NuVasive, Inc.
Q1 2017 Earnings Call Transcript

Published: 26 Apr 2017

[Operator:]

Greetings, and welcome to the NuVasive First Quarter 2017 Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. It is now my pleasure to introduce to your host, Ms. Carol Cox, Executive Vice President, External Affairs and Corporate Marketing. Thank you, Ms. Cox. You may begin.

[Carol A. Cox:]

Thank you, Michelle, and welcome, everyone to our first quarter 2017 earnings call. The company's earnings release which we issued earlier this afternoon is posted on our website, as is an investor presentation, both of which have been filed on Form 8-K with the Securities and Exchange Commission. We've also posted supplemental financial information on the Investor Relations website to accompany today's discussion. On the call, we will be covering information that is included in the investor presentation, and I encourage you to access these materials so that you may follow along. Before we begin, I would like to remind you that the discussions during today's call will include forward-looking statements, which are based on current expectations and involve risks and uncertainties, assumptions and other factors, which, if they do not materialize or prove to be correct, could cause NuVasive's results to differ materially from those expressed or implied by such forward-looking statements. Additional risks and uncertainties that may affect future results are described in NuVasive's news releases and periodic filings with the Securities and Exchange Commission. We assume no obligation to update any forward-looking statements or information, which speak as of their respective dates. This call will also include a discussion of several financial measures that are not calculated in accordance with Generally Accepted Accounting Principles or GAAP. We generally refer to these as non-GAAP financial measures. These measures include our cost of goods sold, gross margin, sales, marketing and administrative expenses, research and development expenses, operating margin, non-GAAP earnings per share, free cash flow and EBITDA. Reconciliations to the most directly comparable GAAP financial measures may be found in today's news release and the supplementary financial information, which are accessible again, from the Investor Relations section of the NuVasive website. Joining me on today's call are Greg Lucier, our Chairman and Chief Executive Officer; Jason Hannon, our President and Chief Operating Officer; and Quentin Blackford, our Chief Financial Officer. With that, I would like to turn the call over to Greg.

[Gregory T. Lucier:]

Thank you, Carol, and good afternoon everyone. NuVasive is off to a solid start in 2017 with our International business exceeding our expectations and momentum building in our U.S. business as we exited the quarter. Earlier this afternoon, we reported first quarter results in line with the guidance we provided back in February including revenue of $250 million, representing year-over-year growth of approximately 16%. Revenue highlights include our International business achieving greater growth – growth greater than 20%, along with acceleration in our Integrated Global Alignment or iGA platform, driven by continued adoption of our RELINE posterior fixation system and recent introduction of cervical iGA. We continue to be pleased with the momentum building in our newly acquired companies. Before I discuss our results in more detail, I'd like to comment on the dynamics we saw play out during the quarter. On the field sales front, we continue to make strategic hires during the quarter. These long tenured competitive sales reps have significant experience in spine and are attracted to NuVasive, because they understand the value of our end-to-end procedurally integrated solutions and want access to our leading spine portfolio. They also bring strong relationships with them that we expect will drive surgeon conversions as we head into the second half of 2017 and beyond. Additionally, while surgical volumes in our U.S. business were a bit softer in January and February, we saw those volumes ramp up in March. We exited the quarter more in line with our internal expectations. The softness in the U.S. was offset by strength in our International business. Now, let me elaborate on first quarter U.S. revenue results. In our U.S. spinal hardware business, we've continued to see momentum within our iGA platform particularly with the adoption of our RELINE posterior fixation system leading to greater penetration in the deformity market, and we expect this trajectory to continue. Results also reflected a strong resurgence in our cervical business due to the success of introducing the iGA system for cervical in October 2016, and in turn, driving the strength in our differentiated Archon plate, VuePoint II fixation system. We continue to gain share on our NSO portfolio, which includes MAGEC for early-onset scoliosis and PRECICE technology for limb lengthening. During the quarter, we made progress in our efforts to build out a pediatric sales channel to further increase our reach with MAGEC and infused in combination with RELINE. We have hired a long tenured medical device executive with sales, sales management and market development experience to lead efforts and look forward to providing updates on our progress throughout the year. In our surgical support business, results were driven by the inclusion of Biotronic, which we acquired in July 2016. With our integration on track, we are seeing the benefits of building out an at-scale service business beginning to play. The addition of Biotronic has enhanced our service offerings and is delivering greater integration across our procedurally integrated portfolio. Turning to our International results for Q1, we saw above-market growth across all our geographies, including Europe, Asia Pacific and Latin America. In Q1, revenue grew 34% on a constant currency basis to $38.8 million or 35% on an as-reported basis. We continue to see strong revitalization in our Western European markets of Italy, Germany and the UK, as our investments continue to drive significant growth. In Asia Pacific, we benefited from the reintroduction of XLIF into the Japanese market in January, continued acceleration in our posterior fixation system business, as well as strong results in Australia. Importantly, we also saw Latin American return to meaningful growth driven by increased volumes in our Brazilian operations where the business is beginning to deliver the growth we projected since closing Mega Surgical acquisition and going direct in Brazil. We continue to build out our talent internationally and earlier this year placed new long-tenured fine industry leaders in both the UK and Australia. These leaders are already delivering results which we saw play out in the first quarter. In April, we also acquired our sales agent for NuVasive Specialized Orthopedics products in Germany and France and now have a direct selling presence in those two markets. With this momentum, we remain confident in our ability to continue to grow our share of the International market from the 4.5% we have today to doubling that over the next several years. As we've been communicating, margin expansion is a key element in our effort to deliver value creation for our shareholders. We continue to execute strongly against these efforts and during the first quarter of 2017 delivered a non-GAAP operating profit margin of 14.1% in line with the guidance we've provided in February. Our results reflected well-controlled operating expenses, partially offset by increased investments in R&D as we continue to drive innovation in our portfolio. Our efforts towards self-manufacturing remain on track with the tremendous amount of work going on in our West Carrollton, Ohio manufacturing facility as we add new equipment and train new employees. We ramped production up in Q1 and we continue to build out the facility, increasing our in-sourcing activities and releasing new titanium milling machine to production. During the quarter, we continue to see success with our efforts to bring new surgeons into the NUVA family as we continue to build out our end-to-end procedurally integrated solutions to drive better clinical predictability and continue to move towards a more systems-based offering in spine, we see the opportunity to go deeper with our current surgeon base, as well as attract new surgeons to NuVasive. Innovation remains at the heart of what NuVasive does best, and we aspire to lead the industry by delivering the technologies and innovations that surgeons want and need. As I talked about last quarter, we have a strong pipeline of new technologies, some of which we are introducing in 2017. These technologies will help us meet our commitment to proceduralize the entire surgical experience, expand our current offerings, and enter new markets. Now, let me highlight a few examples. Our new radiation-reducing X-ray technology, LessRay, underwent successful base testing in Q1. We're in the process of building out a small capital sales force to sell LessRay and have a healthy pipeline of customers who are interested in investing in the platform. Over time, LessRay will be integrated into our next-generation capital platform, become our committed real estate in the OR. We believe LessRay will be a game changer in the surgeon and patient safety in regards to significant radiation reduction. We're also actively expanding our core implant offerings. Specifically, we launched our first two expandable interbody devices called MLX and TLX. Both are used in lumbar fusion procedures, which remain the largest overall portion of the spine market. In Q1, we entered into our alpha phase for our UNYTE system, which uses our magnetic growth rod technology to help heal complex fractures and fractures that fail to heal due to poor bone quality or poor fixation. We completed eight cases (09

