NuVasive, Inc.
Q2 2015 Earnings Call Transcript

Published: 29 Jul 2015

[Operator:]

Greetings, and welcome to the NuVasive Second Quarter 2015 Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Ms. Carol Cox, Executive Vice President, Strategy, Corporate Development and External Affairs. Thank you, Ms. Cox. You may begin.

[Carol Cox:]

Great. Thank you, Ronnie, and welcome to NuVasive second quarter of 2015 earnings call. Joining me on today's call are Greg Lucier, our Chairman and Chief Executive Officer; Pat Miles, our President and Chief Operating Officer; and Quentin Blackford, our Chief Financial Officer. During our comments and responses to your questions today, certain items may be discussed which are not based entirely on historical facts, including without limitation anticipated growth rates and trends in our business. Our earnings and expectations regarding our market penetration and expansion efforts, our expectations and beliefs regarding the impact of investigation, claims and litigation, risk associated with the acceptances of the company's surgical products and procedures by spine surgeons, development and acceptances of new products or product enhancements, those regarding revenues, gross margins, operating expense, other income and expense, taxes, future products and capital allocation plans. Our actual results or trends could differ materially from our forecast. Any such items should be considered forward-looking statements that are based on current expectations and involve risks and uncertainties, assumptions and other factors which, if they do not materialize or prove to be correct, could cause NuVasive's results to differ materially from those expressed or implied by such forward-looking statements. These and other risks and uncertainties are more completely described in today's press release, and in our most recent 10-K and 10-Q forms filed with the Securities and Exchange Commission. We assume no obligation to update our forward-looking statements or information, which speak as of their respective dates. This call will also include a discussion of several financial measures that are not calculated in accordance with Generally Accepted Accounting Principles, or GAAP. We generally refer to these as non-GAAP financial measures. These measures include our cost of goods sold, gross margin, sales, marketing and administrative expenses, research and development expenses, operating margin, non-GAAP earnings per share, free cash flow and EBITDA. We believe this information is useful to our investors because it provides 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 news release and the Supplementary Financial Information, which are accessible from the Investor Relations section of the NuVasive corporate Web site. With that, I would like to turn the call over to Greg.

[Greg Lucier:]

