Surgalign Holdings, Inc.

Wendy Crites Wacker - VP, Global Communications Brian Hutchison - President and Chief Executive Officer Robert Jordheim - EVP and Chief Financial Officer

Chris Cooley - Stephens Matt Hewitt - Craig-Hallum Capital Jayson Bedford - Raymond James

Good morning. And thank you for joining RTI Surgical for our third quarter 2016 conference call.

Today, we will hear from Brian Hutchison, President and Chief Executive Officer, and Robert 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 that 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.

During the call, we will also present certain financial information on a non-GAAP basis. Management believes that non-GAAP financial measures, taken in conjunction with US GAAP financial matters, provide useful informational for both management and investors by excluding certain non-cash and other expenses that are not indicative of our core operating results.

Management uses non-GAAP measures to compare our performance relative to forecasts and strategic plans to benchmark our performance externally against competitors and for certain compensation decisions. Reconciliation between US GAAP and non-GAAP results are presented in tables accompanying our earnings release, which can be found in the Investor Relations section of our website.

Now, I’ll turn the call over to Brian Hutchison.

Good morning, everyone. Thank you for joining us.

I’ll start with a few key takeaways from the quarter. First, as detailed in the press release issued this morning, we reported third quarter revenues of $66.5 million comparable to the third quarter of 2015.

We also reported third quarter net loss per fully diluted common share of $0.08. On an adjusted basis, excluding certain pretax charges outlined in our press release this morning, we reported breakeven results.

Second, we saw continued strong performance from our direct business with growth of 14% compared to third quarter last year. This growth was offset by declines in our commercial business, primarily due to lower orders from our commercial distributors in our spine and orthofixation product line.

At this point, I’ll review the performance of each of our business lines within the global direct business. Third quarter direct US spine revenue increased 30% compared to third quarter 2015.

Based on published market data, our US direct spine business is one of the fastest-growing spine businesses in the United States market. During the third quarter, revenue from the spine business, biologics, increased 33% compared to the third quarter 2015.

Additionally, hardware revenue increased 28% over the same period. Surgeon users increased 27% compared to third quarter 2015 and our distributor relationships increased by 25% over the same time period.

The direct spine team has expanded its distribution footprint in every quarter year-to-date. Our US direct sports and orthopedics business was flat compared to third quarter 2015, largely due to continued softness in our sports medicine Allograft business.

Continued rapid growth with map3 Allograft helped offset the softness in sports medicine allograft business. Sports allograft decreased 4% compared to third quarter 2015, while map3 allograft in sports and orthopedics space increased 88% within the same time period.

Our customer base remains stable and pricing is steady and the move to autograft seems to have leveled off. Third quarter surgical specialties revenue for our US direct business increased 74% compared to third quarter 2015.

We’ve been pleased with the performance we’ve seen from the new direct representatives that we mentioned last quarter. They, along with the existing distribution team, continues to expand the business within their focused regions.

A number of recent contract wins gives us confidence that we have a customer pipeline that continues the growth trajectory of our direct surgical specialties business. Also in the third quarter, the team hosted its first surgeon symposium with a panel of leading plastic and reconstructive surgeons.

We gained valuable insight on both existing implant platforms as well as exciting opportunities to drive this business forward in the future. Third quarter revenue of our US direct cardiothoracic business increased 30% compared to the third quarter of 2015.

Additionally, in the third quarter, we achieved our first month of revenue in excess of $1 million, a significant milestone for this business line. Notably, revenues from our Tritium SCP plate system increased 66% and revenue from the Tutopatch ECM implant increased 71% in the third quarter 2016 compared to third quarter 2015.

We’re very excited about the growth we’re seeing in our cardiothoracic business. Third quarter revenue from our direct international business decreased 9% on a reported and constant currency basis compared to third quarter 2015.

Third quarter revenue growth was affected by weakness in spine surgical cases and EMEA as well as delay in the transition of an international distributor. We expect to regain momentum in this area as we work through the distributor transition in early 2017.

To wrap up, the direct portion of our business, our focused product of map3 allograft, nanOss Advanced Bone Graft Substitute and US surgical specialties portfolio grew 50%. At this point, I’ll turn it over to Rob to provide additional details.

Thank you, Brian. Worldwide revenues of $66.5 million for the third quarter of 2016 was comparable to the third quarter of 2015.

