NuVasive Inc (NUVA) 2017 Q1 法說會逐字稿

Greetings, and welcome to the NuVasive First Quarter 2017 Conference Call. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Ms. Carol Cox, Executive Vice President, External Affairs and Corporate Marketing. Thank you. Ms. Cox, you may begin.

Thank you, Michelle, and welcome, everyone, to our first quarter 2017 earnings call. The company's earnings release, which we issued earlier this afternoon, is posted on our website as is an investor presentation, both of which have been filed on Form 8-K with the Securities and Exchange Commission. We have also posted supplemental financial information on the Investor Relations website to accompany today's discussion.

On the call, we will be covering information that is included in the investor presentation, and I encourage you to access these materials so that you may follow along.

Before we begin, I would like to remind you that the discussions during today's call will include forward-looking statements, which are based on current expectations and involve risks and uncertainties, assumptions and other factors, which, if they do not materialize or prove to be correct, could cause NuVasive's results to differ materially from those expressed or implied by such forward-looking statements. Additional risks and uncertainties that may affect future results are described in NuVasive's news releases and periodic filings with the Securities and Exchange Commission. We assume 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, again, from the Investor Relations section of the NuVasive website.

Joining me on today's call are Greg Lucier, our Chairman and Chief Executive Officer; Jason Hannon, our President and Chief Operating Officer; and Quentin Blackford, our Chief Financial Officer.

With that, I would like to turn the call over to Greg.

Thank you, Carol, and good afternoon, everyone.

NuVasive is off to a solid start in 2017 with our international business exceeding our expectations and momentum building in our U.S. business as we exited the quarter. Earlier this afternoon, we reported first quarter results in line with the guidance we provided back in February, including revenue of $250 million, representing year-over-year growth of approximately 16%. Revenue highlights include our international business achieving greater growth -- greater than 20%, along with acceleration in our integrated global alignment or iGA platform driven by continued adoption of our ReLine posterior fixation system and the recent introduction of cervical iGA. We continue to be pleased with the momentum building in our newly acquired companies.

Before I discuss our results in more detail, I'd like to comment on the dynamics we saw play out during the quarter. On the field sales front, we continue to make strategic hires during the quarter. These long-tenured competitive sales reps have significant experience in spine and are attracted to NuVasive because they understand the value of our end-to-end procedurally-integrated solutions and want access to our leading spine portfolio. We also bring strong relationships with them that we expect will drive surgeon conversions as we head into the second half of 2017 and beyond. Additionally, while cervical volumes in our U.S. business were a bit softer in January and February, we saw those volumes ramp up in March. We exited the quarter more in line with our internal expectations. The softness in the U.S. was offset by strength in our international business.

Now let me elaborate on first quarter U.S. revenue results. In our U.S. spinal hardware business, we continue to see momentum within our iGA platform, particularly with the adoption of our ReLine posterior fixation system, leading to greater penetration in the deformity market, and we expect this trajectory to continue. Results also reflected a strong resurgence in our cervical business due to the success of introducing the iGA system for cervical in October 2016, and in turn, driving strength in our differentiated Archon plate, VuePoint II fixation system. We continue to gain share of our NSO portfolio, which includes MAGEC for early onset scoliosis and PRECICE technology for limb lengthening. During the quarter, we made progress in our efforts to build out a pediatric sales channel to further increase our reach with MAGEC and its use in combination with ReLine. We have hired a long-tenured medical device executive with sales, sales management and market development experience to lead efforts, and look forward to providing updates on our progress throughout the year.

In our surgical support business, results were driven by the inclusion up Biotronic, which we acquired in July 2016. With our integration on track, we are seeing the benefits of building out an add-scale service business beginning to play. The addition of Biotronic has enhanced our service offerings and is delivering greater integration across our procedurally-integrated portfolio.

