NuVasive - Earnings Call - Q2 2017

Transcript

Operator (participant)

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

Carol Cox (EVP of External Affairs and Corporate Marketing)

Great. Thank you, Kevin, and welcome to NuVasive's second quarter 2017 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 on Form 8-K with the Securities and Exchange Commission. We've also posted supplemental financial information on the IR website to accompany today's discussion. On the call, we will be covering information that is included in the investor presentation, and I encourage you to access these materials so that you may follow along.

Before we begin, 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 may affect future results as described in our news releases and periodic filings with the Securities and Exchange Commission. 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, marketing and administrative expenses, research and development expenses, operating margin, non-GAAP earnings per share, free cash flow, and EBITDA. Reconciliations to the most directly comparable GAAP financial measures may be found in today's news release and in the supplementary financial information, both of which are accessible from the investor relations section of NuVasive's website. Joining me on today's call are Greg Lucier, our Chairman and Chief Executive Officer, and Quentin Blackford, our CFO.

Greg Lucier (Chairman and CEO)

Thank you, Carol, and good afternoon, everyone. Today, we are in Dayton, Ohio, hosting our quarterly Board of Directors meeting and a celebratory opening of our state-of-the-art 180,000 sq ft facility with local officials who were essential in our decision to further build out our capabilities in the Dayton area. These officials, along with our board, received an overview of our newly installed equipment, digital capabilities, and learned more about the training programs we are implementing to ensure we have the advanced manufacturing skill sets required to produce ever more sophisticated designs with novel materials. I'm proud of our operations, engineering, R&D, and HR teams who have collaborated over the last 18 months to bring this project to life in record time. Before I cover the results of the quarter, I would like to say a few words about the organizational updates we just announced.

With incredible opportunities ahead, we are taking steps to refine our operating structure to tightly align strategy, product development, and marketing, and integrate our global commercial channels while scaling up our global operational capabilities as we cross over the $1 billion revenue mark this year and execute on our plans to expand the adjusted operating margins to 25% over time. As part of this optimized structure, Matt Link is taking on key leadership roles as Executive Vice President, Strategy, Technology, and Corporate Development, a newly created position to further drive NuVasive's innovation agenda. Matt, who has most recently served as our leader for US Commercial, is a long-tenured NuVasive veteran with extensive knowledge of the US marketplace and deep understanding of the spine industry, as well as surgeon and hospital dynamics.

There's no one better positioned to understand the needs of our surgeon customers as we continue to deliver technologies that drive surgical predictability. I'm also pleased that Pat Miles, Vice Chairman and member of the NuVasive Board of Directors, will be an advisor to this new function by providing his unique perspective on the innovations to create an unrivaled technology roadmap. This is in addition to his current focus on enhancing NuVasive's strategic plans for the future of spine surgery by supporting our myriad investments in emerging technology companies. We're also going to combine our US commercial and international sales functions into a global commercial organization. Skip Kiil, who joined us in early June to lead our international operations, is appointed head of global commercial.

Skip has more than 15 years of experience as a global business leader managing and growing complex global commercial enterprises, both internationally and domestically, within the healthcare and spine technology industries. I could not be more thrilled about him taking on these additional responsibilities. We are also elevating Steve Rozzo into an expanded role heading up our new global process transformation function, reporting to me. Steve is an experienced medical device leader, including more than 20 years with Zimmer Biomet. He joined NuVasive in 2015 and has led dramatic improvements in our supply chain and fulfillment capabilities, as well as the successful development of our new manufacturing facility here in West Carrollton, Ohio. I want to thank Jason Hannon for his countless important contributions during his successful 12 years with the company.

He has decided to step down from his position as President and COO to pursue other interests and will remain an advisor to the company for the balance of the year. We wish him the absolute best going forward. Unrelated to these organizational updates, Quentin Blackford has resigned to pursue another opportunity outside the spine industry and will remain with NuVasive until August 25th. I want to thank Quentin for his leadership in helping us focus on increasing profitability and becoming a more financially astute organization. I'm pleased to announce that Vicky Caps, in her role as an independent member of NuVasive's Board of Directors and a member of the audit committee, will provide guidance and support to our financial organization during the transition period. We have initiated a search for our next CFO, and Vicky will assist in that process.

Since becoming CEO over two years ago, I have been working with the board to build a world-class leadership team to support our five-year revenue growth and profitability goals. The actions I'm announcing today are part of that transformation effort and will position us well to take on the next $1 billion of growth. Now, let's turn to the highlights of our second quarter results. Revenue for the quarter was approximately $261 million, representing year-over-year growth of approximately 10% on a reported basis and approximately 11% on a constant currency basis. Our revenue performance, coupled with continued execution against our commitment to drive efficiencies and improve our core SM&A spend, drove our non-GAAP operating profit margin to 16.3%, a full 80 basis points higher than our guidance and 40 basis points of improvements year-over-year, resulting in a 15% increase in non-GAAP EPS to $0.46.

Revenue growth in the quarter was primarily driven by strong international sales with above-market growth across all geographies. In the U.S., procedural volumes were in line, on average, with our expectations for the quarter. Our results, however, were impacted by two dynamics specific to NuVasive, both of which I'll cover here and are within our control to improve. First, we continued to convert new surgeons to NuVasive during the quarter at a rate higher than we've ever seen, increasing new surgeon volumes by more than 20% year-over-year, especially those surgeons focused on posterior fixation as we gain traction with our RELINE Posterior Fixation system. That's the good news. We're building a deeper and broader foundation of surgeon customers and are gaining access to more procedures. Where we need to make adjustments is our ability to capture more of the entire procedure, not just a portion of it.

Today, we are not executing completely against the full procedural sale, and this impacted our second quarter revenue results, primarily in our biologics business, where we thought we would see sequential improvement from Q1. We see this as a short-term issue and one that is largely within our control where better execution and incentives for our sales force, aligned to a full procedural sale, will deliver results. Second, in NuVasive Clinical Services, where we are growing the number of procedures, we experienced a higher-than-normal backlog in billing during the quarter, which put pressure on the estimated reimbursement we could designate as revenue by about $1 million. We believe this is a temporary matter as we further integrate Biotronik into the combined NCS billing system. Several years ago, when NuVasive acquired IMI, we worked through a similar process to reduce the billing cycle time.

