NuVasive - Earnings Call - Q3 2014

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, Strategy and Corporate Communications. Thank you. You may begin.

Carol Cox (Executive VP of Strategy and Corporate Communications)

Thank you, Roya. Good afternoon, everyone. Welcome to NuVasive's third quarter earnings call for the period ended September 30, 2014. Joining me on today's call are Alex Lukianov, our Chairman and Chief Executive Officer; Keith Valentine, our Chief Operating Officer; and Quentin Blackford, the company's Chief Financial Officer. During our comments and responses to your questions today, certain items may be discussed which are not based entirely on historical facts, including without limitation those regarding revenues, gross margins, operating expenses, other income and expense, taxes, future products, and capital allocation plans. Actual results or trends could differ materially from our forecast. Any such items should be considered forward-looking statements that are based on current expectations and involve risks and uncertainties, assumptions, and other factors which, if they do not materialize or prove correct, could cause NuVasive's results to differ materially from those expressed or implied by such forward-looking statements.

These and other risks and uncertainties are more completely described in today's press release and in our most recent 10-Q and 10-K 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 in 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 gross margin, sales, marketing, and administrative expenses, research and development expenses, operating margin, and non-GAAP earnings per share. We believe this information is useful to investors because it provides important information regarding earnings generation at NuVasive and is helpful for measuring our progress.

We use these non-GAAP financial measures along with the most directly comparable GAAP financial measures in evaluating our actual and forecasted operating performance, capital resources, and cash flow. The most directly comparable GAAP financial measures and information reconciling these non-GAAP financial measures to our financial results prepared in accordance with GAAP are included in today's press release and the supplementary financial information file, both of which have been posted on the company's investor relations section of our website. With that, I would like to turn the call over to Alex.

Alex Lukianov (Chairman and CEO)

Thank you, Carol. Good afternoon, and thank you, everyone, for joining us on today's call. We are extremely pleased to report third quarter results that exceeded our expectations on the top line, generated strong free cash flow, and again demonstrated strong increased operational efficiency across our global operations. We reported revenue of $190 million, which represents year-over-year growth of 12% and non-GAAP earnings per share of $0.19. Revenue growth was driven by stronger-than-expected performance in the U.S., especially in lumbar and biologics, and continued strong growth in our international geographies. In addition to better-than-expected revenue growth, we made solid progress in our efforts to improve operating profitability, resulting in a non-GAAP operating margin of 16.7% in the quarter, which is a 130 basis point expansion year-over-year.

The expansion was driven primarily by ongoing efforts to bring manufacturing in-house, driving asset and sales force efficiencies, and the operational initiatives that we have underway in all areas of the organization. In the quarter, we also made solid progress on reducing discretionary SM&A spend as a percentage of revenue both year-over-year and sequentially. As a result of our strong operating performance, we generated a quarterly record for free cash flow at $35 million. As a result of the outperformance in the third quarter and with the majority of 2014 behind us, we are updating and increasing full-year revenue guidance to approximately $755 million, implying growth of approximately 10% over 2013 performance.

While we are pacing ahead of our operating margin improvement plan for 2014, we are maintaining guidance of 16.5% for the year, which takes into account strategically reinvesting a portion of our increased profitability back into the business to drive future growth. This guidance represents a 150 basis point improvement over 2013 and is well ahead of our commitment to deliver at least 100 basis points of improvement per year. For non-GAAP EPS, we are increasing full-year guidance to $1.12. As a reminder, we will be hosting our investor morning on November 13 in San Francisco. Based on this timing, I intend to keep my comments somewhat shorter on today's call.

Members of our senior team will participate in the investor morning, where we intend to cover several topics: our market share-taking strategies by market segments and geography, efforts around significantly increasing profitability and leveraging earnings per share, improving our operational efficiencies, and scaling the company to $1 billion in revenues and beyond. While executing on these value-driving priorities, we will stay true to our culture of innovation that will continue to deliver best-in-class surgical solutions, resulting in better outcomes, faster recoveries, and increased efficiencies for the healthcare system. In other words, faster, better, and cheaper. We hope that you can join us in San Francisco, where you will also be able to learn more about the less disruptive procedural solutions and products we are showcasing at the NAS conference.

On the macro level, we continue to see stability in the global spine market with growth in the very low single digits. While we continue to see pricing pressure of less than 2%, this is right in line with what we expected and consistent with what we have experienced all of this year and last. As demonstrated by our results, we continue to outpace the market as we execute against our market share-taking strategy, which focuses on three main drivers. First, by further driving the shift toward MIS and less disruptive solutions. Second, penetrating and converting the traditional spine market with less invasive solutions. Third, expanding our international footprint. I am very pleased that our results for the third quarter demonstrated solid progress across all three of these drivers.

In the MIS market, our flagship XLIF surgical procedure and the Decade Plate provided solid growth, which is particularly exciting because these solutions are laying the foundation for greater utility of single-position surgery. As the spine market continues to shift toward less invasive solutions and as better patient outcomes and clinical and economical evidence are driving surgeon adoption, we remain committed to expanding our leadership in this market. We fully believe that our procedural offerings will allow us to further penetrate what is estimated to become a $5 billion MIS market opportunity over the next decade. Increasingly, we have invested in new procedural offerings to enter the traditional spine market and convert it to less invasive solutions with improved surgical outcomes. These new solutions, like Precept for posterior fixation, ALIF-ACR to correct sagittal alignment, Armada and Bendini for deformity, and MIS PLIF, support our patient outcome philosophy.

Both Precept and Armada continue to grow at an aggressive clip during the quarter and are blurring the line between traditional and MIS techniques. Several years ago, we made the decision to expand our geographical footprint by strategically and methodically entering the $2.2 billion international spine market. Today, we have commercial operations across EMA, Asia Pacific, and Latin America. During the third quarter, we continue to benefit from investments with strong results in Australia, Japan, the U.K., and Italy, driving 45% growth. Our approach focuses on entering large and rapidly developing spine surgery markets and then to thoughtfully build up our infrastructure to match the market dynamics and opportunity.

