NuVasive, Inc.
Q1 2013 Earnings Call Transcript

Published: 1 May 2013

[Operator:]

Greetings, and welcome to the NuVasive Inc. First Quarter 2013 Earnings Release Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Quentin Blackford, Senior Vice President, Finance and Treasury for NuVasive. Thank you. Mr. Blackford, you may now begin.

[Quentin Blackford:]

Thanks, operator. Welcome to NuVasive's First Quarter 2013 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; and Michael Lambert, Executive Vice President and Chief Financial Officer. During our management 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 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 NuVasive's most recent 10-Q and 10-K forms filed with the Securities and Exchange Commission. [Operator Instructions] With that, I would like to turn the call over to Alex.

[Alexis V. Lukianov:]

Thank you. NuVasive kicked off 2013 nicely, executing solidly against our full year strategy to take market share. Revenue in our first quarter was in line with our expectations, growing about 5% to $160 million. The performance of each of our major product categories was strong in the quarter, placing us squarely on track to execute into the full year growth expectations we guided to at the start of the year. Operating profit translation was also strong. We generated a non-GAAP operating margin of approximately 13.5%. As I mentioned last quarter and we'll reiterate again, we run our business based on a multi-year plan, emphasizing 1 full year at a time. We believe that aligning external guidance with that full year focus will enable us to demonstrate execution against our long-term strategy. As such, we anticipate that revenue for the full year 2013 will grow 6% to $655 million. We also expect non-GAAP operating margin to come in at 14% with non-GAAP earnings per share of approximately $1. Today, I will provide an updated view of the spinal market, where there has been some positive news recently. Then I'll spend a moment on the top drivers of NuVasive's future growth toward $1 billion in revenue and a greatly improved profitability profile. Lastly, I'll provide a legal update and then turn the call over to Michael to cover financial results and detailed guidance. So let's begin with an overview of the spine market. We estimate that the U.S. spine market was down fractionally in 2012. The slight acceleration that materialized in year-over-year growth in the fourth quarter of 2012 was against the easiest growth comparison of 2011. So while the improvement in growth late in 2012 is a positive, we do not believe that it is enough to suggest a significant change in market trend. We continue to expect U.S. market growth in 2013 will be in line with last year, very similar. That said, I am pleased to report several developments on some of the issues that have pressured market growth for the last few years in the U.S. As you know, the U.S. spine market growth has been negatively impacted by pushback from insurers. In spite of substantial evidence in support of spine fusion, there has never been a formal summary or review of the available literature to demonstrate a consensus of outcomes and efficacy. Commercial insurance payors have been exploiting the lack of conclusive clinical data, relying on actuarial data and financially-based judgments to dictate patient treatment. The ensuing difficulties the spine surgeons faced in obtaining pre-approval for surgery led to a dramatic slowdown in the volume growth of spine procedures. In response, NuVasive marshaled the members of the surgical societies to formulate a cohesive collection of data that will educate payors and help ensure patient access to the care that they need. On April 1, The Spine Journal published the outcome of that massive undertaking. In a systematic review, the first of its kind, the authors evaluated the literature related to fusion for degenerative disc disease, or DDD, which included more than 3,000 patients across 26 studies. They concluded that the literature as a whole is in support of fusion surgery as a viable treatment for reducing pain and improving function in selected patients with chronic lower back pain. The study found that lumbar fusion surgery for DDD patients delivers 45% to 50% improvements in back pain, disability scores, quality of life metrics, as well as patient satisfaction rates of over 70%. The degree of clinical improvement that was comparable to that seen in other common, well-accepted orthopedic procedures like total knee reconstruction, hip revision, spinal decompression and so forth are very similar. I commend the authors and outstanding researchers for the mammoth effort involved in collecting, reviewing and summarizing the data so that our industry can begin a scientific fight against insurer pushback. On a case-by-case basis, spine surgeons will now be able to use the review to facilitate medically indicated patient access to care, but the work is not done. We will continue to support the surgical community in the next step of the process, which will require the collaboration of several spine societies to establish a set of clinically supported guidelines for spine fusion. The final set of guidelines will demonstrate clinical agreement within the spine community and will dramatically strengthen the industry's argument as we work to execute the last step of the process, encouraging insurers to adopt clinically supported guidelines written by clinicians as policy. Our industry is validating that spine surgeons, not insurers or consultants, understand what is best for spine patients. The process I described aligns well with what is unfolding in medicine on a grand scale. Medical coverage and health care decisions are increasingly being driven by data. NuVasive is helping the spine industry demonstrate that there are copious data for the payors to utilize to ensure the best patient care. As insurer pushback reduced spine market volumes over the last few years, surgical practice incomes declined. That led in some cases to an accelerated adoption of physician-owned distributorships, or PODs, which we estimate represent close to 15% of the U.S. market, up significantly from a few years ago. In another positive development for the long-term growth of our spine market, the Office of the Inspector General, or OIG, recently issued a strong written fraud alert regarding PODs, which may help to slow their adoption. We expect it may encourage those surgeons contemplating PODs and those hospitals who are doing business with them to reconsider. The alert specifically says that PODs are "inherently suspect" under the anti-kickback law and that hospitals or ambulatory surgery centers who do business with PODs are also at risk. It is now our understanding that the OIG's nationwide review of hospitals that bill Medicare for spine surgery is still underway. The timeline for a conclusion to that review is unknown. Whether the OIG will determine the additional guidance on PODs is necessary is also not certain. However, we view the fraud alert as a very positive step in the right direction and an affirmation that NuVasive chose the correct course of action in choosing not to distribute through models that present such an ethical dilemma. We intend to continue to raise awareness of the ethical issues at stake and it is our hope to ensure spine patients receive the best care available and that innovation in the spine market continues to thrive. So next, I'd like to talk about what are the top 5 future growth drivers. Well, positive market developments are very encouraging for the future of the U.S. spine market. They alone will not return our market to the growth rate experienced a few years ago, but they are giant steps in the right direction. With the positive news as a backdrop, we will continue to focus on crisp execution of our market share-taking strategy to drive industry-leading growth. Our vision for growth extends to $1 billion in revenue and beyond with unmatched opportunity for operating margin expansion. The top 5 drivers of our long-term top line growth line will be

