NuVasive, Inc.
Q1 2014 Earnings Call Transcript

Published: 30 Apr 2014

[Operator:]

Greetings and welcome to the NuVasive First Quarter 2014 Earnings Release Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded. I would now turn the conference over to Ms. Tina Jacobsen, Director of Investor Relations. Thank you. Ms. Jacobsen, you may begin.

[Tina Jacobsen:]

Thank you. Welcome to NuVasive's first quarter 2014 earnings conference call. NuVasive's senior management on the call today will be Alex Lukianov, Chairman and Chief Executive Officer; Keith Valentine, President and Chief Operating Officer; Michael Lambert, Executive Vice President and Chief Financial Officer; and Quentin Blackford, Executive Vice President of Finance and Investor Relations. During our comments and responses to your questions, certain items may be discussed which are not based entirely on historical facts. Any such items should be considered forward-looking statements that are based on current expectations and involve risks, 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. These and other risks and uncertainties are more completely described in today's press release and in NuVasive's most recent 10-Q and 10-K forms filed with the SEC. This call will also include a discussion of several financial measures that are not calculated in accordance with generally accepted accounting principles. We generally refer to these as non-GAAP financial measures. These measures include our gross margin, sales, marketing and administrative expenses, research and development expenses, operating margin, and non-GAAP earnings per share. We believe this information is useful to investors, because it provides important financial information regarding earnings generation at NuVasive and is helpful for measuring our progress. We use these non-GAAP financial measures along with the most directly comparable GAAP financial measures in evaluating our actual and forecasted operating performance, capital resources and cash flow. The most directly comparable GAAP financial measures and information reconciling these non-GAAP financial measures to our financial results prepared in accordance with GAAP are included in the press release and in the supplementary financial information file, both of which are accessible from the Investor Relations section of our website. With that, I would like to turn the call over to Alex.

[Alex Lukianov:]