I am very proud of the leadership teams we have built across our international markets, and I am confident that the opportunity to replicate the success we've been able to achieve in the U.S. will be a significant driver of revenue growth moving forward. Our market share-taking strategy is working well, and while revenue growth is a key priority, I want to assure you that the entire management team and shareholder base is also keenly focused on improving operating profitability. For a couple of quarters now, I've been speaking about NuVa 2.0, our process innovation mindset that we are applying across the company. We have made it the cornerstone of our culture as we approach $1 billion in revenue and undertake the work that will allow us to simplify operations and scale NuVa's world-class organization. Culture has been and continues to be a differentiating factor and competitive advantage for NuVasive.

Our vision of changing spine surgery and improving patient outcomes is the foundation from which we drive our internal focus as we apply our NuVa 2.0 mindset to achieving greater efficiencies, streamlining our processes, and strategically reinvesting in game-changing innovation to improve even more patient lives. We are also committed to driving greater shareholder value, and one of the ways we intend to do this is through enhanced profitability. Our goal is to expand our operating margin from the 15% level we reported last year to more than 20% as we approach $1 billion in annual revenue. We have articulated and sized several clearly defined drivers that we anticipate can get us to this goal.

These include international scale, vertical integration as we scale our in-house manufacturing capabilities, asset efficiency, improved sales force effectiveness, and the February 2015 expiration of the patent for which we accrue the majority of our Medtronic-related royalties. We are working hard to execute against these drivers, and our results, again this quarter, demonstrate excellent execution against that goal. I am confident in our ability to achieve our stated operating margin goals, and I hope to exceed them as we continue to identify additional opportunities to drive profit growth. Before I turn the call over to Quentin, we have nothing new to report on the OIG subpoena, but we'll provide further updates if and when they are needed.

In sum, our execution in the third quarter and year-to-date has been very strong, and I believe that our current portfolio and pipeline position NuVasive very well as we finish 2014 and head into 2015. With that, I'll turn the call over to Quentin.

Quentin Blackford (CFO)

Thank you, Alex, and good afternoon, everyone. Before we get started with the financials, let me remind you that many of the financial measures covered today will be on a non-GAAP basis. Please refer to the supplementary financial information file on our website in the investor relations section for all of the detail covered on today's call and to reconcile our non-GAAP items to their GAAP counterparts. As Alex mentioned, we were very happy with our underlying operational performance in the quarter, exceeding operating margin expectations and generating a record $35 million of free cash flow. Revenue for the third quarter 2014 exceeded our expectations at $189.9 million. As a result, we are increasing full-year revenue guidance to approximately $755 million, which includes nearly $2 million of incremental FX headwinds versus prior guidance.

This translates to just over 10% growth year-over-year and is a $10 million increase from the $745 million that we previously expected. Let's walk through the composition of revenue growth in the quarter and our revised expectations for the full year 2014. Third quarter US lumbar growth of 8% was solid on the continued momentum of our minimally invasive solutions, particularly Precept, ALIF-ACR, and MIS PLIF. Based on the strength we are seeing, we now expect about 7% US lumbar growth for the full year, up from the 6% growth that we previously expected. US biologics growth of about 13% exceeded our expectations. The strength of demand for our US lumbar solutions continues to drive excellent procedural pull-through, and the recent launch of Osteocell Pro continues to generate solid surgeon interest in trialing. Stocking orders were about $1 million higher than the prior quarter.

We are very encouraged by the positive momentum being built in this business, but also need additional time to determine what portion of the impact between trialing and stocking orders, if any, will prove to be temporary. As a result of the Q3 outperformance, we now anticipate full-year US biologics growth of about 11%, up from the 7% growth that we previously expected. US cervical sales decreased 2% versus prior year, primarily driven by soft performance from our motion preservation device. With our new plating product set for launch at the upcoming NAS conference and an initiative in place to improve the availability of sets in the field, we continue to be optimistic that we can revive growth within our cervical category over time. We are now modifying our cervical growth expectations to about 1% for the full year, down slightly from the previously forecasted 4%.

US monitoring service growth also exceeded our expectations, increasing almost 14% in the quarter. Unlike the last couple of quarters, case volume growth drove the outperformance in the third quarter, while the impact from focus collection efforts moderated in the quarter and were nominal. We continue to expect strong volume growth will be offset somewhat by pushback from insurers. As a result of the Q3 outperformance, we now expect US monitoring service growth of 6% for the full year, an improvement from our prior expectations for 2% growth. On the international business, which includes Puerto Rico, we also exceeded our expectations. International growth was 45% in the quarter, with strong contributions from each of our key geographies. During Q3, we continued to make progress in Latin America, including collections in Brazil, despite economic turmoil in several countries. We expect that progress may fluctuate from quarter to quarter.

Still, in consideration of the strong results, we now expect full-year 2014 international growth of approximately 35%, up from the previously forecasted 30% annual growth. As noted before, updated full-year guidance contemplates an incremental currency headwind of about $2 million versus our prior guidance in this category. In sum, we are very pleased with year-to-date revenue results. As you model the fourth quarter and begin to project 2015, please note that we do not expect to continue to benefit from some of the temporary impacts we've discussed over the course of the year. Turning to the rest of the P&L, gross margin in the third quarter was 74.9%, up 50 basis points from the 74.4% reported in Q3 2013. The expansion demonstrates continued strong operational gains driven by our move to insourced manufacturing and improved asset efficiencies.

Included in the quarter was a 100 basis points negative impact related to a non-recurring product royalties charge and continued mixed pressure of approximately 40 basis points from the strength of our biologics performance. This was more than offset by nearly 200 basis points of improvement related to our focused efforts to insource manufacturing and to drive asset efficiencies. Price was consistent with prior periods at less than negative 2% and not a material factor in the quarter. We continue to expect a full-year gross margin of approximately 76%. Non-GAAP sales, marketing, and administrative, or SM&A, expenses totaled $102 million in Q3 2014, compared to $93 million in Q3 2013. SM&A expense was 53.7% of revenue for Q3 2014, representing 130 basis points of improvement compared to the 55% we reported in Q3 2013.

