NuVasive, Inc.
Q3 2016 Earnings Call Transcript

Published: 26 Oct 2016

[Operator:]

Greetings, and welcome to the NuVasive, Inc. Third Quarter 2016 Conference Call. At this time, all participants are in a listen-only mode and a brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Ms. Carol Cox, Executive Vice President, External Affairs and Corporate Marketing. Thank you, Ms. Cox. Please go ahead.

[Carol A. Cox:]

Thank you, Chris, and welcome to NuVasive's third quarter 2016 earnings call. Earlier today we've issued our earnings release, which 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. Additionally, we have posted supplemental financial information on the IR 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 can follow along. Before we begin today, 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 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 release and periodic filings with the SEC. 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 can be found in the news release and the supplementary financial information, which are accessible from our Investor Relations section of the website. Joining me on today's call are Greg Lucier, our Chairman and Chief Executive Officer; Jason Hannon, President and Chief Operating Officer; and Quentin Blackford, our CFO. With that, I'll turn the call over to Greg.

[Gregory T. Lucier:]

Thank you, Carol, and good afternoon, everyone. We are pleased to be hosting this afternoon's call from Boston where we are attending North American Spine Society Conference. First, I'm going to provide an overview of our results for the first quarter – I'm sorry, for the third quarter. Then Jason will discuss his new responsibilities and Quentin will review our financial results in more detail and provide updates to our 2016 guidance. Earlier this afternoon we reported third quarter results including revenue of $239.6 million, representing year-over-year growth of approximately 19.5% on a reported basis. On an organic basis, our revenue grew approximately 5%. Revenue growth in the quarter continued to reflect strong procedural growth in the U.S. as well as strong performance in our European and Australian markets. Revenue came in a few million dollars short of the guidance we provided back in July due to U.S. capital and stocking orders that did not materialize late in the quarter as we had forecasted. These orders generally come in very late in the quarter as hospitals evaluate their budgets and make final purchasing decisions. As mentioned, procedural growth in the U.S. remained strong and was consistent with prior quarters despite tough comparables. Excluding the impact of these orders not materializing, our business results came in as we expected when we provided guidance in July. While we are disappointed at the revenue shortfall in the quarter, we believe this minor disruption is temporary and we are not seeing changes or shifts in the marketplace that give us concern. We continue to have an active pipeline of capital and stocking deals, several of which we are currently negotiating and expect to close in the fourth quarter. Furthermore, surgeon conversion rates are outpacing our normal trend. Now having run public companies for a long time, I understand the importance of giving reliable guidance. So believe me, nobody is more unhappy about missing our top line forecast than me. We ask our investors to focus on our ability to grow the top line and expand profitability at the same time, and trust us that we will deliver. While the revenue shortfall was relatively minor and we over-delivered on margin, we still missed the mark. We will do better from here and continue to strengthen our rigor to be the investment you make in the spine medical device arena. Turning to the rest of our results. As I just mentioned, I am pleased that even with revenue coming in a little light, we exceeded our expectations for profitability in the quarter with a non-GAAP operating margin of 16.1% and a non-GAAP earnings per share of $0.40, representing year-over-year growth of approximately 14.3%. Now let me elaborate on third quarter U.S. revenue results. We saw strength across both our Spinal Hardware and Surgical Support businesses, both of which delivered double-digit growth for the quarter on a reported basis, including NuVasive Specialized Orthopedics, or NSO, and Biotronic NeuroNetwork. In line with the last several quarters, we see momentum with our Integrated Global Alignment, or iGA platform. Growth in our Spinal Hardware business reflects the strong acceptance of the platform across the product areas within the iGA strategy, including our Reline posterior fixation system, ALIF, Bendini and IOS. In particular, the adoption of Reline within iGA is leading to greater penetration in the deformity market and we expect this trajectory to continue. Results were also driven by strength across our procedural offerings including posterior lumbar, anterior, lateral and cervical, and the integration of our NSO portfolio which includes MAGEC for early onset scoliosis. The PRECICE technology for limb lengthening that we acquired with Ellipse Technologies is now part of NSO and also had a very strong quarter. In our Surgical Support business results were driven by the inclusion of Biotronic, which we acquired in July and is included in our results for the first time, and by M5 neuromonitoring platform disposable growth. Our results benefited from the inclusion of NSO and Biotronic, both acquired during 2016 as part of our strategy to augment NuVasive's leadership in spine with complementary technologies. I'm pleased to report our integration efforts for those deals remain on track and are delivering the substantial growth that we forecasted as part of their respective deal models. Now let me share some updates for both of these businesses. NSO is providing exciting opportunities for our portfolio to support pediatric, adolescent and adult deformity patients. Now that we have NSO fully on board, we're making solid headway integrating it within our iGA platform. During the third quarter NSO achieved several regulatory milestones including CMS approval for an add-on payment, or NTAP, for magnetically controlled growth rods, and FDA clearance for the MAGEC system to be used with our Reline system. Combining the game changing innovation of MAGEC and the versatility of Reline, we are now able to offer surgeons a comprehensive solution for treating the most difficult spinal deformities, transforming the experience for these young patients by reducing the number of distraction surgeries from as much as 15 to an only single one. On the commercial side, we have growing momentum in our U.S. MAGEC sales and are working closely with high volume hospital customers on opportunities to lock in longer term contracts. In early July, we closed the acquisition of Biotronic and combined the service offerings of Biotronic with our existing Impulse Monitoring business, form NuVasive Clinical Services, the nation's largest intraoperative neuromonitoring services company. At a strategic level, the acquisition advances our strategy to transform how spine procedures are approached, measured and valued from a clinical and economic perspective. And on an operational level, we have doubled the footprint of our service business across the U.S., allowing for the delivery of intraoperative neurophysiological monitoring services to surgeons and healthcare facilities for more than 75,000 cases annually in the United States. We made solid progress in bringing the Biotronic team on board and aligning the commercial business development and national strategic accounts to facilitate procedural integration and service line partnership opportunities. Additionally, we are leveraging the last two years of IMI experience with account optimization across the Biotronic business now to achieve synergies and accelerate cross-selling and account integration opportunities. For example, we are integrating our M5 platform into Biotronic contracts, resulting in a significant number of incremental cases being performed utilizing our M5 in Q3. And on a cultural level, the energy in our services organization has never been higher. IMI recently received its Joint Commission reaccreditation and the two teams are working closely together to target new accounts, convert business to M5, and implement best