NuVasive solidly executed against our full year strategy to take market share in the first quarter of 2014. Revenue was in line with our expectations, growing 11% to $177 million on strong contributions from each of our major product categories. Operating profit translation also met our expectations. We generated a non-GAAP operating margin of approximately 13.2% and a non-GAAP EPS of $0.29. First quarter results place us on track to achieve the full year expectations outlined at the start of the year. We continue to anticipate full year revenue of approximately $725 million. We also expect to demonstrate excellent progress against our commitment to improve operating profitability. We continue to anticipate a full year non-GAAP operating margin of approximately 16% and non-GAAP EPS of $1.06. This afternoon, I'll provide an update on our views of the US spine market. Then I'll walk through the key drivers of our future earnings growth. Following my comments, Michael will walk through first quarter financial results. So let's begin with an update on the US spine market. Gradual progress continues to be made with respect to both insurer pushback and physician-owned distributorships or PODs, two forces that have negatively impacted market growth for the last few years. With respect to insurer pushback, we are encouraged that the North American Spine Society or NASS is becoming increasingly active on the advocacy front. The society intends to more proactively recommend credible and reasonable clinically-supported physicians to help drive consensus on spine patient coverage before it becomes a matter of controversy. NASS is also more actively working to settle controversies that already exist. Their efforts have been impactful with the recent obtainment of a new Category I code for two-level total disc arthroplasty. Soon this society expects to publish clinically-based coverage recommendations for multiple techniques, including cervical and lumbar artificial disc replacement, lumber fusion and the use of BMP. We are pleased to see the surgical community collaborating to more assertively ensure spine patient access to the care that they really need. Progress is also being made against PODs as adoption continues to decline. Numerous hospital networks have increased disclosure requirements for physicians and device companies. Some of those networks are not just refusing to work with PODs, but more broadly refusing to work with any structure in which physicians are financially incented. We continue to believe that the prevalence of PODs has peaked, but we do not expect the progress made thus far to materially impact US growth in 2014. With that market backdrop, let's zero in on NUVA. In 2014, we are celebrating a decade as a public company and a decade of industry leading growth. All that we've achieved thus far has been driven by a differentiated culture focused on the execution of our strategy to take market share. We have a company-wide commitment to change spine surgery in order to improve patient outcomes. In our next decade as a public company, that core philosophy will not change. That said, we're actively evolving NuVasive, so that even as much larger more profitable global organization, innovation continues to be the foundation of all that we do both technologically and operationally. This year, you'll hear us talk about NUVA 2.0, a shift in focus for our organization with three points of emphasis, increasing market share in a profitable way, driving innovation in our products and in our business, and making culture and people our competitive advantage. NUVA 2.0 will focus the entire organization on achieving growth in a profitable way and on driving innovation throughout every single area of our business. A critical first initiative will involve collaborating with our sales team to change and improve our operations, supply chain customer service and distribution flow. That changed management process is underway with an objective to provide the best customer service and fulfillment in conjunction with the greatest financial efficiency. Beyond that, we're focusing on identifying other opportunities and deploying in a way solutions. The process will unfold over the next few years and will fortify our cultural foundation as we evolve into a $1 billion startup with improved profitability. With a differentiated culture as a strong backbone, we have our sights set on continued industry leading growth as we enter our second decade as a public company. The growth will be multi-faceted. And importantly, we can speak to drivers of not just revenue growth, but also operating profitability growth and EPS growth. Let's walk through each of these. First, with respect to revenue growth, our progression toward $1 billion in revenue and beyond will be driven by continued market share taking. At the close of 2013, we estimate NuVasive had 8% share of the global spine market. The drivers of our extension beyond 8% will be the shift in spine for minimally invasive surgery or MIS, our penetration of the traditional or open spine market and the continued launch of our share-taking strategy internationally. Most of you have heard me speak about these, but let me touch on them very briefly. As a market share leader within the $2.2 billion MIS market, NuVasive is championing the shift toward less invasive surgery, which continues to unfold in spine. We estimate that MIS solutions represented about 27% of the global market at the close of 2013. Better patient outcomes, superior economic evidence and the growth in the number of institutions teaching MIS and fellowship programs continued to drive adoption of MIS. We believe that as MIS becomes a standard of care in spine, NuVasive will be a key beneficiary. Our mission to change spine surgery and improve the patient outcomes isn't limited to MIS. Our core patient outcome centered philosophy, which drove growth throughout our first decade, is equally applicable to traditional or open techniques. Gradual penetration of this 46.5 billion traditional market, where we historically haven't participated in a meaningful way, will be another key driver of our future market share expansion and revenue growth. To penetrate that space, we are leveraging the experience gained as a pioneer of MIS to make traditional procedures less invasive for patients and more reproducible for surgeons. It has been an immensely successful strategy, considering the sales achievements and the continued strong momentum behind recent product launches like Precept, MAS PLIF, MAS TLIF and VuePoint II, new solutions like Bendini, our anterior column realignment techniques and the global spinal column realignment solutions under clinical evaluation in our pipeline are all intended to further our ability to provide patient-specific procedurally integrated care. Each is capable of addressing both MIS and traditional techniques and over time can advance our penetration of the traditional market. Another key driver of our market share expansion and revenue growth will be international expansion. As we drive toward $1 billion, we expect the revenue we generate internationally to almost triple from where it is today and approach $200 million. Let me update you on some progress made this year. In the EMEA, the leadership changes effected last year have begun to reap rewards resulting in strong results in Q1. In Asia-Pacific, we continue to ramp aggressively. Australia and New Zealand are performing to plan and gaining share. The momentum in Japan is also solid. We trained more Japanese surgeons during the first quarter than in any quarter last year. Adoption rates also remained strong. All together, it has been an exceptional start to a strong future in the world's second largest spine market in Japan. The excitement in our overseas markets is absolutely palpable. And our international NUVA family is eager and well positioned to take market share on a global scale. In addition to industry leading revenue growth, we're also targeting operating margin expansion from the 15% level reported last year to at least 20% as we approach $1 billion. Profitability improvements will be driven primarily by increased international skill as we lever several years of investment, increased vertical integration as we work to more than double the 20% of total implants that we current manufacture internally, improved asset efficiency with initiatives to improve inventory positions and distribution methods, rationalize our real estate footprint and lever IT investments, improved sales force effectiveness to the mobility platforms and revamped sales teams and finally the February 2015 expiration of the patent behind the majority of our royalty expense accruals. Lastly, we are implementing a globalization initiative that will provide a long-term P&L lever for us. The initiative is designed to consolidate and standardize the management of our international business activities. Over the next several years, its various benefits will materialize, including streamlined operations and a steady improvement in our GAAP tax rate from its high point in 2014 down to an eventual rate in the low to mid-30s. In sum, NuVasive's future growth outlook has never been more exciting. We have a proven strategy to drive revenue growth by expanding our market share beyond the 8% that it is today. And in addition to revenue growth, we have numerous drivers of operating profitability and earnings leverage expected to unfold over the next several years. Briefly turning to the legal front, as we previously disclosed, we received an unfavorable jury verdict this month relating to our use of the trade name NeuroVision in the amount of $30 million despite being the trademark owners. We strongly disagree with the verdict and will promptly petition the US District Court with post-trial motions in an attempt to have it all returned. If necessary, we plan to appeal the verdict. As we described in 2011 when we first dealt with this issue, the case is merely about the name NeuroVision and has no impact on our products, procedures or ability to supply and service the surgeries that are the heart of our business. We also are actively compliant with the OIG request. We have no further report on that front, but we'll provide updates if and when they are required. With regard to our ongoing patent litigation with Medtronic, the appellate process related to Phase 1 of the litigation is moving forward. Initial briefs have been filed by both sides and additional briefs will be filed in the coming months. We expect the appeals court to then schedule a hearing with the potential decision by mid-way through 2015. With that, I will turn the call over to Michael.

[Michael Lambert:]