Further progress with our focused efforts to drive both sales force and asset efficiencies continued to more than offset both planned and opportunistic investments into our international business. For the full year, we continue to anticipate SM&A expense of approximately 54.5%. Non-GAAP research and development, or R&D expenses, totaled $8.6 million in Q3 2014, compared to $6.8 million in Q3 2013. R&D expense was 4.5% of revenue for Q3 2014 versus 4% in Q3 2013. The planned increase in spending continued to be driven by investments in talent and new product development projects. We continue to anticipate a full-year R&D expense of approximately 5%. Third quarter, non-GAAP operating margin was strong, coming in at 16.7%. We demonstrated an exceptional 130 basis points of operating margin expansion compared to the 15.4% we reported last year, while absorbing approximately 100 basis points of a non-recurring charge related to the product royalties.

We continue to balance the translation of operational improvements while opportunistically investing to enable the acceleration of our market share gains. As a result, we continue to expect a full-year operating margin of approximately 16.5% and impressive non-GAAP operating profit dollar growth of greater than 20% this year, more than two times the expected rate of revenue growth. Interest and other expense net on a GAAP basis totaled $9.2 million in the quarter, which included a $2.5 million FX loss or a negative impact of $0.03 per share net of tax related to the currency swings we saw late in the quarter. This compared to a $3.4 million expense in Q3 2013, which included the favorable impact of a legal settlement. We now anticipate full-year 2014 interest and other expense to be approximately $29.3 million, including roughly $14.7 million of non-cash interest expense.

We recorded an income tax expense of $9.1 million in the quarter, compared to the $900,000 in the third quarter of 2013. This resulted in a tax expense rate of 128% for the quarter, which was higher than we had anticipated as a result of a greater amount of pre-tax losses residing in low-tax jurisdictions, which provide nominal tax benefits, and a greater portion of pre-tax profits residing in our highest tax jurisdictions, resulting in greater tax expense. The higher-than-anticipated tax rate negatively impacted results by approximately $0.08 per share, all of which we expect to recover in the fourth quarter and is reflected in the revised increase to our full-year EPS guidance. We now anticipate a full-year GAAP tax expense of approximately $7 million, and we continue to expect non-GAAP adjustments for the full year 2014 to be tax-affected at approximately 40%.

With the higher-than-expected tax expense in the third quarter, non-GAAP earnings were $9.6 million, or $0.19 per share, compared to the $18.3 million, or $0.39 per share in Q3 2013. As a result of increased full-year revenue expectations and recovery of the tax impacts that I mentioned previously, we now anticipate full-year non-GAAP EPS of approximately $1.12, up from the previously forecasted $1.11. Please refer to the supplementary financial information file on our website in order to put the year-over-year EPS comparison into proper context and to review all of the items that will be excluded for non-GAAP reporting purposes. For the third quarter, we generated record operating and free cash flow. Cash flow from operating activities totaled just over $48 million, well ahead of the roughly $38 million that we saw in Q3 of 2013, driven by strong top-line growth and operating margin performance in the quarter.

Free cash flow of $35 million reflected a $13 million capital expenditure investment in the quarter, most of which was product-related. Our cash and investment balance at the end of the third quarter was $384 million, up about $34 million from last quarter and up $58 million year-to-date, primarily driven by approximately $51 million in year-to-date free cash flow. I'm exceptionally proud of the tangible progress that is increasingly evident both in our reported results and forward-looking guidance. For the quarter, we continue to make solid progress in increasing our operating profitability as we not only improved our operating margin year-over-year but also sequentially by roughly 70 basis points from the second quarter, despite revenues being relatively equal. Our performance reflects our ability to absorb margin impacts while at the same time enabling margin expansion.

In fact, we are now positioned to achieve a fourth quarter operating margin of nearly 20%, illustrating our ability to reach the longer-term sustainable 20% or greater operating margin objective that we have spoken to previously. With this strong operating performance combined with continued execution of our market share-taking strategy, we expect to end 2014 on a strong note and enter 2015 with meaningful momentum. I look forward to seeing you at the investor morning in a few weeks, and now I'll turn the call back over to Alex for closing comments.

Alex Lukianov (Chairman and CEO)

The third quarter was a clear demonstration of our aspirations for NuVasive. Our market share-taking strategy delivered double-digit organic revenue growth, which we achieved in conjunction with operating margin expansion of 130 basis points and record quarterly free cash flow of $35 million.

Last quarter, we announced that we could clearly claim to be the number three spine player in the world. This was an incredible accomplishment for the NuVa family, and we are proud that we were able to continue our strong market share gains in the third quarter. Our dynamic share-taking strategy, combined with well-defined levers to improve profitability, will drive revenue growth and improve shareholder value over the next several years. Onward and upward. We will now take your 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 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press Star 2 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 that participants limit their remarks to one question and one follow-up during today's Q&A session. One moment, please, while we pull for questions. Thank you. Our first question comes from a line of Matthew O'Brien with William Blair. Please proceed with your question.

Matthew O'Brien (Analyst)

Hi, guys. This is Kayla in for Matt. So you lifted full your expectations for the lumbar segment, but this would still assume a deceleration in the fourth quarter. Can you just comment on the momentum and opportunity that still exists with products in that segment, such as Precept, and what sort of runway of growth you see ahead?

Quentin Blackford (CFO)

Sure. This is Quinn here.

In terms of the runway that's ahead of us, I think we're incredibly excited about what we see with Precept in particular. That's a product that can compete in the entire 1.8 posterior fixation space that's out there, which leaves for us incredible runway. There is a ton of opportunity that's there. When you think about the Q4 performance, last year we had an incredibly tough comp that we're up against. We had a very strong performance last year, and as a result of that, I do expect that growth is going to slow a bit. When you look at it, though, I think we're trying to look at that from a prudent perspective.

We certainly do not want to get ahead of ourselves, but if you look at the momentum that we have seen in Q3 in Precept, MIS PLIF, ALIF-ACR, all new products that have come to market here within the last 18 months or so, incredibly excited and a lot of runway left in front of those.

Matthew O'Brien (Analyst)

Okay. Great. And then you did lower cervical expectations for the full year, and you mentioned that the cervical motion preservation disc performance remained soft. Can you just elaborate on what you are seeing competitively there and what has to happen in order to really accelerate performance in that segment?