Thank you, Carol, and good afternoon everyone. I'm pleased to be here today to talk about NuVasive results for the second quarter of 2015 and our continued marketplace momentum as the innovation pioneer, its fun. We delivered solid results for the quarter as we continued to take market share and gain momentum in all our efforts to improve operational efficiencies. We drove revenue growth in line with our commitment to drive to mid to single digit growth expanded our non-GAAP operating margins by an impressive 460 basis points and reported non-GAAP earnings per share of $0.31 an increase of more than 100%. Our sales force continues to be highly engaged and is laser focused on extending our leadership in spine with increased penetration of minimally invasive surgeries. Conversation of traditional surgical procedures and accelerating our international expansion. We remain very optimistic as NuVasive looks to accelerate our market share taking strategies. I will provide an overview of our results for the second quarter and Quentin's is going to provide more detail in his section. We reported revenue growth of $203 million which represents 6.4% growth year-over-year or 8.5% on an constant currency basis. Our revenue performance for the quarter was driven primarily by strength in lumbar, cervical and monitoring in the U.S. U.S. biologics was flat to prior year as a result of a very difficult year-over-year comparison related to the launch of Osteocel Pro in the same quarter last year. International revenue increased 7% as reported, or up 23% on a constant currency basis for the quarter. Our international results were led once again by a strong growth in Asia Pacific and European regions were Japan, Australia and Italy continued to outperform our expectations. In these geographies, our team has been able to deliver growth that outpaces the market by leading with what NuVasive does best. We first penetrate with our XLIF procedure and then radiate throughout the market training surgeons in our lateral approach to revolutionize spine surgery in these regions. We are going to look to use the same penetrate and radiate strategy in existing geographies and evaluate opportunities to be exquisite in key growth markets. We also continued to execute strongly against our profitability goals during the quarter delivering non-GAAP operating margins of 15.3%, which represents an impressive 450 basis points improvement compared to last year. This increase reflects improved supply chain efficiencies, international expansion as well as the benefit of the Medtronic royalty expiration in the first quarter. Based on our progress to-date, and over performance in the first half of 2015, we are increasing our non-GAAP operating margin expectations for the full year from 14.4% to even 15% or an increase of approximately 360 basis over 2014 results. As we mature as an organization increasing our profitability is a key priority for us, for this year and the next several years. We have a tremendous amount of runway in front of us to leverage our scalability while maximizing profit and efficiencies to deliver meaningful profit improvements towards our goal of achieving 20% operating margins as we reach the $1 billion mark in revenue. This will allow us to further invest in R&D and in programs designed to accelerate our market share taking strategies both of which we expect will drive that further revenue growth. More recently, we announced changes in our executive leadership team that will create greater alignment and allow us to focus on our most important strategic goals. Our executive leadership team reflects that deep bench of talent and expertise within NuVasive and the addition of new individuals who bring complementary experience improving records of execution. With the team in place and a new roles and responsibilities to find, we can now move even faster to drive NuVasive next phase of growth and success. We will scale our operations and drive efficiencies and integrate our sales, service and specialized customer marketing programs. We believe that these efforts will turn NuVasive into a commercial powerhouse. This is going to allow us to successfully expand our global footprints, so that over time, we can grow two to three times the size we are today. Additionally, we made moves to further diversify the depth of Board experience and enhance the governance of NuVasive with the recent appointment of Vicky Capps and Dan Wolterman. Vicky brings extensive financial expertise and executive leadership experience as the former Chief Financial Officer of DJO Global. Dan who currently leads and serves as the President and CEO of Memorial Hermann Health System, one of America's top health systems brings a relentless focus on quality, patient safety and a commitment to redefining healthcare economics. With our leadership team largely in place, we are laser focused on transforming spine surgery to drive us to that number one position. I came to NuVasive because I saw incredible promise in the people, the products and the possibilities to completely redefine the spine business. Together, I have no doubt that in a few years time we will further transform our company's spine surgery both clinically and economically. One of the first things I did when I came on Board was to reach out for our field sales team to understand customer satisfaction. I was also interested in how the market was responding to the launch of our Integrated Global Alignment platform or iGA and learn what challenges, our sales representatives might face. The impact from those many phone calls and I spoke to well over a 150 sales professionals, they have been incredibly enlightening and encouraging and I corroborated their feedback by visiting over 80 key spine surgeon customers. I also had the opportunity to visit our manufacturing facility in Ohio and our distribution center in Memphis in addition to visiting some of our international markets and meeting one on one with those leaders to build a complete picture of this company. He had first had experience of insights gathered are shaping my might thinking to the approach we are going to take commercially and operationally and I have learned a few things, I want to share with you. First, we are on the right track with the launch of iGA platform. The feedback we received from the field team has been tremendously positive. The utilization of our pre-case planning software Nuvaline as well as our intra-operative reconciliation capability NuvaMap O.R. has been very strong, as has the initial experience with our ReLine comprehensive posterior fixation system. The market is properly understanding the value of surgical planning to achieve sagittal balance and the iGA technology we are integrating are creating genuine enthusiasm. While we understand the broader adoption of iGA will take time as we continue to educate and shift surgeon mindset, there is no doubt that iGA has become a competitive door opener for NuVasive. It is giving our sales force an important tool to call a new account and get access to surgeons with whom we have not previously done business. We have also connected with more than 100 surgeons through our peer to peer engagement programs in iGA and we will continue to focus on surgeon education, marketing and sales training to drive further awareness and adoption of iGA. Beyond our push around iGA, we also remain committed to increasing investments in R&D as we fortify our position as the industry's innovation pioneer and continue to differentiate NuVasive from the competition. It this commitment to innovation and a regular introduction of new products that allow us a much less price erosion than our peer group as we bring clear value to the marketplace. Second, it's critical that we both fix and revolutionize the way we supply tools and implants for surgery. We have committed to our sales team that a meaningful progress would be made in the eight months and normalcy will be achieved in 24 months. Beyond that two year mark, we will run toward world-class performance. The new operating mechanisms we have put in place consistently reviewing our supply chain progress are just a start. More strategically we intend to radically increase the percentage of implants and fixation products we self-manufacture. Today, we manufacture approximately 30% with our current resources, we can increase that up to 60% with some investment we can push the self-manufacturing goal to nearly 100% which has the potential to nearly double the benefits over the next several years than we what we currently anticipated from our insourcing initiatives. We can move further and faster with this type of target investment and the return will be profound. This planned overall of our operations capability will become an example of how we transform our company to deliver the best customer experience and provide incredible support to the sales process team. Third, to accelerate growth and continue to take market share in the global spine market, our international efforts are also expanding. With Jason Hannon now leading our highly capable international team, we look to capitalize on a strong foundation we have built across Latin America, Europe and Asia Pacific markets. Our immediate focus will be centered on globalizing our business including accelerating investments for rapid growth in very targeted ways as well as aggressively pursuing in organic growth options to supplant NuVasive's already strong organic expansion. We will continue to build out the infrastructure needed to more rapidly expand this global footprint. Additionally, we are undertaking a comprehensive evaluation of our international business and actively building plans to accelerate momentum in each of these international markets particular Europe, Middle East and Africa. Our plan is to replicate the incredible success we have had in market like Japan, Australia and Italy where we led with our expert technology, garnered immediate attention around our differentiated offering and been able to use it at the tip of the spear to get even further success. Finally, we were pleased to announce that we have reached a definitive settlement with the U.S. Department of Justice related to the company's investigation by the Office of Inspector General of the Department of Health and Human Services or OIG. Under the terms of the settlement agreement, we will pay $13.5 million plus fees and accrued interest. Importantly, the settlement is neither an admission of liability or wrong doing by NuVasive. The company was not required to enter into a corporate integrity agreement by the OIG as part of the settlement. We are happy we have this matter finalized. In all, we have immense opportunities to ahead. Our teams are focused, they understand the priorities and they are totally energized to go after the number one position. With that, let me turn it over to Quentin.