practices to further scale the business. As we have been communicating, margin expansion is the key element in our efforts to deliver value creation for shareholders. We continue to execute strongly against these efforts and during the third quarter 2016 delivered non-GAAP operating profit margin of 16.1%, which is a full 60 basis points better than the guidance of 15.5% we provided in July. This included absorbing approximately 40 basis points from the acquisition of NSO and more than 150 basis points from incremental investment in core NuVasive R&D and our sales force versus the prior year. Our efforts to achieve 100% in-house manufacturing remain on track with a tremendous amount of work going on at our West Carrollton, Ohio manufacturing facility. We achieved significant milestones during the quarter as the facility passed its initial inspection, the computer-aided manufacturing systems came online, and machining production was released for the first two titanium turning product families. Balance of 2016 will be focused on ramping up production volumes and getting to a point in late 2017 when we can close the smaller existing plant and have all our volume running through this state of the art factory. As I mentioned earlier, we are attending NASS this week where we are hosting surgical innovation workshops, in-booth presentations and scientific sessions focused on minimally-invasive spine surgery and the importance of alignment. We have a strong history delivering disruptive spine technology and now are increasingly doing business model innovation as well. From XLIF to iGA to spine service line partnerships, we continually seek to outpace our peers in addressing unmet market requirement and overcoming barriers. In line with these commitments, we are announcing the introduction of two compelling solutions designed to provide more reproducible outcomes through a less invasive procedural approach to spine surgery. First, cervical Integrated Global Alignment platform, and second, our new proprietary integrated software program called Lessray that helps OR staff reduce the levels of exposure to surgical radiation. Let me provide a little bit of color now on both. Surgical iGA. As we know, spinal regions are not independent of one another. Cervical lordosis depends heavily on thoracolumbar alignment and vice versa. Every clinical data is demonstrating a strong correlation between cervical alignment and positive patient outcome. Specific cervical parameters and their relationship are significant indicators of successful outcomes in the body's attempt to maintain the head over the pelvis and sustain a horizontal gaze. Building on the momentum of our iGA platform launched in May 2015, we are now expanding the platform to address cervical alignment. This makes us the first company to offer a solution for surgeons to address spinal alignment for all spinal procedures. Our surgical iGA platform incorporates a suite of proprietary, procedurally-based technologies, designed to enhance clinical outcomes by increasing the predictability of achieving global alignment in cervical-spinal procedures. These include NuVaPlanning software solutions to navigate through the surgical workflow for pre-, intra- and post-operative planning and confirmation, interbody systems to complement the anterior column realignment, or ACR procedure, and our Bendini Rod Bending System. With this suite of technologies we expect to build off of those and have tremendous success that we have seen so far with iGA to meet the needs of those suffering from cervical pathologies. Now let me talk about Lessray. With our focus on providing end-to-end procedurally integrated offerings that are truly differentiated, we have communicated our interest in key areas such as imaging, navigation, radiation reduction and service enhancements to continue to strengthen our offerings. Radiation in the OR is a known issue, one that plagues the surgeon, the staff and the patient, and yet it remains largely unaddressed. Data shows significant increases in radiation results in a two-fold increased risk of cancer, and a three-fold increase of breast cancer to orthopedic surgeons. To directly address this potential barrier to widespread adoption of minimally invasive surgery, in September we acquired the Lessray software technology suite from a private company called SafeRay Spine. This company developed a proprietary software algorithm to drive image registration and enable management of radiation exposure, while maintaining high quality, intra-operative images with the existing C-arm workflow. A deal was structured where we pay for success as we incorporate the Lessray technology into our procedural offering. Let me tell you how it works. Lessray software is integrated into current surgeon workflow and transforms low radiation images without loss of visual accuracy. The technology supports the surgeon, transforming their environment to be safer, more productive, while reducing one of the leading barriers to adopting minimally invasive surgery. In addition, the technology can be incorporated into our portfolio of differentiated solutions as a foundational element of our imaging, navigation and surgical automation development strategy. We are very excited to have the technology in-house, and are in the process of building out a small capital sales team to sell the system alongside our portfolio of hardware, software and service offerings. As a postscript, I must tell you that this software solution is a far more economical way to solve radiation reduction than purchasing one of those clunky, expensive robots that will be pedaled by our peers in this space at NASS. Now let me talk about the macro environment. When I meet with healthcare executives and surgeons, what I hear and observe is that most hospitals have not changed how they think, act and execute on spine surgery as a business. That will absolutely change, and NuVasive wants to be actively involved in how it does change. When I took on the role of CEO of NuVasive, I looked to find a forum where a broad group of leaders could work together to come up with better solutions. What I found was a clear void. So we set up to create this opportunity and two weeks ago, we hosted the inaugural NuVasive Spine Summit in San Diego. This invitation-only educational event brought together hospital executives, healthcare leaders, industry visionaries and surgeons together for two days to discuss the future of spine care and hospital service line optimization. We hosted over 100 participants and spent the time discussing and brainstorming on the value that can be created when surgeons, hospitals and industry partner for better outcomes. There was great agreement that capturing and measuring outcomes and reducing overall costs while improving care remain critical themes. Given these dynamics and the challenges of delivering high-quality care in an environment of regulatory and expanding payment changes, we are confident we have the right strategy in place with our service line partnerships to infuse our industry expertise with that of our hospital partners to transform how spine procedures are approached, measured and valued from a clinical and economic perspective. In closing, I continue to be encouraged by the overall trends we see in both the macroeconomic environment and competitive landscape, as well as the opportunities we have to continue to bring differentiated solutions to market. We've had a very active year so far integrating iGA and NSO, continue to build out our capabilities across the deformity market, creating NuVasive Clinical Services, which is now the national's largest intraoperative neuromonitoring services company, and ramping up our internal manufacturing capabilities in West Carrollton as we work towards 100% self manufacturing. We intend to finish the year strong, to take share in the U.S. and internationally, and deliver on our financial goals for 2016. Now I'd like to turn the call over to my colleague, Jason Hannon, who has recently taken on the role of President and COO. In his 11 years with NuVasive, Jason has led key areas of our business, including international operations, strategy, corporate development, legal and regulatory. Jason has extensive knowledge about our business operations and the markets we serve, as well as strong relationships with our customers. Jason?