Alex Lukianov (Chairman and CEO)

I would say that overall we are pretty disappointed in the performance of PCM. The main reason for that is that it is a device that is designed for single-level applications. We are simply not seeing the uptake of that particular application.

It seems the market is more interested in two-level applications. We do not have FDA clearance for that. So we just simply are overall disappointed in that area. Cervical otherwise is performing well. The procedural volume has been up, but really the downside for us has been on motion preservation.

Matthew O'Brien (Analyst)

Okay. Great. Thank you.

Alex Lukianov (Chairman and CEO)

You bet.

Operator (participant)

Thank you. Our next question comes from a line of Matt Miksic with Piper Jaffray. Please proceed with your question. Matt Miksic, your line is live for questions. Please proceed with your question.

Matt Miksic (Equity Research Analyst)

Sorry about the I had you on mute there for a moment. Sorry about that. Can you hear me okay?

Alex Lukianov (Chairman and CEO)

Yep.

Matt Miksic (Equity Research Analyst)

Thanks so much for taking our questions. So one on just the environment, it is a question that we get a lot.

I do not want to focus on it too much, but I would love to get your sense of where sort of pricing trends felt like they were heading in the quarter. Some folks have seen sort of sequential easing of pricing slightly. Others have seen kind of steady. Maybe pricing and just what you thought of the strength here in the seasonal quarter, just maybe a couple of market questions, and then I have one follow-up.

Alex Lukianov (Chairman and CEO)

As I mentioned in my prepared comments, what we are seeing is about 2% negative on price. It is very consistent with last year. I think, as you know, because of all the products that we launched, it is offset by mix for the most part of new products. That is consistent. We are not seeing a trend that is any different than what we have been reporting.

Matt Miksic (Equity Research Analyst)

In the seasonality, we would typically expect a little bit of falling off here in the third quarter, and yet you and a number of other folks have reported some pretty strong and sort of unseasonably strong growth. Your thoughts on that?

Alex Lukianov (Chairman and CEO)

I think that's really reflected in the fact that the market overall is just more stable. I think that there's a more positive sentiment in general right now with regard to spine surgery, and the volumes are slowly picking up. As you say, I mean, typically we'd expect it to be down a little bit more, but it outperformed our expectations, and we're certainly pleased with that.

Matthew O'Brien (Analyst)

Just to follow up, if I could, on Precept and where you're seeing the uptake here. Is there any areas of strength in sort of types of procedures where you're seeing particular uptake?

Is it in TLIFs? Is it in one or two-level cases? Is it viewed as a good system for more complex cases, or is it sort of across-the-board uptake that you're seeing?

Alex Lukianov (Chairman and CEO)

It's across the board, and Precept has been out there now for pretty close to two years, not in full launch, but pretty close to that. It started off largely because we were able to start to back up XLIF procedures, and I think that's how we began moving into that space. Over time, it's been applied more for scoliosis, more for everything across the entire spine. I think as I've talked about now for the last couple of quarters, what we continue to see is surgeons that are used to doing big open procedures being able to apply a product like Precept and utilize it in that fashion.

It is designed for both open and closed procedures, and then slowly move that into less and less disruptive applications of the technology. It is exactly as we have been talking about, and it is very broad.

Matthew O'Brien (Analyst)

If I could, Alex, just one clarification when you hear with open and minimally invasive.

Alex Lukianov (Chairman and CEO)

Are you asking? That is number four. [crosstalk]Yeah. This is like your number four question. Okay.

Matt Miksic (Equity Research Analyst)

Just to clarify, I am sorry. When you say open and minimally invasive, are you picking up share in we think of you maybe as picking up your fair share of your posterior fixation on XLIF cases, but are you also just picking up open cases that are not necessarily would not have put you in the case with XLIF?

Alex Lukianov (Chairman and CEO)

Yes. Correct.

That's really been the posterior fixation success that we've had with Armada, with Precept, with other systems, Bendini, which has allowed us to get into more deformity cases. We're seeing good strength from XLIF, from lateral plating, and also from all of our posterior fixation business.

Matt Miksic (Equity Research Analyst)

Great. Thank you. Sorry for that.

Alex Lukianov (Chairman and CEO)

Okay. Don't do it again.

Operator (participant)

Thank you. Our next question comes from a line of Bill Pavonic with Cunningham. Please proceed with your question.

Bill Pavonic (Analyst)

Great. Thanks. Good evening. Can you hear me okay?

Alex Lukianov (Chairman and CEO)

Yes. You can have three questions, Bill, just to be sure.

Bill Pavonic (Analyst)

I'll keep it to two. Other people can ask my questions. For Quentin, it's on the Medtronic royalty.

When that goes away in mid-February, looking at that today, now that you have a pretty clear path on the run rate, how many basis points of operating margin benefit will you pick off of it?

Quentin Blackford (CFO)

Yeah. We're going to see right around the 150 basis points. And that's what we've been talking to for some time now. It's going to come right into being right around that number.

Bill Pavonic (Analyst)

As we think about 2015, if you've got 150 basis points of Medtronic rolling off, should we expect continued leverage from the core business and sales and marketing, what have you, so that you're shifting towards a 200-250 basis point or 300 basis point improvement for next year? Or how should we think about 2015?

Quentin Blackford (CFO)

You're thinking about it appropriately. From our perspective, our goal is to drive roughly 100 basis points of underlying operational improvement in the business.

Certainly, we kind of look at the 150 basis point improvement for Medtronic outside of that. You are thinking about it appropriately as you size it up to that 200-250 basis point improvement.

Bill Pavonic (Analyst)

I'll stop there. Thank you.

Alex Lukianov (Chairman and CEO)

Thanks, Bill.

Operator (participant)

Thank you. Our next question comes from a line of Chris Pasquale with JP Morgan. Please proceed with your question.

Chris Pasquale (Director and Senior Analyst)

Thanks. Where are you guys now with the OsteoCell Pro launch? How much more of your account base do you still have to upgrade before we could see these big stocking orders start to wind down?

Quentin Blackford (CFO)

Yeah. As you look at OsteoCell Pro, and prior to having that product available for us, we saw penetration in our own cases somewhere around 60%. We historically said we thought it'd be hard to penetrate beyond that without another innovative product in the space.

