NuVasive - Earnings Call - Q1 2016

Transcript

Operator (participant)

As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Carol Cox, Executive Vice President, External Affairs and Corporate Marketing. Thank you. You may begin.

Carol Cox (EVP of External Affairs and Corporate Marketing)

Great. Thank you, Darren, and welcome to NuVasive's first quarter 2016 earnings call. The company's earnings release, which we issued earlier this afternoon, is posted on our website, as is an investor presentation, both of which have been filed with the Securities and Exchange Commission on Form 8-K. We have also posted supplemental financial information on the Investor Relations website to accompany our discussion. On today's call, we will be covering information that is included in the investor presentation, and I encourage all of you to access these materials so that you can follow along.

Before we begin today, I would like to remind you that the discussions during today's call will include forward-looking statements which are based on current expectations and involve risks and uncertainties, assumptions, and other factors which, if they do not materialize or prove to be correct, could cause NuVasive's results to differ materially from those expressed or implied by such forward-looking statements. Additional risks and uncertainties that may affect future results are described in our news release and periodic filings with the SEC. NuVasive assumes no obligation to update any forward-looking statements or information which speak as of their respective dates. This call will also include a discussion of several financial measures that are not calculated in accordance with generally accepted accounting principles, or GAAP. We generally refer to these as non-GAAP financial measures.

These measures include our cost of goods sold, gross margin, sales margin and administrative expenses, research and development expenses, operating margin, non-GAAP earnings per share, free cash flow, and EBITDA. Reconciliations of the most directly comparable GAAP financial measures can be found in the news release and the supplementary financial information which are accessible from the Investor Relations section of the NuVasive website. Joining me on today's call are Greg Lucier, our Chairman and Chief Executive Officer, and Quentin Blackford, our Chief Financial Officer. With that, I will turn the call over to Greg.

Greg Lucier (Chairman and CEO)

Thank you, Carol, and good afternoon, everyone. NuVasive is off to a strong start in 2016 as we continue to drive innovation, growth, and profitability throughout the business. I'm pleased to report we delivered on each of these strategic elements in the first quarter of 2016. This translated to a total revenue increase of 11.8%, or 12.3% on a constant currency basis, representing a return to double-digit growth and included re-accelerated growth in our key markets in Western Europe, where we have been investing over the last several quarters. This strong revenue performance, coupled with improvements in our gross margins and reductions in our SM&A spend, drove our non-GAAP operating profit margin higher with 150 basis points of expansion to 14.1% and resulted in a non-GAAP EPS of 31 cents.

Additionally, during the quarter, we executed against several inorganic opportunities to augment our internal growth and to improve our capital structure. We completed the acquisition of Ellipse Technologies in mid-February, which now operates under a newly created division called NuVasive Specialized Orthopedics, or NSO, and completed the purchase of our Brazilian distributor, Mega Surgical, at the end of March. Both of these assets will contribute to our growth in 2016 and beyond. During the quarter, we also took steps to enhance our capital structure by putting in place a revolving credit facility and issuing new convertible notes to refinance our existing convertible notes. This provided us with greater liquidity and certainty around our capital structure out to 2021.

I'm pleased that we were able to reach favorable terms, extend our maturities by five years, and address the dilutive impact our previous notes had had as our stock traded into the money. We were highly opportunistic in the timing of the offering, securing an attractive deal and one which also benefits our shareholders. Quentin's going to provide you with more details in a moment. Now, let me elaborate about Q1. Total revenue exceeded our expectations, coming in at $215.1 million, or 11.8% growth year-over-year. This included a standout performance in NuVasive's Core U.S. Spinal hardware business, which was up 11.6%. This robust growth was driven by the continued adoption of our Reline posterior fixation system, along with ongoing uptake of IGA, our surgical planning technology, which pulls through spinal hardware. Our results were up in all procedural categories: posterior lumbar, anterior, lateral, and cervical.

Customers see NuVasive as the emerging full-line spine company, and the buying patterns are reflecting that preference. Additionally, we benefited from the inclusion of NSO's results for part of the quarter, which reflected exceptionally strong MAGEC sales and continued robust growth from our side. The integration process for NSO is on track and proceeding very well. In fact, I'm pleased to report that a few weeks ago, a Chief of Surgery at a leading children's hospital fixation system went implanting the MAGEC rod for the first time in a young patient. This is an early symbolic event, as we not only broaden our reach to the early onset scoliosis market but also begin to deliver upside of the NSO acquisition with a pull-through of NuVasive hardware and MAGEC procedures.

In Q1, international revenues grew 20.7% on a constant currency basis to $28.7 million, or 16% as reported, including the partial contribution of NSO during the quarter. In Q1, we successfully drove growth in our core direct markets, including Japan, Australia, New Zealand, the U.K., Italy, and Germany, as we concentrated our efforts to go deep in each country. Once again, Asia-Pac continued to be an exceptional grower, with Japan leading the way at approximately 45% on a constant currency basis. I'm particularly pleased to report that EMEA grew approximately 18% on a constant currency basis, thanks to the continued strength in Italy and bolstered by ongoing positive results now in Germany, as well as a growth resurgence taking hold in the U.K.

We're particularly pleased with our return to growth in Germany and the U.K., as it reflects the progress spurred by the localized business plans we put in place in the second half of 2015. Latin America continued to experience weakness during the quarter, down about 34%. This decrease was driven largely by Brazil, which delivered almost no revenue in Q1, as we expected. To better realize the potential of Brazil's very sizable market, including a new opportunity to compete in Brazil's large public healthcare market, we transitioned Brazil to a direct model and have now closed the acquisition of our exclusive distributor, Mega Surgical. By virtue of this deal, we can now provide the appropriate inventory to serve the business and have direct contact with surgeons and key opinion leaders throughout the country, where direct relationships are the preferred method of doing business.

All in all, our resurgence in Western Europe, coupled with our confidence in 30-plus % growth in Japan and now going direct in Brazil, we're setting the company up for a strong international performance in 2016, where we expect to see actually accelerated growth for the balance of the quarters. As we've been communicating to you this past year, margin expansion is a key element in our efforts to deliver value creation for our shareholders. During the first quarter of 2016, we delivered a 150 basis point year-over-year improvement in our non-GAAP operating profit margin to 14.1%, thanks to a nice leverage of the cost structure. We remain committed to delivering a nearly 1,000 basis point increase in profitability in the medium term.