[Quentin Blackford:]

Thanks Greg, and good afternoon, everyone. Before we get started with the financials, let me remind you that many of the financial measures covered today will be on a non-GAAP basis. Please refer to the Supplementary Financial Information file on our Web site in the Investor Relations section for all of the detail covered on today's call and to reconcile our non-GAAP items to their GAAP counterparts. As Greg noted, we delivered solid revenue growth to the quarter of 6.4% as reported or 8.5% growth on a constant currency basis. We also continued to deliver on our commitment to improved profitability with 460 basis points of expansion in our non-GAAP operating margin for the second quarter of 2015. The majority of which came from our focused efforts to reduce our selling, marketing and administrative expenses. We are reiterating our revenue guidance for the full year, with growth expected in the mid-to-high single-digit range, despite increased currency headwinds. At the same time, we are very happy with our progress on focused efforts to increase operating efficiencies and increasing our expectations for non-GAAP operating margin to 15% resulting in at least 360 basis points of operating margin expansion for the full year, it's up from our previous expectations of 300 basis points improvement. Now beginning with our revenue performance. Revenue for the second quarter 2015 came in at $202.9 million or 6.4% growth year-over-year, including approximately $4 million of currency headwinds. On a constant currency basis, revenue for the quarter was $206.9 million, or 8.5% growth year-over-year. As a reminder, we are up against our toughest comp from the prior year where we grew 15% in the second quarter 2014 due to the launch of Osteocel Pro and some benefits in our Latin America markets that were not expected to repeat. Adjusting for this comparison, our growth in the quarter was approximately 11% on a constant currency basis. Our performance for Q2 was driven by strength in our U.S. lumbar and cervical businesses. Turning to the composition of revenue in the quarter as we continue to deliver on our guidance to driver mid-to-high single-digit growth on the top line, sales for U.S. implants and services which includes the lumbar, cervical, NVM5 and services business performed ahead of expectations growing 7.8% for the second quarter. We continued to experience strong results in our lumbar and cervical product portfolios or products like our precept posterior fixation system, ALIF ACR, Vuepoint 2 posterior cervical fusion system and Archon interior cervical plating system continue to be growth drivers. For the quarter, our cervical portfolio grew 11.9%, we continued to expect that U.S. implants and services will grow by approximately 5% for 2015, which includes approximately 5% growth expected in cervical up from our previous expectations of 4% given the strength we have experienced in cervical during the first half of the year. As a reminder, we realign our comprehensive posterior fixation system which is part of the iGA platform is expected to be more of a significant revenue contributor into 2016 as we drive awareness and adoption of this exciting new platform. U.S. biologic sales were essentially flat to prior year primarily due to the difficult comparisons created by the launch of Osteocel Pro in the second quarter of last year where we realized growth of more than 18%. Within the quarter, the penetration of our existing procedures continued to increase moving beyond 70% and getting closer to our longer term goal of 80%. We continue to expect that U.S. biologics business can grow approximately 7% in 2015. Our international business which includes Puerto Rico grew 7.4% in the quarter or 22.6% on a constant currency basis. We continue to expect significant growth from this area of the business where we have tremendous runway ahead of us and currently only an estimated 4% share of that total market. We continue to experience significant growth in markets like Japan, Australia and Italy, we refocus our efforts on leading with the differentiation of XLIF and our lateral solutions. As Greg, mentioned with our recent leadership change in international, we are incorporating those learnings and optimizing our market approach in other countries which include greater direct engagement with customers to create focus on our differentiated solutions and capitalize on our market leading surgeon education programs. As a result, we expect some near-term disruption in Q3 2015 from these changes, however, we remain confident in our full year performance outlook for international. As such, we continue to expect our international business to grow by approximately 9% on a reported basis for more than 20% for the full year in constant currency. In summary, we are pleased with our revenue results for the second quarter of 2015 as we have continued to execute our share taking strategy. We continue to expect revenue approximately $810 million for 2015, which now includes a $13 million impact from currency headwinds for $1 million increase from prior guidance. For the full year, this represents approximately 6.2% growth year-over-year or 7.9% on a constant currency basis. Turning to the rest of the P&L and results, non-GAAP gross margin in the second quarter was 76.1%, down 40 basis points from the 76.5% reported in Q2 2014. The expiration of the royalty associated with the Medtronic 973 patent resulted in a benefit of 160 basis points to prior year as expected. But, this benefit was more than offset by 1-time incremental charges related to new products and inventory management, specifically 130 basis points was attributable to new product launches ahead of schedule and approximately 70 basis points related to inventory efficiencies realized last year in the second quarter that did not repeat. The impacted price continued to be consistent with prior periods defining approximately 1% and was not a material factor in the quarter. We now expect non-GAAP gross margins for 2015 will improve from the prior year to approximately 76.7%. Non-GAAP sales, marketing and administrative, or SM&A expenses, totaled $114.7 million in Q2 2015 down from $116.3 million in Q2 2014. SM&A expense was 56.5% of revenue for Q2 2015, representing 450 basis points of improvement compared to the 61% reported in Q2 2014 as we continue to leverage our