OPRO has certainly allowed us to have that opportunity. I think what you're seeing now is that has moved closer to 70% in terms of penetration of our own case. Certainly, to the extent we can go even further, we'd like to do that. I think the growth that you're seeing there has the potential to sustain itself into the future. Now, we're only two quarters into that launch, so we need a bit of time to see that that's going to stick. It's not just trialing, but when you look at it, it seems like there's an opportunity to capture more of our own procedural opportunity with our surgeon base. It has the potential to stick.

Chris Pasquale (Director and Senior Analyst)

Corollary to that, you haven't mentioned Attrax in a little while. Any update there?

Is the OsteoCell Pro success kind of taking away the urgency of having a product like Attrax?

Alex Lukianov (Chairman and CEO)

It's not a lack of urgency. It's more of the ongoing delays we've had with FDA. At this point in time, we're hopeful to have clarity on whether or not we'll be able to launch in the U.S. by the middle of next year, but we've continued to have delays in that area. As Quentin has pointed out, we're certainly very pleased with the biologics segment progress that we've had so far.

Chris Pasquale (Director and Senior Analyst)

Okay. If I could, just one on the IOM segment. It's now been five straight double-digit growth quarters there. At what point do we start to think about that as the sustainable growth business that maybe it was expected to be when you first did that acquisition and not just a temporary phenomenon?

Alex Lukianov (Chairman and CEO)

I think what it's doing for us strategically is exactly what we had envisioned, which is it's allowing us to go deeper into accounts where we provide both monitoring and get more implant business on a pull-through basis. That's really where we're seeing more of that success. We're pleased with that. I don't think we're prepared to say it's going to continue growing at this pace as we're seeing this year, but we're certainly having a banner year having caught up on collections and now moving towards a significant increase in procedural volume.

Chris Pasquale (Director and Senior Analyst)

Thanks.

Alex Lukianov (Chairman and CEO)

You're welcome.

Operator (participant)

Thank you. Our next question comes from a line of Richard Neuter with Leland Partners. Please proceed with your question.

Richard Neuter (Analyst)

Hi. Thanks for taking the questions. I just wanted to start off. Quentin, you went through a bunch of the gross margin drivers in the quarter and what does and doesn't repeat.

Can you just quickly give us the high-level summary of those again?

Quentin Blackford (CFO)

Yeah. Sure. So when you look at gross margin, we were up 50 basis points year over year, but you start to peel it back a little bit, and we would have been up 200 basis points year over year just from the insourcing and the inventory efficiencies that we've been driving through that business. Now, we lost a bit of room with the non-recurring one-time product royalty-related charge that came through in the quarter and then a bit of mix just related to the strength in our biologics portfolio. Net-net, 200 basis points of improvement offset by roughly 100 basis points of that one-time item and 40 basis points of mix.

Richard Neuter (Analyst)

Okay. That gives you the confidence that you'll recoup most of that, and that keeps you on track for 76%.

Quentin Blackford (CFO)

Yeah. Absolutely.

The 74.9% is not going to be a sustainable margin level. You're going to see that go back to the 76% that we've been operating at. Excluding the item in the quarter, we would have been sitting right on 76% again, and our guidance implies that we'll see Q4 coming around 76% also. We feel confident in what we're seeing there to be able to get into that number for the year-end.

Richard Neuter (Analyst)

Thanks. Then just quickly, tax rate is something that you guys said you've been planning for. You think you can bring and ratchet that number down. Can you just give us a sense of where you think that can go down to in 2015? Or if you don't want to give 2015, where can that be in the next two years? How far down can that go?

Quentin Blackford (CFO)

Sure. When we started to work through making the tax position for the company much more efficient, the goal we had in mind was to get that down into the low 30s over the next three to five years. I think we're still aligned to being able to achieve that. You'll see the rate come down next year somewhere in the mid-40% range. From that, as revenue continues to increase in the OUS markets, we'll likely see that rate move down into the low 30s.

Richard Neuter (Analyst)

Thank you.

Operator (participant)

Thank you. Our next question comes from a line of Raj Denho with Jefferies. Please proceed with your question.

Raj Denhoy (Equity Research Analyst)

Hi. Good afternoon. I wonder if I could just ask a question.

There seems to be this, the last several quarters, kind of this dichotomy between the numbers you guys keep putting up and yet your unwillingness to sort of talk about any sort of sustainable trends. One thing you've also alluded to a little bit is how these new products are allowing you to penetrate into less invasive procedures. I'm curious if you can offer anything in terms of whether you're, how quickly you're expanding the customer base, the number of surgeons who you're bringing into the new invasive fold, and how much more room you think you have to continue to add new customers in with these products.

Alex Lukianov (Chairman and CEO)

I think that we're just scratching the surface when it comes to adding customers, and that's really been through the advent of posterior fixation systems.

That is really what I think, as I have been talking about for a while, our fate is very much linked to how well we do in the lumbar growth rates, right? That has afforded us double-digit growth rates for the last two years, and we are pretty excited about that. Actually, longer than that, but the last two years in particular. We are certainly excited about that. We think there is huge upside for us to continue to move in that direction. At the same time, there is a fair amount of pressure when it comes to reimbursement, as you very well appreciate, and I will not go and list all of the things that are pushing back on growth. That is the reason that we remain prudent with regard to our guidance and want to really continue the effective trend that we have had here to 4.

Raj Denhoy (Equity Research Analyst)

Let me ask it a different way. In terms of the step-up in growth we've seen over the last kind of four or five quarters, how much of that can be tied to completely new customers that have come into NuVasive, completely new surgeons versus you taking these new products, whether it's Armada or Precept or some of these new ones, and simply penetrating them into your established base?

Alex Lukianov (Chairman and CEO)

I don't have a mixed distribution to share with you. I can tell you that we certainly continue to go much deeper with our existing customer base, and we add accounts at a pretty fast basis. On a fast basis, we haven't been talking much about our sales force, but this year, we've got a net add of about 35 heads.

We're pretty pleased with how that's moving forward, and I think that reflects the number of accounts that we need to address beyond what we've typically been able to cover.

Raj Denhoy (Equity Research Analyst)

Okay. If I'm just hearing you correctly, it sounds like, again, you're not seeing any sort of limits in what you can do here. It's simply just still conservatism on your part in terms of the sustainability.