Thank you, Alex, and good afternoon, everyone. Before we get started with the financials, let me remind you that when we cover gross margin, SM&A expenses, R&D expenses, operating margin and EPS numbers today, we will be speaking to non-GAAP results. Please refer to the supplementary financial information file on our website in the Investor Relations section for all of the detail that we covered on today's call and to reconcile our non-GAAP items to their GAAP counterparts. Revenue for the first quarter 2014 was in line with our expectations at $177.5 million, an 11% increase over the first quarter of 2013. We continue to anticipate full year 2014 revenue of approximately $725 million or 6% growth year-over-year. Let me walk through the composition of revenue growth in the quarter and for the full year 2014. US lumbar growth grew about 8% in the first quarter. We continue to expect about 5% growth for the full year, driven by the continued strong momentum of our new procedural solutions, albeit within the context of a still stabilizing US spine market and increasingly difficult year-over-year comparisons as the year progresses. US biologics growth of about 9% exceeded our expectations. As a result of the first quarter's strength, we now expect growth of about 2% for the full year 2014, up slightly from the 1% growth we previously expected. Pull-through from our US lumbar solutions continues to be strong and the recent launch of Osteocel Pro with improved handling characteristics is driving increased surgeon interest. That said, we're again mindful of increasingly difficult year-over-year comparisons. US cervical growth of about 9% was below our expectations on slower than expected penetration of the cervical market. In consideration of the first quarter result, we now expect cervical to grow about 10% in 2014 compared to the 12% growth that we previously expected, still much faster than the growth rate of the cervical market in aggregate. US monitoring service exceeded our expectations, increasing nearly 11% in the quarter. We are encouraged by the improvement in collections we have achieved over the last several months, but we don't yet feel fully confident in the sustainability of that dynamic. As a result of the Q1 outperformance, we now expect US monitoring service will be flattish for the full year, an improvement from our prior expectations of down 4%. That assumes that strong volume growth will continue to be offset by pushback and collections impacts from insurers. Our international business, which includes Puerto Rico, grew over 30% in the first quarter. We continue to expect it to grow just over 20% for the full year, as solid results in Europe and Asia-Pacific continue to be offset to a degree by economic turmoil in several Latin American markets. Non-GAAP gross margin in the first quarter was 75.7%, up fractionally from 75.5% reported in Q1 2013. The fact that gross margin expanded slightly is especially favorable in light of about 20 basis points of mixed pressure related to the outperformance of lower margin product categories like biologics and IOM and about 60 basis points of pressure from the incremental royalty expense, which we will begin to anniversary during Q2. We more than offset those negative impacts with operational improvements, including cost efficiencies from NUVA manufacturing. Price was not a material factor in order. With the increased growth expectations for biologics revenue and IOM service revenue that I mentioned earlier, the mixed pressure experienced in the first quarter could persist for the remainder of the year. In spite of that mixed segment, we continue to anticipate a full year 2014 gross margin of approximately 76%. Non-GAAP sales, marketing and administrative or SM&A expenses totaled $102.4 million in Q1 2014 compared to $92 million in Q1 2013. SM&A expense was 57.7% of revenue for Q1 2014, in line with the 57.7% reported in Q1 2013. Relative to last year, SM&A reflects increased investment in our international infrastructure and about 40 basis points of spending related to the OIG request, which we will begin to anniversary during Q2. Those sources of pressure were offset by gains in sales rep productivity on the domestic side and by an approximate 40 basis point benefit from the change in the estimated useful life or EUL for the instrument sets used in our international operations. The change brings the depreciation cycle for our international business in line with our domestic business. Over the course of this year, we currently expect the EUL's slight positive contribution will be partially absorbed by incremental spend related to the NeuroVision trademark litigation. As a result, we continue to anticipate a full year SM&A expense of roughly 54.5%. Before I move on to the rest of the P&L, I want to point out that included in Q1 GAAP SM&A expense is a litigation liability of $30 million related to the trademark case that Alex mentioned earlier. That $30 million may ultimately be set aside on the balance sheet as restricted cash pending the outcome of post-trial motions and the likely appellate process. Also included in GAAP SM&A is a leasehold termination charge of $6.4 million, which we signaled last quarter. This item is related to our ongoing effort to rationalize our domestic real estate footprint and drive enhanced asset efficiency. Non-GAAP research and development or R&D expenses totaled $8.5 million in Q1 2014 compared to $7 million in Q1 2013. R&D expense was 4.8% of revenue for Q1 2014 versus 4.4% in Q1 2013. Relative to last year, the increase in R&D was driven by investments to support several significant projects in our pipeline. We continue to anticipate a full year R&D expense of approximately 5.5%. First quarter non-GAAP operating margin was roughly in line with our expectations totaling 13.2% compared to 13.5% in Q1 2013. As a reminder Q1 operating margin has typically been the annual low point, given the front-end loaded nature of our normal spending pattern and the quarterly spread of revenues across the year. In addition, I mentioned earlier several of the moving parts that were unique to Q1 2014, including the incremental royalty expense, spend related to the OIG's request and the benefit from EUL change, which if they are all neutralized, we have driven a Q1 operating margin of approximately 13.8%. Considering our Q1 results, our proactive management of unanticipated variances and our current outlook for the remainder of the year, we feel comfortable in our ability to demonstrate the roughly 100 basis points of improvement with targeted for full year. Accordingly, we continue to expect a full year non-GAAP operating margin of approximately 16%. That expectation now contemplates the offsetting incremental impacts that I mentioned earlier, including the potential mixed pressure related to higher expectations for lower-margin product categories like biologics and IOM, the incremental spend related to the NeuroVision trademark litigation, and the EUL benefit. Importantly, still implied in our 2014 guidance is non-GAAP operating profit dollar growth of about 14% or operating profit growth that is roughly double the expected rate of revenue growth. Interest and other expense net on a GAAP basis totaled $6.3 million in the quarter compared to $6.6 million in Q1 2013. We continue to anticipate full year 2014 interest and other expense to be approximately $27.5 million, including roughly $14.7 million in non-cash interest expense. Our Q1 GAAP effective tax rate or ETR was affected by the recognition of a litigation liability. On an absolute basis, we recognized a Q1 GAAP tax benefit of approximately $15.1 million, which equates to a GAAP tax benefit rate of roughly 45%. As a result, we now expect a full year 2014 GAAP effective tax expense of approximately $6.5 million compared to the estimated $19 million that we previously expected. We continue to expect non-GAAP adjustments for the full year 2014 to be tax affected at approximately 40%. First quarter non-GAAP earnings were $14.3 million or $0.29 per share compared to $11.9 million or $0.26 per share in Q1 2013. In the move from a tax expense rate to a tax benefit rate in the quarter, we saw this shift to contribute about $0.04 to EPS. That benefit is timing related and will be offset over the course of this year. So we continue to anticipate full year non-GAAP EPS of approximately $1.06. Please refer to the supplementary financial information file on our website in order to put the year-over-year EPS comparison and its proper context and to review all of the items including any updates that will be excluded for non-GAAP reporting purposes. For the first quarter, cash flow from operating activities totaled about $23.3 million, down slightly from our roughly $24 million total last year, driven by higher investment in inventory. Free cash flow totaled $9.9 million, down from last year's total of just under $15 million, driven by higher capital expenditures. For the full year, we continue to expect free cash flow will be roughly flat with 2013's results. Our cash and investments balance at the end of the first quarter was just $340 million, up about $14 million from $326 million at the end of 2013. The increase was driven by operating cash flow generation and proceeds from the issuance of common stock. I am looking forward to what 2014 will bring. We continue to simultaneously execute a share taking strategy and drive operational improvements. Now, I'll turn the call back over to Alex for closing comments.

