Surgalign Holdings, Inc.

Good afternoon and thank you for joining the Surgalign Holdings Inc. fourth quarter and full year conference call.

Joining me today on the call is Terry Rich, our President and Chief Executive 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.

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 our 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 provide useful information for both management and investors by excluding certain noncash 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 the 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 Terry.

Thanks John. Good afternoon, everyone.

On today's call I'll provide an overview of our fourth quarter performance, an update on events that occurred during 2020 and then turn the call over to Jon to provide financial overview, after which I'll provide our thought on 2021. Total revenue for the fourth quarter was $26.2 million down from $31.6 million during the fourth quarter of 2019, primarily driven by the negative impact of COVID-19 on elective procedures both in the US and internationally.

Taking a step back, 2020 was a transformational year for the company. Amidst all the uncertainty associated with COVID, we pursued an organizational overhaul in July, which included the separation of two businesses to create a standalone pure play spine company now known as Surgalign.

Just a few months later in September, we acquired Holo Surgical, immediately shifting our priority to becoming a leader in the digital surgery space with an initial focus on spine. At the time we want Surgalign, we laid out our growth strategy for the business, which was made up of three components build, innovate and acquire.

We've made tremendous progress towards each of these during the remaining five months of the year. Starting with build; we've assembled a world-class team throughout the organization from our employees, the management team and the Board of Directors.

We talked at length on previous calls about the [indiscernible] we've been able to add and we continue to do so in recent months. When looking at the senior leadership team, John, Henriquez and Sangiorgio our Head of International and myself are the only members of the team who are part of the organization at the beginning of 2020.

Along with senior leadership appointments, we have brought insubstantial experience to round out the team in literally every department within the organization. Our marketing team is in large part completely new.

Our R&D team is entirely new and we have added a number of people within our finance, quality, regulatory, clinical, medical education, marketing and communications functions. On the innovation side, we made progress towards the overall development of our portfolio during the third and fourth quarters which included product line extensions and expansion of the Biologics portfolio, the application of new materials and manufacturing capabilities and most importantly, additional functionality of the digital platform.

However, as we progress through the back half of 2020, we intentionally slowed down the pace of new product launches. One take time to re-imagine our current portfolio and our innovation roadmap to ensure it supports our shift to digital.

In conjunction with the development of our product roadmap, we need to properly onboard, integrate and align all of the new talent within the organization. We are now confident that beginning in the back half of 2021 and into 2022, a best in class portfolio will emerge, which includes innovative products and systems that are highly integrated with the Holo platform.

Our last component is acquire; following the close of the Holo acquisition during the fourth quarter core members of the Holo team have joined Surgalign in key roles with two of its cofounders Prof. Cristian Luciano and Dr.

Kris Siemionow, joining the head up of the continued development of the Holo platform and lead our digital surgery R&D initiatives. In the fourth quarter, Paul Lewicki, the third Cofounder of Holo joined the Surgalign Board of Directors.

Paul is widely known as one of the forefathers of predicted data mining and continues to be a thought leader in the promotion of artificial intelligence in healthcare and we are excited to have him as part of our organization. With the integration of Holo behind us, the company is completely aligned on our long-term strategy and what needs to be done going forward to deliver.

We continue to believe that there are a variety of interesting products and technologies out in the market and we'll continue to evaluate acquisition, licensing and partnership opportunities that we feel would fit within our strategic framework and be supportive of our digital portfolio. Our commitment to digital surgery aligns with the perspective of many industry thought leaders that medical device companies will see significant change in the near future as the currency of the industry moves from implant to digital services.

These services include machine learning to leverage outcomes and additive manufacturing to create patient-specific implants, all informed by AI, resources leveraging predictive analytics and a move towards personalized medicine. We believe companies that embrace this new paradigm will thrive in the transformation.

2020 was a transformational year for Surgalign where we made significant progress in building a foundation to deliver on the promise of digital surgery. While, I'm proud of what we accomplished in the past six months, we expect that it will take an additional 12 to 18 months to complete our transition from an implants company to a digital surgery company delivering Surgical Solutions.

With that, I'd like to turn the call over to Jon for a financial update.

Thank you, Terry. Global spine revenue for the quarter ended December 31, 2020 was $26.2 million compared to $31.6 million for the prior-year period.