Alex Lukianov (Chairman and CEO)

Yeah. I think that's fair.

Raj Denhoy (Equity Research Analyst)

Okay. Thank you.

Operator (participant)

Thank you. Our next question comes from a line of Matt Taylor with Barclays. Please proceed with your question.

Matt Taylor (Senior Equity Research Analyst)

Thanks. I had one question on the cervical business. You mentioned in your comments that you see that as being able to be turned around over the longer term. How long is longer term, and what do you think will turn that around?

Alex Lukianov (Chairman and CEO)

It's increasing the volume beyond where we're at right now.

We have some reconstructive systems that we've already started to launch with the Archon Plate and additional things that we're doing. We would certainly expect to see some better growth over the next year or two, but we're not expecting to see that really jump up dramatically. We'll talk further about guidance at a subsequent time. At this point in time, what we're really seeing is a drag coming out of cervical because of PCM.

Matt Taylor (Senior Equity Research Analyst)

Just to follow up, are there any areas of your portfolio now that you feel like you really need to add? What should we expect in terms of the new system, the imaging system that you've been talking about that we might get a peek of at NAS?

Alex Lukianov (Chairman and CEO)

Yeah. We'll talk about that a little bit during our analyst morning.

That is really moving us in a broader direction of addressing deformity and being able to do that with what we are, in simple terms, calling more of a three-dimensional correction with preoperative planning processes and the same all the way through to outcomes. We will talk about that some more next month and certainly a lot more next year.

Matt Taylor (Senior Equity Research Analyst)

Great. Thanks a lot.

Alex Lukianov (Chairman and CEO)

Yeah.

Operator (participant)

Thank you. Our next question comes from a line of David Roman with Goldman Sachs. Please proceed with your question.

David Roman (Managing Director)

Thank you. Good afternoon, everybody. Can you hear me okay?

Alex Lukianov (Chairman and CEO)

Yeah, Dave. Go ahead.

David Roman (Managing Director)

Thanks, Alex. First, maybe just starting with the revenue picture. Quentin, you wrapped up your discussion around revenue, indicating that there were a number of one-time factors that benefited the growth rate this year that would not recur next year.

Can you maybe just go into that in a little bit more detail? At this point last year, you did provide some context on four-year revenue growth. Are you willing to bless the 6.5%-7% growth number that's in consensus right now for 2015?

Quentin Blackford (CFO)

Yeah. I think you're certainly thinking about forward-looking estimates in the mid to upper single-digit range is fine from that perspective at this point in time. We'll talk a lot more about that as we get to analyst day here in a couple of weeks and start to think about 2015 a bit more as we exit the year. When you think about kind of the one-time items that we've brought up over the course of the year, I think they really come back to the service business.

We did have some impacts of collection benefits that came through in really the first two quarters of the year. Now, we did see strong volume growth in Q3, which was really the first time that that became the significant driver in the business. Prior to that, it was the collection growth, and we certainly do not expect that we are going to continue to see that into next year. As a matter of fact, that is going to set up for a relatively tough comp in that business in the first part of next year. Beyond that, you get into the international business, and we have talked about this. In Latin America, the underlying business procedurally is performing very well, but the ability to get paid in those markets is highly unpredictable.

To the extent that we put that into our forward-looking guidance, it gets difficult to do that because you can never really predict exactly when you're going to get paid. Certainly in the international business, just around Latin America, a bit of concern there with regard to how you think about it and how you plan for it. The last one would just be in biologics. We've seen strength in the last two quarters. Certainly, we're excited about what we're seeing, but to some extent, we need a couple of quarters yet to go to really determine whether or not that's just trialing of the new product and whether it sticks or whether it doesn't. Those are the kind of things that I'm referring to in the prepared remarks.

David Roman (Managing Director)

Okay.That's helpful. Alex, maybe just a follow-up on your comment.

I think you made a reference earlier to people feeling better about spine surgery. I mean, some of your competitors have referenced spine as a potential area of benefit from expanded coverage around ACA. Are you willing to sort of give us any more perspective on what it is that's making people feel better? Is it expanded coverage? Is this just a seasonal boost that we normally see in the end of the year? Or is there something about the perception of the surgery that's sort of sustainably changed from the concerns that existed several years ago?

Alex Lukianov (Chairman and CEO)

We haven't seen much of a boost from ACA. I mean, obviously, there are more patients available, but we haven't really seen much of a positive impact from that. I think there's a more positive tone.

As you know, NAS has put forward quite a few guidelines to address the various issues that have been out there with regard to pushback. I think that that's buoyed the surgeons pretty dramatically and made them feel a lot more positive about the tools they have to push back when the insurance companies are not approving procedures. I would say that, generally speaking, there's a small uptick with regard to the number of procedures that are being done versus those that are being slowed down by insurance companies. We do not have an exact number. It's more through dialogue with our customers.

David Roman (Managing Director)

Okay. That's helpful. I'll drop. Thank you.

Alex Lukianov (Chairman and CEO)

Okay.

Operator (participant)

Thank you. Our next question comes from a line of Jeff Johnson with Robert W. Baird. Please proceed with your question.

Jeff Johnson (Senior Research Analyst)

Thank you. Good evening, guys.

Most of my questions have been answered, but Alex, I guess I'll just ask you an obligatory question on pods. You talked about the payer pushback there in the last answer, but anything you can say on the pod front?

Alex Lukianov (Chairman and CEO)

I think that they are diminishing, but ever so slowly. They're still out there. Despite the actions taken by the government, which you would think have had a more positive impact or at least on diminishing them faster, we haven't really seen that. What we have seen, of course, is the hospital networks pushing back. A lot of them have implemented policies. We're certainly not seeing the growth, but it's hard for us to assess the level of shrinkage at this point in time.

Jeff Johnson (Senior Research Analyst)

Any sense yet that that's helping your numbers, if at least that rate of growth is slowing or maybe not shrinking but not growing?

Alex Lukianov (Chairman and CEO)

Yeah. We don't believe so. I think we'll have to see how that plays out next year. Maybe there'll be some impact next year. We're not forecasting that to happen just yet.