[Quentin Blackford:]

Thanks, Greg, and good afternoon, everyone. Before we get started with the financials, let me remind you that many of the financial measures covering today's call are a non-GAAP basis, unless noted otherwise. Please refer to today's earnings news release as well as the supplemental financial information on nuvasive.com for further information regarding our non-GAAP reconciliations. During the course of today's call, I'll be referring to reports and pro forma results. Unless specifically noted, all comments are on an as-reported basis. When discussed, pro forma comparisons reflect the results of the business as if NSO and Biotronic have been combined to the full reporting period being referred to. For the first quarter of 2017, we reported revenue of $249.9 million, which reflects growth of 16.2% or 16% excluding the impact of currency. On a pro forma basis, growth was 6.5% or 6.3%, ex-FX. Our U.S. spinal hardware revenue grew 10% for the quarter to $139.4 million, which was fueled by our NSO business as well as building momentum in our cervical portfolio, following the launch of cervical iGA in the fourth quarter of 2016. We continue to be excited about the opportunity to capture more of the underpenetrated cervical market with a truly unique and differentiated solution. On a pro forma basis, U.S. spinal hardware grew 7% for the quarter, despite being up against the toughest growth comp in this category in more than three years. Revenue from U.S. surgical support came in at $71.7 million for the quarter, up 20% which was driven by the acquisition of Biotronic, offset by weakness in our biologics business. On a pro forma basis, our U.S. surgical support revenue declined 2% due to soft results in biologics. Our International business delivered strong revenue results coming in at $38.8 million for the quarter, an increase of 35% on a reported basis or 34% excluding the impact of currency. On a pro forma basis, International revenue grew 24% excluding the impact of currency with strengths coming from all regions, where our share-taking plans and innovative product introductions are generating results. Momentum in our Latin America business continue to build in the first quarter where we saw growth of more than 70%, primarily the result of a steady increasing performance from Brazil where we chose to go direct in early 2016. In addition, the remainder of the region performed ahead of expectations. Our European and Asia Pac businesses also contributed nicely, led by markets like the UK, Italy, Germany and Australia. In Japan, we saw solid equipment growth as we introduced the XLIF procedure and our Japanese proctors resumed XLIF procedures as of mid-January as anticipated. We also saw a strong performance in our posterior fixation business as a result of our sales team focusing on that in the second half of 2016 while XLIF was off the market. Now, let's turn to the rest of the P&L where non-GAAP gross margin for the first quarter was 75.3%, down 180 basis points from the prior year as anticipated. The lower gross margin was driven by a 240 basis points impact as a result of the lower gross margin profile of the Biotronic business as well as a 60 basis point impact related to transition of our manufacturing facilities in Ohio. Partially offsetting these headwinds were greater inventory efficiencies and mix benefits net of price of 90 basis points and 30 basis points respectively. Pricing pressure was consistent to past quarters, remaining at very low single digits at negative 1.5%. Our new manufacturing facility in West Carrolton, Ohio continues to ramp as anticipated. In the first quarter 2017, we doubled our output from the last quarter, producing more than 80,000 pieces. Recall we will start to realize benefits from this in-sourcing initiative in the second half of 2017 and ramp up more fully in 2018. Non-GAAP SM&A expenses as a percent of revenue decreased 180 basis points from the prior year to 56.2% in the quarter or $140.5 million. The lower SM&A expense profile of Biotronic contributed 260 basis points. Excluding the benefit of the Biotronic business, SM&A expenses as a percent of revenue increased 80 basis points, which was primarily driven by higher non-cash stock-based compensation expenses. In addition, the partial quarter of XLIF revenue in our Japan business put incremental pressure on our International operating margins, which was fully offset by leveraging greater asset efficiencies across the business. Non-GAAP research and development or R&D expenses totaled $12.4 million in Q1 2017, compared to $10.6 million in Q1 2016. R&D expense was 5% of revenue for Q1 2017 versus 4.9% in the same period of last year. Excluding the benefit of the Biotronic business, R&D expenses as a percent of revenue increased 30 basis points. The increased R&D spend reflects our continued commitment to supporting internal R&D efforts and investing in strategic assets we acquire to drive further innovations. As we have communicated before, we expect R&D expenses as a percent of revenue to increase, with a long-term goal of investing approximately 7% of revenue on these efforts. Our path has not changed. We continue to make investments in key areas, including the NSO technology and efforts around imaging, navigation and surgical automation, as well as continued improvement and evolution of the iGA platform. We have started to see the investments in involving our technology pay off, like our iGA for cervical platform extension and proprietary magnetic drive mechanism in our MAGEC rods which you will start to