[Alex Lukianov:]

Our strategy to take market share is alive and well and while staying true to NuVasive's core philosophy, innovating to achieve better patient outcomes. We are evolving our organization to maintain our startup mentality and to lead spine innovation as a much larger and increasingly profitable global organization. From my comments today, my hope is for you to better appreciate our numerous future earnings growth drivers. We are simultaneously driving revenue growth through market share expansion, while making profitability improvements and generating EPS leverage and we are very excited about our future prospects. Before we take questions, I would like to express my sincere gratitude to Michael, our Captain Profit, as he affectionately known at NUVA for his numerous contributions to our continued evolution as a company. Michael has made a real difference in his tenure with us. And we are far better off as a result of his active engagement. I would also like to express my confidence in Quentin Blackford whom all of you have had the opportunity to meet over the last few years. During Quentin's tenure at the company, he has excelled in every role Michael and I have challenged him with. As many of you know, we added Investor Relations to Quentin's responsibilities almost two years ago. And more recently, he has also assumed responsibility for the accounting team and joined our executive committee. Through his increasing responsibility, Quentin has helped drive the strategy for our expanding profitability as we've been identifying areas for increased efficiency in our business. I have every confidence that Quentin will continue and expand this effort in the years to come. As Quentin assumes the CFO role in August following our Q2 earnings call, he and Michael will continue to work closely together into the spring of next year to ensure an exceptionally smooth transition over the many CFO responsibilities. I look forward to working with Quentin and the rest of our executive team to drive NuVasive for $1 billion in revenue and beyond with improved profitability. We will now take your questions.

[Operator:]

(Operator Instructions) Our first question is from Matt Miksic of Piper Jaffray.

[Matt Miksic:]

So first, I had a question for you, Alex. This has come up a few times in the past, this idea of the societies getting more involved and sort of helping drive some of the evidence and policy and coverage guidelines for the industry. When do you think we'll start to see some of the fruits of those efforts?

[Alex Lukianov:]

Well, Matt, I think we've already seen some of that, the pushback on the cervical issues with pretty good success. They haven't fully resolved the issue. They did get the two-level approval for cervical arthroplasty that's in the works. And they're working hard on the various other areas that I mentioned from lumbar fusion to broader utilization for arthroplasty. So they're making, I think, pretty good headway. I also don't think it's going to be over once they do address these things. This is the new way things are done in the healthcare environment. So this will be an ongoing process for them. And I'm very happy to see them as well as ISAS and other organizations take it seriously and really get together, collaborate and move forward with the right recommendations.

[Matt Miksic:]

We were pretty impressed with the systematic review that was published last year and that maybe was 70%, 75% efficacy, which was surprising for those DDD patients in those trials. And it's been a year. Just love to get a sense of when and if we are able to start to move the needle on that, but apparently not just yet.

[Alex Lukianov:]

Yeah. And my sense, Matt, is that it's going to take a lot longer to move the needle on DDD. That's probably the biggest area of pushback by the insurers and that's probably the hardest one to make a change in. So I think that's going to take a while, despite, as you say, the very strong prevalence of excellent data.

[Matt Miksic:]

Then on the guidance, I know some of the results in the quarter, which obviously better than our expectations, the couple of points I wanted to ask just is where maybe notched around your expectations a little on biologics came up a touch and cervical came down a touch. I'm wondering, A, was there anything that you see sort of driving some of the strength in biologics other than just a pull-through in lumbar fusion? And then B, on the cervical side, anything to be concerned about there?

[Alex Lukianov:]

No, nothing to be concerned with on the cervical side. We're still growing at a very healthy double-digit pace. I think that you've pointed appropriately, which is we continue to see more and more pull-through into our procedures of biologics. Somewhat anecdotally, one of the pushback points on cervical has been the utilization of PEEK devices. And so it's hard to say for sure and with a lot of certainty. But just anecdotally, I think we may see some additional uptick of biologics versus, let's say, some additional uptick of PEEK-type products like (inaudible). So it's not a big change at this point in time. And either way, I think we have the product covered regardless of which way they choose. But I think that has something potentially to do with some of the change in those numbers.

[Matt Miksic:]

Can I ask just one follow-up to that? I'm sorry. I'm just curious on that issue of PEEK versus titanium or biologics, I'm wondering if you have anything that we can expect to see as maybe an answer to the sort of bone-friendly products other folks are rolling out in fusion as opposed to PEEK?

[Alex Lukianov:]

Well, we certainly have that with our allograft line and also with Osteocel. So I think that people really like our allograft and it's been very popular. So I think we're in very good shape on that.

[Operator:]

The next question is from Matthew O'Brien with William Blair.

[Unidentified Analyst:]

This is (inaudible) in for Matt. Just had a couple quick ones for you. So with respect to the lumbar strength in the quarter, can you just provide an update on the competitive landscape there? Specifically, just given the recent merger between two sizeable players and then taking into account the integration issues that we've seen in other larger companies, are you foreseeing any changes in the competitive dynamic that may allow NuVasive to potentially capture new accounts in the coming quarters?

[Alex Lukianov:]

Yeah, that's a hard one to answer. Clearly, based upon the results that we've seen, we're taking share. We're taking share obviously from a number of different players. And a lot of the larger players have pretty flat results, if not negative. So one would assume that it's really not so much the strength of market growth obviously that's chewing results for us, but our ability to take share, and we're been doing that effectively for some time.

[Unidentified Analyst:]

And then internationally, growth was again better than we anticipated and particularly in Japan. And so the 20% guidance appears quite achievable. Can you just help us understand the risk there that may result in that deceleration from the 30% to 40% growth that we've seen in recent quarters?