Jeff Johnson (Senior Research Analyst)

All riht. Helpful. And then, Quentin, just a modeling question. I was wondering if we could do kind of an EPS crosswalk here. Your full-year guidance going up by a penny. I think the ETR in the GAAP I know this quarter was impacted by $0.08. I think that was a non-GAAP $0.08 impact. Is that right as well this quarter?

Quentin Blackford (CFO)

That's right. It would have impacted both GAAP and non-GAAP by roughly $0.08.

Jeff Johnson (Senior Research Analyst)

Yeah. That reverses in fourth quarter, so that really does not impact your full year, but the FX loss of $0.03 in the third quarter does impact the year. The negative $2 million in the top line probably has a penny or two flow through to the bottom line. Is it fair to think of you absorbing maybe $0.05 in FX-related headwinds for the year as far as the raise of $0.01 plus the $0.05 absorption?

Quentin Blackford (CFO)

No. I would think, for the most part, the FX that you are seeing come through the revenue is primarily offset by the same change coming through the operating expense profile. We have essentially a natural hedge baked into the P&L just from a small operating margin within the international business.

The FX loss that I spoke to in other income and expense was really driven by revaluing the balance sheet at the end of the period, which unfortunately realizes the significant change in the rate that all came at the end of September. That FX loss will flow through on the full year. That's going to be a 3% impact, but more than offset that from the incremental revenue that we're increasing the full-year expectation by. FX will be offset. The tax rate, to your point, is going to come back on the full-year basis. We're not changing full-year expectations from a tax perspective, really. We did increase full-year tax expense by $1 million, but that's due to the $10 million increase on the top line and the profits associated with that. Outside of that, we wouldn't have been changing our tax guidance at all.

Jeff Johnson (Senior Research Analyst)

Yep. Got it. Thank you.

Operator (participant)

Thank you. Our next question comes from a line of Glenn Navarro with RBC Capital Markets. Please proceed with your question. Glenn Navarro, your line is live. Please proceed with your question. Are you perhaps on mute, sir?

Glenn Navarro (Research Analyst)

Hi. Can you guys hear me okay?

Operator (participant)

Yes, sir.

Alex Lukianov (Chairman and CEO)

Yeah. Now we can.

Glenn Navarro (Research Analyst)

Yeah. Something's wrong with my phone. Hello?

Alex Lukianov (Chairman and CEO)

Yeah.

Quentin Blackford (CFO)

Yeah.

Alex Lukianov (Chairman and CEO)

You there? Why don't we go on to the next caller and then give Glenn a chance to get back in queue?

Operator (participant)

Certainly. Our next question comes from a line of Bob Hopkins with Bank of America. Please proceed with your question.

Bob Hopkins (Managing Director and Senior Equity Research Analyst)

Oh, thanks. And good afternoon, everybody. I just really had one question, and it was a follow-up to some of your comments on NAS, and I realize you kind of have highlighted what you're going to be talking about there a little bit.

I was wondering if I could ask specifically on the product side, just kind of the relative importance of the things that you'll be talking about and highlighting at NAS in terms of thinking about potential impact in terms of 2015 and 2016 on overall revenue growth. What are the key new product launches at NAS, and how impactful could those be as we think about t he next 12-18 months?

Alex Lukianov (Chairman and CEO)

I think what we'll be talking about at Investor Morning really has to do with what we're calling IGA, Integrated Global Alignment. We'll just start discussing that because we're starting to get pretty far along now in our beta trial, and that's going very well. We're going to start laying out the foundation for how this changes all of our fixation systems over the next few years.

We think it's a very significant change, again, to spine surgery in terms of what we're doing. As I've alluded, it's really taking the principles of scoliosis surgery and applying them not just to the thoracic spine but also to the lumbar spine. I would say that that's the biggest shift that we're working towards. We're going to continue to drive out XLIF ACR at the meeting. That's really gaining a lot of support. I think we're going to be obviously putting forward a series of other products, including Archon. Archon was just in limited release. That's rolling out, as you know, biologics with Pro and with Plus both, but really pushing those out further at NAS and then gaining additional traction with the posterior systems that we've been talking about.

Bob Hopkins (Managing Director and Senior Equity Research Analyst)

On the scoliosis side, is there a way to help us think about quantifying that opportunity if you're successful?

Alex Lukianov (Chairman and CEO)

We'll talk about that some more in a couple of weeks. Bob, we'll get into some specifics on that in terms of how we're viewing the market. What we think it does is it really is transformational as far as what we can do in the thoracic spine and starts to also move us into adolescent idiopathic applications, which right now we're really not focused on at all, just very little. I think it just broadens for us the whole field over the next couple of years. As I said earlier, the real application is not just in what you can do in the thoracic spine, but changing how you treat the lumbar spine.

That fundamentally is going to shift, I think, our business applications dramatically over the next three, four years.

Bob Hopkins (Managing Director and Senior Equity Research Analyst)

Great. Thanks for the caller.

Operator (participant)

Thank you. As a reminder, 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. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key. Thank you. Our next question comes from a line of Joanne Wench with BMO Capital Markets. Please proceed with your question.

Andrew Hanover (Equity Research Associate)

Thanks for taking our question. This is Andrew Hanover in for Joanne. Wanted to start out with the international business that continues to deliver healthy growth and wanted to get some color on some of the puts and takes and specifically the progress in Japan. Sure.

Quentin Blackford (CFO)

We saw that business grow roughly 45% in the quarter, and Alex talked to really the key markets that were driving that growth, which continue to be Japan. Australia is well up over that 45% growth clip as well, which, again, we have probably the second largest market share position in that local market. To continue to see that kind of growth coming from it is encouraging. Italy, U.K., both doing very well also. When you look at international, we have roughly 3% of the total international market share. The runway is still incredible for us. I think, for the most part, in most of the major markets with maybe just an exception of one or two countries.

I think that speaks to the runway that's in front of us with just having that small market share and just getting into the key markets that will enable us to take more of that over the next several years.

Andrew Hanover (Equity Research Associate)

Great. Thanks, Quentin. One last question from us, which is any distributor changes in the last six months? Thanks for taking the questions.

Quentin Blackford (CFO)

No.

Alex Lukianov (Chairman and CEO)

No.

