Surgalign Holdings, Inc.

Nathan Elwell - Investor Relations Camille Farhat - President and Chief Executive Officer Jonathon Singer - Chief Financial and Administrative Officer

David Turkaly - JMP Securities Jayson Bedford - Raymond James Matthew Hewitt - Craig-Hallum Capital

Good morning and thank you for joining the RTI Surgical First Quarter 2018 Earnings Conference Call. On the call today are Camille Farhat, our President and Chief Executive Officer and Jonathon Singer, our Chief Financial Administrative Officer.

Before we start, let me make the following disclosure. 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 this call.

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, provides useful information 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 forecast 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 on the Investor section of the website.

Now I'll turn the call over to Camille. Please go ahead.

Good morning, everyone and thank you for joining us. I have been with RTI for just over a year and wanted to highlight something I said during my first call, almost exactly a year ago.

I said then one of the biggest reasons I chose to join RTI is the considerable untapped potential of the business. RTI is a company with a solid foundation and substantial opportunities for growth.

And in looking back on the year, I firmly believe what I said then is still a 100% true today. We have made significant strides in tapping that potential and material changes are underway as we forge ahead with our three strategic objectives, focused on reducing complexity, driving operational excellence and accelerating growth.

Highlighting briefly the changes we have effected, we initiated our efforts to reduce complexity last year with a successful divestiture of the CT business. We paid down the debt and strengthened our balance sheet to support our ability to advance in the acceleration of growth.

We kicked off our operational excellence initiatives with a focus on Tissue acquisition and processing which, in 2018, will produce $13 million of savings, which is approximately half of our $25 million target. Importantly, we have upgraded 50% of the top-50 leadership roles at RTI over the past twelve months and most recently, we successfully completed the Zyga acquisition.

While many more initiatives relating to accelerating growth and driving consistent predictable cash flow are well underway, they will likely take more time to show results. The key takeaway is that our strategic objectives are driving an operational, financial and cultural transformation at RTI, which are key to driving long-term shareholder value.

We are pleased with our progress to-date and our forward-looking trajectory. Turning specifically to the first quarter, 2018 is off to a positive start.

During the quarter, we delivered revenue of approximately $69.9 million, which was driven by strong performance in our OEM and international franchises, offset by reduced revenue due to the sale of the CT business and softer results in certain parts of our Spine and Sports franchises. We recorded adjusted EBITDA of $7.8 million or 11% of revenue and adjusted net income of $0.5 million or $0.01 per fully diluted share.

Our performance this quarter highlights an important point that shouldn't be overlooked. The strength of our core manufacturing competencies in tissue, biologics and spinal hardware supports growth across our core business lines to ensure we deliver a balanced financial performance.

The continued strength of our OEM and international franchises demonstrates the importance of the diversity of our customer base and our culture of achieving results in areas of strategic focus. It's a credit to our teams that we have been able to both successfully refocus the OEM franchise over the past year to drive growth by getting closer to our customers and to reset our international franchise while still growing the business in the process.

With the executive leadership team in place for the first full quarter, the company is stabilizing and executing on numerous initiatives with a focus to deliver on commitments. In short, our strategic transformation continues and we remain optimistic about our prospects.

Our Spine’s franchise produced decent results for hardware with biologics exhibited softer results attributable mainly to map3, which we were expecting. We are maintaining an open and cooperative dialogue with the FDA, but this situation has created some opportunities for competitors to displace us in some accounts.

That said, we are encouraged by the cadence and timing of Spine product launches set positively to impact the second half of the year and we remain committed to our outlook for the year and our belief that we will grow our Spine franchise at twice the market growth rate. In our Sports franchise, certain products were oversold during the fourth quarter of 2017, which left us being on back order in the first quarter impacting results.

I am pleased to say that the situation has been rectified. We began the year with the acquisition of Zyga in early January and have produced solid procedural and revenue performance.

Thanks to the hard work of numerous people across the company, the integration is proceeding well and is actually ahead of schedule. The team led by Brad Swatfager from the Zyga team and supervised by Jon Singer are doing an outstanding job.

Acquiring Zyga added an innovative, minimally-invasive treatment that enhances our spine portfolio and opens significant opportunities. It is perfectly aligned with our Spine expansion strategy to pursue niche differentiated products to gain scale to improve customer retention and to support portfolio pullthrough.

