Surgalign Holdings, Inc.

Roxane Wergin - Director, Corporate Communication and Investor Relation Rob Jordheim - Interim Chief Executive Officer Wy Louw - Interim Chief Financial Officer

Matt Hewitt - Craig-Hallum Capital

Good morning and thank you for joining RTI Surgical for our fourth quarter and year-end 2016 conference call. My name is Roxane Wergin, I’m the Director of Corporate Communications and Investor Relations at RTI.

Today, we will hear from Rob Jordheim, Interim Chief Executive Officer; and Wy Louw, Interim 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 call 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. Reconciliations 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 will turn the call over to Rob Jordheim.

Good morning, everyone. Thank you for joining us.

Our fourth quarter and full year 2016 financial results while demonstrating some early signs of improvement are not what we’d like them to be. We know we have work to do.

The good news is that we have started this work and I’ll focus my remarks today on describing the actions we have initiated to refocus RTI and improved execution efforts that we believe will enhance our operations and optimize our platform to return the company to sustainable long-term growth. The board and management team have begun to strategically direct investments in the company towards areas where we see the greatest growth potential.

This effort has already started to deliver results as evidenced by the strong double-digit growth we are seeing in our direct businesses and the signs of stabilization we are seeing in our commercial business. Another important factor in this equation is our recently announced deployment of Camille Farhat, as RTI's next Chief Executive Officer effective March 15.

Camille is a highly experienced executive and growth focus leader with proven expertise in revitalizing and growing global health care businesses. He will bring a disciplined approach, deep operations experience, and a seasoned track record to RTI.

We know we need to align our cost structure with our revenue projection. In advance of Camille’s arrival we have started a restructuring program that is expected to improve operational performance and financial results going forward, and position RTI's operating platform to better capitalize on future growth opportunities.

The initial phase of the restructuring program is expected to yield annualized savings of approximately $8 million. We expect to realize these savings beginning in the second quarter.

As a result of this program, we anticipate incurring a restructuring charge of approximately $4 million this year, the majority of which we will take in the first quarter of 2017. I want to assure you of our commitment in 2017 to streamlining our business to deliver cost efficiencies and an enhanced platform.

At the same time, we will continue to make certain strategic investments in our business, products, and people that will best set us up to deliver on our growth force. Now, I’d like to turn the call over to Wy Louw to provide an overview of our fourth quarter and full-year financial performance, as well as highlights from our business segments.

Wy?

Thank you, Rob. I would like to focus my focus my remarks on the three areas we see as key drivers for our fourth quarter results.

These are: we delivered double-digit growth in our direct business during the quarter; our commercial business results reflected negative growth impact when compared to an unusually high order volume in 2015; and results include financial impacts of additional charges, primarily related to asset impairment in Germany and an inventory write-off. Now, I will go through the detailed results.

In our press release issued this morning, we reported fourth quarter revenue of $71.3 million, a 6% decrease from fourth quarter 2015. This includes domestic revenue of $64.6 million, a decrease of 9% from the prior year period, primarily due to the reduced number of orders in our commercial business.

This decline was partially offset by strong growth we saw during the fourth quarter 2016 in the domestic direct-to-business. International revenue was $6.8 million, an increase of 24%, compared to the fourth quarter of 2015, primarily due to growth in the international direct spine business.

On a constant currency basis, international revenue for the fourth quarter of 2016 was comparable to the fourth quarter of 2015. We saw continued strong performance from our direct business with revenue of $44.5 million in the fourth quarter of 2016, an increase of 22% compared to the prior year fourth quarter.

We experienced double digit growth in spine, surgical specialties, cardiothoracic, and international direct business segments. However, this growth was offset by declines in our commercial business, which delivered $23.7 million in revenue in the fourth quarter of 2016, a decrease of 36% compared to the fourth quarter of 2015, primarily due to significant orders from commercial distributors in 2015 that did not repeat in 2016.

2015 was an anomaly for our commercial business, which returned to a more normalized revenue pace of approximately $25 million per quarter in 2016. As we noted in our press release, we expect our commercial other revenue to be relatively flat to down low single digits on a percentage basis in 2017 versus 2016.

We also reported a net loss of $12 million or $0.21 per common share for the fourth quarter of 2016. The loss in the quarter was driven by pre-tax charges totaling $16 million, largely related to inventory write-downs of $9.6 million, primarily for excess hernia and sports medicine inventory and a long-lived asset impairment related to our German operations of $5.6 million.