[Michael J. Lambert:]

Thank you, Alex, and good afternoon, everyone. As Alex mentioned, our revenue for the first quarter 2013 was $159.5 million, a 5.2% increase over the first quarter of 2012. We continue to expect full year revenue growth of approximately 6%, with the second quarter of 2013, expected to be flat in dollar terms when compared to Q1. Revenue guidance contemplates market share gains in solid contribution from new procedural solutions and new geographies, offset by the continued risk from the market-related challenges that surfaced mid-last year. Let me be very clear, we believe that the market issues like PODs, as well as aggressive competitor tactics, still have the potential to have lumpy and abrupt impacts on the U.S. spine market overall. We are optimistic that the host of initiatives that we put in place to reestablish momentum late last year will support continued solid execution. Our full year guidance reflects this combination of items. Let me provide some insight into the drivers of growth in the first quarter. Year-over-year revenue growth for U.S. lumbar was just over 1% while U.S. biologics declined about 2%. We continue to expect full year 2013 U.S. lumbar and U.S. biologics revenue growth of about 2% as new products and geographies ramp over the course of the year. U.S. cervical revenue grew about 16% in the first quarter. We expect a continued penetration of our cervical portfolio combined with gradual surgeon training and adoption of our PCM device to drive revenue growth of about 14% for the full year 2013. The services revenue from our U.S. monitoring business grew almost 3% in the first quarter. We continue to expect full year 2013 growth to be about flat, with solid volume growth offset by continued monitoring reimbursement challenges. International revenue, which includes Puerto Rico and the biologics component of our international business, grew approximately 47% in the quarter. While international revenue growth was slightly ahead of our expectations in the quarter, we are not changing guidance for the full year 2013. Our performance in Japan has been solid and our expectations for procedural volumes and product sales into that market are unchanged. However, the significant weakening of the yen relative to the U.S. dollar year-to-date suggests an approximate $8 million contribution from Japan compared to the up to $10 million that we had previously expected. As a result, we continue to expect international revenue growth of about 35% for the full year 2013. All of this detail is provided for your reference in the supplementary financial information posted on our website in the Investor Relations section. Gross margin in the first quarter was 75.5% compared to 75.7% in Q1 2012 and 74.6% in Q4 2012. Year-over-year gross margin was pressured by 130 basis points from the combination of med device tax and international mix. Offsetting that impact in the quarter was the reversal of some past royalty accruals related to the cervical legal settlement. The settlement eliminated the need for any royalty payments up to the date of its enforcement so we were able to reverse approximately $600,000 of past royalty accruals, aiding gross margin by about 40 basis points in the quarter. Operational improvements to minimize cost related to scrapped or damaged product drove the remainder of the year-over-year gross margin delta. Hospital pricing pressure was largely immaterial in the quarter. We continued to anticipate a full year 2013 gross margin of approximately 74%, which contemplates a roughly 150-basis-point impact from the med device tax. Research and development, or R&D, expenses, adjusted to exclude stock-based compensation and acquisition-related items, totaled $7 million in Q1 2013, compared to $9.5 million in Q1 2012 and $7.9 million in Q4 2012. R&D expense as adjusted was 4.4% of revenue for Q1 2013 versus 6.3% in Q1 2012 and 4.8% in Q4 2012. Relative to last year, the decrease in R&D, both as a percent of revenue and in aggregate dollars, was caused by lower spending on clinical trials, several projects reaching completion and active management of discretionary expenses. We continue to expect non-GAAP R&D expense as a percent of sales to ramp in the second half of the year, approximating 5% for the full year 2013. Sales, marketing and administrative, or SM&A, expenses, adjusted to exclude stock-based compensation, certain intellectual property litigation expenses and acquisition-related items, totaled $92 million in Q1 2013 compared to $87.6 million in Q1 2012 and $90.8 million in Q4 2012. SM&A expense as a percent of revenue was 57.7% in Q1 2013 versus 57.7% in Q1 2012 and 54.8% in Q4 2012. Relative to last year, flattish SM&A