The Zyga team hit the ground running and have maintained their focus and positive procedural momentum. In addition to differentiated technology, we gained a tremendous team who are filling leadership roles in the broader RTI organization.

Finally, I'd like to give an update regarding the next steps of our focus areas. Starting with reducing complexity, we are looking for and exploring opportunities with potential partners who are well positioned to better – to be better stewards of select assets.

Regarding driving operational excellence, we are working to finish the tissue-focused projects that will yield the committed savings in 2018 and has identified additional operational excellence initiatives to maintain the positive momentum and cultural shift. We are also expanding our lean manufacturing initiatives to additional sites and have made significant leadership changes to our facility in Marquette, Michigan and of course, accelerating growth.

With the management team in place, I am shifting more of my energy towards accelerating growth. We are working to strengthen our R&D discipline and rebuild our innovation pipeline.

We are developing product roadmaps for each of our business lines. We are on track to launch some important new products during the second half of 2018, including Fortilink, our 3D printed radio translucent interbody, which is receiving very positive feedback from the surgeons who have participated in prelaunch evaluation.

With the Zyga integration on track, we are turning our attention to sourcing new deals and we are prudently exploring deals that will add products or companies that would advance our strategy and competitiveness at logical valuations. As we have already said, 2018 will be a year of continued focused execution for RTI.

Our world-class management team has quickly gelled into an effective unit, closely aligned around driving our strategic transformation. We had a solid foundation for continued long-term profitable growth, which is highlighted by the 2018 fiscal financial guidance we are reiterating today and our commitment to achieving our long-term strategic goals of reaching $500 million in revenue with an EBITDA margin of 20%.

By successfully executing our strategic initiatives, we are ensuring the company is focused on its core capabilities with a solid tissue-based portfolio generating predictable earnings and strong cash flow to support advancements in our growing Spine portfolio. With that said, I will hand over to Jon to outline our financial performance.

Thank you, Camille. Jump right in - jumping right in at the top, revenues for the first quarter of 2018 were $69.9 million, comparable with the prior year first quarter.

First quarter revenues were driven by growth in the OEM and international lines of business, which were partially offset by declines in Sports and Spine and a $3.2 million reduction from the sale of substantially all the assets of the Cardiothoracic Closure business completed in August of 2017. Adjusted for the impact of the CT sales, revenue increased $3.1 million or 5%.

We estimate that approximately $1.1 million of the increase was timing of OEM shipments from the second quarter of the year. Gross profit for the first quarter of 2018 was $33.7 million or 48.2% of revenue, compared to $35.8 million or 51.2% of revenue in the first quarter of 2017.

Gross profit for the first quarter of 2018 was impacted by an inventory charge of $1 million from the write-off of inventory related to our international restructuring and $0.2 million due to the purchase accounting step-up of Zyga inventory. Marketing, general and administrative expenses decreased $1.3 million or 4% to $28.4 million in the first quarter of 2018 from $29.7 million in 2017.

The decrease was primarily due to the sale of the CT business and the reduction of our organizational structure driven by improvements in organizational efficiencies, partially offset by the addition of Zyga. Marketing, general and administrative expense decreased as a percentage of revenue from 42.4% for the three months ended March 31, 2017 to 40.6% for the three months ended March 31, 2018.

Research and development expenses were $3.4 million in the first quarter of 2018, compared to $3.7 million in 2017. The decrease was primarily due to the reduction of our organizational structure.

R&D spending decreased as a percentage of revenue from 5.3% for the three months ended March 31, 2017 to 4.9% for the three months ended March 31, 2018. The company incurred the following non-recurring pretax charges in the first quarter, severance and restructuring charges related to reduction in headcount, improvement in operational efficiencies resulted in $0.9 million of expense primarily in support of our international reduction of complexity and acquisition-related expenses of $0.8 million related to accelerating growth with the investment in Zyga.

During the first quarter of 2017, the company incurred $4.4 million of non-recurring pretax charges, primarily related to management restructuring. Adjusted earnings before interest, taxes, depreciation and amortization for the first quarter of 2018 was $7.8 million or 11% of revenue, compared with $6.5 million or 9% of revenue for the first quarter of 2017.

