NuVasive Inc

F:NK8

Earnings Call Transcript 2018-Q2

[Operator]

Greetings, and welcome to the NuVasive, Inc. Second Quarter 2018 Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Suzanne Hatcher, Vice President, Internal and External Affairs. Thank you. You may begin.

[Suzanne Hatcher, NuVasive, Inc.]

(00:35) the second quarter 2018 earnings call. The company's earnings release, which we issued earlier this afternoon, is posted on our website, as is an investor presentation, both of which have been filed on Form 8-K with the Securities and Exchange Commission. We've also posted supplemental financial information on the IR website to accompany our discussion. On today's call, we will be covering information that is included in the investor presentation and I encourage you to access these materials so that you may follow along.

Before we begin, I'd like to remind you that discussions during today's call will include forward-looking statements which are based on current expectations and involve risks and uncertainties, assumptions and other factors which, if they do not materialize or prove to be correct, could cause NuVasive's results to differ materially from those expressed or implied by such forward-looking statements.

Additional risks and uncertainties that may affect future results are described in NuVasive's news releases and periodic filings with the Securities and Exchange Commission. NuVasive assumes no obligation to update any forward-looking statements or information, which speak as of their respective dates.

This call will also include a discussion of several financial measures that are not calculated in accordance with the generally accepted accounting principles, or GAAP. We generally refer to these as non-GAAP financial measures. These measurements include our cost of goods sold, gross margin, sales, marketing administrative expenses, research and development expenses, operating margin, non-GAAP earnings per share, free cash flow and EBITDA.

Reconciliations to the most directly comparable GAAP financial measures may be found in today's news release and the supplementary financial information, which are all accessible from the IR section of NuVasive's website.

Joining me today on the call are Greg Lucier, Chairman and Chief Executive Officer; and Raj Asarpota, our Chief Financial Officer. With that, I'd like to turn the call over to you, Greg.

[Gregory T. Lucier, NuVasive, Inc.]

Thank you, Suzanne. Earlier this afternoon, we reported second quarter 2018 revenue results of approximately $282 million, representing year-over-year growth of 8.5% on a reported basis or 7.7% constant currency. On an organic basis, excluding SafePassage and the impact of currency, our growth rate was 5.4%.

This mid-single digit top line performance was driven by strong case volume growth of 7% in the U.S., improvement in our services business, and another quarter of solid execution internationally. I am pleased to see the positive impact of our new technology introductions and ever-expanding base of surgeons on our ability to take share globally.

Our non-GAAP operating profit margin came in at 16.3%. While we improved our operating profit margin, we still have work to do. We continue to make progress in reducing our operating expenses and gaining operational efficiencies during the quarter. The gross margins were pressured by the ramp-up of our state-of-the-art manufacturing facility in West Carrollton, Ohio. Non-GAAP earnings per share were $0.58, a 29% increase year-over-year.

Now, let me describe in more detail the drivers of our second quarter results by each business line. U.S. Spinal Hardware grew about 6%, which can be attributed to the strong results in our TLIF, PLIF and XLIF franchises, and continued penetration of our RELINE Posterior Fixation system. Our expandable implants, along with our Porous PEEK implants are doing very well, too.

Adoption of our Lateral Single-Position Surgery procedure continues to gain momentum and is a catalyst for attracting new surgeons. Recall, this procedure was launched late last year and eliminates the need for the patient to be repositioned during the surgery, leading to improved OR efficiency.

Surgeons are seeing this as a true benefit to both patients and their practice by reducing the time in the OR and the time spent by the patients under anesthesia. The number of surgeons trained on this procedure has grown significantly each quarter, and we have seen a nice uptick in cases by those surgeons.

U.S. Surgical Support revenue, including NuVasive Clinical Services, or NCS, and SafePassage, increased 6% year-over-year. Excluding the $6 million contribution from SafePassage, organic NCS revenue growth also grew approximately 6% due to higher average selling price per case and stronger collections.

Recall last quarter, we purposely exited certain accounts that did not meet our profitability targets. And so, I'm pleased that in the second quarter we have stabilized existing accounts and are now seeing new business ramp up.

The Biologics business was down 9.5% over prior year against a tough comparison versus second quarter 2017, and flat sequentially to first quarter 2018. We see this business progressing and anticipate further improvement in the back half of the year. Raj will describe in more detail some of the drivers within that business line this quarter and our plan to move forward.

Turning to International results for Q2, revenue increased 21% on a reported basis or 17% on a constant currency basis. This is roughly in line with our forecast and driven by solid performance in nearly all geographies, especially in Japan and Brazil.

This consistency from our International business is the result of an intense focus over the last several years to develop the infrastructure, higher proven regional management teams, and execute a strategy of leading with our lateral offering and expanding the surgeon relationship from there.

I want to express my continued confidence in our ability to take share across key International markets. We expect the second half of the year will continue to play out strong and anticipate 20% growth for the full year.

Now, I'd like to spend a minute updating you on our West Carrollton manufacturing facility. We addressed the bottlenecks from the first quarter and are starting to see improvement in throughput and absorption rates as we exited June.

As we look further out, I want to make sure there is a good understanding of what we will accomplish through self-manufacturing. First and foremost, the cost per unit savings is significant. On average, we expect to see approximately 30% improvement from the unit costs outsourced to the unit costs insourced at our facility.

Moving to utilization, where we exited the second quarter around 50% of our hardware demand and not around roughly 60% that had been planned. And so, we anticipate making this up over the next six months and ending 2018 producing 70% of the products that we intend to self-manufacture at that factory.