performance as a percent of revenue was due to investments made to support international expansion, especially in Japan. The investments were partly offset by sales force productivity and leverage in freight and G&A. On an absolute dollar basis, the year-over-year growth in SM&A expense is primarily attributable to investment activity to support future domestic and international growth and to higher legal spend, partly offset by G&A leverage. For the full year 2013, we continue to expect non-GAAP SM&A expense as a percent of revenue to approximate 55%. Noncash, stock-based compensation in the first quarter was $6.8 million. Both year-to-date stock price appreciation, as well as the recently finalized details of our 2013 long-term incentive plan, resulted in increased expectation for stock-based compensation. We now expect full year 2013 stock-based compensation of approximately $35 million compared to our prior $30 million guidance. First quarter non-GAAP operating margin was 13.5% compared to 11.7% in Q1 2012 and 15% in Q4 2012. In the quarter, the med device tax pressured non-GAAP operating margin by roughly 100 basis points and the legal settlement benefited us by about 40 basis points. Adjusting for these 2 items, we demonstrated roughly 240 basis points of operating leverage compared to Q1 2012. For the full year 2013, we continue to expect non-GAAP operating margin including the negative impact of med device tax and the slight positive impact of legal settlements to approximate 14%, which compares to the 14.5% reported for full year 2012. Investments to support future growth have been mapped more heavily toward the first half of this year. As a result, we anticipate that non-GAAP operating margin in the second quarter of 2013 will be down some compared to the first quarter, with the greatest degree of operating leverage in the fourth quarter. Excluding the expected full year med device tax impact of 150 basis points, we anticipate generating about 100 basis points of operating leverage in 2013, demonstrating continued steady progress against our goal to improve NuVasive's profitability profile. Interest and other expense net totaled $6.6 million in the first quarter compared to $6.2 million in Q1 2012 and $5.9 million in Q4 2012. For the full year of 2013, we continue to expect interest in other expense to approximate $26.5 million. We booked the GAAP tax benefit in the first quarter of $764,000, driven by the roughly $1 million benefit from the 2012 R&D tax credit. We will continue to actively manage our tax line and we expect to make gradual progress, but this year will be a bit of an anomaly in terms of taxes given that we now anticipate GAAP pretax book income to land around breakeven, driven by our increased expectation for noncash, stock-based compensation. The most important item to focus on here is that in absolute dollar terms, we now expect our full year tax expense to be down from about $4 million previously to roughly $1 million. The updated view of stock-based compensation changes our projected full year 2013 GAAP effective tax rate from the 60% we anticipated previously to just over 80%, which assumes a roughly 120% effective tax rate in each of the remaining quarters of 2013. We continue to expect non-GAAP adjustments to be tax effective at approximately 40% for the full year 2013. Our Q1 2013 GAAP net income was approximately $596,000 or earnings per share of $0.02. With the increased expectation for full year stock-based compensation, we now expect full year 2013 GAAP EPS of about $0.02 compared to $0.07 previously. Excluding an aggregate adjustment of approximately $11 million net of tax for the adjustments detailed in today's press release, first quarter non-GAAP earnings were approximately $11.9 million or $0.26 per share. We continue to expect full year 2013 non-GAAP earnings per share of approximately $1, which contemplates the following adjustments

[Alexis V. Lukianov:]

Thank you, Michael. Results in the first quarter demonstrate solid execution against our 2013 plan. Our dedication to being absolutely responsive by supporting the spine societies and advocating on behalf of our industry are beginning to make an impact. The positive developments that have resulted have the potential to improve long-term U.S. market growth. And regardless of what market growth ultimately looks like, we have massive opportunities to drive sustainable top and bottom line growth, as I have outlined today. Our proven share-taking strategy of Superior Outcomes, Absolute Responsiveness and Speed of Innovation will enable us to execute our plan for growth toward $1 billion in revenue with an improved profitability profile. Onward and Upward! Ready for your questions.