operating expenses. During the quarter, we realized more than 280 basis points of benefit from our efforts to drive sales force and asset efficiencies as well as an additional 160 basis points of improvement in share based compensation related charges. While happy with the progress we see additional opportunity to drive leverage within our SM&A expense profile over the longer term. The opportunities are numerous and as we mentioned last quarter, we are driving initiatives design to address our fixed cost expense base, renegotiating vendor agreements, better understanding the true cost of serving our customers, reducing the needs to deploy unnecessary assets for surgeries and reducing the loss associated with our loaner instrument model. As a result of the progress made through the first six months of the year, we are now improving our outlook for SM&A expense to be approximately 56.9% for 2015 an improvement of 100 basis points from the previous estimate of 57.9% and now 300 basis points better than prior year. Non-GAAP research and development, or R&D, expenses totaled $8.8 million in Q2 2015 compared to $9.1 million in Q2 of 2014. R&D expense was 4.3% of revenue for Q2 2015 versus 4.8% in Q2 2014. These decrease follows higher levels of spending earlier in the year to support the launch of iGA platform in May 2015 and reflects continued investment in our game changing procedural solutions that we planned to introduce in additional new products and line extensions through the year. We remain committed to investing in innovation in 2015 and now anticipate a full year of non-GAAP R&D expense to get approximately 4.8% of revenues. We are pleased to report second quarter non-GAAP operating margin increased to 15.3% resulting in an exceptional 460 basis points of operating margin expansion, compared to the 10.7% we reported last year. We continue to make significant progress on our goal to improve profitability across the board delivering roughly 500 basis points in improvements from leveraging our operating expense profile. We are very pleased with our performance for the first half of the year and where we are positioned relatively to our underlying core operating margin improvement for the year. To that end, we are increasing our profitability guidance and now expect a non-GAAP operating margin of approximately 15% for 2015 an improvement of 60 basis points from our previous estimate of 14.4% for the year now resulting in a non-GAAP operating profit dollar growth of 40% for the year. Our non-GAAP results for the second quarter excluded the following charges as follows; $3 million related to amortization of intangible assets; $1.4 million for one time and acquisition related cost; and a net charge of $0.6 million related to litigation liabilities. In addition to be consistent with prior practice we realized a charge of $0.2 million of leasehold related charges and $0.1 million related to our CEO transition. The net charge of $0.6 million related to litigation liabilities reflected a $3.3 million charge associated with a unfavorable verdict in a general litigation matter which was partially offset by a gain of $2.8 million related to the settlement of Neurovision trademark dispute. You may recall that we had accrued $30 million for Neurovision litigation in the first quarter of 2014 which we ultimately settled for $27.2 million. Interest and other expense, net, on a GAAP basis totaled $7.2 million in Q2 2015, relatively consistent with what it was in Q2 2014. Included in the quarter was $3.9 million of non-cash interest expense related to our convertible notes. We continue to anticipate full year 2015 interest and other expense to be approximately $29.5 million, including roughly $16 million of non-cash interest expense. Income tax expense on a GAAP basis for the second quarter of 2015 was $8.6 million compared to a $1.1 million of expense in the second quarter of 2014. This resulted in a GAAP tax expense rate of 46.3% for the quarter. As a result of our improved profitability outlet, we now expect both our GAAP and non-GAAP effective tax expense rate to be approximately 45% for the full year of 2015. Second quarter non-GAAP earnings were $15.7 million or $0.31 per share more than double when compared to $7.6 million or $0.15 per share in Q2 2014. We now expect non-GAAP earnings per share of approximately $1.17 for 2015 versus a prior expectation of $1.10. Additionally, we now expect GAAP EPS to be approximately $1.18 versus our prior guidance of $1.12 for 2015. In addition, adjusted EBITDA margin which excludes the impact of non-cash share based compensation was 24.9% for Q2 2015 compared to 21.5% in Q2 2014 reflecting a 340 basis point improvement in the business. We now expect an adjusted EBITDA margin of approximately 25.2% versus our prior guidance of 24.6% for 2015. Our cash and investments balance at the end of the second quarter was $306.6 million down about $10 million from last quarter as a result of an incremental $23 million of tax payments made in the quarter as we transitioned to a cash tax payer. In closing, we have finished the first half of the year with a very strong performance. On a year-to-date basis, revenue growth is $9.2% on a constant currency basis and non-GAAP operating expenses are essentially flat with prior year resulting in non-GAAP operating margin expansion of 460 basis points and non-GAAP operating profit dollars growing nearly 60%. In addition, non-GAAP earnings per share were more than 80% year-to-date as our strong leverage story continues to fly up. As we came into the year, we laid out a multi-year path that would have us driving our non-GAAP operating margins to 20% with adjusted EBITDA margins growing to 13%. Six months to the year, we are well on our way to achieving those goals and have direct line of sight that how we will execute on those longer term stated expectations. We remain committed to delivering on those plans in creating incremental shareholder value. We are excited as we head into the back half of the year to deliver on our full year commitment by delivering mid to high single digit revenue growth while delivering 360 basis points that improved non-GAAP operating margins and adjusted EBITDA margins surpassing 25% an improvement in non-GAAP earnings per share of nearly 75% for the year. With that, I will turn the call back over to Greg for closing comments.