The build-out of our West Carrollton, Ohio, manufacturing facility is on track, with initial production starting as early as this summer and a full ramp-up by year-end. Both asset and sales force efficiencies are an ongoing process as we continue to drive operational excellence throughout this organization. As you have heard today, our confidence in the international business is high, and we expect the associated economics to follow as we get bigger overseas. These strides will allow us to meaningfully improve our financial profile. With an increased focus on disciplined spending and improved efficiencies, we will continue to drive our adjusted EBITDA higher. Reducing our non-GAAP effective tax rate is also an area for significant improvement as we scale the business. We have targeted to reach approximately 41% this year, move into the mid to high 30% range next year, and drive to the mid to low 30% beyond that point.

Lower depreciation will also come into play to further enhance our financial profile as we target reducing our CapEx burn rate from approximately 8% to 6% of revenue. We'll achieve this through a laser focus on better set configuration and utilization in the near term, while opportunities for 3D printing could be sizably beneficial in the longer term. As we look to build on our strong momentum in Q1, we remain focused on three core initiatives: drive innovation that addresses unmet clinical needs and improves clinical and economic outcomes. Number two, drive organic growth in the U.S. and the international market while also pursuing strategic M&A that strengthens our leadership in spine. Number three, deliver increased profitability through operational excellence. Now, there's no doubt that there's a tremendous amount of consolidation taking place in the spine industry today.

As large players like NuVasive bring both innovation and breadth of offerings to the table, our surge in customers in hospital systems are increasingly consolidating the myriad of vendors. This means the smaller players with limited offerings are getting squeezed out of the equation. We believe there will be only a handful of companies that will be able to compete in this new industry order, and NuVasive is clearly one of them. The trends are absolutely in our favor, and you are seeing this play out as we continue to take share. Today's healthcare environment is increasingly moving away from fee-for-service, and procedural selling is becoming more and more relevant. That means that shorter hospital stays are critical, and the increased adoption of minimally invasive techniques that NuVasive has pioneered will play an ever more central role in delivering better recovery time.

Our leading Lateral XLIF procedure alone is still massively underpenetrated, and there remain tremendous opportunities ahead to drive conversion to MIS as surgeons move away from traditional approaches with high morbidity. We know what it takes to compete effectively, and we are building a company ready to capture the opportunities before us. When you consider the possibilities of our computer-assisted IGA system or the potential of imaging and navigation technologies to allow for even greater surgical clarity and precision, or designing implants that uniquely fit the patient, at NuVasive, we believe we have barely scratched the surface of what can be achieved. With our focus on providing end-to-end procedurally integrated offerings that are truly differentiated, we intend to extend and own each aspect of the spine care continuum, from diagnostics on the front end to measuring clinical value on the back end and everything in between.

From a corporate development perspective, we are very focused on making moves to build capability along this spine care continuum. We have a very active pipeline that includes acquisition targets, strategic partnerships, and truly out-of-the-box thinking. Top priorities include opportunities that complement our technology leadership position in spine, targeted geographic expansion, technology that makes procedures even safer, as well as possibilities to further enhance our unique service offerings, just to name a few. We're going to use our deep industry knowledge around spine surgery to take advantage to not only convert surgeons but increasingly partner with the leadership of healthcare systems to help them develop highly competitive and profitable spine franchises. Through our service line partnerships, we intend to infuse our expertise to help hospital partners transform how spine procedures are approached, measured, and valued from a clinical and economic perspective.

Going deep into an account will allow us to pursue even more attractive agreements that include performance-based and risk-sharing relationships. Once consolidation narrows the playing field, there is no question that outcomes-based care is next, and we're ready. We have a clear vision of the future and are confident that we are managing our business today to meet the needs of tomorrow that will drive our next phase of growth and position us strongly in the evolving healthcare environment. Now, for more details on the quarter, let me turn it over to Quentin.

Quentin Blackford (CFO)

Thanks, Greg. We are extremely pleased with the strong results of our first quarter, which continue to demonstrate the building momentum in our U.S. implant business, as well as our continued commitment to improving our profitability profile. For the first quarter of 2016, growth in core NuVasive U.S.

Spinal hardware accelerated sequentially for the fifth time in a row, with the U.S. business hitting its highest growth level since early 2014. In addition, we delivered 150 basis points of non-GAAP operating margin improvement versus prior year, inclusive of the recently acquired NuVasive Specialized Orthopedics, or NSO. Let me run through some of the highlights driving our performance. As a reminder, the financial information that I refer to during the course of these prepared remarks will be on a non-GAAP basis unless noted otherwise. Please refer to today's earnings news release, as well as the supplemental financial information on our company website for further information regarding our non-GAAP reconciliation. NuVasive revenue, including the contribution from NSO, was $215.1 million, resulting in double-digit revenue growth of 11.8% as reported, or 12.3% excluding the impact of currency.

NSO generated $5.8 million of revenue in the quarter, which contributed approximately 3 percentage points to our overall growth rate on both the reported and constant currency basis. Our U.S. spinal hardware, which includes MAGEC and PRECICE, performed extremely well for the quarter and was up 15%, including roughly 3 percentage points of growth from the acquisition of NSO. Excluding the benefit of NSO, our core NuVasive U.S. spinal hardware revenue grew 11.6% for the quarter. As mentioned earlier, this represents the fifth consecutive quarter of increasing growth rates in our U.S. spinal hardware business, which demonstrates the building momentum of our IGA product platform. Notably, in the quarter, our core U.S. lumbar business returned to double-digit growth, growing more than 13%. Revenue from U.S. surgical support came in at $59.6 million, up 3.7% compared to the same period last year, primarily driven by increased volumes.

There was no revenue contribution in this category from the acquisition of NSO. Our OUS business performed ahead of expectations for the quarter, growing 16.7% on a reported basis or 20.7% on a constant currency basis. NSO contributed roughly 8 percentage points of growth for the quarter on both the reported and constant currency basis. Our underlying core NuVasive international business saw a nice acceleration in growth from the fourth quarter of last year to 12.5% on a constant currency basis. This was good in light of the fact that we recognized minimal revenue from Brazil during the first quarter, which resulted in Latin America being down meaningfully in the quarter. As we head into the remaining three quarters of the year, we would expect Latin America to begin to contribute to growth once again.