see extending into some of our new product launches later this year. First quarter non-GAAP operating profit margin was 14.1% in line with the prior year. After adjusting for the different P&L profiles of the Biotronic business, core gross margins showed nice improvement from prior year as a result of greater inventory efficiencies, which were offset by continued investments into R&D, higher non-cash share-based compensation charges and a temporal impact of the restart of the XLIF business in Japan for the first quarter. First quarter adjusted EBITDA margin which excludes the impact of non-cash share-based compensation was 24.1%, a meaningful increase of 160 basis points compared to 22.5% in the same period last year, reflecting the continued focus of improving the cash earnings profile of the business. Moving further down to P&L, interest and other expense net on a non-GAAP basis was $5.1 million in Q1, up from $4.1 million in the same period last year. This increase is primarily a result of the interest expense associated with the 2021 convertible notes which were issued in March of last year. Now turning to tax. Our non-GAAP tax expense in the quarter was $10.6 million, resulting in a non-GAAP effective tax rate of 35.1% in line with expectations and reflective of our continued efforts to drive year-over-year improvement in our corporate tax rate as we work to bring this down into the mid- to-high 20%s over time. First quarter 2017 non-GAAP net income was $20 million or non-GAAP earnings per share of $0.38 compared to non-GAAP net income of $17.2 million or non-GAAP earnings per share of $0.34 in the same period last year. Turning to our GAAP results. GAAP net earnings for the first quarter of 2017 were $12.8 million or $0.22 per share compared to a loss of $3.4 million or $0.07 per share in the same period last year. Please refer to our earnings press release or the supplemental financial information filed posted on nuvasive.com for further information related to our GAAP versus non-GAAP adjustments for our first quarter 2017 performance. I'd also like to spend a few minutes reiterating our full-year 2017 guidance, which we shared during our full year earnings report out in February of revenue of $1.065 billion, non-GAAP operating margins of 17.1%, and non-GAAP EPS of $2. Our revenue growth to-date is in line with our expectations, and we're going to continue to focus efforts on making good progress on the operating margin front. NSO reached its one-year anniversary in February, it is now fully integrated into our business with Biotronic's one year anniversary coming up in July. We're driving the business hard with laser focus on operational improvements and efficiencies in order to meet or exceed our non-GAAP operating margin goal of approximately 25% over time. We are confident about continuing our strong momentum throughout the year. With respect to the second quarter 2017, as a result of the acquisitions of Ellipse Technologies and Biotronic in 2016, as well as the re-launch of XLIF in Japan, we expect that seasonality in our business may be a bit different than historical NuVasive averages. Therefore, to provide greater clarity in terms of the expectations and for your modeling purposes, we anticipate that revenue for the second quarter will be approximately $262 million and that non-GAAP operating margins will increase sequentially by 140 basis points to 15.5%. We expect revenue growth will accelerate in the third and fourth quarters as we come up against easier comps in the business. As a reminder, the third quarter of last year did not realize much of any capital sales in the period and the temporal impact of not selling XLIF in Japan for a portion of the third quarter and all of the fourth quarter will result in easier comps and accelerated growth rates. In addition, the launch of technology such as LessRay, the TLX and MLX expandable cages RELINE Trauma and UNYTE are expected to fuel further growth as we come into the second half of the year. Finally, I'd like to spend a moment giving you a little more color on our new line of credit we announced earlier today. We took the opportunity to amend and restate our existing credit agreement to expand our revolving line of credit from $150 million up to $500 million. The interest rates, covenants and other terms are substantially similar or better than the previous line of credits and in line with market dynamics. The expanded line of credit will provide us with the added flexibility to deal with the upcoming maturity of our convertible notes in July 2017, and is for future investment in both organic and inorganic growth initiatives. It's important to note that we will continue to be disciplined and diligent in how we deploy our capital. We remain committed to the previous parameters that we've detailed for our investors. For full details on the line of credit, please refer to our filing with the SEC. In summary, NuVasive is off to a solid start to 2017. While in three months into the year and there is still a great deals to accomplish. We are very encouraged to see our International growth plans that we set into motion a few years ago, playing out in driving significant results for the business. In addition as NuVasive's reputation for being an innovation leader, we see several of our new technologies being well received in the market and we continue to be disciplined in the management of our business and seek every opportunity to extend excellence throughout our operations and push our profitability higher. With that, I'd like to open up the lines for Q&A.