Net loss applicable to common shares for the fourth quarter of 2016 was $12 million or $0.21 per common share, based on 58.4 million common shares outstanding. This compares to net income applicable to common shares of $3.3 million or $0.06 per fully diluted share common share based on 58.5 million fully diluted shares outstanding for the fourth quarter of 2015.

Excluding the $16 million in pretax charges, we reported adjusted net income applicable to common shares of $515,000 or $0.01 per fully diluted share common share. Let me now review the revenue performance for each of our business lines.

Fourth quarter direct US spine revenue increased 37%, compared to the fourth quarter of 2015. Based on published market data, our US direct spine business is one of the fastest-growing spine businesses in the US market.

During the fourth quarter, revenue for the spine business biologics increased 57%, compared to the fourth quarter of 2015. Additionally, hardware revenue increased 24% over the same period.

This represents five quarters of sequential growth in total spine revenue. Harnessing this momentum is clearly a strong area of focus for us.

Our US direct sports and orthopedics business was relatively flat compared to the fourth quarter of 2015, largely due to continued softness in the sports medicine Allograft business, primarily tendons. Continued record growth rate with map3 Allograft helped offset the softness in the sports medicine Allograft business.

Fourth quarter surgical specialties revenue for our US direct business increased 44%, compared to the fourth quarter of 2015. Growth was driven primarily by our Cortiva Allograft surgical mash used in breast reconstruction procedures.

We continue to host surgeon symposium in order to stay close to what is almost on surgeons minds. Fourth quarter revenue for our US direct cardiothoracic business increased 23%, compared to the fourth quarter of 2015.

Revenues from our Tritium SCP system increased 54% and we had a 63% increase in biologics in the fourth quarter of 2016, compared to the fourth quarter of 2015. We’re pleased to announce that we executed the dignity and Trinity National Healthcare contracts and successfully completed a pilot study of Tutopatch ECM for expanded indications.

We're very excited about the growth we are seeing in our cardiothoracic business. Fourth quarter revenue for our direct international business increased 28%.

On a constant currency basis, our direct international business increased 30%, compared to the fourth quarter of 2015. Fourth quarter revenue growth was led by strong performance in the Asia-Pacific market, primarily in spine.

We are regaining momentum in this area as we continue to work through the distributed transition in China, which should be completed in the first half of 2017. Our commercial/other business decreased 33%, primarily due to significant orders in 2015, including from one of our trauma distributors that did not repeat in 2016.

Despite the decline, we saw signs of stabilization in the commercial other business during the year as the commercial other business averaged $28 million over the last four quarters of 2016. Fourth quarter adjusted earnings before interest, taxes, depreciation and amortization or adjusted EBITDA was $6.1 million or 9% of revenues for the fourth quarter of 2016.

This compares to $14.1 million or 18% of revenues for the fourth quarter of 2015. Gross margin for the fourth quarter of 2016 was 39%, compared to 53% for the fourth quarter of 2015.

The decrease in gross margin was primarily due to the $9.6 million pretax inventory charge related to excess inventory driven by the reduced outlook of these products in hernia and sports markets. Adjusting for this, our gross margin for the fourth quarter would have been 53%.

During the fourth quarter of 2016, marketing, general, and administrative expenses totaled $31.4 million, an increase of $4.1 million or 15%, compared to the fourth quarter of 2015. The increase was primarily due to higher variable compensation and distributed commission expenses on direct revenue and investments in the development of our international direct sales network.

Research and development expenses totaled $4.1 million, an increase of $483,000, due to increased project spend. Operating loss for the fourth quarter of 2016 was $13.8 million, compared to operating income of $6.8 million for the fourth quarter of 2015.

Excluding the $9.6 million charge of inventory and the $6.4 million in other charges, operating income in the fourth quarter of 2016 would have been $2.1 million. Our tax rate for the fourth quarter 2016 was 23% benefit compared to a 34% provision in the fourth quarter of 2015.

Our comparable income tax benefit rate was lowered due to our German operations entering into a three-year cumulative loss position. For the full-year, revenues were $272.9 million, down 3% from 2015, mainly due to the same commercial stocking factors that impacted fourth quarter revenues in 2015.

Domestic revenues were $247.8 million, a decrease of 5%, and international revenues were $25.1 million, an increase of 15%. On a constant currency basis, international revenues for the full-year 2016 increased 15% from 2015.

Direct revenues were $160.8 million for the full year, an increase of 16% over 2015, primarily driven by double-digit growth in the spine, surgical specialties, cardiothoracic, and international businesses. Commercial other revenues were $112 million for the year, down 22%, compared to 2015, primarily related to significantly higher orders in 2015 that did not repeat in 2016.

However, as noted above, the commercial business showed signs of stabilization during the year. In addition, RTI is starting taking actions to reinvigorate this business by strengthening relationships and investing in innovation.

During the year, the company recorded pre-tax charges totaling $25.6 million, related to hernia and sports medicine inventory, asset impairment of the company's German subsidiary, strategic review costs, CEO transition and retirement costs, contested proxy fees, restructuring and severance costs. In addition, the company recorded a foreign net operating loss valuation reserve of $1.2 million.

The company reported a full year net loss of $18.1 million in 2016 or $0.31 per common share. Adjusted net income was $2.1 million for the full year or $0.04 per common share.

For the full year 2016, adjusted EBITDA was $29.8 million, compared to $46.3 million reported in 2015. Turning to the balance sheet, our cash position at the end of the fourth quarter was $13.8 million, an increase of $2.2 million from the end of the third quarter.

Working capital at the end of the fourth quarter 2016 totaled $121.3 million, a decrease of $10.6 million, compared to working capital at the end of 2015. At the end of the fourth quarter, we had $83.3 million of debt and approximately $9.5 million available under our one remaining revolving credit facility.

I will now turn the call back over to Rob.

Thank you, Wy. As I mentioned earlier in my remarks, we are pressing ahead with steps towards refocusing our business on execution and returning RTI to sustainable profitable growth.

The addition of Camille Farhat as a new CEO on March 15 will be an important catalyst in this regard. Camille will be aggressively focused on improving execution and leading and developing RTI's path to profitable and sustainable growth.

Camille will be assessing additional opportunities to streamline our cost structure, improve cash flow, and redirect or accelerate deployment of our resources to the markets and business segments with the most attractive growth opportunities. He will also be instrumental in furthering our commitment to focused innovation and delivering the best surgical implant products in the marketplace.

Upon Camille’s arrival, I will return to my previous role as Chief Financial Officer and Wy will return to the role of Vice President and Controller. It has been a privilege for us to serve in our Interim roles over the past few months, as we have initiated the first steps in this plan.

As we look ahead, our core priorities will centre on execution, continued and focus information, and profitable growth across each of RTI's business line. As I mentioned in previous earnings calls, the company's board of directors engage strategic consultants in 2016 to independently assess the current business operations and provide recommendations for growth opportunities.

Report’s findings will help us call us around the actions that are already underway. We will have more to share with you at a later date about the specific steps we're taking to implement the findings of the report.

Surprised to say, we are already taking action and we will intensify our activity in this regard once Camille is on board as our CEO. We have developed our guidance for 2017 based on a conservative view of our restructuring and operational improvement program and by taking into account the company's current business profile, existing market conditions, and the investments we plan to make to support our growth initiatives.

Within this context, RTI expects full year revenues of 2017 to range from $274 million to $285 million, when compared to the full year 2016, direct revenue is expected to grow mid-to-high single digits on a percentage basis, while commercial other revenue is expected to comp for a relatively flat-to-low single-digit decline on a percentage basis. Excluding the approximately $4 million pre-tax charge for severance-related expenses in 2017, adjusted net income for fully diluted common share is expected to be in the range of $0.05 to $0.10 based on $59.5 million fully diluted shares outstanding.

RTI will continue to evaluate its operating platform throughout the year and will update its 2017 top and bottom line guidance as its actions might warrant. In summary, we have initiated new actions that are focused on execution and improving RTI's platform, which are beginning to yield early results.

We are committed to continuing this restructuring program throughout 2017, as we refocus the company towards growth areas, reduce our cost structure, improve cash flow, and drive to our returning RTI to profitable growth. With the addition of Camille’s leadership starting in March, we are optimistic about RTI's future and confident in our new direction.

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

Good morning and thank you for taking the questions.

Good morning Matt.

Good morning Matt.

First, regarding the strategic review, is that complete? And if so, when or how will you be disseminating the findings from that review?

Yes Matt, this is Rob. It is still effectively underway.

We’ve had some early returns on the initiative. What we are planning on doing is when Camille arrives, Camille will use this information as one of the many inputs as he assesses the business, the product lines, the people, our capabilities and use that as effectively a tool as we set the strategy for 2017 and beyond.

Okay alright. Obviously, a very strong quarter for direct and spine in particular, what do you think was the primary driver or where there multiple drivers for that or are you just getting better coverage with the sales force, any color behind those strength would be helpful?

Yes Matt. Really there is two things here, one is we continue to add to our distribution network, which is a positive throughout their converting distributors and by extension that increases the number of surgeon users that are using our products and in particular in the fourth quarter, we had real strong usage of map3, which is great and gives us momentum in this product area as we get into 2017.

And that’s a great lead in regarding map3, as you just mentioned there, strength factor in the quarter, I call over the course of the year you were slowly ramping that business up trying to make sure that if you had adequate supply where is the inventory regarding the map3, I mean do you feel comfortable now to kind of open the floodgates on that product?

Yes I think that’s happening Matt. I mean right now, our supply is really not an issue, as we go into 2017, as you recall it was in the past, but we’ve cracked that code.

So supply is not a problem at this point.

Okay. Maybe two more.

One of your commercial distribution partners had some pretty significant issues in the fourth quarter with the manufacturing facility being shut down, running into supply issues of their own, did that cause any positive or negative impact on your business in the fourth quarter?

No matter, it really didn't. Our business has been pretty stable with every one of our commercial distributors.

Okay. One last one from me and then I’ll hop back in the queue, the $4 million charge it sounds like most of that is going to hit in the first quarter, how should we be think about that from a modeling perspective, I am guessing it will fall mostly into the and MG&A line, it had been running just under 29 million a quarter, big pop in Q4, but that’s due to the charges, should we - adding the $4 million to the $29 million or off of the Q4 number?

Thank you.

It would really be of the Q4 number Matt, and it’s related to restructuring organization streamlining the reporting structure. And most of that will fall in Q1, some of it will fall in Q2 and remember that this is really just the initial phase of our actions here, when Camille gets on board in March, we expect through this analysis and the management team's analysis that there might be additional restructuring that follows?

Understood, all right thank you.

Thank you.

Hi this is actually Dominic [ph] in for Jayson. Thanks for taking the question.

I had a clarification, a bit of a follow-up, I wanted to make sure that the 90 day effort that’s mentioned in the press release when Camille joins, that’s going to be separate from the restructuring going on proposed by the consultants?

You know I wouldn't say it is separate, it is really an addition. Again, the consultant action is really going to be an input into Camille's analysis, you know as he starts in March.

Okay, understood. I had a question on the restructuring for the $8 million annualized, where should we see this come from, is it R&D, gross margin?

You’re going to see that, really it is going to be across the board, it’s going to fall in the operating section of our P&L and some in the gross margin section also. And as I stated in the earlier comments, we expect this to kind of fully annualize around Q4 at this point.

Okay. Thank you.

And then, this first restructuring as mentioned as the first step, I was wondering when we might see step two and three, and what those might look like?

Yes, at this point it is really too early to tell. I mean we need to get Camille on-board and have him perform his assessment, and that’s all I can say right now.

We will obviously update everybody as we get more information on this initiative.

Okay, makes sense. Turning to guidance for 2017, I was wondering if there are gross margin and cash flow assumptions we should be thinking of.

Yes, we don't comment specifically on that, but I think you're going to see an improvement over the 2016 gross margin as our mix improves with the acceleration of the direct business. And on the cash flow the actions we’re taking even now in our Phase I initiative here will yield some cash flow improvements in 2017.

Okay. And last question, I noticed the international direct, looks like the number was a bit higher than we were expecting, should we still expect that distributor to go to market in China, sometime in first half of 2017 and when might we see an upside from that?

Yes, that’s correct. We factored that into our guidance numbers, but it is a large distributor and we're hoping to even do better than what is factored in our guidance.

Okay. Thank you, guys.

Thank you. I mean just to know if you could expand on the asset impairment in Germany.

This is Wy. The asset impairment is really, it kind of follows of the operating losses coming out of Germany impacting our tax assets.

There are strict accounting rules you need to follow around the facility. So it is a one-time charge, it will occur, it relates predominantly to just the fixed assets, non-cash charge.

Thank you all for joining us this morning and for your interest in RTI Surgical. Have a good day.