Surgalign Holdings, Inc.

Wendy Crites Wacker - VP, Global Communications Brian Hutchison - President & CEO Rob Jordheim - EVP & CFO

Kyle Rose - Canaccord Matt Hewitt - Craig-Hallum John Gillings - JMP Securities Keith Hinton - Sidoti & Company

Good morning, everyone, and thank you for joining RTI Surgical for our second quarter 2015 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're 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'll start the call today with an overall review of the second quarter, and then Rob will review our financial results.

I will follow up with financial guidance for the third quarter and full year 2015. As detailed in our press release issued this morning, we reported record second quarter revenues of $71.6 million, a 10% increase over the second quarter of 2014 on a constant currency basis.

The increase over the prior year was due primarily to the strength in domestic revenue, which was up 12% over the second quarter of 2014, offset partially by weakness in international revenue which decreased 7% on constant currency basis over the prior year. The decline in international revenue is due in part to strong currency headwinds, as well as non-recurring set sales in the prior-year period in the international spine business.

During the second quarter, the General Manager of our European operations left RTI to pursue other opportunities. We're in the process of hiring new leadership and expect to fill that role very soon.

We believe this is an opportunity to provide a higher level of execution for international business. With new leadership in place, we expect the execution to our plan to improve significantly by the end of this year.

Overall, our business model continues to work very well. We exceeded our guidance on the top and bottom line for the quarter.

Revenue mix shifted somewhat to commercial in the quarter, which we anticipate will reverse during the second half of this year. Although Rob will share later, we're able to keep operating expenses low and deliver profitability despite the impact of gross margins.

Turning to review of each of our business lines, second quarter spine revenues decreased 6% compared to second quarter of 2014. The decrease was primarily due to international set sales in the second quarter of 2014, with no comparable set sales in the second quarter of 2015.

The U.S. direct team continues to convert surgeons.

Our customer base has consistently grown quarter-after-quarter. We anticipate that these new customers will have an impact in the third and fourth quarters.

Our strategy to lead with our best-in-class biologics and pull through our high-quality hardware continues to be very successful for the direct spine team. At this time, we are anticipating spine will be flat for the full year of 2015.

We anticipate that worldwide direct spine growth will accelerate in the second half of this year, but will be offset by declines in the commercial business due to timing of orders. Our sports medicine business increased 3% compared to second quarter of 2014.

The increase in our U.S. direct sports business was muted by a decrease in international business.

We anticipate growth in the mid-single digits for this line of business for the full year 2015. Second quarter surgical specialties revenues decreased 8% compared to the second quarter of 2014.

This is due primarily to a decrease in revenue from our commercial distributor in the hernia and breast reconstruction markets. As we mentioned on our first quarter call, our distributor in the breast reconstruction market relinquished their exclusive distribution rights.

As a result, our direct surgical specialties team has access to our full line of biological surgical specially implants for both you for both hernia and breast reconstruction markets. RTI surgical is the only provider to offer complete line of biologic implants for hernia repair, complex abdominal wall repair cases and breast reconstruction surgeries, providing surgeons multiple tissue types to better meet the patient's clinical need.

The portfolio includes Fortiva porcine dermis, Tutopatch bovine pericardium, Tutomesh fenestrated bovine pericardium, and Cortiva and Cortiva 1 millimeter allograft dermis. All of these implants are currently on the market, and a full launch Cortiva and Cortiva 1 millimeter allograft implants for homologous use applications in reconstructive surgeries is expected at the American Society of Plastic Surgeons meeting this fall.

We had a record quarter in US direct surgical specialties and are enthusiastic about the long-term opportunity to market these implants on a direct basis. At this time, we anticipate that the surgical specialties business will decline in the low-single digits for the full year 2015 due to declines in the commercial business, partially offset by growth in the direct business.

We expect that the business with our primary commercial partner will begin to level out in the second half of 2015. Second quarter BGS and general orthopedic revenues increased 15% compared to second quarter of 2014.

The increase in revenue for the quarter was due to growth in our direct business, offset by declines in our commercial and international businesses. We continue to see strong growth in our BGS/GO portfolio, specifically with our focused products of map3 cellular allogeneic bone graft and nanOss advanced bone graft substitutes.

The customer base using both map3 and nanOss implants continued to grow consecutively each month during the first half of this year. We anticipate that BGS/GO revenues will grow in the low-20% range for the full year 2015 due to growth in the direct BGS/GO business.

