NuVasive - Earnings Call - Q4 2015

Transcript

Operator (participant)

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

Carol Cox (EVP External Affairs and Corporate Marketing)

Great. Thank you, Stacy, and welcome everyone to NuVasive's fourth quarter and full year 2015 earnings call. Earlier today, we issued our earnings release, which is posted on our website as is an investor presentation, both of which have been filed in Form 8-K with the Securities and Exchange Commission. We've also posted supplemental financial information on our investor relations section of the 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 can follow along.

Before we begin today, I do need to remind you that the discussions during today's call will include forward-looking statements, which are based on current expectations and involve risks and uncertainties, assumptions, and other factors which, if they do not materialize or prove to be correct, could cause NuVasive's results to differ materially from those expressed or implied by such forward-looking statements. Additional risks and uncertainties that may affect future results are also described in NuVasive's news releases and periodic filings with the SEC. We assume no obligation to update any forward-looking statements or information which speak as of their respective dates. This call may also include a discussion of several financial measures that are not calculated in accordance with generally accepted GAAP principles. 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 rates per share, free cash flow, and EBITDA. Reconciliations to the most directly comparable GAAP financial measures may be found in the news release and the supplementary financial information, which are also accessible from the investor relations section of the company's website. Joining me on today's call are Greg Lucero, our Chairman and CEO, Pat Miles, our President and Chief Operating Officer, and Quentin Blackford, our CFO. With that, I'd like to turn the call over to Greg.

Greg Lucero (Chairman and CEO)

Thank you, Carol, and good afternoon, everyone. 2015 was a year defined by NuVasive's category-focused innovation. In May of last year, we launched the biggest innovation platform since the introduction of XLIF with Integrated Global Alignment, or IGA, to address a critical element in successful spine surgery: alignment. In conjunction with IGA, we entered the adult deformity market in a big way with our RELINE comprehensive posterior fixation system that is helping drive strong thoracolumbar results. We saw a strong resurgence in our cervical business with the success of our differentiated Archon plate and ViewPoint 2 fixation system. Finally, at the beginning of 2016, we announced the acquisition of Ellipse Technologies to enter the high-value, early-onset scoliosis market. 2015 was indeed a very big year.

Our revenue performance for 2015 delivered growth at multiples of the market, ending the year at $811.1 million, up 8.2% on a constant currency basis. This growth underscores strengthening U.S. performance and included a continual, sequential improvement in lumbar for the fourth quarter in a row following the launch of IGA and ongoing strength in cervical. I'm also pleased to report that our localized business plans are driving positive results in Western Europe as we look to re-accelerate our growth in key international markets. Asia-Pacific continued its strong growth trajectory as well, offsetting weakness in Latin America and the Middle East. We also delivered record profitability expansion for the year, with a 400 basis point improvement in our non-GAAP operating profit margin to 15.4%.

This was driven by our continuing dedication to capturing well-identified operating efficiencies to optimize our scale and rapidly bring our profitability profile in line with our peer group. Our full-year non-GAAP EPS performance came in at $1.31, nearly doubling over our 2014 results and growing at a rate significantly higher than that of revenue growth. We expect this strong leverage to continue as we benefit from increasing scale. 2015 was a dynamic year for NuVasive, with a change of CEO and other members of the leadership team. While the natural reaction to this event, and certainly the initial reaction from Wall Street, was one of concern, this changing of the guard actually provided an opportunity to strengthen the company. Not taking anything away from the previous administration, we have moved fast to put in place new processes and systems to fundamentally improve execution.

How you see it as investors is a commitment to ever-higher profitability. How we do it is through a much more rigorous examination of where we spend money today and what return we will get for the next incremental dollar of investment. We enter 2016 with a much more aligned and disciplined organization ready to do even bigger things. Looking ahead, there is no doubt we are operating in not only a rapidly evolving healthcare landscape, but one that is becoming ever more complex. With an increasing amount of market influencers to navigate, NuVasive's ability to clearly demonstrate clinical and economic value has never been more relevant. It will define our success going forward. We expect then to continue to take advantage of the lack of focus we've seen from the larger players in spine, while also strengthening our competitive stance with more dynamic peers.

Central to this effort will be our strategic move from a vendor focused on transactions to a true partner focused on transformation. We have a new vision for comprehensive spinal health that permeates our commercial strategy and leads the industry in supporting one of the most profitable service lines for hospital systems: spine surgery. Today, hospitals garner upwards of 15% of their profitability from spine-related procedures, and yet their ability to measure that performance, let alone impact it for the better, is very limited. That is where we come in. Our approach is to not only partner on technology but the entire service continuum. We believe this differentiated value proposition will keep NuVasive in a leading position even as the market landscape continues to evolve. At the same time, we will continue to execute against our clear formula for success.

First, driving innovation that addresses unmet clinical needs and improves clinical and economic outcomes. Second, driving organic growth in the U.S. and internationally while also pursuing strategic M&A that strengthens and deepens our leadership in spine. Finally, number three, delivering increased profitability through operational excellence in sourcing and scale. Now, innovation remains at the heart of what NuVasive does best and enables us to operate at a generation above the competitive set. In 2016, we expect to deliver innovation up and down the spine with new products and line extensions for anterior and posterior applications, as well as the innovation for cervical offerings, including IGA for cervical spine procedures. We're also committed to investing in Ellipse Technologies platform to further strengthen our disruptive leadership in deformity.

We will continue to drive revenue growth at multiples of the market, targeting approximately $923 million in revenue for 2016, or approximately 14% growth over 2015, inclusive of our acquisition of Ellipse Technologies. Organic growth in our core spinal hardware business and pull-through of biologics and monitoring services will come through an unrelenting focus on our commercialization strategy. This centers around compelling hospitals and surgeons to use more NuVasive technology and services. Key initiatives will include our enhanced surgeon conversion and a push around winning national and strategic accounts and securing service line partnerships. Finally, we'll look to optimize our globalization initiatives to increase our scale and to nearly double revenue contribution from our international business over the medium term. In 2016, this includes a deeper penetration in markets like Japan, Australia, Italy, Germany, and the U.K.