[Operator:]

Thank you. Our first question comes from the line of Matthew O'Brien with Piper Jaffray. Please proceed with your question.

[Matt O'Brien:]

Great. Thanks so much for taking the questions. I'll just ask both of these here together. First of all, Greg or Quentin, just curious about the commentary about surgical volumes in January and February the softness that you saw there and why you're so confident that whatever was causing that weakness is behind us? And then secondly, on the biologic side. I know that's been an area that's been somewhat soft for a while now. Just would love to get some sense for how much longer we think that potentially could be weak. And then what the new NASS guidelines on allograft or DBM may do either positively or negatively for that business?

[Gregory T. Lucier:]

You bet. Let me say a few words on January and February, and then I'll have Quentin take the biologics. But we spend a fair amount of time looking at the analytics in the U.S. business and trying to understand what we were seeing in the industry. And whether it was our own sale of implants, we're able to see actually the industry in a broader base given our service business. We believe the volumes that were somewhat depressed in January and February were industry-related. In terms of the cause of it, we then followed up in talking into a few administrators of hospital systems and the like and at least, one theory of the case is high deductible plans and it just takes some time for those to start to work through as you begin a new calendar year. And that's somewhat validated by fact that the March came back into real strengths certainly at our expectation and it's continued now on into April. So, that's our best guess of what we're seeing. And in terms of our results, I think we continue to grow above market in the U.S. and you could see us doing very well internationally. So, we think the company is doing fine. We think we're just experiencing a temporal kind of restart of the year that may be a new reality given high deductible plans. Equipment biologics?

[Quentin Blackford:]

Matt, with respect to the biologics, I would say, we expected that to be flat to slightly down over the course of the year, certainly coming in at 6% in the quarter was a bit disappointing relative to where we thought that we might see that come in, I think a couple of things, one, price has been under a bit more pressure there. I noted prices of 1.5% decline in my prepared remarks, biologics is closer to 3% right now, so you see a little bit of price pressure there. But I would also tell you there is this tremendous amount of opportunity in this business with respect to that biologics portfolio that we haven't got after yet. I think there's real opportunity to see incremental growth come from that. Our full year expectation is to be relatively flat year. I think you'll start to see that if we get into the back of the year and start to explore some of these things that can drive incremental growth for us. So, I think it's more of a temporal impact, despite the fact that it's been negative for several quarters now, but I think you'll start to see that turn.

[Matt O'Brien:]

Thank you.

[Operator:]

Our next question comes from the line of Richard Newitter with Leerink Partners. Please proceed with your question.

[Richard S. Newitter:]

Hi, thanks for taking the question. I'll also try to put two in one here. So, the first one just on your trauma strategy. You have the RELINE launch and also you have UNYTE that's going to be – it sounds like coming in the back half. I would just love to hear kind of how you're envisioning either a sales force build out here on the non-spine trauma side? And then the second question is just on the cadence for the year, you gave some color on margin expansion, I was just thinking from a gross margin standpoint. Do we think of gross margin tracking similarly to operating margin expansion, is there anything to call out there? Thank you.

[Gregory T. Lucier:]

Why don't we take the last part first and Quentin, gross margins?

[Quentin Blackford:]

Yeah. So Rich, with respect to both gross margin and operating margin, I gave you some color around Q2 and sequentially we expect operating margin to increase roughly 140 basis points. You're going to see all of that improvement in Q2 really coming from the leverage of our selling, marketing and administrative expenses. I would expect gross margin in Q2 as relatively flat with where you saw it in Q1. You've got the headwinds coming out the Biotronic business that has a lower gross margin profile. And keep in mind, we didn't have that in Q2 of last year. So you've one more quarter of headwind in the gross margin profile. By the time you get to Q3 and Q4, we will have annualized that, you no longer have it. So you're not going to see a sequential change from it. And then, you're going to start to get the benefit of the in-house manufacturing starting to roll through with what we're doing (30

[Gregory T. Lucier:]

And the first part of your question on UNYTE, a little bit more context. So our PRECICE business, which does limb lengthening or the opposite of the UNYTE technology, which does compression and as you say fracture healing, we've experienced some very fast growth with that business. That's all done through third party distributors at present and they are doing a very effective job. We're in the process as we speak of taking through the right distribution approach for the UNYTE technology. We believe it will probably entail more third party distribution that's augmented by investment on our side or further managerial health, as well as some sales specialists to bring in that extra understanding of the technology. But we're trying to do this in a lighter investment way just as we continue to build out that business and get to scale.

[Richard S. Newitter:]

Thank you.

[Operator:]

Thank you. Our next question comes from Kaila Krum with William Blair. Please proceed with your question.

[Kaila P. Krum:]

Hey, guys. Thanks for taking the questions. So, first is just on company priorities and where you expect to invest in both organic and inorganic growth opportunities going forward, because obviously you guys have a lot going on here. So I mean, is it still deformity, is it expandable, is it more in trauma expanding the portfolio there, LessRay building a capital sales force? And I guess if it's all of the above, then how do we think about prioritizing those initiatives relative to one another over the next 12 months, 18 months?