[Alex Lukianov:]

So we think 20% is a good way to start. I think that we are a bit conservative on international simply because of the pressure we see in Latin America that has more to do with the economic environment certainly than the spine industry per se. But we do expect international to perform better than 20%. And I think as we've stated at least 20%, so we do expect to see some pretty strong performance out of international this year, somewhere north of 20%.

[Michael Lambert:]

And I would just add on that, the second half comparisons are very, very tough for us internationally. Low-30%s, low-40% growth rates Q3 and Q4 year-over-year by comparison.

[Operator:]

Our next question is from Bob Hopkins with Bank of America Merrill Lynch.

[Bob Hopkins:]

So a couple quick things here. Alex, first on your 2.0 commentary, I appreciate all the detail you laid out. I was just curious, is there anything new with the programs that you were talking about in your introductory comments relative to things that you've talked about in the past that you really want to highlight here in this call? I'm just trying to understand exactly what's new here and is anything changing with commissions or anything like that.

[Alex Lukianov:]

Sure. Really what I'm talking about, Bob, is that we've always been very good at innovating with regard to products and services. That's been our strength. And what I'm trying to do now is to drive innovation into the entire fiber of the organization and keep coming up with more and more ways for us to achieve profitability, efficiency right down to every single person. So I think as the company is approaching our size, it's rather easy to become complacent about some of those things. We refuse to do so. And so we're driving a series of innovation programs that we're calling 2.0 over the next few years and starting off with really tackling operations to make that a more profitable area.

[Bob Hopkins:]

So this has nothing to do with commissions.

[Alex Lukianov:]

It has nothing to do with commissions per se. That's an ongoing process of what we'll do on driving down commissions over a longer period of time, which we're doing anyway.

[Bob Hopkins:]

And then I also wanted to ask you a longer-term question, because obviously your results last couple quarters have sort of spoken for themselves. I'm just curious again with all the merger activity you're seeing in orthopedics, if you think about the world in terms of three to four year chunks of time. Do you ever envision a time when spine will be bundled more aggressively with other orthopedic products, or do you just not see that happening? Just curious as to your thoughts.

[Alex Lukianov:]

I don't see that happening over the next five years, Bob. I think that we've been very effective at winning some bigger and bigger accounts lately. But we are bundling in terms or moving towards bundling spine products with other services. And I think that is the change that clearly is moving in our direction. I think what's important for us is to continue to have a very differentiated offering of products and services. And so that's where we're focused on. And we have a number of things in the works that we've referenced from global spinal balance to what have you that we believe will drive that growth for the next four, five years easily.

[Bob Hopkins:]

The services that you're talking about like neuromonitoring and other things, or are you referring to something else?

[Alex Lukianov:]

Neuromonitoring, Bendini, things that we're doing to resolve the simplicity or to create the simplicity of rod bending. Preoperative planning is a big area of focus. That's part of a service that we'll be providing in the future.

[Operator:]

Our next question is from Bill Plovanic of Canaccord.

[Bill Plovanic:]

So a couple of questions. Really it all stems from one is you talk about the five levers that you can pull on margin improvement over the next couple of years, but I was wondering if you could just detail exactly the five levers and the timing, the cadence, when we'll start to see this in the P&L.

[Quentin Blackford:]

So we've laid out those five levers really speaking to those as international scale. So we've talked about this for several quarters now. As we continue to grow into that international business into the investment that we've made over time, we expect that to become much more profitable and at some point exceeding the overall corporate average. So that's just going to be a matter of time in terms of how the growth translates out across different regions. So we'll see that over the course of, call it, the next several years as we grow to roughly 20% of overall revenues. The in-house manufacturing, bringing production in-house, we've talked that we're nearly around 40% of the implants today, trying to double that over the course of the next couple of years. So again, I think you're looking at something that's going to be in the timeframe of the next year. So to continue to see those benefits playing out. And then you look at sales force leverage, asset efficiencies, Alex talked a bit about that in terms of the whole new 2.0, those are things that are front and center in terms of where we're trying to drive efficiencies. And I think that's a matter of both playing out over the next year to two years as well. So I'm not going to get specific with regards to how it played out and the 16% by category, but certainly the big part of how we get into 16% and then on to the greater 20%. And then probably the easiest one is the Medtronic royalty, which we all know is going to expire in February of 2015. And that's going to be somewhere around 150 basis points or so that's going to fall out of the P&L pretty quickly.

[Bill Plovanic:]

The reason I ask is I was looking at this, on a sales and marketing line or SG&A line, I mean you've been at like non-GAAP at the same amount for the last two years. If I look at Q1 '14, Q1 '13, Q1 '12, I believe they're all the same on a non-GAAP basis. So that's really what I'm getting at. I mean can we expect that in 2015, we're actually outside of the manufacturing and the Medtronic royalty that we'll actually see it on the operating expense line?

[Quentin Blackford:]

Yes, yes, absolutely. We expect you will. And I think, if you will, you've got a bit of an anomaly playing through the quarter. Keep in mind we have OIG spend this year that we didn't have last year in the first quarter, roughly 40 basis points. We also spoke to a bit of the investment in the international footprint, which is more along the lines of the global initiatives. So there is another roughly 40 basis points in the quarter that we didn't have last year at the same time. That gets a bit difficult comparing on the SM&A line specifically. We'll anniversary those over the middle part of the year and into the back half of the year. So you'll start to leverage in SM&A over the course of this year and certainly into the future.

[Operator:]

The next question is from Rich Newitter of Leerink Partners.

[Rich Newitter:]

I was just wondering if there were any distortions for the 1Q growth rates to be called out either in selling days or was there any impact from weather or what you saw from kind of 4Q to 1Q seasonality?