[Jason M. Hannon:]

Thanks, Greg. Good afternoon, everyone. As Greg said, I've been involved with NuVasive for almost 15 years, initially to help the company raise money and go public, then I joined full time in 2005. I recently took on the role of President and Chief Operating Officer, along with maintaining responsibility as Head of International for NuVasive. I couldn't be more excited than to step into this role at this point in time. Our ability to improve spine care, and specifically surgery, is just getting started. We've been the driving force of change and advancement in spine surgery for many years now, and our leadership on these fronts will only get stronger. I'm already digging in, and as my colleagues well know, I'm very involved in the day-to -day operations of the company. I'm honored to assume this role from Pat Miles, my close friend and colleague. Pat's a tremendous leader and product visionary, and our view of spine surgery as integrated procedures, rather than individual products, is a testament to his understanding of the business. In his new role, Pat will continue providing input into the future of our procedure and technology roadmap, and I look forward to his contributions as we leverage our spine expertise to deliver the next advances for our spine surgeon partners and their patients. My most recent experience in running our international business has uniquely positioned me to further advance NuVasive as a truly global company. Everything we do in San Diego, Amsterdam, Japan, Australia, the UK, Germany, Italy, and all of our locations must be consistently executed such that our surgeon customers receive the very best products and the most clinically adept service in the business. This shouldn't change whether you're in London, Tokyo or Chicago. We are the ultimate partner to assist a surgeon in delivering the best possible surgical outcome. Over my tenure at NuVasive, I've seen firsthand what's working well and what needs to continue to evolve and improve. My focus in the first 90 days will be on working with our teams on each of the following. First, aligning the company's resources behind the future of our products, procedures and technologies. This means even greater definition around the evolving needs of spine surgery. The core requirement is the integration of technology and information to enable better clinical decisions and execution by surgeons. It's not just about an interesting robot or piece of technology or printing a custom implant. It's about delivering the most relevant information and tools at the right time. This is the future of our efforts. Second, fostering our key surgeon relationships and the ways in which we provide service. The execution point of our business is in the operating room. This is where our procedures show their value, and our people shine. We'll stay focused on integrating the input of surgeons in the product development process, as well as the highest standards of clinical service in the OR. Third, creating great alignment between our product teams and the field sales teams in the U.S. and internationally. As we continue to grow, our advancing products and procedures require great alignment among our teams. The practical result is a field team that is fully educated and able to service our customers. Matt Link, who's our President for U.S. Commercial, and I are committed to this common goal. And fourth, focusing maniacally on the core cultural values that make NuVasive unique. High performance standards, delivering results and continually improving. Our culture isn't words on a wall. It's who we are. Our sales rep doesn't track down surgical trays for a colleague at three in the morning to satisfy a metric. It's because a surgeon and a patient depend on us, and that's the mutual commitment that we've made. Let me now comment on our third quarter international performance. When I took on the international leadership role in mid-2015, our business had flattened and we immediately implemented a recovery plan for several of our international markets. The strategy is simple. We lead with what we know best. Our MIS procedural solutions in our key markets. And from these platforms, we build out a local plan to concentrate and go deep in each country. This approach has returned us to growth over the last several quarters with particular expansion in Germany, the UK, Italy and Australia. I'm confident this strategy will allow us to better support efforts to go further into mature markets where we are currently underpenetrated as well as into new growth markets, such as those across Latin America where we will need to navigate these geographies as their economies continue to mature. Now let me comment about the current situation in Japan. In July, the Japanese Ministry of Health requested an industry-wide reclassification of certain surgical accessories, including dilators that are used in lateral access surgeries which includes XLIF. We like other similarly situated spine companies are working through this and removed our dilators from circulation in Japan in early July. This has had a temporary impact on our XLIF business as dilators are instruments needed for XLIFs to be properly performed. This issue is not unique to NuVasive or to XLIF. Our dilator in Japan was originally approved as a class two device in August 2011, with additional sizes approved in January 2014. Per our communication with the government authorities, we agreed to resubmit our dilator for approval as a class three medical device. We made our re-submission in early October and are now in the formal review process and in regular communication with the regulators. We initially believed the dilator would be reapproved and back on the market by early Q4, however, additional testing was required so the process has taken longer than expected and we now anticipate the review process should be complete in late Q4. XLIF procedures would resume as soon as the dilator is reapproved. I am extremely proud of how our Japanese team has dealt with this situation. We have long tenured leadership in the region and everyone is working diligently to resolve this matter as quickly as possible. Our sales and leadership teams are completely committed to success in the Japanese market, and our Japanese surgeon customers remain steadfast in their support of XLIF as a procedure of choice for their patients. The team in Japan has temporarily refocused their commercial efforts on our other product offerings in recent weeks, particularly our Posterior Fixation business, the launch of iGA, Bendini, and Reline. This quick pivot will allow us to continue to drive growth in the market despite the short term challenge, and gives me confidence that we'll be in an even stronger position when XLIF procedures resume. I couldn't be more excited about my expanded role and the talented team of NuVasive share owners I get to work with every day. Our product teams are hands down the best in Spine. We don't innovate for the sake of putting new things into the market; we don't follow our competitors. We use our industry-leading knowledge to identify unmet clinical needs of surgeons and patients, then we innovate solutions. Looking across our business globally, we continue to build out our international footprint thoughtfully and with our customers in mind. In just a few short weeks we'll be moving into our new international headquarters in Amsterdam, having outgrown our current offices. And in the first quarter of 2017, we'll be opening our first surgeon education center in Amsterdam. This will allow for dedicated clinical education. We have the right strategy, the most innovative product portfolio and pipeline in the industry, and a culture that drives results and outcomes for our customers and patients, and ultimately drives value for our shareholders. I look forward to meeting many of you over the coming months. And with that, I'd like to turn the call back over to our CFO, Quentin Blackford.