The decline in revenue was primarily due to the impact of the COVID-19 pandemic and global electric procedural volumes. Domestic revenue was $22.7 million, a $4.5 million decline from the fourth quarter of 2019 and international revenue was $3.5 million, a $0.9 million decline from the fourth quarter of 2019.

We believe that demand for our core implants and biologics, both domestically and internationally will return to historical levels globally in line with the return of global elective procedures. However, we anticipate complex product family will return to historical levels at a slower pace than the rest of our portfolio.

Gross profit for the fourth quarter of 2020 was $12.8 million, inclusive of $6.9 million incremental inventory charges, predominantly related to the recall of the Surgalign ACP System and purchase accounting related mark-ups to inventory. Adjusted for the impact of the charges, gross profit was $19.7 million or 75% of revenue compared to $23.6 million or 75% of revenue in the fourth quarter of 2019.

Marketing, general and administrative expenses for the fourth quarter of 2020 was $27.3 million compared to $39.9 million in the prior-year period. The decline in marketing, general and administrative expenses is predominantly driven by the decline in sales-related costs due to the decline in revenue and a reduction in the administrative infrastructure, as a result of the OEM sale.

R&D expenses for the fourth quarter of 2020 was $2.2 million compared to $4.4 million in the prior-year period. The reduction in R&D relates to the separation of the OEM business and the transition of R&D headcount.

We expect R&D spend to return to prior-year levels as we rebuild the competency with enhanced spine experience and invest in the Holo Surgical platform. Company occurred approximately $101 million of nonrecurring operating expenses during the fourth quarter of 2020, primarily related to the Holo acquisition.

In conjunction with the purchase of Holo, we determined that substantially all of the fair value of the acquisition within the acquired in-process research and development asset, which resulted in us treating the acquisition as an asset purchase with the total purchase price of $95 million comprised of $30 million in cash, $12.3 million in common stock, $2.1 million of transaction related costs and a $50.6 million related to our present value assessment of the contingent payments. Since the right platform is pre-commercial, it has not reached technical feasibility as defined by the accounting rules.

The transaction was expensed in the fourth quarter resulting in a one-time charge of $94.5 million. Adjusted EBITDA for the fourth quarter of 2020 was a loss of $7.7 million compared with a loss of $14.3 million in the prior-year period.

Improvement in adjusted EBITDA was predominantly driven by the reduction in operating expenses as outlined above. As of December 31, we had approximately $44 million in cash and on February 1, 2021, we closed secondary equity offering raising approximately $40 million of incremental cash.

Turning to guidance, the COVID-19 global pandemic is continue to impact demand for our products through the first quarter, which would be sequentially down by approximately 10% in the fourth quarter of 2020. We anticipate full-year growth in the range of 5-10% compared to 2020 full-year global spine revenue from continuing operations of approximately $102 million.

Our guidance assumes the global procedures volume returned to normal levels during the second quarter of 2021 with a relatively slower return to historical revenue levels of coflex in limited contribution from the Surgalign ACP which was withdrawn from the market due to a recall by our manufacturing partner in January. Based on this revenue, we anticipate adjusted EBITDA will be in the range of a loss of $35 million to $40 million.

I'd now like to turn the call back to Terry.

Thanks, Jon. Before shifting to our 2021 outlook, I wanted to discuss our long-term vision for Surgalign and how we are approaching our transformation from a spinal implants company to a digital surgery technology company.

The whole of platform is a revolutionary foundational technology and we believe it will impact how surgery is performed and ultimately how care is provided to patients. The initial application of the Holo platform is enabling digital spine surgery.

The platform addresses limitations that exist in today's computer-assisted surgery and robotic platforms by introducing smart applications, enhanced visualization, real-time guidance, warnings, and alerts thus, enhancing surgical performance. We will leverage the autonomous anatomy segmentation and identification software to develop smart instruments to improve surgical workflows makes spine surgery safer, which we believe will lead to better patient outcomes.

We intend to expand the applicability of the platform outside of the EOR as we believe it has the potential to provide benefits throughout the surgical landscape from diagnostic and predictive analytics capabilities to autonomous pre-op planning and intelligent post-op analysis functionality. While the spine market is a significant opportunity, we view it as a stepping stone application for the platform.

Once the model has been proven, we intend to expand into other surgical specialties beyond spine. We are in the early innings of our journey through this transformation, but we are excited about the potential of this innovative technology.

