NuVasive Inc

F:NK8

Earnings Call Transcript 2017-Q4

[Operator]

Greetings and welcome to the NuVasive, Inc. Fourth Quarter Full Year 2017 Conference Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the conference over to your host, Carol Cox, Executive Vice President, External Affairs. Thank you. You may begin.

[Carol Cox, EVP, External Affairs and Corporate Marketing]

Thank you, Karen, and welcome to everyone to NuVasive's fourth quarter and full year 2017 earnings call. The company's earnings release, which we issued earlier this afternoon, is posted on our website and the 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.

For 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 today, I would 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 SEC. 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 our cost of goods sold, gross margin, sales, marketing and administrative expenses, research and development expenses, operating margin, non-GAAP earnings per share, free cash flow and EBITDA. Reconciliation 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 the NuVasive website.

With that, I'd like to turn the call over to our Chairman and CEO, Greg Lucier.

[Greg Lucier, Chairman and CEO]

Thank you, Carol, and good afternoon, everyone. Earlier today, we reported fourth quarter and full year 2017 results, in line with the preliminary results we announced in January. On today's call, I will provide an overview of our full year 2017 results and a high level commentary regarding outlook for 2018. Then, Raj will give a detailed review of our fourth quarter 2017 performance and provide detailed guidance for 2018.

In 2017, our global revenue grew 7% on a reported and constant-currency basis to $1.030 billion. On a pro forma basis, revenue grew approximately 3.5%. These results were primarily driven by international sales growth in excess of 20% across key regions, strength in our U.S. hardware business and strategic and tuck-in acquisitions. Internationally, we continue to see success with our strategy to lead with XLIF, going direct in key markets and overall maturation of our efforts to build a global infrastructure and sales operations footprint.

Results in our U.S. spine hardware business were driven by continued adoption of our ReLine posterior fixation system within our iGA platform and new product introductions such as XLIF Modulus, TLX, and Base. The decline from our expected growth in U.S. hardware business was driven by the unexpected slowdown of the U.S. spine market that started to play out around the midyear of 2017, resulting in muted case volume growth. It was also affected by competitive and market dynamics in our biologics business, which we are actively addressing with a multipronged approach that includes building commercial infrastructure to address known market issues, reenergizing the approach for our portfolio and efforts to gain access to new accounts for previously lost accounts.

Despite the impact of these headwinds, we continue to drive operational efficiencies and make steady progress against our profitability expansion goals. As a result, we delivered non-GAAP operating margin of 16.6% for the full year and exited the year with non-GAAP operating margins of 18.2% for Q4, achieving another all-time high milestone for NuVasive. Our non-GAAP earnings per share grew more than twice the rate of revenue growth at 15.1% to $1.91 per share.

Now beyond our financial results, we made solid headway in our efforts in key areas that when combined, differentiate and place NuVasive in a strong position to compete for both the clinical and economic perspective and will support our growth in 2018 and beyond. These areas include further adoption of minimally invasive lateral surgery, phase-in of our surgical intelligence platform, and the continued build-out of our service organization that we believe will deliver a highly competitive integrated offering over time.

Let me briefly highlight a few of the launches that are anticipated to ramp throughout 2018 and positively impact our ability to lead with our procedural offerings. In the fall, we celebrated the 15th anniversary of XLIF and launched the expansion of its key portfolio to enable single physician surgery. Lateral surgery is not only the seed from which NuVasive story was born, it's also our future. XLIF is supported by clinical evidence in over 400 and related peer-reviewed articles, making it the gold standard for lateral.

With the launch of XLIF Crestline, lateral ALIF and lateral MIS fixation, we're enabling single-position surgery for lateral from T6 to S1. These new technologies are designed to increase operating room efficiency by reducing the frequency at which a patient has to be repositioned, expanding the benefits of lateral surgery to more spinal level and decreasing the duration a patient is under anesthesia. While these launches are in the early stages, we're encouraged by the feedback we're receiving from surgeons who are extremely pleased with the ease of the procedure and the significant time savings it is able to provide.

Looking ahead to 2018, we will redefine the experience for our surgeon partners and patients with the launch of our surgical intelligence platform, spine’s only integrated surgical platform, connecting technology and tools to align the right patient with the right surgery for the right outcome. When we unveil this one-stop shop for surgical intelligence later in 2018, the industry will experience a true paradigm shift in what defines an OR. The surgical intelligence platform will be a connected system, phased in to bring together monitoring, planning, imaging, 2D and 3D navigation and automation, and further insights to help deliver an optimized OR and quality patient outcome.

We are really excited about this comprehensive solution composed of monitoring and surgical planning. It is a significant step in our evolution from a product-focused company to a systems-based company focused on delivering end-to-end solution that not only enables predictable clinical and economic outcomes, but also pull-through our implants and creates stickiness in the market.

As the only spine company of size with both technology and service capabilities, we are partnering with hospitals now to help architect a roadmap for integrated OR of the future. While most investment heavy OR technologies are tailored to support complex deformity cases, which really only make up 15% of spine surgery, we are offering cost-effective solutions designed to meet the needs of 70% of all spine surgeries, those 1 to 2 level basic fusion and discectomy cases. Our commitment to deliver sustainable healthcare centered on economic and clinical outcomes for the hospital, the surgeon and the patient, is paramount.

We will also continue to build-out our proprietary Advanced Materials Science portfolio of spine interbodies. Following our acquisition of Vertera in September 2017, NuVasive became the only medical device company to offer porous interbody technology across both PEEK and titanium materials. In the second half of 2018, we will be introducing new offerings across both our porous PEEK and titanium portfolios, including the addition of Modulus ACDF and the expansion of our porous PEEK portfolio to include the XLIF footprint.