Turning to our international results for Q1. We saw above-market growth across all our geographies including Europe, Asia Pacific and Latin America. In Q1, revenue grew 34% on a constant currency basis to $38.8 million or 35% on an as-reported basis. We continue to see strong revitalization on our Western European markets of Italy, Germany and the U.K. as our investments continue to drive significant growth. In Asia Pacific, we benefited from the reintroduction of XLIF into the Japanese market in January, continued acceleration in our posterior fixation system business, as well as strong results in Australia. Importantly, we also saw Latin America return to meaningful growth driven by increased volumes in our Brazilian operations, where the business is beginning to deliver the growth we projected since closing Mega Surgical acquisition and going direct in Brazil. We continue to build out our talent internationally, and earlier this year, placed new long-tenured spine industry leaders in both the U.K. and Australia. These leaders are already delivering results, which we saw play out in the first quarter. In April, we also acquired our sales agent for NuVasive specialized orthopedic product in Germany and France and now have a direct selling presence in those 2 markets. With this momentum, we remain confident in our ability to continue to grow our share of the international market from the 4.5% we have today to doubling that over the next several years.

As we've been communicating, margin expansion is a key element in our efforts to deliver value creation for our shareholders. We continue to execute strongly against these efforts and, during the first quarter of 2017, delivered a non-GAAP operating profit margin of 14.1% in line with the guidance we provided in February. Our results reflected well-controlled operating expenses partially offset by increased investments in R&D as we continue to drive innovation in our portfolio.

Our efforts towards self-manufacturing remain on track with a tremendous amount of work going on in our West Carrollton, Ohio manufacturing facility as we add new equipment and train new employees. We ramped production up in Q1, and we continue to build up the facility, increasing our in-sourcing activities and releasing new titanium milling machines to production.

During the quarter, we continue to see success with our efforts to bring new surgeons into the NUVA family. As we continue to build out our end-to-end procedurally-integrated solution to drive better clinical predictability and continue to move towards a more systems-based offering in spine, we see the opportunity to go deeper with our current surgeon base as well as attract new surgeons to NuVasive. Innovation remains at the heart of what NuVasive does best, and we aspire to lead the industry by delivering the technologies and innovations that surgeons want and need.

As I talked about last quarter, we had strong pipeline of new technologies, some of which we are introducing in 2017. These technologies will help us meet out commitment to proceduralize the entire surgical experience, expand our current offerings and enter new markets. Now let me highlight a few examples. Our new radiation reducing x-ray technology, Lessray, underwent successful base testing in Q1. We're in the process of building out a small capital sales force to sell Lessray and have a healthy pipeline of customers who are interested in investing in the platform. Over time, Lessray will be integrated into our next-generation capital platform, become our committed real estate in the OR. We believe Lessray will be a game changer in surgeon and patient safety in regards to significant radiation reduction.

We are also actively expanding our core implant offerings. Specifically, we launched our first 2 expendable inter-body devices called MLX and TLX. Both are used in lumbar fusion procedures, which remain the largest overall portion of the spine market.

In Q1, we entered into our alpha phase for our UNYTE system, which uses our magnetic growth rod technology to help heal complex fractures and fractures that fail to heal due to poor bone quality or poor fixation. We completed a (inaudible). An upcoming plan include publication of the June edition of the Journal of Orthopaedic Trauma. We believe UNYTE will bring some of the most significant innovation with the potential to obsolete the $800 million external fixation market.

At this week's AANS, we are launching our ReLine trauma system, which will serve as the foundation of our trauma portfolio, as we invest particularly in the estimated $100 million U.S. spine trauma fixation market, currently growing about 5.6% annually. Spine trauma cases are performed approximately 90% open and only 10% minimally invasive. As the leader in minimally disruptive spine technology, we bring unique expertise in understanding how to develop new technologies that take traditionally open procedures and make them minimally invasive.