As part of this transformation, we intend to move away from the traditional model of selling screws, implants, and access as a package for procedural pull through instead moving towards delivering better outcomes by re-imagining what is possible through integrated intelligent technology. This shift will not happen immediately, but everything we are doing from this point onward will be done with the intention of moving towards personalized medicine through the application of the digital platform and supporting technologies.

Before opening the call up to Q&A, I'd like to discuss our key priorities for 2021. At a high level 2021 will be a year of transition and investment building the foundation for growth in 2022 and beyond.

Our priorities for the year are first continue to build out the organization in support of our digital strategy. Second, continue the development of our Holo platform with the goal of performing first cases in the U.S., by the end of the year.

And third, reimagine our product portfolio to accelerate the pace of new product introductions. Starting with the continued build-out of our organization support of our digital strategy, we have put tremendous senior leadership team in place over the last nine months, which includes the integration of the team from Holo and we have now shifted to optimizing the structure and scale of the company.

We also brought on a significant number of very talented people across the organization and will continue to add talent aligned with our strategy. Turning to the ongoing development of Holo, there are a number of key milestones we expect to achieve this year.

First is the FDA 510(k) clearance for the platform. We expect to happen in the back half of the year.

We are very confident in the technical foundation of the platform and continue to work to put together the absolute highest quality filing to ensure a timely clearance. Despite a short delay associated with a requirement to complete additional third-party testing, we expect to file this submission as an initial submission in the near term.

We expect the initial indication for use to be specific to lumbar spine procedures. Following clearance, we expect to file a steady stream of submissions for indication expansions, as well as for additional software capabilities related to diagnostic and predictive analytics.

After FDA clearance, the second milestone for 2021 is the launch of the initial IRB studies. The purpose of these studies are to prove the efficacy in humans, optimize the software and hardware interactions and prepare the platform for initially use before proceeding to the marketing phase, marketing development phase of our launch.

Following the successful clearance, we anticipate having the first cases using the Holo platform performed in the U.S., later this year. Shifting to our third priority, re-imagine our product portfolio.

Given the material change to our focus, we are working to re-imagine our long-term product development roadmap to support Holo and the promise of digital Surgical Solutions. In addition to focusing on identifying new development initiatives, we will also undergo a critical assessment of our existing portfolio to identify any individual products or product segments that we don't believe will be supportive of our digital strategy going forward.

In summary, we are very excited about the future at Surgalign. 2020 was a transformational year for the organization.

We stood up a pure-play spine company, brought together a world-class spine leadership team and positioned ourselves as a leader in digital surgery through the acquisition of Holo Surgical, all while successfully managing our operations during an ongoing global pandemic. Looking ahead, 2021 will be a year we invest to build the foundation of our digital surgery offering to support our long-term growth initiatives in the years to come.

With that, I'd like to open the line for questions.

Afternoon, and thanks for taking my questions. Terry or Jon, can you just talk a little bit more about that, the way that you saw on Holo maybe just quantify a bit how long the delay was and specifically what it was on was it software, was it hardware was it something else?

Just any more color there would be helpful.

Yes, thanks, Matt. So yes, the software is perfect, which is the great news as we had to go through some third-party testing prior that was required for the submission.

We ran into a couple of minor issues relating to some hardware and electrical systems that – the fix was quickly identified and are in process of finishing up that testing now. So it's really a nominal delay.

Okay. We're talking a couple of weeks, basically?

Yes.

Yes, that's exactly right.

Got it, okay. And then, on the new product side, I guess the first thing.

It sounds like you feel pretty comfortable with the approval timelines. I don't know how much you're kind of factoring in some of the slowdown at FDA that we're seeing just COVID-related, but I'd love to hear just confidence again in that timeline that you're talking about that.

Then secondly, on the new product side, I guess what happens, if the Holo does get delayed, can you still roll out those new technologies and then how differentiated can you really make those products can you get pricing premiums on et cetera?

Yes, sure. So again, we don't have any insight to the FDA and how COVID is back them [ph] up.

We've had good conversations with them and it put together an outstanding submission. And so we feel very confident about that and certainly are contemplating what you mentioned into the timeframes.

The other products – that you referred to look our sales forces has been starving for products for a number of years now. So we believe they just getting them into the field will continue to drive revenue growth, it will increase our products per distributor, per surgeon and drive all of those metrics up.