[Alex Lukianov:]

Well, it definitely wasn't weather, but I know Michael wants to talk about selling days.

[Michael Lambert:]

So, Rich, there was one extra day in the quarter. So if you adjust for the math, a little bit under $3 million or so in terms of revenue, and it takes the 11.3% down to 9.5% from a growth perspective.

[Quentin Blackford:]

In terms of anything outside the norm in the quarter, the only thing that had a point to is in the services business. We saw some strength there, growing roughly 11%. A bit of that continues to be our ability to collect on some of the historic procedures that is more one-time in nature and not necessarily sustainable into the future. And that's playing into the guidance of our full year expectation of somewhere around flat. The other thing to keep in mind is when you look at Q2 versus Q1, in 2013 there is roughly a three selling day increase quarter two versus quarter one. This year, we don't have that same phenomenon. So seasonality will be a bit different for us. We're going to see a one-day increase.

[Rich Newitter:]

And then maybe, Alex or Michael, can you just talk a little bit about you kept your full year guidance unchanged despite some nice upside in the first quarter. Just could you help us think about the puts and the takes there, kind of what was a little bit better than expected, and where do you perhaps try to temper your expectations most in the back half to not want to let that flow through?

[Alex Lukianov:]

Rich, revenue statement or an op margin statement?

[Rich Newitter:]

On the revenue side.

[Alex Lukianov:]

On the revenue side and in sort of the next extension or continuation of the Q1 result, right, biologics and IOM certainly outperformed and cervical in the overall scheme of things came in a little bit light. So we have updated our forward guidance to try and reflect that over the course of the remainder of the year. And still looking for continued momentum on the lumbar side, still looking for some progress in cervical, and we've got new product coming out anterior plate side in the latter half of the year, which will help. But I do think the really primary message on all this as we think about how Q1 looks relative to the full year guidance is that the second half comparisons are extremely difficult for us this year. Lumbar last year, Q3, Q4, we were 12% growth each quarter. Biologics last year, 11% and 12% growth each quarter, Q3, Q4. International, as I mentioned earlier, 31% growth Q3, 41% growth Q4. And what that means is from a comparison standpoint, there's high bar jump over. Last I'll leave you with on it and we've said this time and time again. I hope in the last couple of years it's registering. We are really focused on executing to a full year at this stage, not on any given quarter. And of course if performance dictates, we'll update guidance later in the year.

[Operator:]

The next question is from Mike Matson of Needham & Company.

[Mike Matson:]

I guess I just wanted to start with the cervical business. I was wondering if you could provide a little bit more commentary around the slower growth there and maybe what you're seeing there and why it's not living up to kind of what you thought it would be earlier in the year.

[Quentin Blackford:]

As we get into the cervical and certainly spend some time really trying to dig into the details there, what I can tell you is there is nothing from a product perspective, surging customer perspective that really jumps out yet. We got off to a bit of a slow start over the course of January, February. March was a very strong month for us on the cervical side. And I can tell you that the leadership team here is very excited about what we have gone for on the cervical side of things with regard to new products that are going to come out in the later part of the year, particularly the Archon Plate that gives us another offering in the interior portion of the cervical spine. So for us, the change in the full year guidance is more or less flowing through what we saw in the first quarter. But our growth expectations in terms of accelerating that over the remainder of the year remain intact, and we feel very good about it. So nothing of significant concern that we've seen.

[Mike Matson:]

And then just with regard to the latest patent litigation with Medtronic, I was wondering if you could maybe sort of frame out the range of possible outcomes there. I mean I would assume it wouldn't possibly be as bad as kind of the first round in term of the amount of royalties that you had to pay, but I know it's kind of up in the air. But just in terms of the percent of your sales that these products account for and so forth, maybe any metrics you could give us there would be helpful.

[Alex Lukianov:]

As you know, with regard to Phase 1, we don't even see ourselves getting an answer from the appellate court until sometime in '15. So we'll see where that ends up and then we'll prepare for in all likelihood a new trial. Phase 3 is in the very early stages and basically looks like it's going to be effectively just a couple of patents and dispute, one on the biologic side for Medtronic and one on [ph] by letter designed for us. So it's a pretty straightforward process versus the very convoluted one that was part of Phase 1. But that also has a bit of runway to it and wouldn't see anything until sometime in mid to late '15.

[Mike Matson:]

And then just one final question on the patent situation. So with the spacer patent that you were paying the bulk of the royalties on that's going to expire, there is no risk that Medtronic could somehow extend the life of that patent, is there?

[Alex Lukianov:]

Not without changing the law. I'm not saying they wouldn't do that. I'm just saying it's unlikely. They do have a lot of attorneys. Obviously there's something they can do.

[Operator:]

The next question is from Jeff Johnson of Robert W. Baird.

[Jeff Johnson:]

Alex, was hoping I could maybe start with you on new products. The computerized spinal alignment system that you've been talking about for next year, any update there, and I would assume still planning on maybe beta testing and maybe moving into the deformity next year, but just want to make sure that's still on track as well?

[Alex Lukianov:]

That's correct and that is on track. And we've actually started with alpha. So beta will scale up over the second half of this year. And if all continues to move forward, so far it looks like it will, then we'll be able to launch probably in the first or second quarter of next year.

[Jeff Johnson:]

And then, Quentin, you had made some comments on OIG spending as we start lapping those, at least the incremental impact of those and some other comments you made. But I know you guys can't predict what happens with the OIG. I wouldn't ask you to do that. But I guess if it would go on to a formal investigation, would it be your assumption that your OIG investigation costs, that line item would go up then over a year or two period as maybe that process played out, or is your spending at a level now where you think due to that issue alone it may stay stable here?

[Quentin Blackford:]

Yeah, at this point, I think this is too early to try to even assess what will take place in that situation. We have no idea what the go-forward requirement would be to support anything that might come out of that. So it's too early to say.