Second quarter dental revenues increased 21% compared to second quarter 2014. The increase was due to higher-than-expected orders from our dental distributor.

At this time, we anticipate that dental revenues will grow low-teens for the full year of 2015. Second quarter revenues for of ortho-fixation increased 48% compared to second quarter 2014.

Both of our commercial businesses and our direct cardiothoracic business continued to show strong growth. Our direct distribution team has done an excellent job, having seen nine quarters of consecutive year-over-year growth.

Additionally, the team successfully launched two line extensions for the Tritium SCP System during the quarter. Our commercial distributors have shown solid incremental growth.

At this time, we anticipate that the ortho-fixation will grow in the mid-20% range for 2015. At this point, Rob will provide some details on the financial results.

Thank you, Brian. Worldwide revenues of $71.6 million in the second quarter increased 8% on a reported basis and 10% on a constant currency basis compared to the second quarter of 2014.

Domestic revenues were $66 million for the second quarter, compared to $59 million in the second quarter of 2014. International revenues, which include exports and distribution from our German and Dutch facilities, were $5.6 million for the second quarter of 2015, a decrease of 20% over the second quarter of 2014.

On a constant currency basis, international revenues decreased 7% over the second quarter 2014. Gross margin for the second quarter of 2015 was 52% as compared to 53% for the second quarter of 2014.

The decrease in gross margin was due to channel mix, as a higher percentage of our overall revenue came from lower-margin commercial distribution. The percentage of our overall revenue commercial distribution was unusually high in the second quarter of 2015, and we do not expect this to continue in the second half of the year.

During the quarter, marketing, general and administrative expenses totaled $27.4 million, which was comparable to the second quarter of 2014. Research and development expenses totaled $4.1 million, an increase of $777,000 or 23% higher than the second quarter of 2014.

The increase in expenses was primarily due to higher investment in research and development related activities as well as abnormally low research and develop expenses in the second quarter of 2014. Despite the lower gross margin in the second quarter of 2015 related to the previously mentioned channel mix, we were able to control operating expenses and deliver record operating income and a record operating margin of 8%, excluding the non-recurring $1.5 million acceleration of deferred revenue from the first quarter of 2015.

We are on track to deliver an operating margin approaching 10% for the full years 2015. Our tax rate for the second quarter 2015 reflects a tax expense of 35%, compared to 40% in the second quarter of 2014.

Our second quarter 2015 tax rate was positively impacted due to increased profitability in lower tax rate jurisdictions. Net income applicable to common shares for the second quarter 2015 was $2.7 million or $0.05 per fully diluted common share, based on 58.8 million fully diluted shares outstanding compared to $1.6 million or $0.03 per fully diluted common share for the second quarter of 2014, based on 57.1 million fully diluted shares outstanding.

As detailed in our press release this morning, the Company's second quarter adjusted earnings before interest, taxes, depreciation and amortization or EBITDA was $10.8 million or 15% of revenues for the second quarter of 2015, compared to $8.8 million or 14% of revenues for the second quarter of 2014. EBITDA growth for the second quarter of 2015 was 22% over the second quarter of 2014.

Turning to the balance sheet, our cash position at the end of the second quarter was $12.7 million compared to $15.7 million at the end of 2014. The decrease was primarily due to a decrease in accrued expenses and principal payments on long-term debt obligations.

At the end of the second quarter, we increased the maximum revolving credit amount from $20 million to $30 million with our lending institutions. 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. Working capital at the end of the second quarter totaled $139.2 million, an increase of $5.7 million.

During the second quarter, the Company made the second quarterly principal payment of $1.5 million on the $60 million term loan. At the end of the second quarter, we had $73.1 million of debt and approximately $15 million available under our revolving credit facilities.

With that, I will turn the call back over to Brian.

Thanks, Rob. As we continue on the multi-year path to become a $500 million revenue company with gross margins approaching 60% and operating margins approaching 20%, we remain focused on three key areas; our base biologics business, which includes allograft and xenograft implants; our hardware business, which includes metals and synthetic-based implants; and our focused products, which include nanOss advanced bone graft substitute, Fortiva porcine dermis, and map3 allograft.

As we've mentioned in the release this morning, second quarter was in line with our expectations for each of these areas. Our base biologics business grew slightly over the prior year period.