ReLine trauma is now the most versatile trauma system on the market designed to provide surgeons the flexibility to customize their approach interoperatively, including traditional open, maximum access surgery or hybrid procedures depending on the pathology the patient needs. The system offers surgeons the ability to customize implant types and supports a multitude of techniques depending on surgeon preference. Also, ReLine trauma enhances the surgeon's ability to dial in fracture correction to a dual-rack system, enabling procedures to be completed by 1 surgeon rather than 2, dramatically reducing the total time of the procedure. In collaboration with our surgeon partners, we succeeded in creating a platform design not only to improve clinical outcomes but also to reduce the total cost of care. This technology introduction once again demonstrates how NuVasive has gone deep in an area and is delivering the next-generation innovation to meet unanswered requirements in an underserved market.

Finally, we continue to drive innovation around our XLIF procedure and expand on our portfolio. XLIF is a world-leading lateral spine procedure having helped treat more than 150,000 patients since 2001. Last week, we began an early alpha release of our modulus XLIF, a fully porous titanium implant created in a 3D manufacturing process and designed to match the porosity and stiffness of bone. What is so novel about the modulus XLIF is the way the titanium implant mimics the physiological properties of bone. Spine surgeons are moving increasingly toward the use of titanium implants, and NuVasive has delivered the most bone-like implant to market. In addition, by manufacturing the modulus XLIF with 3D printed technology and packaging in a sterile pack, NuVasive will help hospital operations by eliminating the need for sterilization at the slightest surgery.

To support and complement our internal product development, we have a very active corporate development pipeline that includes a number of strategic investments, acquisitions and partnership opportunities to further build out NuVasive's product and technology road map. Our specific areas of focus include opportunities that enhance our technological leadership position in spine, targeted geographic expansion, clinically differentiated surgical tools as well as opportunities for imaging and navigation. As we talk to our surgeon partners, it is ever more clear that the technology we're investing in today will help meet their most pressing needs. We intend to be disciplined and very highly selective in our approach, seeking targets that are both a great strategic fit, meet the return on invested capital goals and fit into our long-term margin expansion plans.

Over the past year or so, we've undertaken effort to increase our financial flexibility, including refinancing our convertible debt last March and putting in place $150 million credit facility back in February of 2016. To further build out our flexibility to make strategic acquisitions as well as support the day-to-day operations of the business, we entered into the new credit agreement with a syndicate of banks for 5 years' secured revolving line of credit with an aggregate available balance of up to $500 million. This credit facility replaces the $150 million credit facility we put in place in February 2016, and Quentin is going to provide more details in his commentary.

So closing, we're off to a solid start to the year. Our international business is executing on all cylinders and delivering growth well above the market. Our iGA platform has continued to ramp with our expansion into cervical iGA, and we're still in the early phases of this platform launch. We also have a number of exciting product launches that will continue to expand our leadership in spine and are on track with our internal manufacturing capabilities in Ohio as we work toward becoming self-manufactured.

Now I'd like turn over the call to Quentin to provide more details on the quarter.

Thanks, Greg, and good afternoon, everyone.

Before we get started with the financials, let me remind you that many of the financial measures covered in today's call are in 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. During the course of today's call, I'll be referring to reported and pro forma results. Unless specifically noted, all comments are on as-reported basis. When discussed, pro forma comparisons reflect the results of the business at the NSO and Biotronic as they combine to the forward-reporting period being referred to.

For the first quarter of 2017, we reported revenue of $249.9 million, which reflects growth of 16.2% or 16% including the impact of currency. On a pro forma basis, growth was 6.5% or 6.3% ex-FS.

Our U.S. spinal hardware revenue grew 10% for the quarter to $139.4 million, which was fueled by our NSO business as well as building momentum in our cervical portfolio following the launch of cervical iGA in the fourth quarter of 2016. We continue to be excited about the opportunity to capture more of the underpenetrated cervical market with a truly unique and differentiated solution. On a pro forma basis, U.S. spinal hardware grew 7% for the quarter despite being up against the toughest growth comp in this category more than 3 years.

Revenue from the U.S. surgical support came in at $71.7 million for the quarter, up 20%, which was driven by the acquisition of Biotronic, offset by weakness in our Biologics business. On a pro forma basis, our U.S. surgical support revenue declined 2% due to soft results in biologics.