In September, we commercially launched our first-ever capital equipment platform, LessRay. LessRay is a software technology designed to help address overexposure to radiation in hospital operating rooms, particularly in the case of minimally invasive spine surgery. While we are in the early days of the capital product cycle, we are pleased with the growing customer interest in pipeline, resulting from our active trialing. As the LessRay platform evolves, it will service our fully integrated platform and a key component of our surgical intelligence platform, offering advanced and intuitive navigation with realtime visibility in complex cases and enabling single physician surgery.

Finally, in early 2018, we invested further in our NuVasive Clinical Services business with the acquisition of SafePassage. With this acquisition, we solidified our leadership position as the largest provider of outsourced intraoperative neurophysiological monitoring services with over 550 neurophysiologists and oversight physicians in the U.S., delivering services to 1,000 customers and 3,000 surgeons.

As the only spine company in the world with dedicated neuromonitoring services, NuVasive is uniquely positioned to deliver greater value across our procedurally integrated portfolio and expand our ability to transform how spine procedures are approached, measured and valued from a clinical and economic perspectives.

Now I'd like to turn to our self-manufacturing efforts. When I took on the CEO role at NuVasive, one of my top goals was to increase our internal manufacturing capabilities and enhance our operational efficiencies. Over the last year, we've made great progress and I'm pleased to announce we exited 2017 having fully completed the construction of our 180,000 square-foot in-house manufacturing facility in West Carrollton, Ohio. This new facility supports our goal to quicken the tempo of product launches, increase our customer responsiveness, speed up design time velocity and, ultimately, increase our control over supply chain and operations.

We were able to close down our second smaller facility and fully integrate our high-performance work teams. I'm truly amazed at the quality work our operations, engineering, R&D, IT and HR teams have produced. The teams took an empty shell of the building and turned it into a state-of-the-art facility with newly installed equipment and digital capabilities. Additionally, we hired and trained over 200 new people with advanced manufacturing skillset. So while the project took a bit longer than we originally anticipated, we expect the financial benefit to begin to flow in mid-2018.

Looking forward into 2018, I understand questions remain about the state of the U.S. spine market and its impact on NuVasive's growth. We continue to talk regularly to our surgeon customers, hospital systems and insurance executives as part of our work to assess and address challenging market dynamics. Based on the feedback and our own results over the last couple quarters, we believe the U.S. spine market is stable, but largely flat overall. We see organic growth for 2018 in the range of 4.4% to 5.4% within the mid-single digit range we had projected.

When you include the contribution from our recent acquisition of SafePassage, we would expect reported revenue growth in the range of 6.4% to 7.3%. Accordingly, we are guiding to revenue in 2018 in the range of $1.095 billion to $1.105 billion. Based on this revenue range, we expect non-GAAP earnings per share to increase approximately 28% to a range of $2.44 to $2.47, reflecting continued expansion of our operating margin profitability and the impact of tax reform in the U.S. Raj will provide more details in his commentary and give guidance on our tax rate expectations as well.

What I want to leave you with today is, while we continue to deal with some softness in the U.S. market, we are continuing and confident with our focus on new product introductions and increased rigor on day-to-day execution by our sales leaders. We know we can take share in this environment. We also know we have to be that much better in 2018 than we were in 2017. We recently held our annual sales meeting where we brought together our commercial sales force for several days of training, surgeon meetings and a detailed review of our key priorities for 2018.

Our team came away from the meeting excited and equipped with new tools and analytics to better compete in the challenging U.S. market. If you are a sales rep for Nuva, you will have the best supporting tools to help you gain share in 2018. And perhaps, even more important, we have a leadership team in place that is focused on intensive teamwork and on collectively delivering results in both the short and the longer term.

So in conclusion, I have been in the CEO's seat for over two years and I'm confident with our strategy to build-out a unique set of capabilities will allow us to compete at the highest levels to address the needs of our surgeons and the clinical and economic dynamics of this market place. The combination of our cutting-edge implant portfolio, our leadership in MIS, especially in lateral; the newly introduced surgical intelligence platform; and a robust services business moves us even further on our path to having a fully integrated procedural offering and positions us to execute well in this evolving healthcare environment.

Now I'd like to turn the call over to my colleague, Raj.

[Rajesh Asarpota, CFO]

Thanks, Greg, and good afternoon, everyone. Before we get started with the financials, let me remind you that many of the financials 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 fourth quarter 2017, we reported revenue of $271.7 million, which reflects generally flat performance year-over-year on both reported and constant-currency basis. This was primarily driven by strong international growth of 34% in constant-currency basis, offset by declines in the U.S. revenue of approximately 6%. The decline represents slowdown in procedural volumes in the U.S. spine market, pressure in our biologics business as expected as well as the difficult comp to the prior year results due to a $4.8 billion magic quarter that did not repeat in 2017. On a positive note, we saw key volume growth in our core hardware business.

In addition, we continue to experience a headwind in our international sales resulting from the 2017 hurricanes in Puerto Rico of approximately $1.5 million. Our U.S. spinal hardware revenue declined approximately 4% year-over-year to $148.4 million. If you adjust for the fourth quarter 2016, MAGEC sales of $4.8 million, U.S. spinal hardware was flat the prior year resulting from case volume growth of approximately 5%, offset by a combination of a slight increase in pricing pressure and product mix.