[Operator:]

[Operator Instructions] Our first question comes from the line of Matt Miksic from Piper Jaffray.

[Matthew S. Miksic:]

So 1 question, Alex, for you in terms of market on your view this year. And I know -- I don't want to push you to get sort of more optimistic this early in the year in particular. But sitting back and looking at the growth last year and your assessment that this year's growth will be kind of like last year's growth. I'm wondering, is that sort of just for lack of visibility and it's a good business planning assumption? It's just that with things like the OIG language and the assessment that you described, some of the other dynamics in the Spine market that seem to be kind of removal of sorts of tailwinds that we faced last year, that things ought to be just a little bit better. So if there's anything else incremental that you're worried about, I'd love to just get a sense of what they are. And then I have one follow-up.

[Alexis V. Lukianov:]

I think, Matt, everything we just went through is reason for optimism. However, I don't think we can actually correlate that into a tailwind at this point in time. So we've got to wait for that to play out a little bit longer. I think these are all very positive signs. We're pleased with our execution for the first quarter. It's consistent with what we expected to see for the year. So I think that we are guardedly optimistic when it comes to these various improvements. But nothing's really happened yet. So what's happened is things have been published. There's various things that have taken place in terms of alerts but I think it's going to take a couple of quarters to play out, and if it picks up, all the better for all of us.

[Matthew S. Miksic:]

And then the follow-up for Michael, if you're going through the detail of sort of litigation and the royalty accruals and that sort of thing. Just looking back at some of the accrual rates in past, I believe the older language around the cervical plate patent was accruing at 2%, this kind of -- looks like it sets a rate for all cervical plate patent accruals at 3%. Understanding that was a pretty small part of the accruals before, does that affect the rate at which we should be thinking about a full-year accrual this year and next until some of these things roll off?

[Michael J. Lambert:]

Matt, it doesn't affect really how you ought to be thinking about the royalty expense for the full year. While it's a slightly higher royalty rate on an effective basis, there's also some shifting and movement of months to products that we think would be affected and so we'll still come out at about the $11 million or so that we had guided everybody to at the start of the year.

[Operator:]

Our next question comes from Matthew O'Brien from William Blair.

[Matthew O'Brien:]

Just a follow-up on Matt's question. With respect to the royalty settlement, I think, Alex, you mentioned historically, that this was something you didn't want to settle. You kind of wanted to see it all the way through. I'm just curious as to why you decided to go ahead and settle now. Was it something that's coming from Medtronic? Was it coming from you guys? And there has just there been any more correspondence or chatter between the two of you on something broader for the retractor and the implants as well?

[Alexis V. Lukianov:]

So we settled on the cervical part, which is Phase 2, and as you know, because of the complexity of this case, there were a lot of patents that were involved. And so the court simplified it down to 2 phases. So we're all over Phase 1. Phase 1 is the -- it's really -- let's call it the XLIF patent situation. And so our intention is not to settle on that. Unless Medtronic made us a fantastic offer. And so I think really what we did is we went after the thing that made a lot of sense here, which was the cervical piece. And I think we arrived at something that made sense to us from a business standpoint.

[Matthew O'Brien:]

Okay. But has there been any more correspondence as far as potentially looking at other areas of litigation?

[Alexis V. Lukianov:]

No.

[Matthew O'Brien:]

And then, Michael, I'm just a little curious and I understand the conservatism that you tend to provide us. But the operating -- adjusted operating margin performance in the quarter, 13.5%, typically Q1 is your low water mark in term to that metric. Why would you go ahead and stick with the 14% rate if you should benefit a little bit also from the Medtronic settlement today? Why not go ahead and just boost that up a little bit higher? And then why, on top of that, is stock-based compensation expected to be a bit higher?

[Michael J. Lambert:]

Yes. So we think of op margin, as I mentioned, will ramp later in the year. We're sort of layering in a few investments in the Q2, Q3 time frame both to continue the momentum that we have particularly in Japan, as well as to hopefully start to stage us up for 2014. 2014, that's on the back of a strong Q1 start, right? When you think about the guidance view and you think about how to characterize it, we would characterize it as realistic. We've got 2 quarters of solid execution behind us. So whether you're talking about top line or op margin, 2 quarters don't make a long-term trend. Alex talked about some of the challenges that are still out there that we battle day-to-day, and that we're trying to manage this thing really to a full-year instead of paying attention to the ups or downs of any one particular quarter. And then what was the last?