As for premium pricing, there isn't a lot of it anymore with IDNs and GPOs really driving pricing at the product level. But we will certainly look to maximize the opportunity, the best we can.

Okay and last one for Jon, just on the EBITDA loss for the year? How do we think about that ramp over the course of the year as we getting closer to the Holo approval and rollout – that we're going to see a big loss in Q4?

And then that carries into next year, how do we think about the cadence there? Thank you.

Yes no, we don't anticipate we're going to build the competency through the course of the year. So as you kind of, we were at 7-7 in the fourth quarter.

And I think it's just, it's pretty the cost will build a bit between now in the end of the year, but we're talking less than 10 resources incrementally to support the IRB. And then, really based on the output of that we'll get an assessment of what we need for the full commercial alpha [ph] launch.

And so yes, I think that it will look, I don't anticipate that it's going to grow significantly in the fourth quarter, it's going to be more in line with the overall revenue cadence.

Understood. Thank you.

Hey, Terry, hey Jon, thanks for taking the questions. Just a follow-up on Matt's question on array and Holo real quick?

So if we think about first case is kind of at the end of the year, how are you thinking about that launch in 2022 in terms of the size and scale? Is that, should we think of that is kind of a gradual launch – kind of beta testing going on, maybe in the first half of 2022?

Just some color in terms of, once we get that product out to market, you know what that could look like, initially?

Yes, sure. Look, we plan on getting a number of these systems out as quickly as we get clearance and we'll be prepared to do so that we can begin to gain experience.

Based on the success of the initial experience, we should be ready to begin to launch multiple units throughout the course of 2022, especially through the back half, and the key is that we want to do it responsibly as we scale up and build the field competency to ensure that these units are deployed in the way that delivers the best possible outcomes for physicians and patients.

Understood. And then, with the launch of products that are coming.

Just for Jon kind of how to think about the capital expenditures that you're anticipating particularly with set [ph] investments and things with that? What are you thinking you may need this year as you start – as you launch some of those other products?

Yes so, I think overall when you look at our CapEx budget for the year between Holo and set, there is probably somewhere between $4 million and $7 million of capital and then there is. The other piece of capital that comes into play is, as we've talked about previously, we're working through an ERP implementation as part of the separation from RTI, that's probably another $3 million of capital.

And then, there's probably another $2 million to $4 million related to a variety of activities its – we’re beginning to prepare for movement into a new space in San Diego. We just signed a lease, last week, and you'll see an 8-K on that – it's going to take about a year to build it out.

But as we work through the build out, we're going to be building surgical suites that highlight the digital technology and they will begin to be some capital for that this year.

Got it. Thanks for taking the questions, guys.

Thank you for taking the questions. First off, with the step back or the step down a little bit here in Q1 versus Q4, how much of that is COVID versus the winter storms that you saw in the southern part of the country.

If not for those storms, is it – has the market somewhat stabilized from a COVID perspective?

Look there's probably a handful surgeries that were impacted by the winter storms, but it's really hard to tease that out from the COVID impact. I would say the vast majority of the shortfall was COVID-related.

And we're beginning and its global, right and I think the important thing to keep in mind is that yield 20% of our revenue is international in the impact of COVID. They were much more draconian in the way they shutdown elective procedures.

And so, the impact was felt more significantly is that portion of the business. I would say, as we've gone through the end of Q1, everybody is watching the statistics.

And so, you're starting to see the return of elective procedures. I don't think we're going to – what we're seeing is that many patients are waiting to get vaccinated.

At this stage in order to return to procedures. So yes, I'm not sure we'll see a full return to the levels we saw in Q3, but we think we should see kind of steady return to normalized levels in the second half of the year.

Got it, all right. And then, as far as gross margins are concerned, I think you said your adjusted gross margin in Q4 was 75%, is that how we should be thinking maybe a little bit lower for Q1, but then kind of getting back up and maybe above that level as the year progresses or how should be thinking about gross margins?

Yes, that's probably a reasonable way to think about it.

Fantastic all right, that's it from me. Thank you.

Thanks for taking my question. Just two today, I know it's been brought up in the past, but just curious if you could elaborate a little bit further on some of the potential models that Holo could use once it's commercially approved.

And then speaking to some of the different packages software packages that you develop over time? Are those going to be additional add-on services or is there potentially going to be some sort of a subscription model pay-per-click?

Just trying to get a little bit of understanding of the potential models on the Holo platform?