[Greg Lucier:]

Thanks Quentin. As we look ahead, we are committed to capitalizing on the strong fundamentals in NuVasive's business and the market as a whole to attract the very best talents, to drive value for our shareholders and make a difference for our customers. We are energized by what our future holds and are confident in our ability to execute to continue NuVasive's positive momentum in 2015 and beyond. Before I open the call for your questions, I want to make you aware of our intention to hold an Investor Day at our headquarters at San Diego on December 10th. We hope you will save the date. I promise it will be something. With that, operator, we will be pleased to answer any questions.

[Operator:]

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Thank you. And the first question comes from Matt O'Brien of Piper Jaffray. Please go ahead. Q - Matt O'Brien Afternoon, thanks for taking the questions. I was hoping to start with the U.S. implant business and the strength that we saw there this quarter. Quentin or Greg, was – can you just provide a little bit of a sense in terms of where the components of that strength came from be it the market or the physician or distributor shipped away from those entities share taking or deeper penetration within your existing accounts? And then as you look forward to some of those levers that you have among those areas, you keep generating that type of performance going forward.

[Quentin Blackford:]

Yes. Matt, this is Quentin. There is couple of reasons that we can point to it. And without question we believe we continue to take share in the marketplace. And I think you can point to products like precept where we continued to grow at a rate that far outpaces our overall growth certainly a contributor there. ALIF ACR really the focus around sagittal alignments were gaining traction with that product line which highlights the fact that that the marketplace is starting to appreciate the important sagittal alignment which is something critical to iGA and success that we believe will come with that over time as well. And then certainly you get into the cervical portfolio where we're seeing nice results around Archon, we launched the interior cervical plating system in the fourth quarter saw some nice adoption there as well as [2.2] [ph] which is our posterior fixation system for the cervical spine and we're seeing nice results coming from that as well. So there are certainly new product launches that are fueling the growth continue to gain traction and we would believe that into the future have the potential to continue to demonstrate this kind of results as well. Q - Matt O'Brien Okay. So it seems like it's a combination of going deeper in your existing accounts plus taking some share throughout the market as well, is that fair?

[Quentin Blackford:]

Absolutely, without question. Q - Matt O'Brien Okay. And then I know we're supposed to keep it to one, but if I could sneak in one more. Greg, I just was interested in the commentary you had on the insourcing opportunity that you see going forward going from 60% to 100% potentially, how much of that is internal investment versus external investment? And can you give us any sense for timeframe and then potential improvements to gross margin from doing that? Thank you.

[Greg Lucier:]

So right now we have a modest size factory in Dayton, Ohio with that set of capabilities we can go from about 30% that we are today towards the 60%, I mentioned in the script. What's new is that we're going to move beyond that facility and open up a much larger manufacturing capability somewhere here in the United States, we'll be announcing that probably in the next few months and with that increased capability we'll be able to take our potential for some manufacturer up to 100%. In terms of its impact on our trajectory to becoming a 20% operating margin company or greater as I referenced, we think it will accelerate that and potentially move us beyond 20%, but we haven't fully quantified that yet for investors. Q - Matt O'Brien Great. Thank you.

[Operator:]

Thank you. The next question is from Richard Newitter of Leerink Partners. Please go ahead.

[Richard Newitter:]

Hi, thanks. I don't know either Greg or Quentin, you -- just enlight us some of the leadership transitions that are taking place. So I think I might have missed it, but Greg I think you mentioned this might have caused a little bit of transient disruption, I was just wondering if you could may be give a little more color on that and what we should expect going forward? And then as you answer that question, you mentioned some inorganic activity, I'm guessing some of that is probably going to focused O-U.S., can you elaborate on what your ambitions and initiatives are as you look forward through M&A?

[Greg Lucier:]

You bet. So just to be hopefully very clear, the company executed I think extremely well in the second quarter perhaps the narrative that there would be disruption in the sales force was in the end not true. The sales force is very stable, very focused and as you could see by the results very successful. On your second point, in terms of inorganic growth, I am indicating to investors that we will begin to be more acquisitive, very -- I think responsible in what capital we would deploy and the focus would be to continue to build on our strength and international markets and so further expanding where we can open up new geographies potentially by using our balance sheet.

[Richard Newitter:]

Great. And just may be to follow-up on that Greg. How should we think about your willingness or as you look at opportunities, what's your view on how M&A impact the P&L or what criteria are you more focused on do you provide -- have a greater weighting on to expect deals to be accretive first and foremost or can you give us anything there?

[Greg Lucier:]

Well, the first filter for any M&A is that it has to support and enhance the strategy and it has to do it in a way that we couldn't do it on our own. Here is an example, this company is incredibly innovative a lot of implant technology sits up there a lot of it is of no interest to us because we're so innovative on our own. So it has to fit in with our strategy. The second would be that we can get a proper return on invested capital because we all know in this low interest environments today getting accretion is not the challenge getting the return is. And so we would have expectation to get a return on our invested capital on a smaller deal within three years, it was a larger deal certainly with five. The last would simply be the capacity of the organization to absorb the particular acquisition at that moment and time and so that's the filter if you will by which will consider deploying our balance sheet at the right opportunity at the right time.

[Richard Newitter:]

Thanks. Congrats.

[Operator:]

Thank you. The next question is from Ben Andrew of William Blair. Please go ahead.

[Kaila Krum:]

Hi, guys. So this is Kaila in for Ben. Just to follow-up on the M&A comments, Greg, can you just elaborate on your comment to be more acquisitive? I know you mentioned that I mean NuVasive does have a lot of innovation across segments, so I can imagine it would be difficult to pinpoint a specific area, but can you just touch on maybe a potential few segments that you are interested in getting into?

