1.5 billion, and we are going to do that by spending less than 10% in R&D over the next 5 years. And what that will give you is we think we can give investors high single-digit growth as we do this, accelerating as the pipeline matures. We're going to try to get 1 point of gross margin per year. And we think as those channels gets fixed in '20 as you move to the second half of the 5-year plan that you will start to see our operating margin move up into the 20% range.

So again, I think -- we think this is a great company, and we've got lots more to do. But we are extremely excited about our future, and we appreciate all the support from our investors. Thank you, and have a great day.

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Operator [33]

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Ladies and gentlemen, this does conclude today's teleconference. Again, we thank you for your participation and you may disconnect your lines at this time.