[Gregory T. Lucier:]

Sure. I'd say we have three major priorities and then obviously, there's more being done in the company. But at the highest level, there are three things we're trying to get done. One, we're evolving the company from purely degen to degen and deformity and you're seeing that happen as we speak through 2016, 2017 and 2018. Second on the innovation side, you're seeing us go from a world leader in proceduralization to also becoming a world leader in the systems around spine surgery. And there's a whole host of products coming out again over the next couple of years that will drive that. And then the last priority is a very meaningful investment that has not produced any drama, thank God, and that's becoming self-manufactured in Ohio in what will become the largest spine factory in the world. So, all of that is taking place. And I think we're doing it in a way with minimal disruption and pretty good execution.

[Kaila P. Krum:]

Okay. That's helpful. And then just a question, real quick, for Jason on International. Can you just talk a little bit more about your efforts internationally, and specifically, I guess, the progress that you've made in Japan, thus far, where we're at in terms of getting back to the historical run rate there? Thanks, guys.

[Jason M. Hannon:]

Sure. So, we laid out a strategy for International almost two years ago now that was really focused on going deeper in core markets, the biggest – our most direct markets, the UK, Germany, Italy, Australia, Japan and then ultimately Brazil, which we've done. Well the success you're seeing is really the execution of that strategy, it's primarily coming from the markets where we're direct, they're the biggest opportunities, we've made investments in our direct teams and in product launches in all of those market. So that strategy is playing out over the last couple of years and obviously, well in the first quarter. With respect to Japan is reintroduced, there's significant interest from Japanese surgeons who truly believe in the procedure, those procedural volumes are coming back quickly. We would expect to be nearing historical run rates where we were the middle of 2016 by the summer, maybe the late summer into the fall, it's going to come back pretty quickly because there's significant interest.

[Kaila P. Krum:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Matt Miksic with UBS. Please proceed with your question.

[Matthew Miksic:]

Hi, can you hear me okay?

[Gregory T. Lucier:]

We can.

[Matthew Miksic:]

All right. Thanks for taking the question. So, I wanted to – and I keep bouncing back and forth between calls here, so I hope this question hasn't been asked. But I wanted to ask a little bit about your sort of initial response to your demand analysis, I guess, if you will, how interested are hospitals and docs in LessRay, kind of where are you in terms of the business model for rolling that out?

[Gregory T. Lucier:]

Yeah. So, Jason and I will Frick and Frack on that one. As I said in the script, we've now done the beta launch. We're finalizing the complete systems and we'll be on market in a big way here in May. And Jason, can give you more colored commentary on the initial channel reaction. So, Jason?

[Jason M. Hannon:]

Sure. So, the initial reaction has been very positive. As you can imagine, we acquired technology. We're in the process of truly productizing it. Meaning, that's the alpha-beta process we're going through, putting it in a package that actually makes it work functionally and from an industrial design perspective in the hospital. The response to the way the technology works, the level of radiation reduction it can provide and its ability to be integrated into our future capital platform have all been extremely good. And so, we are going back now, and we start to build the units. We will place a good number of LessRay units standalone that will reduce radiation in the operating room by themselves. And that will then be followed by the inclusion of that technology into our capital platform that comes later in 2018. So, significant interest, the understanding that this is one of those topics that is on the front of mind of every surgeon and should be with respect to patients as well, and yes something that is rarely talked about sufficiently because people didn't believe there was a sufficient answer to it or a sufficient solution. So, it's got great interest from obviously surgeons, from practice management, from hospitals. So we look forward to trying to meet the demand.

[Matthew Miksic:]

And just to understand the business model. How are you, I guess for the lack of a better way of asking the question, how are you pricing it, how are you anticipating being paid for delivery of the technology?

[Gregory T. Lucier:]

Jason?

[Jason M. Hannon:]

Yeah. So we're starting to build a bit of a capital sales force that will manage the LessRay opportunity, as well as ultimately our capital platform in 2018, obviously a different sales cycle and a bit of a different call pattern, when you're starting to sell capital. So we will do that. It'll be priced with options essentially, either a straight capital purchase or we'll provide a leasing opportunity to the hospital. And that paves the way for us ultimately to build the capacity, as well as the coverage to then be selling a larger capital unit, like I said, towards the end of 2018. So pricing options, supported by capital sales team.

[Matthew Miksic:]

Okay. That's helpful. And if I could just one question on sort of the core MIS business. I mean XLIF is obviously – is the leadership platform and lateral and also just generally I think an MIS you could say in spine. And I'm just wondering is there a place if it's lower abdomen, if it's thoracic, where do you feel like there's an opportunity to expand that and maybe paint color on how you're looking at expanding that leadership franchise?

[Gregory T. Lucier:]

Jason?

[Jason M. Hannon:]

So, we have worked (39

[Matthew Miksic:]

That's great. Well, thanks so much for the color.

[Operator:]

Thank you. Our next question comes from Andrew Hanover with JPMorgan. Please proceed with your question.

[Andrew Ronald Hanover:]

Just for taking our question. Quentin, I just wanted to start with you quickly on the second quarter guidance, I just want to make sure I actually heard $262 million. And one of the reasons I'm asking is I think that would be a slight sequential deceleration on an organic or pro forma growth basis. And just wanted to understand what some of the underlying factors are within a $262 million guidance for the second quarter.