[Matthew O'Brien:]

About stock-based comp.

[Michael J. Lambert:]

Oh, stock-based comp. So stock-based comp, for us the driver there was the stock has appreciated quite a bit year-to-date. So that combination, combined with the final planned details of our long-term incentive plan, is really what drove the Delta to the original guidance. The thing to pay attention to on that is that it's essentially all stock price-related, because the plan moved to a TSR, a total shareholder return-based metric in 2013. It was not that methodology last year.

[Operator:]

Our next question comes from Bill Plovanic from Canaccord Adams.

[William J. Plovanic:]

If I could just leverage off some of the questions asked. You talked about kind of in 2012 international was breakeven. In 2013, we'll see that leverage. But then you also talk about investments. Should we really think about 2013 almost being breakeven and 2014 being the year of operating leverage for the International business?

[Alexis V. Lukianov:]

Well let me just -- before Michael jumps in here. As far as international is concerned, I think it's exactly as we stated; we expect this to have a positive contribution when it comes to 2013. What we have done though is, because Japan is such an important market, we've made sure that we have expended appropriate resources in that market. So we've probably done a little bit more than we would have otherwise, I think, contemplated a couple of years ago. We've put more time and more emphasis on having surgeons go over there for XLIF training. We're extremely pleased with what were seeing. We think that's going to bear fruit for us. With regard to the kind of revenue we see especially next year, Michael made some adjustments with regard to the impact of the yen. So that notwithstanding, we do believe that those were some relatively small investments that we've made. So when we say international, we're really talking about Japan and talking about some ways to further accelerate that growth plan for '14.

[Michael J. Lambert:]

Yes. So I'll jump in on the back of that. We talked about this, 2012 was essentially roughly a breakeven year for us. OUS, as Alex mentioned, we certainly do expect international to be positive in aggregate in 2013 and then to be improving every year beyond that. So we'll make a contribution to some of the leverage we expect to drive in 2013. Now all that said, Japan is still in investment mode from that perspective. We just got our last quarter to our earliest revenue dollars. But the race will be for us to ramp that up as fast as we can and take advantage of what's an incredible opportunity in the second-largest spine market in the world, $400 million or so.

[William J. Plovanic:]

And then on the cervical settlement with Medtronic. Will that royalty expire in 2015 with the rest of the royalties or would that go in -- on for longer?

[Alexis V. Lukianov:]

I think it's '17 or '18.

[Michael J. Lambert:]

It's February 2018.

[Alexis V. Lukianov:]

'18.

[William J. Plovanic:]

And then if I could, the MedTech tax, just what was that actual dollar amount for you in the quarter?

[Michael J. Lambert:]

It was a bit over a $1.6 million, Bill.

[Operator:]

Our next question comes from Bob Hopkins from Bank of America.

[Robert A. Hopkins:]

So to start, I just want to make sure that I got a handle on your organic growth in the quarter. I understand you -- in the press release, you said this slightly above 5% number. But I think I recall you saying earlier in the year that you have fewer selling days this quarter. Is that correct?

[Alexis V. Lukianov:]

Yes, 3 fewer selling days.

[Robert A. Hopkins:]

Three fewer selling days. So then, organically, the growth was more like...

[Alexis V. Lukianov:]

2 or 3, whatever it is.

[Michael J. Lambert:]

So let me jump in on that. Essentially...

[Alexis V. Lukianov:]

2 or 3?

[Michael J. Lambert:]

2 fewer official selling days. The third day Alex was mentioning is the fact that we take our sales force essentially out for a day when we have our national -- our NuVasive sales kickoff meeting at the beginning of the year. So you got sort of 2 official holidays moving around. But when you think about what that means or implies for selling day adjusted growth rates, here's how we suggest that you look at it. The impact of that is not the most easy to quantify. The reason for that is, we've gone out and surveyed a few of the hospitals, and really, I think truly the hospital operating days are probably the biggest driver. We actually heard a bunch of hospitals who are actually doing surgeries on some of the holidays, so probably the days lost were not officially 2. Maybe a little bit less, somewhere between 1 and 2. You could adjust for selling days. You could adjust the growth rates up. The way to think about that is probably 200, 300 basis points to each bucket for most of the categories and then international would adjust up by a bit higher even, probably 400 or 500 basis points higher. If you are making that full 2-day adjustment.

[Robert A. Hopkins:]

And then on the gross margin this quarter, was that number that you gave for the medical device tax less than you expected? And then as we go through the year, why should it come down from here? I know you had sort of a onetime benefit, but that still left you over 75%. What are the things that will take it down over the course of the year?

