Surgalign Holdings, Inc.

Wendy Crites Wacker - IR Brian Hutchison - President and CEO Rob Jordheim - EVP and CFO

Matt Hewitt - Craig-Hallum Kyle Rose - Canaccord David Turkaly - JMP Securities Chris Cooley - Stephens Michael Rich - Raymond James

Good morning everyone and thank you for joining RTI Surgical for our fourth quarter and year end 2014 conference call. Today, we will hear from Brian Hutchison, President and Chief Executive Officer; and Rob Jordheim, Executive Vice President and Chief Financial Officer.

Before we start, let me make the following disclosure about forward-looking statements. The earnings and other matters, we will be discussing on this conference call will involve statements that are forward-looking.

These statements are based on our management's current expectations, but they are subject to various risks and uncertainties associated with our lines of business and with the economic environment in general. Our actual results may vary from any statements concerning our expectations about future events that are made during the course of this meeting, and we make no guarantees as to the accuracy of these statements.

Accordingly, we urge you to consider all information about the company and not to place undue reliance on these forward-looking statements. Now, I'll turn the call over to Brian Hutchison.

Good morning, everyone. And thank you for joining us.

I will start the call with an overview of the fourth quarter then Rob will review our financial results. I will follow-up with financial guidance for 2015.

As detailed on our press release issued this morning, we reported record fourth quarter revenues of $71 million, a 17% increase over the fourth quarter of 2013. We exceeded our fourth quarter guidance of $68 million to $69 million.

We achieved record annual revenues of $263 million, an increase of 33% from 2013 and exceeding our annual guidance of $260 million to $261 million given at the beginning of the fourth quarter of 2014. If Pioneer revenues had been included for the full year of both 2013 and 2014, worldwide revenues would have increased by 8%.

When reviewing each of our lines of business, fourth quarter spine revenues increased 18% compared to fourth quarter of 2013. The increase was due to strong growth in US direct business specifically for their high quality hardware.

Our direct spine team continues to do an excellent job of converting surgeons. In 2014 we launched six new spine products including streamline OTC, Aspect Anterior Cervical Plate System and the MaxFuse VBR System.

Each of these products continues to do well and they are showing steady growth. At this time, we're anticipating spine will grow in the high single digits for the full year of 2015 compared to prior year.

Our sports medicine business increased 15% compared to fourth quarter of 2013. The strong quarter is a result of U.S.

direct sports business successfully converting accounts and gaining market share. We experienced steady growth throughout 2014 concluding in a solid fourth quarter.

We anticipate growth in the mid to high single digits in this line of business for the full year of 2015. Fourth quarter surgical specialty revenues decrease 19% compared to fourth quarter of 2013.

This was due primarily to decreases in revenue from some of our commercial customers. Our focus continues to be on building our direct business.

At this time we anticipate that Surgical Specialty's business will grow in the high single digits for the full year of 2015 due to growth from our direct distribution globally offset by declines in our commercial business. Fourth quarter BGS general orthopedic revenues increased 17% compared to fourth quarter of 2013.

The increase in revenues for the quarter was due to growth in our direct business, offset by lower orders in our commercial business. We had strong momentum leaving the fourth quarter across our BGS GO portfolio specifically with our Map3 Cellular Allogeneic Bone Grafts and nanOss Advanced Bone Graft Substitute.

During the quarter we updated the manufacturing process for nanOss 3D Advanced Bone Graft Substitute a synthetic bone void filler. The product shelf life was extended and handling consistency was improved.

nanOss 3D was introduced in early first quarter of 2015 and feedback from customers has been positive. I want to give you a brief update on our ongoing interactions with FDA regarding our Map3 allograft.

Since our third quarter earnings call, we have met with and have been in dialogue with the FDA and our discussions are ongoing. We expect that this maybe a lengthy process and as we have news to share, we will update you.

We continue to be confident that the Map3 allograft provides clinical value and our expectations for the potential of this implant have not changed. We anticipate that BGS GO revenues will grow in the low 20s for the full year of 2015 due to strong growth in our direct BGS GO business.

Fourth quarter dental revenues increased 6% compared to fourth quarter of 2013. This is inline with our exclusive distributors contracted minimums, which met our expectation.