Direct revenue of $38.1 million for the third quarter of 2016 increased 14% compared to the third quarter of 2015, [inaudible] double-digit growth in the spine, surgical specialties and cardiothoracic business lines, partially offset by a decline in our international business. Global commercial revenue of $25.3 million for the third quarter of 2016 decreased 16% compared to the third quarter of 2015 due to lower orders from certain commercial distributors, primarily in the spine and trauma market.

Domestic revenue of $61 million for the third quarter of 2016 was comparable to the third quarter of 2015. International revenues of $5.6 million, which includes direct and commercial exports and distribution from our German and Dutch facilities, the third quarter of 2016 increased 2% compared to the third quarter of 2015.

On a constant currency basis, international revenue for the third quarter of 2016 was comparable to the third quarter of 2015. Net loss applicable to common shares for the third quarter of 2016 was $4.5 million or $0.08 per fully diluted common share based on 58.4 million fully diluted shares outstanding.

This compares to net income applicable to common shares of $2.7 million or $0.05 per fully diluted common share based on 58.9 million fully diluted shares outstanding for the third quarter of 2015. Included in net loss applicable to common shares for the third quarter of 2016 is $5.1 million in pretax other charges as follows: $4.1 million for pretax expense associated with CEO retirement and transition costs, $650,000 of pretax expense associated with strategic review costs, and $328,000 of pretax expense associated with severance costs.

Also, included in net loss applicable to common shares for the third quarter of 2016 is $1.2 million charge to the tax line related to a foreign net operating loss valuation reserve. Excluding other charges in the foreign net operating loss valuation reserve, adjusted net income applicable to common shares for the third quarter of 2016 was $47,000 or zero cents per fully diluted common share based on 58.4 million fully diluted shares outstanding.

The company's third quarter adjusted earnings before interest, taxes, depreciation and amortization, or adjusted EBITDA, was $8.1 million or 12% of revenues for the third quarter of 2016. This compares to $10.7 million or 16% of revenues for the third quarter of 2015.

Gross margin for the third quarter of 2016 was 52% compared to 53% for the third quarter of 2015. The decrease in gross margin in the third quarter of 2016 was primarily due to lower production output, driven by a reduced outlook for the global commercial business.

During the third quarter, marketing, general, and administrative expenses totaled $28.7 million, an increase of $3.3 million or 13% compared to the third quarter of 2016. The increase was primarily due to higher variable compensation and distributor commission expenses on direct revenue and investments in the development of our international direct sales network.

Research and development expenses totaled $3.8 million, which is comparable to the third quarter of 2015. Operating loss for the third quarter of 2016 was $3.3 million compared to operating income of $6 million for the third quarter of 2015.

Excluding the $5.1 million of aforementioned other charges, operating income in the third quarter 2016 was $1.8 million or 3% of revenue. Our tax rate for the third quarter of 2016 was a 2% benefit compared to 37% provision in the third quarter of 2015.

Our comparative income tax benefit rate was lower due to our German operations entering into a three-year cumulative net loss position. And as a result, we recorded a full valuation allowance of $1.2 million on our German subsidiaries’ deferred tax asset, with no comparable charge in the third quarter of 2015.

Turning to the balance sheet, our cash position at the end of the third quarter was $11.6 million, a decrease of $1 million from the end of the second quarter. Working capital at the end of the third quarter 2016 totaled $132.7 million, an increase of $753,000 compared to working capital at the end of 2015.

During the third quarter, the company made a quarterly principal payment of $1.1 million on the $60 million term loan. We also consolidated our debt by paying off and terminating our credit facilities with three German banks.

At the end of the third quarter, we had $83.4 million of debt and approximately $12 million available under our one remaining revolving credit facility. As you will recall from the last quarter, we announced that we would undertake a comprehensive strategic review of the company's business lines and operations to leverage the company's expertise, technology and products, and identify opportunities that can generate the most value for RTI’s customers, employees and shareholders.

As part of that effort, we retained a global management consulting firm to assist with the review, which is well underway. At this time, the management consulting firm, in collaboration with management and RTI’s Board of Directors, are reviewing a set of strategic options, with the goal of improving company performance and increasing shareholder value.

Additionally, RTI’s Board of Directors has retained an executive search firm to identify a new CEO to succeed Brian, who is retiring after 15 years of service. RTI’s Board of Directors is in the process of evaluating potential candidates.