[Michael J. Lambert:]

Yes, at a 100 basis points, it did come in a bit below. I think we have guided to in the range of 150 basis points at the beginning of the year. There's couple of drivers underneath that. International mix was obviously strong in Q1, given the growth rates of that business and the mid-to high 40s. That mix will be different over the rest of the year and given the exemption of the OUS revenues, that's a piece of the picture. The other piece of the picture is that it's still not perfectly clear how to apply the guidance that came out of the IRS. Probably the best example of that is with instruments. Depending on what you read, those could be exempt from the tax or not exempt from the tax and so we have got to wait a little bit to see how all that plays out.

[Robert A. Hopkins:]

But just in terms of what's really driving it down from the current level though, I guess I still don't really understand.

[Michael J. Lambert:]

Sorry, say the last part again? You what?

[Robert A. Hopkins:]

So just from the 75, I mean you reported 75 5s, there's a onetime item in there that particular maybe closer to 75. I guess I'm still not clear from here maybe just the incremental MedTech tax, what gets you down to 74, what the drivers are taking you from 75 to 74, just a little bit of incremental MedTech tax?

[Michael J. Lambert:]

No, under the Med, they total gross margin percent of Medtronic agreement, the operational items that we have that affect the gross margin in the quarter. We talked about the positives, which were the benefits on damage and scrap product. Those items may not continue. That maybe what you're trying to struggle with on the gross margin line. So for us, we want to make sure that those are in place and sustainable quarter-to-quarter before we sort of think about that in terms of forward guidance.

[Operator:]

Our next question comes from Chris Pasquale from JPMorgan.

[Christopher T. Pasquale:]

Alex, you received a FDA warning letter in March. Could you just comment on what the impact, if any, that letter has in your business? And obviously, AttraX has held up anyway, but does it preclude you from getting any PMA products approved until it's resolved?

[Alexis V. Lukianov:]

It had no connection with AttraX whatsoever. And this had no commercial impact whatsoever. So it's a very straightforward process, it's effectively been resolved administratively. There are some final details, but we really see it as an non-event.

[Christopher T. Pasquale:]

And then I think Michael made a comment about 2Q revenues. I just want to make sure that I heard you correctly. Did you say that you expect sales to be flat sequentially?

[Michael J. Lambert:]

Yes, flattish Q2s revenues sequentially.

[Christopher T. Pasquale:]

Your 2Q sales, historically, have been up sequentially from 1Q virtually every year. Any other fewer selling days in 1Q. So why should we expect it to be flat this year?

[Michael J. Lambert:]

We've talked about new product launches playing out over the course of the year. That's ECM, back-end-loaded, MIS PLIF just getting started, Japan and the other country impacts, we've mentioned, going to take some time to ramp. Always, the drivers on surgeon training and adoption for new products and new geographies just takes some time to build momentum. And also you could look at the 2 selling days shifting out to Q1. Those were all contributors to us. Those days land towards the back half of the year. Those are all really the drivers that support probably a flattish Q2.

[Alexis V. Lukianov:]

It's pretty consistent with last year. If you look at the contribution of the first quarter relative to last year is about 24.5%. It's the same this year. It's what we anticipated when we set our guidance. I think what Michael's talking about is we anticipate a similar type of process as took place in the first half of last year, taking place again the first half of this year.

[Christopher T. Pasquale:]

I guess I can see how some of those factors would make the second of the year stronger than the first half but wouldn't necessary make the first quarter stronger than it would be normally relative to the second quarter. Was there anything else in the first quarter that you viewed as somewhat onetime and that would lead to 2Q being flattish instead of up?

[Alexis V. Lukianov:]

No.

[Operator:]

Our next question comes from Matt Taylor from Barclays.

[Matthew Taylor:]

So I guess first question was, you called out a couple of things in the beginning of the call there, potential positives for you longer-term. I was wondering whether you thought the the Spine Journal article could actually translate into the guidelines that you mentioned. And then on the PODs, you mentioned you think it could be inhibitor to more PODs forming. Do you think that that fraud alert could actually cause people to want to drop out of PODs in the near term?

[Alexis V. Lukianov:]

So, I think as far as how long it's going to develop clinical guidelines, I don't think it's going to happen faster than about 1 year. I think it could be anywhere between 12 and 18 months. Just depends how fast the societies are able to move. It's not an unwillingness to move. There's just a lot of societies and they are trying to come to an agreement. As far as the PODs are concerned, I do believe it will be a deterrent with regard to, I think, physicians joining PODs. Now whether or not PODs start to -- or members drop out of their PODs as a result -- I think they should. Whether or not they will, we just don't know. This is a pretty recent development. We do think that the hospitals will take this very seriously because it has potential ramifications for them. And so I think we're going to expect to see a lot more scrutiny on the part of hospitals when it comes to any physicians out there that are -- have formed PODs and are either doing or trying to do business with a hospital.