The growth of our core NuVasive international business was led by our Asia PAC and Europe regions, which realized growth of more than 23% combined, excluding the impact of currency. Japan, Australia, Italy, and Germany all contributed nicely to growth in the quarter, and we saw the U.K. return to near double-digit growth after refocusing our efforts in that market in the third quarter of 2015. The efforts we made in 2015 to reposition ourselves in our Western European markets are beginning to produce results. That, together with the fact that we will begin to operate on a direct basis in the Brazilian market for the remaining three quarters, has us feeling very good about our international business for the remainder of the year.

Importantly, on a pro forma basis, which would assume a full quarter of NuVasive and NSO revenues in both 2015 and 2016, our total revenue grew approximately 10%, or 10.6% excluding FX, as we outperformed our expectations to drive high single-digit growth with the addition of NSO. Turning to the rest of the P&L, non-GAAP gross margin for the first quarter was up 80 basis points year-over-year to 77.1%, improving from 76.3% in the same period last year, and was also up from the fourth quarter of 2015 levels of 76.2%. This year-over-year improvement was primarily driven by the temporary repeal of the med device tax of 70 basis points, while lower royalties and greater asset efficiencies, together with product-related transition costs, combined to offset in the quarter. Pricing pressure remained in the very low single digits at -1.2% and had a negligible impact on gross margin.

As a reminder, we did not realize any contribution from our in-house manufacturing initiatives in the quarter as those benefits are expected beginning in 2017. Non-GAAP SM&A expense as a percent of revenue improved 80 basis points year-over-year to 58%, down from 58.8% in the same period last year, which demonstrates our ongoing commitment to drive operating leverage from this particular area of focus. Notably, we saw nice leverage in SM&A from our core NuVasive business, which drove 210 basis points of improvement, primarily from greater asset efficiencies, which included leverage for better utilization of our instruments and back-office efficiencies. Partially offsetting these improvements was a -130 basis point impact from the higher spend as a percent of revenue that NSO realized. We increased non-GAAP R&D investment during Q1, with spending up 10 basis points to 4.9% of revenue, compared to 4.8% in the same quarter last year.

This was primarily attributable to investments being made in our NSO technologies as we continue to pursue the numerous opportunities available with MAGEC's unique magnetic drive mechanism. In addition, investing into core NuVasive also continues with investments into the IGA platform, as well as further efforts to expand our procedural offerings. In all, we are making great progress in our efforts to drive profitability improvements, with non-GAAP operating profit margins up 150 basis points year-over-year to 14.1% in the first quarter, compared to 12.6% in the same period last year. Excluding the impact of NSO, operating margins would have been up 340 basis points versus prior year, or at 16%. The improvement is meaningful and coming from the areas that present the greatest opportunities, both cost of goods sold and selling, marketing, and administrative expenses.

Most importantly, we are making this progress on the profitability front while at the same time accelerating the growth profile of our overall business. Moving further down the P&L, interest and other expense net on a non-GAAP basis was $3.8 million in Q1, up $1.3 million compared to the same period last year. This increase is primarily driven as a result of the new interest expense associated with the 2021 convertible notes we issued during the quarter and the incremental interest expense associated with our $150 million revolver, which was also established during the first quarter. I'll speak more to the refinancing efforts in a moment.

Now, turning to tax, as a result of the various purchase accounting impacts associated with the acquisition of NSO and our Brazilian distributor and accounting for the repurchases of 2017 convertible notes during the quarter, we realized a pre-tax net loss on a GAAP basis for the first quarter of 2016. As a result, we recognized an income tax benefit of $4 million on a GAAP basis for a GAAP tax benefit rate of 29.8% for the quarter. Adjusting for the items that we exclude for our non-GAAP results, we realized a non-GAAP effective tax rate of 40.6% for the quarter. First quarter 2016 GAAP loss was $8.9 million, or a loss of $0.18 per share, compared to GAAP income of $31.6 million, or earnings per share of $0.61 in the same period last year.

The variance of prior year was primarily the result of the new convertible notes issuance and repurchases of existing convertible notes during the first quarter of 2016 and the net litigation gains during the first quarter of 2015. Adjusting for the items that we exclude from our GAAP results, non-GAAP earnings for the first quarter of 2016 were $16 million, or $0.31 per share, compared to $15.1 million, or $0.30 per share in the same period last year. In addition, adjusted EBITDA margin, which excludes the impact of non-cash share-based compensation, was 22.5% for Q1, a 50 basis point decline compared to 23% in the same period last year as a result of the acquisition of NSO. Our cash and investments balance at the end of the first quarter was $331 million. For the quarter, free cash flow was strong at $39.1 million and included a $15 million tax refund.

Adjusting for this item, underlying free cash flow improved 50% versus the prior year, which was driven by reduced capital expenditures related to our corporate office remodel in the same period last year and lower instrument set investments. Now, I'd like to spend a moment walking you through the details of our convertible notes issuance in March. The purpose of this transaction was to execute a corporate refinancing that would provide certainty around our capital structure after 2021 with favorable economic terms, while also working in the best interest of our investors to eliminate the potential dilutive impact of our 2017 convertible notes, which had traded into the money on several occasions. We raised $650 million, including a $100 million overallotment option, which generated net proceeds of approximately $634 million.

The notes have a coupon rate of 2.25%, in addition to a callable feature that provides us the opportunity to control future dilutive impacts to our shareholders. In addition, we used the proceeds to put in place a bond hedge at a cost of approximately $66 million. It takes the effective conversion price from $59.82 to $80. Of the remaining proceeds raised, we used approximately $344 million to repurchase roughly 70% of our 2017 notes. We expect to use the remaining proceeds to make additional purchases of 2017 convertible notes and for general corporate purposes. In addition, within Q1, we decided to pay down the original $50 million draw on our revolver. We were very pleased with the outcome of the new debt offering and were opportunistic in our timing to take out the majority of our existing 2017 converts when the market pulled back.