We continue to make progress on both of these initiatives and will update you when we have significant developments to share. While we conduct a strategic review and CEO search, we will continue to provide guidance based on the current operations of the business.

For the full year, based on the lower outlook for the commercial business, primarily due to lower orders from commercial distributors in spine and dental and the lower outlook for the direct business, primarily due to the previously mentioned distributor transition delay in international, the company now expects that revenue for 2016 will range from $268 million to $270 million compared to prior guidance of $274 million to $280 million. In addition, the company expects full-year direct revenue to grow in the range of 13% to 15% as compared to the previous range of 16% to 17%.

The company expects full-year commercial and other revenue to decline in the range of 21% to 23% as compared to the previous guidance range of 18% to 21%. Despite the lower outlook for commercial, orders are stabilizing on a sequential quarter basis.

As a result of the lower revenue guidance and the previously mentioned other charges and the foreign net operating loss valuation reserve, the company now expects that full year 2016 net loss per fully diluted common share will range from $0.11 to $0.13 based on 58.3 million fully diluted shares outstanding as compared to prior guidance of net income per fully diluted common share of $0.03 to $0.06. Excluding the other charges and foreign net operating loss valuation reserve, adjusted full-year 2016 net income per fully diluted common share is expected to range from $0.01 to $0.03 based on 58.3 million fully diluted common shares outstanding as compared to the previous guidance of $0.09 to $0.12 based on 58.5 fully diluted shares outstanding.

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

Good morning and thanks for taking the question. Can you hear me okay?

Yeah, good morning.

Good morning. So just three from me and then I'll get back in queue.

Help us take a little bit closer look at the direct business here. If I'm doing the math right, it had a pretty significant increase sequentially and the marketing, general and administrative and also you’ve got to make the adjustments there for the one-time items.

And if I look back at the prior year, it’s a pretty easy comp, down about 7.5% in that business. While you’re making traction, help me parse out how much is really being driven by the direct growth that you’re seeing broad-based there in the rep adds.

What kind of has to happen here over the next several quarters for that to really start to further accelerate? And then I’ve got just two quick follow-ups.

Well, I think if you break down the different pieces, cardiothoracic, 30% growth and it’s been record quarter after record quarter. I don’t think anything is going to change there, except that they add the Tutopatch to it.

Might even get a little stronger. So, that one is going very, very well.

If you look at spine, spine has been one of the top performing spine companies in the country for the last eight quarters in a row. And what’s really driving that is the combination of map3 and nanOss combined with metal and the conversion rate there of both distributors and customers has been outstanding.

And I don’t think that’s going to change, I think, there. We made some changes, if you recall, a year ago in some of the field management and it’s really showing up.

And I think that’s going to continue, do think ultimately the company will make more investments in some of the key areas that are growing rapidly. So, those are the two that I would highlight that are growing very, very well.

On the surgical specialties, although it’s a small base, we seem to have in recent quarters found a formula to at least get sales really moving in the right direction right now. They are showing very, very strong growth.

And the opportunity looks very strong there. And we’ve been winning more contracts in recent days.

So, those all look good. In sports, it’s stable.

And that’s probably the good news, is that this cycle of allograft to autograft seems to have stabilized. So, I think what has to happen going forward is keep driving the areas that are growing and keep – and just get sports to grow single digits and I think overall direct will continue to perform very, very strong.

And then just my second quick question here, when I look at the growth, you had a fairly significant, a 3.5%, 4% increase in receivables sequentially, even though revenue was down about 1.5%, and if we adjust for the deferred that you recognized in the quarter, almost 3%, should I think of that as being the additions to distributors that you are referring to. I think it was up 25%, now carrying the product on the spine side or was there any other kind of one-time event there that we should take into consideration when you look at the increase both in inventory and also in receivables there sequentially.

Chris, this is Rob. When you look at the receivables and you look at the percentage of our business now and our revenue, which is direct versus commercial, it would show up – and receivables would increase because typically on a direct basis, our receivables are a little bit longer than they are with our commercial partners.

The large commercial medical devices companies tend to pay pretty quickly. And on the direct side, the hospitals tend to pay a little bit slower.

Understood. And then just lastly from me and I’ll get back in queue, apologize if I missed this [indiscernible] that you gave us there during the call, I think you mentioned that about 50% growth year-over-year in the focus products, and so those are trending at about 10-ish percent of total revenue, did I hear that correctly?