As we move into the second half of 2017, we expect our US revenue growth to accelerate from the growth rates we saw in the first half of the year with the introduction of new products, new surgeon business, and the impact of strategic sales reps we hired over the last 18 months rolling off their non-competes, all of which should give us good positive momentum heading into 2018. Innovation remains at the heart of what NuVasive does best, and we aspire to lead the industry by delivering technologies that move the spine industry closer to clinical and economic predictability. In the coming quarters, you will learn more about how we plan to expand our leading position in the lateral category, investing further in our flagship procedure.

Just like we did when we perfected lateral spine surgery, we have spent the last two years reimagining the entire requirements for trauma surgery of the spine. The result of that effort is now the launch of RELINE Trauma System, the most advanced, versatile trauma system on the market, designed to provide surgeons the flexibility to customize their approach intraoperatively, including traditional open, maximum access surgery, or hybrid procedures, depending on the pathology and patient needs. Seamlessly integrated with our IGA platform, RELINE Trauma allows for controlled fracture correction throughout the procedure with or without a rod present in the construct. Feedback from world-renowned trauma surgeons has been incredibly positive, and we expect to make solid inroads in the estimated $150 million a year US spine trauma fixation market.

Another new market we are entering is pediatric fixation with the launch of our RELINE Small Stature system, which is designed to work in conjunction with the Magic System adjustable magnetic growing rods, providing best-in-class care for early-onset scoliosis pediatric patients. As a low-profile pediatric fixation system to help minimize the implant-related revision surgeries, RELINE Small Stature is the first-of-its-kind system to offer competitively sized pediatric implants that accept a 5 mm rod, the largest nitinol rod diameter available in the space. Surgeons are using the system, calling it game-changing. In a little over two years, we have made meaningful gains in both the adult and pediatric deformity markets, a $2.5 billion opportunity. Last quarter, I talked about 3D printing. We have since begun clinical validation of our Modulus XLIF, a fully porous titanium implant created in a 3D-printed manufacturing process.

Our approach is differentiated from the rest of the market by using 3D printing techniques to alter the actual stiffness of the material to more closely mimic the properties of bone. The family of implants will increase in the coming quarters to cover not only XLIF, but also TLIF, ALIF, and ACDF. We already implanted nearly 100 surgeries with the XLIF Modulus implant, putting us on track for full launch later this year. In September, we plan to launch our new radiation-reducing and image-enhancing technology, LessRay. The system has undergone successful clinical testing with units out in the field for evaluation trials. We are extremely pleased with the feedback so far, including how the technology works and the level of radiation reduction it can help provide.

We are currently in the late stages of building out the units for commercial sale and have staffed and trained a capital sales force and clinical support team to manage the LessRay platform. As you know, this is a bit of a different sales cycle and a call pattern from our traditional spine hardware business. The capital sales force is partnering with our US commercial implant sales team on lead generation, and then we'll be responsible for hospital staff training and installation of the systems. It will be priced with options, including a capital purchase and a leasing opportunity to the hospital, as well as service and support agreements. As we move into 2018, LessRay will be integrated with our next-generation capital platform, becoming our committed real estate in the OR to address the increasing need for a more systematic approach to spine surgery.

This solution will include radiation reduction plus the additional capabilities of neuromonitoring, IGA technologies, navigation, and advanced imaging. Before I turn the call over to Quentin, I want to briefly address a new disclosure in today's Form 10Q filing. In June, we received a subpoena from the OIG in connection with an investigation into a possible false or otherwise improper claim submitted to Medicare and Medicaid. The subpoena seeks documents for the period January 2014 through June 2017, primarily associated with sales to a particular customer and relationships related to that customer account. We are working with the OIG to understand the subpoena scope, but do not expect to have greater clarity regarding the request for several months. We certainly intend to fully cooperate with their request.

As I'm sure you are aware, receiving an OIG subpoena is not uncommon in the medical device industry and, in many ways, is now a normal part of the business landscape. Here at NuVasive, we have a comprehensive compliance program in place, and I can assure you that we have an unwavering commitment to conduct all of our business activities in accordance with the highest standards of ethics and integrity. We expect to work through this process over the coming quarters and will provide any material updates as we have them. In closing, I'm encouraged by our results for the first half of 2017 and excited about the remainder of the year as we launch new products and drive momentum into 2018. Our international business is executing at all cylinders and delivering well above market growth.

In the U.S., our IGA platform is continuing to ramp, and we're making solid headway into the deformity market with RELINE and Magic, and I'm confident we can move faster in our efforts to capture the procedural sales model with our new surgeon customers. We are well-positioned to finish strong in 2017, crossing over the $1 billion revenue milestone and moving into 2018 with real momentum. Now, I'd like to turn the call over to Quentin to provide more details on the quarter.

Quentin Blackford (CFO)

Thanks, Greg, and good afternoon, everyone. Before we get started with the financials, let me remind you that many of the financial measures covered in today's call are on a non-GAAP basis unless noted otherwise. Please refer to today's earnings news release as well as the supplemental financial information on nuVasive.com for further information regarding our non-GAAP reconciliations. During the course of today's call, I will be referring to both reported and pro forma results. Unless specifically noted, all comments are on an as-reported basis. When discussed, pro forma comparisons reflect the results of the business as if Biotronik had been combined for the full reporting periods being referred to. For the second quarter of 2017, we reported revenue of $260.6 million, which reflects growth of 10.3% or 10.7%, excluding the impact of currency. On a pro forma basis, growth was 4.6% or 4.9% XFX.

Our US spinal hardware revenue grew at or above US market at approximately 3% year-over-year to $141.9 million. We continue to see strong adoption of the RELINE Posterior Fixation system within our IGA platform, leading to greater penetration in the deformity market. Also, as Greg mentioned, we saw strong uptake for our recently launched expandable interbody cages in our base TI interfixated within the ALIF procedure. Revenue from US surgical support came in at $72 million for the quarter, up 19%, primarily driven by the inclusion of Biotronik, which we acquired in July 2016. As we bring Biotronik together with our legacy services business, we are seeing the benefits of building out an at-scale operation. The addition of Biotronik has enhanced our service offerings and is providing greater market opportunities.