In doing so, we achieved our goals of establishing certainty around our capital structure, extending maturities out to 2021, securing favorable economic terms, and addressing the dilutive impact of the majority of our 2017 notes. All in all, I couldn't be more pleased with how 2016 has started for NuVasive. Our revenue growth momentum is extremely strong, and we continue to make great progress on the operating margin front. We are moving quickly to fully integrate both NSO and NuVasive Brazil, in addition to enhancing our financial flexibility with our convertible notes issuance. We are driving the business hard and are confident about continuing our strong momentum throughout the year. That said, we will continue to be prudent with our approach to guidance. As a result, at this time, we are not updating our constant currency revenue expectations from our previous guidance.

However, to reflect the changing currency environment, we are increasing our revenue expectations on a reported basis to $928 million, up $5 million from our previously issued guidance of $923 million. We now expect our reported revenue growth to be 14.4%, and our constant currency revenue expectation remains unchanged at approximately 14%. I want to be clear, this is not a signal that we expect any of the momentum from the first quarter to materially change. Rather, our preference is to let the upside play through our numbers first and then revisit revenue guidance in Q2 or Q3, as we normally do. Turning to the rest of the P&L, due to the acquisition of our Brazilian distributor and our new capital structure, we are updating certain aspects of the P&L.

However, we are not changing our non-GAAP operating profit margin or non-GAAP EPS guidance for the year, only the buckets within. By acquiring our distributor in Brazil and moving to a direct model, we now expect gross margins to approximate 77.4% for the year, up 50 basis points from our initial guidance. In addition, we now expect our SM&A expense as a percent of revenue to approximate 56% for the year, also up 50 basis points from our initial guidance. Our expectation for non-GAAP operating profit margin remains unchanged at 15.8% for the year. The impact of issuing our new 2021 convertible notes, while extinguishing roughly 70% of the 2017 convertible notes, will result in an increase in interest expense of approximately $4 million for 2016.

This is reflective of the new interest expense associated with the 2021 convertible notes, the fact that we will continue to carry roughly $126 million of the 2017 convertible notes at a coupon rate of 2.75% for the remainder of the year, and a reduction in interest costs associated with our $150 million revolver. We now expect non-GAAP other income and expense to approximate $19 million for the year. Offsetting the impact of this higher interest-related cost on EPS is reduction to our weighted average shares outstanding, which reflects the elimination of the incremental dilution from the 2017 convertible notes that we repurchased. We now expect non-GAAP weighted average shares outstanding to approximate 51.3 million shares, down from our original guidance of approximately 52.5 million shares.

Our expectation for our non-GAAP tax rate of approximately 41% remains unchanged for the year, and the net result of all these changes is neutral to non-GAAP EPS, as we remain committed to our prior guidance of $1.48 per share. As a result of the acquisitions of NSO and our Brazilian distributor, as well as the issuance of the new convertible notes and partial retirement of the old notes, we now expect our GAAP tax rate to be approximately 63% and GAAP EPS to approximately $0.20 for the year. In summary, we are certainly encouraged with NuVasive's strong start to 2016. However, we are only three months into the year, and there is still a great deal to accomplish. We are actively managing integration of NSO and our Brazil distributor to ensure we optimize their contribution to our business going forward. We are very encouraged by our international performance.

Our plans are working, and we are eager to see our international growth plan continue to play out and drive even better results throughout the year. We continue to be disciplined in the management of our business and seek every opportunity to extend excellence throughout our operations and push our profitability even higher. With that, I'll turn the call back over to Greg.

Greg Lucier (Chairman and CEO)

Thank you, Quinn. It's been years since I participated on my first earnings call. Looking back over the past 12 months, I couldn't be more proud of our NuVasive family and how we've all grown and excelled together. We've adapted to change and minimized any disruption to our business along the way. We've attracted some terrific leadership to the company to bolster an already strong workforce.

We're operating now with better systems and processes, as well as having an operational excellence attitude that permeates the organization. We successfully launched IGA, our single greatest technology innovation since XLIF. And now we've added NSO and our Brazilian distributor as we look to extend our innovative leadership and expand our geographic reach on the way to reaching and surpassing $1 billion in revenue. It's been a phenomenal journey so far, but I would tell you we're really just getting started. With that, we'd be pleased to take any questions.

Operator (participant)

Thank you. We will now be conducting a question-and-answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue.

For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star keys. Please also note that we ask participants to limit their remarks to one question during today's Q&A session. One moment, please, while we pull for questions. Our first question comes from Matthew O'Brien with Piper Jaffray. Please state your question.

Matthew O'Brien (Senior Research Analyst)

Thanks. Good afternoon, and thanks for taking the questions. Quinn and Greg, I know you guys are trying to be conservative with guidance here, but we've seen other companies put up good Q1 results and go ahead and raise numbers for the year. I think it'd just be helpful if you could give us a sense for some of the areas that you're monitoring that potentially could lead to some weakness beyond what you're seeing here in a very strong first quarter, kind of across the board.

Then kind of roll within that question. Clearly, there's very good strength domestically in the spine market right now that we've seen from you and some of your competitors. Can you just give us a sense for what's going on here and what's seasonally a soft quarter and how you feel about the durability of the U.S. market throughout 2016?

Quentin Blackford (CFO)

Hey, Matt. It's Quinn here. We tried to make it clear in the prepared remarks. There's nothing that we're seeing in the business that we're trying to acknowledge or highlight as we think about the remaining quarters ahead of us. I think we're certainly very pleased and encouraged with what we're seeing. The momentum behind IGA is building. There's no question about that. At the same time, we're going to anniversary that launch here in the second quarter.

In our domestic business, the growth rates are going to start to get tougher, both from a lumbar perspective as well as a cervical perspective. While we feel good about the momentum we see, we're just simply not going to get ahead of ourselves 90 days into the year. There is not anything else that we're trying to signal in that. I wouldn't walk away from this trying to read into it. There is not a message that we're trying to send for you. Again, we're early in the year, happy with where we're at, but we're going to let this play out a little bit. In terms of the overall market, we've seen the results put up from several of the competitors, just as you have.