[Johnson:]

Quentin, can you give us just selling days, or, Michael, either one, selling days over the balance of the year on a year-over-year basis?

[Quentin Blackford:]

Yes, we talked to this earlier. In Q1, we had one extra selling day. Q2 was one less. And the remainder of the year will be equal each quarter. So full year comes in line year-over-year, no change.

[Operator:]

The next question is from Chris Pascale with JPMorgan.

[Chris Pasquale:]

Just wanted to understand the issues in the IOM business a little bit better. There's two quarters in a row that that's been stronger than expected. So it sound like this is a case where you've been doing more procedures historically than you've actually been getting paid for, and now that's changing. Just tell me if I have that right and why that yield, so to speak, has changed now and what drives your conservatism over the balance of the year?

[Alex Lukianov:]

Yeah. So when you look at the fourth quarter and really in Q1 as well, we took upon ourselves the effort to go back and essentially get back to some of the historic cases that we were having trouble collecting on, and we found some success in that both in the fourth quarter and in the first quarter. A good chunk of that is now being collected on. So those cases are no longer there to go back and try to clean up. So you're not going to see that. That same issue can repeat itself now for Q2, Q3, and Q4. We've always had good growth volume-wise in the business itself. The issue has been from a rate or reinvestment perspective, we see that stepping down year-over-year at least for the last two years. So we continue to expect that we're going to see those same rate challenges into the future offsetting any volume growth that we have.

[Chris Pasquale:]

And then one kind of broader picture on the US hardware business. Any sense what percentage of your business today posterior fixation represents, how that compares to the broader market, and then maybe how that's changed for you from maybe a year or two ago?

[Michael Lambert:]

It's certainly been less than, let's say, most of the other companies that are out there that do carry the bulk of that area. Probably wouldn't make sense to get into a percentage analysis of it per se. But I think it's fair to say that posterior fixation is what really drive lumbar growth for us in 2013 and we are certainly hopeful that it will do so again in '14 and it's off to a good start.

[Chris Pasquale:]

I guess part of my question is to trying to understand what kind of runway there could be left given how important it's been for the last several quarters.

[Michael Lambert:]

I think there is a huge amount of runway. We're just getting started. And I think with the things we're doing on global balance and '15, hopefully that's where we're going to be able to pick up the paces in '15.

[Alex Lukianov:]

Yeah, I think when you look at procedural solutions and you look at how we're advancing small incremental advances in our excellent platform with new styles, new devices, that drives longer constructs sometimes. Those longer constructs then lead to posterior fixation, rod and screw fixation also, that leads to just a bigger case overall. And so the whole strategy is as you look at a procedural solution, you look at the global balance of the entire spine. And that's important for all of the systems that compose our posterior procedural offering.

[Operator:]

Ladies and gentlemen, in the interest of time, we do ask that you limit yourself to just one question. And the next question is from David Roman of Goldman Sachs.

[Unidentified Analyst:]

It's Chris in for David. My first question, Alex, you touched on this a little bit on the tax side of things, but I was hoping that you could walk through a little more detail on the initiatives that you're taking in order to reduce the costs in the outer years, and maybe a little bit on the cadence of when we should start seeing some of these benefits?

[Alex Lukianov:]

We'll have the finance guys answer that, but there is a lot going on in that area.

[Michael Lambert:]

So if you think about it on the tax side, you need to understand this is multi-year implementation, which essentially got started on in the last year and through this year. So we would expect real tangible benefits start to emerge, meaning read that as GAAP tax rate below sort of standard statutory levels in the 40% range out in 2016, 2017 and beyond. What we expect in the medium-term period is from the high of this year in mid-80s or so, that tax rate will start to come down over the course of next couple of years and approach statutory and then as I said eventually go below statutory. Part of what's driving that is really the mix in the growth of our OUS business. The faster that OUS business grows, the faster the tax rate will lever down from a magnitude perspective. And as I mentioned before, we think that ends up in the low to mid-30s range once you get out medium to long term. And we're working actively still today, as Quentin mentioned earlier, putting in place the groundwork in that globalization initiative, because we understand, as you suggest, what a lever it's going to provide in the out years.

[Unidentified Analyst:]

And if I could, Michael, one quick follow-up, if I can pick up where Rich's question left off, on the full year guidance asked differently, if I were basically to flat-line the sales for the first three quarters and then assume only a modest acceleration in the fourth quarter, it seems like these numbers would be fairly easy to get to. And I understand the issue with the more difficult comps, but asked differently what really has to go wrong in order for you not to get to that $725 million?

[Michael Lambert:]

I guess I would articulate it this way. And Alex and Quentin can jump in. We talk a lot about our aspirations. And last year, we set our aspirations to be a double-digit grower. And we turned around and guided to the Street sort of mid single-digits essentially at the start and for the vast majority of the year. We executed well and delivered above that. I would emphasize again the difficult comps in the second half of this year and I reenter those numbers earlier, if you look at them, they're very aggressive comps to drive growth off of when we think about the year-over-year comparison to this year. But Q1 results came in aggregate, in line with where we expected to be. So it's current course and speed and we hope we will meet our aspirational objectives.

[Alex Lukianov:]

Our full year guidance is prudence and it's what we set at the start of this year. And what we've reiterated today is our confidence in being able to achieve that guidance. So we're staying with the full year objective. We don't intend to change that.

[Operator:]

The next question is from Matt Taylor with Barclays.

[Matt Taylor:]

I guess first question I had was you moved away in the past couple of years from giving us the reps and those kind of metrics by quarter. But I wonder if there's anything qualitatively you can talk to in terms of your productivity per rep and how that's been tracking, and I guess how important is rep growth versus productivity growth to your goals over the next couple of years?

