Surgalign Holdings, Inc.

Wendy Wacker - IR Brian Hutchison - CEO Rob Jordheim - CFO

Matt Hewitt - Craig-Hallum Capital Group John Gillings - JMP Securities Kyle Rose - Canaccord

Good morning, everyone, and thank you for joining RTI Surgical for our third-quarter 2015 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. Thank you for joining us.

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

As detailed on our press release issued this morning, we reported third quarter revenue of $66.5 million, a 3% increase over the third quarter 2014 on a constant currency basis. Our results for the quarter were mixed with revenues coming in below our guidance and earnings meeting our guidance.

Even though we did not meet our expectations in revenue, we were able to moderate our costs in order to meet our earnings goal. As many of you know, the third quarter is traditionally impacted by seasonal trends and surgery.

However, this impact this year was greater than we anticipated, especially when compared to the same period last year. As a reminder, in the third quarter of 2014, seasonality did not have as great an impact.

Our revenue shortfall was largely due to lower than expected growth in our direct distribution businesses, slightly offset by higher than expected growth in our commercial orthofixation and dental businesses, as well as our direct international business. As we mentioned during the second quarter conference call, the general manager of our European operations left RTI to pursue other opportunities.

New leadership for that area was put in place toward the end of the quarter. In addition to new leadership in our international business, we recently made sales leadership changes in certain segments of our direct domestic business.

While we expect it will take a couple of quarters while this new leadership gains momentum, we expect that these changes will drive improvement in execution of our growth plan through the remainder of this year and beyond. Overall, we believe we are in the right markets, we have the right -- we have the industry leading products, and we remain highly focused on executing our opportunities and are confident that we will achieve our growth goals.

Turning to a review of each of our lines of business, third quarter spine revenues decreased 12% compared to third quarter 2014. The decrease was due to declines primarily in our commercial business.

Our direct spine business did not grow as we anticipated in the quarter and was essentially flat. This was primarily driven by lower volumes with some of our large users.

We anticipate volume will pick up in the fourth quarter, and early results so far support this view. Despite the challenges we saw in the third quarter, U.S.

direct team continues to convert surgeons, distributors and their surgeons. Our customer base is growing, and we've added 18% increase in distributors over the second quarter.

We anticipate these new customers will have an impact over time. Our strategy to lead with our best-in-class biologics and pull through our high quality hardware has been successful for the direct spine team.

Our legacy distributors or those that were in place before RTI acquired Pioneer Surgical have recently shown a nice trend in biologic sales growth. Meanwhile, our new distributors or those that we brought on following the acquisition have consistently shown strong biologic sales and solid, growing hardware sales.

At this time, we are anticipating spine will decline mid-single digits for the full year of 2015. We anticipate that worldwide direct spine will show modest growth in the fourth quarter, but will be offset by declines in the commercial business due to lower orders from our largest commercial distributor.

Our sports medicine business decreased 5% compared to the third quarter of 2014. The decrease in our U.S.

direct sports business was due to a longer than normal summer slowdown that extended into September for our customers. We saw procedure volumes start to accelerate at the end of September.

We've seen some mix shift towards lower price grafts due to trends in surgical technique. We anticipate growth in the low single digits for this line of business for the full year of 2015.

Third quarter surgical specialty revenue decreased 25% compared to third quarter 2014. This is due primarily to a decrease in revenue from our commercial distributor in hernia and breast reconstruction markets, partially offset by growth in direct surgical specialties.

Our entire portfolio of Fortiva porcine dermis, Tutopatch bovine pericardium, Tutomesh fenestrated bovine pericardium and Cortiva and Cortiva 1 millimeter allograft dermis are currently available to our direct surgical specialties team. The Cortiva and Cortiva 1 millimeter implants for homologous use applications and reconstructive surgeries were launched to our sales force with an intensive training session in August and followed by a full market launch earlier this month at the American Society of Plastic Surgery meeting.