Again, I think it's a bit too early to speak to what might be playing out in the marketplace. We're 90 days off of where we ended last year, and I think there were some questions around Q3 and Q4 with the bigger players and how they were performing. Certainly, we saw one of those perform very nicely in Q1. I think it's a bit too early to say exactly what's going on in the marketplace, but from our perspective, it feels very good. Volumes are strong. Pricing environment's very healthy. We've been talking about this for a while. It seems there's more tailwinds out there potentially than headwinds, and hopefully, that's what we're starting to see play through. We're not going to get ahead of ourselves until we see that play out for a couple of quarters.

Matthew O'Brien (Senior Research Analyst)

Understood. Thank you.

Operator (participant)

Our next question comes from Richard Newitter with Leerink Partners. Please state your question.

Richard Newitter (Managing Director)

Hi. Thanks for taking the questions, guys. Maybe one question on OUS. Quinn, I think you guys acquired your Brazilian distributor, and that's probably going to result in some amount of revenue capture that we were not seeing previously. I guess maybe just what would be the logic for keeping the organic growth guidance constant, given the upside in the first quarter and the likelihood that you are going to actually see revenues creep in into the future quarters for that Brazilian distributor? Just how should we think about that as we model it?

Quentin Blackford (CFO)

Yep. We framed this up as we talked about the acquisition of that Brazilian distributor. I think historically, we have talked to the run rate in that business of being $1 million-$1.5 million a quarter.

Obviously, we acquired them at the very end of Q1, and you can do the math and come into a couple of million dollars of potential upside on the full year. At this point, again, 90 days in in that international business, we're working through some transitions that have performed nicely so far in Western Europe, but just working through some of these changes. It really comes back to us just waiting to see into the mid-part of the year before we come out and update expectations and just not getting ahead of ourselves. I would say the confidence in that international business is as high as it's ever been, and certainly even more so than where it was coming into the year after executing the acquisition of that Brazilian distributor.

Richard Newitter (Managing Director)

Okay.

Just to be clear, Quinn, I mean, it sounds like based on all else equal, there is absolutely nothing you are seeing in the business that would suggest that that should not be incremental to your previously and current guidance, OUS. For now, you are not ready to go and raise your guidance. You would like to give it another quarter. Is that a fair summary?

Quentin Blackford (CFO)

I think you are thinking about it the right way. I mean, obviously, we have played out our guidance. It is what it is for the full year, but we feel confident that Brazil is going to start to contribute. We were very clear in our prepared remarks. In Q1, there was no contribution from Brazil or very minimal, less than a couple of hundred thousand dollars of revenue. That will not be the case in Q2, Q3, and Q4.

Richard Newitter (Managing Director)

Okay. That is helpful. Very clear. Thank you.

Greg, one for you. You talked a little bit about this kind of continuum of care in spine. I know that you from diagnosis to measurement on the back end of spine kind of procedure results. We're seeing bundled payments kind of begin to take hold in April in hips and knees. There's some possible speculation that that kind of payment model could spread to spine. One, what are you aware of as to timelines or whether or not this is an initiative that is likely to hit the U.S. spine market anytime soon? Two, maybe just describe a little bit more clearly how NuVasive is potentially positioned with that continuum of care mentality to kind of service that kind of business model. Thank you.

Greg Lucier (Chairman and CEO)

In terms of formal bundled payments in spine, we see that happening, but probably not happening for a couple of years. That said, I would tell you the way we are approaching the industry and approaching customers is to essentially offer that already through procedural pricing and creating more of an even-priced approach to procedures and reducing the variability for the hospital. We are ready if it formally comes about and probably will be well-penetrated with what I just spoke about well before any formal bundling announcement. In terms of our preparation along the spine continuum of care, it is not lost on me that this is a surgery that when the patient is chosen right and the doctor is trained right, delivers incredible restoration of vitality to life.

We will, in subsequent earnings calls, certainly by the investor day at the end of the year, be sharing with investors what we're doing on the front end as well as the back end in terms of post-operative recovery of services and technology. We're just not going to do that here in Q1 just yet.

Richard Newitter (Managing Director)

Thanks.

Operator (participant)

Our next question comes from Kayla Crum with William Blair. Please state your question.

Hi, guys. Thanks for taking my questions. A follow-up on the international question. I mean, you suggested that some of your efforts in Germany and the U.K. are beginning to drive improvements this quarter. I don't believe even the U.K. was expected to rebound until later this year. I guess I'm curious specifically, what do you believe is driving, I mean, that earlier-than-expected outperformance?

Is it fair to assume that, again, I understand you're trying to be conservative, but that that international guidance specifically now represents more of a base case assumption at this point in time?

Greg Lucier (Chairman and CEO)

As we said to investors last year, we made a management change of our international business to a longstanding executive, Jason Hannon. We wanted to give him a couple of quarters on the ground to both change attitudes and change investment to get the right type of performance. If our investors would just hang tight with us, they would see international growth rebound to where it had been earlier. I think this first quarter is a good proof statement that we did as we said, and further, we've, I think, foreshadowed it gets better from here. Now, specifically, what's driven it?

I could tell you about the countries that continue to do well, but I think you'd be more interested in the inflection, that is, the changes. I would highlight Germany as a poster child of that. This is a business that has been flatlined for a lot of years for NuVasive. We flew in everybody who's responsible for Germany. We had everybody here in San Diego responsible to help them. For several days, we worked out an action plan very early on of what it would take to become much more profound and much more relevant in Germany. You're starting to see that play out. We're doing that country by country. It's intensive management. It's good management, and it's delivering the results. We didn't have that before. That's what I'd say is changing in international.

It's just much more aggressive management at a level of detail that we weren't operating the business at previously.

Okay. That's helpful. I mean, you've mentioned the intention to expand IGA into the cervical space in the U.S. and also extend the product reach internationally in Japan. Can you just give us an update in terms of where we're at in those processes? How should we think about those initiatives over the course of 2016? Should we still be focusing on the lumbar segment and just pull through revenues from there?

Yeah. The majority of the driver this year, Kayla, is going to be the pull-through in that lumbar segment. You'll see something in cervical over the course of the year. Lumbar is going to be the big driver at this point in time.

With respect to Japan, IGA is something that we're focused on, but that's going to take a bit longer. What you're seeing there is Reline being introduced into that marketplace over the course of the year. So you're getting the fixation system, but not yet the software capability on the planning and intraoperative reconciliation. So components are going into that market, but not all at one time.