During Q2, our MVM5 conversion revenue grew over 40%, and the NCS organization significantly grew the number of hospitals that we have both the NuVasive hardware and services presence with. However, we also realized the impact of some integration challenges in the quarter as we relocated our billing and collection functions from Ann Arbor to Baltimore over the course of the first half of the year. As a result of the transition, we've seen our timeliness of billing and collections be pushed by roughly one month, which we anticipate impacted revenues by approximately $1 million in the quarter. These challenges are entirely within our control and are being managed appropriately with increased attention and resources to work through the processing backlog as a result of the transition. On a pro forma basis, our US surgical support revenue declined 2% due to soft results in biologics.

The delayed billing has also increased our DSO, which was at 66 days for the quarter. The increase in DSO over the prior quarter of approximately four days is almost entirely attributable to the NCS billing and collections backlog. In addition, the strength of our international business, which has a longer collection cycle on average, has created mixed pressure on our DSOs and has been partially mitigated by solid collections on the US hardware side. In Q2, international revenue grew 26% on a constant currency basis to $46.8 million, or 24% on a reported basis, with strength coming from all geographies growing well above market rates. This is the third consecutive quarter where our international business has posted above 20% growth, and we feel confident this type of growth will continue well into the future. We also anticipate continuing to look at opportunities to go direct in certain markets.

This is another indication of our focus to penetrate further into the markets we are already in, as well as seek opportunities to enter emerging markets over the next year. Measured investments in MEA over the last few quarters continue to provide strong returns as the region collectively led international with 33% growth on a constant currency basis. All key Western European markets saw above 20% growth driven by strength in the U.K., Italy, Germany, and Benelux. Our Asia-Pacific business also had a solid quarter, reporting very strong growth of 21% on a constant currency basis. We were pleased to see XLIF continue to regain momentum in Japan and experience solid sequential growth. In addition, we are also seeing nice strength in our posterior fixation business, and Southeast Asia posted nice growth as well at 17%, contributing to our overall positive performance in the region this quarter.

Latin America grew 25% on a constant currency basis, driven by nice performances in both Puerto Rico and Brazil, as they contributed significant growth in the quarter. Brazil delivered to our growth expectations, and we feel the growing pains of going direct in 2016 are now behind us. We anticipate this momentum will continue into the future. Now, let's turn to the rest of the P&L. Non-GAAP gross margin for the second quarter was 74.5%, down 330 basis points from the prior year. The lower gross margin profile of the Biotronik business that we acquired in July of last year had a 280 basis point impact to our year-over-year decline. Within that 280 basis point headwind was roughly 50 basis points of pressure created by the temporary billing and collections backlog mentioned before.

There was also a 30 basis point headwind related to inventory inefficiencies as we transferred production from our Fairborn facility into West Carrollton. As we continue to work through that transition, we anticipate that these headwinds will turn to tailwinds in the third and fourth quarters. Pricing pressure continues to be consistent from past quarters, remaining in the low single digits at negative 1.9%. Our efforts towards self-manufacturing remain on track with a tremendous amount of work going on in our new West Carrollton, Ohio manufacturing facility, as we add new equipment and train new employees. All of the phase two interior construction is finished, with the exterior construction projected to be completed by mid-August. We continue to ramp production within the new facility, having it machine nearly 80% more in Q2 than it did in Q1.

Non-GAAP SM&A expenses as a percent of revenue decreased 350 basis points from the prior year to 53.4% in the quarter, or $139.1 million. The lower SM&A spend profile of Biotronik contributed 230 basis points. Excluding the benefit of the Biotronik business, meaningful progress was made within our SM&A expense profile as it decreased 120 basis points from prior year as a percent of revenue, which was primarily driven by greater asset efficiencies related to freight and workforce productivity. Non-GAAP research and development, or R&D expenses, totaled $12.6 million in Q2 2017, compared to $11.9 million in Q2 2016. R&D expense was 4.8% of revenue for Q2 2017 versus 5% in the same period last year. Excluding the benefit of the Biotronik business, R&D expenses as a percent of revenue increased 10 basis points.

As we have communicated before, we expect R&D expenses as a percent of revenue to increase over the long term with a goal of investing approximately 7% of revenue on these efforts. Our path has not changed. We continue to make investments in key areas, including the NSO technology and efforts around imaging, navigation, and surgical automation, as well as continued improvement and evolution of the IGA platform. Second quarter non-GAAP operating profit margin was 16.3%, 80 basis points above the guidance we provided in April and 40 basis points above the prior year. Neutralizing for the various impacts of the different P&L profile of the acquired Biotronik business, we are making great progress in our efforts to drive efficiencies within the business and position the company for further operating margin expansion far into the future.

Second quarter adjusted EBITDA margin, which excludes the impact of non-cash stock-based compensation, was 26.2%, a meaningful increase of 90 basis points compared to 25.3% in the same period last year, reflecting the continued focus on improving the cash earnings profile of the business. Moving further down the P&L, interest and other expense net on a non-GAAP basis was $6.1 million in Q2, up from $5.6 million in the same period last year. Turning to tax, our non-GAAP tax expense in the quarter was $12.7 million, resulting in a non-GAAP effective tax rate of 35%, in line with expectations and reflective of our continued efforts to drive year-over-year improvement. As we have said before, we are committed to bringing our corporate tax rate down into the mid to high 20s over time, and we continue to make nice progress in that direction.

Second quarter 2017 non-GAAP net income was $24.1 million, and non-GAAP earnings per share was $0.46, compared to non-GAAP net income of $20.6 million and non-GAAP earnings per share of $0.40 in the same period last year. Turning to our GAAP results, GAAP net earnings for the second quarter of 2017 were $12.7 million, or $0.22 per share, compared to $30.2 million, or $0.57 per share in the same period last year. The year-over-year reduction is primarily due to the Medtronic litigation settlement that occurred in the second quarter of last year. Please refer to our earnings press release or the supplemental financial information file posted on nuVasive.com for further information related to our GAAP versus non-GAAP adjustments for our second quarter 2017 performance.