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

Third quarter BGS and orthopedic revenue increased 6% compared to third quarter 2014. The increase in revenue for the quarter was due to growth in our direct business, partially offset by declines in our commercial and international businesses.

We continued to see strong growth in our BGS/GO portfolio, specifically with our focused products of map3 cellular allogeneic bone grafts and nanOss advanced bone graft substitutes. The customer base using either the map3 or nanOss implants has continued to grow consecutively each quarter during the first nine months of the year.

To-date, thousands of map3 allografts have been implanted with encouraging clinical results. We've seen case studies for foot and ankle and spine and anticipate clinical data will be submitted for publication sometime next year.

We anticipate that BGS/GO revenues will grow in the mid-teens for the full year as growth in the direct business is partially offset by declines in the commercial business. Third quarter dental revenues increased 20% compared to third quarter of 2014.

The increase was due to higher than expected orders from our dental distributor. At this time, we anticipate that dental will grow in the mid-teens for the full-year 2015.

Third quarter revenues for orthofixation increased 44% compared to third quarter 2014. Both our commercial business and our direct to cardiothoracic businesses continue to do very well.

Our direct distribution team capitalized on successful launch in the second quarter of two line extensions for the Tritium SCP system. The Tritium product line has grown nearly 60% over the third quarter of 2014.

Our commercial distributors also continued to show solid incremental growth. At this time, we anticipate that orthofixation will grow in the high 20% range for 2015.

At this point, Rob will discuss more detail on our financial results.

Thank you, Brian. Worldwide revenues of $66.5 million in the third quarter increased 2% on a reported basis and 3% on a constant currency basis compared to the third quarter of 2014.

Domestic revenues were $61 million for the third quarter compared to $59.7 million for the third quarter of 2014. International revenues, which include exports and distribution from our German and Dutch facilities, were $5.5 million for the third quarter of 2015, which was comparable to the third quarter of 2014.

On a constant currency basis, international revenues increased 13% over the third quarter of 2014. Gross margin for the third quarter of 2015 was 53% and remained flat against the third quarter of 2014, but increased 100 basis points on a sequential basis over the second quarter of 2015.

During the quarter, marketing, general and administrative expenses totaled $25.5 million, a decrease of 5% compared to the third quarter of 2014. The decrease was primarily due to lower compensation expenses of $1.1 million, resulting primarily from the corporate reorganization to flatten our organizational structure in 2014.

Research and development expenses totaled $3.8 million, a decrease of $431,000 or 10% lower than the third quarter of 2014. The decrease was primarily due to lower research and study-related expenses.

Despite the aforementioned revenue challenges in Q3, we were able to control operating expenses and deliver record operating income and a record operating margin of 9%, excluding the nonrecurring $1.5 million acceleration of deferred revenue from the first quarter of 2015. Our tax rate for the third quarter of 2015 reflects a tax expense of 37% compared to 40% in the third quarter of 2014.

Our third quarter 2015 tax rate was positively impacted due to increased profitability in lower tax rate jurisdictions. Net income applicable to common shares for the third quarter of 2015 was $2.7 million or $0.05 per fully diluted common share based on 58.9 million fully diluted shares outstanding compared to $1.2 million or $0.02 per fully diluted common share for the third quarter of 2014 based on 57.5 million fully diluted shares outstanding.

As detailed in our press release this morning, the Company's third quarter adjusted earnings before interest, taxes, depreciation and amortization or adjusted EBITDA was $10.7 million or 60% of revenues for the third quarter of 2015 compared to $8.2 million or 13% of revenue for the third quarter of 2014. EBITDA growth for the third quarter of 2014 was 32% over the third quarter of 2014.

Turning to the balance sheet, our cash position at the end of the third quarter was $10.3 million compared to $15.7 million at the end of 2014. The decrease was primarily due to increased payments to vendors in principle patients on long-term debt obligations.