Great. Thank you.

Operator (participant)

Our next question comes from Kyle Rose with Canaccord. Please state your question.

Kyle Rose (Director of Equity Research)

Great. Thanks for taking the question, and congrats on a good quarter. I just wanted to kind of dig in on the U.S. surgical support and other segments there. I mean, it came in a bit stronger than we were expecting.

Just wondered if you could talk about where the biologic business stands as of the Q1 2016, top comp in the prior year, but a good performance in this quarter. Also, how much of that is AttraX, and how should we be thinking about AttraX as we move through the year?

Quentin Blackford (CFO)

Yep. Good question, Kyle. Really, not any contribution from AttraX yet in the U.S. marketplace, which is where we were recently approved. We have sold AttraX internationally for a period of time, but no meaningful improvement in the contribution from AttraX just yet. You are looking at that being in the back half of the year before you are going to see a meaningful contribution. Within the surgical support, I would say biologics was down again in the quarter. It was certainly up against a tough comp of Q1 last year.

We should start the anniversary of that as we get into the remainder of the year. Biologics was down. Offsetting that was very strong growth in our disposable business of Neurovision or NVM5, which is really being driven by the services business. As you see our service business continuing to progress well, and there is incremental revenue coming from that, it generally comes from a disposable sale. That was up very meaningfully in the quarter, more than offsetting the biologics pressure that we saw. We were extremely pleased with what we saw coming out of what we call our IOS or that NVM5 disposable business and excited about what we are seeing there.

Kyle Rose (Director of Equity Research)

Great. And then just one quick follow-up. You have got the IGA initiative as well as the broader surgical planning software.

We've heard a lot in the industry about robotics and more specifically robotic-assisted pedicle screw placement. I guess, what are your thoughts on that market and that opportunity within the space? And do you have anything in the works to develop a product offering for that?

Greg Lucier (Chairman and CEO)

We believe that ever more sophisticated preoperative planning, imaging that integrates into these preoperative plans, navigation that actually can work in spine, which nothing really does today to the degree we think it needs to, and maybe down the road, robotics to place pedicle screws, although we would say that's kind of third on our list, are all technologies that we believe in. They'll come about, and you'll see them come from NuVasive.

Kyle Rose (Director of Equity Research)

Great. Thanks a lot.

Operator (participant)

Our next question comes from Jeff Johnson with Robert W. Baird. Please state your question.

Jeff Johnson (Senior Research Analyst)

Thank you. Good evening, guys.

Quentin, let me ask you a question, I guess, on margins. You did 150 basis points of operating margin expansion this quarter, still guiding to 40 basis points for the year. If I fully load Ellipse into the one Q, it looks like to me you still would have been over 100 basis points. Is there anything over the next three quarters that you need to highlight or call out from a margin perspective that we should keep in mind? Or again, are we just talking the conservatism like we're talking on the revenue side?

Quentin Blackford (CFO)

No. What you are going to see in that NSO business is a continued investment into that MAGEC magnetic drive mechanism and how we can expand the applications beyond just the current MAGEC and PRECICE portfolio.

We guided early in the year that R&D spend would accelerate up into the mid-5, 5.6% or so of revenue. We're still sitting down sub-5. You are going to see some incremental investment go into R&D. At the same time, I'll tell you the core business will continue to lever. We're focused on driving that leverage like we did in Q1. To the extent that we can pass that through the bottom line, we'll do that. Again, we're not going to get ahead of ourselves until we execute on that. There are some incremental investments we'll make, but at the same time, we're driving leverage hard in the core business.

Jeff Johnson (Senior Research Analyst)

All right. Any decision yet, or are you leaning one direction or another on how you think of the large joint business or the PRECICE part of the Ellipse field there?

Greg Lucier (Chairman and CEO)

We would tell you the reason we named it Specialized Orthopedics is we intend to be very specialized. In the pipeline, the team led by Ed Rorschach has a number of great ideas that will follow PRECICE. Big indications, but relatively specialized per the word in terms of the general orthopedic market.

Jeff Johnson (Senior Research Analyst)

Yeah. Greg, I guess my question was more the go-to-market strategy with that, with some of those new products or the current even products. You do that alone? You do that with a partner? Just any insight there?

Greg Lucier (Chairman and CEO)

The MAGEC technology is all going direct via NuVasive. Obviously, we have strong channel presence there. The PRECICE technologies and subsequent general orthopedic technologies, I think we're going to be open-minded about whether we want to invest and build out specialized channels or partner with some of the bigger players if they can take it into the market with real success. What we know for sure is we want to be a great design house. This actuation technology, I think, has a ton of multi-billion dollar potential markets. Again, we're not necessarily wedded to having to build out all of the channel ourselves to go attack them.

Jeff Johnson (Senior Research Analyst)

Thank you.

Operator (participant)

Our next question comes from Larry Bigelsen with Wells Fargo. Please state your question.

Hi, guys. It's Craig on for Larry. Thanks for taking the questions. Just one, first, I want to clarify. Did you guys have extra days in the quarter?

Quentin Blackford (CFO)

No. No extra days. Comparable days year-over-year.

Okay. Thanks.

On Ellipse, I think in the script, you mentioned that you saw your first case where MAGEC was used or Reline was used with a MAGEC. I just wanted to get a sense for the access. Are you getting improved access already from the Ellipse acquisition into surgeons that you previously weren't, that weren't NuVasive surgeons?

Greg Lucier (Chairman and CEO)

The answer is yes.

If I could just ask a follow-up on M&A, you guys kind of cleared up the balance sheet. The Ellipse deal is closed. I just wanted to get your thoughts on M&A priorities, any specific technologies. Are you willing to do a deal of size? Would you add any debt to do a deal?

As I said in the script, we laid out, I hope, a fairly clear filter of what we would be interested in relative to M&A, geographic expansion, value-added technologies, elements that expand our services offering to name three. In terms of those other hypothetical questions of adding debt or adding your question, would we put dilutive deal? I just want to be very clear. We are going to continue to be extremely disciplined in the deployment of capital. We have very clear hurdles of what we want on return on investment. I want to be cautious about adding too much debt. Our general philosophy is this is a phenomenal franchise growing very well. We do not have to do any deal, but we can do good deals that make it an even better franchise. That is the attitude we approach when we are doing M&A.