Turning now to profitability, we remain committed to driving profitability to an even higher level. We have plans in place to deliver nearly 1,000 bps of improvement in our non-GAAP operating profit margins as we reach beyond $1 billion in revenues. This significantly increased profit performance will be driven by the overall better management of our business, including a clear focus on improving both asset and sales force efficiencies, in addition to our insourcing initiatives and international scaling. There are tremendous efficiencies where we can gain in asset management that will impact sales force effectiveness. We only turn inventory one time a year right now. To date, we've made solid progress with backorder reductions, increased fulfillment throughput, and accuracy in improved field asset management. These changes are setting the foundation for a dramatic improvement in our working capital over the next 36 months.

With regard to insourcing, it will be a particularly meaningful source of margin expansion, with approximately 400 bps of improvement expected over the next several years. Central to our efforts will be the development of our new West Carrollton, Ohio, manufacturing facility. Improvements to the building have begun, and recruiting efforts are well underway as we work to have the manufacturing facility up and running by year-end and at full capacity by the end of 2017. International scalability will be another profitability driver in 2016. As I mentioned, our localized and differentiated surgeon conversion plans are working now in Western Europe. We've experienced particularly encouraging results in countries like Germany, where we saw nearly 30% growth in revenue for the fourth quarter of 2015, setting us up for ongoing momentum this year as our strategies take hold in that market.

We are also layering on the added benefit of the geographic strength we gained from Ellipse Technologies to drive scale internationally. Importantly, we can achieve significant overall profit margin expansion while continuing to drive top-line growth. We are committed to reinvesting in the business appropriately to drive this growth but have tremendous runway to dramatically improve our profitability at the same time. Another contributor to our success and strong performance going forward is the acquisition of Ellipse Technologies, which we officially closed today. Integration efforts are underway, and we are very excited to bring together NuVasive with this highly scalable platform that has exceptional growth prospects. Ellipse ended 2015 strong with approximately $44 million in revenue, or nearly 70% year-over-year growth. This team remains committed to delivering approximately $60 million on a pro forma basis revenue in 2016.

With our acquisition of Ellipse Technologies, we are entering the early-onset deformity market in a big way. We see an initial addressable market opportunity of $570 million for the Magic technology alone, which provides novel spinal bracing and distraction systems for the treatment for early-onset scoliosis. This does not include the meaningful opportunity to pull through NuVasive hardware, which we expect to be further upside in the future. We'll also look to capture the $700 million market opportunity for the Precise limb lengthening system to drive market share with this highly differentiated orthopedic technology. Finally, we'll look to further exploit this innovative magnetic technology platform to fuel our R&D pipeline to address broader spine and niche orthopedic applications. Now, for our performance in the fourth quarter of 2015 and guidance expectations for 2016, I'd like to turn the call over to our CFO, Quentin Blackford.

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 today will be on a non-GAAP basis. Please refer to the supplementary financial information filed on our website in the investor relations section for all of the details covered on today's call and to reconcile our non-GAAP items to their GAAP counterparts. Let's begin with our revenue performance for the fourth quarter of 2015. Revenue came in at $215.3 million for 5.4% growth year-over-year, including approximately $2.9 million of currency headwind. On a constant currency basis, revenue for the quarter increased 6.8% year-over-year. Our revenue growth was driven primarily by accelerating procedural volume growth in our U.S.

Lumbar and cervical businesses as a result of new product introductions, somewhat offset by softer-than-anticipated growth in certain of our international markets, particularly in Latin America and the Middle East. Turning to the composition of revenue in the quarter, sales for U.S. implants and services accelerated for the fourth consecutive quarter in a row, growing 9.9% for the fourth quarter of 2015, representing record quarterly growth for the year. Procedural volumes and mix were strong, up 11.3% during the quarter. We continue to experience strong results in our lumbar product portfolios thanks to the increased adoption of IGA and its industry-leading case planning and reconciliation capabilities and the increasing utilization of our Reline posterior fixation system. Our cervical portfolio also showed exceptional growth during Q4, up approximately 15% as momentum continues around our Archon anterior cervical plate. U.S.

Biologics sales for the fourth quarter were down 2.7% to prior year, below our expectations. The weakness that we saw in the prior quarter continued into Q4 as we continue to deal with what may have been cyclical or trialing by surging users. Over time, we do expect that the growth in our biologics portfolio will return to approximate the procedural growth of our hardware business. Our international business, which includes Puerto Rico, increased 1.9% on a constant currency basis and was down 8% for the fourth quarter on a reported basis. We continue to experience significant growth in markets like Japan, Italy, and Australia, where we lead with the differentiation of XLIF in our minimally invasive solution. We are also making progress with the refocusing of our efforts in several of our key Western European markets.

In particular, we were pleased with resurgence we've begun to see in Germany, which Greg pointed out grew nearly 30% for the fourth quarter on a constant currency basis. Our localized plans are driving this important momentum, significantly strengthening our position to meaningfully grow NuVasive's international market share over the long term. Our Latin America performance continued to experience weakness primarily due to monetary policy factors unrelated to the procedural volumes we see in countries like Brazil. We also experienced softer-than-expected results in the Middle East, as well as Puerto Rico, where we saw a lighter surgery schedule than normal in Q4. Turning to the rest of the P&L and results, non-GAAP gross margin in the fourth quarter was 76.2%, down 100 bps from the 77.2% reported in Q4 2014, and up 70 bps sequentially from the third quarter.

The decrease versus prior year was driven primarily by cost-related to product transitions associated with the introduction of new products and softer international sales, as well as some one-time benefits mentioned in the fourth quarter of last year that did not repeat. These headwinds more than offset the 130 bps of benefit related to the expiration of certain Medtronic-related royalties. We did not realize any benefit from our in-house manufacturing efforts in the quarter. However, as previously announced, we purchased a manufacturing facility in West Carrollton, Ohio, which will allow us to drive approximately 400 bps of benefit to our gross margins over time. The effort to set up and transfer manufacturing will take place throughout 2016, and we expect to begin to realize the benefits in 2017.