Our international business delivered strong revenue results coming in at $38.8 million for the quarter, an increase of 35% on a reported basis or 34% excluding the impact of currency. On a pro forma basis, international revenue grew 24% excluding the impact of currency with strength coming from all regions where our share-taking plans and innovative product introductions are generating results. Momentum in our Latin America business continue to build in the first quarter where we saw growth of more than 70%, primarily the result of a steady increase in performance from Brazil, where we chose to go direct in early 2016. In addition, the remainder of the region performed ahead of expectations. Our European and Asia Pac businesses also contributed nicely led by markets like the U.K., Italy, Germany and Australia. In Japan, we saw solid sequential growth as we introduced the XLIF procedure, and our Japanese proctors resumed XLIF procedures as of mid-January as anticipated. We also saw a strong performance in our posterior fixation business as a result of our sales to keep focusing on that in the second half of 2016 while XLIF was off the market.

Now let's turn to the rest of the P&L, where non-GAAP gross margin for the first quarter was 75.3%, down 180 basis points from the prior year as anticipated. The lower gross margin was driven by a 240 basis point impact as a result of lower gross margin profile of the Biotronic business as well as the 60 basis point impact related to the transition of our manufacturing facility in Ohio. Partially offsetting these headwinds were greater inventory efficiencies and mixed benefits, net of price of 90 and 30 basis points, respectively. Pricing pressure was consistent with the past quarters, remaining in the very low single digits at negative 1.5%.

Our new manufacturing facility in West Carrollton, Ohio continues to ramp as anticipated. In the first quarter of 2017, we doubled our output from the last quarter, producing more than 80,000 pieces. Recall, we will start to realize benefits from this in-sourcing initiative in the second half of 2017 and ramp up more fully in 2018.

Non-GAAP SM&A expenses as a percent of revenue decreased 180 basis points from the prior year to 56.2% in the quarter or $140.5 million. The lower SM&A expense profile of Biotronic contributed 260 basis points. Excluding the benefit of the Biotronic business, SM&A expenses as a percent of revenue increased 80 basis points, which was primarily driven by higher noncash stock-based compensation expenses. In addition, the partial quarter of XLIF revenue in our Japan business put incremental pressure on our international operating margins, which was fully offset by leveraging greater asset efficiencies across the business.

Non-GAAP research and development or R&D expenses totaled $12.4 million in Q1 2017 compared to $10.6 million in Q1 2016. R&D expense was 5% of revenue for Q1 '17 versus 4.9% in the same period last year. Excluding the benefit of the Biotronic business, R&D expenses as a percent of revenue increased 30 basis points. The increased R&D spend reflects our continued commitment to supporting internal R&D efforts and investing in strategic assets we acquired to drive further innovations. As we have communicated before, we expect R&D expenses as a percent of revenue to increase with a long-term goal of investing approximately 7% of revenue on these efforts. Our path has not changed. We continue to make investments in key areas, including the NSO technology and efforts around imaging, navigation and surgical automation as well as continued improvement in evolution of the iGA platform. We have started to see the investments in evolving our technology pay off, like our iGA for cervical platform extension and proprietary magnetic drive mechanism in our MAGEC rods, which you will start to see extending into some of our new product launches later this year.

First quarter non-GAAP operating profit margin was 14.1% in line with the prior year. After adjusting for the different P&L profile of the Biotronic business, core gross margins showed nice improvement from prior year as a result of greater inventory efficiencies, which were offset by continued investments into R&D, higher noncash share-based compensation charges and a temporal impact of the restart of the XLIF business in Japan for the first quarter.

First quarter adjusted EBITDA margin, which excludes the impact of noncash share-based compensation, was 24.1%, a meaningful increase of 160 basis points compared to 22.5% in the same period last year, reflecting the continued focus of improving the cash earnings profile of the business.

Moving further down the P&L. Interest and other expense net on a non-GAAP basis was $5.1 million in Q1, up from $4.1 million in the same period last year. This increase is primarily a result of the interest expense associated with the 2021 convertible notes, which were issued in March of last year.