At this time we anticipate that dental revenues will grow mid single digits for the full year of 2015 per our contract with our exclusive distributor. Fourth quarter revenues for Orthofixation increased 44% compared to fourth quarter of 2013.

We continue to be pleased with the growth of our direct cardiothoracic business, particularly around the Tritium Sternal Cable Plating system. During the year, we renewed our contracts with both of our major commercial customers in ortho fixation, Zimmer Trauma and DePuy Synthes.

At this time, we anticipate that orthofixation will grow mid-single digits for 2015. At this point, Rob will provide some more detail on our financial results.

Rob?

Thank you, Brian. Worldwide revenue of $70.9 million in the fourth quarter increased 17% compared to the fourth quarter of 2013.

Domestic revenues of $65.4 million for the fourth quarter increased 20% compared to the fourth quarter of 2013. International revenues, which include exports and distribution from our German and Dutch facilities were $5.4 million for the fourth quarter of 2014, a decrease of 11% over the fourth quarter of 2013.

On a constant currency basis, international revenues decreased 4% over the fourth quarter of 2013. Net loss applicable to common shares for the fourth quarter of 2014 was $136,000 or $0.00 per fully diluted common share, based on $56.9 million fully diluted shares outstanding.

This compares to net loss applicable to common shares of $8.5 million or $0.15 per fully diluted common share for the fourth quarter of 2013 based on $56.4 million fully diluted shares outstanding. The fourth quarter of 2014 included a pre-tax severance charge of $4.3 million and a pre-tax litigation settlement charge of $185,000.

On a non-GAAP basis, excluding the severance charge and the litigation settlement charge, the company reported adjusted net income applicable to common shares of $2.7 million and adjusted net income per fully diluted common share of $0.05. The company's fourth quarter adjusted before interest, taxes, depreciation and amortization or EBITDA was $10.2 million or 14% of revenues for the fourth quarter of 2014 compared to $5.8 million or 10% of revenues for the fourth quarter of 2013.

Gross margin for the fourth quarter of 2014 was 53% as compared to 35% for the fourth quarter 2013. On a non-GAAP basis excluding a pre-tax inventory purchase accounting adjustment of $9.5 million taken in the fourth quarter of 2013, gross margin improved 200 basis points versus the prior period as a result of an improvement in product mix.

In addition on a non-GAAP basis excluding our pre-tax inventory purchase accounting adjustment of $5.7 million taken in the first quarter of 2014, adjusted gross margin improved sequentially each quarter for the full year 2014. During the quarter, our marketing, general and administrative expenses totaled $21.1 million, an increase of $2 million or 8% higher than the fourth quarter of 2013.

The increase in expenses was primarily due to increases in variable compensation and distributor commission expense. During the fourth quarter of 2014, the company recorded a pre-tax severance charge of $4.3 million to reflect elimination of certain positions in the company in an effort to flatten reporting structure and enhance speed to decision making.

As result of this effort, the company expects to benefit from $3.2 million in annualized savings. Also during the fourth quarter of 2014, the company recorded a pre-tax litigation settlement charge of $185,000 to settle a dispute with a foreign distributor.

Research and development expenses totaled $4.1 million for the fourth quarter of 2014, which was comparable to the fourth quarter of 2013. Lastly, our tax rate for the fourth quarter of 2014 reflects a tax expense of 17% compared to a tax benefit of 36% in the fourth quarter of 2013.

Our fourth quarter 2014 tax rate was favorably impacted due to the inclusion of full year 2014 research and development tax credit in the fourth quarter of 2014. Turning to the balance sheet, our cash position at the end of the fourth quarter was $15.7 million compared to $18.7 million at the end of 2013.

The decrease was primarily due to the construction of our new logistics and technology building and investment and spine instrument sets to drive growth. For 2015, we anticipate being cash flow positive from operations.

We are confident that with current cash balances and available debt, we have adequate liquidity to support our future operations and meet our financing obligations. Excluding an inventory purchase accounting adjustment of $5.7 million included in the inventory balance at the end of 2013, inventories of $113.3 million increased $12.9 million as compared to the end of 2013.