We're pleased with our ongoing efforts to convert new surgeons to NuVasive, which was strong in the fourth quarter 2017. Revenue from U.S. surgical support came in at $70.9 million for the quarter, down approximately 10%, primarily related to the continued weaker U.S. case volume experienced within our services business and the expected weakness in our biologics product line.

On a positive note, as we exited the fourth quarter 2017, we saw a slower decline in Biologics as we started to execute on some of the levers we shared during our third quarter 2017 earnings call. Under new biologics leadership, we have adjusted our efforts to be more competitive and reentered several lost accounts with offerings across the entire biologics portfolio. We're also actively renegotiating cost structures with our supplier as we speak, allowing us to be more competitive on that front. Finally, we kicked off a sales force wide retraining in biologics at our global sales meeting a few weeks ago with well-defined metrics and incentives in place to track attachment rates.

Turning to LessRay, it's certainly early days but I'm pleased with the progress we are making as we convert customers who have been trialing the new platform into the sales process. LessRay results for the quarter were in line with our expectations. Our international revenue was $52.3 million, growing approximately 34% on a constant-currency basis, and approximately 35% on a reported basis in the fourth quarter. Notably, this is the fifth consecutive quarter with above 20% growth and I'm pleased to see the strong performance across key regions.

The investments in the International business made several years ago continue to pay off, along with strong leadership that is focused on taking market share, building surgeon relationships and understanding each country's specific requirements to be successful in that market. I see this type of growth as sustainable.

On a constant-currency basis, EMEA grew 19% year-over-year, where all key Western Europe markets had solid performance, driven by Italy and Germany. Emerging markets performed well, with strong growth in South Africa and Saudi Arabia. Finally, we acquired our Swiss distributor in September and as a result, are now direct in that market and seeing immediate benefits in growth and profitability.

On a constant-currency basis, Asia Pac grew 53% with strong results from Japan's reintroduction of XLIF, stimulating core growth as well as our performance in Southeast Asia. Our Australia, New Zealand region, in particular, is accelerating nicely and growth rates there nearly doubled year-over-year with new leadership in place and reenergized focus from our sales team there. On a constant-currency basis, Latin America grew 15% and delivered its fifth consecutive quarter of growth, driven by strong performance in Brazil. Results in Q4 are encouraging considering the impact of hurricane Maria on our business in Puerto Rico.

Turning now to the rest of the P& L, non-GAAP gross margins for the fourth quarter was 72.4%, a decline of 290 basis points below prior year of 75.3%. About 80 basis points were attributable to the slower-than-expected in-sourcing ramp of our new manufacturing facility in West Carrollton, along with approximately 50 basis points attributable to a slight uptick of pricing pressure.

We have been operating and therefore, consuming out of duplicate facilities, which is increasing variances throughout the quarter. We exited a duplicate facility in the last week of December. The validation of new and transferred equipment took longer than anticipated, resulting in higher spend and lower absorption of current spend plan. The good news is, as we head into the first quarter of 2018, West Carrollton is fully on lined, is registered with the FDA and all product is now officially being shipped from the facility. It will take us time for us to work through the favorability we expect, but we continue to see this as a huge operational lever for us. It allows us to take control of our supply chain.

Other contributors were 50 basis points due to the mix of international sales versus domestic sales as well as product reserves, which amounted to an additional 40 basis points. Non-GAAP SM&A expenses as a percent of revenue decreased 300 basis points from the prior year to 49.5% in the fourth quarter or $134.5 million.

With the growth in our International business, we're taking advantage of our expanding scale and accelerating this leverage. Domestically, we are seeing the benefit of a more cost efficient sales force as we convert U.S. distributors to our direct sales force and see the impact of improved productivity relative to revenue performance on our cost structure. We continue to manage our expenses in a disciplined way, which drives further improvement in leverage.

Non-GAAP research and development, or R&D expenses, totaled approximately $13 million in the fourth quarter of 2017 or 4.7% of revenue, which is nearly the same as the fourth quarter 2016. Our R&D spend reflects continued commitment to supporting internal R&D efforts and investing in strategic assets we acquired to drive further differentiated innovation. Fourth quarter 2017 non-GAAP operating profit margin increased to 18.2%, resulting in 20 basis points of operating margin expansion compared to the 18% we reported in the fourth quarter 2016. The gross margin pressures from pricing and temporal manufacturing inefficiencies as we optimized our West Carrollton facility were offset by improvements in our SM&A profile compared to prior year.

Moving further down the P&L, interest and other expenses, net, on a non-GAAP basis was $6.6 million in the fourth quarter, up from $5.9 million in the same period last year. This increase is primarily a result of new interest expense associated with the larger credit facility we put in place in Q1 of 2017.

Now turning to tax, our non-GAAP tax expense in the quarter was $14.2 million, resulting in a non-GAAP effective tax rate of 33.2%, which is an improvement of more than 350 basis points for the prior year. This significantly lower rate is a direct reflection of our continued focus on our tax initiatives over the last few years as well as our International business becoming more profitable for the first time in 2017.

In just a minute, I will talk more specifically about our expected tax rate in 2018 based on the recent U.S. tax reform. Fourth quarter non-GAAP net income was $29.1 million or non-GAAP earnings per share of $0.56 compared to non-GAAP net income of $27.6 million or non-GAAP earnings per share of $0.53 in the same period last year. Given challenged revenue performance, we continue to manage the business in a disciplined way, resulting in operating margin expansion and double-digit earnings growth.

