Surgalign Holdings, Inc.

Roxane Wergin - Director, Corporate Communication and Investor Relation Camille Farhat - Chief Executive Officer Rob Jordheim - Chief Financial Officer

John Gillings - JMP Securities Jayson Bedford - Raymond James

Good morning, and thank you for joining RTI Surgical's second quarter 2017 conference call. My name is Roxane Wergin, Director of Corporate Communications.

Today, we will hear from Camille Farhat, RTI's Chief Executive Officer; and Rob Jordheim, our Chief Financial Officer. Before we start, let me make the following disclosure about forward-looking statement.

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 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 statements.

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 U.S.

GAAP financial measures, 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 U.S. 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 Camille.

Thank you, Roxane, and good morning, everyone. I'm pleased to report on the progress we are making toward achieving our goals.

RTI has now delivered two consecutive quarters of top line improvement. What is especially encouraging is that each of RTI's businesses generated revenue growth during the second quarter.

Our overall revenue for the quarter was $72.1 million. Adjusted EBITDA was $8.3 million.

Our adjusted net income applicable to common shares was $915,000. And adjusted net income per diluted common share was $0.02.

On last quarter's call, we told you that we would be laser-focused on improving execution and performance in our commercial business. This quarter I'm pleased to report that commercial continues to stabilize and has returned to growth.

The first time we have reported top line growth in this business in five quarters, and we intend to continue to work on improving its performance. Our direct business is strong performer for several quarters, again reported double-digit growth, with spine growing at an above-market rate and strong performance from our cardiothoracic closure, sports and surgical specialties businesses.

And once again, our international segment also generated solid results. Our initial results demonstrate that our broader strategy is working as we focus on reducing complexity in our business, driving operational excellence and accelerating our growth.

Last week we took a significant first step towards reducing the complexity of our business by selling substantially all of the assets of our cardiothoracic closure business to A&E Medical Corporation for up to $60 million in cash. Concurrent with the sale of the business, we entered into a multiyear contract manufacturing agreement, whereby RTI will continue to support the cardiothoracic closure business under A&E Medical's ownership through the manufacturing of existing products and the engineering development and manufacturing of potential new products in the future.

By way of background, RTI acquired the cardiothoracic closure business as part of our 2013 Pioneer Surgical Technology acquisition. We applied a focused R&D and a disciplined direct channel strategy and grew the cardiothoracic closure franchise by a compounded annual growth rate of more than 25% over the last five years, transforming the business into a leading global provider of cardiothoracic sternal metal cable and plating systems.

The RTI board and management determined that in joining with A&E Medical and through having access to Vance Street Capital's industry knowledge, our cardiothoracic closure business will have even greater opportunity to grow and thrive. We used the portion of the proceeds from the sale to pay down debt and intend to use the remaining proceeds, net of anticipated taxes and transaction expenses, to shore up our working capital and deepen our investments to build scale and strengthen our product portfolio.

And Rob will provide further details shortly. Over the long-term, we will continue to take a methodical approach to evaluating all aspects of our business.

As I have said before, we are taking a very hard look at each of our business segments to determine which ones will be made part of RTI and which we will look to divest or pair back. As we focus on driving operational excellence, we will continue to work on taking costs out of our business, especially the tissue business.

We remain on track to achieve our goals from the initial phase of our restructuring program and we plan to build on this throughout the year. Look, we know that cost management will play a critical role in setting up our platform for sustainable profitability and we are laser-focused in this regard.

We also recently implemented personnel changes, as we strive to complement our strategic initiatives by the upgrading our leadership team's balance. I am pleased to welcome Paul Montague and Enrico Sangiorgio to the RTI family.

Paul has achieved a distinguished career with the global human resources roles at a number of large public companies, including Kellogg, Johnson Controls, Baxter Healthcare and GE Healthcare. As RTI's new Head of Human Resources, Paul will ensure that we are aligning our culture, talent management and professional development with our long-term strategy.

Enrico is leading our international operations and brings nearly two decades of experience and leadership positions at the European healthcare organizations to RTI and will be invaluable, as we continue to expand into new markets. In addition, we are actively recruiting for the two top R&D positions within the company.

As you can see, we are putting many of the right pieces in place. However we also know that we have much work to do.

Before turning the call to Rob, I'll close by reiterating that while we are early in our journey, I am encouraged by our results thus far. RTI has delivered two consecutive quarters of revenue growth.

The strategic initiatives we have implemented are beginning to bear fruit, and our operating performance continues to improve. And by focusing on operational excellence and enhancing our platform, we will drive towards greater stock price appreciation and shareholder value.