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 third quarter totaled $149 million, an increase of $15.5 million compared to working capital at the end of December 31, 2014. During the third quarter, the Company made the third quarterly principal payment of $1.1 million on the $60 million term loan.

At the end of the third quarter, we had $79 million of debt and approximately $8 million available under our revolving credit facilities. With that, I will turn the call back over to Brian.

Thanks, Rob. As many of you know, we've been on a path of aggressive growth with a focus on a milestone of $500 million in revenue.

When we set out on this path, we said that our expectation was that our expectation was that we would not be linear. There would be bumps along the way.

While this quarter did not meet our expectations, it does not take us off our path. We believe we're making the changes and adjustments necessary to get past this quarter and continue to meet our goal.

We remain focused on the three areas; our base biologics business, our hardware business and focused products. Our base biologics business declined slightly over prior-year period, our hardware business grew 20%, and our focused products grew 23%.

We believe that the changes we've made in the quarter, we will see improvement in coming quarters. Turning to guidance.

In our press release this morning, we outlined expectations for revenue and EPS for the fourth quarter and full-year 2015. For the fourth quarter of 2015, we expect revenues to be between $68 million and $69 million.

This would result in a 3% decrease in revenues compared to Q4 last year at the midpoint of our guidance. As many of you know, we are subject to the varying ordering patterns of our large commercial distributors.

Based on orders currently in hand and projected orders through the remainder of the quarter we expect the commercial business to decline in Q4, but be partially offset by strong growth in worldwide direct business. This has been reflected in our guidance.

We expect net income per fully diluted common share for the fourth quarter of 2015 to be approximately $0.05. Based on the results from the first nine months, we are lowering our full-year guidance for 2015.

We now expect full-year revenues to be between $274 million and $275 million as compared to prior guidance of between $282 million and $286 million. This would result in an increase of 4% 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 approximately $0.19 based on 58.8 million fully diluted common shares outstanding as compared to prior guidance of $0.20 to $0.23. The key value drivers we shared with you throughout the year remain the same.

They are driving growth in 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, returning to our international business to growth, specifically in Europe and Asia-Pacific, and finally, controlling spending and implementing additional lean manufacturing processes in order to improve margins. The management team and our employees are aligned with shareholders and our desire to create long-term value for this Company.

We have a solid inventory position of high quality products. With the right sales execution, we will make this model work.

We hope to see some of you this quarter. We will be presenting at the Stephens fall investment conference on November 10 in New York and the Brean conference on November 16 in New York.

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

Just a couple for me, first, and I am sorry if I missed this, the percentage of revenues from the focused products in the third quarter?

Yes, Matt, this is Rob. It's the same as it was in the second quarter, high single digits.

And then you announced some sales changes, some heads of sales changes, and I'm curious if it was a seasonality issue and we have heard this from others in the industry that surgical procedure volumes were very weak in the third quarter, more than typical seasonality, if that was the case, what prompted the change in the sales organization, I guess I'm not quite sure what the disconnect is there.

Well, we really saw inconsistency across our regions across the country, and we wanted to see stronger performance from selected regions. So we've made changes in that area specifically to align all of the regions to get solid performance.

And one last one, I guess. Are these people -- I'm assuming these are people from in-house that were promoted, so you're not going to see the typical six to nine months to ramp, or is that accurate?

Pretty much internal changes, not entirely there was a couple of outsiders broad in, but they are people with tremendous experience with the top leadership in the Company. So we've not seen any -- in fact, all of the new people that have been on, even though they've only been on for a few weeks, some of them are already bringing business.

Just a follow-up quickly on the focused products I appreciate you giving us the mix. I apologize if I missed it, because we do have a couple of overlapping calls this morning.

But did you give the growth from the focused products this quarter?

Yes, we did say that in our comments. Growth was about low 20s%, low 20%.

Okay. I appreciate that.

