Integra Lifesciences Holdings Corp (IART) 2018 Q3 法說會逐字稿

Good day, and welcome to the Integra LifeSciences Third Quarter 2018 Financial Results Conference Call. Today's call is being recorded.

At this time, I would like to turn the call over to Mike Beaulieu. Sir, please go ahead.

Thank you, Katie. Good morning, and thank you for joining the Integra LifeSciences Third Quarter 2018 Earnings Conference Call. Joining me on the call are Peter Arduini, President and Chief Executive Officer; Glenn Coleman, Chief Financial Officer and Corporate Vice President of International; and Sravan Emany, Senior Vice President, Strategy, Treasury and Investor Relations.

Earlier this morning, we issued a press release announcing our third quarter 2018 financial results. The release and corresponding earnings presentation, which we will reference during the call, are available at integralife.com under Investors, Events & Presentation in the file named Third Quarter 2018 Earnings Call Presentation.

Before we begin, I'd like to remind you that many of the statements made during this call may be considered forward-looking statements. Factors that could cause actual results to differ materially are discussed in the company's Exchange Act reports filed with the SEC and in the release.

Also, the discussions will include certain non-GAAP financial measures. Reconciliations of any non-GAAP financial measures can be found in today's press release, which is an exhibit to Integra's current report on Form 8-K filed today with the SEC.

I'll now turn the call over to Pete.

Thank you, Mike, and good morning, everyone. If you turn to Slide 4 in the earnings presentation, I'd like to start by sharing a few highlights from the quarter.

Total sales in the third quarter were $366 million, an increase of 31% on a reported basis, and 6.2% on an organic basis over the prior year. Adjusted earnings per share were $0.59, an increase of 31% compared to the third quarter of 2017.

Our performance in the third quarter showed continued improvement, and our commercial teams achieved their plans in most areas. While total reported revenues were at the low end of the guidance range on a constant currency basis, our profitability and organic growth were in line with our guidance, and operating cash flow exceeded expectations.

The execution of our Codman integration plans remains on schedule, and as previously communicated, we're now managing all commercial support services and functions in the U.S., Canada, Australia, New Zealand and China. Most recently, we successfully completed the transition of those services and functions for Italy and Mexico. Taken together, these countries represent roughly 65% of the global revenues associated with the acquired Codman business.

Earlier this month, we also successfully converted the manufacturing plant in Switzerland to our ERP platform and now have full operational control of this facility. This represents a critical milestone given the key strategic products that we manufacture at this facility.

The next step in the integration plan is to exit the transition services agreements in Western Europe, which will largely take place in the first half of 2019. The services are very similar to the first wave of TSAs that we exited in the U.S. and that transition will position us to manage all commercial support services and functions in approximately 15 European countries, including France, Germany and the U.K. We have completed the planning required for this transition and we'll have the necessary resources in place before the end of this year.

Upon completion of this exercise, we will have transitioned over 85% of the acquired Codman revenue to Integra's operating control. After the conclusion of that exit, the largest remaining country to move off the TSA agreements will be Japan and its transition is expected to be completed by the third quarter of 2019.

Moving to our OTT segment. Organic sales increased 11.5% in the quarter despite disappointing performance in our orthopedics business, which declined mid-single digits year-over-year. Double-digit growth in Regenerative Technologies drove OTT's results for the quarter. We sell these products through our Acute Wound Reconstruction, Advanced Wound Care, Surgical Reconstruction and private-label franchises, all 4 of which made great progress in the third quarter.

We're very pleased with the continued sales momentum in Acute Wound Reconstruction, which increased double digits and accelerated sequentially from the second quarter. This acceleration resulted directly from the investments we made to expand the sales channel, both domestically and internationally.

The Advanced Wound Care franchise, which makes products used in outpatient procedures, grew high single digits, demonstrating strength across the portfolio. We expect growth to accelerate in the coming quarters based on continued market expansion and our broad product offerings.

As many of you know, Integra was recently selected as the primary provider of cellular tissue products for the Healogics iSupply program. This is a multiyear growth opportunity that provides preferred access to the roughly 700 wound care clinics that Healogics manages. The potential from this program and similar enterprise contracts gives us confidence in the growth trajectory of our Advanced Wound Care business.

As I reflect on the priorities and progress in 2018, we've made significant changes that we believe will position the company for faster growth over the long term. The integration of the Codman business has gone better than expected, including the realignment of all our global sales territories. And we continue to exit TSAs without major disruption, and we have integrated our product development efforts and advanced a number of new product introductions that will be launched in the first half of 2019.

In our OTT segment, the channel expansion we announced earlier this year was designed to improve sales growth in both our Acute Wound Reconstruction and Extremity Orthopedics franchises.

In our Acute Wound Reconstruction business, we're already realizing the benefits from this expansion, which was completed in the first quarter in the form of improved clinical focus, better account coverage, and ultimately, accelerating sales. However, in our orthopedics franchise, where we completed the expansion at the end of the second quarter, these benefits are taking longer to realize as evidenced by the mid-single-digit sales decline we experienced during the quarter.

We believe we have the right people and right teams in place, but meaningful progress in this channel will likely take several more quarters to allow the sales force to mature in their new territories. As a result, we have lowered our full year 2018 revenue growth expectation to reflect this ramp-up period for our orthopedics channel.

The other area I want to discuss is related to the acquired Codman business. The countries that have transitioned and are in full control of commercial operations have performed in line with our plans. However, there are a number of indirect countries outside the United States, representing about 10% of the acquired Codman revenues where commercial operations have not yet transferred to Integra. We refer to these as Day 2 countries, and recently performance in select Day 2 Countries has declined, which we believe is associated with a lack of focus.