RTI's talented employees will be critical in achieving our goals and I'm very grateful for their dedication, commitment and receptivity to the changes we are making, as we move RTI toward the strongest path to achieving success. And with that, I'll turn the call over to Rob to provide a more in-depth overview of our second quarter financial performance, as well as highlights from a business segments.

Rob?

Thank you, Camille. I'd like to focus my remarks on the three areas we see as key drivers of our second quarter results.

These areas are: for the sixth quarter in a row, we delivered double-digit growth in our direct business. Our commercial business continues to stabilize and grew 4% in the second quarter.

We are starting to see the results of our cost reduction initiatives. Now I'll go through the detailed results.

Our second quarter revenue of $72.1 million, represents a 7% increase over the second quarter 2016. We saw continued strong performance from our direct business in the second quarter of 2017, with revenue of $43.6 million, an increase of 10% compared to the second quarter of 2016.

We experienced double-digit growth in the spine, surgical specialties and cardiothoracic closure businesses. We also experienced growth in our sports and direct international businesses.

We saw return to growth in our commercial business in the second quarter of 2017 with revenue of $25.8 million, an increase of 4% compared to the second quarter of 2016. Growth was driven by the increased orders from our dental and trauma distributors.

We continue to see signs of stabilization in this business and we intend to solidify and grow it. Our net loss applicable to common shares for the second quarter 2017 of $2.6 million, or $0.04 per common share, compares to net loss applicable to common shares of $3.2 million, or $0.05 per common share, reported in the second quarter of 2016.

The net loss in this year's second quarter was primarily driven by our previously disclosed pretax severance charges, totaling $3.4 million. Excluding those charges, we reported adjusted net income applicable to common shares of $965,000, or $0.02, per diluted common share.

Let me now review the performance of each of our business lines. Second quarter direct U.S.

spine revenue increased 10% compared to the second quarter of 2016. Growth was driven primarily by strong performance in spine biologics.

We continued to add new surgeon users and had a record number of surgeon users of our spine products during the second quarter. Our direct U.S.

sports and orthopedics business increased 3% compared to the second quarter of 2016, largely due to strong growth in Map3 allograft in the foot and ankle market. Revenue for our direct U.S.

cardiothoracic closure business in the second quarter increased 26% compared to the second quarter of 2016, representing eighth consecutive quarters of 20%-plus growth. Growth in cardiothoracic closure was driven by sternal closure hardware and biologics.

Second quarter revenue for our direct international business increased 6%. On a constant currency basis, our direct international business increased 7% compared to the second quarter of 2016.

This growth was led by strong performance in the Asia-Pacific markets, primarily in spine. Our global commercial other business returned to growth in the second quarter of 2017 and increased 2% partly due to the higher orders from our dental and trauma distributors.

We are encouraged by the second quarter growth and the commercial other business and the continued signs of stabilization. Second quarter adjusted EBITDA was $8.3 million or 11% of second quarter revenues.

This compares to adjusted EBITDA of $6.4 million or 10% of revenues for the second quarter of 2016. Gross margin for the second quarter of 2017 was 51.3% compared to 50.2% for the second quarter of 2016.

The increase in gross margin was primarily due to favorable product mix. During the second quarter of 2017, marketing, general and administrative expenses totaled $29.5 million, an increase of $1.1 million or 4% compared to the second quarter of 2016.

The increase was primarily due to higher variable compensation and distributor commission expenses on direct revenue, mostly in our spine business. Research and development expenses totaled $3.7 million, a decrease of $344,000, or 8%, due to lower project spend.

Operating income for the second quarter of 2017 was $327,000 compared to operating loss of $2.7 million for the second quarter of 2016. Excluding the $3.4 million of severance charges, adjusted operating income in the second quarter of 2017 was $3.7 million.

Turning to the balance sheet. Our cash position at the end of the second quarter was $13.7 million comparable to our cash position at the end of 2016.

Working capital at the end of the second quarter of 2017 totaled $118.3 million, a decrease of $3 million compared to working capital at the end of 2016. At the end of the second quarter this year, we had $80 million of debt and approximately $9.5 million available under our revolving credit facility.

As previously mentioned, on August 3, the company sold substantially all the assets of its cardiothoracic closure business to A&E Medical Corporation for total consideration of up to $60 million in cash. Of the $60 million in total consideration, $3 million is being held in escrow for up to 12 months to satisfy indemnification obligations, if any, and $6 million of contingent on achievement of certain milestones.

The company used the majority of the proceeds from this sale, net of transaction fees and anticipated taxes, to reduce its term loan of $22 million. The remaining proceeds will be used to shore up working capital.

Concurrent with the sale of the cardiothoracic closure businesses, the company restructured its credit facility to include a revolving line of credit with a total capacity of $42.5 million and a term loan of $25.4 million. As part of this restructuring, the maturity date of the credit facilities was extended to September 15, 2019.