Yes, you did, Chris.

Okay. So if I look back, I guess, not to push too much here, if I just kind of look back over time, you’ve been tracking here at about 10-ish percent of revenue for a while in those, and I guess kind of a similar question while we’re good as a percentage basis year-over-year growth, just kind of curious what you think those products maybe would represent as a percentage of sales, say, three years from now or five years from now because clearly those have the greatest potential to give the lift to both gross and operating margin and maybe the higher growth rate as well longer-term?

That’s true, Chris. I guess the way I look at it, this is one of the bigger growth drivers within the company, obviously, and I think we’ve had probably three or four quarters of 50% plus growth.

So, that trend is holding nicely. What it will be in three years, I don’t want to venture a guess right now.

But I will tell you, Q3 was a record quarter in terms of revenue derived from the focus products. So, if we can continue with this kind of run rate and growth and market acceptance, I think we’ll be happy.

Understood. Thanks so much.

Good morning. Just a couple from me.

First, just so I understand that these stock comp, there was a 3x spike in that, is that related to Brian’s changing role?

That’s correct.

Okay. And next quarter, obviously, I would expect they would fall back down.

Is that correct?

Yeah, it will certainly normalize.

Okay. All right.

And then couple of questions about the business, the commercial business, specifically the distributor change that you’re making internationally, what was the hold up there and why the delay in getting that up and running starting in January?

Matt, the international distributor delay is in our direct business, not in the commercial business. And it’s really – we’re moving from kind of more of a C player to a B or an A player in terms of distribution in China, so we’re really upgrading our distribution efforts there.

And we’re working through some issues with our distribution partner for market – for them to go to market in China. If you look at our guidance, we expected that to come in Q4, but is being pushed into probably the first half of 2017.

So, it’s really a delay. We’re very excited about the distributor.

It’s a huge opportunity for us. But it looks like it’s going to come in probably the first half of 2017 versus Q4 of 2016.

Okay. And then once that change has been made because you’re moving from a C or a B player to an A player, obviously, you would expect faster growth.

But how should we be thinking about that since most of us have modeled through 2017 at least?

Well, I think it’s – obviously, like I said, it’s going to be a big opportunity. We’ll give – work hard on that on our next call.

But, again, the opportunity is large for us.

Okay. And then one last one, on the strategic review and CEO search, is the hope and expectation that you’ll have that wrapped up before the end of the year or is this going to linger into 2017?

Thank you.

Matt, this is Brian. I think they are two different issues.

I think that our review will wrap up in Q4 to be communicated on the – whatever will be communicated may be communicated on the next call. The CEO search is hard to predict.

I don’t know how long that is going to take. So, I think the company is going to be patient and wait till they have the right person.

And so, I think that’s the right move. And as soon as they know what that is, they’ll inform you.

All right. Thank you.

Thanks. Good morning.

Just a couple of quick ones. I guess, on spine, I think you’re seeing some good growth.

You’re also adding a lot of distribution there. How big can the distribution effort get?

And what point does the pace of new distributor add slow?

Jayson, this is Brian. I think the base can certainly continue for the runway that we can see in front of us through next year.

I think the spine team has identified opportunities to continue the expansion and we’ll continue to push forward the way they have. I think the opportunity is still very, very strong in front of us.

I really do see that group continuing to have good opportunities, at least through next year, if not longer.

Okay. And then on the direct guidance for the year, the 13% to 15% growth, what’s implied for international, I’m just trying to figure out kind of where international goes here in the fourth quarter and how should we look at it for 2017?

For the full year, on international?

International direct.

On international direct, we’d be looking at growth kind of – for the year, kind of a net high single digits area.

Okay.

So, while the third quarter is a little bit of a hiccup, we expect to return to growth in the fourth quarter.

And, Rob, I apologize, but what is the baseline for 2015, direct international?

The number is $18.3 million.

Okay, okay. That’s good.

Okay, and then just the delay, you mentioned the delay in the international distributor, is it related to regulatory issues that must be met, meaning is you waiting for an approval of some sort.

I would describe them, Jason, as operational. The distributor operates differently and has very specific requirements on what they expect from us as a supplier and we are working through all of those issues as we go forward.

Okay, thanks.

Thank you very much for joining us on this call. The next call will be probably in early February of 2017.

So, everyone, take care and have a good end of the year.