This is the primary measure I evaluate to determine our progress on reduction and complexity and improving operational excellence, which will drive us towards our long-term goal of 20% EBITDA margin. Net loss applicable to common shares was $1.9 million or $0.03 per fully diluted common share in the first quarter of 2018, compared to a net loss applicable to common shares of $2.8 million or $0.05 per fully diluted common share in the first quarter of 2017.

As outlined in the reconciliation tables provided in our earnings release excluding the impact of the various non-recurring charges, adjusted net income applicable to common shares was $0.5 million or $0.01 per fully diluted common share in the first quarter of 2018. Briefly looking at liquidity, our cash position at the end of the quarter was $13.8 million and working capital totaled $131.5 million.

During the quarter, we borrowed approximately $18 million for the acquisition of Zyga and at the end of the first quarter we had approximately $61 million of debt outstanding. Ending with guidance, based upon our current business outlook, the company is reiterating financial guidance for 2018 originally issued on January 5, 2018.

The company expects full year revenues in the range of $280 million and $290 million. The company expects full year EBITDA to be in the range of $32 million to $38 million.

The following assumptions underpin our guidance, relatively stable market conditions and regulatory environment; positive revenue contribution from the acquisition of Zyga technologies; ongoing positive impact of efforts to reduce complexity and implement operational excellence; and our ability to continue the marketing of map3 cellular allergenic bone graft to minimally – our ability to continue to market map3 despite the FDA warning letter. Our guidance is intended to be for the full year.

However, given that everyone develops quarterly models, I'll share some thoughts on the performance drivers in the second quarter of 2018. In Q1, 2018, we had approximately $1.1 million in the revenue related to the OEM business that has been planned in the second quarter.

In addition, we continue to experience some mild headwinds from the map3 warning letter and most of our new product revenues are driven by late Q2 and Q3 launches. Accordingly, we anticipate that the second quarter of 2018 to be sequentially flat in comparison with the first quarter in line with our initial guidance when adjusted for the Q1 OEM revenue performance.

Operator, I would now like to open the line to questions.

Providing details on your progress.

Sorry, Matt.

Did you hear me okay?

We didn’t pick up the first part.

Just thank – thanks for taking the questions. Congratulations on your progress to-date.

Thank you.

A couple questions for me. First, could we get the Zyga contribution in the quarter?

Yes, so Zyga contributed just short of $1.2 million in revenue and it was dilutive by about $1.1 million from an operating earnings or EBITDA perspective.

Okay, great. Thank you.

And then, looking at the OEM segment was this broad base? Was this, maybe one of your partners coming in a little bit earlier than expected or any color you could provide on the OEM contribution in Q1?

Yes, it was predominantly around ortho fixation, which correlates to a couple of customers with that product line out of Marquette and yes, I think it was just – we had a long-range forecast from each of the partners that we had produced against and so, when they saw what we had available, they pulled their Q2 orders forward.

Okay, all right. And then – but you would expect them to come back in Q3 maybe?

We don't anticipate that over the course of the year. So they did not change their twelve month forecast for demand and so it's really just – it's timing versus anything else.

Okay. And how does that factor in to – and I know that you had some inventory charges in Q1.

But how much did that OEM shift maybe impact the gross margin in Q1 and how should we be thinking about that for the remainder of the year?

Yes, so if you adjust for the charges, the gross margin was right around 50%. And so, if you were to compare it to last year, I would say the sequential change year-over-year is predominantly driven by the shift from direct to OEM, in particular, sale of the CT business that had 70 plus margins.

So, when you look at the 50% baseline that we're starting, we anticipate with the cost savings that we've got in place that that should sequentially increase quarter-over-quarter. We are on track or ahead of plan from the cost savings perspective.

But as you guys know, given our inventory turns, we end up capitalizing the vast majority of the savings. So we are sitting with a fair amount of capitalized variances at the end of the quarter that give us confidence that we are on track relative to the cost savings and we are monitoring it pretty closely.

So, kind of a long answer to your question that it just comes back to about 50% margins when you adjust for the charges expanding through the course of the year, ending the year probably somewhere between 300 and 400 basis points above where we are in the first quarter.

Well, that's really helpful. Thank you for the color.

Maybe one more and then I'll hop back in the queue. Camille, maybe this one is for you.

I know that you put a lot of emphasis on - I don't know if re-negotiating is, but working with your tissue partners a little bit closer to find ways that both you, as well as them can benefit, how have those discussions gone? Where do they sit and more importantly, what can that mean as we look not only through the rest of this year but into – in some of the upcoming years?