Okay.

Thanks for taking the questions.

Operator (participant)

Our next question comes from Matt Miksic with UBS. Please state your question.

Vicken Medazoumian (Director)

Hey, guys. This is Vicken from Matt. Thanks for taking the questions. A couple of questions for me. First, going back to Brazil, can you talk a bit about the revenues there and if it's just collections that are impacting revenue recognition or if there's also lower utilization? Can we expect some sort of a bounce back in the remaining quarters of the year? How should we think about the growth on a full-year basis now that the deal's completed? Secondly, on Ellipse and MAGEC, it's nice to hear that you guys are picking up some incremental hardware revenues. Can you walk through how you think about the opportunity here?

Is it initially with screws and then followed by a transition to rods to more conventional fixation systems? And if so, what's the timeline for that process? Thanks.

Quentin Blackford (CFO)

Yeah. In Brazil, we mentioned the fact that we did not see any contribution in the first quarter. That was really due to the fact that we acquired that distributor in the quarter itself. Anything we would have been selling into that distributor that would have been going into their inventory after we acquired them, we would have been reversing it right back out and netting that off against revenue. There was really no incremental revenue coming from the Brazilian distributor within the quarter. We acquired them very late in the quarter, so they had very little opportunity to contribute to our revenue over the last week or so that they were part of NuVasive.

Historically, we've talked about Brazil being $1 million to $1.5 million a quarter. That was under our distributor model. If we take them direct, that revenue stream obviously is going to increase as you now approach the customer directly and cut out the distributor margin, which we'll keep for ourselves. You can do the math based upon the old run rate and get into a pretty good sense of what that new business would look like. With respect to Ellipse, the initial contributions that we've talked about and that we've modeled into our guidance are primarily around the MAGEC and PRECICE products themselves. The incremental pull-through associated with the screws haven't necessarily been contemplated in our guidance. That's further out in our deal model.

Getting into 2017 and 2018 is where we would really expect to see some of that incremental benefit, although you heard Greg talk about the fact that we're starting to see some of that early on. We haven't contemplated that in our guidance at this point in time. I think you get beyond just the MAGEC product, the PRECICE product, the pull-through opportunities. It's the opportunity to get into a much bigger adult deformity market that we just haven't played in very aggressively. This starts to open up doors with relationships that get you into that final fixation procedure, at least on the MAGEC side of things that we haven't participated in much historically. That is close to what many people have put out there at a $2 billion market opportunity for NuVasive that we haven't competed in. That's where we start to get excited.

Operator (participant)

Our next question comes from Glenn Novarro with RBC Capital Markets. Please state your question.

Glenn Novarro (Analyst)

Hi. Good afternoon. A few questions. First, for you, Greg, I was wondering if you can talk a little bit about the competitive dynamics in the United States, especially as it relates to the number one player, Medtronic. The reason I'm asking is on the last call, Medtronic talked about recapturing share, rebounding. Now, they've been saying this for several quarters. I'm wondering if you're seeing any of that rebound in the marketplace from Medtronic. I had two quick follow-ups.

Greg Lucier (Chairman and CEO)

I think our results speak for themselves, the difference between rhetoric and reality. I would maybe add a little bit more color just to simply say, given our growth rates now, we're hiring aggressively. I'd say the hiring process of bringing people to NuVasive has gotten easier.

Hopefully, that provides a little color.

Glenn Novarro (Analyst)

Yep. No, that's what we're seeing in the marketplace too. Two quick follow-ups. One, Quentin, you called out a tough comp in 2Q created by IGA. But I thought IGA was more of a measured launch, and I did not think it had contributed much in the second quarter of last year. Can you quantify IGA, and do you want to offer any more color around why you mentioned a tough comp for 2Q? You guys acquired your Brazilian distributor. Are there other opportunities around the world to acquire distributors? Thanks.

Quentin Blackford (CFO)

Yeah. With respect to the IGA and the tough comp, there was not an intent there necessarily to point it out. The question was, is there anything that we should be thinking about over the remainder of the year?

All I wanted to highlight was just that in the lumbar business, in the cervical business, the growth comps do get more difficult over the remainder of the year, but not anything that creates significant concern for us. To your point, IGA was launched sometime around May last year and really started to contribute more in Q3 and Q4. However, RCON was launched back at the beginning of Q1. You did see significant ramping growth in Q2 with that product line. I would not say there is anything that we are trying to highlight in terms of concern that we want to create your awareness to. The question was just, what is out there that we ought to be thinking about? That was why we mentioned it. The second question, remind me of that question again.

Glenn Novarro (Analyst)

It is just on distributors.

You acquired your Brazilian distributor in one queue. Are there other territories around the world where you can also acquire distributors?

Quentin Blackford (CFO)

Yeah. We're direct in the majority of the countries we operate in. There are some smaller distributor markets that we have in Latin America and throughout the Middle East. Generally speaking, those are probably intended to be distributor markets for the long term. Brazil was the last large opportunity we had in terms of the size of the distributors we deal with. Brazil was a marketplace that was interesting to us to be direct, in large part because it opened up the whole public channel of that marketplace that we could not compete in. I would not say there is a whole lot of incremental distributor opportunities at this point in time.

Glenn Novarro (Analyst)

Okay. Great. Thank you.

Operator (participant)

Our next question comes from Josh Jennings with Cowen & Company.

Please state your question.

Josh Jennings (Managing Director)

Hi. Good evening. Thank you. Quinn, I was just wondering about you've reiterated operating margin guidance for the year. I know you're not going to provide out your guidance, but you've spoken about 20% adjusted operating margins. When the revenue base reaches a billion, you could get there at least close to that revenue target next year. Can you just help us think, or any incremental color you can provide, about the operating margin expansion trajectory as we get close to a billion dollars in 2017?

Quentin Blackford (CFO)

Yeah. The time that we talked about the billion dollars and 20% operating margin was at our analyst base at the end of last year. Our whole goal is to continue to drive that operating margin improvement. We're committed to getting to 20%. As a matter of fact, we're committed to getting to 25% over time.