[Quentin Blackford:]

Thanks, Jason. And good afternoon, everyone. Before we get started with the financials, let me remind you that many of the financial measures covered in today's call are on a non-GAAP basis unless noted otherwise. Please refer to today's earnings new release as well as the supplemental financial information on nuvasive.com for further information regarding our non-GAAP reconciliations. Let me jump into the results for the third quarter of 2016. While revenue was a bit lighter than anticipated, profitability improvements progressed faster than projected and we delivered earnings that exceeded our expectations. Revenue came in at $239.6 million, representing year-over-year growth of 19.5% or 18.9% on a constant currency basis. As Greg described, revenue results for the quarter were impacted by U.S. capital and stocking orders that did not come through late in the quarter, as we had planned. I would like to reinforce the point that we see this as temporary in nature as U.S. procedural volumes continue to grow at a strong pace and were in line with the prior quarter, despite more difficult comps. On a positive note, we delivered a non-GAAP operating margin of 16.1%, which was 60 basis points higher than our guidance for the quarter of 15.5%. Revenue contributions from the acquisitions of NSO and Biotronic were in line with expectations, and helped drive revenue performance in the quarter with each contributing roughly seven points of growth to our overall growth rate on both the reported and constant currency basis. NuVasive's core business excluding the impact of NSO and Biotronic during Q3 grew approximately 5% on a reported basis and 4.4% on a constant currency basis. On a pro forma basis, NuVasive, NSO and Biotronic combined to grow 6% in the quarter. Adjusting for the temporary impact of the previously mentioned U.S. capital and stocking orders in addition to the temporary delay of XLIF procedures in Japan, both core NuVasive revenues and pro forma revenues grew in line with our goal to deliver high single-digit growth as a combined company. Our U.S. Spinal Hardware business had another strong quarter, coming in at $133.2 million, an increase of 14.6% year-over-year primarily driven by contributions from MAGEC for early onset scoliosis and PRECICE for limb lengthening, as well as the continued adoption of the Reline posterior fixation system within our iGA platform. Excluding the benefit of NSO, our core U.S. Spinal Hardware revenue grew approximately 6% year-over-year to $123 million. Revenue from U.S. Surgical Support came in at $73 million, up 25.6% compared to the same period last year primarily driven by the addition of Biotronic and growth in our M5 neuromonitoring disposables business as we continue to integrate M5 into our service accounts and ramp up integration efforts between Biotronic and legacy IMI Service business. Excluding the benefit of Biotronic, our core Surgical Support revenue came in at $58.9 million, growing 1% year-over-year, primarily driven by continued double-digit growth in our M5 disposables business offset by softer biologics performance. Our international business came in at $33.5 million, up 27.6% on a reported basis or 23% on a constant currency basis. NSO contributed 18 percentage points of growth for the quarter on both the reported and constant currency basis. As Jason indicated, with lower XLIF revenues in Japan during the quarter, our core NuVasive revenue growth in our international business was 9.3% on a reported basis, or 4.7% in constant currency. If XLIF procedures in Japan had been performed at the normal pace, our international growth would have been approximately 26% on a reported basis or 21% in constant currency. The meaningful growth in our international business, aside from the impact of Japan, has been driven by strong performances in our core European and Australian markets. Based on these dynamics, we expect our core international growth rate to return to approximately 20% in the fourth quarter. Now I would like to discuss Japan for a minute. As Jason noted, the Japanese Ministry of Health requested an industry-wide reclassification of dilators used in lateral access surgeries and we anticipated this would have a temporary impact on our XLIF business in Japan. We did not and do not see this as material and the temporary disruption of lateral access surgeries was built into our assumptions when we provided third quarter guidance. While we lead with XLIF in the Japanese market, our product offerings spans well beyond XLIF to include key product offerings, including Reline and Precept. When we provided financial guidance in July, we expected to obtain approval of the reclassification of our dilator early in the fourth quarter. As we now anticipate obtaining approval late in the fourth quarter, we have adjusted our expectations to remove XLIF procedural revenues in Japan for the entire fourth quarter. Given the longer than anticipated timeframe for obtaining the dilator reclassification in Japan and the shortfalls in the third quarter as a result of the capital and stocking order sales in the U.S., we are reducing full year revenue expectations by approximately $10 million to $952 million. As a result of our focused efforts to drive efficiencies and improved profitability, as well as some good tax planning initiatives, we are maintaining our previously communicated full year profitability guidance of a non-GAAP operating margin of 16% and full year non-GAAP EPS guidance of $1.64. Turning to the rest of the P&L. Non-GAAP gross margin for the third quarter was up approximately 80 basis points year-over-year to 76.3%, improving from 75.5% in the same period last year. This improvement was particularly meaningful considering the incremental headwinds of more than 200 basis points associated with the lower gross margin profile