Sure. So Matt, these – we've done these almost now six months ago.

So, these we did in the third quarter of last year and every one of our OPOs, I am happy to say they truly partnered with us on this and we had new contracts in place in the first part of the Q4 effected actually and that's part of what Jon was referring to in our ability to capitalize some of these savings. There are different parts actually.

So it's a little bit more complicated than just the musculoskeletal, there are other areas that we are seeing our customers expand in our distribution, asking for where we can provide them with opportunity of them expanding their margin. But on some of the basics, we just are resetting or we have reset back in market dynamic of where we are.

We kept all of our OPOs. We are happy to continue to work with them productively.

We are looking longer-term to find ways to both adjust – both of us adjusting to the markets and staying where we need to be. That issue has been addressed, tackled satisfactorily in the beginning of the fourth quarter or last year.

Okay, all right, great. Thank you.

Thanks. I don't think I had asked you guys sort of an update on the sales force in a while and given sort of the strategic transformation you are doing, I'd love to just get a little color on how big the teams are and if you think you have the right people and the right size for the different businesses?

Sure. So, we can go around and talk about it.

I think that the best way to start with it is on the sales side. We have augmented that team through the Zyga acquisition and we are provided and added more training, as you can imagine and we are investing on the demand generation side and augmenting that through outside of the resources that allows us to flex and develop that demand generation engine.

So, the existing Spine sales force on the biologic and the Spine did not really change a lot. It's exactly where it was at the end of last year and where it was at the beginning of last year and we just augmented that with a part of the Zyga team and dedicated sales force to match with our team and then training.

On the OEM side, we are in the process actually of revamping the wholesales team and we are in the process of recruiting, given our new emphasis to drive growth. We need different profile for that organization and in the process of recruiting right now.

And so, we anticipate that that group largely would look different, but with the same headcount that we had and maybe added a couple more. On the Sports side, we haven't done anything to change the footprint in the last year-and-a-half, I would say.

However, on the plastic and reconstructive surgery, we are seeing a lot of growth and we are augmenting that through expanded distribution network and more 1099s from that aspect. And then lastly on the international side, fully upgraded in many areas.

Headcount flat, but a better focus and much more productive and really they deserve a lot of credit for changing product focus, country focus and teams and still delivering growth this year. So I don't know if, Jason, that answers the question, but that's kind of our commercial footprint right now.

Yes. So I guess, I was trying to get it sort of since you started this whole process, it sounds like you haven't had a lot of attrition.

It sounds like you are kind of net adders and you plan to be so going forward in terms of the size of your sales team?

Sorry, that's David, I thought that was Jason. Sorry, David.

So we are – look, we look very carefully here on two things. One is the productivity of the sales force and then coverage.

And where we find the opportunity and if it’s like we said on the PRS side, we are doing that where we can be productive, as you can see on the international side, we are solely for productivity and where we need to maintain focus and drive like Zyga, that's what we are doing, not only are we adding on the sales side, but also on the support to drive the demand, marketing and training.

Great, and then, just on the Zyga side and I know you’ve spoken about in the past, but any update on sort of what you think the opportunity is there? And you mentioned some new products you expect in Q2 and Q3, I just wondered if you can maybe share if there is a meaningful one or two with us today?

Yes. So, staying with the Zyga, we believe that this market will double in size by 2022.

So we think that the sacroiliac joint goes from $100 million to $200 million by the end of 2022. And we feel very bullish about being the company that talks about fusion with the codification and clinical data that supports it.

We are well over 200 implanted patients right now and a 250 patient study with published one year data demonstrating fusion, we believe as we continue to drive patient access including reimbursements, that that is going to drive a lot of growth and that's what we are supporting it with training and with a lot of marketing activity on the demand generation. So, we stand to benefit from market growth, as well as we stand to benefit from the support of the clinical data and the marketing activity on demand generation.

So we feel very bullish about the potential growth that it would not be small increments as you projected out for 2022, but it would be in big steps. In terms of product introductions, whether it's the cervical, whether it's a lumbar, the whole Fortilink family of products is getting a lot of positive feedback in control evaluations and we look forward to a big launch on that front.

And then, we also have a lot happening on the Sports side with different thickness of dermis with Fortiva even on breast reconstruction and trilogy and large sizes and thickness. And we are added some distributed products to fill the portfolio, I guess, in the short-term.