I would also like to point out, as many of you have seen in our filing with the SEC in May, we entered into agreements to terminate the warrants that we issued in 2011 in connection with the issuance of our convertible notes due July 2017 and the related bond hedge. When we repurchased some of our outstanding convertible notes last year, we intentionally did not unwind the related bond hedge due to the fact that the warrants would continue to be in place without any future protection against potential dilution. In addition, the warrants had a maturity date that extended out to January 2018 versus the bond hedge, which had an expiration date of July 2017. To ensure that the warrants did not sit outstanding beyond the bond hedge and create any potential dilutive impact, we negotiated their unwind to take place in the June and July timeframe.

As a result, we successfully let the underlying notes and bond hedge mature while unwinding the warrants with a less-than-expected net impact of 100,000 shares being distributed by the company, decreasing the anticipated dilutive impact to our weighted average shares outstanding on the year by roughly 500,000 shares. We are very pleased with the outcome and have eliminated any future potential dilution concerns associated with these instruments. With the first half of 2017 behind us, we are reiterating our full year 2017 guidance, which we shared during our earnings report out in February, with expected revenue of $1,065 million, which now reflects approximately $4 million in year-over-year currency headwinds and updated growth rates for both our international and US businesses.

Based on the performance of the business in the first half of 2017, we are increasing our forecasted growth rate for our international business to 26% or 29% on a constant currency basis and modifying our growth rate for the US business to 8%. Please refer to our supplemental information file on our website for greater details of the updated revenue guidance. We now expect gross margins of 75.6%, down roughly 50 basis points from our original expectations, as the stronger-than-anticipated performance in our international business has put some mixed pressures on our gross margin. In addition, we now expect that our SM&A expense will approximate 53.5%, down 50 basis points from prior guidance as we continue to execute ahead of plan with our operating expense efficiencies. We continue to anticipate non-GAAP operating margins of 17.1% and non-GAAP EPS of $2.

As you think about your financial models, I want to point out a few important dynamics impacting the second half of 2017. I know our guidance implies a significant acceleration in revenue growth as compared to the first half of the year, but as I walk through the items, it should be clear where we are expecting the acceleration in growth and why Q4 should have a greater growth rate than Q3. We expect revenue growth will accelerate in the back half of the year driven by stable procedural volumes, several new product launches, strong demand from recently launched products like TLX and MLX expandable cages, the impact of the new surge in conversions, and contributions from sales reps we have hired over the last 18 months beginning to come off their non-competes.

Also, in the third and fourth quarters of 2017, we are facing easier comps in the business than we did in the first half of the year. As a reminder, in Q3 2016, we did not realize much in the way of capital sales in the period, and in the second half of 2016, our results were negatively impacted by approximately $10 million as we were unable to sell XLIF in Japan for a portion of the third quarter and all of the fourth quarter. Also, as you build the launch of LessRay into your model, keep in mind that we plan to launch in September with the anticipated ability to recognize revenue from these September sales in the fourth quarter as we meet the accounting criteria for revenue recognition.

This slight shift out in the launch timing means that we will see estimated sales of about $2-$3 million be recognized in Q4 instead of Q3. We are extremely excited about the building excitement and demand of this unique and unmatched technology and have meaningful interest already expressed upon launch. As we close out our formal remarks, we are excited about the catalysts we see in the business in the back half of the year. Like Greg said, we see the challenges in the second quarter as temporary issues that are well within our control to change and improve fairly quickly. Like always, we are driving the business hard with a focus on operational improvements and efficiencies. We are very pleased with the strength we are seeing in the expansion of our non-GAAP operating margin and 15% growth in our non-GAAP earnings per share.

Finally, I'd like to touch on my decision to leave the company to pursue another opportunity. It's important for everybody to understand that in no way was this decision connected to any conflict or disagreements with Greg, our audit committee, or our board. I'm extremely grateful for the opportunity that was afforded me here at NuVasive and am proud of the financial direction that we have created for the company and the future ahead of it. Behind me is a world-class team that has been involved in the intricate details of our financial path, and I'm confident that you will see them continue to steward the organization down the path we've been heading for the last four years. I'd like to thank Greg, our board, and our entire shareholder population for allowing me to be part of this incredible journey.

With that, I'd like to open up the lines for Q&A.

Operator (participant)

Thank you. Now I'll be conducting a question-and-answer session. If you'd 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'd 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 that participants limit their remarks to one question during today's Q&A session. One moment, please, while we pull up our questions. Our first question today is coming from Matthew O'Brien from Piper Jaffray. Please proceed with your question.

Matthew O'Brien (Senior Research Analyst)

Good afternoon. Thanks for taking the question. Just to be clear, I guess kind of two questions bundled here into one, but just to be clear as far as the shortfall in Q2, you're saying that was entirely because of a weakness that you saw in your biologics business, and if that's true, my math is about $1 million in lost revenue. So on an annual basis, $4 million of lost revenue for a $100 million business. Is that right? Why would that turn around quickly, just given your portfolio of products? If I could sneak another one on top of that, the pricing that you're seeing, the pressure that you're seeing on the pricing side continues to get a little bit worse.

Is that a function of the lack of new products, or is this kind of the new level we should be expecting going forward?

Quentin Blackford (CFO)

Hey, Matt. This is Quentin here. On the biologics side of things, we were down roughly 7% in the quarter, which compares to roughly 6% in Q1. Our expectation was we would begin to see that turn around and be closer to flat coming out of the quarter and into the back half of the year. I think what you heard Greg touch on is our ability to capture that entire procedure. There's a bit of leakage there, which happens around the biologic portfolio, and it's probably more like $2 million-$2.5 million of potential impact in Q2. What you saw in the updated guidance by taking the US to roughly 8% is that you reflected that in the back half of the year, as well as some of the incremental softness on the procedural or hardware side of the business as well that we reflected also.

Now, offsetting that was the strength of the international business. We brought that up, and then we also reflected the currency rate. So biologics was part of that driver, and then part of it was the hardware side of the business. On the pricing side, I would say in the U.S., we haven't seen much change, but what you do see is with the strength of international, we've historically seen a little bit more pricing pressure in that international business, which a lot of times will be more commoditized product lines. We'll generally launch with the new products, new innovation in the U.S., and then the international will come behind that. As international is a bit higher in terms of its overall contribution to our total company's revenue result, you get a bit higher mix or, sorry, price as a result of the mix.