Our hardware business grew 14%, and most notably, our focused products grew 80%. Turning to guidance, in our press release this morning, we outlined expectations for revenue and EPS for the third quarter and full year 2015.

For third quarter 2015, we expect revenues to be between $69 million and $70 million. This would result in a 7% increase in revenues compared to Q3 last year at the midpoint of our guidance.

We expect net income per fully diluted common share for the third quarter 2015 to be approximately $0.05. Based on results from the first half, we are narrowing full year guidance for 2015.

We now expect full year revenues to be between $282 million and $286 million, an increase of 8% year-over-year at the midpoint of our guidance compared to 2014. Full year net income per fully diluted common share is expected to be in the range of $0.20 to $0.23 based on 58.7 million fully diluted common shares outstanding.

The key value drivers we shared with you on our 2014 year-end call remain the same. We are driving growth in our focused products, capturing market share in spine hardware through targeted customer conversions, building additional spine instrument sets to support more surgeries and by leveraging our broad biologics portfolio.

We're returning our international business to growth, specifically in Europe and Asia Pacific. And finally, controlling spending and implementing additional lean manufacturing processes in order to continue improving margins.

Based on the first half of the year, we believe we have the right people and right products to help us achieve our goals, and we're confident in our ability to deliver results. We hope to see some of you this quarter as we will be presenting at the Canaccord Annual Growth Conference on August 13 in Boston.

At this time, let's open up to questions. Katherine?

It's actually Kyle. Just had a question, I wanted to see if you could give us a little more color on the U.S.

direct business as we enter the back half of the year, just kind of what gives you confidence that you're able to hit that guidance while guidance down for both the spine and the sports on this quarter? Just wanted to see what kind of gives you confidence?

What are the puts and takes as you go into the second half of the year, there?

I just met with all the sales teams in the last week, and I've had follow-ups with each of them. First thing we needed was to ensure that we had the proper inventory for -- whether it's tissue for the tissue based groups or metals and synthetics for the other groups, as well as having the proper balance of the focused products inventory available.

And we believe and they agree that they see the same thing we do that we have them, and we can now expand the customer opportunity for both map3 and nanOss well beyond where we have been. And that's exciting for both sports as well as spine.

Those sales forces are extremely hungry to turn on to additional customers which will drive volume in the second half. So, that's the number one reason we have confidence.

The next reason I would tell you is that the management is incredibly focused on delivering their commitments for the year and they are really digging in to make sure that the opportunities, they identified are in fact deliverable this year and they've all reinforced their commitment to do so. So based on my conversations, dialogs, deep dive into this and making sure that the inventory in place and the flow of inventory matches our projections is all in line.

Just two more questions and I'll hop back in the queue. First, you talked a little bit about map3 and also mentioned your Inventory levels.

I guess, one, where do we stand from an inventory ability standpoint on map3, but then also any regulatory updates there? And then Rob, I saw a little more leverage in the operating profile than we had modeled.

Can you just talk about how we should think about that MG&A line moving forward and was there anything unique to this quarter? Is that a new base to really start building from?

Kyle I'll take the first part and Rob will take the second part. The first part, on the regulatory side, there really isn't a new update.

We're still in productive dialog with FDA that I think is going to take a considerable amount of time. So there's nothing really to update anyone on there.

As it relates to the inventory and flow, we are at an all time high right now of map3 inventory and frankly, at an all time high of flow that starts from donation, all the way through processing. Yields have been improving.

All the indicators that we track are on the right track to meet or exceed our budget for this year. So that's good news for us, and I would say it is good news for investors as well.

Kyle, this is Rob. I'll talk about the MG&A question you asked.

If you remember, last year, we took a restructuring charge and kind of resized the cost structure of our business, and what you're seeing now is really some of the dividends coming through on that action. Last year, MG&A was roughly 40% to 42% of our revenue.

This year is trending down in to the high-30s and we expect that trend to continue. So we are seeing some leverage from some of the actions we took in the past.

Just a couple of housecleaning items. First on, can we get the total percentage of revenues for the focused products, as well as for the hardware, what those broke down as far as percentage of revenues?

Matt, this is Rob. For the focused products, the total percentage of revenue was in the high-single digits.

Okay?

Okay.

And then for the hardware, it is -- for the second quarter, is roughly 30% -- 30% to 35%.