As we transition commercial operations and take control of these countries in the first half of 2019, we expect to stabilize the business. Taking the Day 2 country performance and the timing of sales improvements in our orthopedics franchise into consideration, we're revising our 2018 revenue guidance to a new range of $1.467 billion to $1.472 billion with an organic growth rate of approximately 4%.

We have specific plans in place which I just discussed and believe the company is well positioned to accelerate growth in 2019. We're outperforming in a number of businesses, including Regenerative Technologies and our U.S. neurosurgery business and are confident organic sales growth in 2019 will be within our long-term range of 5% to 7%.

With that, I'll now turn the call over to Glenn.

Thanks, Pete. Good morning, everyone. Total third quarter reported sales were $366 million, an increase of 31% compared to the third quarter of 2017 and 6.2% on an organic basis. The acquisition of Codman contributed $79 million in the quarter, puts us roughly flat on a sequential basis for the second quarter.

Before I review the segment performance, let me bridge the $4 million revenue shortfall versus the midpoint of our guidance range that we provided in July. Both areas of our business performed in line with our expectations, including the U.S. Codman business. The 2 exceptions were Extremity Orthopedics and the acquired Codman business outside the U.S.

Relative to the guidance we provided in July, each of these accounted for about $2 million of the revenue shortfall with a stronger U.S. dollar resulting in an additional foreign currency headwind of about $1 million.

Now let me move to review of Codman Specialty Surgical, or CSS, segment shown on Slide 5. Reported sales for the segment grew 45% to $239 million. Organic sales grew 2.4% over the prior year, in line with our expectations.

Moving to franchise performance. Dural Access and Repair had a strong quarter and grew organically over 5% compared to the prior year's quarter. This global strength was driven by mid-single-digit growth in both our graft and sealant product lines. In the fourth quarter, we expect Dural Access and Repair to grow low to mid-single digits, consistent with our previous guidance.

Organic sales in the advanced energy increased high single digits compared to the prior year's quarter, driven by CUSA Clarity sales, which demonstrated growth in both capital and disposable product categories. We continue to receive great feedback on CUSA Clarity from neurosurgeons and the funnel of opportunities remains strong heading into the fourth quarter. As a result, we expect CUSA to grow double digits in the fourth quarter, which also will provide us with double-digit growth for this part of our business for the full year of 2018.

Sales in precision tools & instruments were down low single digits year-over-year. This decline resulted mainly from lower sales in some of our most mature product lines such as stereotaxy and brain mapping and slightly lower sales in our Mayfield cranial stabilization product family.

The remaining 2 franchises within CSS, neuromonitoring and cerebrospinal fluid management, performed in line or slightly better than our expectations.

Total organic sales for the international portion of our CSS business were flat in the third quarter compared to the prior year. We saw strength in Asia Pacific, most notably in our advanced energy and dural repair franchises, which was offset by lower sales in Europe.

Based on our performance in the CSS segment through the first 9 months of the year and our revised forecast for the Codman business outside the U.S., we're reducing our organic revenue growth guidance for the segment by 0.5 point. We now expect organic growth of about 2.5% for the full year 2018, specifically as a result of the lower forecast for Day 2 country revenues. And as a reminder, Codman revenues will become organic in the fourth quarter.

Let me now move to our Orthopedics & Tissue Technologies segment on Slide 6. Third quarter sales were $127 million, representing an increase of over 11% on both the reported and organic basis compared to the prior year. During the third quarter, the commercial expansion strategy drove nearly 13% organic growth within Regenerative Technologies.

As Pete mentioned, in the acute setting, we have market-leading products and sales reps who've been able to spend more time with clinicians, both of which are translating into stronger growth. We also saw continued strength in our Advanced Wound Care business, which grew high single digits in the third quarter over the prior year, mainly driven by PriMatrix. Consistent with our commentary in July, we expect low double-digit growth in our regenerative products in the fourth quarter and for the full year.

Sales in our private label business grew 20% over the same quarter last year led by continued strong demand from existing private-label partners, new partner agreements and easier comps versus last year's third quarter. We expect to see another solid quarter of growth in private label in the fourth quarter.

Third quarter sales in orthopedics decreased about 5%. Growth in our U.S. ankle product lines was not enough to offset the performance in our lower fixation portfolio, which is down mid-teens. As Pete discussed, the benefits of our channel expansion in this part of our business will take several more quarters to reach our expectations. As a result, we've assumed no incremental improvement in our orthopedics business in 2018 and believe that new product launches such as our XT ankle revision and our new fusion nail called the Panta II, coupled with the larger fully developed channel will drive improvements in 2019.

International sales in OTT increased high single digits, driven by sales of Regenerative Technologies in EMEA and Canada. For the OTT segment, given my comments in orthopedics, we're lowering our previous full year 2018 guidance and now expect reported revenues to increase approximately 9% and organic revenue to increase in the range of 6% to 7% over the prior year.

Please turn to Slide 7 where I'll review highlights from our third quarter P&L performance and provide full year 2018 guidance. We're adjusting the midpoint of our full year 2018 total revenue guidance to $1.47 billion, representing a reduction of about $13 million from the midpoint of our previous guidance range. This reduction reflects a slightly larger fourth quarter impact in actual dollars as compared to the third quarter from orthopedics and Codman Day 2 countries, along with increased foreign currency headwinds. We now expect organic growth to be approximately 4% for the full year.

Let me now move to some of the profitability metrics in the third quarter. Adjusted gross margin was 67%, a decline of 170 basis points compared to the prior year, largely resulting from the expected dilution from the acquired Codman business.

Based on our performance through the first 9 months of the year, we're now projecting a full year adjusted gross margin of about 67%, which reflects the impact of lower volumes than previously planned.