Matthew O'Brien (Senior Research Analyst)

Got it. Thank you.

Operator (participant)

Thank you. Our next question today is coming from Richard Newitter from Leerink Partners. Please proceed with your question.

Richard Newitter (Managing Director)

Hi. Thanks for taking the questions. I wanted to just start with I might have missed it. We're juggling a couple of calls here. What is the kind of the trend in the underlying core spine business? If you could just kind of catch us up with respect to the January, February kind of softness you had seen earlier in the year, where are you now relative to that? What's the actual growth rate of the market? Where would you say you are relative to that market rate for your core spine business in the US?

Greg Lucier (Chairman and CEO)

Right. So the fidelity of our analytics on the overall market has some squishiness to it, like anyone looking at this market, because there's no real published rates. Our general view is that the market might be a slight down check softer here in 2017 than in 2016. I do believe, I think we believe as a company that there is an incremental move to a back half of the year type business due to high deductible plans. Remember, most of these surgeries that we do are elective. At the margin, yeah, the market's probably a little bit different than it was in 2016. I don't know, Quentin, if you want to add anything there.

Quentin Blackford (CFO)

No, I think that's accurate. I think in terms of the results of our hardware business, we've seen relatively consistent results in Q1 and Q2 with the hardware somewhere around 4-5% on average throughout the first half of the year.

Richard Newitter (Managing Director)

Okay. Thanks. That is helpful. Maybe just second, Quentin, with respect to LessRay, I just want to make sure that because this is a very important product cycle for you guys. I just want to make sure I'm hearing correctly. You plan to launch in September. Due to revenue recognition criteria, you won't recognize whatever revenue you generate in September or the third quarter, really, until the fourth quarter. I heard you give a $2-$3 million number in there. Is that LessRay revenue that you're anticipating in your guidance for 2017 all recognized in Q4? Or did I mishear that? Is that the right way to think of the ramp in LessRay?

Quentin Blackford (CFO)

Yeah. I would tell you from an accounting perspective, the challenge you run up with is these units have a setup period of time. You are going to place them into the accounts, and then you are going to bring a team in who is going to train and set up the product to be used. You are really not able to recognize the revenue until you get to the point where the machine is usable by the staff there at the hospital. We are accounting for a short period of time, a couple of weeks in there that we anticipate we will be required to train and get them up to speed on being able to use it. That will enable us the opportunity to recognize the revenue. With the launch happening in September, we anticipate most of that falls into Q4.

The comment we made around that was there was about $2-$3 million that originally may have been in Q3 that will go into Q4. That would represent some of the pent-up demand upon launch, which there's a lot of interest right now, and we're confident we'll have that demand when we launch. The normal run rate will settle down from there.

Richard Newitter (Managing Director)

Okay. Sorry, just to follow up on that. The $2-$3 million was purely just whatever LessRay revenue you earmarked for 3Q gets shoved into 4Q, and then whatever else you can do in 4Q is in addition to that.

Quentin Blackford (CFO)

Yes. You would have a bid in addition to it. Yep. That's right.

Richard Newitter (Managing Director)

Okay. Great. Thank you very much.

Operator (participant)

Thank you. Our next question today is coming from Matt Miksic from UBS. Please proceed with your question. Hello, Matt. Your line is now live. Perhaps your phone is on mute. Mr. Miksic, your line is now live. Perhaps your phone is on mute.

Greg Lucier (Chairman and CEO)

Next question.

Operator (participant)

Our next question today is coming from Kaila Krim from William Blair. Please proceed with your question.

Kaila Krum (Senior Research Analyst)

Hey, guys. Thanks for taking my questions. First, as it relates to the leadership changes you announced, I mean, first, I guess you're integrating your US commercial and international sales functions into a global commercial organization. I guess can you talk a little bit about the strategy there, I guess why broaden the role in that way? Then recognizing that you're reiterating guidance, how are you thinking about potential dislocation in the sales force prompted by that leadership change?

Greg Lucier (Chairman and CEO)

Let me take a moment to expand your question and talk about the organizational changes. Where I want to first start is not the sales force, but upstream of that in the creation of this new function, strategy, technology, and corporate development. I think it's important for investors to realize an incredible transformation that has begun to take place inside NuVasive from, call it, three years ago. Three years ago, this company was essentially a lateral company, an XLIF company. Now here, three years later, as we pass through a billion, we have a much broader innovation agenda. By creating this capability where our strategy team, our technology teams are linked together, we think we're going to have a lot better planning process, cadence to the launches that we're doing to match up to key contracts we have with customers through the course of a year.

That is the synchronization we are looking for, and that is the job that Matt Link is going to take. In terms of your question then of the sales force, as we try to get to higher revenue and more profitability, there are some great economies that we can capture by merging together the support functions of international and US. Sales operations is an example. There was an earlier question on pricing. We are creating a much broader pricing capability all over the world now under a single leader. That is how we intend to both capture best practices and the efficiencies of bringing those two organizations together. Lastly, let's talk about sales disruption because actually we do not see any of that happening. Here is the reason why. Skip Kiil has been known to the international teams for the last 45 days or so.

Even before that, became an official employee. He was on garden leave and had begun to meet some people just informally. In the U.S., what we did announce in the press release is a promotion of one of our finest U.S. leaders, incredibly well-respected, named Paul McClintock. Paul has led the West for us, incredibly successful sales leader. He'll be moving to San Diego to take on the U.S. commercial team. I will tell you that just preliminary feedback has been overwhelmingly positive about Paul's elevation. That explains what we're trying to do, trying to create a better cadence to the organization, try to capture some efficiencies with well-known people inside the organization.

Kaila Krum (Senior Research Analyst)

Got it. Okay. That's helpful. Thank you. Then I guess just to follow up on LessRay, when I think about LessRay longer term, and I know we're all starting to get excited about the first-generation system, how do you see LessRay evolving from this first-generation platform? Because you mentioned navigation. Is there an opportunity to potentially sort of integrate that within LessRay or even potentially add a robotics arm to it longer term if that's ultimately where the market takes you? Just want to learn more a little bit about the vision you have from that perspective.