Turning to our GAAP results, our GAAP net earnings for the fourth quarter of 2017 were $24 million or $0.46 per share compared to $6.4 million or $0.11 per share in the same period last year. Please refer to our earnings press release or the supplemental financial information posted on nuvasive.com for further information related to our GAAP versus non-GAAP adjustments for both our fourth quarter and full year performance.

Adjusted EBITDA margin, which excludes the impact of noncash stock-based compensation and other non-GAAP adjustments, was 27.7% for the fourth quarter 2017 compared to 26.8% in the same period last year. This increase was due to operating margin expansion as well as noncash expense increasing over prior year. Finally, free cash flow for the year was at $68.8 million compared to $67.9 million in 2016. The slight increase over the prior year was due to operating margin expansion; offset by timing related to some working capital accounts and increased CapEx spending. We ended the year with cash and investments balance of $72.8 billion.

Now I'd like to spend some time discussing guidance for 2018. We estimate revenue for full year 2018 to be in the range of $1,095 billion to $1,105 billion, reflecting organic growth in the range of 4.4% to 5.4% and reported growth of 6. 4% to 7.3%, inclusive of an approximate $20 million of contribution from the recent acquisition of SafePassage, which closed on January 17. Assuming currency exchange rates remain similar for the rest of the year, we expect currency to have a positive impact in 2018 of approximately $5 million.

I'd like to provide a bit of commentary and context around the guidance I just shared and how we can achieve results within the range we have provided. We assume the U.S. market continues to remain soft and we are coming off the fourth quarter results that were essentially flat. Our assumptions include international sales of at least 20% growth for the year, excluding the impact of currency and new product launches in the U.S. driving incremental sales. These contributions will be partially offset by continued pressure in our biologics business as we continue to undertake efforts to make improvements and turnaround the level of decline of that business line.

With that backdrop, let me also provide some color on how we see the year playing out. First, we expect the quarterly cadence to revert back to our historical averages versus what we saw last year, meaning revenue should be higher in the second and fourth quarters with typical seasonality and lower in the first and third quarters. The first quarter 2017 will be our hardest comp due to a couple of factors. Recall that in the first quarter of 2017, we reported the strongest growth in our U.S. spinal hardware segment before we saw the slowdown in the U.S. spine market at midyear.

In addition, biologics declined approximately 6% in Q1 of 2017 or less than half the rate it was down as we exited the year. Second, we anticipate new product launches from the second half of 2017 and those launching in 2018 to run through the year, and have a greater impact in the back half of the year. Third, West Carrollton year-over-year gross margin impact will be slightly favorable in Q2 and come significant accretive to margin improvement in Q3 and Q4 of 2018. We will get there by increasing manufacturing volumes with decreased overhead cost and realization of operating efficiencies.

U.S. spinal hardware revenue is expected to be flat to up 2%, driven by the adoption of more than a dozen new products we launched last year, including our lateral procedure portfolio, enabling single-position surgery, the continued adoption of our ReLine posterior fixation system, TLX and MLX expandable cages and our titanium Modulus interbody.

We expect U.S. surgical support, including SafePassage, to grow approximately 8%, driven by increased contribution from our core NuVasive clinical services account, disposable pull through and the addition of SafePassage. We expect U.S. surgical support on an organic basis to grow approximately 1%. Biologics will continue to be down year-over-year, however, at a rate lower than how we exited in 2017. For 2018, on a constant-currency basis, we expect international to grow approximately 21%, which will continue be fueled by markets like Italy, Germany, the U.K. Australia and Japan.

Our strategy will be to go deeper into markets where we already have a presence and infrastructure, while being opportunistic in emerging markets. We remain confident in our ability to nearly double our current international market share over the coming years. We expect non-GAAP gross margins to be approximately 74% for 2018 or 10 basis points higher than prior year. The lower gross margin profile of SafePassage, which is in line with our current NCS business, will create a headwind of roughly 70 basis points along with pricing erosion, overall for the company of 40 basis points.

These headwinds will be partially offset by the full ramp of our new West Carrollton manufacturing facility, which will deliver 130 basis points of benefit in 2018. Like I discussed, we have a good plan in place on how to significantly neutralize the headwinds shared by the end of the second quarter 2018 and really gain momentum in the second half of the year. We anticipate full year 2018 non-GAAP R&D expense to be approximately 5.3% of revenue, an increase of 40 basis points over 2017.

We will continue to invest in innovation to develop new and differentiated products and technologies each year. We expect to expand non-GAAP operating profit margin to 17.6% for 2018, an improvement of 100 basis points versus 2017 performance, driven by improvements in manufacturing efficiency, operating expense initiatives that include sales force enhanced efficiencies, disciplined SM&A spend and scale we're achieving as we continue to grow our International business.

For 2018, we expect our non-GAAP effective tax rate expense to be approximately 24%, including the provisional impact of the U.S. tax reform. The company estimates non-GAAP earnings per share for the full year of 2018 in a range of $2.44 to $2.47 or 28% to 29% increase in EPS over our performance in 2017. On a GAAP basis, we estimate the range to be $1.56 to $1.59 per share. You can find further details of our GAAP expectations on nuvasive.com or in today's press release.

Now I'd like to provide greater clarity in terms of expectations for the first quarter 2018 for your modeling purposes. We anticipate revenue for the first quarter to be in the range of approximately $259 million to $262 million, inclusive of SafePassage. From a profitability perspective, we expect pressure in our gross margins, driven by continuous headwinds from the ramp up in production of West Carrollton in the first half of the year and the acquisition of SafePassage, which has a lower gross margin profile.