The increase in inventories is due to set bills to support the growing spine business as well as inventory bills to support our biologics business. Working capital at the end of the fourth quarter totaled $134.5 million an increase of $5.9 million excluding the previously mentioned inventory purchase accounting adjustment of $5.7 million.

At the end of the fourth quarter, we had $75.9 million of debt and approximately $5.6 million available under our revolving credit facilities. With that I will turn the call back over to Brian.

Thanks, Rob. At the beginning of 2014, we laid out a series of goals for the company.

They work to return the growth in our sports and spine business, gain traction in our direct surgical specialty business and expand distribution of our Map3 Allograft. Not only did we achieve each of these goals, we also saw above-market growth in spine, sports medicine, BGS and general orthopedic and orthofixation businesses and we met or exceeded our guidance every quarter.

In 2015, our key value drivers will be driving growth in our focused products, NanOss, advanced bone graft substitute, Fortiva porcine dermis and Map3 Allograft; secondly, capture market share in spine hardware through targeted customer conversions, billing additional spine instrument sets to support more surgeries and by leveraging our broad biologics portfolio. Growing international revenue, especially in Europe and Asia pacific and finally controlling spending and implementing additional lean manufacturing processes in order to continue improving margins.

Turning to guidance, in our press release this morning we outlined expectations for revenue and EPS for the first quarter and full year of 2015. For the first quarter of 2015, we expect revenues to be between $66 million and $67 million.

This would result in a 9% increase in revenues compared to Q1 last year at the mid point of our guidance. We expect net income per fully diluted common share for the first quarter 2015 to be approximately $0.03.

We expect full year revenues to be between $279 million and $285 million, an increase of 7% year-over-year to mid point of our guidance compared to 2014. Full year net income per fully diluted common share is expected to be in the range of $0.17 to $0.22 based on $58 million fully diluted common shares outstanding.

Following the integration of pioneer we’ve realigned the business as well as to find the goal that will grow our company into the future. We’ve set on our path to become a $500 million revenue company with gross margin approaching 60% and operating margins approaching 20%.

To reach this goal, our leadership team has created a plan and has three major areas. First, our biologics business, which includes allograft and component graft implants; second, our hardware business, which includes medals and synthetic based implants and third, our focused products, which includes NanOss, Fortiva and Map3 Allograft.

As we concentrate on these three key areas, we will gain momentum and ultimately achieve our long term objectives. With the successful integration of Pioneer behind us and a clear strategy for growth, now implemented companywide we believe that RTI is set up for success with the right leadership and the right products.

We hope to see some of you this quarter. We'll be presenting at the BTIG Medical Technology Conference on February 19 in Snowbird, Utah and the Canaccord Musculoskeletal Conference in on March 24 in Las Vegas.

At this time, let’s open up to questions. Operator?

Good morning, thank you taking our questions.

Good morning, Matt.

Good morning.

Couple different topics, first and foremost, the Milwaukee facility, the pioneer facility there was piece out recently that you guys have added, I think 40 people there. You have plans to add 20 more.

Obviously the spine segment has been putting up good numbers. I’m curious is the additions in people at that facility, is that in response to the demand that you've been seeing or is that trying to get out ahead of anticipated demand in FY15 and beyond.

Well Matt, this is Brian. The facility is actually in Marquette, Michigan not Milwaukee.

Sorry.

And it is actually -- we’ve actually now hired over 60 people and we will continue -- we'll continue and we're actually adding -- we’ve added approximately 10 new CNC machines, we'll add another 10 this year. So it's really just to keep up with current demand.

It's not -- we don’t have excess capacity at the moment. In fact we're -- if anything were in a back order situation.

Has that -- how much has that impacted your ability to grow that segment? Are you running into some challenges there?

Well at this stage, like all companies that are growing fairly rapidly, when we acquired the company, there had been a lack of investments. So we had to catch up first, which we did and now we've been launching new product lines, which also requires instruments and so we've been building new sets and where we're trying to go now is to try to build enough sets to reduce the loaner activity in the field to the extent we possibly can.

But we’ve also launched an effort to grow aggressively this year in Europe and Asia and we need tremendous set builds for both those markets right now. So it's bid of everything, but to us, it's all good news.

It’s a matter of just trying to control the growth and control our investment while we do grow as Rob said, to be sash flow positive in 2015.