Greg Lucier (Chairman and CEO)

LessRay is an important technology that can stand on its own, and that's what we're launching this year. As I inferred through the other comments, we have a series of other capital technologies under development that we'll launch next year. All of them will be able to be sold standalone or integrated together as we try to create a more systematic approach to spine. We're fundamentally believers in better imaging technology with less radiation because when you look at one of the primary drivers for anyone even thinking about robotics, which again, our fundamental view is anything on the system today, on the market today, doesn't really address the fundamental requirements, is radiation reduction. LessRay is an important part of that.

As I say, it's one part of a broader technology platform coming about, and we couldn't be more excited about being on the front end of this technology curve.

Kaila Krum (Senior Research Analyst)

Thanks, guys.

Operator (participant)

Thank you. Our next question is coming from Matt Miksic from UBS. Please proceed with your question.

Matt Miksic (Executive Director)

Hi. Sorry about that earlier. Thanks so much for taking the question. Just one, and I've been hopping back and forth like a lot of folks. I don't know, Greg, if you've spoken about this or Quentin, but there is a sense that the market in the U.S. has been a little bit tougher and not terribly so, but maybe payer, maybe utilization, maybe down to pricing. Your thoughts on what you're seeing in the market? Is it incrementally more challenging and why? I had one follow-up.

Greg Lucier (Chairman and CEO)

Yeah. As I said in an earlier question on that point, we think at the margin that's probably right. I don't think anybody's fidelity of their analytics can fully say for sure. Again, our basic knowledge base based on a few different data points is that 2017 is softer than 2016. Pricing is not any different. It's important. It's really more at the margin volumes. It could be one of two things, perhaps more. The one of two things that we think could be the high deductible plans have pushed the business more towards the second half of the year because these are all mostly elective surgeries that we do. Secondly, I think insurers are getting tighter in their standards for review of surgical appropriateness. We actually think that's a huge opportunity for technology.

As you work through that, you're seeing probably a little higher case of denials or at least temporary denials as the physicians are working through getting their approvals. At the margin, yeah, I think 2017 is a little softer than 2016.

Matt Miksic (Executive Director)

Okay. And then on follow-up, and I apologize for sort of the two parts of this question, but I'd love to understand what's working. It appears to be working very well OUS. And then just a follow-up to the question just now on LessRay, the business model for LessRay, I wonder why sort of a capital consumable element of a platform like this isn't something that you're talking about or at least considering given what you have in LessRay.

Greg Lucier (Chairman and CEO)

Versus what? If I could understand the question.

Matt Miksic (Executive Director)

Just in terms of just capital sales. In other words, just a straight-out sale versus something that is interwoven with your implant business in a way that some of your larger competitors are doing, frankly.

Greg Lucier (Chairman and CEO)

Oh, yeah. Just to be clear, that will be certainly the model we pursue. There are some customers who want to do a capital sale outright. We will have a variety of flavors to merchandise that particular technology. I'm sorry. Just remind me again on the first part of your question.

Matt Miksic (Executive Director)

The first part was just international. Just what.

Greg Lucier (Chairman and CEO)

Oh, what's working.

Matt Miksic (Executive Director)

Yeah. Exactly.

Greg Lucier (Chairman and CEO)

Exactly. Look, let's step back. I think the company is executing pretty darn well. As Quentin pointed out, the EPS is up 15%. We've got double-digit growth going across all geographies now internationally. The technology pipeline is incredibly robust. That said, there's always things we can do better. The analytics around what's going on in the US in terms of capturing this incremental dollar amount per procedure, look, we're not being in any way untransparent. We've got to figure out a better approach to biologics. Some of that may be actually obsoleting biologics through new materials of the implants. All companies have their smaller challenges. We've got a few of our own.

I want to convey to investors that we feel pretty darn good about our execution, but we feel even better about the plans going forward of what we're going to do next.

Matt Miksic (Executive Director)

Thanks.

Operator (participant)

Thanks. Our next question today is coming from Matt Taylor from Barclays. Please proceed with your question.

Matt Taylor (Business Relationship Manager)

Hi. Thanks for taking the question. I guess I wanted to try to reconcile your comments about the new surge in acquisition being at an all-time high and having some kind of lower results in the quarter. Maybe you could just help us understand when you talk about the 20% new surge in growth, what percentage of your customers is that, or how does that compare to a normal quarter?

Quentin Blackford (CFO)

Hey, Matt. This is Quentin here. The comment around the new surge in acceleration is quarter over quarter, we continue to see the number of new surgeons working with NuVasive increase at that clip, which we mentioned roughly 20% in Q2. That could be them doing two or three cases with us, or it could be 10 or 20 cases with us. It just depends on what the mix of that looks like on any given quarter. What you see when that happens is you typically do not get the entire procedure with that new surgeon. As you introduce RELINE with IGA, for example, you may get posterior fixation, but you are not getting the cage or you are not getting the biologic. The revenue per procedure is not as great as what you might have from an existing customer, if you will.

While we're very happy with what we're seeing happen or occur in the new surgeon portion of our business, and we've identified incentives to really target that, and it's having a great result, where the weakness is coming from, and Greg mentioned this a little bit, is the slippage around holding the entire procedure across the business where you start to lose some of the biologics revenue per procedure, or maybe you start to lose a fixation component of a procedure that you historically had. It's primarily around biologics is what we see. The challenge is just when you bring these new surgeons in, they come in with less revenue per procedure than what you normally would see in the business.

Matt Taylor (Business Relationship Manager)

Thanks for that. One just clarification point on the biologics capture that you're talking about. You have had a pretty decent conversion of biologics in the past, and it seems like this capture issue has increased over the last two quarters. Has there been some kind of change in terms of incentives or, I guess, the mix of customers? What's really the reason that you're not having as good capture now as you did, say, two or three years ago?