[Quentin Blackford:]

Yeah. So, Andrew, $262 million, that is correct. That's the number that we've put out there. You've got to look at it on a constant currency basis. Certainly, when you look at on a reported basis, you're right, it would be roughly 5%, 5.3% somewhere in there. But neutralizing for the impact of the currency effects, it's actually up around 7%. So, it's an increase coming off of Q1 on a pure constant currency basis when you neutralize that impact. So, I think when you start to look at that way, it makes a whole lot more sense.

[Andrew Ronald Hanover:]

Okay. And then as far as how to think about the contribution from these competitive surgeons or reps, obviously there's probably some non-competes that are going on in the first half that probably lapse in the second half. But can you help tease through, was there any contribution in the first quarter and how that sort of ramps throughout? And then on top of that, I'm just trying to understand the commentary. I think you're talking about giving second quarter guidance, so that we can understand some of the cadence that's going to be a little bit different this year. Does some of that have to do with the fact that you're launching these deformity systems and because deformity is bigger in the third quarter, then it sort of plays out through the second and third quarter might be bigger? Appreciate it.

[Quentin Blackford:]

Yes. Well, certainly, the seasonality of the different businesses, whether it's NSO with deformity where you've got different seasonalities and historic hardware business where you've got Biotronic, that's a bit different as well, all of that's being contemplated in the numbers that we're giving you for Q2. And the point is when you're integrating these businesses that have a decent revenue stream to them, they don't all perform (42

[Andrew Ronald Hanover:]

Thanks.

[Operator:]

Thank you. Our next question comes from Joanne Wuensch with BMO Capital Markets. Please proceed with your question.

[Matthew Henriksson:]

Hi. This is actually Matt Henriksson in for Joanne. My first question is following AAOS and kind of the buzz surrounding robotics, has your view changed on spine robotics than you guys had commentated previously?

[Gregory T. Lucier:]

Our view remains unchanged. We fully appreciate that a shiny new object, an interesting piece of technology like a robotic arm might grab some attention and ultimately might grab some buyers. But that's not the path we're going to follow, because we don't think it actually fundamentally addresses what drives the unpredictability aspect in spine surgery. And so, we're confident of our path, we recognize it will be short-term kind of a chatter in the market, but we'll get through that. And we like where we're going with our whole concept of automation over the next couple of years.

[Matthew Henriksson:]

Okay. Great. And then, my follow-up question is, you guys have commented on preplanning surgeries and how that's going to help with managing inventory levels. Are you guys starting to see that materialize? And then, how important of that is a driver for your risk-sharing program with the hospitals and the payers?

[Gregory T. Lucier:]

Yeah. Good questions. There's a few pieces to ultimately creating more patient-specific implants and you're seeing us put out the key building blocks here in time. So now we just have been able to finish out the iGA system for the entire cervical part of the spine, so now we have the whole spine covered. That's an important element. We're moving forward with sterile pack technology to allow us to be shipping products out in a sterilized way, so it can be more patient-specific. And unbeknownst, because we haven't talked about it to investors very much, we're radically revolutionizing the entire delivery process to the surgical suite. And so, as we get all of that in place, it's then leading to the ability to do preplanning on the software systems to then do much tighter selection of the implants and bring them into the OR. As we said before, that's more of a kind of late 2018, 2019 type of phenomena that builds on the back of the Ohio plant coming fully online, which will give us a great economic boost.

[Matthew Henriksson:]

Great. Thank you very much.

[Operator:]

Thank you. Our next question comes from the line of Jonathan Demchick with Morgan Stanley. Please proceed with your question.

[Jonathan Demchick:]

Hello, thanks for taking the questions. International continues to be a great spot for the business, but I was just wondering a little bit on the margin side there given the near-term benefits for manufacturing and asset management over the balance of this year and just the momentum that we've seen in International, is this an area where you're likely to I guess invest more for to kind of maintain this growth rather than start to really see any margin uptick in this business or have we already kind of seeing some of the margins in International start ticking higher?

[Gregory T. Lucier:]

Quentin, why don't you grab that one?

[Quentin Blackford:]

Yep. So, Jon, I think great question. It is a great opportunity for the organization. When you think about our market position there at 4.5% of the overall market that we have today and there's no reason we can't see that more than double over the next several years. It does take investment, but we've also committed ourselves to that investment strategy and plan in the broader margin goals that we've given to the investors. And so, I would say, we're tracking right in line with where we expect to be. You will see the profitability of that International business continue to ratchet-up. But at the same time, balancing it with key investments that are needed in that area, for example, last year, we continue to invest in International in a pretty meaningful way, despite the fact that we had to pull XLIF from the market for part of Q3 and all of Q4. We didn't look at that as a situation where we need to reconsider the investments and pull back on investing in some of the initiatives that we had there and we continued with it. And so, we're committed to investing for the long-term in our business. I think there's tremendous potential. But we will balance it. There will be opportunities to drive profitability improvement, but at the same time make the key investments necessary to get that to a 10% share position or better over time.

[Jonathan Demchick:]

Thank you. And just had a quick follow-up on, I guess both the Ellipse and Biotronic acquisitions. Product pull-through from screws on Ellipse and disposables on Biotronic could be a substantial driver. Where are we on the adoption there?