And then I just wanted to get just a little bit more insight on guidance and how that's impacting the fourth quarter. So if I look at the miss from this quarter versus the midpoint of your guidance, it's about $3 million, and the change in annual guidance would imply there's something a little bit more in the fourth quarter.

Was there anything sort of late in the quarter that's continuing on now that is affecting that more, or is it more the sales changes or the changes in the sales force and the time the new guys need to get up to speed? Just kind of help us walk through that.

For the fourth quarter, the biggest contributor is really, as we said in the script, it really is the drop in commercial orders for the fourth quarter. So you know that these can be lumpy in the fourth quarter.

We're seeing a holdback.

And then just the last one, you mentioned sort of the long-term goal of getting to $500 million, and this is a bump in the road. This is something we should think about pushing things back a bit, or is it something where you think you'll be able to potentially backfill and get back on track in 2016?

Well, for the most part, I think we need some more time to sort out how these changes that we've made impact the growth rates early in the next -- well, the next really two to three quarters will tell us how close we are to being really right on track to get this thing, whether it's a quick fix whether or it's going to take a little bit longer. Early indications are these are going to work.

So we are already seeing the positive lift in Europe from the changes we made earlier this year. That's a plus.

We’d like to see more consistency across our regions, especially in the United States. So we think the changes that we made will give us that, and in a couple of more quarters, I'll be able to tell you definitively if it's working or not.

But we think it's the right thing to do, and we think it's going to work out the correct way.

It is actually Kyle on for Bill. I wanted to continue along the path of guidance.

I just needed a little help with the bucketing. But first I wanted to start-off with Q4 you are guiding a lot of that down to lower commercial orders.

I just wanted to see how should we think about the previous nine months or the 2015 to date? Has there been any meaningful stocking from the commercial side that would lead to some sort of destocking event at the end of the year, and then how should we think about that going into 2016 as well?

Kyle, hey, this is Rob. As you know, through the last three quarters, our orthofixation has grown at about a 40% per quarter.

As you look at Q4, the comp is starting to get a little bit tougher. And as we said, we do know some -- we have a pretty good handle on what the orders are that are going to be coming into Q4.

Right now it tells us that we need to put in a little bit lower number for Q4 on the orthofixation line. On the spine line, it's a little bit of the same.

You know our largest distributor has been decreasing a little bit quarter over quarter, and we see that pattern continuing. So when you look at our guidance and you look at the commercial takedown from what we did on the last call, our guidance on the last call, it's really between those two businesses, orthofixation and spine.

And that answered one of my follow-on questions, which was I am just trying to kind of walk through the buckets relative to full-year guidance and also year to date thus far. So I think you kind of touched on what the step down is orthofix there is as far as you have seen lower commercial orders.

But then, what gives -- when I think about surgical specialties, surgical specialties is down 17% year to date, but you are giving guidance here for a low single-digit decline. So I mean how do I reconcile that?

What is giving you confidence that the Q4 is going to have such a big leg up in growth? And then also, you can walk us through where the commercial business stands there and any metrics we can get more comfortable with for the direct side starting to offset some of that decline there?

And then I've got one follow-up.

Yes, well, the commercial side, the decline in our orders to our hernia and breast partner is starting to moderate a little bit in Q4. I still expect that it is going to decline from Q3 to Q4, but that decline is slowing.

The direct side is still continuing to grow, which is obviously a good thing, and we anticipate within the next 18 months or so that the direct side will actually eclipse the commercial side in terms of composition of revenue and growth.

So the big part there is you're starting to see stabilization on the commercial side, and there is relative expectation for a nice step-up in growth in the year-end on the direct side, is that fair?

That's the expectation, correct.

And then the last question is on focused products. I understand the same relative mix quarter over quarter, but last quarter we saw 80% growth in that segment, and this quarter we're seeing 23% growth.

How should we think about that step down in the year-over-year growth number? And then if you can kind of -- any color you can give as far as that 6% growth that you had in BGS -- how much of that [Call Ended Abruptly]