[Greg Lucier:]

Well, I'm cautious about doing just that, I apologize. But let me try to be at least responsive to your question perhaps in more generalities. As I said in the previous question, we're growing very fast internationally, we like what we're doing and so the question we ask ourselves can we grow even faster by moving into new countries inorganically. And I'll leave it at that for you to consider how that to be done.

[Kaila Krum:]

Okay.

[Greg Lucier:]

We do look at a lot of technologies and we're going to ramp up that surveillance and think about other things that may accelerate the overall building on for portfolio, but as I said we're caution because we are quite innovative on our own. The third area would be to think about data, data systems, it's very clear as you go out a few more years that there is going to be the need for capitation around these bigger surgeries and we want to be a physician to understand the economics of spine surgery better than anybody. And so perhaps an inorganic move might be in order at the right time there. So there are some generality for you just what we're thinking about to become number one in this marketplace.

[Kaila Krum:]

Okay. That's helpful. And that makes sense. And then just given the improvements that we've seen in operating margin in the quarter and the lift in guidance, just looking at the out years beyond 2015, do you think, do you still think of 100 basis points as a multi-year expansion goal kind of again beyond 2015, or is that more of a baseline case?

[Greg Lucier:]

It's a good question. And what I've been very cautious to do here is to not change the fundamental longer term or may be medium term guidance that Quentin and the team have provided so far, which is, we said for is a 100 basis points improvement a year as we get to $1 billion, we get to the 20%. And I think that's a good guidance you should still build into your models. All that said when you visit us on December 10 on that sunny day we'll give you a lot more medium term guidance about where we're taking the company.

[Kaila Krum:]

Great. Thank you.

[Operator:]

Thank you. The next question is from Chris Pasquale of JPMorgan. Please go ahead.

[Chris Pasquale:]

Thanks. Greg, I just want to follow-up first on your comment about opening up a second manufacturing site in the U.S., and I'm curious why you view that as the right approach, versus maybe filling out your footprint with O-U.S. manufacturing in a cost advantaged location?

[Greg Lucier:]

It's a very good question. And our answer is that we want to continue to execute flawlessly. And our worry not being historically, I would say awesome at operations is to then immediately take a higher risk approach of building a plant in Singapore or somewhere else like that. And so we believe the more prudent approach is to build the plant somewhere in the United States that leverages the expertise we do have and allows us to get a much bigger economic improvement from our current path get that done and get that done where it doesn't causes any problems but only causes us pure upside. And then towards the 2020 timeframe probably looking at a second plant given our volume growth overseas just like you described.

[Chris Pasquale:]

Okay. That's helpful. And one for Quentin. Can you just walk through some of the puts and takes on gross margin in the quarter and the slightly lower full-year forecast? I would have expected with the royalty winding down that we would have seen a bigger improvement and I know you mentioned a couple items that were weighing on that.

[Quentin Blackford:]

Yes, sure. So within a quarter gross margin was down year-over-year by 40 basis points we did see the benefit year-over-year of the Medtronic royalty falling off that benefited us by about 160 basis points. But we also had some one-time product related costs with new product launches and transitioning different product lines for about 130 basis points. And then we had some benefits last year of 70 basis points just simply didn't repeat this year and if you recall going back into that second quarter we had talked about the inventory efficiencies around the loaner model or filled inventory have benefited us at that point in time. So you had a bit of a tough comp there, but if you would normalize for the one-time item gross margins would have been up for the quarter, there is no question. Over the course of the full-year, it's not that the product transition related item is impacting us we have contemplated that on a full year basis, it just came in a little bit different from a timing perspective. But the challenge here is really two things. One, we've got the mix in our international business, Japan is doing incredibly well for us, but we're seeing Precept be a bit stronger in that local market which had a little bit of a higher cost profile associated with it so putting some pressure on us. The other thing is NML. We didn't generate as much of the savings in the second quarter that we anticipated and the reason being is really aligned to what Greg has talked about which is how we take our manufacturing capability from the 60% we once talked about to 100%. And what that means is that we've got to spend time building up the capability and the processes around bringing more products into that facility, not just focusing on the few that we were producing, but expanding that up and we can produce all products. So working through design engineering, manufacturing engineering, setting up the manufacturing process, it's not going to have those machines running a full efficient capacity here in the next couple of months, but it's going to put us in a position to drive significant better efficiencies over the longer term. And so we're going to feel a bit of that in the near-term over the remainder of the year which puts a bit of pressure on the gross margin that optimally is going to put us in a much better position long-term.

[Chris Pasquale:]

Thanks.

[Operator:]

Thank you. The next question is from Larry Biegelsen of Wells Fargo. Please go ahead.

[Craig Bijou:]

Hi, guys. It's Craig on for Larry. I don't believe Greg that you in your international comments or your comments on the international business in the script that you mentioned China. And I just wanted to touch on that and see what the strategy is there I know at the analyst meeting obviously different management, but last year was a key focus for 2015. So just wanted to know is the focus on China may be pushed to 2016, so just strategy and timing on China?

[Greg Lucier:]

We remain committed to expanding in China in some ways some of the disruption as the top NuVasive may have worked to our advantage given the disruption going on in China now. And so my hope is that we'll be able to bring something to shareholders here in the next six to eight months regarding China.

[Craig Bijou:]

And I guess just from a market or Chinese market perspective there is no – I mean is that, is it specifically something that's happened in the market environment there that may be pushed you a little further out?