of the recently acquired Biotronic business. The improvements from the prior year were primarily driven by the suspension of the medical device tax and greater inventory efficiencies. Pricing pressure remain consistent to past quarters and continue to remain in the very low single digits and negative 1% and had a negligible impact on gross margin. To note, we began manufacturing our first products in our new facility in the third quarter and are excited about the future benefits we expect to realize from this initiative. However, we did not realize any contribution from our in-house manufacturing initiatives in the quarter as those benefits are expected beginning in 2017. We continue to expect full year non-GAAP gross margins to be approximately 76.4%. Non-GAAP SM&A expense as a percent of revenue decreased 10 basis points year-over-year to 55%, down from 55.1% in the same period last year. This decrease is primarily the result of lower SM&A profile of the recently acquired Biotronic business, partially offset by the higher SM&A profile of the NSO business and less than anticipated leverage from our international business as a result of the temporary impact to revenue in Japan. Despite the reduction in revenue for the full year, our focused efforts to drive asset efficiencies are expected to offset the incremental pressure on operating margins, and we therefore expect full year non-GAAP SM&A expense as a percent of revenue to be approximately 55.3%. We increased non-GAAP R&D investment during Q3 with spending up 110 basis points to 5.2% of revenue compared to 4.1% in the same quarter last year. This was primarily attributable to continued investments in NSO technology, and efforts around imaging, navigation and surgical automation as well as the cervical iGA which we are launching here at NASS. We continue to expect full year non-GAAP R&D expense as a percent of revenue to be approximately 5.1%. In terms of driving profitability improvements, we continue to make solid progress with a non-GAAP operating profit margin of 16.1%, which is up 60 basis points versus our previously issued guidance of 15.5%. Operating margin results were meaningful considering the fact that when compared to prior year, we absorbed approximately 40 basis points of headwinds from the acquisition of NSO and increased investments into our core NuVasive R&D, and our U.S. sales force by more than 150 basis points. As mentioned earlier, we expect a full year non-GAAP operating margin of 16%, unchanged from prior guidance. Moving further down the P&L, interest and other expense net on a non-GAAP basis was $5.8 million in Q3, up from $2.6 million in the same period last year. This increase is primarily a result of the new interest expense associated with the 2021 convertible notes we issued in the first quarter. We expect full year interest and other expense net on a non-GAAP basis to be approximately $21 million, unchanged from prior guidance. Now, turning to tax. Our non-GAAP tax expense in the quarter was $12 million, resulting in a non-GAAP effective tax rate of 36.7%. We expect a full year non-GAAP effective tax rate of approximately 37%, in line with the prior guidance, as our continued focus on initiatives to reduce our annual effective tax rate are expected to offset the impacts of the reduced revenue expectations from our international business. Also, as communicated last quarter, we anticipate that our rate in 2017 will move below 35% and will be sub-30%, approaching the mid to high-20%s by 2020. Third quarter non-GAAP net income was $21.1 million, or non-GAAP earnings per share of $0.40, compared to non-GAAP net income of $18.1 million, or non-GAAP earnings per share of $0.35 in the same period last year. We maintain our full year non-GAAP earnings per share guidance of $1.64. Turning to our GAAP results, GAAP net earnings for the third quarter of 2016 were $3.9 million, or $0.07 per share, compared to $13 million or $0.24 per share in the same period last year. On a full year basis, we now expect GAAP earnings per share to be approximately $0.76. Please refer to our earnings press release or the supplemental financial information file posted on nuvasive.com for further information related to our GAAP versus non-GAAP adjustments for both our third quarter performance and full-year expectations. Adjusted EBITDA margin, which excludes the impact of non-cash share-based compensation, was 25.9% for Q3, compared to 26.7% in the same period last year. Our cash and investments balance at the end of the third quarter was $204 million, and for the quarter, free cash flow was negative $26 million due to the $45 million litigation settlement payment with Medtronic, which we paid during the period. Excluding this one-time payment, free cash flow would have been $19 million for the quarter. In closing, I am pleased with the significant progress we were able to deliver against our profitability goals, with operating margins coming in ahead of expectations despite revenue coming in a bit lighter than anticipated. As a result, we delivered earnings in line with expectations. The integrations of NSO and Biotronic remain on track to deliver on the financial expectations that we have outlined for you. We continue to take market share and lead with our innovation. We're converting new surgeons at a faster pace than ever before, and we are successfully growing our sales force at the fastest rate we've seen in years, as new sales territory leaders from competitors are seeking to be part of the NuVasive team. We look to finish the fourth quarter and full year strong, managing the business efficiently and prudently to increase our momentum with year-over-year double-digit top line growth, continued expansion in our non-GAAP operating margin, and 25% growth in our non-GAAP earnings per share. Thank you. And we'll now open the call to Q&A.