As we achieve increased utilization, improved throughput and burn off capitalized variances, investors will start to see a 130 to 150 basis point expansion in gross profit margin. And, certainly, gross margin improvement will drive operating profit margin substantially higher. You can visually see the current and future progress of West Carrollton that I just described in our earnings slide on the IR section of nuvasive.com, along with our financial supplement file.

This is just a timing issue. Our original insourcing thesis is still intact, and we continue to believe this is the right decision to help us lower our costs while controlling quality of our ever-increasing sophisticated implant portfolio.

Innovation remains at the heart of NuVasive as we aspire to lead the industry by delivering technologies that move the spine industry closer to clinical and economic predictability. To that end, we launched several new technologies this past quarter, including our next-generation MAGEC rods, called MAGEC X, to treat early-onset scoliosis; RELINE MAS Midline, the latest addition to our RELINE portfolio that incorporates extremely low profile modular implants and advanced system instrumentation to address alignment; and AttraX Scaffold, a bone graft biologic with an optimized surface that have shown in pre-clinical testing to increase bone formation and faster fusion than traditional ceramic bone grafts. This new product further broadens the Biologics portfolio, enabling NuVasive to offer several different biologic types based on the surgeon preference and clinical requirement.

In addition, we have several key FDA clearances in the second quarter, including the XLIF Lordotic Expandable Interbody, NuVasive's first lateral expandable, making the further build-out of our expandable interbody portfolio, and the PRECICE STRYDE Nail, which is an innovative part of the NuVasive Specialized Orthopedics portfolio.

STRYDE is a third-generation precise limb-lengthening system that can be used in both the tibia and femur and provides over 200% increase in postoperative load-bearing capacity. It allows patients to non-invasively lengthen or shorten the implant to a prescribed length using External Remote Controller post-surgery from their home. It can be used in adults and children with limb-lengthening discrepancy and in stature-lengthening for cosmetic purposes. STRYDE can increase the patient's height by more than 3 inches and challenges the traditional external fixation protocols.

We also received FDA clearance for the 2D and 3D navigation as part of our game-changing Pulse surgical automation platform. Pulse is the brand name for the foundational piece of hardware and software that supports our vision of Surgical Intelligence, an ecosystem connecting technology tools to align the right patient with the right surgery for the right outcome.

The Pulse platform is designed to provide a cost-effective, singular source of information for surgical teams through the procedural integration of neuromonitoring, surgical planning with iGA, rod-bending through Bendini, smart imaging, a new-to-market 2D navigation and 3D navigation system and additional surgical automation capabilities. It can be used by a surgeon for broad spectrum of needs for all types of spine procedures and requires minimal setup in the OR.

The first clinical cases utilizing Pulse started back in June and the feedback has been overwhelmingly positive. We remain on track to demonstrate and take orders for Pulse at the end of September at NASS with commercial delivery anticipated to occur at the beginning of Q2 2019.

It is a significant step in our evolution from a product-focused company to a systems-based company committed to delivering end-to-end solutions for surgeons and hospital systems. I'm extremely proud of our internal R&D, engineering product teams for all their great work to deliver this exciting new technology. So stay tuned as we plan to share more about Pulse in the coming weeks and months.

And with that, I'll turn it over to Raj.

[Rajesh Asarpota, NuVasive, Inc.]

Thanks, Greg, and good afternoon, everyone. Before we get started with the financials, let me remind you that many of the financial measures covered in today's call are on a non-GAAP basis unless noted otherwise. Please refer to today's earnings news release, as well as the supplemental financial information on nuvasive.com for further information regarding our non-GAAP reconciliations.

For the second quarter 2018, we reported revenue of $281.6 million, which reflects strong growth of 8.5% or 7.7% on constant currency basis. Excluding the impact of our SafePassage acquisition, which closed in mid-January of 2018, organic revenue grew 5.4% on a constant currency basis. Organic results were primarily driven by strong U.S. hardware case volume growth and core NCS along with solid International growth, offset by the expected decline in the Biologics business.

U.S. Spinal Hardware revenue grew above the U.S. market rate at 5.6% year-over-year to $150.8 million. I'm pleased with the sequential and year-over-year growth and anticipate we will see strength in this business line for the remainder of the year.

Specifically, the increase was driven by new product introductions in the U.S., notably modular 3D printed titanium implants for TLIF and XLIF, Porous PEEK offerings, COHERE and COALESCE, expanded PLF implant offerings and RELINE Small Stature.

Revenue from the U.S. Surgical Support came in at $74 million for the quarter, up 5.9% year-over-year, as Greg mentioned, revenue growth of approximately $6 million from the acquisition of SafePassage and approximately 6% growth in the legacy services business which was partially offset by the expected decline in the Biologics product line.

The market conditions we saw in the services business that played out in the first quarter with accounts not meeting profitability target have been stabilized. Our strategy to win new accounts and redeploy assets by going deeper in existing accounts is working well.

We are continuing a balanced integration of our service businesses in key value and implementing processes that helped make SafePassage so successful. This includes strategic account management and neurophysiologist deployment, which is already improving the return to growth in this business.

In Biologics, we have seen positive momentum from the back half of 2017 with the growth in the second quarter of 2018 down 9.5% against a higher comp in the prior year. We have adjusted efforts to be more competitive and recaptured several lost accounts with offerings across the entire portfolio.

We continue to see higher volumes compared to the prior year with product mix in the quarter being different with customers broadly purchasing products within the Biologics portfolio beyond Osteocel. As we move to the back half of the year, we are confident we will be able to continue to improve the declining growth rate in this franchise.