Quentin Blackford (CFO)

Yeah, Matt. To be very specific, we used to see kind of that capture rate up around 70% of our own procedure using our biologics. What we saw in Q2 was roughly around 63%. I think the only thing that's really changed in the first two quarters of the year is Infuse certainly has a specific indication that's now out around use with their procedures. I have to imagine that's having a bit of traction and probably impacting our results a bit. We've got some things in the pipeline that we'll talk about more into the future that can start to combat that. There's some other growth channels in biologics that we can explore as well as we bring a new leader on board. I'm sure we'll start to get more focused in that area. There's some things we can do to return that to growth.

That's what we're seeing right now in the quarter.

Matt Taylor (Business Relationship Manager)

Okay. Thanks very much for the comment.

Operator (participant)

Thank you. Our next question today is coming from Andrew Hanover from JP Morgan. Please proceed with your question.

Andrew Hanover (Equity Research Analyst)

Thanks for taking our question. I just wanted to go back to the volumes and insurance delays. Greg or Quentin, are there particular parts of the U.S. where you're seeing some of the volumes or the insurance delays? Are you seeing it across all the U.S., or is it in areas where you're seeing some of these insurers pull out of certain regions?

Greg Lucier (Chairman and CEO)

I think having a statement that it's insurers pull out of regions, that would be far extreme of what we're talking about. In terms of surgical review by insurance companies, it is standard for them to review it, check for its appropriateness, and then double-check for it. All I was inferring to is at least notionally, we've heard here in 2017, the payers are tightening that up evermore. That will afflict everyone virtually in every region in the country. I don't think that's going to be just a spine issue, quite frankly. That's a healthcare issue. What we were talking about earlier in terms of our work with payers in terms of our NuVasive Clinical Services business is a problem unto ourselves and relates completely to the integration of the back offices of Biotronik and the NuVasive Clinical Services business.

As Quentin said, we're going to get past that. We're already working through that here in third quarter, and that will not impact our results going forward.

Andrew Hanover (Equity Research Analyst)

All right. And then one last one, which is a little bit broader, but a big part of the investment thesis on NuVasive has been re-acceleration of the top line as well as margin expansion. You have a bunch of changes right now. How can you give investors confidence that these changes won't impact that margin opportunity moving forward? In terms of the top line, you have LessRay, but you also have a number of sales reps coming on board. Maybe this part is for Quentin. How should we think about the contribution of those sales reps in the back half of this year?

Greg Lucier (Chairman and CEO)

Let me start with the first one, then I'll give Quentin the chance to answer the second part of your question. If you look at our business, we're executing pretty darn well on the margin expansion. I think, as Quentin said earlier, his team, the teams across the world are doing an extremely good job managing to a new level of effectiveness and efficiency. I don't see that changing at all. I think we're feeling pretty good about that. We're also feeling pretty darn good about our international momentum. As I said, this is not just any one particular geography. This is all geographies. We feel very good about our ability to continue to expand outside the United States. In the U.S., look, we're still growing. We think faster than the market, taking share.

I think that'll be further proven in the second half of the year. Again, we think we have a number of factors that will drive that. One in particular is the second part of your question around competitive reps coming off and things of that nature. Quentin, why don't you maybe get into that?

Quentin Blackford (CFO)

Yep. Andrew, I think your question was specifically around kind of staffing up for the launch of LessRay. As we continue to bring these reps on, how does that jive with the margin expansion plans that we have? I will tell you, all of that is factored into the plans that we've already laid out. We've been accelerating the pace of hiring for a little, well, I guess roughly a year now. That's already kind of been baked into our run rate, and we'll continue to be contemplating heading into the future. I think the one thing around LessRay and this whole idea around a capital sales force, this isn't a large sales team of 50-100 people that we're going to be dropping into the commercial channel immediately. This is something we'll grow into over time.

Instead, we'll generate leads with the local sales reps that are there today, and then we'll take the capital sales team or these experts that we've put in place, and they'll come into these local regions and really close out the sell for us and then work on implementing the product. It is not a huge investment in the way of incremental heads before a revenue curve comes. I would imagine as revenue starts to ramp in this, you'll see us continue to expand that sales team as well.

Andrew Hanover (Equity Research Analyst)

Thanks. And good luck, Quentin.

Operator (participant)

Thank you. Our next question today is coming from Kyle Rose from Canaccord Genuity. Please proceed with your question.

Kyle Rose (Director of Equity Research)

Great. Thank you very much for taking the question. Just quickly wanted to get a little bit more color. Greg, you talked about changing some of the incentives in the back half of the year for the sales organization, specifically focused on driving more of that procedural sale and the biologics revenue there. Can you just talk about how we should think about that and what that really looks like there? Quentin, I wanted to see if we could get a little color on the NSO business in the Q2 and how we should think about that business in the second half of the year.

Greg Lucier (Chairman and CEO)

In the last 18 months, we created an incentive structure to drive the adoption of new surgeons to NuVasive because one of our problems we had two-plus years ago was a concentration of revenue in too few of surgeons. I think we've done a great job getting what we wanted. Now we've got to be even more explicit that we've got to drive the dollar per procedure up with all surgeons. I'm not going to get into the incentives. I think it's fairly straightforward of what the problem is or the opportunity is in this case. That's what's going to be Paul McClintock and the rest of the team's job here in the second half of the year.

With respect to the NSO business, I would say through the first six months of the year, that continues to perform the way we would have anticipated. Very pleased with what we're seeing on the Magic side as we continue to integrate that into our commercial channel in the U.S. And Precice, I think we remain as bullish as ever around the opportunities that are present there. Our view has not changed on NSO at all and happy with where that's at through the first six months of the year.

Kyle Rose (Director of Equity Research)

Great. I appreciate that you can't comment too much with respect to the OIG just because it's still early. You mentioned it specifically deals with one customer in the relationships there. Can you give us any idea as far as the size and the scale of what that customer represents?

Greg Lucier (Chairman and CEO)

No, we can't do that. I just, again, want to put it in context that we feel very good about our compliance programs. We're going to respond to the subpoena, and we'll work through it in a workman-like fashion. Regrettably, this seems to have become part of being in the medical healthcare world. Again, we'll deal with it in due time. Just rest assured, the board's been briefed on it. The legal team is on it, and we'll get through it.