[Operator:]

Thank you, Mr. Blackford. Ladies and gentlemen, at this time we'll be conducting a question-and-answer session. And our first question comes from the line of Mr. Matthew O'Brien with Piper Jaffray. Please go ahead, sir.

[Matt O'Brien:]

Good afternoon. Thanks for taking the questions. Just to start with, I think, Quentin and Greg, the message here really is, this is a temporary issue. Don't overstate the impact here that you've seen in Q3. But I think what would help investors and me a little bit is just, if you could provide some details on what happened from a capital and stocking order perspective in Q3? Why it pushed? Why you're confident that you're going to get that back here in Q4, or even early next year? And then if you could provide some sort of metrics on the surgeon conversions or new sales force hires that I think investors could really use to grasp onto, to measure whether or not this really is a temporary issue and is something that can be rectified as quickly as Q4?

[Gregory T. Lucier:]

You bet, Matt. Quentin, why don't you take that one first, and then I'll say a few words?

[Quentin Blackford:]

Yeah. Matt, from a capital perspective, I think the key here is, capital sales are not what drive this business. It's a very small percent of the overall business, generally less than 2% or so on any given quarter. But generally it's pretty consistent. And the reality is in the quarter, in the third quarter alone, we didn't see anywhere near that 2%. As a matter of fact, it was nearly zero coming through, and just the nature of these things tend to happen in the last part of the quarter, generally the last week of the quarter. And so, we had good line of sight into the quarter coming into that last week, but none of these ended up materializing. Now, we could give you some good examples where likely we could have closed a couple of those down, but it was better for the business to go ahead and continue to work through the details of those. One example, for instance, was an ability to combine the MAGEC product line with our broader implant product line. We could have closed a partial part of that deal in Q3, but it would have put the broader deal at risk. We weren't going to do that for the long-term health of the business, so we had to look at that a little bit differently. But certainly we thought, coming into the end part of the quarter, we were going to be able to close that down. That's business that over time will come back. Whether it's all in Q4 or early next year, yet to be seen. We haven't counted on that coming back in our guidance, but that's not a systemic issue and it doesn't speak to any underlying weakness in the business. As we pointed out, the procedural volume growth was as strong as it's been, even against the tougher comp in the quarter. So we remain bullish on what we're seeing from a procedural volume perspective and the overall health of the market. In terms of the sales reps, we haven't commented on the exact number of reps that we have in the field. I'll just tell you, we pay very close attention to it on a quarterly basis and we saw meaningful increase in the third quarter with the net number of new additions that we saw come into that sales force. So, that's not contributing yet to any of the growth that we see. Generally, that's going to take 12 to 18 months to play out. But in the future, you should see a contribution come from that.

[Gregory T. Lucier:]

And let me just add, I think in the third quarter, you can see the confluence of events where we were just a little thinner against guidance, given the Japanese issue. And while we were able to hold profitability, which I think speaks a lot to how rigorous the discipline has become inside the company, just as issues unfolded that Quentin spoke to, we couldn't quite get across the finish line. It is very temporary in nature. And I would also just give a qualitative comment that the confidence inside the business has never been stronger. As we say, we're not going to comment on how many new reps we've hired, but the sales force is bigger and stronger than ever and I think seasonality, we'll have a very, very strong fourth quarter.

[Matt O'Brien:]

Great. And then just a real quick follow-up on Japan. I think when we had talked earlier, the expectation again was end of Q3 that you would get the reapproval. Then the Ministry of Health comes back, asks for some more data from you. Just again, Japan typically is a difficult market to get things back onto the market, so just your confidence level and being able to be back by the end of the 4Q and then all systems go into 2017? Thank you.

[Gregory T. Lucier:]

Yeah. Let me have Jason answer that one and I think he can do so from a surgeon perspective. Jason, why don't you just give a little discussion about how the surgeons are involved here?

[Jason M. Hannon:]

Yeah, absolutely. As you all know, the XLIF adoption in Japan has been very strong and there is strong surgeon support of it, both during this regulatory process as well as the expected resumption of XLIF. So through this process of additional testing back and forth, we've gotten good indications that we should be on track for the end of Q4 and then the same surgeon involvement and support that's been with us all along gives us confidence in those procedures resuming as we build into Q1.

[Matt O'Brien:]

Got it. Thank you.

[Operator:]

Ladies and gentlemen, we do ask that questioners limit themselves to one question per. Now our next question comes from the line of Mr. Matt Miksic from UBS. Please go ahead, sir. Mr. Miksic, your line is live.

[Matt Miksic:]

Hi. Sorry about that. So thanks for taking the question. As a follow up to Matt's question, I think understanding it's transitory, understanding it sounds like there's two places where the numbers came in, these delayed contracts and the issue in Japan. Can you put, Quentin, maybe just a dollar range on these things? You talked about 2%. So is it $5 million, $6 million in a given quarter that this would normally come in and that was a zero in the U.S. and Japan? Just a similar bigger than a breadbox kind of guidance would be helpful. And then I just have one follow-up, if I may.

[Gregory T. Lucier:]

Go ahead, Quentin.

[Quentin Blackford:]

So, Matt, the difference in the U.S. was about $3.5 million on the capital sales and that would have got you right back into our guidance. We had Japan dialed in right in line in our guidance with where it fell for the quarter. So there was no variance to how we had set expectations for Japan. Now internally, we were hopeful that we would see the ability to capture a bit of that XLIF shortfall with some of the posterior fixations still coming our way. We didn't see that materialize all the way in the quarter like we had anticipated. So that was a bit of a gap to the internal expectation, but it was not a gap at all to the guidance. So really the whole gap to guidance was that $3.5 million of U.S. capital sales. Now the impact in Japan in the quarter related to XLIF was about $4.5 million, and you could back into that given the different growth rates that I had provided to you on the international business. But that was the overall impact from Japan.

[Matt Miksic:]

Great. And we were excited to see the products at NASS. And I don't want to the focus on the minutia here again. You have some great things to talk about over the next couple of days, but the follow-up is on the sales force, because I think it's something that's a little difficult for investors to get their mind around, myself included sometimes. The types of investors – I mean, I'm sorry, the type of reps, the potential impact of the reps, the timing of those reps that you're bringing in the door? If you could maybe just provide some color? And if what you're seeing now is any different, for example, than you might have seen a year ago? Your approach to hiring those reps? That kind of color would be very helpful.

[Gregory T. Lucier:]

You bet. And I think we had this conversation at the last earnings call, and so importantly let me give some update on just how it is unfolding in 2016. So in 2016 I think, as I've just referenced, the confidence in NuVasive as a place to come work and build surgical relationships has never been stronger. And when you think about if you are really good at your game, where you want to go, you actually kind of do deduce that this is the best place. I think we have the best product line. We have the most momentum (46

[Matt Miksic:]

Thanks so much.

[Operator:]

And our next question comes from the line of Kaila Krum with William Blair. Please go ahead.

[Kaila P. Krum:]

Hi, guys. Can you hear me okay?

[Gregory T. Lucier:]

Yeah, we can.

[Kaila P. Krum:]

Perfect. So first one for Jason. Congrats on the new role and I appreciate all the color on the initiatives you have planned. But I guess I'm just curious how you plan to balance your new role as COO with your current position as Head of International and just the responsibilities associated with bringing back the business in Japan. Can you just help us understand how you'll be splitting your time between those two positions?

[Jason M. Hannon:]

Yeah, absolutely. So one of the great opportunities in this role is to accelerate and advance the globalization of the business. The business internationally was started in small pockets and the ability to bring those teams together by having the product teams directly and more closely linked with the international teams it is probably the single biggest thing I can do to support the growth of the international business and no better position to do it than from where I sit today. So I don't look at it so much as splitting the responsibility or splitting my time as I do the opportunity to bring those teams together. We have great international leadership in the regions, sales and commercially focused leadership. We have strong operations leadership. You can see it in the development of our manufacturing sites and our logistics and customer service sites that are now more closely linked internationally. So those are growing as well. I see it frankly as primarily an opportunity to genuinely globalize the business and get our product teams more closely linked to the regions.

[Kaila P. Krum:]

Okay. That's really helpful. And then I guess just on the core business, can you guys talk a little bit more about where we're at in terms of the adoption curve with iGA and just the strategic rationale behind adding Lessray to the portfolio? Because I know there's been feedback around Lessray has been really bullish and I'm just trying to gauge whether or not this software provides another catalyst similar to iGA that could accelerate core performance.

[Gregory T. Lucier:]

You bet. Let me take the last part of your question first and then I'll have Quentin talk about where we are in the adoption of iGA and Reline. When you look at the top 10 pain points of spine surgery, placing a pedicle screw is probably number 9 or 10. And yet if you look at the number one duty of all of these current robots being sold by our competitors, that's all it does. And so it's a complete mismatch between investment that these companies are asking customers to make versus the actual value they go create. I think NuVasive has had a great heritage of always aligning up what are the top pain points and then what's the technology to address it? When you do look at the top pain points, the top five, depending on the group of surgeons you speak to, but inevitably in the top five is radiation reduction. When you start and you have minimally invasive surgery, regrettably one of the byproducts is a lot of radiation. And we think just a far more precise way to solve it using this very, very cool technology to use the C-arm in the normal way in the operating room and yet radically reduce the amount of radiation up to in certain instances 90%. So you're going to see us talk a lot about that. We think it will be a great catalyst for a whole strategy we're building out in the operating room, and NASS is just when the conversation begins. Let me pivot over to Quentin on Reline and iGA.

[Quentin Blackford:]

Yeah, Kaila. So clearly you can see we're extremely excited about the opportunity that Lessray is going to bring. And when you think about where we've initially targeted Reline and iGA and now with the ability to bring Lessray into it, the whole deformity segment is really a greenfield for us, and we would still estimate less than 2% share of that entire market opportunity, which all-in early onset and adult is probably a $2 billion market opportunity, so the opportunity in front of us is tremendous. You look at even posterior fixation and bringing Reline outside of deformity into more of your traditional procedures or XLIF, we don't have more than 5% of that market opportunity today. Again, a greenfield for us when you consider the fact that we have north of 10% of the overall U.S. market. So I would say we're in the very early stages, still no more than second inning of a nine-inning ballgame here that we have in front of us. We couldn't be more excited about it.

[Kaila P. Krum:]

That's it. Thank you, guys.

[Operator:]

And our next question comes from the line of Andrew Hanover from JPMorgan. Please go ahead.

[Andrew Ronald Hanover:]

Thanks for taking our question. Quentin, I just wanted to start with one really quickly. Can you remind us what the impact was from the fewer selling day in the quarter?

[Quentin Blackford:]

There's not a fewer selling day year-over-year in the quarter. The fewer selling day is really when you go sequentially from Q2 to Q3. So seasonality is a bit more pronounced when you just look at Q2 to Q3. But year-over-year there is no difference.

[Andrew Ronald Hanover:]

Okay. And then in regards to NSO in the quarter, it looked like, if I'm right, that NSO had a sequential step-down in the quarter and just wanted to get an understanding of what that might have been because of? I think my understanding was we would have seen a stronger deformity season you all are partaking now in Reline and Ellipse. So we were thinking the deformity season would have pushed U.S. lumbar and cervical strength in the quarter, and just wanted to get your thoughts on the growth in the quarter? Thanks.

[Quentin Blackford:]

Yeah. If you look at the U.S. business for our NSO product line, the U.S. MAGEC business in particular, growth was really in line with Q2 and the overall (53

[Andrew Ronald Hanover:]

What was growth for U.S. lumbar and cervical in the quarter?

[Quentin Blackford:]

U.S. lumbar and cervical or NSO?

[Andrew Ronald Hanover:]

U.S. lumbar and cervical.

[Quentin Blackford:]

So U.S. lumbar and cervical was about 6%. If you were to adjust for the capital orders, you'd see that pushing upwards of 8%.

[Andrew Ronald Hanover:]

Thanks.

[Operator:]

And our next question comes from the line of Mr. Josh Jennings from Cowen & Co. Please go ahead, sir.

[Joshua Jennings:]

Hi. Good evening. Thanks for taking the questions. I think you've laid out nicely, Greg and Quentin, the impact on the Japan issue, but I just was curious about, as we look out into 2017 and the recovery of Japan, and just with the international business being a big part of the operating margin expansion story, would there be any residual headwinds in terms of the operating margin expansion expectations for 2017?

[Gregory T. Lucier:]

I think, let me just jump in and then Quentin will follow. I think actually just the opposite. I think you'll see a rebound because of, obviously, Japan. I think we're reaching evermore a critical scale in our international operations overall. And so one quarter does not make the strategy here. We feel very good about the long-term play going on in international. Quentin?

[Quentin Blackford:]

Yeah, I would agree with that. Obviously, some of the softness here in Japan in the back half of the year, we expect that to come back next year. It's going to put us in a position for meaningful growth off of a lower base than what we would have naturally had had we not seen the softness here. And frankly, with that growth comes incremental operating margin leverage, so we're not going to set 2017 expectations today, but we still are very bullish on what OUS is going to deliver, both from a top line growth and operating margin expansion opportunity into 2017.

[Joshua Jennings:]

Okay. Thanks for that. And then just lastly, as you guys look at your portfolio, Greg, if the two areas that I'm just curious about is in cervical and the updated thoughts on motion preservation and that hole in your portfolio. And then secondarily, just in scoliosis and adolescent scoli particularly, any new thoughts in terms of how you're going to attack that segment of the complex spine market? Thanks a lot, gentlemen.