While we anticipate being able to offset a portion of these pressures with growth in our International business and controlled spend, we do expect lower gross margins in Q1 of 2017. In terms of operating margins, keep in mind, we historically have lower operating margins in the first half of the year than the second half, which this year, is amplified by the ramp up in West Carrollton.

Finally, I have a housekeeping item to go over. As many of you know, a new revenue standard under the ASC 606 is required for all public companies, including NuVasive, in 2018. For NuVasive, the impact is generally a timing issue on when revenue and its related cost is recognized. We have adopted this standard using a full retrospective method, which will restate prior periods revenue and associated costs to reflect the change in the method of revenue recognition. We believe this method will allow for better comparability from period-to-period. For details of the impact of the change, please refer to our Form 10-K, which we will file today, as well as the reconciliation we will make available on our website as part of the supplemental we file every quarter.

In closing, while 2017 had its challenges, I don't want it to be lost that we continue to make good progress against some of our most critical and the foundational initiatives that will make and enable NuVasive to continue growing above market rates, taking share from competitors and delivering against our profitability goals. We remain committed to delivering at least 100 basis points of operating margin improvement through the execution of the initiatives we have spoken to.

Thank you, and with that, we will open the call to Q&A.

[Operator]

Thank you. [Operator Instructions] One moment please while we poll for questions. Our first question comes from Matthew O'Brien of Piper Jaffray. Please proceed with your question.

[Matthew O'Brien, Piper Jaffray]

Thanks so much and thanks for taking my questions. Just to start off with on the outlook for the U.S. hardware business, essentially, what you're saying here is you think you're basically going to grow in line with the market. And I get what you're saying about new products coming out later this year. There's just a lot of them with the new lateral products, expandables, LessRay, et cetera.

The comparisons are getting a lot easier for you as well. The biologic headwind isn't going to be as bad, pricing gets a little bit worse. But what is it that you're seeing that's making you a little less bullish on your ability to take meaningful share of what's still a pretty sizable market here in 2018? And then just the follow-up question is, on the pricing side, that continues to deteriorate. Are we're going to get NuVasive being similar to the rest of spine as far as being it down kind of 4% to 5% or is this historically was down 1% to 2%?

[Rajesh Asarpota, CFO]

Yes, Matt, so to your two-part question. This is Raj. So on the U.S. spinal hardware, right, our guidance right now assumes that market conditions generally remain the same as we saw in -- as we exited fourth quarter. So we've been very prudent in terms of guiding at the low end to roughly flat growth. Having said that, to your point, right, as we start to see the traction on new product launches and with LessRay et cetera -- well LessRay is on the surgical side but on the spinal hardware, assuming we get to 1% increase rather than a flat number, we get to about 5.4% organic growth, and at 1.5% which we think is also doable, we get to the 6.6% organic growth.

So I mean, we feel pretty good in terms of making sure that the NPI launches are going to make their way into our revenue growth. On pricing, again we exited Q4 a little bit weaker than how we – what we expected, it was at about 2.7%. Having said that, we would assume 2% guidance going forward in the New Year. And from what we've seen so far, we are basically on budget and the NPI launches, along with some more discipline we have around our deal desk and deal scoring, we expect to keep pricing in that 2% range.

[Matthew O'Brien, Piper Jaffray]

Okay, Raj. But just to be clear, you're not seeing anything on the sales force side in terms of the disruptions or anything material versus what you've seen over the last several quarters?

[Rajesh Asarpota, CFO]

No, no. Absolutely not. I think the just our education and intelligence, our pricing is going up. We see a little bit of vendor consolidation. We're going to be making those price volume trade offs. So it's all good and we expect in the wash to be at around that 2% and not getting any worse than that.

[Matthew O'Brien, Piper Jaffray]

Okay, thank you.

[Operator]

Our next question comes from Josh Jennings of Cowen and Company. Please proceed with your question.

[Joshua Jennings, Cowen and Company]

Hi, good evening. Thanks for taking the questions. Wanted to follow-up on Matt's question on U.S. spinal hardware guidance. Can you just help us think about your surgeon customer base exiting 2017 and whether you were net adders of new surgeons in '17 and what your assumption is in terms of both new surgeon adds for '18 and also do you plan to be a net adders of sales reps as well, net additions to the feet on the street, if you will.

[Greg Lucier, Chairman and CEO]

This is Greg. So yes. In 2017, we exited as net adders of surgeons and we are in our internal plan, planning for further additions of surgeons in 2018, particularly around the single-physician surgery techniques. We anticipate gaining more surgeons via that approach. In terms of adding sales reps, we will be adding sales reps, most certainly outside of the United States fairly aggressively. Inside the United States, we'll continue to do some infill in key markets where we have great density and good penetration to go even further. So yes, there will be an investment in the front end of the business.

[Joshua Jennings, Cowen and Company]

Great. And just one follow-up on the U.S. surgical support and hardware guidance, it sounded, Raj, you talked about ex SafePassage, about 1% growth. Correct me if I'm wrong for the core services business pressure in biologics, but you also have LessRay and surgical intelligence platform in that line item. Any type of directional color or any more detail you can give for the capital business that’s going to be coming more into play for '18.

[Rajesh Asarpota, CFO]

Yes, so I'm not going to give you any specific, but let me just put it this way. If you look at the surgical support business, which is essentially our services business, NCS, the biologics, and LessRay keeping SafePassage out of it, those 3 items in aggregate will be about neutral to growth, right? Because biologics is going to be, like we've said, it is going to continue to decline not any worse than this year, but it's going to -- as it starts to improve, it will still be a driver for the business for a little bit.