[Greg Lucier:]

No. It's just simply -- may be I was being too okay, simply with the change in the management with Alex to me, we've just have to reorient some priorities and in parallel with that we know the de-valuation have taken place in the China stock market as well as potentially sellers expectations regularly so. And I'm simply saying that timing may not work to our advantage because our ambition to move into China is not [Technical Difficulty]

[Carol Cox:]

[Technical Difficulty] talking about how the deformity parameters are now being sought in degenerative surgery based upon creating more durable long-term outcome. And so that there is a lot of literature out there [Squabb] [ph] is very well published in this one and we will continue to invest in post market research to continue to affirm the value we are recreating both clinically and economically.

[Unidentified Analyst:]

Great, thanks. Congrats on another good quarter.

[Carol Cox:]

Thanks.

[Operator:]

Thank you. The next question is from David Roman of Goldman Sachs. Please go ahead.

[Kyle Conlee:]

Hi, this is actually Kyle filling in for David. Good afternoon thanks for taking the questions. Greg as you continue to reach out to the sales force could you provide us with some of the feedback from those conversations for example what has surprised you on the upside and have you fielded in any concerns?

[Greg Lucier:]

Three areas may be I can comment on. First, the operational support to the sales force. As we've alluded to both in this call and I'm sure earlier call the supply chain approach the company had historically taken was not fully serving the sales force and we brought on a new team under Pat a team that has substantial experience and realigning supply chain and building factories and running them and just in the last 90 days, we've made nice progress increasing and creating predictability of one that will get their trade sets. Less anxiety more time selling, it's been a huge win, but a long way to go, but we're on the right path. Second is our best people as you know are really great because not only do they sell, but they support surgeon in the operating theater. We're going to continue that but we're going to augment their capability with increased hiring of clinical associates to allow them to be more productive on the sales side. This will allow us to continue to take market share and I say the sales force is really received that with great enthusiasm. The last that I've been personally impressed by and the sale forces commented back to me don't change it and keep going with it is just the very high investment the company makes in training. I think its recognized and may be this is just me repeating what I've heard, but its certainly what they've told me is they feel that they are best trained sales force in the industry, they are best trained clinically and increasingly are starting to hear from us economically and how best to talk to the C suite of hospitals to become a spine partner of choice. That's a whole new arena for us as we've gotten bigger we can become bolder in our ability to partner and you'll see that unfold over the next couple of quarters. So that's a bit of the context to the dialog with the sales force.

[Kyle Conlee:]

Thanks very much for the detail that's helpful. Switching gears, one question quickly on the U.S. biologics business, I know that this quarter represented a difficult comparison with the Osteocel launch annualizing, but I think the number came in a bit lower -- where we were expecting the sales decline in quarter-over-quarter, can you perhaps briefly walk us through the drivers of this quarter's performance relative to first quarter?

[Quentin Blackford:]

Yes. This is Quentin here. I think for the most part it really wasn't the tough comp issue in the quarter itself. One way to look at it is to go back to last year and normalize the second quarter and just assume that we grew that second quarter in line with what we grew the entire year for which is about 10.5% to 11%. If you were to do that you'd come into about 7% growth in biologics this year in Q2 on a normalized basis which is essentially right in line with the way we guided to it. So and we start to parse apart the business and try to understand the true impact of that tough comp and then pay attention to things like penetration in our own existing cases which we saw move north of 70% this quarter. We're still very bullish on that potential in that product lines. So normalizing for all of that and still growing roughly 70% right along with full year guidance that is felling pretty good with where we're at.

[Kyle Conlee:]

Great. Thanks very much.

[Operator:]

Thank you. The next question is from Bob Hopkins of Bank of America. Please go ahead.

[Bob Hopkins:]

Hey, thanks. Can you hear me okay?

[Greg Lucier:]

Yes.

[Bob Hopkins:]

Great, good afternoon. Thanks for taking the question, so just two quick questions. First on back on the topic of M&A, that's gotten a little bit of attention in this call. Can you just give us a sense for the size of the deal that you may consider, we're talking about deals in the 10s of million may be low 100s of million or we should consider a larger transaction?

[Greg Lucier:]

Good question. I don't think that we have talked about the size of acquisitions at this point more around the question earlier around the economic return of them. So that's really more where we would be focused on making sure that whatever money we invest we get the right return on it.

[Bob Hopkins:]

So is that -- should we take from that that you would consider larger deals?

[Greg Lucier:]

Look, if a larger deal allowed us to create the tremendous shareholder value we're going to take a loot at it.

[Bob Hopkins:]

Okay.

[Greg Lucier:]

But I mean you're asking a question that's hypothetical and I'm trying to give a more principled answer of -- I think its important that the company remains grounded on the return on its invested capital.

[Bob Hopkins:]

Great. No, I was just trying to get a sense for what to expect. And then lastly just Quen really quickly on the Q3 O-U.S. growth given full year guidance and you explained kind of that what's going on in Q3, but just in terms of expectations for Q3 specifically. I would assume we're still talking about double-digit growth in third quarter O-U.S., is that fair?