[Matthew Taylor:]

And then just on Phase 1, I know a couple of quarters ago, you said you're still waiting for the District Court. Is that still the case? Do you have visibility on timing there?

[Alexis V. Lukianov:]

You mean with regard to the royalty rates? Or what do you mean?

[Matthew Taylor:]

Yes, just the next court date, or any kind of guide post for us.

[Alexis V. Lukianov:]

Yes. No, we're still -- we don't have anything. That's what's still really preventing us from moving forward here with regard to the appellate process. So that's the same. We've -- as we talked about settled out Phase 2 on the cervical side, but Phase 1 remains in the same status that it was before.

[Operator:]

Our next question comes from David Roman from Goldman Sachs.

[David H. Roman:]

Mike, I know you made some comments regarding free cash flow when you give the $15 million number for the quarter in some of the moving parts that impact 2013. But can you maybe help us think about the cash flow characteristics of the business and the context of Alex's sort of long-term trajectory on margins, and when you think we're going to start to see a more material inflection point in that segment of the financials?

[Michael J. Lambert:]

Yes. I mean, David, conceptually, I think the way to think about it is as op margin improves, right? And as we continue to drive the growth that we're driving, we absolutely should expect, generally speaking, the cash flow situation to improve from an operating cash flow standpoint. We also expect over time to try and drive a more efficient base on the capital expenditure side and we're making progress on that so far this year, which will contribute to a more favorable view on the free cash flow side. So conceptually, I think that's right. This is one of those years where we're running into sort of a catch-up point associated with becoming a cash taxpayer, essentially for the first time, the med device tax coming in and impacting us. And then I forget what the third one was, but there's another big item. It's really trying to anniversary the working capital improvements, which were significant that we made in 2012. All those things will affect us in 2013, but as those get anniversary-ed, then we should see the growth you're looking for.

[David H. Roman:]

And then, Alex, when you're walking through sort of the long-term market opportunity, one of the data points you gave was that, I think, the number of cases of XLIF done in L4-5, but that's still the majority of spine procedures. Can you maybe just put that into perspective just from a penetration standpoint if you just look at your overall? How does your share compare -- your overall share versus where it is in that segment of the market. And should we think about that converging or maybe just help us think a little more about that opportunity.

[Michael J. Lambert:]

So Alex was talking about the number of cases being done. What I was talking about was that there were over 3,000 L4-5 cases reported in the literature and that's a lot of data that's out there. And that's what I was referring to. And so that -- as you are well aware, I think that our competitors make the argument that you can't safely access L4-5 and we would generally concur with that assessment given their technology. We believe that our technology does allow you to safely and reproducibly access 4-5. 4-5 is the lion's share of the market. We've talked about that before. It's, depending upon which estimate you go by, it's certainly 50%. It could be even as high as 60% of the market. So I think it's a very important point of anatomy to be able to access with lateral.

[Operator:]

Our next question comes from Richard Newitter from Leerink Swann.

[Richard Newitter:]

Just quickly, just to go back to the gross margin, Michael, could you just quickly say what the precise benefits were this quarter? And then what is going to kind of get a little bit worse going forward and what isn't? Just to clarify on Bob's question earlier.

[Michael J. Lambert:]

Okay. So Q1 we landed at about 75.5%. That was down 20 basis points year-over-year. The drivers on that were med device tax and impact unfavorable of about 100 basis points, a little bit over that. We also had about 30 basis points unfavorable of international mix. Those things were offset by the benefits from the cervical legal settlement of about 40 basis points and then we had operational improvements on scrap and damaged product that was favorable about 70 basis points. That's how you net down to the 20 basis point unfavorable delta net-net. As we think of that progressing towards Q2 and beyond, certainly, what I talked about a little bit earlier for gross margin in Q2, the drivers there are things like -- there'll be a shift and change in product mix and some of the assumptions there. As I mentioned earlier, we also want to see that our Q1 operational progress on the loss and damage is sustainable before we think about continuing it out in guidance. And then as Q2, you also -- as an unfavorable thing, you won't get the benefit we saw in Q1 from the favorable cervical legal piece. That was 40 basis points. Those are the main drivers.

[Operator:]

Your next question comes from Glenn Novarro from RBC Capital.