The NCS business will be, obviously, growing a little bit along as we kind of -- the comps in the third and fourth quarter were pretty -- we had those billing issues, so those are behind us. And we'll see some of that growth, and LessRay will be a contributor as well. But overall, it's going to be neutral to growth. And in SafePassage, assuming that, that delivers $20 million like we've guided to, will be about a 2% growth number to that portfolio.

[Operator]

Our next question comes from Kaila Krum of William Blair. Please proceed with your question.

[Kaila Krum, William Blair]

Hey, guys. Thanks for taking our questions. So first one, a multipart question on LessRay, and then one on operating margin expansion. So can you talk a little bit more about the foundational work that you're doing in support of this one-stop shop intelligence platform you guys have talked about? I mean, can you expand your platform into just one-stop shop organically? And I guess, what have you learned thus far, as it relates to hospitals' willingness to invest in that sort of a platform through your active trialing of LessRay?

[Greg Lucier, Chairman and CEO]

So to the first part of your question, the LessRay platform is the first installation of a multistep implementation of this surgical intelligence platform. In the fall of this year, there will be further enhancements to that platform. And in our discussions with hospitals, we are laying out a upgraded path that allows them over the course of the next three years to build increasing functionality to create this OR of the future in a very incremental, so they can absorb it, learn it, and use it, in economical way that matches what our profitability of these surgical ORs are for Spine.

So that's the past. In terms of what we've learned, this is a big change for NuVasive. We have a big sales force selling spinal hardware for the most part, and over the next 36 months, they got to learn how to sell not only hardware but systems to drive spine surgery.

As we said in other calls, we've augmented that big sales force with a specialist team that is selling and kind of specializing in that capital equipment pathway and that team will get bigger and bigger. But will never obviously be able to carry the full load in terms of the sales approach because that will have to default back onto the full line spine specialist.

So we're learning a lot. We're getting going, but we think in a few years' time, the competitive dynamics of how you play in spine will have changed. It will be more of a system sell, and we think we're going to be very well positioned over the pathway.

[Kaila Krum, William Blair]

Okay. That's really helpful. Thanks guys. And then just in terms of operating margin expansion, you guys are calling for at least 100 bps in 2018. Can you just talk through the specific drivers, I guess, of that expansion? And specifically, I guess, any pressures that potentially weighed on 2017 that perhaps should ease in 2018?

[Rajesh Asarpota, CFO]

Yes, sure. This is Raj. So if look at where we exited 2016, 2017 at 16.6%, that walk basically gets you 100 basis points in expansion. Part of that, I just alluded to in our in-sourcing manufacturing, right? So we get about 130 basis points of gross margin pick up through efficiencies that we gain by ramping up our sales manufacturing capability. You get another 80 basis points on international scale, right? So as international operating margin improves, as given the historical investments we've made, we'll pick up 80 basis points there.

We get another 90 basis points from essentially sales force efficiency through headcount coverage model, expanding their territory profitability, that type of thing. Pricing, as I alluded to, the 2% erosion equates to about 40 bps of unfavorability in that walk and SafePassage is about 10 basis points of unfavorability as well. And then there's a little bit of internal operating expenses year-over-year that have unfavorability of about 150 basis points. So as you do the math on these three or four elements that I walked you through, you get to the 100 basis points of expansion.

[Kaila Krum, William Blair]

Thanks Raj. That's helpful.

[Rajesh Asarpota, CFO]

Sure.

[Operator]

Our next question comes from Matt Taylor of Barclays. Please proceed with your question.

[Matt Taylor, Barclays]

Thank you for taking the questions. So first question I had was I want to understand through your philosophy behind guidance. I think historically, the company's philosophy has been to be conservative and try to set up numbers that can raise [ph] throughout the year. And I think that was the idea last year, but obviously, a lot of things came out of left field to knock you off that. So my question is wondering when you thought about this year, do you take a different approach in terms of your level of conservatism or you view this guidance as more realistic?

[Rajesh Asarpota, CFO]

Okay. This is Raj. And so as we look at guidance for this year, my direction is that the guidance -- is the guidance is not conservative. It's just prudent based on what we're seeing. As I've been in this chair for the last couple of quarters and kind of what I have seen played out, I'm looking at a guidance that is achievable, is very prudent and has gone through a lot of iterations to get us to the numbers that we think are achievable. The range and some of the commentary I gave earlier definitely leads to ensuring that we meet these expectations within the range.

[Carol Cox, EVP, External Affairs and Corporate Marketing]

Hey, Matt, this is Carol. If I may just add to Raj's commentary, I think we've laid out clearly what our assumptions are, that are going into the guidance. I think if you look at the website deck and Raj's commentary, we made it very clear what we have laid out, what our expectations are. Obviously, if the market were to improve, there are some items that could go in a different direction, but we're clear on what our expectations were there.

[Matt Taylor, Barclays]

Thanks you and thanks for all the detail. So I have one follow-up on operating margins, and you're still keeping a cadence of 100 basis points, but I guess, really, I was thinking about sources of margin expansion from a couple of years ago and your international revenue hasn't going really strongly, that was a big source. So my question is, how profitable that international growth's been? And can you give a sense for where you are on the curve in terms of international margins catching up with your U.S. margins?