The initial interest rate on credit facility is LIBOR plus-350 basis points subject to certain adjustments. The proceeds from the sale of the cardiothoracic closure business and the restructuring of the credit facility improves RTI's liquidity position and provides a greater flexibility to make strategic investments for future growth.

We continue to make progress on our cost reduction initiatives. Building on top of our initial restructuring in the first quarter of 2017 with the actions taken in the second quarter of 2017, we are on target to generate a cumulative $12 million of annualized cost savings as we exit 2017.

Turning to guidance. Based on second quarter results and the transition of our cardiothoracic closure business from a direct business to a commercial business, as a result of the previously mentioned sale, we expect full-year revenues for 2017 to be between $274 million and $280 million compared to prior guidance of between $274 million and $285 million, with direct revenues anticipated to grow low-to-mid single digits and commercial other revenues anticipated to be relatively flat.

Excluding the $7.8 million in pretax charges for severance-related expenses in the first half of the year, the expected third quarter gain on the sale of the cardiothoracic closure business and the transition of the cardiothoracic closure business from direct to commercial as a result of the sale, we expect full-year 2017 adjusted net income per diluted share to be between $0.04 and $0.08 compared to prior guidance of between $0.05 and $0.10. With that, Camille and I would be happy to take your questions.

Hi guys. Can you hear me okay?

Yes, we can.

Okay, great. So I want to start out with the divestiture.

You've given some high level comments both when you first announced today and on today's call. But could you just give us a little bit more color into what went into that decision, because as you mentioned, it was an area that have been able to run with really well and get growing quite quickly?

Just help us understand strategically how you thought about that and decided that selling it was the right decision?

This is going to be a longer answer but that's because you asked for more data behind it. Last call when we talked about things, we said that there are three fundamental questions that we ask ourselves as we look at our businesses.

The first part is, are these market attractive and in line with our strategy? The second part is, are we good operators of these assets?

And the third question is, are we rightful owners of this asset in the long-term? What is undeniable from what we talked about is we are phenomenal operators of this asset.

However it probably is not in line with our long-term strategy. And as such, we don't believe we are the rightful owners of this asset in the long-term.

In our business, there are a lot of fast growing parts of our business that require investment, that require focus and require cash. And in this case, as much as the organic growth can continue to grow in this business, it's not going to be commensurate with our aspirations of growth long-term.

And so then what do you do? We basically look to partner with A&E.

Strategically it's a great fit. Our products will be prominently displayed in that basket.

It adds to the offering that our team has. It transfers our existing team to their team to manage that.

We maintain the OEM business, so no changes on that one. We partner with them on developing new products for them, which can also increase our OEM collaboration with them.

And in general, unlocks a lot of value that was trapped in our business. We paid down the debt.

We shore up the working capital and we can redeploy that and it gives us the nimbleness and flexibility to take advantage of that as other opportunities present themselves for us to shore up our position, build scale and complete our portfolio. So it really is a win for A&E strategically.

It's a win for our team, where they can add more products to their basket and get investments where here they are competing with other high-growing businesses. And for us, where like I said, it gives us the financial flexibility.

It makes us stronger. And it's candidly one less business to focus on, which is in line with our strategy when we talk about focusing on reducing complexity.

Okay.

Is that a good enough answer?

That's a great answer. I really appreciate the detail.

And it actually provides a good segue into the next question I would ask, which is now that you have a more flexible financial backdrop, are there any other areas in the business that you're looking at specifically where you'd like to - you've identified something specifically that you'd like to add or change in the portfolio?

Look, from our perspective, right now what I'd say is we are busy building the foundation. We believe that with our activity and our focus on continuing to evaluate the businesses, like I said in my remarks like I said last time as well, we are still assessing every part of our business which ones do we want to double down on, which ones do we want to pay back and which ones we can part ways with based on the three guiding questions I shared with you.

At the same time, we do have an improved cash position. We don't really have a size in mind but we clearly have a view in evaluating opportunities when they come up that are in line with our strategy to enhance our portfolio, scale platform and capabilities in our market position.

So we have the option that we did not have a week ago. It's a little bit premature for us to comment.

But yes, we are very active in looking and eyeing things. But we are not ready to pull the trigger yet.

Yes, that makes sense. I appreciate that.

And then just one last one from me just looking specifically at spine. As some of the bigger players that reported earlier seem to have had some challenges in the quarter and commented on maybe some market-wide sluggishness.

And I know you guys are still at a size where you're not necessarily driven entirely by the market but you did manage to still pull off some pretty solid double-digit growth. Just any comments that you could you give us any color on things you're hearing back from the field just related to the market as a whole or things that you're doing specifically that are working in this environment, would be helpful.

Thanks.