[Quentin Blackford:]

Yes, Bob. I think the thing that you've got to keep in mind is last year we also had a one-time benefit coming out of that Latin America market those things are hard for us to predict when they recur and we've said that we're not going to try to do that on a quarterly basis. But, I think if you go back and look at the remarks that we made it was about $3.5 million of benefit last year in the third quarter alone. So if you don't seen that coming out, I think growth in the double-digit territory is going to be hard to produce in the third quarter. But for the full year, we have every bit of confidence that we're going to be able to achieve the 20% constant currency growth that we've laid out.

[Bob Hopkins:]

Perfect. Thanks very much. I appreciate the color.

[Operator:]

Thank you. The next question is from Matt Taylor of Barclays. Please go ahead.

[Matt Taylor:]

Hi, thank you for taking the question. I wanted to ask one follow-up on the insourcing initiative which is an interesting one. I guess can you provide us number one, with any context in terms of what the timing of that might be both in terms of when you break ground and when it would benefit the P&L? And then on the insourcing initiative that you outlined last year, did you ever actually quantify that, I know there is the little chart with like the bar of contribution towards 20% growth but did you give a number?

[Quentin Blackford:]

We did. So we've talked about moving towards the 20% operating margin goal we had laid out insourcing as being a primary driver of that. We said there is about 200 basis points of improvement that would come from insourcing and that was, if we could get ourselves to 60% that the product coming in-house. You listen to Greg talk early our goal was really to take that 60% and move it to close to 100% which over time we think its going to have the opportunity nearly double that 200 basis points. And I think the way to think about that is an incremental 200 basis points improvement on say $1 billion company is $20 million of improvement in any given year. So there is a substantial return that comes with that investment -- that we're looking to make. In terms of timing, I think we realized the opportunity there to create the leverage and realize that benefit, we want to move quickly in this area. So we're focused on it, it's a high priority for us and its one of those that we believe has relatively low risk that the manufacturing capability here is not significant in terms of know-how we're doing some of it already. We just seem to accelerate the efforts around it.

[Matt Taylor:]

Great. And in addition to iGA, any other products or line extensions that we should watch out for that are coming or either or keep an eye on that or driving some of the momentum?

[Carol Cox:]

Yes. I think at this point we've launched the foundation of the iGA platform. What you're going to see is a bag full of a lot of technique related devices what will ultimately continue to support whatever that the approach preference is to the surgeon. And so you will see a lot of smaller type of launches through the end of this year that will ultimately reflect in continued elegance.

[Matt Taylor:]

Great. Thank you.

[Operator:]

Thank you. And our next question is from William Plovanic of Canaccord Genuity. Please go ahead.

[William Plovanic:]

Hi, great thanks good evening. Can you hear me okay?

[Greg Lucier:]

We can.

[William Plovanic:]

Great, thank you. So just two questions, one, I think Quentin on the last quarter you said that you expected some major disruption in the impulse monitoring services business this year and kind of what degree of that impact are you seeing from the changes that were made?

[Quentin Blackford:]

Yes. So Bill, that disruption was really contemplated in the back half of the year. So as we talked about disruption that is really focused around ensuring that we're strategically aligned with our service business and the hardware business. And so we've taken the opportunity in, of course the 2014 and even the beginning of 2015 to trial that with some incremental hires of clinical associates into targeted locations. What we've contemplated in the back half is potentially walking away from some of those territories where hardware business is not aligned to service and making those more aligned in the future where we think we can drive even greater growth. So we haven't see an impact in Q2 or Q1 as a result of that, that was more focused in the back half of the year.

[William Plovanic:]

Great. And then secondly just on the O-U.S., I know a lot of people have asked about it but just clarify your comments on the O-U.S. impact of leadership changes for the second half of the year? Are there specific geographies, is this going to be significant impact are you changing distributors kind of what exactly just more granularity would be helpful. Thank you.

[Quentin Blackford:]

Yes. I think the focus is primarily around Europe Bill. We're doing very well through out the Asia Pac region. We've taken very specific targeted approach with leading with XLIF in our lateral solutions in both Japan and Australia and have seen significant results. We've seen the same in Italy. What we want to do is take that know-how and take that experience and to really double down in some of these other European markets that, we've been in for a period of time to have an experience the same kind of growth. And so in the near-term, what you end up with is a focused effort that historically might have been more around the traditional spine surgery products and now you pull back from that just a bit to get a more focus on XLIF, you spend some time training the surgeons, the sales force, which is going to create some near-term disruption, but ultimately we believe leading in greater growth opportunities for us. So that's why when we highlighted as a Q3 disruption but still feel very good about the full year expectation that we laid out.

[William Plovanic:]

And is that changing distributors out or what exactly going direct, what exactly does that mean?

[Quentin Blackford:]

Yes. So we are direct in most -- all the major market there in Europe. We've talked about this historically right. We're direct in the U.K.. We're direct in Germany. We're direct in Italy. We've just gone direct to Spain looking to go direct in Benelux. There are couple of smaller markets where we may look at those opportunities to be direct as well and that could potentially be looking at distributors from time-to-time, but right now it's how we can grow in some of these bigger markets in a much more meaningful way.

[William Plovanic:]

That's helpful. Thank you very much.

[Operator:]

Thank you. I would now like to turn the conference back over to Mr. Lucier for any closing remarks.

[Greg Lucier:]

No, that's concludes our second quarter earnings conference call. Thank you very much for your interest in NuVasive. And we look forward to talking to you in 90 days.

[Operator:]

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