[Alex Lukianov:]

Yeah, they're equally important, as you know. And we've actually had a very nice net increase in the number of sales representatives both in the United States and in other key international markets in the first quarter. So I'd say it's a substantial increase over prior year. So we find ourselves in a very good position there and we are driving into getting much deeper penetration in every one of our territories.

[Matt Taylor:]

And just a follow-up on your litigation strategy, so I know that you're pursuing a number of inter-parties' reviews of electronics patents. Could you talk about how that plays in or coincides with your district court litigation strategy?

[Alex Lukianov:]

Yeah, I'm not going to comment on that at this point in time. I will be happy to give an update next quarter. But at this point in time, I'm not going to get in that deep with regard to the legal strategy.

[Operator:]

The next question is from Joanne Wuensch of BMO Capital Markets.

[Joanne Wuensch:]

Congratulations both to Michael and to Quentin. That's really great for both of you. A quick question, spine robotics, are you seeing any impact from that and what's your current view on it?

[Alex Lukianov:]

You mean in terms of there's really one company doing it, no.

[Joanne Wuensch:]

Any interest in the area or is just something not so much?

[Alex Lukianov:]

Not so much.

[Joanne Wuensch:]

And then just as a follow-up question, is there any update on the launch of your biologics in the US, AttraX? We sort of moved that off to the side for quite some time now.

[Alex Lukianov:]

Sure. So the update on AttraX is that we hope that we will have a favorable answer from FDA hopefully at the end of this year. We've done some additional work, as they requested. And so we hope to have an answer by sometime in the end of the fourth quarter.

[Joanne Wuensch:]

Can you tell us what kind of work that is? Was it clinical or was it paper?

[Alex Lukianov:]

It was additional preclinical work.

[Keith Valentine:]

As you may have heard from the message earlier, there was a nice Osteocel Pro was launched and has been going well. So it has new hand-on characteristics and more malleable, formable. And so that is a nice addition to the biologics offerings.

[Operator:]

The next question is from Larry Biegelsen of Wells Fargo.

[Larry Biegelsen:]

On the last call, you guys talked about normal seasonality, first quarter representing 23.5% to 24.5%. Is that still valid, guys?

[Michael Lambert:]

Yeah. And I think you would see the Q1 result would certainly put you right in that range that we talked about.

[Larry Biegelsen:]

Because that would get you to, Quentin, $725 million to $755 million, but that would be the math on that.

[Quentin Blackford:]

We gave you the range of 23.5% to 24.5%. We came in right toward the upper end of that, 24.4% to 24.5%. So in line with our expectations.

[Larry Biegelsen:]

And then last question from me guys. SI joint fusion got a positive coding recommendation earlier this year. Alex, how attractive is that market to you and what's your plan for that?

[Alex Lukianov:]

We don't really have anything that directly competes with that per se. So it's not an area that we've participated in. We've been watching it for several years and really waiting to see if it flourishes or not. It's done fairly well, but it also hasn't really taken off and really run in a big way.

[Keith Valentine:]

Yeah, I would categorize that we are keeping close tabs on it, especially trying to see how the reimbursement finally plays out. There has been some, I think, nice inroads on the reimbursement side, but it's still not clear what's been finalized for surgeon and hospital payment.

[Operator:]

And our final question comes from Jason Wittes of Brean Capital.

[Jason Wittes:]

Just real quick on PODs, I think you've mentioned on the last few calls that the regulatory landscape is certainly becoming less favorable. We've noticed that as well. But you've also at least on the last call mentioned that the number of PODs hasn't really changed materially. From your comments in the beginning, is that starting to change, and what is your outlook for the rest of the year in terms of how many PODs will remain standing?

[Alex Lukianov:]

As you know, that's a really tough number to measure and it's entirely anecdotal. So what we hear really is the chatter among surgeons, talking about a lot more and then of course the position that the hospitals have taken. I think if we were to be absolutely guess, the higher 15% maybe has dropped down to the 10%, 12% range. That's just a complete guess. There is no way for us to really quantify that number with any degree of accuracy. I spend a fair amount of time in the field. Astonishing to me is the fact that I've heard of three surgeon groups recently joining PODs despite all of the fervor over this issue. So there's still some people out there that just want to keep pushing the envelope. But generally speaking, it's on a decline.

[Jason Wittes:]

And then perhaps you could help us out just on sort of product cadence for this year. If we think about launches that you guys have planned for this year, which one should we be paying attention to and what kind of quarters will they hit roughly speaking?

[Alex Lukianov:]

So we'll be launching a total of 10 products over the course of this year. We're just in the process right now of rolling out Osteocel Pro. We're also increasing the availability of Bendini. We have a series of cervical plates. And most of our product launches coincide with the third quarter, because we like to time it around NASS. So that will be pretty consistent, although last year's [ph] Cellpro is already out. So almost everything else from us outside of this line extensions and straightforward additions of that sort, you'll see at NASS. So we hope to get somewhere around the fourth quarter benefit of those launches. And usually it's not that much, because we just ramp it in the fourth quarter and then look to do a full national and then international launch more in the following quarter, the first quarter of '15.

[Jason Wittes:]

So 10 new product launches roughly speaking, at least three that you mentioned are the ones to focus on.

[Alex Lukianov:]

Yes. As well as we're doing additional things in posterior fixation. We're doing some additional plating options with the anterior spine. And we'll be talking about all of that stuff around NASS time.

[Operator:]

We have no further questions at this time. I would like to turn the floor back over to Mr. Lukianov for any closing remarks.

[Alex Lukianov:]

Thanks, everybody, for joining us. We look forward to chatting with you the next quarter, which will be Michael's last as CFO and look forward to him passing the mantle to Quentin. And we will certainly spend a little bit more time remembering some of his contributions. So until then, thanks everybody.

[Operator:]

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