Thanks for the compliment on our performance. I also want to complement our team on a great performance.

We are growing to almost at - well, definitely ahead of market but almost double the market. And that's a testimony to truly our commercial teams.

We haven't introduced any product as of late. This is a very intense and a very competitive market, as all of you know.

From our perspective, I don't think that there is anything more secretive. I think you have seen consistently that our direct channel is working in every part of the business, and spine is no exception except that it's just more fiercely competitive.

I don't think I have any other comment to add, except that we continue to compete. We do feel the intensity.

But we are happy to be on the scoreboard with the results the team has helped us with the score.

All right, well, thanks a lot guys. Appreciate it.

Okay.

Good morning and congratulations on the progress. Just a couple of quick ones.

As it relates to the guidance on the top line, can you just give us a little idea as to the impact of moving cardiothoracic from direct to commercial? If you had been doing, let's call it, $3.5 million a quarter in the first half of the year on the direct basis, what's contemplated for cardiothoracic revenue in the second half of this year?

Yes, I'll speak in terms of the full-year guidance, Jayson, and I'm going to talk in terms of the midpoint here. In our prior guidance, our midpoint was $2.80 million, okay.

The midpoint in the guidance I just gave you is $2.77 million and there is a couple of things working there. There is the sale of the cardiothoracic business, which lowers the midpoint by a net amount of about $5 million, okay.

And even within that you got something working in that direct would go down $6 million and the transition to OEM would be a positive $1 million. So your net there is the $5 million.

The other part of the swing in the guidance here is that due to the performance of the non-CT businesses improving in the first half of the year and expectations of the second half of the year, we would look for an increase there of about $3 million. So there is two components here.

The sale of CT business and then there is the improvement of the non-CT businesses affecting the midpoint.

Okay. Rob, can you just maybe walk through a similar analysis on the earnings line as well?

Yes, I can do that, Jayson. On the earnings line, the midpoint of our prior guidance was $0.08, okay, and the midpoint of our current guidance is $0.06.

And you have the same swings. We are adding a penny to the midpoint due to the performance in the first half and we are deducting $0.02 from the midpoint due to the sale of the CT business.

So the net effect there is $0.02 and we are dealing with increments of cents here because we have so many shares outstanding with a net effect of $0.02.

Okay. And if my memory serves, it sounds like you had mentioned at the end of the call there $12 million in gross savings exiting '17.

Is that up from the $8 million prior and is that mostly due to the cardio sale?

No. It really has nothing to with the cardio sale.

These are actions that we took in the first quarter of 2017. Then followed up in the second quarter of 2017 with additional restructuring.

That's the $3.5 million in severance. So as the severance rolls off and the payroll gets smaller, we should be at the end of the year.

And as we go into 2018, have gross cost savings of about $12 million.

Okay. And maybe, Rob, while I have you here, the gross margin dynamic.

I think you had previously talked about this as an area of opportunity to grow and I realize it expanded year-over-year but sequentially there wasn't much of a change and I'm just wondering what do you guys need to do here to improve that gross margin line?

Well, as Camille said in his comments, we are looking hard at the tissue part of the business to take costs out of that and improve gross margins there. As we look out through the remainder of the year and we affect more cost saving type initiatives, I see that our gross margin on a sequential basis should step up in Q3 and Q4.

Let me add a little bit more color, Jayson. It's Camille.

When you think about where we are and what we got to do, it really is a combination of things. On the tissue side, we are working closely in non-traditional ways actually with our partners on the donor acquisition side.

We are also looking at our operations in what we can do and should do differently to reduce our cost structure in that vein. But thirdly, and as importantly, we are looking at revenue optimization.

So we have started - and we're in the early phases at looking at the SKU analysis, the inventory analysis and potentially we will come back and we'll share that with you when we're done, but I think we may be in a situation where we may vote for less revenue and more module [ph] in cash. So it's really all around and that's where you said what are we doing to improve margin?

It's better collaboration with our partners on the donor acquisition on the tissue side. It really is about us getting leaner, more focused, nimble on the manufacturing side, and it's us getting smart on optimizing revenue that is accretive and profitable.

And I don't want to underestimate the impact that this could have.

Sure, okay. That's very helpful.

I'll get back in queue and let someone else jump on.

Thank you.

Thank you again for joining us this morning and for your interest in RTI. We are encouraged by our strong second quarter results.

And I am very confident that RTI is on the right path towards achieving predictable and sustainable profitability over the long-term. However we have more work to do.

But there should be no doubt about our commitment to simplifying our business, accelerating our growth and driving operational excellence. We will continue to be driven by disciplined and focused on execution in everything we do.

We are looking forward to staying in touch and continuing to update you about the progress we are making toward our long-term plan. Thank you for calling in and have a great day.