[Rajesh Asarpota, CFO]

Yes. So look, if you look at the trend last year, international profitability, right? In Q1, we were at 12% and by the time we exited Q4, we were at roughly 23% and change for an aggregate number of 19.3%. So the margins in international business are -- the profitability is growing significantly. As far as the contribution from the International business to overall 25% operating margin, we think that international scale gives us about 400 basis points of improvement and as those margins go from, like I said, roughly 19% or so today to about 25% in the near future.

[Matt Taylor, Barclays]

Okay, thank you.

[Operator]

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

[Robbie Marcus, JPMorgan]

Hi, thanks for taking my question. I wanted to circle back to the fourth quarter numbers and the U.S. spinal hardware where case volume growth was 5%, offset by pricing and product mix. Can you breakout how much pricing pressure was in the quarter and what was price product mix?

[Rajesh Asarpota, CFO]

Okay. So pricing, like we said, was 2.7%. So that has the biggest impact in terms of growth in Q4.

[Robbie Marcus, JPMorgan]

Okay. But what is it in spinal hardware?

[Carol Cox, EVP, External Affairs and Corporate Marketing]

It's about the same.

[Rajesh Asarpota, CFO]

About the same.

[Robbie Marcus, JPMorgan]

Okay. So as we look to next year with pricing no worse than 2%, I guess, what makes you think that pricing will improve a little bit going into '18 and similar?

[Greg Lucier, Chairman and CEO]

Yes, so I think as I said on your questions, the both of products we launched in the second half of the year and with the products we are launching in 2018, along with the discipline around the deal depth, the deals scoring and how we are managing discounts will make sure that we stay in the 2% zone. And as we started off the year, like I said, in January, we saw pricing improved over the Q4 exit number. So we feel pretty good that 2% will hold and is in line with the guidance.

[Robbie Marcus, JPMorgan]

Okay. And just as a follow-up. I wanted to see if you could give a little more clarity on rep adds in 2017. So how many reps did you add and maybe how many are you expecting to next year?

[Greg Lucier, Chairman and CEO]

No. I mean, they're not providing that level of detail right now. We don't break that out.

[Operator]

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

[Glenn Novarro, RBC Capital Markets]

Hi, good afternoon, guys. Two questions on the surgical intelligence platform you're announcing. Number one, will it have a robotic arm? And then number two, I think, you mentioning in your prepared remarks that you will be launching it later this year. So when can the Street see this platform? Do we have to wait for NASS or could it be sooner?

[Greg Lucier, Chairman and CEO]

You should expect to see the platform at NASS and I think the first part of the question will be answered when we unveil it at NASS.

[Glenn Novarro, RBC Capital Markets]

Okay. And just as one follow-up. Did I hear you correctly? It does include navigation? Because that's the other thing we're hearing most from surgeons that they want robotics plus navigation.

[Greg Lucier, Chairman and CEO]

Yes. Again, I think it's important to look at the text of what we just said. Most surgeries don't require a robot. 70% of them are more straightforward and it is those surgeries that we're focusing on and navigation is a far more impactful tool than adding in a robot. And so I think it's super important that you segment the market properly and then segment it in terms of the right solutions for it.

So navigation has big impact across very complex surgeries as well as what we would say is a little bit more simpler ones, but robotics is really relegated to, at least our view, in terms of economics that will support it that much more complex deformity cases.

[Glenn Novarro, RBC Capital Markets]

Okay, great. Well, look forward to seeing it at NASS.

[Greg Lucier, Chairman and CEO]

You bet.

[Operator]

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

[Joanne Wuensch, BMO Capital Markets]

Good afternoon and thank you for taking the question. Can we go back to the U.S. market, which if I heard you correctly, you're defining as stable? Maybe philosophically, how do you measure stable? And how do you think about it improving from here? Can it improve from here?

[Greg Lucier, Chairman and CEO]

When we use the word stable, we're defining it as relatively unchanged from the trajectory we saw in the final six months of 2017. And so per Raj's earlier comments, we're assuming a flat market. So that's stable in our definition. Can it improve from here? Certainly. But in our guidance, we're trying to be prudent, is the word I would use, and that's just the assumption we've made so far.

[Joanne Wuensch, BMO Capital Markets]

All right. Moving to a more technical one. You have 74% gross margins for the year and you're going to start off, I would assume around 72% in the first quarter. Am I correct in thinking you're 75-ish as we exit the year?

[Rajesh Asarpota, CFO]

74%.

[Joanne Wuensch, BMO Capital Markets]

For the year. But I'm trying to think about the ramp throughout the year. I'm trying to set up the model that way.

[Rajesh Asarpota, CFO]

We'll have to get back to you.

[Greg Lucier, Chairman and CEO]

Yes, we'll have to get back to you.

[Joanne Wuensch, BMO Capital Markets]

But you got the improvement [ph] and you talked about the 130 basis points.

[Rajesh Asarpota, CFO]

Yes, right. Maybe we can provide that color. So the biggest lever there or the needle mover is, as West Carrollton starts to ramp up, and like we said, it's going to be slightly dilutive in Q1, but then start to get accretive in Q2 and then significantly accretive in Q3 and Q4. So as you do the walk up to the 130 basis points, it will be slightly dilutive in Q1 and then start to pick up in the second half of the year, significantly.

[Joanne Wuensch, BMO Capital Markets]

Okay, thank you very much.