Okay. That sounds like a good position to be in.

Two more, first surgical specialties has kind of ticked down here last couple of quarters, have we hit bottom? Your guidance imply -- or you stated that guidance for that segment should grow in 2015.

So is Q4 kind of the low water mark or how should we be thinking about that sequentially over the course of the coming year.

Matt, this is Rob. I think that’s a good way to look at it.

Q4 is primarily in our hernia and breast business with Davol, but I think we've hit the bottom there. I think the growth you’re going to see in 2015 is really going to come through the direct business.

Okay, great. And one last one, the FDA recently put out some draft guidance on human tissue based products.

I think the 23rd is when the common period ends. How or which products is that impacting for you guys?

Does that impact to the Map3 product and if so, are you watching that closely? I would assume that you guys have submitted your own comments, but maybe you could walk us through that situation a little bit.

Sure, I can give you an update and update in Washington twice in the last two weeks on both those topics; one representing the industry and one representing RTI. So I would say this, the guidance is out there.

We got some news yesterday that indicated that they -- they have a lot more guidance documents to go and that they’ve indicated that this comment period -- while they won’t extend the comment period on this specific guidance, they’re actually going to allow comments on all the guidances through the next several that the issue. So in effect, this guidance -- this comment period is actually going to be extended.

So not just our company, but the industry and all medical devices, so even some of the larger groups, that are members will get a chance to comment as we'll. So it's going to -- this will be a lengthy process.

This could take quite a long time to play out. We don’t expect any immediate changes and while this could have a variety of impacts on a variety of players in the industry, actually RTI believes that we are in good position in regards to this guidance and will continue to try to work with the agency to be a responsible party in this industry.

So at this stage, we don’t see any impact on our business for 2015 at this stage.

Great, thank you very much.

Great this is Kyle for bill, can you hear me all right?

Yes, good morning, Kyle.

Good morning and congratulations on a strong quarter, just kind of want to play off on the previous question there. It just seems like and just to start off I guess, the FDA is obviously putting a lot more, for lack of better word, pressure on the industry and a lot more of a focus from a regulatory standpoint, just so the updated guidance and lot of the untitled letters and warning letters to some of the industry participants.

When you think about in that respect, how do you think about Map3 specifically and then commercializing and developing products moving forward, is this something where we should start to expect increased conical trial cost and things of that sort? Or I mean, how can we think about regulation moving forward and how it impacts the business, near and long term?

Well, I think your judgment or assessment that they're trying to up regularly may not be wrong. We don’t know that for a fact, but you may not be wrong and so that would lead one to believe that there will be more emphasis on clinical evidence and some, way or form and that wouldn’t surprise us it that ultimately occurs.

So we're working on it from all angles. There certainly has been a lot more focus on the industry, not all of it bad, frankly.

Some of it helps the industry progress and grow and that’s okay. We just want to make sure that it’s done in a responsible and fair manner and with transparency that Margaret Hamburg said, she was going to work on it when she was the Commissioner.

So we fully expect that we will continue to work with them for a long period of time. I don’t think this is going to be over with anytime soon.

This could extend well beyond the next year easily as the process unfolds, it could be a rather lengthy process. So I don’t think we know the outcomes yet, but I do think your assessment is accurate in that there is lot more focus on the industry and I think that’s going to continue.

Good. So then I guess when we think about the BGS in general ortho line, 30% plus growth this year guiding the low 20s next year or in '15, that’s a bit higher than we were looking for.

With the increased focus on regulatory side and the question about Map3, can you kind of walk us through what gives you confidence that you continue to see really strong growth in that business line or maybe help breakout where some of that growth is specifically going to come from, whether it’s synthetic versus the Map3 or how can we get comfortable around that growth?

Well, I think for us, that encompasses certainly nanOss as well as basic allograft as well as Map3 and while there -- we have an untitled letter and if you have looked at the website, there are a number of untitled letters out there regarding these types of products, some of which have been out there three and four years. So while we worked with the FDA, we don’t expect that we will remove our product from the market while we’re going through this process, based on the fact that the other ones have all been out there and the products are still in the market.

So we still expect that we will continue along with our plans, which do reflect growth year-over-year and as we said, that’s part of our focus products, which we will report on together, which includes both Map3 and nanOss and Fortiva. We clearly have a huge opportunity in front of us with both map3 and nanOss.

They're both really great products. They're both in really good markets and we have good opportunities in both spine as well as foot and ankle space to use these products.

So, we will be working on strategies for both and all we can do is keep you posted on quarterly results as we go through this.

Great. And then one last question, I’ll hop back in the queue.

Very strong quarter on sports medicines, strongest we've seen in the past couple of years. So that’s very encouraging.

I just wanted to talk specifically about the cadence for 2014 and the step function of growth we saw in the Q4. We saw pretty steady growth, steady from a nominal perspective for the first time once in the year and then a big step up in Q4.

How much of that is going to be the base moving forward? Or is there any stock in that happen?

Just wondering how we should think about Q4 relative to modeling for 2015.

Kyle, this is Rob. If you remember in 2013 the comparable there were a little bit -- lights were benefiting a bit from that.

But that being said, we have been getting good account recapture and we're getting some new accounts. As you look at 2015 as the comparable really start to normalize a little bit, like we said, we expect that the growth rate going forward is going to be somewhere in the mid to high single digits for 2015.

Great, thanks a lot.

Thank you. Just to clarify quickly, the comments -- the up-regulated comments, as you look at your portfolio, are we really talking about just Map3 that you think would even fall under anything in terms of minimum of the manipulation things that they're looking to kind of focus on of did you say that nanOss might have some overlap there as we'll?

I just wanted to get your clarifying points there.

Well, actually that’s a good point Dave. The guidance documents are out there in fact everything and it depends on who interprets and how they get interpreted.

They could have some extremely negative impact on the entire industry around minimal manipulation. To give you an extreme example, if you put polls or fenestrations into a piece of dermis, does that change its -- is that more than minimal manipulation?

We had some dialogues together as the industry in the last week about how far the extremes could be interpreted by different reviewers as they are looking at things. And so our concerns are basic and that there needs to be a lot more discussion and definition around what things can and cannot be done and understand some of these guidances have been in place for many, many, years and we've been processing human tissue in the United States since World War 2.

So these things have been -- we've been grinding tissues to make bone paste and doing things with tissues for a very, very long time. They have now come into question under this guidance.

So at the end of the day, I just think the guidance wasn’t that well written. It’s going to take a bit of time to get it to where it should be, but as an industry working with the agency and Capital Hill, I believe we’ll get there.

This is going to take time.

I got you. Thank you and congrats on the progress this year.

The sequential progress and then the guidance for next year, we're looking at sort of the midpoint being 7% growth and that’s kind of organic now with Pioneer fully in. So I’m looking at these growth drivers and I just wanted to clarify, so if we took those three important ones are those in order in terms of how you think about the impact they’ll have on your '15 numbers and then maybe ahead NanOss, Fortiva and Map3 in that order, in terms of the contribution?

Okay. This is Rob.

And there is no real order. We kind of speak to these three products in a group.

There is no question that they're going to be leading the growth of the company as we look into 2015 for sure.

I was trying to get in the way. But I understand.

And then lastly for me I guess I followed you guys for a long time, I guess Europe has been a focus somewhat in the past, but APAC is certainly not in my recent memory. I guess, what is driving your thoughts of expanding there and what would be the primary -- what would be the leading products that you bring to those geographies or what do you really focus on there?

In Asia, well this is Brian, we've actually been -- through Pioneer, we were distributing spinal implants into China and we've been distributing our allograft implants into Korea for years. We've been talking about Australia for some time.

We've actually been -- we actually distributed in probably about 10 countries in Asia now. So, we opened an office in Singapore.

We hired an employee and we now, I think have two or three employees total in Asia and our key markets are going to be China, Singapore, Korea and Australia and they will all be spine. They will -- we will try and get nanOss into all of them.

We're actually working on approvals now and we will continue to market allograft and Xenograft in Korea, which is a very, very strong market opportunity for us as well. So we continue moving down that path.

None of those markets will see Map3. They will all see everything else.

And over time, we expect that the opportunities are really large. We just need to be careful which countries we pick and focus our efforts correctly in each one.

Great thanks.

Thank you, and congrats on a great quarter. Just a quick question if I may, didn’t you have the second annual biologic symposiums during the fourth quarter?

Just kind of curious what kind of interest you generated from industry from that? And then kind of the pull through that you expect to see post the symposium here as we think through the first half of the year and then I’ve got one quick follow up.

Thanks.

We had really good success last year with all of our symposiums and the one in New York was very, very strong. We had outstanding leader for that conference as well as really strong participation of what I would describe as some fans and people that know RTI and some not.

Some that were from independent groups that wanted to learn about what we’re talking about or wanted to participate in the dialogue regarding biologics in spine and it was a really good meeting. Net-net each time we’ve had one of those conferences, we've gained more knowledge and exposure and opportunities to talk to more surgeons out there and engage them in conversations and its gone extremely well.

And that was the foundation for us creating our first Surgeon Advisory Board, which we’ve now opened and begun dialogue with and that will help us in the future. So, while we certainly we like them talking about things like nanOss and Map3 as it relates to spine, we also like talking about the future and the next big invention and what it might be, not just a next metal hardware piece, but the next biologic need.

So those have been really, really good for us and they help fuel the company and help create excitement in the field. It’s been a good thing for us.

Super, I appreciate that Brian and then maybe Rob just quickly, two follow-ups, on the balance sheet, did I hear you correctly that you have approximately $5.5 million available on the revolver? I think you have a payment coming up, is it mid -- I won't say July of this year.

Could you just maybe walk us through as you’re thinking about basically building out additional inventory here in the shorter run to support this growth? How you’re thinking about cash allocation and I'm assuming paying down that revolver going forward.

And then another one quick and I'll get back in the queue. Clearly the company continues to focus on going direct and controlling its own destiny and that’s yielding great results.

But are you seeing a little bit of drop off in commercial? Should we assume that as being the new normal or performing closer to minimums there in those businesses as you guys allocate the newer products and the focus to your own direct channel?

Just want to make sure I get that make shift correct as we go through the year. Thanks so much.

Sure Chris. To your question about cash, this year 2015 we were required to amortize the term loan that we have with TD Bank.

So we will be making approximately $5.2 million in principal payments throughout the year starting in March I guess to be paid at the beginning of April. But we expect to fund that out of operating cash because we’ll be generating enough operating cash to certainly make those principal payments and hopefully during the back half of the year start to pay down some of that revolver a bit.

To your question on commercial, commercial we’re going to do our best to supply our commercial customers, but as we’ve said for a couple of years now direct is where our focus is going to be and in fact our focus products are in our direct businesses. So we're going to obviously serve our customers.

Our commercial customers do drive good cash flow. They're very good payers, but the focus for 2015 is going to be on the direct side of the business.

Thank you.

Hi, this is Mike calling for Jason. Congrats on a nice quarter.

Thank you.

First question of Surgical Specialties, can you give us an idea what the direct side of the business grew in the fourth quarter absent the Davol impact. And then as a follow-up to that, can you give us a little more color on the cadence of that on that line item in 2015?

Was fourth quarter more of an anomaly or is that more backend loaded as you look at 2015 for Surgical Specialties?

This is Rob. For Surgical Specialty, the direct side Q4 was bit of disappointing on the commercial side, but we expect that we’ve hit kind of that baseline now as we look out into 2015 with those orders from our commercial partners.

The growth you're going to be seeing is on the direct side with our direct hernia and direct breast businesses. Albeit it's a small base right now on the direct side, we're expecting quite a bit of growth coming from that business.

Okay. And then you mentioned that you reported on the focus product as a whole going forward.

I guess they don’t want to necessarily provide guidance for that yet, but can you give us an idea what the base is for 2014, so we can forecast that when you do provide it going forward?

Yes. For 2014 the base is approximately about 5% to 6% of our revenues.

Okay. That’s helpful.

And then lastly the other segment of revenue actually grew quite nicely in 2014, I know its small, but it does help. I'm wondering what the expected contribution from other revenue is in 2015.

I think - this is Rob. Other revenue is going to normalize to about $2.5 million to $2.6 million a quarter.

Okay, great. Thank you very much and congrats on the quarter again.

Thank you very much and thanks for joining us today. We will speak to you in about 90 days.

Take care.