Yes, sure. So look, I think we’ll follow as we've said before, in the short-term to prove out the technology and the ability to validate better patient outcomes.

The existing models which depending on a variety of factors, some hospitals like the capital purchase programs others like the lease programs. There certainly, the need for some software licenses, but the key portion of the revenue for the next couple of years.

Anyhow, will be the pull-through of the hardware implants.

Got it, okay. And then maybe one for Jon, just to finish it off, any comments on assumptions of international growth within the fiscal year 2021 guidance you're comfortable sharing with us?

Yes, I think international will grow slightly faster than the overall business, they've got a number of new product introductions we talked about HPS 2.0, which is a dynamic coupler which is approved in Europe, but nice PMA pathway in the United States. So, we're not introducing this year and then a number the Fortilink family has gotten CE Mark, so there'll be launching that.

So, we anticipate the international market will grow slightly faster than the domestic market. But overall it's, we're not going to see a significant deviation from kind of 20% of the overall revenue.

Perfect, all right. Thanks for taking my questions.

Hi, thanks for taking my questions, and congratulations on the quarter. And sorry, if I missed this as I was hopping between two calls here, but I saw the spine revenue guidance?

Do you contemplate any potential Holo revenue in 2021 and yes Terry, your comments on installs in 2022, but just wondering sort of how early, you could get an impact from Holo? And then maybe secondly…?

Brad, sorry I interrupted finish your questions.

Sorry and then maybe secondly, can you just talk about either lost days the expansion of the partnership into the impacts you’ve see there and your willingness to continue to do these sort of partnerships as you launch Holo into the field. Thank you.

So yes Terry referenced in the previous question, in the short term the majority of the revenue that we anticipate seeing from Holo is going to be through products. There is a small disposable portion that goes along with the procedure and so -- and that revenue you would be recognized in conjunction with IRB and so we do anticipate what I would call some pretty moderate revenue driven as we start placing the products for purposes of the study, but again it's going to be predominantly seen through implants.

And we anticipated that that will accelerate obviously as we transition from the IRB and the output to the field for commercial launch, but that's going to take both to work for us. From a standpoint [indiscernible] its early days in the relationship and we're seeing a subset of users like the handling characteristics of that product but it's surplus at this point in time the progression of that.

It's a nice product but early I guess would be the best way to characterize it. And then from a standpoint of similar relationship, yes I think we're very open to partnering, licensing, acquiring for purposes of accelerating the transformation of the product portfolio and so there's certain competencies that we had no intention to develop internally.

So Biologics is an example, there is a lot of categories within the Biologics space that we're not currently competing in. Those we work to either upgrade or expand our Biologics operating.

We anticipate there will be number of additional distributions or licensing relationship and then as we look at the new product development pathway, we're going to constantly do a make or buy decision on the product portfolio in order to determine what's best economic use of cash. I think that we've got aggressive cohorts for the investment in R&D of the organization to re-imagine the portfolio and exploit the Holo technology, but there are some gap pillars that I can will be very valuable to our customers that probably make more sense to partner on that to develop internally.

So Terry your company has changed quite a bit considering their much super model now and you made some pretty significant changes to the distribution and the sales teams. Now that you're going in the direction of becoming more of a digital story, do you think that you have the right people in place, the distribution or do you think there will be more changes on that front going forward?

Yeah Jim it's a great question and it's an evolution. So we will begin to add those competencies to support the sales teams, but as we continue to build out and become more of a digital player, it's going to come down to those partners and whether they're willing to go through the various trainings and protocols that we have if they want access to the technology.

So my thought is that we'll have broad internal organization to support them and we'll move to both in a direct and distributors that are committed to following the same path.

And then my second question for Jon, can you just give us an update on where you think the share count will end up for 2021 and what you think the cash burn for the year will be?

The share count will be 110 million, which is representative the shares we issued for the Holo acquisition as well as the impact of the offering that we did in the first quarter here. So that's what I would use for modeling purposes at this stage and then we anticipate EBITDA guidance, we don't anticipate a significant investment in the working capital as we move through the year.

I think there's some opportunity to improve in certain of those categories. So I think if you just look at EBITDA guidance plus the direction that we gave around CapEx is to give you a sense of the cash burn for the purpose of the year.

Thanks again for joining us today everyone. We look forward to updating you on our progress on our next quarterly call.