As it pertains to LessRay, we made good progress in converting trials to revenue in the second quarter. This piece of capital equipment has now been commercially available for about nine months, and we're starting to see contract negotiations accelerate. As we continue to refine our selling strategy, we have more trials recorded than our previous three quarters and are seeing very good traction with hospital capital allocation committees.

In Q2, International revenue grew 21% on a reported basis to $56.8 million and 17% on a constant currency basis, driven by solid results in nearly all geographies. Investments in EMEA over the last few quarters continue to provide returns as the regions collectively delivered 17% constant currency growth. This growth was despite softness in the UK due to challenges with the healthcare system where we've seen a delay in surgical procedures. We see this continuing in the short-term and will make adjustments to offset this dynamic.

The DACH region within our EMEA geography grew about 25% on a constant currency basis, driven by Germany and Switzerland where we continue to see strong synergies from the acquisition of our Swiss distributor in late 2017.

The Asia Pacific business also had another strong quarter, reporting growth of 21% on a constant currency basis, with Japan leading the way as XLIF continues to outperform in that region in addition to strength in the posterior fixation business. The Australia-New Zealand geography recorded constant currency growth rate at 14%, contributing to the overall positive performance in the region for the quarter.

Latin America delivered its seventh consecutive quarter of growth, driven primarily by Brazil. These results were especially robust, given the continued impact of Hurricane Maria on the business in Puerto Rico. As anticipated, we saw year-over-year decline in that market and recovery of procedure volumes remains very slow.

Now, let's turn to the rest of the P&L. Moving to profitability, non-GAAP gross margin for the second quarter was 72.8%, down 170 basis points from prior year. We experienced a decline in gross margin as a result of slower production throughput and insourcing of SKUs at our West Carrollton facility, which is about 70 basis points of pressure on our margins in the quarter.

The good news is that this was sequential improvement from Q1, which had a negative impact of 120 basis points. Margins were also impacted by the acquisition of SafePassage, which has a slightly lower gross margin profile.

With regard to our manufacturing facility, we spent the quarter focused on addressing inventory accuracy tied to systems tracking and bottlenecks associated with final processing flow, impacting throughput and shipments out the door.

In addition, the previously outsourced anodization and passivation lines were brought in house via a major capital expenditure, and are now speeding up production velocity. As a result of these improvements, we exited the quarter hitting our targeted absorption rates for the month of June, which we believe represents stable operations for the second half of the year. The continued effort around accelerating in-sourced manufacturing and the significant contribution it will make to margin improvement thesis remains intact, and we believe getting this right represents a tremendous margin opportunity for the future. At the end of Q2, we achieved in-sourcing of 50% of all SKUs at this site. By the end of the year, our exit rate is expected to be around 70%, which sets up a nice runway for 2019 and beyond. In addition to improved (18:54) and inventory levels more tightly.

Non-GAAP research and development or R&D expenses totaled $14.9 million in Q2 of 2018 compared to $12.6 million in Q2 of 2017. R&D expense was 5.3% of revenue for Q2 versus 4.8% in the same period last year. As we have communicated before, we expect R&D expenses to increase over the long-term to approximately 7% of revenue. We continue to make investments in key areas, including imaging, navigation and surgical automation, as well as the build out of our Porous PEEK implant line. Non-GAAP SM&A expenses as a percent of revenue decreased 240 basis points from the prior year to 51.2% in the quarter, or $144.1 million. The lower SM&A expense profile of SafePassage contributed 60 basis points. The remaining decrease was primarily driven by the reduction of performance-based compensation expense, and leveraged from the scaling of our International business.

On our last call, we've stated that we would accelerate our expense efficiency initiatives to offset the delayed benefit from West Carrollton. In the second quarter, the organization streamlined certain non-sale functions, and realigned the back-office areas of our workforce to enable the company to continue to invest in our sales force and product development. Due to these efforts we took an approximate $3 million one-time restructuring charge in the quarter, and expect to see the go-forward benefit on the P&L in the second half of the year. Second quarter non-GAAP operating profit grew 10.3% to $46 million, driven primarily by strong revenue growth and non-GAAP operating profit margin was 16.3%, 20 basis points above prior year. The increase in operating profit margin was primarily due to our improved operating expense profile, partially offset by in-sourcing efforts in West Carrollton, and increased investment in R&D.

Moving further down the P&L, interest and other expense, net on a non-GAAP basis was $8.1 million in Q2, up from $6.1 million in the same period last year. Our non-GAAP tax expense in the quarter was $7.6 million, resulting in a non-GAAP effective tax rate of 20%, in line with expectations and reflective of continued efforts to drive year-over-year improvements. Second quarter 2018 non-GAAP net income was $30.3 million, and non-GAAP earnings per share was $0.58, compared to non-GAAP net income of $23.6 million, and non-GAAP earnings per share of $0.45 in the same period last year. Adjusted EBITDA grew to $69.9 million or 24.8% as a percent of revenue, a decrease of 120 basis points compared to 26% in the same period last year. This decrease was primarily driven by the increase in expense related to net currency exchange losses. Turning to GAAP results, GAAP net earnings for the second quarter of 2018 were $11.5 million or $0.22 per share, compared to $12.2 million or $0.21 per share in the same period last year.