The impact of price continued to be consistent with prior periods, declining approximately 1% and was not a material factor in the quarter. Non-GAAP sales, marketing, and administrative or SM&A expenses totaled $118.8 million in Q4 2015, up nominally from the $118.4 million in Q4 2014. SM&A expense was 55.2% of revenue for Q4 2015, representing 280 bps of improvement compared to the 58% reported in Q4 2014. This year-over-year improvement was the result of our continuous effort to reduce SM&A spending as a percent of revenue and was primarily driven by increased asset efficiencies associated with our instruments and our support functions. Additionally, we continue to realize benefits fpsrom stock-based compensation expenses resulting from the better management of our equity plans and management changes earlier in the year. Non-GAAP research and development, or R&D expenses, totaled $8.5 million in Q4 2015 compared to $9.4 million in Q4 2014.

R&D expense was 4.0% of revenue for Q4 2015 versus 4.6% in Q4 2014. The lighter spend in R&D is primarily related to the timing of development projects. Over time, we expect that R&D expense as a percent of revenue will increase with long-term goals of spending roughly 7% of revenue on research and development efforts. We are very pleased to report that fourth quarter non-GAAP operating profit margin increased to 17.1%, resulting in a strong 240 bps of operating margin expansion compared to the 14.7% we reported last year. As we continue to introduce greater discipline to the organization, the tangible benefits are being realized through our performance as we meaningfully enhance the underlying core operating margin profile of our business. Interest and other expense net on a GAAP basis was essentially flat at $7 million in Q4 2015 versus the prior year.

Included in the quarter was a $4.1 million charge of non-cash interest expense related to our convertible notes. Income tax expense on a GAAP basis for the fourth quarter of 2015 was $11.4 million compared to $10.4 million of expense in the fourth quarter of 2014. This resulted in a GAAP tax expense rate of 50.7% and a non-GAAP tax expense rate of 47.2% for the quarter. For the year, we finished with a GAAP and non-GAAP tax expense rate of 41.7%. Fourth quarter non-GAAP earnings were $18 million, or $0.35 per share, compared to $13 million, or $0.26 per share in Q4 2014, a 37% increase in non-GAAP EPS year-over-year. In addition, adjusted EBITDA margin, which excludes the impact of non-cash share-based compensation, was 25.9% for Q4 2015, an 80 bps improvement compared to 25.1% in Q4 2014.

Our cash and investments balance at the end of the fourth quarter was $470.1 million, up from $451.2 million last quarter. With the closing of the Ellipse Technologies acquisition today, we used a significant amount of our cash and investments to fund the $380 million upfront payment due at closing. To give ourselves some additional financial flexibility, we entered into a credit agreement with Bank of America earlier this week for a five-year secured revolving line of credit with an aggregate available amount up to $150 million. We drew down $50 million under the facility, which we expect to use for general corporate purposes. The credit facility has terms consistent with general market conditions, and more details can be found in the Form 8-K that we filed with the SEC today in connection with their earnings announcement.

You will see that we also filed a standalone Form 8-K today regarding the closing of the acquisition of Ellipse Technologies. That Form 8-K includes information regarding the acquisition as well as financial information for Ellipse Technologies and pro formas for the combined company. Free cash flow for the fourth quarter of 2015 came in at $24.9 million, which included purchases of equipment during the quarter related to the build-out of our new manufacturing facility. For the year, free cash flow was $13 million, which was negatively impacted by payments for litigation settlements noted in the third quarter in our continued transition to a cash taxpayer over the course of 2015. These items together represented approximately $65 million of incremental headwinds in the year. Adjusting for these items, underlying free cash flow grew by 26% for the year. We finished 2015 with a very strong performance.

Revenue growth for the full year 2015 was up more than 8% on a constant currency basis, with non-GAAP operating profit margins expanding 400 bps, more than 100 bps ahead of our initial guidance for the year. In addition, non-GAAP operating profit dollars were up more than five times revenue growth, growing well over 40% for the year, while non-GAAP earnings per share were up nearly 100% as our strong earnings expansion story continues to play out. Before I turn to guidance, let me highlight a change we will be making to our revenue disclosure and guidance practices commencing with Q1 2016. We are taking steps to further refine our revenue categories to better reflect how we manage the business, better communicate the underlying performance of the company, and be more in line with our peers.

Additionally, it is a structure that we believe will best incorporate Ellipse Technologies into our revenue disclosure practices and also provide a flexible go-forward reporting structure that should allow for the easy integration of any future acquisitions. Beginning in the first quarter of 2016, we will begin to report revenue in the following three categories: one, U.S. final hardware and other; two, U.S. surgical support and other; and three, international. U.S. final hardware and other will be inclusive of our implants and hardware and include the performance of the Ellipse Technologies product families, the Magic EOS final bracing and distraction system for treatment of early-onset scoliosis, and the Precise limb lengthening system. U.S. surgical support and other will be inclusive of monitoring, biologics, and disposables. We believe this breakout most accurately reflects our core business drivers in the U.S.

Final hardware and other, with key pull-through of products and services represented by U.S. surgical support and other. International will continue to be reflective of total international results. Going forward, our revenue results and guidance will be aligned to this breakout. For ease of modeling and to help you better understand this change, we have provided a historical two-year recap of this revenue detail as a part of our supplemental financial information posted on our IR website this afternoon. Additionally, we expect to disclose pro forma results highlighting the impact of Ellipse Technologies in our quarterly performance this year to both underscore its contribution and the continued growth of our core NuVasive business. With this in mind, let me take a moment to run down our performance guidance for 2016, which is inclusive of the impact of Ellipse Technologies acquisition that we will report in our results for 2016.

To be clear, this includes the anticipated results of Ellipse Technologies from today through the end of the year. With regard to revenue, we expect full year 2016 revenue to grow double digits at approximately 13.8% year-over-year to approximately $923 million. This includes $870 million of organic revenue from NuVasive's core business that we previously communicated and $53 million of revenue that we expect to recognize from the acquisition of Ellipse Technologies from today through the end of the year. Our revenue growth assumptions reflect an estimated negative impact of $2 million from currency headwinds during the year. On a pro forma basis, normalizing for a full year of NuVasive and Ellipse Technologies combined in both 2015 and 2016, we would expect 2016 revenues of roughly $930 million or approximately 9% growth, which is consistent with our high single-digit go-forward growth expectations as a combined company.