[Gregory T. Lucier:]

You bet. So in terms of motion preservation, as I said on the last earnings call, that's an area of our portfolio we would like to have a solution, but we're not going to be irresponsible on the economics of what we do to go get it. It's nichey, but it would be nice. In terms of the overall scoliosis market, that is an area we are investing heavily in. You are going to see some news about the MAGEC Rod that will make that even more applicable shortly. You are seeing a fast, rapid build-out of entire Reline system that will be even smaller in stature. And then technologies beyond that, that we think will, just as Quentin said, take us from a very small share of a big market to, we hope to be the market leader over the next couple of years.

[Joshua Jennings:]

Thanks again.

[Operator:]

And our next question comes from the line of Mr. Kyle Rose with Canaccord Genuity. Please go ahead.

[Kyle William Rose:]

Great. Can you hear me all right?

[Quentin Blackford:]

Yes.

[Kyle William Rose:]

Great. Thank you for taking the questions. One quick question related to the cervical iGA and then one follow-up on biologics. So, just to start, just wanted to see if you could give us a little characterization of the launch of cervical iGA? How does that help you drive it, the iGA initiative, from what you characterized as the early innings a few questions ago, and help accelerate that moving forward? And then secondly, a follow-up on biologics, can you talk about weakness in the quarter; just wondered if you could add a little more color there?

[Quentin Blackford:]

Sure. Jason will talk to cervical iGA here and then I'll take the biologics piece.

[Jason M. Hannon:]

So, think about cervical iGA as obviously an expansion of the overall iGA platform, the goal being – the goal of iGA being delivering information to the surgeon that enables better clinical decisions. And the whole point being, a consistent planning process pre-surgery allows a consistent set of decisions to be made in surgery. When you can extend that up into the cervical spine, you're better able to address global balance of the entire spine and then the pathology of cervical. So to keep it simple, the goal is, every surgery should be planned. And by now rolling out the cervical aspect of iGA, it's possible to do that. A lot of surgeons have become fond of saying, they're all deformity surgeons. They're either creating a deformity or they're fixing it. You got to plan every surgery, and now we finally can put the tools in their hands to do it.

[Quentin Blackford:]

Yeah, Kyle. And on the biologics side, last quarter we saw that rebound a bit to just a point of positive growth after being down a couple points the prior quarter. Here in Q3, we saw it drop down to negative 2% again. So it continues to hover right around that flat area, but it was a bit weaker than what we had anticipated. You look at the procedural adoption, we continue to hover around 70%. We had seen that move closer to 73% at one point. So it continues to hold in there, but it's just not driving the incremental growth yet that we would expect it to, and that AttraX can open up the door to enable us for, but in the quarter it was down roughly 2%.

[Kyle William Rose:]

Great. Thank you very much for taking the questions.

[Operator:]

And our next question comes from the line of Mr. Jeff Johnson with Robert W. Baird. Please go ahead.

[Jeff D. Johnson:]

Thank you. Good evening, guys. So Quentin, maybe just want to start with you, just to make sure I understand two things here. So the capital shortfall in the third quarter was $3.5 million. Basically you're not assuming that comes back next quarter, but you're not assuming another loss in the fourth quarter for the same issue. And conversely in Japan, you had it in your guidance for third quarter, but now you're just assuming another $5 million or so shortfall in Japan in the fourth quarter, and that's now in guidance. Is that the way to think about the two moving parts?

[Quentin Blackford:]

Yeah. On the capital orders, again, early in the fourth quarter here, we see line of sight into closing several of those large deals that just didn't happen to fall into the third quarter, but we're not going to get ahead of ourselves and forecast that you're going to double up on normal levels of capital sales in the fourth quarter. To the extent you do, then great, we're all talking about a really strong finish here, but we'll wait and let that play out. With respect to Japan, the impact in the fourth quarter, we've removed all XLIF revenue from Japan altogether, including the fixation component of those procedures, until it's about a $6 million impact. So if you take the $3.5 million U.S. capital shortfall, plus the $6 million XLIF removal of Japan in the fourth quarter, combined you get the $10 million reduction in the overall number for the full year. That's the full extent of the changes that we made.

[Jeff D. Johnson:]

Yes. That makes sense. And then if I look at the third quarter number, if I had to (1

[Quentin Blackford:]

Yeah and you pick up on a good point, Jeff. Two areas really. In Japan, to your point, in the external guidance that we had provided we had dialed in roughly $4.5 million of potential impact related to the temporary hold of the XLIF procedures. Internally we were aspiring to be able to capture part of that Posterior Fixation and recover a bit of the shortfall on XLIF with that. We didn't see that play through in the quarter as we had hoped for, so that alone was roughly $1.5 million of an incremental opportunity that we didn't capture. And then if you look at Brazil, roughly $1 million there that – that business continues to demonstrate progress as we move into the year, and we'll continue to see it ramp into the back part of this year, into the fourth quarter. But it was about $1 million short of where we would have liked to have seen that internally. Again, it will contribute nicely to growth in the fourth quarter, but just wasn't moving quite as fast as we would have hoped. So those two combined with the U.S. capital orders, had that all come through we'd be talking about a quarter that was probably $3 million to $4 million ahead of that guidance we had set.

[Jeff D. Johnson:]

Thank you.

[Operator:]

We've reached the end of our question-and-answer session. I'd now like to turn the call back over to you, Quentin, for any closing remarks.

[Quentin Blackford:]

Well, thanks, guys. We appreciate you guys taking the time to join us on the call this evening. We look forward to following up with each of you guys throughout the evening and into tomorrow. But thanks a lot, and we'll talk to you guys later.

[Operator:]

Thank you. Ladies and gentlemen, this does conclude our teleconference for today. We thank you for your time and participation, and you may disconnect your lines at this time. Have a wonderful rest of the day.