Please refer to the earnings press release or the supplemental financial information file posted on nuvasive.com for further information in regards to our GAAP versus non-GAAP adjustments for the second quarter performance, and the recast financials for the prior quarters as a result of the adoption of ASC 606. They also reflect the impact of non-GAAP adjustments of certain litigation-related expenses. Finally, free cash flow for the quarter was $16.6 million, compared to $4.7 million in the same period in 2017. Normalized for the payment of $27.8 million legal settlement discussed last quarter, adjusted free cash flow was over $44 million. With the first half of 2018 behind us, we are updating our full year 2018 guidance.

Revenue expectations for 2018 remain the same, in the range of $1.095 billion to $1.105 billion, and takes into consideration approximately $3 million in currency tailwinds. Similar to last quarter, we believe this is a modest change in potential contribution from currency, and therefore are staying within the range provided. At this time, we believe it is prudent to revise gross margin and operating margin guidance for the year. We're adjusting gross margin guidance from 73.5% to 72.6% given the challenges we faced in the first half of the year from West Carrollton, and we are adjusting down operating margin guidance for the year to 16.7% as a result of the fall through on gross margin from West Carrollton.

Our work going forward will continue to be focused on accelerating the throughput and utilization from in-sourcing at the West Carrollton plant, and optimizing the operating cost structure through the initiatives that have been in place to achieve the gross margin expansion plan. Please refer to the supplemental information filed on our website for greater details on updated financial guidance. In closing, I'm extremely pleased with our organization's results and execution in the quarter. We have seen progress at the manufacturing plant, our NPI launch has performed as planned, the sales force executed on our strategy, and we made solid progress in the development of our Surgical Intelligence platform. We look forward to carrying all of this momentum into the back half of the year.

With that, I'd like to now open up the lines for Q&A.

[Operator]

Thank you. Our first question comes from the line of Josh Jennings with Cowen and Company. Please proceed with your question.

[Joshua Jennings, Cowen & Co. LLC]

Good evening. And thanks for taking the questions. I was hoping to just start off on the operating margin guidance revision driven by the gross margin outlook here. I'm sorry to make ask you to do this again, but just to be clear, could you just help us think through where you'll be at the end of 2018? And then just, how we should be thinking about your historic kind of multi-year operating margin expansion guidance of approximately 100 basis points annually? Sorry, not trying to get 2019 guidance, but just so we can think about modeling the out years, and will you be exiting 2018 from an in-sourcing effort at the West Carrollton facility.

[Rajesh Asarpota, NuVasive, Inc.]

Yeah. So the operating margin, just to set the numbers straight for the guidance, we had guided to 17.6% for the year. And as a result of what transpired in gross margins in Q2, like I said, we thought it was prudent to ensure that guidance was now being reset to take into account what happened at the West Carrollton facility. So as a result of the miss on gross margins, we're taking that guidance on operating margin down to 16.7%. And as we think about next year and on a go-forward basis, the assumption around margin expansion has not changed, so we continue on our path to 25%. You would expect 400 basis points of gross margin expansion. We're still committed to 100 basis points of margin expansion year-over-year, and that's pretty much what I'll say for now.

[Joshua Jennings, Cowen & Co. LLC]

Okay. Thanks for that. And then just on the top-line side, specifically for U.S. Spinal Hardware, you guys experienced case volumes of 7% growth. I was just wondering if you could give us any insights in terms of hardware revenue per NuVasive cases. Are you seeing positive trends there as well, and if you are, what are the drivers of that increased revenue per case on the Hardware side? Thanks again for taking the questions.

[Gregory T. Lucier, NuVasive, Inc.]

I appreciate the question. This is Greg and sorry for the gravelly voice. We, as you saw by our results, had very good case volume growth. We had good new surgeon adoption of our technology. We're not going to get into revenue per case in terms of these quarterly results though.

[Joshua Jennings, Cowen & Co. LLC]

Okay. Understood. Thanks.

[Operator]

Our next question comes from Isaac Ro with Goldman Sachs. Please proceed with your question. Isaac Ro, your line is now live.

[Isaac Ro, Goldman Sachs & Co. LLC]

Thanks. Sorry about that. I appreciate you taking the question. Greg, could you maybe spend a little bit more time going through the moving parts on the margin guidance? I'm just trying to understand the extent to which you've de-risked the range of likely outcomes. It'll be helpful to know kind of some of the key moving parts that maybe haven't been covered yet, and really kind of what you're trying to do to make sure the trajectory there is more consistent with your expectations. Thank you.

[Gregory T. Lucier, NuVasive, Inc.]

You bet. So look, the only update for the guidance is the flow-through from the first half of the West Carrollton ramp-up. And it pertains to the gross margin coming out of that factory. As we try to convey in the script and the slides, the thesis of the plant is strongly intact. We are getting unit cost reductions on a SKU basis. And so the whole focus of our effort right now is getting more and more throughput to absorb the fixed cost of that factory. We exited June much stronger than we did exit March, so we're making great progress. But simply because of the tardiness in hitting our plan, as we tried to show in that slide, we have to update the overall annual guidance on our operating margin. All that said, as we exit 2018 and we move into 2019, at a minimum you will see an updraft of 130 basis points to 150 basis points out of the West Carrollton factory due to just ramping up in second half of the year.

[Isaac Ro, Goldman Sachs & Co. LLC]

Okay. That's helpful. And maybe as a follow up, could you detail a little bit more on the pacing as we think about the balance of the year between Q3 and Q4? Just want to make sure we understand the trajectory of margin improvement that you expect. Thank you.

[Rajesh Asarpota, NuVasive, Inc.]

Yeah. So let me take that one. So I think, if you followed along the first half of the year, in Q1 we had 120 basis points year-over-year of a decline, and that improved to 70 basis points this quarter. And as we think about the second half of the quarter, we will be accretive and continue to make improvement. As we start to see stable operations, and the throughput velocity comes through, you will see accretion in Q3, and a significant accretion in Q4 as we exit the year. So we will be, as far as 2019 is concerned, like Greg mentioned, 130 basis points to 150 basis points of margin improvement will come from West Carrollton.

[Isaac Ro, Goldman Sachs & Co. LLC]

Okay. Thank you, guys.

[Operator]

Our next question comes from Matthew O'Brien with Piper Jaffray. Please proceed with your question.

[Matthew O'Brien, Piper Jaffray & Co.]

Good afternoon. Thanks so much for taking my questions. Greg, can you talk a little bit about the U.S. Hardware business? It turned nicely here in Q2, but the guidance for the back half implies still a fairly soft business there, even though the comps are getting easier. So why is that? And then secondly, I'll ask both the questions upfront here, International business still growing really, really well, but the comps are going to get a lot tougher in the back half. Why are you so confident in being able to get to guidance for the full year, given how difficult the comps are getting, and if that business seems like it's slowing ever so slightly here in the first half of the year? Thanks.

[Gregory T. Lucier, NuVasive, Inc.]

So on the International side, as I said in our script, we put in place a great set of people leading the franchises around the world. We have done a deep dive on every country we're in. And we feel bullish about the second half of the year in terms of what's coming our way. So we feel comfortable in our guidance as the 20% growth rate on the International side. On the domestic side, look, I think there's – at least I can speak to NuVasive, a strengthening of our hand. Our sales force has never been more engaged and stable. The new products in their hands have never been more exciting. And I think we're really on the forefront of some good momentum for NuVasive in the U.S. market. All that said, as I'll say in my final closing comments, we don't see the overall U.S. market change demonstrably. It's still a flattish environment. We think we're just doing well in particular.

[Matthew O'Brien, Piper Jaffray & Co.]

Helpful. Thank you.

[Operator]

Our next question comes from Jonathan Demchick with Morgan Stanley. Please proceed with your question.

[Jonathan Demchick, Morgan Stanley & Co. LLC]

Hello. Thanks for taking the question. First one, just had a quick question on Pulse, and I think you mentioned that the first clinical cases were out in June and expecting to be taking ordering of mass. But I was just curious to the planned rollout there, and how it balances with maybe some of the LessRay plans you have, as well as why it's going to take, I guess, until Q2 2019 to really kind of get the systems out into the field?

[Gregory T. Lucier, NuVasive, Inc.]

Good question Jonathan. At NuVasive, we have had a historical practice of doing a fairly long alpha period with our new technologies. Other companies probably don't have as extended alpha test periods as we do. But the benefit is, knock on wood, you've never seen a major recall with this company. And so as we launched, what we think is incredible new technologies, totally changing the workflows in the operating room, we want to make sure that thing is a 100% right. And so we're going to take an extra, probably 90 days to just make sure it's a longer alpha period, a broader alpha test environment, more surgeons before we open it up to all comers. I will tell you, based on our experience of looking at other automation systems in the market, they didn't take that approach, and you can hear the word in the field that these systems are going through a fairly lengthy shakeup period. We don't have that with what we do. And so that's a result that it's fairly long alpha period.

[Jonathan Demchick, Morgan Stanley & Co. LLC]

So should I take that as automation capabilities are going to be included when the 2Q 2019 rollout kind of starts?

[Gregory T. Lucier, NuVasive, Inc.]

I'm not going to talk about more details around automation just yet. But in 2019 you're going to see some exciting automation from the company.

[Jonathan Demchick, Morgan Stanley & Co. LLC]

Understood. Looking forward to it. And just a quick follow up. I know that we've talked a bit about margins. I just wanted to make this – just get clear on a little thing. It sounded like this quarter came in relatively in line with the expectations, I guess, that we kind of were thinking about after the first quarter. So I was really just trying to understand what changed from the first quarter to the second quarter that kind of led to the revision of guidance.

[Gregory T. Lucier, NuVasive, Inc.]

Yeah. Good question. Again. We had a certain plan of how fast the Ohio plant would ramp up to give us gross margin improvement. As I said, we are behind that plan. But we will exit the year pretty much on track. Not quite right, we will exit the year kind of set up for 2019 in a good way. And so just the accumulated variances of being slightly off-plan is why we're having that reduction of the operating margin guidance. It all is attributed to the Ohio plant, and just a phasing of the ramp-up of what we're trying to do there.

[Jonathan Demchick, Morgan Stanley & Co. LLC]

Understood. Thank you.

[Operator]

Our next question comes from Glenn Novarro with RBC Capital Markets. Please proceed with your question

[Glenn John Novarro, RBC Capital Markets LLC]

Hi, good afternoon, guys. Two questions. First, just one more on West Carrollton. In the prepared remarks, you talked about seeing progress and improvement in June. Did you see that continued improvement in July? And Greg, is that the reason why you're so confident that the worst is behind you on gross margin? That's question one. And then, Greg, in your LessRay comments, you talked about contract negotiations accelerating. Is this for outright sales, or are you seeing more negotiations on leases versus outright sales? Thanks.

[Gregory T. Lucier, NuVasive, Inc.]

Yeah. You bet. So gross margin and West Carrollton, it's all being driven by daily output of the factory. And as I said in my one answer, if you look at the average daily output in the first quarter compared to the average daily output in the second quarter, it was demonstrably better in the second quarter.

And to your question, July was actually an important inflection point, and we ramped it up demonstrably even from June. So that is why Raj said in the second half of the year we're actually seeing a lot of goodness starting to come out of Ohio. Still behind the original plan, but we're on the right track now in the second half of the year.

In terms of LessRay, what you heard from Raj is that the company was getting its footing in terms of how to sell capital in an effective way. Look, historically, we've been an implant selling company; now, we're becoming a spine systems selling company. We've had to teach people how to do presentations in VAC committees. We've had to learn how to do leasing. We've had to do a lot of different things.

And what we're just conveying to our investors is that in the second quarter, qualitatively and to some extent quantitatively we're actually doing a lot better. We're getting our footing. We're doing well. And we're both selling and leasing systems now. And we feel good about our ability to move LessRay pretty aggressively in the second half of the year.

[Glenn John Novarro, RBC Capital Markets LLC]

Okay, great. Thanks, Greg.

[Gregory T. Lucier, NuVasive, Inc.]

You bet.

[Operator]

Our next question comes from Richard Newitter with Leerink Partners. Please proceed with your question.

[Richard Newitter, Leerink Partners LLC]

Hi. Thanks for taking the questions. I was hoping to just get a little more clarity, and this might be my own misunderstanding. Just what exactly is launching with the Pulse system? What we're going see at NASS? And then, what we have to wait for kind of for the full launch, so to speak, in early 2019? The word automation, is that something that actually facilitates the surgery and gets down into the disc space? Or is automation a more efficient overall procedure from kind of getting into the OR to prep and to finishing the procedure? Thanks.

[Gregory T. Lucier, NuVasive, Inc.]

So what we will be demonstrating at NASS is a 2D/3D navigation system. We will be demonstrating the next-generation neuromonitoring system. We will be demonstrating a very advanced next-generation surgical planning system with artificial intelligence embedded in it. We will be demonstrating a rod bending technology, the next-generation of Bendini. We'll be talking about imaging, and there's more to come on that that we haven't fully announced. And we will be demonstrating automation at NASS as well.

So that's what we'll be demonstrating, and we'll be taking orders on large pieces of everything I just said. And when I say taking orders, to connect your question with Jonathan's question, we will also be delivering this system, but some of those customers will be alpha customers and they'll be working through the system with us over the course of a four-month period or so.

[Richard Newitter, Leerink Partners LLC]

Okay. That's helpful. Thank you. And maybe just one follow-up. If I'm looking at this correctly, your full-year gross margin outlook is lower – it implies less than 73% in the back half of the year. And why wouldn't this improve if you feel so confident in the benefits of the Carrollton facility playing out?

[Rajesh Asarpota, NuVasive, Inc.]

So the back half of the year should be in the 73% range, and that's essentially what gets us to the guidance of 72.6% that we have kind of pictured in our outlook.

[Richard Newitter, Leerink Partners LLC]

Right. I'm just curious why wouldn't it get better if you're getting some of the benefits of the Carrollton facility to the tune of 150 basis points exiting the year?

[Rajesh Asarpota, NuVasive, Inc.]

Yeah. Look, I think it's a function of the variance roll-offs. We have a whole schedule in terms of the ones we've built up since the second half of last year and to Q1 and Q2. We initially thought in Q2 we would have a less of that burden. But as you think about this whole schedule and as it passes through this year and through 2019, it takes a little bit of time to burn through. So that's why we don't see that faster acceleration. It's just going to take some time for those capitalized variances to roll-off.

[Richard Newitter, Leerink Partners LLC]

Thank you.

[Operator]

Our next question comes from Joanne Wuensch with BMO Capital Markets. Please proceed with your question.

[Joanne Karen Wuensch, BMO Capital Markets (United States)]

Good afternoon, everybody. Two questions. One, it looks like you did a little bit better versus the spine market this quarter in hardware. Could you please address how you're thinking about the spine market and why that might be?

And then the second one is sort of the sister question to that, which is, can you discuss a little bit the sales force, what kind of churn rate you're seeing and how the training is different of these individuals, given the different sales cycle that you're now doing? Thanks.

[Gregory T. Lucier, NuVasive, Inc.]

Yeah, you bet. So the lifeblood of this business is new product introductions. You've got to equip your sales force with the most cutting-edge technology so that they have the most compelling offering to persuade surgeons to come your way. And I think we are doing an extremely good job of doing that.

Second, we have, over the last three years, created very sophisticated training environment for our sales force. NuVasive was always regarded as the premiere training company, both for surgeons and the sales force, and I think we've taken that now to the next level with a series of online tutorials, online certifications, spot training and, importantly, an online system that allows the sales rep to access information in a much more readily way so that they are armed and equipped to have great conversations when they happen spontaneously.

I'd also say the sales force has just been very well managed, and it's been very well managed, in particular, over last year; very stable. We have good plans in place. People know what they need to do. And so, I think we're just in a good spot executing right now.

[Joanne Karen Wuensch, BMO Capital Markets (United States)]

And the market?

[Gregory T. Lucier, NuVasive, Inc.]

As I said in the earlier question, we're not making any prognostications about the U.S. market. We think it's still flattish to 1% growth. And, for us, it's about new product introductions, new concepts to spine surgery to hopefully take market share.

[Joanne Karen Wuensch, BMO Capital Markets (United States)]

Thank you. See you at NASS.

[Operator]

Our next question comes from Kyle Rose with Canaccord Genuity. Please proceed with your question.

[Kyle William Rose, Canaccord Genuity, Inc.]

Great. Thank you for taking the question. I just wanted to ask another question on the U.S. strength that you saw in hardware. I am just wondering, you talked about surgeon conversions. I mean, obviously, you have a lot of new products here as well. Maybe just touch a little bit on the productivity of some of the historical rep hires that you made in 2017? And just what's really driving that? I mean, it seems like you're obviously taking share, but just wondering how much of that's share taking versus also mix shift with some of these new products as far as legacy customers? And then I have one follow-up.

[Gregory T. Lucier, NuVasive, Inc.]

So we're expanding nicely in new geographies. I won't highlight what they are here to you because our competitors are listening. But important areas of the country that are growing fast, where we have historically not been, we've become quite strong. Think of those as low-tax states. So we're doing very well there.

We're also doing well with our existing surgeons. We've doubled down on retention of those key surgeons, making sure that NuVasive is a powerful partner in their practice. And we want to get ever better at that.

And then, the other important thing I would say is that we've focused quite successfully on young new surgeons. Fellows, residents, coming out, building their practices, starting minimally-invasive practices, we've done quite well with the younger people coming into the industry. So surgeon conversion, in that category, have been quite robust. Hope that helps.

[Kyle William Rose, Canaccord Genuity, Inc.]

Very helpful. Thank you. And then just one follow-up on Pulse. And I understand we're going to get the big unveiling at NASS. But you talked about a lot of additional features that are going to go in there. I mean is it fair to think that this is a modular system that, if I'm a hospital, I can choose two of three of the items you highlighted, between neuromonitoring, imaging, 2D/3D navigation in automation? Or is it something that's going to come in, in one big capital stack? I'm just trying to understand the potential on a revenue per unit basis, or is it going to vary by customer, do you think?

[Gregory T. Lucier, NuVasive, Inc.]

Thank you for that, too. So we have been very thoughtful about what has to be done in spine surgery. And we have quietly, while others have done things, built up a formidable R&D capability here in San Diego to develop navigation systems, automation systems, things that you'll start to see at NASS that will become ever more important over the next decade.

What was most important to me wasn't only the product, but also the capability of the company to become a true medical technology company, not just a spine implant company. And you'll see the full manifestation of that at NASS.

So now to your question, again, because we're living in a constrained cost environment, and you have to make sure that investments in capital by hospital truly pay off. And I don't mean by marketing billboard, but really change the economics of the surgery. The Pulse system is incredibly modular. You can buy it with just 2D navigation. You can buy it with Bendini rod-bending end navigation. The permutations of what a customer wants and our ability to deliver it are quite strong. And it's all because we wanted to make it modular to what the hospital wanted, what the surgeon needed in that particular OR.

[Kyle William Rose, Canaccord Genuity, Inc.]

Great. Thank you for taking the question.

[Operator]

Our next question comes from Larry Biegelsen with Wells Fargo. Please proceed with your question.

[Larry Biegelsen, Wells Fargo Securities LLC]

Hey, guys. Thanks for taking the question. One on the guidance, one on Pulse. So organic growth was about 3% in the first half. I think the implied organic growth in the second half is about 7%. So what drives the acceleration in the second half? And any color on the cadence for growth in Q3 versus Q4? I would think Q4 might be a little higher because of the extra day. And I did have one follow-up on Pulse.

[Rajesh Asarpota, NuVasive, Inc.]

Yeah, I think that's right. So if you think about the growth in the first half, we were at about 1% growth in Q1; 5.6% as we just reported for Q2. As we think about the balance of the year, it provided nothing else changes in terms of our assumptions, we feel comfortable that that rate can be achieved through case volume growth.

We think the International business continues to be at 20%. We have the extra billing day dynamic and we also have the impact of the hurricanes behind us. So as you think of all that momentum and our sales – new competitive hires also performing, we think that is definitely achievable in the second half.

[Larry Biegelsen, Wells Fargo Securities LLC]

Thank you. And then, Greg, on Pulse, a bunch of questions here, some you may or may not be able to answer. But, first, what's the real value proposition of Pulse? Second, do you need a partner with a big box company to drive the capital? Is this an open or closed system?

And I guess just lastly, the system ASP, I think in the past you've talked about it being kind of below the cost of a robot, which we think about at a million dollars, but there are lot of pieces here. Is it still the total system ASP below the robot or is that the goal? Thanks for taking the questions.

[Gregory T. Lucier, NuVasive, Inc.]

Well, those are all good questions and I'm not sure I'll be able to be complete in my answer. But back on that my earlier question about could we sell it in its totality or was it able to be sold incrementally or in a modular way, I think that gets to the answer to your value question.

What's really important is to look at the value of each of these elements of Pulse. So rod-bending through Bendini delivers OR time improvement and is a great technology that has a quick payback. And certain surgeons and increasingly larger number of surgeons really like it. As you and I both know, navigation has historically not been used very much in spine surgery. And mostly because when you look at the workflow of the historical systems that were used, none of them were ever designed for spine. They were all designed for cranial applications.

And so, our navigation system is the first ever to be designed from scratch for spine. It's incredibly intuitive, easily integrated to the workflow of spine surgery and the whole idea here is driving clinical and economic predictability. And so, what's that worth to a hospital? That will be the value proposition dialogue we'll have with them.

You asked about if it's an open or closed system. It's an open system. Having said that, like most of these, the planning technology, the navigation technology will work best with our implants. And so, there is a little bit of a razorblade strategy here for sure. But because hospitals need to be more open, the system will allow other implant systems when necessary.

In terms of price, we're not going get into price on this dialogue here. But suffice to say, come NASS, we'll be having those conversations and customers will know where they can purchase the Pulse system, both in its totality or in modular way. And it will be, I will tell you, lower price than the robot systems.

[Larry Biegelsen, Wells Fargo Securities LLC]

Thanks for taking the questions.

[Operator]

Our next question comes from Robbie Marcus with JPMorgan. Please proceed with your question.

[Robert J. Marcus, JPMorgan Securities LLC]

Great. Thanks a lot for taking the question. Wanted to ask, it looked like you had a very good quarter on the top line, yet SG&A came in well below the Street. Part of that was due to lower employee compensation in the quarter. Maybe speak to that and how that dynamic is playing out with better sales, but lower compensation there?

[Gregory T. Lucier, NuVasive, Inc.]

Well, as Raj mentioned in his script, and I'll let him follow-up, in the quarter we made some strategic decisions to streamline the company, particularly in the back office. And we think that will drive better economics, better velocity of decision-making, and that accounts for why SG&A was lower than perhaps in the models. But, Raj?

[Rajesh Asarpota, NuVasive, Inc.]

Yeah, I think I would just add to that, Greg. I mean some of the back office streamlining that we alluded to in Q1, we actually executed on that. So as you go through the balance of the year, you will see some benefit from that. So it was really not touching our front end of the business in terms of R&D, or product management, or sales, but really more so kind of on the fringes on the back office functions streamlining that.

[Robert J. Marcus, JPMorgan Securities LLC]

Okay. And you didn't bring down the SG&A guidance for the year. So should I assume a higher step-up in the second half?

[Rajesh Asarpota, NuVasive, Inc.]

We didn't give any SG&A guidance.

[Robert J. Marcus, JPMorgan Securities LLC]

Right. It'd be 0.6%.

[Operator]

Our next question comes from Ryan Zimmerman with BTIG. Please proceed with your questions.

[Ryan Zimmerman, BTIG LLC]

Great. Thanks for taking the question. Just want to ask a couple on pricing dynamics and Biologics. You talked about moving customers away from Osteocel, I assume, to maybe lower-cost synthetic products that you have. Can you just talk about kind of what you're seeing in the pricing segment of the Biologics market, particularly within stem cells? And how much room you do have on the margin side to lower your pricing to maintain your competitiveness on Biologics? Thank you and I have a follow-up.

[Gregory T. Lucier, NuVasive, Inc.]

Yeah, you bet. So the Biologics pricing was stable in the second quarter around Osteocel. As we've mentioned in earlier calls, we took the price down to where the market was. It has made us now more competitive. And so, that action took place and we're playing that out over the course of 2018. We haven't seen any further price deflation since then.

As I've also said in earlier comments, though, the company relied on Osteocel for too long and we are now broadening the product line, as you just inferred, to have synthetics and, as well, a number of other products being launched to create a full bag of Biologics. The next phase for us will ultimately be to create our own specialized Biologics selling force to work in tandem with our full line selling force. And when we do that, we think we'll see a return to growth of Biologics into the 2019 timeframe.

Again, maybe in the final comment, Biologics is important to us. It's an important element of the bag. I really, really appreciate the team we have running that now. But long-term, five years plus, our goal is to do things even more radically, to create implants that probably don't need hardly any Biologics. And that is the strategy of the company and that's where we go on a longer-term basis.

[Ryan Zimmerman, BTIG LLC]

Understood. That's very helpful, Greg. And then, just can you comment, the hardware was strong this quarter. You introduced MAGEC X at the POSNA conference. Can you just talk about it? And we haven't heard much about it recently, but maybe some of the underlying trends in the NuVasive Specialized Orthopedics division and how that's contributing to U.S. Spinal Hardware.

[Gregory T. Lucier, NuVasive, Inc.]

Yeah, you bet. So strong double-digit growth from NSO. The MAGEC rod continues to become ever more the standard medical protocol for a broader array of early-onset scoliosis. Importantly, on the limb-lengthening side for pediatrics, strong double-digit growth.

And as I highlighted in my prepared comments, the new technology, STRYDE, has a weight-bearing capacity for adults, big adults, and opens up what could be an intriguing cosmetic limb-lengthening market. We're starting to see very robust uptake of adult limb-lengthening for cosmetic purposes, and we'll be talking more about that in subsequent investor calls.

[Ryan Zimmerman, BTIG LLC]

Thank you for taking the question.

[Gregory T. Lucier, NuVasive, Inc.]

Operator, from here, we're going to bring the call to a close, and I'd just like to say a few closing comments. And so, just to our investors, I will tell you I'm very pleased with the overall financial results for the quarter. I think we delivered strong top line revenue results, and I think all of us are encouraged by the U.S. case volume growth we saw in the last 90 days.

We continue to see the market is stable; not seeing any real material difference from what we saw in the first quarter, but stable. And I can tell you that internally we are focused on driving our internal manufacturing capabilities in West Carrollton to achieve the desired impact on our income statement, certainly in the second half of the year, but robustly into 2019.

The International business continues to perform very well and deliver results well above market growth. And last year's new technology introductions are contributing meaningfully at this point, and we continue be a share taker and apply additional focus on new product introductions and increased rigor on day-to-day executions by our great sales leaders.

And with that, I'd like to thank you for calling in today. And we look forward to speaking to you at the next quarterly call. Take care.

[Operator]

This concludes today's conference. You may now disconnect. Have a nice day.