So, all of that is what gives us confidence on the Spine side, on the Sports side, on the OEM side due to and internationally to sustain and accelerate a momentum and maintain the guidance that we shared with you for the year.

Thanks a lot.

Thank you, David.

Hi, good morning. Just a few questions here.

First, I guess, Zyga, is that booked, Jon, in the Spine line?

Correct, yes.

Okay. And then, within OEM, how much of that is from, kind of the CT business?

I think you are still supplying product there, right?

Yes, there is about a $1.06 million in the quarter that correlates to that transition.

Okay. And in terms of map3 and kind of the commercial impact of the warning letter, are you still seeing – I don't know what the right word is here, but are you still seeing some physician defections as a result of the warning letter or is that kind of died down a little bit from last quarter?

The dynamic is less around physician decision-making and more around facility decision-making. And so the physicians continue to see map3 as a great alternative to support fusion in the procedures.

And in fact, we are seeing an acceleration of evaluations and numbers of users, both in the Spine and broader Sports. But where we are seeing headwind is that, just certain facilities, as they go through their evaluation process, they are just saying warning letter, no.

And so, we've lost some pretty significant users, surgeons that were doing big chunks of business who still want the product, but their facility is just saying hey, if you are doing surgery here, we are not going to support utilization of a product under a warning letter. And that's the bigger headwind that we are managing.

Okay. And in terms of the next steps with map3 and the regulatory path, what's next on the agenda here?

Yes, I mean, I don't think there is a deviation or anything new to report. We are continuing to make progress on the same plan that we shared back in November in our response.

And we are tracking to that. We have committed to the agency, we would do an IND study and we are making progress in doing that and submitting there.

So really, that's pretty much kind of where we are.

Okay. And then, maybe for Camille.

You mentioned – I think you mentioned exploring opportunities to sell assets or at least that's the way I interpreted the comments. At the same time, you are looking at deals.

I guess, my question is, do you have to sell assets to see your strategy play out? Or is the current capital structure flexible enough for you to do deals without selling assets?

We are very comfortable not to be dependent on disposition of assets for us to bring our vision to life. We are very, very comfortable in that.

But it's in – what we talk about reducing complexity, increasing focus, strengthening the channel, that is where the comment was driven by. But why don't I also ask Jon to weigh in and add his two cents to it.

But that's a short, I guess, answer to your question. Jon?

Yes. So we've got sufficient capital flexibility to support the strategy as we've outlined it.

If you think about it when we talked about accelerating the growth, specifically around the Spine franchise, two primary objectives, one, scale and I would hypothesize if we were to do a significant scale acquisition that we would probably consider using our equity as a currency to support that and so obviously, quite a bit of flexibility there. And then, similar deals to the Zyga acquisition that help us provide differentiated products would – we would be able to finance that through either existing or future credit approaches.

We are in the process right now of evaluating our credit facility and believe that we are not too far from expanding available capacity there. And so, we are comfortable when we look out across the horizon of the opportunities that we've evaluated relative to the execution of our strategy when you kind of go back to kind of what I would call finance 101 in your masters class, separate the investing decision from the financing decision.

If we make a good investing decision, we will be able to finance it.

Okay. Thank you.

Hi, just one follow-up for me. Last year, you were facing a little bit of a headwind as you saw the market shifting from allograft back to autograft.

I am just curious if that has stabilized or - and what your expectations are for 2018? Thank you.

What I would say, Matt, is, you can go back in as far in recent history as we need to. And there is a – the market is pretty much well declared and delineated.

There is an 80% autograft, 20% allograft. And that's kind of like – there are fluctuations, but it kind of settles back around that.

And we don't see that changing this year. We don't see that changing in the near future.

And I think that's kind of where – when we look at the year, we believe it's stable and we believe that's where it's going to be. So we don't

Okay.

If your – if the question is around specifically the Sports business and the allograft, it's probably modest growth is what you are expecting, but we don't see that market growing.

Okay. Great, thank you.

Thank you for your ongoing interest in RTI Surgical. We are committed to our three strategic objectives of reducing complexity, driving operational excellence, and accelerating growth and we are confident that our transformation is on track.

We are focused on the execution of our plans and look forward to updating you on our progress over this summer. Thank you, and have a great day.