And then -- and I think you gave it, just if I miss it, the split between distributors and direct for the quarter?

In terms of percent?

Yes, please.

The percent of direct in the quarter was in the high-40s and the distributed business was in the low-to-mid 50s.

And then one follow-up question on map3. Brian, you said that you guys continue to have active dialog.

There was a situation here in late May. The House Committee on Energy and Commerce sent a letter to the FDA looking into the way that they've been dealing and using and posting untitled letters.

And I'm curious if you guys have any thoughts on, number one, what the House is looking at specifically, but number two, what the outcome could be? I believe we're currently in the comment period for the new human tissue based regulations.

And I'm curious, on that additional move do you think that will alter what we see in the ultimate guidelines and what this could mean for map3?

So they are really two separate issues. The guidance processes is the guidance process.

I don't believe that's going to change. That's a very well defined process that they've used for very, very long time.

I don't believe that will change. This letter that that you're aware of is out there.

There's actually a response that I read this morning. And we're deeply involved in this.

I don't really want to make a lot of -- I don't want to make any promises to the Street or make any indications because it does involve very specific congressman. It is a significant issue.

People in Congress were unaware of the untitled letter process or how it works. They are now very aware and some of them are very unhappy with it.

And so, we'll have to wait and see how this plays out, as I said. We have a constructive dialog going on with the FDA, and we're also involved on the Hill and I should probably leave it at that.

So first, I just wanted to ask one on the ortho-fixation. That came in significantly better than we've modeled in the quarter.

And I just wanted to ask if there was anything more just good execution and the line extensions in Tritium, just some color there would be helpful.

This is Rob. It's really a combination of the two.

Both the commercial business and the direct business are doing very well. Part of the reason the commercial part of the business is doing well is that our main partner there is preparing to close a deal or has closed a deal with another large medical device company, and we're benefiting from that.

So it's really the Zimmer Biomet close that's benefiting us there. And then on the direct side, with the launch of the new products and acceptance of the Tritium plate, we're growing faster than we expected.

And just looking kind of broadly at the rest of the year, it seems like your overall confidence is pretty good. We've got another uptick in both the top and bottom line guidance this quarter.

But with the turnover in the European management, are you building any potential disruptions in the international business into that or do you think that there won't be any issues there? Just kind of if you can give us a little color around that?

The disruptions that we expected are built into our models. We're very, very comfortable that we've been very conservative with our estimates for specifically Europe as we move through this transition.

This has been going on for me since quite some time. He indicated to me he would leave in early part of the -- late part of the first quarter and he actually left in the second quarter.

So I've been in the search for quite some time and I'm very, very near final in that with very, very experienced folks that actually can bring volume with them when they come.

And then just one last one on breast recon. Last quarter, you mentioned you were selling that directly with your existing surgical specialty sales force.

I just wanted to get a sense of with the current feet on the street that you have, did you have a room to keep ramping that up over time? What kind of milestones would you hit before you needed to start hiring new people?

Any comments you can give us there would be great.

I think, for right now, we have enough feet on the street and we're really focusing in as I described in the past. As we expand opportunities in given markets, we will hire additional people.

I spent time with Roger Rose this week traveling and he's already developing his early plan to approach us to add a few sales people here in the late part of this year, both for this year and preparation of next year and beyond. So he's already in the planning phases of where and when he's going to need certain additional sales people, and they will be direct people.

My first question is with regards to map3 and all that sort of regulatory uncertainty there. I'm curious if you've seen any pushback from any of the end users or GPOs or IDNs as a result of sort of that whole process?

Actually, we haven't. We've been educating them as well as -- on a forward basis as to what an untitled letter is.

And we've had got a couple of people question whether or not it's a warning letter, and we've been able to discuss it with them, educate them on what it is. And then once we do, they're fine.

The surgeons actually seem to know what it is. They seem to be quite comfortable with where we are and what we're doing, and it has not impacted the business.

And the second question I had was, I know you like to speak about the focused product sort of as a unit rather than individuals. But I was curious if you could give any sort of breakout between -- as you look at the growth in the focused products, is the majority of that map3 or is it more sort of an even distribution?

We aren't going to wink not indicate -- we are going to continue to talk about them as group.

Thank you all for joining us and thank you for your interest in RTI. And we'll speak to some of you as this quarter unfolds, and for the rest, we'll speak to you in about 90 days.