Adjusted SG&A for the quarter was 41.4%, an improvement of 230 basis points from the prior year's quarter, driven by better leverage of G&A costs enabled by the Codman acquisition, which we expect to continue into the fourth quarter.

Our adjusted EBITDA margin for the third quarter was 23%, an improvement of 40 basis points compared to the prior year. For the full year, our guidance for EBITDA margin remains in the range of 23% to 24%, which at the midpoint of our guidance range would give us 88 basis points of EBITDA margin expansion over the prior year.

Our adjusted tax rate for the quarter was 17%, an improvement of 650 basis points from the prior year, primarily driven by the changes to the U.S. corporate tax laws as well as the benefit of higher income being generated in low tax jurisdictions.

Adjusted earnings per share increased 31% to $0.59 compared to $0.45 in the same quarter of the prior year. Higher sales, EBITDA margin expansion and a lower tax rate drove this increase.

Based on our performance through the first 9 months of 2018 and our outlook for the fourth quarter, we're maintaining our EPS guidance despite the reduction in revenues. This is a result of improved cost management, better G&A leverage and lower interest expense.

Our updated full year 2018 guidance implies a fourth quarter revenue range of $378 million to $383 million and adjusted EPS of approximately $0.62 at the midpoint of the implied guidance range.

As we begin to look out to 2019, we remain confident that organic revenues will be within our targeted long-term range of 5% to 7% and I would encourage you to model the low end of that range until we report our full year 2018 final results and provide detailed financial guidance on our February earnings call.

Please turn to Slide 8 for a discussion of our cash flow performance. Our operating cash flow in the third quarter of 2018 hit a record high of $79 million. This performance was driven by improvements in working capital, improved profitability and the timing of cash payments from J&J associated with the July completion of the first wave of TSA agreements.

Based on the strong performance through the first 9 months of the year, we now expect our operating cash flow for the full year to exceed $180 million, which is $15 million above the high end of the previous guidance range.

Our capital expenditures were $17 million in the third quarter, an increase of $9 million over the prior year, primarily related to the establishment of our new manufacturing site in Massachusetts. We expect an elevated level of capital expenditures through mid-2019 as we build out this new manufacturing site and expand the infrastructure outside the U.S. After we conclude these initiatives, capital expenditures should return to more historical levels.

Our free cash flow conversion for the quarter was 51.8% on a trailing 12-month basis. And based on our performance year-to-date, we're slightly raising guidance for our full year free cash flow conversion.

As we now turn to Slide 9, I'll wrap up with a brief update on our capital structure. Our cash balance as of September 30, 2018 was $206 million with net debt of about $1.2 billion and a consolidated leverage ratio as defined in the bank covenants of less than 3x, which is better than the target we set at the beginning of the year. In the fourth quarter, we plan on repatriating approximately $100 million of cash to further reduce our total debt, after which, our ratio of fixed to variable rate debt will be approximately 70% fixed and 30% variable.

And with that, I'll turn the call back over to Pete.

Thanks, Glenn. If you turn to Slide 10, I'll provide some closing comments. We are disappointed that we're lowering our organic revenue growth for the full year. And as discussed, the timing of our sales ramp in orthopedics and a more conservative view of our ability to achieve revenues in Codman Day 2 countries were the primary contributors to this decision. That being said, we know how to fix it.

We're confident that we have the right teams in place in our orthopedics business. And as our reps continue to establish themselves in their territories, they'll be supported by several new product launches planned for early 2019. We believe that taken together, these 2 factors will result in improved performance in this segment in 2019.

Likewise, many of the Codman Day 2 countries will transition and come under our full commercial and operational control at the beginning of the second quarter. Plans are already in place to restore their performance once they're transferred to us.

In 2018, the largest acquisition and channel expansion in the company's history impacted nearly everyone at Integra. As we enter 2019, our colleagues will be able to spend a much greater amount of time focusing on driving growth of the business. Together with the momentum that we're already seeing in the Regenerative Technologies and our U.S. neurosurgery business, along with 10 new product introductions in clinical studies, we're confident that we can achieve organic growth in line with our long-term targets. We look forward to updating you on our progress in February.

That concludes our prepared remarks. Thanks for listening. And operator, would you please open up our lines for questions.

(Operator Instructions) Our first question will come from Ryan Zimmerman with BTIG.

So first one on the gross margin pressure you saw this quarter and then secondly on the leverage ratio. Just can you talk about the gross margin pressure you did see and subsequently, the implied gross margin guidance for FY '18 certainly suggesting continued pressure on gross margins in the fourth quarter, but just in light of the growing proportion of sales in wound, I mean how should we think about your gross margins improving or lack thereof into FY '19? And can we expect more -- a return to more normalized levels in '19?

This is Glenn. Thanks for the question. If you look at the gross margins in the quarter, I would say the things that negatively impacted us were twofold. First, the mix, while regen was higher, keep in mind, the Extremity Orthopedics business does have higher gross margins versus the corporate average and private label carries lower gross margins and had pretty stellar quarter with 20% overall growth. So the mix itself was not necessarily favorable in the quarter coupled with the lower volumes and, in fact, we had less fixed cost absorption on the lower sales. Those are kind of the 2 main drivers. Nothing of great concern when we look at where we ended up on gross margins in the quarter. Given where we are year-to-date, we took our gross margin levels down to 67%. As we go forward to 2019, I would certainly expect to see an improvement in gross margins in 2019. If you look at the momentum we've got in the regenerative side of the business, which we'll surely talk about more on the call, growing 13% in the quarter in OTT, dural repair doing quite well, that's going to help our gross margins from a mix perspective as we go into next year. More portfolio rationalization in 2019 eliminates some of the lower-margin SKUs. In the manufacturing area, we've done a lot to automate certain facilities. So our new collagen plant is now fully equipped with robotics and will actually drive more efficiency in certain manufacturing plants like the plant next door here in New Jersey. And then longer term, we're still quite excited about the new Codman facility. I'm certain that once we roll off the J&J TMA in Massachusetts, we'll see a very nice pickup. That's still a few years away, but clearly, that's going to be a driver to improving gross margins over the long term. And I guess, just the last point, we'll talk more about new product launches in 2019, as Pete mentioned about 10 new product launches that we're excited about. In general, I would say all these new product launches are going to carry higher gross margins than previous versions of these products. So that should help us going into 2019 as well.

Okay. And then just turning -- your leverage ratio has come down pretty precipitously over this year, so kudos on that, but how does that change your plan internally as you've gotten it below 3. You've talked about becoming more acquisitive again. So can we see an acceleration even as early as the fourth quarter in terms of how you think about acquisitions or potentially certain tuck-ins that you can add to the bag?

Yes, Ryan, look, I think we're now at a position here that we're aggressively looking at the right types of tuck-ins and assets that we could bring in to the portfolio. There is clearly parts of the company that are very much cranking and unaffected by integration or any of those areas. And so they would be probably some of the more earlier candidates. But as we go into '19, I think even as we start the year with where the balance sheet is and our bandwidth that we have, we feel quite comfortable looking at multiple tuck-in acquisitions. And I think our goal next year would be at least to do a few tuck-in acquisitions to fill out the bag. And particularly, as we now have this larger commercial sales force in different countries around the world than we had before, our capacity to do licensing partnerships as well as acquisitions and just take a given product and add it into the bag goes up. So I think we're -- now at this point in time, we feel quite good about starting to take a hard look at acquisitions and bring them into the portfolio.

Our next question comes from Robbie Marcus with JPMorgan.

This is Christian on for Robbie. Maybe a quick one on dural repair. Saw another nice improvement in the quarter to growth of north of 5%. Maybe if you can provide some color on why it keeps decelerating into 4Q to low to mid-single-digit growth instead of a continued improvement. And then, is there an opportunity for faster growth there with a potential disruption at HyperBranch as it transitions to the Stryker portfolio?

Christian, I'll just comment and Glenn, you can jump in. I think it was a good quarter, and I think this is a good example of seeing the breadth of the expanded neuro sales force. Recall that we're probably up 30% in the U.S. and above that outside the United States. So we're starting to get, particularly in the U.S., the comfort of the team being able to reach more deeply into the accounts and I think we're seeing the benefit. I think our reduction of growth rate in the fourth quarter is simply tied to we had a very nice record year last year. So the comps are a little bit more challenging. But I think as we go forward with a larger sales force, our contracting capability between dural onlay products as well as sealants, I mean, we feel quite good about that ability to continue to grow. To the point about disruption, are there opportunities there? I'm sure there are, but I don't think we think that they're significant in the transfer of a product into a major player that way, but Glenn, I don't know if you want to add any other comments?

Yes, just a little other color. So just keep in mind, we've spoken about the Codman portfolio growing slower than the Integra portfolio until we get these new products launched. One of those products in the dural graft called DuraForm we sell outside the U.S. So in Q4, that becomes organic for us. So we're still modeling to the low to mid based upon that will enter into the organic growth calculation. And then, when we look at opportunities, probably the biggest opportunity we have in 2019 is around launching DuraGen in Japan. And so that's a big product launch for us. We're expecting that to happen early second quarter. Obviously, we're doing what we can to get that done sooner, but that's kind of a nice opportunity that could drive some incremental growth in 2019 outside the U.S.

And then maybe one higher-level question. I know you're not formally giving 2019 guidance today, but you did mention that number should probably be at the lower end of your 5% to 7% organic growth goal. I think The Street going into the quarter was closer to 6% and that's off of a 5% in 2018. So maybe you could just give us some of the puts and takes of a lower 2019 growth backed on a lower 2018 growth and kind of what's your thinking behind there?

Well, Christian, we're not going to get into the breakouts for what our guidance would look like for next year, but just on a higher-level view, I mean, it really comes down to this fact that we've had this very large sales force expansion. And as we'll exit this year, all of those folks will be, I'll say, in mature positions as far as being ramped up. Glenn mentioned some of the catalysts we have. We have a bunch of registrations. The DuraGen in Japan is a good one. And we also have a bunch of new products, particularly in certain areas like in hydrocephalus management, which was a very big high-value asset that we picked up in the Codman deal. We have a bunch of follow-along releases and there have been some recent FDA approvals. And then we've got some really nice dynamics going on in Advanced Wound Care. I mean, we're really excited about the inpatient growth that we've already seen, the pickup we're starting to see in outpatient and that coupled with some bigger contracts that moved us from being 1 of 6 or 7 competitors to being the preferred player gives us good confidence that we can grow. And majority of that growth is at margins that are accretive to the company average. So that's kind of the broader list of items as we get through these 2 items, the Day 2 countries and the lagging performance in orthopedics. Even without those 2 having to turn around significantly, we have a bunch of other catalysts even as we start the year that we feel good about.

Our next question comes from Raj Denhoy from Jefferies.

Maybe, Pete, I could ask a bit about the sales force, the orthopedic tissue sales force. As we've started this year, that transition was, I think, one of the big events. And it sounds like part of what's happening is that, that sales force is simply not gaining traction as quickly as you thought they could. So maybe you could give us little more as to why you think that is and what gives you the confidence that as you move into 2019, you'll start to see that traction develop?

Yes, Raj, thanks for the question. So again, just to kind of repeat what we did. At the beginning of this year, we took a legacy sales force that sold primarily inpatient wound care products and our orthopedics -- it's been like that for over plus a decade. It really started out that way as the cost of sales vehicle. As we've grown, we really needed to split it to accelerate growth. And obviously, as everyone knows, when you split, there is a large opportunity for disruption. I think to your point, the splits went well. We're actually holding onto folks. Folks are feeling very good about their territories. I think the product portfolio that we have now in ankle is a very high quality area. We have some things to fix relative to lower fixation product portfolio. But as we spoke about at the end of this quarter and then beginning into Q1, we'll have some new rollouts that will actually help that out quite a bit. I think the point, though, is our wound care team, whenever we get that channel filled and pretty much have the management as well as all the reps in place by the end of Q1. Between time to hire and also just how many open territories we started with in orthopedics, there was a longer fill time. And I think I mentioned on the last call, the last 30 roles, which were primarily orthopedic, we got filled at the end of second quarter. And I think the team was just a little optimistic that we could see the pickup faster here within the third and fourth quarter and actually what it would come down to. I would say disruption is pretty minimal. It's really the lack of productivity that we're seeing with new folks in those territories. And what gives us confidence is, we have views into the funnels, we have views into the new products that are coming out. And with the increase of the footprint and not having people moving in and out of territories, we just feel pretty good that we'll be able to pick it up. Now my expectations aren't necessarily moving to get market or exceed market growth, our first expectations are just to get back to that this be a positive grower within our portfolio and move to be an accretive player over time and that's kind of how we think about it as we go into '19.

So maybe just to stay on the orthopedic piece a little bit because, again, for the last couple of years, that business has, I think, been questioned in terms of whether you need to be in that business given your scale in it and the results have been a little choppy. And now again, it sounds like it's mostly the sales force issue, but does the results in orthopedics kind of raise those questions again about whether it's an area you guys need to be in?

So Raj, it's about $100 million business for us. And so if you think about where we've been at one point in our career, where ortho was 30-some-percent of the business and now it's under 10% of the business, that's obviously a question that gets raised quite a bit to us, but I think the key is there is still a lot of synergies with our regenerative portfolio and that's why we like extremities. If you think about it in the lower area, there is nerve products for repair, there is tendon repair. If you go to the upper extremities, there's lots of different soft tissue solutions, particularly nerve, tendon, skin. So we think that the synergies there are significantly greater than, say, when we were in the spine business, when it was limited with our broader regenerative portfolio. That being said, these changes are the changes that we think are going to make the difference. I wish I could have done them 2 or 3 years ago, but we just didn't have the bandwidth to do it. But to have the dedicated sales force, which is kind of the bar now in the market that we compete, to have the right located clinical capabilities that we now have in our Texas facility, actually, I think we're well set up to be able to grow that. I think as we get into next year, the proof will be in the pudding, are we making progress within that business? But we have all the items in place now that kind of get us on the right track for growth. And I think as we mentioned, a few added quarters should give the sales force the opportunity to kind of get comfortable within their territories and start putting out some bigger numbers.

Our next question comes from Steven Lichtman from Oppenheimer & Company.

On wound care, you touched on one of a couple of things that occurred during the quarter with the Healogics announcement. What impact can that have on your business over the next 12 to 24 months? And how do you feel about the potential to take advantage of the United Healthcare policy, which removed reimbursement for non-PMA products. I know it's a slight headwind near term, but how do you see it as a potential upside driver over the medium term?

Steve, I think that's the multimillion dollar question for us. I would say, as we think about the look going forward, I would say, how we think about guidance is probably one of our biggest wildcards that we have out there. We're as well positioned as anybody within the space to be able to take advantage of the trends that are happening. So there is obviously some disruption that is taking place, there's competition in the marketplace. There is some level of disruption and changes that are tied to reimbursements. I think, to your United point, where 60 some products are not being reimbursed now and there is a small set of 4 to 5 products that are actually there where we actually have a reasonable part of that portfolio tied to our legacy Integra products. So I would say we haven't really baked in big step-ups or changes in that dynamic, but I think we're well positioned. The contracts like Healogics, we don't expect there to be big changes overnight or month to month. But as that is a multiyear contract, as we get out into 2019, we expect that we start making the types of conversions. And to do that, you have to have not just one product, you need to have multiple products in your portfolio. And the fact that we have 2 different amniotic products, we have multiple other engineered as well as natural basic collagen matrices that perform differently. We're starting to see wound care professionals look at their approach and want a toolbox of solutions. And so we think we've got that solution. So one of the things we needed to do better, I think we need more studies out there and prove, I think, on our amniotic products, particularly our new AMNIOEXCEL, which has been received quite well, but has limited reimbursement at this time. We need to get our study completed, which will be done in 2019. And we think that will be -- if the results are positive, we think that, that will have a nice calloused effect. And then the expansion of the sales channel. We're seeing more and more IDNs look at what they use in the outpatient area and the inpatient area and want a contract. And we're one of those players that's a leader in the inpatient world and growing into a leadership position in the outpatient world. So all the signs are there, but I would tell you, we're being cautious at this point and taking it quarter-by-quarter.

Thanks, Pete. And then just a follow up. On private label, part of the pickup this quarter was easier comps, but I think you talked about higher underlying expectations as well based on your visibility on new projects. What do you see is the growth outlook overall for that business as you look out over the next couple of 3 years?

Yes, Steve, it's Glenn. I would say mid- to high single digits is clearly an expectation that we would set. Obviously, we're going to strive to do even faster than that, but mid- to high single-digit growth is in the foreseeable future. And then it comes from a couple of different areas. One is seeing good strong end market demand from existing private-label partners. We are signing up new agreements as well. And so the combination of the 2 supported with increased manufacturing capacity that we now have that we feel quite confident we can grow mid- to high single digits over the long term.

Our next question comes from Travis Steed with Bank of America.

So you commented on organic growth in 2019 kind of being at the lower end of the 5% to 7% range. The Street is modeling 13% EPS growth today. And you typically talk about 12% earnings growth over the long term. So I'm just curious if you can kind of comment on a good starting point for earnings growth in 2019. And also, some of the expenses, if you're cutting down SG&A and R&D, is that something that kind of gets pushed out into 2019?

Travis, this is Glenn. I guess, a couple of comments. We're indicating that we expect to grow within the 5% to 7% range without giving any specific guidance yet. I'd mentioned model to the low end of the range until we get to the February earnings call when we have detailed guidance. So at this point, we're not providing any guidance, only to say that we're going to be within the 5% to 7% range. But given there's still a few months to go before we close out the year, I would just model low end for now. Again, we're very optimistic when we look at 2019 for all the reasons that Pete mentioned earlier around -- we have the Codman business that we control is doing quite well, Day 2 countries should improve, the market dynamics in the outpatient wound, new product launches and so forth. So we feel good about 2019. We'll give more color on top line when we get to February. On earnings per share, we've been very clear. We are going to consistently strive towards double-digit EPS growth over the next 5 years. I think that's the only thing that we're willing to say at this point until we get to February.

Okay. That's fair. And then, maybe the expenses that you're cutting this quarter and for the full year, is that something that gets pushed into 2019 or is this something that's actually getting cut and maybe you can comment on what's getting cut? And then also on the tuck-in acquisitions that you've talked about earlier in the call, just kind of curious which businesses you think could benefit from tuck-in acquisitions at this point. It seems like you have a pretty full bag now in neuro and wound care. Are a lot of the acquisitions potentially going to be in extremities or other parts of your business going forward?

I'll comment on the SG&A piece and Pete, maybe you could talk on the acquisition piece when I finish. But relative to our expenses, we're not necessarily cutting expenses. What we're doing is growing expenses at a slower rate than revenues, getting us better leverage. And the nice thing about it is we're now seeing some better leverage points with the Codman acquisition. If anything, Codman was dilutive to gross margins, but as we look at EBITDA margins, I'm clearly seeing some upside as we go into 2019 and getting better G&A leverage. What does that mean? Year-over-year, for G&A '17 versus '18, we're probably going to be down close to 200 basis points and hitting a number that's probably in that 13.5%, 14% type range. As we go out to the future, there is further leverage we can get on G&A costs. And I would expect some of the targets that we put out there on G&A leverage going into 2022 would clearly put us below the target that we have out there of 12%. But again, we're still growing G&A, but at a much slower rate than sales. Pete, maybe you can comment?

Yes, Travis, on the PG front, I think the point is the field is wide, I think. Certain aspects of our neurosurgery business, particularly like I had mentioned in the United States, it's already performing above our expectations. The ability to roll in some adjunct products that help fill out the bag help actually complete a bigger procedural scenario that give us a better clinical outcome approach. We think there is clearly opportunities there that are going to be coming up. I think our instruments portfolio, which is a broad portfolio with precision-type products and such, there is different areas and services that play into that range. Tissue, even though we have a broad portfolio, there is lots of associated products and devices that make those procedures more successful. So we think there is opportunities there. I think ortho is an obvious one, but I would say, with ortho, we have most of the items we need right now to be able to put up some improved growth. And so that would be an area that I'd say, we're probably more focused on organic here over the next few quarters before we jump into buy mode. And international, now that we have this larger presence, Japan is a great example or China, where we had very small sales forces just a few years ago. We have organizations now big enough that we can pick up assets or partners just in specific countries and plug them into these larger sales channels we have. So I would say across the board, it will come down to the right strategic fit at the right value, but we've got the necks out looking at all of our business because many of these may take a year to find the right fit for the company.

Our next question comes from Larry Biegelsen from Wells Fargo.

This is Shagun in for Larry. So your 2018 organic growth guidance, it implies about 3.5% growth in Q4. Can you help us understand how do you get to 5% to 7% in 2019, given that you're guiding to 3.5% in Q4? Should we expect 2019 growth to be back end loaded? And then I have a follow-up

Yes, so we're not going to comment on how the quarterly sequencing is going to go next year, but I'll just give you some color around 2018 to 2019 ramp. I think we've commented somewhat earlier on these points, but I think the first point is, new product introductions will drive at least 1 point of organic growth year-over-year. We've got 10 new products we're going to be launching, everything from electrosurgical generator to a new ICP monitoring platform; to a toolkit for our programmable valves on the OTT side, an ankle revision; AMNIOEXCEL Plus, which is an amniotic tissue product; along with Panta II, which is a nail fusion product. So there's lots of new products. Those should contribute by themselves at least 1 point of organic growth year-over-year. You then couple that with the channel expansion, the fact that we have less commercial disruption between the U.S. and OUS things that we had in the beginning part of this year, that should continue to drive more improvement in 2019. Pete mentioned just the overall dynamics in outpatient wound care seems to be playing out in our favor. We've won some new contracts. They'll -- moderately improve throughout 2019 in terms of getting traction on those, but being on these big contracts now as a preferred supplier like Healogics will make a difference going into 2019, coupled with the 2 issues that we had here in the third quarter. So keep in mind, Codman Day 2 countries become organic for us. As we get into the back half of next year and we close those countries where we actually take commercial and operational control, we feel quite confident we'll see an improvement in the revenues for those parts of our business. And then, lower extremities, while we're not counting on market growth next year, we are counting on some improvement, especially as we get to midyear of 2019. So if you take a combination of all those things, the channel expansion, new product introductions, Codman improving outside the U.S., favorable dynamics, we feel quite confident we will be in the 5% to 7% range for next year. I would just say in terms of the quarters, just keep in mind, in Q1 in '19, we still have a lot going on relative to the Codman transition. So we have to still cut over all the TSAs in Western Europe, that will be a major exit point for us in all the Western European countries. So that's a big activity going on in Q1. We will be on one common platform globally by the end of Q1. And that's a big deal for us going into Q2 and having everything on one common platform. But overall, when you look at Q1 year-over-year, we had a lot of disruption in Q1 of '18, clearly not the same level in 2019. I think that's all we're going to actually comment on.

That's extremely helpful. The second question I had was on Stryker recently purchased HyperBranch. And our checks indicate that 90% of your U.S. DuraSeal sales are used in cranial applications, including off-label use and these revenues are associated with very high gross margins of well over 85%. I was just wondering, how we should think about the impact of this acquisition on your P&L, especially beyond 1 year because it does seem that you do have some contracts as well as some opportunity for the conversion of fibrin glue market? So if you can provide some color there, that would be great.

Yes, first of all, I don't agree with your data, but we compete against Stryker in dural repair and have for over a decade plus on. The online market, we compete directly and have done quite well on that head to head comparison. We've obviously been competing against HyperBranch around the world for some period of time and in the United States. And I think as someone who is formidable as Stryker comes into the area, they pick up a product that only has indications for the cranial, it doesn't have indications for the spine. The market is half spine and half cranial where we have 2 products that actually meet that need. Obviously, clinicians make decisions how they want to utilize that product, but our ability to promote in both of those areas is a big differentiator for the United States. And we think when it comes to our sales force, time in the OR, how we go to market, we think we're well positioned to be competitive. Could there be some disruption in the short term as Stryker moves off of distributors to direct? I suppose so. Over the long run, is there some pressure on our short-term share? I suppose so. But over the long run, the biggest opportunity for both of us is over 50% of the market, some with not using anything or they're using products such as fibrin sealants. And the issue with a human-based fibrin sealant, it just doesn't last long enough to assure that there won't be a leak. And we have good clinical data on that done at some institutions such as Johns Hopkins that shows that. So I think in the end of the day, I think 2 viable players in the marketplace talking about the benefits of polyethylene glycol and how it can make a difference ultimately is going to drive the overall market, and I think both of us will end up performing reasonably well in the area.

Our next question comes from Amit Hazan from Citi.

This is Phil on for Amit. I don't want to belabor the HyperBranch point, but I think when we sort of talked about it this time last year, longer-term contracts and breadth of bag were 2 of sort of the key lynchpins for longer-term share maintain. So I'm wondering, I think I heard most of your points just now, but is there anything you can say to the importance of breadth of bag in terms of still being able to maintain share in this market?

Well, I mean, in neurosurgery, we clearly have the largest portfolio from craniotomy all the way through the neuro ICU. It's relative to the products and the breadth compared to Stryker, we're significantly larger as far as the amount of that bag. But that being said, I think how you go to market, our guys spend so much time either being in a tissue ablation case for a tumor resection, a traumatic brain injury associated with what they need to do in the OR, this will come down to that direct one-on-one contact with the surgeon. Again, DuraGen versus all the other products out there, we deal with this all the time. So again, this has been one of the major impact points that we've dealt with really over the last plus-decade and we've done quite well. But again, I think if we think about this as there's one fixed pie and is Integra going to give up a couple of points a share and is it going to go to another company? I think that's missing the point. I think the bigger point here is, the opportunity to actually expand the market here is significant. And I had an owner of the company of HyperBranch that really didn't invest in clinical development or professional education. And I think for a large company, as a large competitor that will -- want to invest in these areas, we think that's only going to help everybody grow. So that's how I think about this market will play out from that standpoint. And again, we interact and play with all the big guys competitively in neurosurgery and have over the years. I'll also remind you, we still have litigation actually with that product on a particular part of this, which is the applicator delivery and still feel very confident in what that litigation looks like.

Okay. Great. That was all helpful color. There's 2 quick clarifications, if I could. I think they probably fall toward Glenn. Glenn, when you're talking to 2019 incremental improvements on the Day 2 Countries, can you just clarify if -- the countries that have been something of a headwind this quarter and for the remainder of the year, they're basically all included in that first half TSA transition, is that correct?

So keep in mind, there's no TSAs attached to these Day 2 countries and countries that we do not control operations or commercial activities. So what happens is once we transition these countries in Q2 of 2019, we will fully be running those countries day 1. So there is no transition involved. And usually the reason why it takes longer to close these is we have to get the regulatory approvals in place and the transfer is complete, it is usually the long gating items. So question really is why don't you just close them sooner? Things have to happen in order for us to close, or transition these countries...

Legal, regulatory changes, things of that nature.

Legal, regulatory changes, but once we take control of these countries, obviously, we have plans in place to stabilizing and grow. So for example, as you could imagine, today the distributors that are carrying the Codman products, they're carrying many other J&J products and this is not a priority focus for them. The changes that are going on is not a priority for them today. When we take these over, these will be front and center in our distributors. We ask our distributors for minimum commitments to ensure accountability around sales and sales growth. We're going to drive much more aggressively on the tendering process. A lot of education around the product portfolio, we will drive in country. So there are a whole bunch of things that we will do when we transition these countries, that's not happening today. So that's why we feel confident that once we takeover control commercially, we'll see an improvement, but that really happens in the second quarter, mid-June of 2019.

Okay. That's a great color, Glenn. Just one quick one, if I can follow up on the currency headwind that was called out for 4Q. Is it fair to think about the impact worsening may be just a bit from 3Q levels and then obviously on a bigger revenue base given the organic that's rolling in, is that fair?

Yes. So in total versus where we were in July, we've got an additional $3 million of FX headwinds. It's about $1 million in Q3 and $2 million in Q4. That's the way to think about the additional headwinds into July guidance.

Our next question comes from Jayson Bedford with Raymond James.

Just a couple of follow-up questions. And I don't want to get too far in the weeds here, but if you look at the pro forma growth in those Day 2 Countries, the 10% of Codman revenue that you called out versus the rest of the Codman business, what's the magnitude of the difference in growth rates?

So keep in mind, it's about $30 million of total sales and in the quarter pro forma, we're down double digits.

In those Day 2 Countries?

Yes.

Okay. And then -- that's helpful. And then in terms of just to tag onto the last question, there still seems like there is a lot going on in the Codman business. I don't fully know if I understand all of the dynamics there, but how did the margins improve in the Codman business in '19 versus '18?

Is it about gross margins?

No, more margin or contribution margin. I'm just looking for the relative step-up in '19 versus '18. What are the drivers of that?

Yes, I think it is a function of we now have a business that we've integrated -- or will have integrated. The cost for us to stand the business up should be lower than what J&J is charging us and so we should get better leverage on G&A costs. We still have work to do outside the U.S., but that's how we get better in terms of our operational margins. It's really doing it at a lower cost than we're being charged by J&J. And candidly, even some of the models that we have built around what we thought it would take to stand up this business I believe will underrun those costs. So we feel quite good around the expansion that we would expect for EBITDA margins coming from Codman and really just getting a lot better leverage versus what we were able to do previous. And just to go back on the point on the Day 2 comment, so I talked about being down double digits for our Codman Day 2 pro forma. The businesses that we actually control grew in the low single-digit range, which is what we expect it, to be clear. So those businesses that we actually control performed right in line with what we were expecting. So I want to just make sure that's a clear point here. The entire decline is coming from the countries that we do not yet control outside the U.S. or what we refer to as the Day 2 countries.

Our next question comes from Craig Bijou with Cantor Fitzgerald.

Just a couple of quick follow-ups. On the Codman Day 2, I appreciate your comments there, especially to the last question, Glenn. But when you look forward in Q4 and maybe even first couple of quarters of next year before you take over control, are you assuming that there is more disruption than what has already happened or what happened in Q3? And if so, I mean, is there anything that you can do to mitigate that disruption?

That's a good question. Relative to Q4 in our guidance, I'm expecting a slight deterioration from what we saw in Q3. So we are expecting it slightly worse. Obviously, we're doing certain things to try to stabilize those countries until we actually take control, but we're anticipating in our guidance sequential further deterioration of Day 2s in Q4. So think of it as close to $2 million off of our guidance for Q3. I'm expecting a $3 million reduction versus our previous guidance in Q4, just to put in the context of a total of $5 million. As we go into next year, the key for us is trying to do some pre-planning activity so that once we actually transfer the businesses, we will see immediate stabilization and then grow towards the back end of the year, but we're somewhat limited in what we can do until we actually transfer the businesses.

Okay. That's helpful. And then one other follow-up on the extremity side. I don't think you guys called out shoulder and ankle growth specifically like you have in the past. So just wanted to see if you can provide that color and then maybe if the channel expansion or changes that were made potentially impacted those businesses, which I believe were growing double digits?

So a good question. I would just say on shoulder, keep in mind, shoulder is a distributed model. So the channel changes we've made did not impact our shoulder business. We saw growth in the third quarter in our shoulder business. We feel good we've got good momentum heading into the fourth quarter. So shoulder continues to show healthy growth rates. Again, the channel changes that we made did not impact shoulder because we use distributors to actually sell the products there. Relative to ankle, we saw growth in ankle of mid-single digits in the U.S. market in the third quarter. It's about the same rate we've seen in the previous couple of quarters, but I would say, over the next 12 months, we would expect to see ankle returning to high single-digit growth as we get better productivity out of the extremity metal sales. That's the way I think about it.

We don't think the slowdown in ankle has anything to do with competitive disruption. It was more about our own doing with the territories getting settled. And again, that's part of what we're counting on for some of that recovery here in Q4. But I think that's pretty well understood when we did our analysis that most of that sluggishness that would be associated with the broader ankle portfolio was the territory changes. And now that they're settled and we've got our running points, we feel pretty good that that's going to pick up. Bear in mind as well, we just launched this new product as well within the ankle portfolio, which that we think is actually going to help drive us well. This is the...

XT revision.

XT revision product.

Our next question comes from Jonathan Demchick with Morgan Stanley.

Just one for me. I had a quick one on free cash flow. So very strong free cash flow quarter for you this quarter and raising the guide. While that's encouraging, I also noticed that it implies, I guess, relatively flat free cash flow next quarter. Is there anything specific next quarter that should drive, I guess, a larger drag there? And how should investors be thinking about free cash flow conversion priorities in the next year?

I guess, a couple of comments. So in Q3, I would say, we had about $20 million of timing that was favorable on the J&J TSA exit. So if you remember, back in Q2, we had an abnormally low quarter. People questioned the high amount of receivables we had at that point in time. And so some of them were just timing relative to the J&J TSA and getting payments from J&J as they were running the operations in the U.S. mainly up until July. Even with all the news, we thought we'd a really strong quarter, a record quarter, even excluding that. The timing issue, I just think as we get to Q4, the reason why the free cash flow is, it's got -- it's really not capital expenditures. So as I mentioned earlier, we still have a lot of expenditures we're making for our Mansfield site build-out. And we're also in the final stages of the IT infrastructure builds outside the U.S. So we'll still see a pretty heavy amount of CapEx, which is bringing down our free cash flow in Q4. But again, once we get to 2019 and pass the second quarter, you'll see a pretty steep hockey stick upward on free cash flow improvement. And so we feel quite good about that. We've been paying down debt, got below 3x leverage as a result of that here in the third quarter. And that sets us up well in terms of our acquisition strategy moving forward.

Thank you, ladies and gentlemen, for your attention today. This does conclude today's conference. You may now disconnect.