Further, this reflects an approximate $60 million of pro forma revenue for the full year from Ellipse Technologies for 2016 as the company continues its exceptional growth trajectory. U.S. final hardware and other is expected to grow approximately 14%, which represents organic growth of 7% and an additional 7% of growth from revenue contributions expected from Magic and Precise. The organic growth of 7% will continue to be fueled by the momentum we are gaining with the utilization of IGA Rewind in our cervical portfolio. U.S. surgical support and other is expected to grow approximately 3% for 2016. The slower growth in this category is reflective of the slower growth expectations of both our biologics and services businesses, consistent with prior year trends. Over time, we would expect this category to approximate the growth of U.S. final hardware and other.

For 2016, we expect our international business to grow by approximately 36%, which includes a negative $2 million currency headwind. On a constant currency basis, we expect international to grow approximately 38%, which contemplates core organic growth of 20% and roughly 18% from the newly acquired Magic and Precise product families. In 2015, we took the opportunity to reevaluate our localized market penetration efforts in certain key markets and began to see momentum as we exited the year. As a result, we expect continued strong performance from markets like Japan, Italy, and Australia, as well as a resurgence in Western Europe in particular, which will offset continued volatility in the Latin America market. As you know, we have tremendous runway ahead of us internationally. We expect significant growth in this area of the business well into the future as we look to nearly double the revenue contribution from global markets.

We expect non-GAAP gross margins to be approximately 76.9% for 2016, or 90 bps better than prior year, primarily as a result of the two-year suspension of medical device tax and favorable product mix from the stronger growth in our lumbar and cervical portfolios, partially offset by the lower margins from Ellipse Technologies. In addition, we expect to make tremendous progress in preparing our new West Carrollton manufacturing facility for full-time production throughout the majority of 2016, and therefore do not anticipate that benefits from our in-house manufacturing initiative will positively impact gross margins until 2017. We expect non-GAAP estimated expense to be approximately 55.5% for 2016, or 90 bps better than the prior year.

This year-over-year improvement will be primarily driven by core NuVasive asset efficiencies focused on better utilization of instruments and our support functions, as well as leveraging our operating expenses through the growth of our international business. In addition, we expect to continue to drive efficiencies in our U.S. sales force. We anticipate full year 2016 non-GAAP R&D expense to be approximately 5.6% of revenues, up 130 bps year-over-year as we continue to fund disruptive innovation. This also includes reinvesting approximately 40 bps of the medical device tax benefit back into innovation. While we expect to increase R&D spending in our core NuVasive business by roughly. The addition of Ellipse Technologies and their focused efforts of expanding the Magic Technology platform results in the additional 70 bps of investment.

This will enable us to support a robust R&D pipeline capable of introducing the continuous innovation of new and differentiated products in line extensions each year. We expect a non-GAAP operating profit margin inclusive of Ellipse Technologies of approximately 15.8% for 2016, an improvement of 40 bps versus 2015's performance. This expectation reflects an improvement in core NuVasive operating profit margins by 140 bps, reflective of the 100 bps of core operating margin improvement that we target annually, plus 40 bps as a result of the temporary repeal of the medical device tax net of reinvestment. Including the acquisition of Ellipse Technologies, we expect that non-GAAP gross margin and estimated expense will improve by nearly 180 bps combined, partially offset by a meaningful 130 bps increase in incremental investments into R&D.

Despite the significant investment into R&D, non-GAAP operating profit dollars are expected to grow roughly 17% in 2016. We anticipate full year 2016 interest and other expense to be approximately $31.9 million, including roughly $17 million of non-cash interest expense. For 2016, we expect our GAAP and non-GAAP effective tax expense rate to be approximately 42% and 41% respectively for the full year. Of note, we benefited from some discrete items that drove our rate lower in 2015 that had us well ahead of expectations and will not repeat this year, which is a factor in our expectation for 2016. We anticipate our 2016 non-GAAP earnings per share to approximate $1.48 for a 13% increase in EPS over 2015's performance and expect GAAP EPS to come in at approximately $1.02 for 2016. Lastly, a quick note on the first quarter of 2016.

While we have not historically provided quarterly guidance, the first quarter of 2016 will include a partial quarter of results from the Ellipse Technologies acquisition. Therefore, to provide greater clarity in terms of expectations and for your modeling purposes, we expect revenue to approximate $205 million for the first quarter of 2016. We also expect that non-GAAP operating profit margin in the first quarter will be in line with the prior year at approximately 12.6% as we focus our efforts on integrating Ellipse Technologies. We are very pleased with our outlook for 2016 as it furthers us on our path of profitable growth. Following our investor day in December, we updated our multi-year goals that would have us driving our non-GAAP operating profit margins upwards of 25%, with adjusted EBITDA margins expanding to approximately 32%.

The acquisition of Ellipse Technologies expands our ability to even further execute against those goals while accelerating top-line growth. We are executing exceptionally well against these goals and are more excited than ever as we remain laser-focused on creating incremental shareholder value for years to come. With that, I'll turn the call back over to Greg.

Greg Lucero (Chairman and CEO)

Thanks, Quentin. We're setting up for a strong performance in 2016 and are well-positioned to deliver on our long-term performance guidance. Our bullish outlook is driven by our focus on reimagining the spine space, thinking in terms of customer transformation, finding unmet clinical needs in spine, and delivering exceptional economic value. With all the uncertainty going on in the stock market right now, NuVasive is a great place to be.

The need for spine surgery is not going away, and the drive to improve the patient experience and change lives for the better has never been more relevant. IGA continues to gain momentum as we not only are known as a lateral company but are defining what global alignment must look like going forward to clients. By sticking to our core strength, NuVasive is set to become the spine franchise by being the best and then being first. I have incredible confidence in our ability to innovate, and we have the right plan in place that will allow us to operate with certainty and deliver the results to you. The world is volatile. We're not going to be.

We will be better at spending incremental dollars to drive growth, and we have a multi-pronged approach for thoughtful surge and conversion, revolutionizing the spine supply chain with strategic service line partnerships, and true globalization of our business is now becoming a reality. We had a great 2015, and 2016 is going to be just that much better. With that, we'd be happy to take any questions you might have.

Operator (participant)

Thank you. We will now be conducting a question-and-answer session. If you would like to ask a question, please press star one on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star two if you would like to remove your question from the queue. For participants using speaker equipment, it may be necessary to pick up your handset before pressing the star key.

Our first question comes from Matt Miksic with UBS. Please proceed.

Matt Muksic (Analyst)

Hi. Thanks for taking our question. Can you hear me okay?

Greg Lucero (Chairman and CEO)

You can hear me fine.

Matt Muksic (Analyst)

Great. Just one question on something that you mentioned that seems to be gaining some traction across the broader med tech space is, call it, I do not know, center of excellence services or assistance in these centers to run their spine services better. Could you talk a little bit about how you put that into play and understanding there are FDEs and headcount and people that need to be associated with that? How you sort of blend that into your P&L, and then I have one follow-up.

Greg Lucero (Chairman and CEO)

Certainly. We have done some studies to better analyze where our customers, that being hospital systems, make their revenue and make their earnings.

The analysis reveals that the spine service line is one of the essential ingredients to driving both the top line and the bottom line. As I said in my prepared comments, about 15%-20% of their profitability comes from the spine care. That said, if you ask most C-suites of a group of people running hospitals where they make their money, I suspect they'd have difficulty answering the question, let alone pinpointing it back down to the spine care service line.

For us, not only that study, but then also our engagement with one of the major healthcare systems in the United States, where we've begun down this path of partnering, has revealed a lot of learnings to us just about how important we can be in a partnership to not only provide technology but provide know-how and consultation to really help them drive that top line and bottom line in spine care. We think for us that's the direction NuVasive is going to go. We're just incredibly focused on, obviously, spine and spine alone, and we think it's going to allow us to move fast, take the right action, and make a difference.

Matt Muksic (Analyst)

Great. That's helpful. One follow-up here is just on the environment in terms of your margin progression this year and how things like price or mix are impacting that.

You mentioned the med tech tax and some other factors, but help us understand in this environment, and is it a stable environment, how those factors play into your margin expectations. Thanks.

Greg Lucero (Chairman and CEO)

Certainly. I'll take the first crack at it, and then I'll have Quentin add to it. For us, we have seen over the last several years about the same amount of price deflation impacting the business. Again, I'll let Quentin get into the exact numbers. That has been through an up-and-down economic cycle. It says to us that our business is somewhat removed from the general economy, as you might expect. As we think about 2016, we have modeled in both certain list price increases, we've modeled in new product introductions, and we've modeled in the normal degradation of pricing that you see in older contracts.

All of that comes together with a pretty tame outlook on price for us in our financials. What we would tell you is that innovation is how you get price in this business. We have been able to be very pinpointed in what we launch and get price with that. That will be the strategy going forward to continue to have important economic changing innovation, but actually more of it.

Quentin?

Quentin Blackford (CFO)

Yeah. In terms of margin expectations, and you point a little bit back to 2015 and the degradation year-over-year, for the full year, we ended up at 76% versus the prior year of 76.1%, and frankly, did not see any benefit from the in-house manufacturing efforts that we had launched. That was a conscious decision on our part to really slow down what we were doing and start to ramp that up at a new facility.

You're going to see that come back through gross margins into the future. There's at least 400 bps of opportunity ahead of us as we become a real manufacturer of our product and take what we do in-house today from 30% closer to that 100% over time. The other thing that you see, and it's reflective in our guidance, is there is a bit of a mixed benefit in next year's gross margin expectation that we put out there of 76.9%. That's being fueled by the fact that we have our lumbar business and our cervical businesses both growing faster than the rest of the corporate average. Even though those areas might be under a bit more price pressure, if that's how you want to think about it, the gross margin profile of those particular categories are higher than the corporate average.

You end up getting a mixed benefit from it. We would definitely think about gross margin as expanding out into the future. It's just the real improvement is going to come in 2017 at the earliest when you start to see the benefits of the in-house manufacturing play through.

Operator (participant)

Thank you. Please remember to limit your remarks to one question. Our next question comes from Matthew O'Brien with Piper Jaffray. Please proceed.

Matthew O'Brien (Analyst)

Afternoon. Thanks for taking the questions. Just real quick, Quentin, on Q1, when I back out the benefit from Ellipse, it looks like your growth in Q1 is only calling for about 3% for the core business. Is that the right math? Is that a function of the biologics business? If you're continuing to contract or any color there, it'd be helpful. I have one real quick follow-up.

Quentin Blackford (CFO)

Yeah.

That's a good question. If you were to normalize it, you ought to get into about a 5% growth rate in the core business on a constant currency basis, which is going to be closer to 4% on a reported basis. We are going to have the largest currency headwind of any quarter in Q1, and that's just the way the rates have moved and when you look at them year-over-year. You have to take that into account. The other thing that you got to consider is the fact that we grew our international business north of 30% last year in Q1. Clearly, we came out of the year flattened down in that international business. That's going to provide a headwind in the quarter itself. Then biologics, to your point, last year grew about 13% in Q1, and we've seen that slow as well.

You are going to have a bit of a tougher comp in the first quarter, but you'll start to see the growth accelerate once you get beyond Q1. That's just on a core organic basis. With Ellipse, too, one of the things that are a bit unique about Ellipse that you may not fully appreciate is the fact that their seasonality is very different than the core NuVasive business. Q1 is a quarter that's generally pretty light for them. Most of the procedures happen over the summer months. You're going to get some different seasonality in the business as a result of Ellipse as well.

Matthew O'Brien (Analyst)

Okay. Just real quick follow-up on the international growth. I think about a third of your year-over-year core growth is going to be coming from international markets.

Quentin, like you mentioned, you're seeing some softness there, especially in Latin America. Just confidence that you guys can deliver that type of growth as you're exiting the year with some pretty soft performance here in the back half. Again, not necessarily NuVasive specific, but just the line of sight that you have from a country perspective or a product perspective that can give us all comfort that that bucket will deliver the growth that you're committing to.

Quentin Blackford (CFO)

Sure. You look at the back half of 2015, and some of the softness we saw in Europe was self-inflicted. We spoke openly about that in Q3, and we saw that rebound in Q4 with Germany approaching nearly 30% growth. We've already seen the results of those efforts.

Frankly, if you were to normalize our international growth for 2015, excluding Latin America, we were growing that business well north of 20% in the mid to high 20s, excluding Latin America. We already have the business performing at that level. Latin America was an incredibly challenging market for us over the course of 2015. As we head into 2016, we're not expecting a whole lot of growth out of Latin America. We expect to continue to do what we're doing in Europe and Asia-Pac. As long as we do that, we'll be able to deliver on those numbers pretty well. I think we've got a pretty high degree of confidence in our ability to execute in the international space.

Matthew O'Brien (Analyst)

Thank you.

Operator (participant)

Thank you. Our next question comes from Raj Denhoy with Jefferies. Please proceed.

Raj Denhoy (Analyst)

Hi. Good afternoon.

Just curious, actually, about the guidance around spending for 2016. When we kind of bake in the percentages you've given us for the various categories, your operating spending goes up by close to $70 million. I realize Ellipse is going to be part of that, but you've kept your spending relatively constant for the last couple of years. Where do you expect to really start to ramp that spending, and can you do it that aggressively so quickly?

Quentin Blackford (CFO)

Yep. Good question. Obviously, we're going to continue to make investments that are going to position us for growth into the future. Greg talked to it earlier around strategic sales, service line partnerships, partnering with those opportunities as we see different ways to create value in the marketplace, and we make sure that we have the investments there to do that.

At the same time, we've been focused on SM&A expense reductions for years. We're going to continue to do that, but we're committed, as we've always said, to that 100 bps of improvement per year. We want to make sure that we have the opportunity to invest into growth opportunities and do that. To the extent that we can go faster, we will. It's just we're not going to set the expectations right out of the gate to be able to deliver more than 100 bps of core operating margin improvement. It's not that we're taking our foot off the accelerator. We'll continue to get focused there, but it's early in the year.

Raj Denhoy (Analyst)

Okay. Maybe just one follow-up. I mean, you mentioned the U.S. implant business was very strong, the 10%. You mentioned IGA.

Is there anything else, anything tangible you can provide us in terms of how adopted that is now by the customer base, any new customers that you're bringing in because of it? Just anything would be helpful to understand its impact.

Pat Miles (President and COO)

Yeah. This is Pat. Raj, there's no specifically hard data other than kind of the subjective dynamic of we're seeing more and more guys appreciate the kind of the requirements of gaining alignment and affirming alignment. I think that clinically, there's such great momentum from a literature and from a podium perspective that we're just seeing people appreciate the value that the thing brings. And so really no hard direction, but it's just one of those things where it's very reminiscent of the Eclipsed experience. It's when something fulfills beyond the expectation of the surgeon, you get more and more momentum.

Raj Denhoy (Analyst)

Okay. Thank you. I'll leave it to you.

Operator (participant)

Thank you. Our next question comes from Josh Jennings with Cowen & Company. Please proceed.

Josh Jennings (Managing Director)

Hi. Good afternoon, gentlemen. Thanks a lot. I just had a quick question on the deformity market opportunity. You guys have been building out your adult deformity product lines and now have Ellipse; you're bookending the adolescent scoli market. How do you view that opportunity, and are you positioning NuVasive to move more formally into the adolescent scoli market at some point?

Greg Lucero (Chairman and CEO)

Let me have Pat answer that one. And if there's any numbers follow-up, we'll give that to Quentin. It's tough to formulate.

Pat Miles (President and COO)

Okay. It's not to give you a diatribe, but I would tell you that we went headlong into adult deformity, which is really extremely complex surgery where, in essence, you have a fixed spine.

The whole IGA element is really trying to bring about kind of the culmination of less invasive approaches to correcting alignment. Clearly, we've made a significant bet on that, and we've seen significant momentum as it relates to the delivery of IGA and in that through Reline and through a number of interbody elements and our IOS contribution. It's clearly an opportunity and a place that we want to participate, and we believe there's significant innovation opportunity with regard to what Ellipse has done with early onset scoliosis and where we're heading into the idiopathic space as well. It's clearly ripe for a fresh look and an aggressive approach. I think that the Ellipse thing gives us nothing but momentum on our way into really exploiting that opportunity.

Greg Lucero (Chairman and CEO)

Yeah.

The only thing I would add to it is I think you got a total deformity market, all inclusive of adult down through early onset, of close to $2 billion of opportunity. With the acquisition of Ellipse Technologies, we can now play really in that entire space, and the whole $2 billion becomes available to us. That is how we think about the opportunity around deformity.

Josh Jennings (Managing Director)

Great. If I could ask one more, I know, Greg, you've talked about some efficiencies in the sales force that you can capture and instituting in this clinical associate role. I was just hoping you could walk us through the risks and the benefits of that, obviously freeing up your sales rep to build out the business in different territories.

A lot of the feedback we get from surgeons is that that sales rep's presence in the OR is one of the reasons why there's historically been success with NuVasive in that account. Can you just help us think about how you're balancing those two things that you brought up in terms of realizing those sales force efficiencies going forward? Thanks a lot.

Greg Lucero (Chairman and CEO)

You bet. We would agree with that last comment that the NuVasive representative in the OR is one of the key factors that drives a surgeon to want to be a partner, a member with NuVasive. That said, early in 2015, we experimented with creating this clinical associate role, a person with a good operating room experiential set, deep training in NuVasive technology, an understanding of how to be a service partner.

We prototyped that in a couple of geographies to see if that could be a way, as we have said in other venues, to then remove the more expensive, if you will, sales representative and let them hunt a bit more. We tried it out in certain geographies. The results came back extremely positive. Having said that, we still are very cautious about the rollout of that idea across the nation, across the world. What happened in the balance of 2015 was we sat down with each of our major sales representatives. We caucused with them to see if they wanted to try this out. We probably deployed—actually, I'm not going to disclose how many we deployed, but a fair amount of them across the United States and measured then their impact.

What we found when we deployed them is we did not lose customers, and we actually accelerated our growth rate in those geographies. It is a good idea. It is an idea that does not fit everywhere. It depends on the surgeon. We are ramping up the idea in 2016 in the right geographies to get additional growth. That is how we think about it.

Operator (participant)

Thank you. Our next question comes from Larry Biegelsen with Wells Fargo. Please proceed.

Larry Biegelsen (Analyst)

Hi, guys. It is actually Craig on for Larry. I wanted to ask on M&A strategy. I think, Greg, on the Ellipse call, you had mentioned that you saw a potential deal coming in the next few months. I want to know if that is still a fair expectation. And then secondly, what is the appetite for new deals, and would you guys be willing to add debt for the right deal?

Greg Lucero (Chairman and CEO)

Let me answer the question by always coming back to first principles. For us, it's about a return on invested capital, and it's about delivering a strategic advantage. We want to be very disciplined on the deployment of capital. If it's going to be more of a tuck-in, a smaller acquisition, we want to get the return on capital above our weighted average cost of capital meaningfully within three years. If it's something bigger, transformational, certainly by five years. As a point, Ellipse Technologies and all of our work and all of our modeling certainly meets those goals because of the very fast revenue growth we're seeing and we have planned for the business.

We built out a very competent, very strong corporate development team to allow us to not only understand our own innovation, but what others are doing and seeing when and if it makes sense to make acquisitions. We are always looking at things. I do anticipate that we'll probably make other acquisitions in 2016, but I'm not going to comment on how big or small they are or if we need to take on debt or not. As I come back to my first principle, we're going to be extremely, extremely principled in the deployment of capital.

Larry Biegelsen (Analyst)

Thanks. If I could just squeeze one more, China was a focus, an acquisition focus for 2015, and just wanted to get your thoughts on 2016. Is it still a focus?

Greg Lucero (Chairman and CEO)

China is still a focus. Beyond the headlines, beyond the volatility, healthcare spending in China remains very strong.

The growth rates in the healthcare market in China are substantially above other markets around the world. We have zero presence there right now. If anything, now is probably a better time than before to buy assets if you're going to move into China, just given the rest of the uncertainty in the world. I'm not ready to announce anything because, again, I come back to first principles. Any deal we do is going to be a good deployment of capital.

Larry Biegelsen (Analyst)

Great. Thanks for taking the questions.

Operator (participant)

Thank you. Our next question comes from Kaila Crumb-Ewalt with William Blair. Please proceed.

Kaila Crumb-Ewalt (Analyst)

Hi, guys.

Just looking at the guide and the slower growth expected from the surgical support segment in 2016, can you just help us understand how you're thinking about driving improvements in that area over the next 12 to 18 months so that that segment might accelerate into 2017?

Quentin Blackford (CFO)

Yeah. Okay. It's Quentin here. The one thing that we're up against in that biologics segment, which falls into the surgical support, is going to be tough comps. We were growing biologics 13% or so in Q1 and still roughly double digits in Q2. In the back half, the comps get a little bit easier. We have to work ourselves through that. Over time, you would expect biologics would pull through comparable to your hardware growth, which is really your procedural volume.

Once you get through the tough comps, you would expect to see that category start to come back in line. The other thing that falls down into surgical support and others is just the services business, which has generally been growing in the low single digits. We would expect that would continue right along that same trajectory, and that's what we've modeled in. That's going to continue to grow at a slower rate than the overall procedural growth, at least for the time being. I think over time, you should see that category get closer to the procedural growth that you're going to see in this final hardware comp category.

Kaila Crumb-Ewalt (Analyst)

Okay. I know with Ellipse, you guys mentioned that incremental R&D spending. We know that the company has a trauma presence there today.

How do you think about that opportunity even versus the corresponding segment? Is that a segment you'd like to have more of a presence in longer term? And are there any R&D dollars today being allocated towards that segment?

Pat Miles (President and COO)

Yeah. This is Pat. We're extremely enthusiastic about the unique utility of that mechanism. And there is a fair amount of experience already, obviously, in the limb lengthening side. And the translation of a limb lengthening strategy to a complex trauma strategy is somewhat straightforward, and it has great momentum. We have great enthusiasm as it relates to the elements of R&D that's been done up at Ellipse prior to the acquisition. I see every reason to perpetuate them.

Kaila Crumb-Ewalt (Analyst)

Great. Thanks.

Operator (participant)

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

Jeff Johnson (Analyst)

Thank you. Good evening. Pat, could I maybe follow up on that?

I do have one other follow-up question. Just on that point, on the Precise side of the Ellipse deal, it's been a month since the deal was announced. Any changes at this point in go-to-market strategy or how you're thinking? I'm sorry about the go-to-market strategy there. Do you partner, as you maybe discussed last month? Do you do that with your own kind of agency and distributor-based business? How do you go to market there?

Pat Miles (President and COO)

I think the same way that we're thinking about the R&D strategy. We believe this to be a nice little assembly of really specialized orthopedic products. We see it as an opportunity for us. Really kind of no change in terms of the way that we're thinking about the go-to-market strategy other than really bullish on what we believe the opportunity to look like.

Jeff Johnson (Analyst)

All right. Fair enough.

Quentin, I just want to make sure I understand the international number from the fourth quarter. We kind of went into this quarter thinking there was going to be maybe a few million-dollar headwind from the European distributor to direct switches that were going on. It sounds like that did not materialize. Instead, was it just all volume weakness in Puerto Rico, Middle East, and Latin America? Were there some payment issues there? Maybe just a little more color on kind of what was happening and how we should be thinking about that as we go into the first half of 2016 here.

Quentin Blackford (CFO)

Yeah. The big issue, Jeff, was around Brazil, frankly, and not being able to get any money out of the country to get paid and recognize that revenue. That is what we saw in the quarter itself.

Our guidance had anticipated that we would continue to sustain kind of the historic trends within that business and their ability to pay. We did not anticipate some of the benefits we had from the prior year. If you remember, we talked about that quite a bit back through the middle of the year that there were some one-time benefits in 2014, and we said they would not repeat in 2015, or at least we would not guide to them. We thought the core business would continue. What we saw in the fourth quarter was the inability to get any dollars out of the country at all. We did not recognize much of any revenue in Brazil. The underlying procedural volumes were still there, though, and they are still being performed in the country. It is more a timing issue. That cash will come. The revenue will come.

In the quarter itself, we were not able to recognize it. That was the incremental challenge that we had not fully anticipated. That was really isolated to Brazil. There were some headwinds in the Middle East that we talked about. Between the Middle East and Brazil, those were really the challenges. The transitions we made throughout Europe, as we noted with Germany specifically, we are seeing growth come back there in a pretty dramatic way, nearly 30% growth in the quarter. It is more a timing issue and just working through the ability to get paid for some of these distributors.

Jeff Johnson (Analyst)

Thank you.

Operator (participant)

Thank you. Our next question comes from Jonathan Demchuk with Morgan Stanley. Please proceed.

Jonathan Demchuk (Analyst)

Hello. I had a quick question on the competitive landscape, I guess, in Spine.

Over the last few quarters, some of your larger competitors have replaced management and appear to have an increased focus on Spine across the board from investing into product lines, selling to hospitals more broadly. Have you seen any change in the competitive landscape? If so, if you kind of maybe describe if there's any sort of changes that you guys need to make to your strategy going forward.

Pat Miles (President and COO)

We get asked that question quite a lot. We reply very simply that we haven't seen any change on the competitive set or the competitive dynamics in the field. I would just make a personal comment that usually management change at those big companies just creates a ripple effect of uncertainty and then a lack of further focus on execution. That's what we think.

Jonathan Demchuk (Analyst)

Understood.

I just wanted to ask one quick follow-up on the emerging markets discussion that we've kind of recently had. Obviously, it's been a big theme across medical devices across the board. Can you maybe describe, I guess, what you're really expecting and for what you're assuming into guidance for next year on your emerging market growth? Are you expecting it to stay relatively muted throughout the year, or do you think that's something that can recover relatively quickly?

Pat Miles (President and COO)

Yeah. I will tell you, it's relatively nominal in terms of its growth expectations next year. We're not looking at it to contribute to growth. We're also not looking at it to go backwards in a meaningful way. At the same time, there's not a whole lot of room to go backwards because it's not a significant part of the business.

With the soft year that Brazil had, there is not a huge base that we are working off of. The plans and guidance is more or less flat year over year in those markets. The growth that you see in international is really coming from our direct markets, which are primarily Japan, Italy, Australia, now Germany that is coming back online with some nice growth. That is what is going to be fueling the overall growth.

Jonathan Demchuk (Analyst)

Understood. Is implied in guidance organically OUS growth of about 20% when you kind of back out of Ellipse?

Pat Miles (President and COO)

You got it. Yep.

Jonathan Demchuk (Analyst)

Great. Thank you very much.

Pat Miles (President and COO)

I think I spoke directly to that. Yes, it is 20%.

Operator (participant)

Thank you. Our next question comes from Robert Hopkins with Merrill Lynch. Please proceed.

Robert Hopkins (Credit Sales)

Hi. Thanks. Just a couple of quick follow-up questions. Just sort of one last one on the OUS growth.

I realize you guys had really good U.S. growth, but we would like to focus on the things that maybe were not going as well. What percentage of your OUS sales are in kind of Latin America and Middle East?

Quentin Blackford (CFO)

Yeah. We have not disclosed that for a while. I will tell you, the last time we did talk about it, it was about a third across each region. Obviously, with the growth in Asia-Pacific accelerating well beyond the overall international growth, it is more weighted in that area. And Latin America has become much less. It kind of gives you a sense of where it might be.

Robert Hopkins (Credit Sales)

Okay. And then a couple of other little things.

Quentin, can you just give an update on the progress on the tax rate and how are things going relative to your expectations here as you close out the year and then the progress that you expect to make over the course of this year and going forward?

Quentin Blackford (CFO)

Yep. Sure. Clearly, the tax rate continues to be well too high for a company of our size. We know a big part of that comes back to our international presence and the ability to drive profitability there. We're focused on doing that. At the same time, we're making good progress in bringing it down. We came into the year guiding to an expectation of around 47% on the non-GAAP tax rate. We saw it come in around 42%. We made good progress over the course of the year.

We would hope to repeat that kind of progress as we head into the future. There were a couple of one-time discrete items that helped us get there in the current year that, at least at this point, would not repeat. I think if you normalize it, you saw us generate probably about 300 bps of improvement. Our guidance is roughly 100 bps of improvement next year. We feel very good about that. To the extent we can accelerate international and the profitability efforts there, we should be able to move more quickly.

Robert Hopkins (Credit Sales)

Lastly for me, the last little thing I wanted to touch on was just Attrax.

I just wanted to see kind of how things are going with that, put that launch into perspective for us, and just wanted to get some general comments on how things are going there.

Quentin Blackford (CFO)

Attrax is coming along well. We plan to roll that out in a broader launch in the U.S. in the mid-part of the year. You'll start to see some contributions from that in the back half of the year. I would say things are going fine there.

Robert Hopkins (Credit Sales)

Okay. Did I hear you correctly? You said the guidance for the year on OUS was 20% growth, excluding the contribution from the acquisition?

Quentin Blackford (CFO)

That's right. If you were just to look at core NuVasive business with no acquisition on a constant currency basis, yeah, 20%.

Robert Hopkins (Credit Sales)

Perfect. Thank you very much, Quentin. Yeah.

Operator (participant)

Thank you.

Our next question comes from Joanne Wuensch with BMO Capital Markets. Please proceed.

Joanne Wuensch (Analyst)

Thank you. Many of my questions have been answered, so I'll be somewhat brief. Frankly, they've all been answered. So I'm going to ask you a different question. What are we going to be talking about in six months or 12 months? I mean, you started laying out OUS, Ellipse, and trying to be a full-service provider. I have the suspicion you have something else in mind as your next phase. I feel like sharing some of that with us now. Thank you.

Greg Lucero (Chairman and CEO)

It wouldn't be any fun if we told you what's coming. What I want to give you assurance on is that the current agenda of fundamentally improving execution, delivering great improvement in profitability, and continuing to invest in innovation, whether it's our own or acquiring key technologies, is going to continue.

I would further add that while I do not control it, I at least anticipate it, that the competitive playing field really will not change very much in the next 12 months. We think we will continue to gain market share as a result. We are feeling, as I said in my prepared remarks, while the world is volatile around us, we are going to be steady, and we think we are going to have a great year.

Operator (participant)

Thank you. We have come to the end of today's call. I would like to turn the floor back over to Mr. Lucero for closing comments.