Quentin Blackford (CFO)

Kyle, just to add to it, if it was anywhere near a material contribution to the revenue stream of the company, we'd be disclosing that and talking about that in our Qs and our Ks. That should give you some sense of it not being a significant material item.

Kyle Rose (Director of Equity Research)

Understandable. Thank you very much, and best of luck, Quentin.

Operator (participant)

Thank you. Our next question today is coming from Jonathan Demchick from Morgan Stanley. Please proceed with your question.

Jonathan Demchick (Executive Director)

Hello. Thanks for taking the question. Quentin, I just had a—you mentioned some of this in the script, but given the mid-single digit growth in the first half, guidance is pointing to obviously a pretty significant uptick in the second half of the year. You mentioned a handful of drivers. I mean, I was hoping you could maybe help us think about some of the main ones and the magnitude of those, and then also really what's being assumed in guidance for any sort of biologics recovery or procedure growth into the back half of the year. Thank you.

Quentin Blackford (CFO)

Yeah. So let's maybe think about it this way. Coming through the first six months of the year, the business is growing on a pro forma basis, right in that 5.5%-6% range. If you look into the back half of the year, you have several things that are going on. There's a lot of the new product introductions that we've talked about, including the expandable cages and the LessRay technology. You've got the contribution from new reps and the new surgeons working with us as well. I think if you start to realize and go back to 2016, the comps are going to get meaningfully easier for us.

Recall that in Q3 of 2016, we did not have any capital sales represented in the number in the US, and we started to pull back the XLIF product out of Japan in Q3 and then had it completely off the market in Q4. Between those two items was roughly $13 million or so of revenue that was not in the base. You have a much easier comp to where if you started to normalize it all, you get to roughly 3% of a potential benefit in your growth rate in the back half of the year. Our guidance would imply that we need to grow somewhere around 9%. Now, to be fair, we have one less selling day in Q3 this year than we did last year. You are going to have a little bit of a headwind to that.

We did have the Magic order in Q4. Even if you net all those together, you're still going to get a net contribution just from an easier comp of roughly 2%. You can take the 6% that we're at in the first half of the year. You're going to get 2 points of incremental benefit just from these items that are easier comps netted together. That gets you up around 8%. Our guidance is at 9%, which that 1 point would come from all these new product introductions and LessRay and the new surgeons and new reps. I think when you start to really get into the details, you see it's pretty achievable and really understandable.

Jonathan Demchick (Executive Director)

Thank you. That's really helpful. I just wanted a quick follow-up on, I guess, the biologics and procedure side. I mean, those were, I guess, some of the weaknesses in this quarter. What's being assumed in those as you kind of look into the back half of the year?

Quentin Blackford (CFO)

Yeah. We've dialed that down to where we're running at in the first half of the year. So we were down 6-7% between Q1 and Q2, and the full year now expects that in the biologic portfolio.

Jonathan Demchick (Executive Director)

Understood. Thank you very much.

Operator (participant)

Thank you. Our next question today is coming from Joanne Wuensch from BMO. Please proceed with your question.

Joanne Wuensch (Managing Director)

Thank you very much for taking the question. It's been a busy evening. Briefly, on gross margins, maybe I missed it, but did you give a full-year gross margin guidance, and how do I think about a recovery from this level?

Greg Lucier (Chairman and CEO)

Yep. Full year, we're expecting 75.6% is what we guided to. That compares to, call it, 75% through the first half of the year. We've always been pretty clear. We would expect that there'd be incremental contribution coming from the ramp-up in our new manufacturing facility here in West Carrollton. You'll see the back half of the year, I think, get closer to that 76-76.5%, which will get you there on the full year.

Joanne Wuensch (Managing Director)

Does LessRay add on top of that 76, or is that inclusive of some LessRay revenue?

Greg Lucier (Chairman and CEO)

That's inclusive of some LessRay revenue.

Joanne Wuensch (Managing Director)

Okay. Quentin, sorry to see you move on, but I suspect I'll be talking to you again soon. Could you please tell us a little bit about the search for your replacement?

Greg Lucier (Chairman and CEO)

Let me handle that one. I won't put you on the spot, Quentin. I would tell you that we have a robust pipeline. It's a great role. Quentin has created a really strong foundation for someone to step into and build from. I anticipate we'll be able to announce a successor here, not in a too far time frame.

Joanne Wuensch (Managing Director)

I take it it's already begun.

Greg Lucier (Chairman and CEO)

Just like we do with everything, cheetah speed.

Joanne Wuensch (Managing Director)

Thank you very much.

Operator (participant)

Thank you. Our next question is coming from Craig Bijou from Wells Fargo. Please proceed with your question.

Craig Bijou (Senior Analyst)

Hi. Thanks for taking the questions. Quentin, I wanted to see if you could provide maybe a little color on the lumbar and cervical business within spinal hardware for you specifically. And then with some of the comments on the market, is lumbar or cervical being focused more? Are either one of those getting more denials than the other?

Quentin Blackford (CFO)

I would say no, not cervical versus thoracolumbar in terms of one category being focused on more than the other. I would say mid-single digits is the way to think about those two product portfolios.

Craig Bijou (Senior Analyst)

Okay. Thanks. And then just in terms of given the market commentary or that 2017 is going to be slightly worse than 2016 and the high deductible potentially being one of the reasons, do you guys expect the market is included in your assumptions is market acceleration in the second half? Is that something that's a basis for your expectation?

Quentin Blackford (CFO)

No. Again, we think the seasonality of the business is changing a bit. Obviously, we'll know more in the second half when we have a conversation in December. We don't think the underlying market changes per se when you look at it in totality for the year. We think maybe, though, there'll be more procedures than historically than we had, let's say, in the fourth quarter. We'll see. That's kind of what our gut tells us right now. No market acceleration, though, if you look at the year in total.

Craig Bijou (Senior Analyst)

Okay. Thanks for taking the question.

Operator (participant)

Thank you. We have reached the end of our question and answer session. I'd like to turn the floor back over to management for any further closing comments.

Greg Lucier (Chairman and CEO)

With that, we'll now bring to a close our second quarter earnings call. Thank you very much for your interest.

Operator (participant)

Thank you. That does conclude today's teleconference. You may disconnect your line at this time and have a wonderful day. We thank you for your participation today.