What we're doing is accelerating the growth of that top line at the same time. Whether it's a billion dollars and 20% at the same time or if it's a year later, here and there, it's going to be right around the same time frame. We haven't given more specific guidance of exactly when 20% hits versus the last time we gave it, which was at our analyst day. What I would tell you is we talked about 100 basis points of core operating margin improvement per year. We've executed well ahead of that for the last two years. Last year was 400 basis points alone. Q1, the core business was about 330 basis points. We're committed to continuing to drive that kind of discipline in the business.

On a go-forward basis, once we get past this year of integrating NSO, we were pretty clear that you would see the improvement. That 100 basis points we've talked about would actually start to accelerate and become much faster. NSO is going to help contribute to that. Our in-house manufacturing that isn't benefiting us this year will start to do that in 2017. That's on top of the improvements we're already making. There are quite a few levers out there that will start to accelerate that 100 basis points a year that you've heard us talk about to something much greater.

Josh Jennings (Managing Director)

Excellent. Just my follow-up question is, on the core lumbar performance, clearly very strong in acceleration from Q4. Is it safe to assume that we're seeing a more meaningful contribution from hardware pull-through from the IGA launch in this first quarter?

Any help, even directionally, in just quantifying the impact of IGA, either sequentially or in the quarter, would be helpful. Thanks a lot.

Quentin Blackford (CFO)

Yeah. You're thinking about the contribution from IGA directly. The hardware pull-through that comes from the planning capability and the interoperative reconciliation is what's driving the results. I would also say that as we get into the specific details with our folks who are managing those product lines, Derek and Ross both articulate very clearly that the complexity of the cases are increasing as well. What historically might have been an average of two levels per case that we're doing from a posterior perspective or fixation perspective is now moving towards three. What that highlights to us is we're getting into more of those complex scoli cases, complex deformity cases, which is what IGA is targeting.

We're very pleased with the progress we're seeing. Clearly, the metrics internally that we're following are indicating we're having success in our strategy. We're not going to get into parsing out the details of the IGA contribution specifically, but clearly, you can see that playing through in the lumbar results.

Operator (participant)

Our next question comes from Jonathan Demchak with Morgan Stanley. Please state your question.

Jonathan Demchak (Analyst)

Hi. Thanks for taking the question. From looking at the results, I mean, clearly, it was a very good revenue and margin quarter, but the majority of the benefits on the margin side seem to come more from the asset and sales for efficiency side and less from international margins.

I mean, as international sales growth increases as it appears to have reflected on the quarter, is the expectation that some of the margin scale benefits as well as some of the tax benefits can flow through more in the near term?

Quentin Blackford (CFO)

You're thinking about it correctly. I would correct you. In Q1, it wasn't necessarily sales force efficiencies. The headcount efficiencies were really back office-driven, more G&A support functions, which is something that we are focused in trying to become more efficient with our processes. That's where we saw some nice improvements, but not necessarily in the sales force. We're investing heavily in that area and seeing some nice benefits from it.

With respect to international, with the lower growth in Q1, we did not see the benefit on the operating margin that we would expect to see as we get into the back part of the year and that growth starts to accelerate and we start to lever that business to a greater extent. To your point, as that happens, you do see opportunities in the operating margin tax rate to benefit as well.

Jonathan Demchak (Analyst)

Okay. Very helpful. Just one quick follow-up, I guess, bigger picture for Greg. When we have talked to a lot of device companies talking about the changing hospital customer, we have heard, I guess, a few lines of thoughts. One is that cross-selling is going to be more broad across segments. Another is that segment depth is going to allow broader agreements within a specialty.

The third is that hospitals are going to continue to be more product-by-product on a transaction basis, the way it probably has been for some time. From your commentary, it sounds like you're more of a depth within a specialty camp. Just trying to think of how you see the customer evolving and the sort of time frame it takes and if you're already seeing customers willing to be more broader purchasers.

Greg Lucier (Chairman and CEO)

Here are the level-setting facts about the spine business through the eyes of a hospital. It is one of the key questions I did a little research on before I decided to step off the board into this role. It turns out the spine business at a typical U.S. hospital represents somewhere between 15%-25% of their EBITDA. It is one of the best service lines they have.

The other reality, though, is that just because of the complex nature of running a hospital, not all of them can see it. When I look at that, I'd say it's also a business that's going in the right direction even from there. Demographics will lead to ever more spine surgery. We all want to live a more vibrant, vital life. To the extent we can make spine surgery more approachable, more minimally invasive, more spine surgery gets done. The bottom line is the conditions for a great business through the eyes of a hospital are there today, and they're even better tomorrow. As NuVasive, we're going to be laser-like focused on helping them make that a great business for themselves and for us.

I just fundamentally believe that focus wins, and we'll win all day long against other competitors that are trying to do something that is very difficult to do, which is combine economies across service lines to then get something done. I mean, I'll take our chances as being a focused company and winning in what is a very good business called spine.

Jonathan Demchak (Analyst)

Thank you.

Operator (participant)

Our final question comes from Mike Weinstein with JPMorgan. Please state your question.

Andrew Hanover (Analyst)

Thanks for taking the question. This is Andrew Hanover in for Mike. I just wanted to touch on Europe for a second. I recall that there was a time when NuVasive thought about leading with XLIF in the market. But given that this is much more of a traditional spine surgery community, it was a tough sale at the time. I know that the OUS business had a strong quarter.

Greg, now that NuVasive is returning back to strategy, how is this time different?

Greg Lucier (Chairman and CEO)

What you are seeing happen in the international business is procedural selling. I think XLIF is an example of procedural selling, but we have a lot of procedures now that we are a full-line spine company. What you're seeing different versus in the past was in the past, we would just be talking about XLIF primarily and then sometimes getting table scraps called pedicle screws. What you're seeing now, though, through intensive training, investment, is we're talking to clients overseas just like we do in the U.S., that you have to focus on procedures. Procedures will deliver better outcomes. I think we're just encouraged so far by what we're seeing in Germany and the U.K. You're also seeing us not a good head of ourselves for the year 2016.

We think it's going to continue on in a very good way. We have got a couple more quarters to prove that out to ourselves and to our investors. All right. With that, we will now bring the earnings call to a close. Operator, you can disconnect us. Thank you very much, everybody.

Operator (participant)

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