[Operator]

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

[Kyle Rose, Canaccord Genuity]

Greats thank you very much for taking the question. So I just wanted to circle back to the sales force here for a quick minute. I mean you talked about the hires over 2017 and I know I think the expectation is to be a net adder in 2018. But maybe just kind of going back to you had some big hires in '16 just from a headcount perspective and I think again in '17. And just maybe overall, just characterize the pace of the productivity ramp you've seen from recent reps that have been hired? I think you also touched on just maybe some efficiencies realized from transitioning from a distributor model to a direct model and just how that ramp has also transitioned as well.

[Greg Lucier, Chairman and CEO]

So I'll give you some color commentary, we continue to add really great reps. In New York City, we did a lift and shift of a competitive team and it is greatly adding to our volume and success in the Burroughs. It's a great example of what I would tell you is that the sales force in NuVasive has never been more stable, never been more equipped to do what they got to do, which is grow share in a flat market.

So we continue to recruit, we continue to recruit in key areas as well as growing our own sales reps, which is the comments, I said in earlier calls, the primary source of how we add spine specialists. What else can I answer? I'm sure there was a second part of your question.

[Kyle Rose, Canaccord Genuity]

Just the overall transition from distributor model to a direct model.

[Greg Lucier, Chairman and CEO]

Right. So we remain committed to the distributor model. We see the model being somewhere around, call it between 60% and 70% direct and then call it 30% to 40% exclusive distributorships. The difference I would tell you though as we now move forward is we expect our distributors to be big time players, to put a lot of their money at work, to take the risks that allow them to be a distributor and not have to use our balance sheet and where I think we've done that well, we're growing very aggressively.

And so you're seeing us support those distributors that have that wherewithal and buy out the ones that don't. But again, the overall mix remains 70-30, 60-40, fluctuating kind of year-over-year depending on our buyouts.

[Kyle Rose, Canaccord Genuity]

Great. And then on the new product front, I mean, you talked about the 5% case volume growth may be offset by higher pricing, but just early contributions from some of the new products you've launched here and I know there's a lot of them, but just maybe the magnitude of some of the new product launches exiting this year and how we should think about those transitioning from a beta launch into a full lunch over the course of 2018, that would be very helpful.

[Greg Lucier, Chairman and CEO]

Yes. We're not going to be able to break out the contribution from new product introductions. Obviously, it's in our internal model. But as you know by our guidance, we've assumed a relatively flat U.S. growth rate. So that tells you, at least our external assumption. Having said that, hopefully you're comforted by the fact that 2018 will be the largest introduction of new products from NuVasive ever.

So we're excited about the ramp of different technologies, whether it's expendables, further iterations of single-physician surgery, the surgical intelligence platform, there is a lot of exciting things coming out that our sales force will have to talk about.

[Kyle Rose, Canaccord Genuity]

Great, thank you very much for taking the questions.

[Operator]

Our next question comes from Mike Mattson from Needham and Company. Please proceed with your question.

[Mike Mattson, Needham and Company]

Yeah, a couple of questions on the service and support business. So, I guess, first, if the spine market is flattish, why is the service business declining? And then why do the SafePassage deal, if this is not a growth market? And then I was wondering if you could just give us some more details around biologics and specifically what you're doing there to try to turn that business around and how much of that falls cutting the price on the Osteocel product? Thanks.

[Greg Lucier, Chairman and CEO]

The services business is, we think, a good growth business and that's because we see a move towards professionalization of that service. There's consolidation opportunities where hospitals want to stop doing it with mom-and-pops and consolidate around a more professional vendor. In terms of reconciling that view with the last two quarters of our clinical services business, we learned some important lessons on how to sell that service in the last 6 months and I think we've got to retool the approach you in 2018 to put more feet on the street, more client services people to make sure we don't lose customers. So there's a whole host of changes that have been implemented in January that we're pretty confident about.

[Mike Mattson, Needham and Company]

Okay. And just on biologics

[Greg Lucier, Chairman and CEO]

Biologics. Biologics is off to a good start in 2018. I think the new leader, with the new leadership focus, doing a nice job revitalizing where we've got to be on price, putting us into the right bids and he's been able to stem the rate of decline so far this year. So knock on wood, we hope we can continue their progress. But we're focused, we see results and that's starting to hopefully bear fruit in the first quarter.

[Mike Mattson, Needham and Company]

Thank you.

[Operator]

Our final question comes from Ryan Zimmerman of BTIG. Please proceed with your question.

[Ryan Zimmerman, BTIG]

Great, thanks for squeezing me in. So I just want to follow-up on the neuromonitoring business for a second. That business as a whole continues to be a very fragmented market and I just want to get your thoughts on whether we can see further consolidation in that market given that you guys have been a net consolidator in that space.

[Greg Lucier, Chairman and CEO]

The answer is yes, but we're going to do it at a prudent pace. And I think from the earlier comments you're hearing that a lot of the growth can also happen organically. And so we're focused on that here in the first part of 2018, integrating SafePassage. Great leadership team there with our leadership team, getting greater density in our key markets, putting more feet on the street to sell the services, but there is no shortage of acquisitions we can make.

But I hope you can see by our track records so far, we've been fairly disciplined in deploying capital in only the right assets, which SafePassage was one of them.

[Ryan Zimmerman, BTIG]

All right. Appreciate you taking the questions. I'll leave it there. Thank you.

[Operator]

Ladies and gentlemen, we have reached the end of our question-and-answer session. I'd like to turn the call back over to Mr. Greg Lucier for closing comments.

[Greg Lucier, Chairman and CEO]

Well, thank you, everybody for calling in on the fourth quarter and full year 2017 call. We look forward to speaking to you in April when we report out our first quarter results. Have a good afternoon.

[Operator]

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation.