NuVasive Inc

F:NK8

Earnings Call Transcript 2018-Q3

[Operator]

Greetings, and welcome to NuVasive, Inc. Third 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.]

Thank you, Sherry. Welcome to NuVasive's Third 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'll 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 the 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 generally accepted accounting principles, or GAAP. We generally refer to these as non-GAAP financial measures. These measures include gross margin; operating margin; sales, marketing and administrative expenses; research and development expenses; EPS; 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 accessible from the Investor Relations section of NuVasive's website.

Joining me on today's 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 third quarter 2018 revenue results of $271.3 million, representing a year-over-year growth of 9.8% on a reported basis or 10.2% constant currency. On an organic basis, excluding SafePassage and the impact of currency, our growth rate was 8.3%. This accelerated, high-single-digit revenue growth is supported by increased U.S. case volumes of more than 7%.

In addition, the U.S. spinal hardware business line continues to grow at multiples of the market through solid and disciplined execution from our commercial sales force and new technology introductions to competitively take market share. These results are against the backdrop of a moderately healthier spine market, one we believe is stable and perhaps returning to growth of about 1-plus percent.

Our non-GAAP operating profit margin came in at 15.6%. Raj will walk you through the specific puts and takes. But at a high level, I want you to think about the third quarter operating margin in two ways. The first, West Carrollton was in line with expectations we set out last quarter. This represents significant progress, as we hit more consistent and predictable absorption rates and throughput for the last several months, giving us continued confidence the facility will be accretive to margins. And two, we've reduced some back-office operating expenses and saw the benefit of operational efficiency actions executed in the second quarter.

We also made the forward-looking decision to invest in a few key areas, including our Clinical Services business, building out infrastructure to support set fulfillment and accelerating spend on certain R&D efforts. Our interactions with surgeon partners in healthcare systems signal better market conditions, and data suggests an uptick in hospital volumes in elective surgeries.

I'd like to pause here for a second and provide a bit more color. I know some of you may question why we made the decision to make these investments when we just told you a few months ago we were tightening our belts. As a CEO, I have to make the tough calls that are in the long-term best interest of NuVasive. During the quarter, it became clear the U.S. spine market was turning for the better and our commercial teams were building momentum. As a result, we decided not to make further operational cuts or slow R&D project funding in order to back into an operating margin guidance we shared during our second quarter earnings call.

Instead, through the lens of our commercial momentum, certain investments were needed to not only take advantage of the improved market conditions, but also position us to have a robust 2019, especially now that we have turned the page on West Carrollton. I believe we are on a transformative inflection point in the market where in the next 18 to 24 months these strategic investments will enable us to become a consistent high-single-digit grower and take even more market share.

Now, let me describe third quarter results in more detail. U.S. spinal hardware grew approximately 7%, which can be attributed to new product launches from last year contributing nicely, as well as the continuation of disciplined U.S. commercial execution. Pricing pressure remained stable at a negative 2%, below the industry average. In terms of product highlights, the cervical business performed well, which tends to be an underrepresented portion of our hardware portfolio, with contributions from the Cervical Porous PEEK interbody launched last year.

The XLIF, TLIF, and pediatrics portfolios also performed well, with growth coming from overall increased case count and our best-in-class expandables like Modulus, XLIF, MLX, TLX and recently launched TLX 20 degree. We are adding to our MAGEC and RELINE portfolio systems for complex spine deformity, and we expect to continue to take market share in this area, given our focus on the development of key opinion leaders and an emphasis on sustained innovation in an area that has generally lacked technology advancements.

U.S. Surgical Support revenue, including NuVasive Clinical Services and SafePassage, increased about 17% year-over-year. Excluding the $5 million contribution from the SafePassage acquisition, organic Surgical Support grew approximately 10%. In the third quarter, we announced our GPO contract with Premier, which takes effect on November 1, and is a tangible result of why being the largest, most geographically diverse intraoperative neuromonitoring business is a key differentiator for NuVasive. We expect to see an uplift in our service business from this preferred vendor status in 2019.

In addition, I'm pleased to say that our Biologics business continues to rebound and was flat this quarter over prior year. This is a tremendous accomplishment achieved by strong execution and new line extensions released over the last nine months. With this faster than anticipated recovery, we now expect the Biologics business will return to growth in Q4 2018, our first growth period since Q4 2016.

Turning to the International results for Q3, revenue increased 8.5% on a reported basis or 10.4% on a constant currency basis. While this is below our expectations for the quarter, the overall company growth rate in 2018 has been solid based on the strength of the U.S. market. Some of the softness on the International side continues to be friction in the UK healthcare system, as well as Puerto Rico not returning to average growth rates since the hurricane last year.

Raj will get into more detail about our International regional performance and our growth projection for the remainder of the year, which we are now estimating to be approximately 15%. Good, but not at our 20% stated goal.

Now let's turn to an update on West Carrollton manufacturing facility. As I mentioned, we made solid progress throughout the third quarter delivering consistent throughput and absorption rates, in addition to bringing in more SKUs into the facility to support even higher output in the coming months. We also hired Dale Wolf in August, a former GE executive with nearly 20 years of medical device manufacturing expertise. I'm pleased with the stable operations we saw, and this comes across in our gross margin results for the third quarter.

The thesis for in-source manufacturing to lower cost per unit remains very much intact. By the end of the year, we will be able to produce about 70% of the SKUs we intend to self-manufacture. With the progress over the last two quarters, we are reiterating our expectation that the facility will deliver 130-basis-point to 150-basis-point improvement in operating margins in 2019. I'm confident our in-sourcing strategy is now becoming a competitive advantage.

Now I'd like to spend a few minutes discussing the significant technology and partnership introductions we made over the last several months to support our innovation mission to improve the clinical and economic predictability of spine surgery.

The unveiling of the NuVasive Pulse surgical automation platform and spine precision partnership with Siemens Healthineers at NASS was a major success. The level of excitement from our surgeon partners and sales force was palpable, and many of you on the call today were able to see first-hand the truly differentiated technology we have internally developed with this modular platform.

Please recall, the Pulse system is designed to provide a cost-effective single source of information for surgical teams through the procedural integration of neuromonitoring, surgical planning with iGA, rod-bending through Bendini, smart imaging, LessRay and a new-to-market 2D and 3D navigation system and additional surgical automation capabilities. It can be used by a surgeon for a broad spectrum of needs for all types of spine procedures and requires minimal setup time in the OR. We are still on track for the delivery of the system in the second quarter 2019.

We're also making significant progress on furthering our Surgical Intelligence vision. What we delivered at NASS last month is just the beginning. We have been working behind the scenes to further disrupt spine with a completely new approach to robotics. We are dead set on being the leader here, and when we bring on folks to NuVasive like Scott Huennekens, the newest member of our board and President and CEO of Verb Surgical; and named incoming CEO, Chris Barry, with his extensive robotics background; you get a glimpse of the competencies we are assembling.

For competitive reasons, we won't be discussing too much on this call. But in the coming months, Chris will share with you the specific technology you'll see in 2019. Personally, I couldn't be more excited with the roadmap ahead.

We have also realigned how we will go to market with Pulse based on the lessons learned from selling LessRay. This includes recently hiring a new Head of Capital Sales who has 25 years' experience in selling capital equipment in the medical device industry, and also aligning more closely to some of our selling and development teams.

This is a continuation of maturing the organization, as we embark on truly being a spine systems company versus a product and features company, which is a key element to our approach of doing business going forward to be competitive, certainly as healthcare systems continue to consolidate spine vendors and shift towards value-based purchasing with measurable clinical outcomes.

Also, we commenced a strategic partnership with Biedermann Technologies, a world-class design company with expertise in the spine and orthopedic sector, and a comprehensive and innovative patent portfolio. Biedermann Technologies has granted NuVasive licenses to intellectual property relating to its proprietary screw innovations that will be integrated into the NuVasive RELINE portfolio.

These enhancements to the RELINE system will offer surgeons a superior solution to treat complex spinal pathologies in adult and pediatric populations for open as well as minimally invasive surgery with customized screw placement and the ability to facilitate various corrective maneuvers based on the clinical needs of the patient. There will be nothing like it on the market.

Finally, we launched four new internally developed products this past quarter, supporting complex deformity and continuing the build out of our expandable implant portfolio. In addition, at the beginning of this quarter, we received (sic) 510(k) clearance for the Porous PEEK XLIF implant that will launch next year. This demonstrates our strategy of proliferating our implant portfolio with this proprietary technology, which is seeing strong clinical validation through recently published studies.

Now before I turn it over to Raj to discuss the third quarter financial results in greater detail, I would like to share a few thoughts on my decision to transition from the CEO role. I firmly believe that succession planning is one of the most important responsibilities for a board of directors of a publicly-traded company.

Earlier this year, I began having conversations with the board about stepping back from running the day-to-day operations, while continuing on as Chairman. The board undertook a comprehensive leadership development and succession planning process that lasted much of this year. There were no timetables or deadlines established. The goal was simply to find the right leader to take NuVasive into the future. After a robust and competitive process, the board identified an exceptional candidate to succeed me in Chris Barry. And once we determined Chris was the right person to take NuVasive into the next phase of growth, we moved quickly.

Many of you know, I stepped into the CEO role suddenly in 2015, and it's been my focus for the last three years to steward this company through an important phase in its development. I saw my mission to advance the company that was still being run as a start-up well past the time when it was appropriate. In the last three years, we have created a supply chain capability, stood up a new state-of-the-art manufacturing plant, deeply strengthened our commercial forces in the U.S. and abroad, and drove an aggressive technology development agenda. In fact, this year more new technology will be launched than any other time in our company's history.

All those initiatives, though, are hard, long-term and certainly make quarter-to-quarter progress uneven. That unevenness is a fair commentary on my tenure, but I also know Chris takes over a company fundamentally stronger than it was three years ago and poised to be the absolute best in the game of spine. I'm super excited Chris shares this ambition and will take us forward along with Matt Link, a long tenured NuVasive executive who is promoted to President.

As you read in our announcement, Chris comes to NuVasive after serving Senior Vice President and President of Surgical Innovations, the second-largest business unit in Medtronic with over $5.5 billion in annual revenue. In this role, Chris led the strategic direction to more than 14,000 employees working in 78 countries, including 10 manufacturing sites and multiple R&D centers. He drove the core growth in Surgical Innovations, while diversifying the business through acquisitions in near adjacencies.

Prior to Medtronic, Chris spent 15 years in sales and product leadership roles at Covidien. Finally, Chris has a strong reputation as a skilled and strategic operator, and has overseen large commercial teams. With Skip Kiil's recent decision to pursue another opportunity outside of spine, Chris has the expertise to sustain the momentum of our commercial growth and execution.

It has been a privilege to serve as NuVasive's CEO. Moreover, it's been both professionally and personally satisfying to watch our company mature, processes improve, people excel and ultimately enable our surgeon partners to continue to help patients around the globe. I can't wait to see what NuVasive accomplishes next.

And now let me 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.

As Greg noted, we delivered great revenue growth for the quarter at $271.3 million, up 9.8% over prior-year period on a reported basis and 10.2% on a constant currency basis. Organic growth, excluding the impact of SafePassage and currency, was 8.3%.

Revenue in the quarter exceeded our expectations, driven primarily by accelerated case volume and new product introductions in the U.S., along with double-digit constant currency growth from our International business.

Turning to the composition of revenue in the quarter, the U.S. spinal hardware business posted another strong quarterly performance of 7% year-over-year growth to $146.1 million on 7.3% case volume growth and beneficial product mix.

In our U.S. hardware business, we experienced pricing pressure, consistent with our expectations of approximately negative 2%. We are seeing continued adoption of new product lines in the U.S. including Modulus for TLIF and XLIF, Porous PEEK offerings, RELINE Small Stature, and TLX launches.

Revenue from U.S. Surgical Support was $72.6 million for the quarter, up 17.1% compared to the same period last year, driven by our services business and better-than-expected performance in Biologics. Excluding the approximately $5 million impact from the SafePassage acquisition, the organic U.S. Surgical Support revenues grew 10%.

Since Q3 of 2017, we have made progress in a number of areas in our core services business, including higher conversion rates of NVM5, shorter reimbursement cycles, and strategic account management. The combination of these efforts coupled with improved billing and collections has helped drive high-double-digit growth in the quarter.

In addition, the Biologics business line was flat year-over-year, achieving a 10% sequential growth rate increase from the second quarter of 2018. Our focus and investment in this area is paying dividends with new product launches and strong, dedicated leadership.

As it pertains to LessRay, we continue to make progress in converting trials, which led to increased revenue performance sequentially from the second quarter this year. The capital sales team remains committed to refining the selling strategy and integrating LessRay with the Pulse system launch scheduled for mid-next year.

The International business recorded revenue of $52.7 million, representing a 10.4% growth on a constant currency basis. This was a solid performance compared to a prior-year growth period of 46%, although below our expectations for the quarter. We saw double-digit growth in both EMEA and Asia-Pacific regions, driven primarily by Germany and Japan, where we continued to see good momentum in MIS adoption. As anticipated, there remain challenges in the UK healthcare system, which is resulting in delays of surgical procedures and surgical volumes in Puerto Rico that have yet to recover from the residual hurricane impact.

Within the quarter, we put in plans to mitigate these pressures by redeploying assets into other regions. However, with supply chain and logistical challenges in certain geographies, the gap was unable to be closed. This dynamic started to play out later in the quarter, and we will continue to work through these issues in the fourth quarter. As a reminder, there remains an incredible runway ahead for the company internationally as our share stands at an estimated 4% to 5% today.

In summary for the quarter, I'm pleased with the results from sustained share-taking strategy within the U.S., new product introductions, momentum in our Clinical Services growth, and faster-than-expected recovery in our Biologics business.

Turning to the rest of the P&L, non-GAAP gross margin for the third quarter was 72.8%, in line with expectations and down 70 basis points primarily driven by the acquisition of SafePassage. In the quarter, we made substantial progress in production throughput at our manufacturing facility in West Carrollton and in-sourcing of SKUs sequentially from the second quarter.

To provide hard numbers for comparison, we exited the quarter at just under 60% of our SKUs in-sourced compared to approximately 50% exiting the second quarter this year. Our goal is to exit the year at 70%, as mentioned in the last quarterly earnings call, and we remain on track to accomplish that objective.

Non-GAAP research and development or R&D expenses totaled $15.3 million in Q3 of 2018, compared to $12.7 million in Q3 of 2017. R&D expense was 5.6% of revenue for Q3 2018 versus 5.1% in the same period last year. The increase in R&D spend is primarily driven by continued investments in key areas including imaging, navigation, and surgical automation aligned with the launch of the Pulse system.

Non-GAAP SM&A expense as a percent of revenue increased 70 basis points from the prior year to 51.6% in the quarter or $139.9 million. Stock-based compensation was a primary driver of the increase as a percent of revenue when compared to Q3 of 2017.

In the prior period, there were adjustments for equity-based awards that were canceled in connection with executive departures, which drove 410 basis points of headwinds. This year-over-year headwind was partially offset by streamlining certain back-office functions of our workforce, as discussed on last quarter's earnings call.

While pleased with our streamlining efforts, we ended the quarter with a slightly higher SM&A profile than expected related to the following: First, our geographic revenue mix where we have seen leverage so far this year from higher growth in the International business was not realized. As a reminder, our infrastructure investments made in prior years internationally result in profitability as we continue to scale. This was compounded by incremental U.S. revenue growth with higher expense profile as many of our regions exceeded their quotas.

The second is increased investment in Clinical Services and set fulfillment teams as a result of our current outlook and an overall improving U.S. spine market. With indicators that the spine market is starting to return to a 1-plus percent growth, we are proactively investing to leverage the opportunity from changing market conditions. I will talk about this impact in Q4 when I discuss the updated guidance.

Moving down to P&L, third quarter non-GAAP operating profit of $42.3 million decreased by 2.4% compared to $43.3 million in the prior-year period. Non-GAAP operating margin was 15.6%, 190 basis points below prior year. As discussed, stock-based compensation and incremental R&D were the largest drivers of the declines compared to prior year.

Our non-GAAP tax expense in the quarter was $7.2 million, resulting in a non-GAAP effective tax rate of 19.6%, slightly better than expectations and reflective of continued efforts to drive year-over-year tax rate improvement.

Third quarter 2018 non-GAAP net income was $29.5 million and non-GAAP earnings per share was $0.56, compared to non-GAAP net income of $26.6 million and non-GAAP earnings per share of $0.51 in the same period last year, representing 11% and 10% increase, respectively.

Adjusted EDITDA grew to $72.4 million or 26.7% as percent of revenue, an increase of 180 basis points compared to 24.9% in the same period last year.

Turning to GAAP results, GAAP net earnings for the third quarter of 2018 were $15.9 million or $0.30 per share, compared to $33.5 million or $0.64 per share in the same period last year. Please refer to the earnings press release or the supplemental financial information file posted in nuvasive.com for further information related to our GAAP versus non-GAAP adjustments for the third quarter 2018 performance. Finally, free cash flow for the quarter was $48.3 million, compared to $23.4 million in the same period in 2017.

Moving on to guidance. With the third quarter of 2018 now behind us, we are revising our outlook for the fourth quarter and full year. This new guidance contemplates our third quarter results and our updated outlook on the U.S. spine market compared to 90 days ago. We are raising the upper end of our full-year 2018 revenue range by $5 million and now expect full-year revenue between $1.105 billion and $1.110 billion.

This new revenue outlook for the year now includes the following three assumptions: First, the U.S. hardware business is expected to grow between 4% and 5%. Second, U.S. Surgical Support is expected to grow approximately 9%. And third, International is expected to grow approximately 15%.

We are also adjusting down our expected non-GAAP operating margin for the year to a range of 15% to 15.5%, as we continue investing strategically in our commercial organization and set fulfillment in the fourth quarter, which lays the foundation for sustained growth in 2019.

We believe these investments will provide long-term benefits to the company, allowing for additional case coverage in our Clinical Services business and improved asset utilization. The efforts to streamline our distribution and supply chain will enable our sales teams to better focus on selling and supporting our surgeon partners.

To recap, I'm encouraged by the commercial execution and the traction of our new product introductions. In light of favorable market conditions, the company continues to transform from a mechanical and implants based portfolio to a truly systems and technology based leader in spine, and we feel that we have made the important decision and the right decision to invest in additional resources to succeed in 2019 and beyond.

In addition to these investments, progress at West Carrollton is on track to drive improved profitability, quality control and management of inventory. Our investment thesis of 400 basis points of expansion from the facility is still the expectation in the coming years.

Before we transition to Q&A, I'll be remiss if I didn't thank Greg on behalf of all NuVasive employees and the board for his service over the last three-and-a-half years. Under his leadership, the company has achieved several important milestones that have set the stage for sustained growth and leadership in the spine space.

While Greg will remain engaged as the NuVasive Chairman of the Board, I will personally miss our daily interaction and wish him all the best during this transition period and beyond. I will also take this opportunity to congratulate and welcome Chris Barry as our new CEO, effective November 5, and I look forward to working with him.

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

[Gregory T. Lucier, NuVasive, Inc.]

Operator, please give us the first question.

[Operator]

Yes. Thank you. Please also note that we ask that the participants limit their remarks to one question during today's Q&A session. Our first question is from Josh Jennings with Cowen & Company. Please proceed with your question.

[Joshua Jennings, Cowen & Co. LLC]

Hi. Good afternoon. And thanks for taking the questions. Greg, congratulations, and good luck on the transition to the next phase of your career.

I was hoping to just start off to ask about operating margins and understanding that you see the opportunity for more sustainable out-year growth with more investment. But I guess what we'd like to hear is, is just – the out-year target of 25% that's been put out there historically, maybe you could comment on that target and whether you're reiterating that or not.

And then more specifically, how should we be thinking about near-term annual operating margin expansion potential? Is this kind of a six-month step-up in investment? Should we still expect 100 basis points of expansion-ish annually, but just starting off at a lower coming-out point from the end of 2018? And then I have one follow-up.

[Gregory T. Lucier, NuVasive, Inc.]

Sure. Well, I appreciate the question. And so, just to be very grounded, we're giving guidance for 2018. That's the operating margin for the balance of the year, and we're not making any proclamations for 2019 and beyond. Now, having said all that, the company is still very much committed to the path to 25%. That remains the long-term goal for the company as we continue to scale it.

As you do think about the next year of 2019 and beyond, I think there are some important points that will help with the operating margin expansion that does come about. The first one is the gross margins will improve. So, as Raj said, the West Carrollton plant investment and all of its start-up issues, if you will, are now coming behind us and will begin to be a benefit for us in 2019. And we remain committed to the 400 basis points in total we'll get out of that investment. That'll be an important element on that path to 25%.

The other thing I would tell you is that we are in this interesting inflection point in the business where we're not going to be irresponsible on our spend around R&D or certain supply chain things, but we are taking advantage of the moment both in terms of capturing some technology and also capturing some markets.

And so, at 15.5% operating margin, it's not where we wanted to be, and certainly for us it's only a 2018 commentary, but I think it builds a great basis for growth at the top line and improvement of that bottom line in the years to come. So I hope that answers the question a bit.

[Joshua Jennings, Cowen & Co. LLC]

Yeah. I appreciate that. And just to follow up, I mean it seems like the market has improved a touch and you're seeing opportunity as you're heading through the end of this year and into 2019 to accelerate the top line. And you talked about investments in the commercial operations or commercial sales force.

And I was just wondering, I mean, do you see a distinct opportunity with some of the issues that one of your competitors, Zimmer Biomet, has had with their spine franchise, but more specifically as we head into next year, the Stryker (sic) K2M combination?

One, is that an opportunity for NuVasive to take incremental share? And two, is part of this investment in commercial operations, is there going to be opportunity for it to pluck off veteran sales representatives to add on to the NuVasive team? Thanks for taking the questions.

[Gregory T. Lucier, NuVasive, Inc.]

You bet. So, our company and its growth premise is on taking market share. And if you look at the third quarter revenue results against others who have publicly reported their segments, you can see we're doing multiples better than they are on an organic basis. So we are taking share in this industry now again, strongly.

We do believe that there will be further opportunity to get more share due to some of the factors you talked about. For example, acquisitions or other big entities just struggling to be focused in this space, and that's why we're continuing to have a laser-like focus on strengthening our commercial position.

In our own particular case, we're making some forward investments to, as Raj said, position the commercial forces to be not only selling implants but selling these systems and potentially locking up larger amounts of an account.

And then, lastly, you asked about getting competitive reps. Look, we're always doing that, but I would remind all investors we've gotten very good at training our own. And so we have a very good training program, a spine associate program that we promote from within, and that is still our preferred path is to promote from within.

Next question, please, operator?

[Operator]

Yes. Our next question is from Isaac Ro with Goldman Sachs. Please proceed with your question.

[Isaac Ro, Goldman Sachs & Co. LLC]

Good afternoon. Thanks for taking the question. Greg, I want to talk a little bit about robotics. It's hard to not notice all the incremental commentary you guys have applied to that theme, whether it be through the new appointments as well as the investments you're making.

I'm just interested – it feels like on that topic you guys are probably going to take a little bit more of a build versus buy approach, please correct me if I'm wrong, on how best to commercialize the technology.

And second to that, how should we think about the incremental investment you're making in robotics versus everything else that you touched on in the updated guidance for this year? I'm just trying to split out how much of the incremental investment is going to robotics versus everything else. Thank you.

[Gregory T. Lucier, NuVasive, Inc.]

Appreciate the question. So our robotics effort will be more of a build than a buy. It'll be, not completely, but definitely more of a build than a buy. Like we've been doing with all of these systems, part of our goal is to build the DNA to allow us to have a long-term sustained advantage in this industry.

We're investing when others are disinvesting. And so, that answers maybe a little bit of your second question of how much of this increased spend is to take advantage of this transformative period you're seeing to build out these systems. And while I'm not going to break it out completely, that explains part of it for sure.

[Isaac Ro, Goldman Sachs & Co. LLC]

Okay. Helpful. And then just a follow up on market share. You pointed out the growth rate you guys are seeing versus the overall market. Can you maybe help us from a bottoms-up view get a sense of what's going on in terms of the accounts that you're winning, the types of situations in which you're gaining share now versus competition?

Because it does feel like all the major players are in varying degrees making key strategic bets all with the goal of gaining share, and you guys are obviously accruing the majority of that right now. So I'd be interested in some bottoms-up view as to how you're doing that. Thank you.

[Gregory T. Lucier, NuVasive, Inc.]

You bet. So, as healthcare systems consolidate, and part of that overall evolution process is to slim down the number of vendors, we like when that happens because we inevitably find ourselves in the final mix. We like it even further now that we're able to potentially offer a complete system of technology into an operating room to make an operating room a NuVasive room, and it changes the dynamic one more turn.

And so, that's changing we think the overall competitive nature of this industry to a few larger, more well-capitalized players that can potentially pull this off. We like our roadmap. We like what we're going to be launching and delivering over the next 12 months. And again, to your earlier question, it's why I chose to further invest right now. And we think it's going to lead to what has hopefully been long-awaited consolidation in this industry around four to five bigger spine companies, and we'll be one of them.

[Isaac Ro, Goldman Sachs & Co. LLC]

Got it. Thank you.

[Operator]

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

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

Good afternoon. Thanks for taking the questions. And, Greg, best of luck in the future to you. Just for starters, on Q4, the guidance on the top line, it's the easiest comp of the year. You're saying the market's getting better. You're seeing a ton of domestic strength. So, can you talk about why only 5% growth again next quarter? Again, easiest comp of the year. How much are you building in as far as conservatism and how much are you building in Skip leaving, those kind of factors?

[Gregory T. Lucier, NuVasive, Inc.]

Well, look, we know the math, and we appreciate you pointing it out. Fourth quarter is, as you know, historically a very good quarter for us. I think you're just trying to see if – to try to get some guidance. So we're being conservative, and yet the growth rates are going to be ultimately pretty good in the fourth quarter.

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

Fair enough. And then, Greg, as far as – and I think this is what I'm hearing here, historically you've said kind of 5% to 7% top-line growth for NUVA. I think you're saying we should expect a little bit maybe towards the high end of that range or even better than that. I think you said high-single digits sustainably going forward.

So, between the International business, which I think will still be strong, it still requires you to be very good domestically and probably take more share than you've been taking over the last couple years annually to get there. So, first of all, is that math right?

And then can you help kind of walk us up to an improvement on the top line, even as the market may be getting a little bit better, although we're moving more cases to lower cost ASCs, et cetera, just all those different moving parts, how do we get comfortable that you're confident you can get to that high-single digits on the top line sustainably?

[Gregory T. Lucier, NuVasive, Inc.]

Well, look, I think you're laying out the math quite well for everybody here on this call. So, as you say, International is going to grow and I do believe 20% is a good, prudent number to put in your plan, certainly what we have in our plan going forward.

If you look at the Biologics business now returning to growth, we've got a great product line that, if you do your homework, you'll see it matches everybody in the industry point-to-point. And with our commercial forces, I think we'll outsell everybody. That's a positive. If you look at our Clinical Services business, I think the team there is doing a bang-up job getting the growth back to where we wanted it to be. That's also good.

And then, finally, commercial hardware or just the U.S. commercial business, you're right, that has to get into the kind of mid-single digits, but I think we're now demonstrating after a couple quarters we can do that. And I would say we feel good we can sustain that, given all of what I know, what we know, on all the technology coming out over the next year or two.

[Rajesh Asarpota, NuVasive, Inc.]

The only thing I would add to that, what Greg said, is, Matt, the Biologics business has continued to be on a tear, right? So we are flat this quarter. We will be growing in the fourth quarter. And we think next year and beyond, as we continue to make investments there, increase attachment rates, that business should be pretty healthy as well.

And just to further Greg's comment on the hardware business, if you look at the last five quarters, we've rapidly started to increase case volume growth all the way up from about 1.4% in Q3 of 2017, progressively walking up to 7.5% or so in the third quarter. So we've got nice momentum there, which is why the investments as well.

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

Very helpful. Thank you.

[Operator]

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

[Jonathan Demchick, Morgan Stanley & Co. LLC]

And thanks for taking the questions. So, Greg, thanks for the commentary around the succession plan, and congrats to I guess both you and Matt for your new roles. But I guess I had a question though on the transition with Skip Kiil leaving. And obviously sales force build and attrition is a big focus in spine. So, just wanted to kind of check in on what controls are being put in place to limit any disruption there.

[Gregory T. Lucier, NuVasive, Inc.]

Fair question. Maybe a little more color. So, as I said, when the board and I started to have those conversations, we put no timetable on it. We hired Spencer Stuart who I thought did a world-class job partnering with the board to help us do succession planning. And, ultimately, we made some decisions, as you now know, to promote Matt Link, and Skip Kiil made his own decision to move on to a new opportunity. And we wish him nothing but the best, and we thank him for his service to our company.

All that said, we have a awesome line of regional leaders around the world ranging from Paul McClintock in the United States to Erin McEachren in Europe to Takaaki Tanaka in Japan. All of those leaders are in place. They are incredibly committed. And as Chris comes in, and the conversations I've had with him, he'll figure out the right structure to move forward with, whether we decide to replace the Skip Kiil role, or perhaps he moves to a more traditional regional structure. Just know we're in a pretty good place right now in terms of our commercial forces, their stability and their direction going forward.

[Jonathan Demchick, Morgan Stanley & Co. LLC]

Thank you. Very comprehensive. Very helpful. Thank you. And then just a quick follow-up for Raj. Just given I guess the high contribution margins of implants, I was a little I guess surprised to hear about the higher expense profile in the United States. So I was just hoping to understand what was driving that and if that's expected to, I guess, normalize in the coming quarters? Thanks.

[Rajesh Asarpota, NuVasive, Inc.]

Yeah. Look, I think what you're asking is a little bit of the revenue mix that I pointed out. And just to give a little bit more color on that, the International business we've told you, as that business starts to grow, given the infrastructure investments that we've made there, you obviously get great profitability there. So, that has been impacted a little bit this quarter in that the mix has been a little bit more skewed towards the U.S. where we're hitting our quotas, we are paying the regions some accelerators on commissions, et cetera. So, that's driven a little bit of the lopsidedness on profitability.

[Jonathan Demchick, Morgan Stanley & Co. LLC]

Understood. Thank you.

[Rajesh Asarpota, NuVasive, Inc.]

Yeah.

[Operator]

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

[Kyle William Rose, Canaccord Genuity, Inc.]

Great. Thank you very much for taking the question. Just had one question. Just it sounds like the commercial team in the U.S. is obviously doing a great job in taking share. Wondered if you could maybe just kind of frame out how some of those incentives have changed.

I think in the past you've talked about that case indexing and variable comp related to what percentage of case revenues you're getting. And then I think you specifically talked about the Cervical business being a strong point in the quarter. Maybe help us understand what specifically is driving the strength in the Cervical. And then I just have one follow-up.

[Gregory T. Lucier, NuVasive, Inc.]

On the Cervical side, we brought in a new leader about a year-and-a-half ago for the global franchise, a long-tenured expert in that part of the spine space. We have assembled the proverbial dream team on the Cervical side, and that's generating a enormous amount of excitement, podium presence about where we're going, which has stimulated current purchases. And then I'd also add because of the Porous PEEK technology being launched, primarily in Cervical where it has great applicability, you're seeing now a nice uptick in Cervical for us.

For the investors on the call, we are grossly underrepresented in Cervical. So this is a massive part of the spine franchise we have a very small presence in. And so it's one of the areas, as I'm mentioning, we're targeting over the next few years to grow by huge amounts. So we started to see some nice progress there.

In terms of the incentives, as Raj referenced, we have growth accelerators, we have quota accelerators. I mean, we're pretty sophisticated on how these variable comp plans work in the United States. And as a result of this growth, people are starting to hit their numbers, people are pretty happy, and things are being paid out. All of that then obviously gets kind of re-base-lined to 2019, but right now the incentives are working quite well for us.

[Kyle William Rose, Canaccord Genuity, Inc.]

Great. And then on Pulse, I mean, obviously it was a big focus of NASS, and it's a big focus of 2019 and the years thereafter. Just wondered if you could maybe frame out a little bit how you think about the commercial plan there. And less specifically about revenue expectations, but more so we had a competitor at NASS who kind of talked about using procedural volume share as a way to justify placing capital units for free. And I just wanted to see how you view NuVasive's position to be able to compete in an environment that's like that? And do you think you'll see that on day one when the product does launch upfront?

[Gregory T. Lucier, NuVasive, Inc.]

Yeah. Well, we hate the word free. I think anybody should hate the word free. And so our goal here is to sell this technology. Our goal is to deeply integrate it with our implant technology. And ultimately our goal is to use it as a platform to allow providers to link closer to ultimately payers on the outcomes of their surgeries, which we think is going to happen in this timeframe of three to five years.

Now, we're assembling, as we referenced in the script, a dedicated sales force that's been trained, has tenure, has experience in the space of selling capital equipment and particularly robotics. We have multiple methods of financing it if we need to. But our goal isn't to do a giveaway and then get implants. I recognize completely others might do that, but that's not where we're starting. There's real value to be created here, and our intent is to get paid for that.

Operator, next...

[Operator]

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

[Steven Plachtyna, BMO Capital Markets (United States)]

Hi. This is Steve Plachtyna on for Joanne. I appreciate some of the earlier commentary about sequential improvement in LessRay converting trials. Can we expect that to slow down as customers sort of await the full launch of Pulse and maybe sit on the sidelines for the next few quarters?

[Gregory T. Lucier, NuVasive, Inc.]

Yeah. Good question. Actually, it's just the opposite. We're going to have a tiered product strategy, and so there will be still a stand-alone LessRay unit with terrific functionality. And what we're noticing, actually, is that as more and more customers get obviously sales calls by us and others about the evolution of spine surgery to be more of a systems surgery, they're starting to wake up, they're starting to ask questions, and some of them just have the first, if you will, appetite to buy a unit like a LessRay that gives them terrific improvement, obviously, on radiation reduction. But if you've ever seen the product, it has some limited kind of but important navigation features to it. And it's obviously at a different price point. So the answer is no, it's actually leading to increased trials and potentially an even more robust pipeline.

[Steven Plachtyna, BMO Capital Markets (United States)]

Okay. Great. Thanks for taking the question.

[Operator]

Our next question is from Jeff Johnson with Robert W. Baird & Co. Please proceed with your question.

[Jeff D. Johnson, Robert W. Baird & Co., Inc.]

Thank you, guys. Good evening. I have one follow-up question on margins and then one additional margin question. So the follow-up question, in your press release, you still talk about 130 to 150 basis points of operating margin improvement next year, tied to the West Carrollton efforts. Are we to read that as 130 to 150 basis points from that effort? But that is before taking into account what could be higher R&D and/or SM&A cost next year as you talked about some of these heightened investments, Greg?

[Gregory T. Lucier, NuVasive, Inc.]

So, look, we're not here to give 2019 guidance, but we wanted to simply isolate West Carrollton in an investor's mind to say we're now through the growing pains. From here forward, it begins to become accretive to the income statement, and we tried to quantify how accretive that piece of what we've done to mature the company is going to do for us in 2019. We're not ready to make any other guidance for operating margins. We'll do that here in due time, and Chris and Raj will do that in the first quarter.

[Jeff D. Johnson, Robert W. Baird & Co., Inc.]

Yeah. Fair enough. Just wanted to make sure that was in isolation, that's not a company-wide type commentary.

[Gregory T. Lucier, NuVasive, Inc.]

Yeah. Very good point. That's not the company-wide. Yes.

[Jeff D. Johnson, Robert W. Baird & Co., Inc.]

Okay. And then other question on margins. Just on the Premier contract, we've tried to size that with patients under coverage at Premier, things like that. And maybe it adds 50 basis points to 100 basis points to company-wide growth over the next year if we make some back-of-the-envelope assumptions. But we have no clue, really, on how you might be pricing that contract. Does that impact at all some of the margin takedown on the guidance here? Just anything you can talk about, maybe the top line or the margin contribution, from this Premier contract. Thank you.

[Gregory T. Lucier, NuVasive, Inc.]

Yeah. So the Premier contract is good for us on the revenue side. It is not dilutive to the operating margin side. But it is – and the reason we highlighted it is an exemplar of how we're seeing the industry evolve to where you're having now a company like ours that can do things nationally in a very ethical, professional way and systems wanting to partner with us and get away from kind of the monkey business you see sometimes in this part of the spine business.

And so the only issue I'd tell you is we've been hiring ahead of that Premier contract because it's going to lead to, as you rightfully point out, a fair amount of growth for the company. And so, that's part of also the margin issue in Q3.

[Rajesh Asarpota, NuVasive, Inc.]

Q4

[Gregory T. Lucier, NuVasive, Inc.]

I'm sorry, Q4.

[Rajesh Asarpota, NuVasive, Inc.]

Yeah. Right.

[Operator]

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

[Richard Newitter, Leerink Partners LLC]

Hi. Thanks. One on Pulse and just one on the market. And, Greg and team, good luck with the next steps and all the transition work. But, on Pulse, I appreciate you're not giving 2019 guidance, but can you help us think a little bit just about when we can expect meaningful revenue contribution? I know 2Q is kind of the commercial effort, but should we think of this as a phased rollout where 2019 is more of kind of a testing period, so maybe no real revenue until the back half and more so in 2020? Or if that's not correct, please correct it. And then I have a follow-up on the market.

[Gregory T. Lucier, NuVasive, Inc.]

Yeah. Look, I think in 2019 you're going to see a number of show sites around the world very strategically placed, and the revenue contribution will be not large because we're going to want to make everything work beautifully and, as I said, bring customers in to see these show sites.

Now the interesting kind of artifact going on though is that, as customers have begun to see the roadmap, and again, we've disclosed more of the roadmap to some of our more strategic customers, you're seeing increased preference towards NuVasive, and that also may be explaining why we're getting ever more accelerated growth rates.

People always love NuVasive implants. Now that they see the roadmap to link it all together, you're seeing a compelling kind of alternative to everyone else, and that may explain why we're getting stronger market share.

[Richard Newitter, Leerink Partners LLC]

Okay. And on the market, you guys, your commentary around kind of turning the corner view of the U.S. trend, it jives with some of the work that we've seen and uncovered in recent months. And it also would seem to be the case with some other competitors that have reported before you. I guess, what do you think is happening here, Greg? Anything that you can provide in terms of a shifting trend? Is it just anniversarying easier comps? Any color there I think would be helpful for investors.

[Gregory T. Lucier, NuVasive, Inc.]

Yeah. I don't think it's really anniversarying easier comps. We look at numbers in absolutes in terms of procedures and the like. So we understand what goes on at a very unit level. I do believe a strong U.S. economy is leading to people to have insurance and people feeling confident to spend whatever out-of-pocket they have to spend to take elective surgery. And so I do believe that's benefiting us here in the United States.

[Richard Newitter, Leerink Partners LLC]

Okay. Thank you.

[Operator]

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

[Lawrence Biegelsen, Wells Fargo Securities LLC]

Good afternoon. Thanks for taking the questions. Hey Raj, hopefully I'm doing the math right, but it looks like the guidance on the gross margin implies Q4 gross margin will be about 71.8% or 100 basis points below Q3. Is that correct? And why would it take a step down? And I had one follow-up.

[Rajesh Asarpota, NuVasive, Inc.]

Yeah. It's in line with your thinking. I think part of it is, as Greg discussed when we were having the discussion of the Premier contract, ahead of that, we are looking to do some staffing in the NCS business. So, part of that hits the gross margin number. So you see that in Q4 coming down, and that's mostly the phenomenon related to the Premier contract hiring.

[Lawrence Biegelsen, Wells Fargo Securities LLC]

Okay. And, Greg, a question on the Ellipse assets, MAGEC X launch and the PRECICE STRYDE. Last time we talked in May, you sounded pretty excited about the opportunity for PRECICE STRYDE for limb lengthening. Any update on that? And how do you feel about the opportunity now? Thanks for taking the questions.

[Gregory T. Lucier, NuVasive, Inc.]

Yeah. Thank you, Larry. Great question. So, MAGEC and PRECICE both had strong double-digit quarters in Q3. The MAGEC rod and now its linkage to our fixation systems, RELINE Small Stature, is working as planned to really penetrate deeply into pediatrics. Part of the Biedermann partnership will now expand that into adult deformity and we think in a very successful way.

We remain incredibly excited first by PRECICE growing, continuing to grow at high-double digits; and now STRYDE, where in a couple of clinics around the world we are doing cosmetic limb lengthening. We're perfecting the protocols, the patient workflow, and we couldn't be more excited about the potential of cosmetic adult limb lengthening in sanctioned clinics around the world. So, more to come on that.

[Lawrence Biegelsen, Wells Fargo Securities LLC]

Thank you.

[Operator]

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

[Robbie J. Marcus, JPMorgan Securities LLC]

Great. Thanks for taking the question. I just want to circle back and maybe tie a few questions together. It looks like that market growth in the U.S. is sort of doing 0% to 1%, like you said, but off pretty easy comps especially in the third quarter. So I'm still struggling to see what changed from second quarter to third quarter that prompted you to lower operating margin guidance for the year and put all this incremental spend in here? Maybe just help tie it all together, because it doesn't seem to me like the change in the market is that substantial between the past 90 days.

[Gregory T. Lucier, NuVasive, Inc.]

Perhaps we should put more weighting on our own experience in the market then in that we're having, we think, more momentum taking share in this industry. Now we'll maybe beg to differ with you about the strength of the market. We would notch it up maybe 1 point or 2 points, but so be it. The bottom line is that within the market context, we're doing quite well now and we thought it was important to position the company going forward. So, that's the decision I made.

[Robbie J. Marcus, JPMorgan Securities LLC]

Okay. And then last question from me. We've heard from several people in industry that NuVasive has been trying to potentially sell itself over the past few months. Can you, A, comment on that; and B, confirm if that process is still ongoing or if it's completed now? Thanks.

[Gregory T. Lucier, NuVasive, Inc.]

It's funny, when I first stepped into this role, I would get asked that question a lot. And I've actually continued to get questioned by that all through the years. And here we are a strong, independent company. So the bottom line is I'm not going to comment on any M&A activities that we would be engaged in, so.

[Robbie J. Marcus, JPMorgan Securities LLC]

Okay. Thank you very much.

[Operator]

And our final question is from Ryan Zimmerman with BTIG. Please proceed with your question.

[Ryan Zimmerman, BTIG LLC]

Thanks for fitting me in. Just two quick questions for me. Raj, I think last time we spoke, you were testing some new strategies related to biologics, specific biologic specialists. And just given the rebound you saw this quarter, should we assume that you continue that strategy and expand those resources around biologic specialists just in the context of the NCS hiring?

[Rajesh Asarpota, NuVasive, Inc.]

Yeah. Absolutely. I mean, the biologics story has been like it's been a really nice story in terms of a turnaround. We continue to invest not just in product line extensions, but also continuing to experiment with our current sales force and, like I told you, specialists. So, that is getting traction and we'll continue to test that out. So it's working nicely.

[Ryan Zimmerman, BTIG LLC]

Okay. Thank you for that. And then just lastly, on International, just the challenges we saw this quarter. You commented certainly about the UK and the Puerto Rico markets being soft, but I just want to reconcile your comments around deployment. It sounded like you were trying to deploy some sets to make up for that shortfall. So, are the challenges market-related or are they just execution? And how should we just take what we saw this quarter and think about it going forward?

[Gregory T. Lucier, NuVasive, Inc.]

Yeah. So, I mean, some of the markets like the UK would be more around the market and Puerto Rico. Some of them like down in South America, you've got to work through some customs issues. Again, we're not signaling anything different in terms of our long-term guidance on International. We'll end up doing about 15% for the year. We think next year will be substantially better. In fact, I just was in the UK on Monday going over the game plan for 2019, and I think it's a very solid one to return to double-digit growth there. So I think International still represents a great growth driver of this enterprise.

[Ryan Zimmerman, BTIG LLC]

All right. Thanks, Greg, and congrats on the new role.

[Gregory T. Lucier, NuVasive, Inc.]

You bet. Thanks a lot. Operator, and to all of you on the call, thank you for joining us. We really appreciate you calling in here on our third quarter earnings call. Let me just maybe say some final words that, as I continue in my capacity as Chairman, I do look forward to working with my fellow board members and with the management team to create as much value as possible for this company's investors and its employees. Again, thanks for your support over the last several years and wishing you all the best. This concludes our third quarter earnings call.

[Operator]

Thank you. This concludes the conference. You may disconnect your lines at this time, and have a wonderful day.