[Glenn J. Novarro:]

On J&J's conference call a few weeks back, they talked about their business being down 10% in the U.S. and a lot of it was due to sales force disruption. So 2 questions

[Alexis V. Lukianov:]

I don't think it's affected the quarter, per se, but I think it's improved and has consistently improved the quality of candidates that we're getting. So that's been an ongoing process for us. But I wouldn't see it as a business shift, per se, that we've seen. That's been an ongoing process for us and I don't think that one event really had that much to do with it.

[Glenn J. Novarro:]

And then one quick follow-up, I jumped on late so you may have already responded or answered to this. But can you talk about pricing in the quarter, if it changed at all? I know pricing has been somewhere down for most companies in the mid-single digit range.

[Alexis V. Lukianov:]

Yes, we talked about it in our prepared remarks. I don't think we've actually taken a question, but Michael is dying to answer your question.

[Michael J. Lambert:]

So price in the quarter was about 20 basis points of impact. Essentially it represents about a 1% price erosion as we analyze it on a same-store basis.

[Operator:]

Our next question comes from Jeff Johnson from Robert W. Baird.

[Jeffrey D. Johnson:]

I wanted to start with a cervical question and then maybe just a couple of clarifying questions. But on the cervical settlement with Medtronic, 2 questions, Alex, does the 3% rate lend any additional credence to the 3% rate on the 9 33 patent or the 10% rate on 9 73? One of the questions I often get is, what happens if the court comes back and those rates are much higher? Did you and Medtronic agree that the 3% here lends some credence to these kind of low mid- single-digit royalty rates on products in the Spine area?

[Alexis V. Lukianov:]

No, it that doesn't really have a direct impact. I think 3% is a reasonable royalty rate. And we made those comments during the course of our prepared remarks. So I think what it is, is it's something that's a, I would say, a customary royalty rate or in that range. So no, it does not have any other impact.

[Jeffrey D. Johnson:]

And with that settlement does that impact at all that angle fix litigation that just came up? Can you maybe give us any kind of thoughts on that new litigation?

[Alexis V. Lukianov:]

It does not, no.

[Jeffrey D. Johnson:]

Any thoughts about that?

[Alexis V. Lukianov:]

No, we have -- that's just something that was -- literally came up very recently and we haven't even looked at that from a legal standpoint yet. That's just, we're just getting arms around that. We think that's a relatively minor situation, to put it mildly.

[Jeffrey D. Johnson:]

And then, Michael, just 2 questions, any PCM update on the quarter or how you still think about it for the year? And the same with Japan, are you still thinking of $10 million for the year? Maybe any update on XLIF procedures in the Japan during the quarter?

[Michael J. Lambert:]

So PCM still anticipating that $3.5 million to $5 million. We did talk about, on the call, a reset in Japan essentially related to deterioration in the yen, weakening of the yen. And so where we had previously talked about, Japan being up to $10 million or so, now we're talking to it, given the yen change, as about $8 million or so.

[Operator:]

Our next question comes from Michael Matson from Mizuho securities.

[Michael Matson:]

I guess, just given what we saw happen in the third quarter of last year, I know that you're -- with your sales force, I know you've rebuilt and you've replaced a lot of folks that left. But I was just curious if you sort of made any changes to the compensation structure, anything to try to make it harder for competitors to poach reps. Or I guess you are pursuing legal actions against some of those folks as well. So just wondering what your strategy there is to try to increase your retention rate.

[Alexis V. Lukianov:]

I think we've made a lot of changes, that we talked about over the course of last year and going into this one. I think -- personally, I don't want to keep anybody that doesn't want to be here. But at the same time, if they break a covenant that they have with us then we will certainly take legal action. So I think we've done a number of very positive things. We've made a series of leadership changes as we've talked about. There's a lot of things we've done with regard to, I think, further improving our overall compensation program, which I think all of our reps really like. So even though on a full out basis, it's not -- we're not paying more on the sales expense line per se, but the way that we've changed the mix is very favorable for the reps and how they're being compensated. So we feel like we're in a stable position. We're very satisfied with all the sales managers that we have in place and their developments. So I think we've done all the right things, so to speak. And just like every company that's out there on the planet, you're always at risk of something going wrong but I think we've thought about every possible precaution you can think of and implemented it.

[Michael Matson:]

And then as a layperson here, with regard to patents, I guess I was just wondering on that Medtronic space or patent you mentioned expires in early 2015. But I know that in some cases, companies can get patents extended. So I was just wondering if there's -- if that's a risk at all that Medtronic had somehow got that patent life extended?

[Alexis V. Lukianov:]

No, we think that one's it. That's it, that's February '15 and it's over. Well, I think that's it for all of our questions. We thank everybody for being on the call today and we look forward to speaking to you in another quarter. Thank you. Bye-bye.

[Operator:]

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.