Operator (participant)

Thank you. Our next question comes from a line of Larry Biggleson with Wells Fargo. Please proceed with your question.

Larry Biggleson (Analyst)

Hey, guys. Thanks for taking my question. Actually, just one question for me. Alex, maybe if you could give us a little bit of color on how you're thinking about business development M&A at this point. Thanks.

Alex Lukianov (Chairman and CEO)

We're really focused on Asia Pacific and EMEA and looking for opportunities to drive both revenue and op margin.

We're also looking at ways to expand our manufacturing process, which is obviously not M&A, but we are looking at other ways to support the manufacturing that we've already taken on. We're absolutely thrilled with the progress that we've made in that area. It's been very substantial, affecting the gross margin and really helping us out with pods. We're looking to expand more in that area. Other than that, we're focused on just other ways to increase our revenue footprint and are working on a number of things. Nothing really big and nothing that we would anticipate to be certainly hugely dilutive. Our process is still built around looking for deals that would be accretive, worst-case neutral, but certainly looking for accretive deals.

Larry Biggleson (Analyst)

Thanks for taking the question.

Alex Lukianov (Chairman and CEO)

Yeah.

Operator (participant)

Thank you. Our next question comes from a line of Mike Matson with Needham Company. Please proceed with your question.

Mike Matson (Managing Director and Senior Equity Research Analyst)

Thanks. Obviously, the move toward the internal manufacturing is helping out your gross margins quite a bit. I was wondering if you could give us some perspective on where you're at with that process. In other words, as of right now, how much of your manufacturing is being done at your own plant? I think it's in Ohio versus being outsourced. How much more of that do you think you can move inside over the next few years?

Keith Valentine (COO)

Sure. This is Keith. We're going to give some color on that too in a couple of weeks. Essentially, when you look at the entire product range, obviously, everything in the product range can't be manufactured. When you look at just the implants, you're looking at 20-25% can be done and is being done in Dayton.

A real opportunity for us over the next five years is seeing that expansion get up over 50%. How do we really leverage that not only in Dayton, but is there other opportunities elsewhere to really get even greater ability to bring more in-house? We view it right now as it's an exercise of efficiency, maximizing what we have in Dayton right now from a machines perspective. We look at the next steps of growth and expansion. There is a lot of runway ahead for us.

Mike Matson (Managing Director and Senior Equity Research Analyst)

Okay. Just a question on the Decade Plate. I think Alex mentioned that in some of his prepared remarks.

It sounds like it's doing well, but I'm wondering if you'd tell us what portion of procedures you think that's being used in and how many of those have moved toward the one position, I guess, procedure, basically.

Quentin Blackford (CFO)

Yeah. This is Quentin here. Decade Plate, just being out here a little over a year now, still a tremendous amount of runway in capturing more of our own procedures. I think still in the early stages of opportunity that's out there.

Keith Valentine (COO)

One thing great about the Decade Plate, and it comes from years and years of learning, right? We've been in this lateral space for as long as we have. We've also had single-position surgery with plating. Without a doubt, this plate really does have a much better accommodation of the vertebral bodies, and it is a great opportunity for single-position surgery. That's why we're seeing nice uptake.

Mike Matson (Managing Director and Senior Equity Research Analyst)

All right. Thanks a lot.

Alex Lukianov (Chairman and CEO)

Okay.

Operator (participant)

Thank you. Our next question comes from a line of Jason Witz with Brin Capital. Please proceed with your question.

Jason Witz (Analyst)

Hi. Thanks. Just two quick follow-ups here. One for PCM. You mentioned labeling is probably the major issue, which is sort of holding it back. Are you guys looking at a way of potentially expanding the label, and what would be involved in doing that?

Alex Lukianov (Chairman and CEO)

Yeah. We're not at this point because it would go beyond a PMA supplement. We'd have to essentially probably start all over with a new device. Frankly, we're not very excited about doing that in this regulatory environment. We've been through several PMAs and have been pretty frustrated with the regulatory process. Our focus is on 510(k) products, and we'll continue to be.

I'm not suggesting we'll never do a PMA, but that's not within the scope of what we're thinking about. So that's what it would entail. I have to say that I am probably less excited about the cervical motion preservation market than we probably were a few years ago. I certainly believe that there's opportunities for two-level applications, but we're probably a little more hesitant right now with regard to how much of fusions will it convert. If you go back several years ago, we were all forecasting it could be anywhere between 30%-50% of that market. From what we've seen from a combination of insurance pushback, surgeon uptake, our guess is that it's going to be significantly less than that. And I don't have an exact number for you, but fair to say that it's certainly going to be much less than 30%.

I guess that really mitigates our interest in making a big investment in that area right now. If that changes, maybe we'll be a little behind, but then we'll potentially chase it. Right now, we're not thinking about anything different.

Jason Witz (Analyst)

Okay. Very helpful. Thanks for the color on that, Alex. The second just follow-up would be I appreciate the pricing has been quite stable for the last multiple quarters. If I could just push you on a little more color, I'd love to get a sense of how new products are pricing versus sort of the older products at this point. Is there a dichotomy there, and could you give us a little color to help us see how this market is moving?

Quentin Blackford (CFO)

Yeah. Sure. When we talk about price, we're really talking about it on a same-store, same-product basis.

It is true product price period over period. What we do not mix into that is the mixed benefits that we do get from our premium-priced innovation, innovative technologies that we are bringing to the marketplace. We do see a positive mixed benefit. Alex alluded to that a bit earlier. Certainly, on the more commoditized space and where you do not have as much differentiation, you do feel a bit more of the pricing pressure in those areas. We see some of that just like our competitors comment on as well. Where we make that up is through the innovation that we are bringing back to the market and see the premium and the pricing that we are getting.

Jason Witz (Analyst)

Great. Thank you.

Operator (participant)

Thank you. Mr. Lukianov, I would now turn the call back over to you for closing comments.

Alex Lukianov (Chairman and CEO)

Thank you, everybody, for joining us.

We hope to see most of you, if not all of you, in San Francisco and those of you listening on today's call. We're very excited about the progress that we've made, especially on the bottom line as well as our top line. We will talk to you real soon. Thank you. Thank you.

Operator (participant)

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