[Gregory T. Lucier:]

Okay. Still, very early stages. For example with the Ellipse products in the MAGEC rod, we didn't have the smaller stature screw to even go with a smaller rods until here in Q1, we've now got a full suite of screws that can meet the requirements of the MAGEC rod to 5.5 mm and 4.5 mm, and I would expect you'll start to see pull through take off and it's probably more of a back part of the year type of opportunity for us. And the same with Biotronic, if you look at what we've done in the IMI business, we've been able to pull through nicely the NVM5 disposables on to that service line. Part of the value proposition with the Biotronic deal was the ability to do that as well, but we knew it was going to take a bit of time. And again, we kind of model that as roughly a12 month timeframe before we start to see that really take off, which puts you in the back part of this year as well. And so, I think you're focusing on and thinking about all the right potential lever to drive expedited growth for us. But you're a bit too early yet. I think in the back half of year you'll start to see some of that benefit and certainly as we roll into the following year.

[Jonathan Demchick:]

Thank you very much.

[Operator:]

Thank you. Our next question comes from the line of Kyle Rose with Canaccord Genuity. Please proceed with your question.

[Kyle William Rose:]

Great. Thank you very much for squeezing me in. Just a couple of quick questions. First, you talked about the LessRay with building out the capital sales force there, but then also mentioned a larger capital strategy coming in 2018. Just wondered if you could give any additional color from that standpoint? And then, on the other products, as far as the expandable cages, I mean, it's a pretty major product gap that you guys are filling there, just thoughts on that overall product opportunity, near-term? And then, just how you think about the overall size of that market?

[Gregory T. Lucier:]

So, Jason, why don't you give a commentary on the capital technology roadmap, and then expandable cages as a category?

[Jason M. Hannon:]

Sure. So on the capital, you know we have our NVM5 unit, which is our hub for neuromonitoring, computer-assisted surgery, multimodality. When you think about that unit, and then you start to – you add in technology like LessRay, the combination of those things becomes our new capital platform. That platform then serves as a platform for navigation (50

[Kyle William Rose:]

Great. And then just one last question on the manufacturing side. I mean you talked about you're doubling the unit volume to 80,000 units in the Q1. Just can you kind of characterize how we should think about that volume as we exit the year – I just can't – put that 80,000 – and if you can frame that for us as we think about Q1?

[Quentin Blackford:]

Yeah. And rather than talking about it on a unit basis, I'll just give you a sense of how much we expect to put through that plant kind of around some timeframe. So as we exited last year, roughly 40% of what we could produce, we were capable of producing within that plant. We would expect that just closer to 60% or so by the end of this year and then move in closer to 100% by the end of next year. So I think that'll give you a sense of just the cadence of how quickly we've moved through there. It's also why we talk about 2018 being the year that will provide even a greater benefit to us from a manufacturing perspective than what you're going to see in 2017. While we're ramping nicely this year, so much of the benefit is caught up on the balance sheet, we're unable to release that back until we turn through the inventory, so that's why you hear us talk about more in the back half of this year and then really 2018 opportunity for us.

[Operator:]

Thank you. Our next question comes from the line of Jeff Johnson with Robert W. Baird. Please proceed with your question.

[Jeff D. Johnson:]

Thank you. Good evening, guys. Quentin, maybe I missed it and I apologize if I did. But were there any selling day issues this quarter, can you walk us through selling days the next few quarters?

[Quentin Blackford:]

Yeah. Selling days were equal year-over-year in the first quarter, we'd expect them to be equal in the second quarter as well, but in Q3, we have one less day; and then Q4, they're equal so.

[Jeff D. Johnson:]

Okay. That's helpful. Thank you. And then on the sales force side, I think this question was already asked in one direction, but I kind of want to push it a little bit differently is, you've talked about that big 15% increase in the end of 2016, I know with some of the garden leaves up, that's not going to help until you get maybe deeper into 2017 as you already talked about. But you're doing some things a little bit differently here as you add those sales reps by putting them kind of into adjacent markets and then you're going to kind of flip the established rep and the adjacent market rep kind of back into their respective markets at the end of this year. That's a little bit different than we've heard other companies do things in the past. How is that going qualitatively at this point? Any hiccups with that or is that seemed to be going as planned?

[Quentin Blackford:]

Yeah, I would say that we're right in line with how we expected them to be contributing to the organization. When we talk about taking them out of a particular territory that's what you're dealing with when you have these non-competes and rather than being able to simply put them on the sideline and not have them produce any type of value for you over the course of whatever that non-compete might be, whether it's 12 months, 18 months, 24 months, we typically find ways to put them in adjacent territories or other territories that they can get out and compete in. And so that's what we do. And then once the non-compete is up, we'd look at putting them back into the territories that they can compete within or that they came from. And that's why we talked about in the early stages of these type of opportunities, the revenue – increased revenue opportunity isn't really there. It's more 12 months to 18 months from the date of hire, and that's when you start to see the benefits, but in between that, you're working through navigating some of these non-compete issues that take them out of their local market.

[Jeff D. Johnson:]

Yeah. And so, I guess, my final question would just be if that's going well, it sounds like the rest of the business is clicking along fairly well. I mean you guys are close enough to Street numbers, the 2Q guidance is maybe a few million dollars light of where the Street's at, 1Q was kind of more in line to maybe $500,000 below Street. But is it end markets that's just a tad softer maybe than you guys were thinking, is it Street just got a little ahead of itself in the first couple of quarters? Just trying to bridge the gap maybe between kind of what you're calling for in 2Q and then where we're all sitting kind of going in tonight's call?

[Quentin Blackford:]

Yeah. Well, I think there's no question, in Q1, the Street was a bit ahead of where we said we would be in the quarter, right? We had put our specific number, the $250 million and the Street was a bit ahead of it. And I think Greg brings that up pretty well with respect to January and February, just being a bit softer than what we anticipated. We saw that rebound in March and feel good about where the volumes are at, at that point in time. I think what the Street doesn't fully appreciate is just the nuances in the business around seasonality when you're starting to integrate organizations that contribute $15 million to $20 million a quarter, they can have an impact on the way you look at seasonality. And so, a lot of folks simply model the second, third, fourth quarter by looking at historic seasonality and saying, hey, we dropped 24.5% of revenue into Q2 on an average basis for the last three years. Well, when you start to consider the fact that you've acquired NSO and now Biotronic, that might look a little bit differently. And so, we need to get out in front and help educate you guys on exactly what that looks like and that's why we're doing this. You could go back and look on a pro forma basis, this company historically for the last three years (56

[Jeff D. Johnson:]

Yeah. That's helpful. Thanks, guys.

[Operator:]

Thank you. Our next question comes from the line of Glenn Novarro with RBC Capital Markets. Please proceed with your question.

[Glenn John Novarro:]

Hello. Good afternoon. Thanks for taking my question. Two questions for Quentin. First for 2Q, Quentin, you gave us sales, you gave us operating margin. Can you give us tax rate, and I may have missed it, did you give us any EPS range for 2Q?

[Quentin Blackford:]

It's in the prepared slides that we have on the website, tax rate 35%. Continuing to think about it that way, we feel very good about where that's going to land at this point in time and that's going to generate an EPS number of somewhere around $0.44 for you.

[Glenn John Novarro:]

Okay. Great. And then as I'm looking at my model – yes $0.44 is right, I came out – the 17.1% operating margin, two questions on that. To get there, it looks like you need to have an operating margin in 3Q of somewhere around 18%, and then 4Q somewhere around 20%. So, is that in the ballpark? And maybe talk about what your confidence level is that you can go from 14% in 1Q to 18% in 3Q and 20% in 4Q? Thanks.

[Quentin Blackford:]

Yeah. Look, we haven't given specific guidance around what operating margins look like in each one of those quarters. I will just remind you, in Q3 we got one less selling day. So, you're going to have a bit of pressure on the operating margin from that perspective and you're going to pick up – or you're going to see a nice ramp back into Q4 operating margins. But at the very highest level, the way you thrown those out there, I think directionally, you're thinking about it correctly. It's going to continue to improve over the course of the year each and every quarter. Now that we have NSO and Biotronic fully integrated and you got XLIF coming back in full way in Japan. So, you're going to see some nice leverage over the course of the year for sure. So, I think you're thinking about it the right way

[Glenn John Novarro:]

Okay. And I think you said to one of the – to earlier questions that gross margin would be a greater contributor in the second half of the year given the comps anniversary in Biotronic and the Ohio facility starts to contribute more, is that accurate?

[Quentin Blackford:]

Yeah, you're thinking about it the right way. Whether you get the contributions from the manufacturing facility in Q3 and Q4, you're going to get a bit of them, but you're not going to have the headwinds that moving out of that like you have in Q1 and it's going to be normalized in Q2, but you're thinking about it correctly.

[Glenn John Novarro:]

Okay. Great. Thanks, Quentin.

[Operator:]

Thank you. Our next question comes from the line of Josh Jennings with Cowen & Company. Please proceed with your question.

[Joshua Jennings:]

Hi. Good evening. Thanks a lot. I was hoping to just ask about surgical volume assumptions, I know you called out some softness in January and February. And does Q2 guidance bake in a reacceleration in surgical volumes and are you seeing some improvement thus far in the quarter?

[Quentin Blackford:]

So I think the right way to think about that is – or the pro forma growth excluding any impact of currency will see us accelerate a bit into Q2 roughly 7% versus the 6% that you saw in Q1. And so that's going to be primarily driven by volumes and I think that answers the question for you. And I think you'll continue to see that play out from what we saw exiting the quarter of Q1. January and February, we talked about being a bit soft. March certainly rebounded and performed well. And if we kind of look at Q2 it's performing in line with Q1 as a whole. That's how we're thinking about it.

[Joshua Jennings:]

Great. Thanks. And just a follow up on Ellipse. I think you guys had called out on the acquisition expectations for accretion in the $0.18 range in 2017. I guess you guys are on track with that accretion target and then also just on the NTAP decision that was positive kicked in I believe in October. Are you seeing any ramp in adoption rates from MAGEC rods since that positive decision was made? Thanks for taking the question.

[Quentin Blackford:]

I would tell you that that MAGEC business has performed in line if not ahead of expectations for us particularly relatively to the deal model. It's exactly where we would expect it to be on the top line. And from a profitability perspective, I would say, it's a little bit ahead. We look at that as an opportunity to accelerate the overall growth profile of the profit margin for the company and we continue to believe that that will be the case longer term for sure.

[Operator:]

Thank you. There are no further questions. At this time, I would like to turn the floor back over to over Greg Lucier, Chairman and CEO to conclude today's call.

[Gregory T. Lucier:]

Operator, thank you very much, and thanks to all of you for participating on the call today. We look forward to speaking with you at the end of the next quarter. Thanks very much.

[Operator:]

This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.