Now turning to tax. Our non-GAAP tax expense in the quarter was $10.6 million, resulting in a non-GAAP effective tax rate of 35.1% in line with expectations and reflected of our continued effort to drive year-over-year improvement in our corporate tax rate as we work to bring this down into the mid- to high 20s over time. First quarter 2017 non-GAAP net income was $20 million or non-GAAP earnings per share of $0.38 compared to non-GAAP net income of $17.2 million or non-GAAP earnings per share of $0.34 in the same period last year.

Turning to our GAAP results. GAAP net earnings for the first quarter of 2017 were $12.8 million or $0.22 per share compared to a loss of $3.4 million or $0.07 per share in the same period last year. Please refer to our earnings press release or the supplemental financial information file posted on nuvasive.com for further information related to our GAAP versus non-GAAP adjustments for our first quarter 2017 performance.

I'd also like to spend a few minutes reiterating our full year 2017 guidance, which we shared during our full year earnings report out in February, of revenue of $1,065,000,000; non-GAAP operating margins of 17.1%; and non-GAAP EPS of $2. Our revenue growth to date is in line with our expectations, and we continue to focus efforts on making good progress on the operating margin front.

NSO reached its 1 year anniversary in February and is now fully integrated into our business, with Biotronic's 1 year anniversary coming up in July.

We're driving the business hard with laser focus on operational improvements and efficiencies in order to meet or exceed our non-GAAP operating margin goal of approximately 25% over time. We are confident about continuing our strong momentum throughout the year.

With respect to the second quarter 2017, as a result of the acquisitions of ALIF technologies and Biotronic in 2016 as well as the relaunch of XLIF in Japan, we expect that seasonality in our business may be a bit different than historical NuVasive averages. Therefore, to provide greater clarity in terms of the expectations and for your modeling purposes, we anticipate that revenue for the second quarter will be approximately $262 million and that non-GAAP operating margins will increase sequentially by 140 basis points to 15.5%. We expect revenue growth will accelerate in the third and fourth quarters as we come up against easier comps in the business. As a reminder, the third quarter of last year did not realize much of any capital sales in the period, and the temporal impact of not selling XLIF in Japan for a portion of the third quarter and all of the fourth quarter will result in easier comps in accelerating growth rates. In addition, the launch of technologies such as Lessray, the TLX and MLX expandable cages, ReLine trauma and UNYTE are expected to fuel further growth as we come into the second half of the year.

Finally, I'd like to spend a moment giving you a little more color on our new line of credit we announced earlier today. We took the opportunity to amend and restate our existing credit agreement to expand our revolving line of credit from $150 million up to $500 million. The interest rate, covenants and other terms are substantially similar or better than the previous line of credit and in line with market dynamics. The expanded line of credit will provide us with the added flexibility to deal with the upcoming maturity of our convertible notes in July 2017 and support future investment in both organic and inorganic growth initiatives. It's important to note that we will continue to be disciplined and diligent in how we deploy our capital. We remain committed to the previous parameters that we've detailed for our investors. For full details on the line of credit, please refer to our filing with the SEC.

In summary, NuVasive is off to a solid start to 2017, well in 3 months into the year, and there's still a great deal to accomplish. We are very encouraged to see our international growth plans that we set into motion a few years ago, playing out in driving significant results for the business. In addition, as NuVasive's reputation for being an innovation leader, we see several of our new technologies being well received in the market, and we continue to be disciplined in the management of our business and seek every opportunity to extend excellence throughout our operations and push our profitability higher.

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

(Operator Instructions) Our first question comes from the line of Matthew O'Brien with Piper Jaffray.

I'll just ask both of these here together. First of all, Greg or Quentin, just was curious about the commentary about surgical volumes, in January and February, the softness that you saw there and why you're so confident that whatever was causing that weakness is behind us. And then secondly, on the Biologics side. I know that's been an area that's been somewhat soft for a while now. I just would love to get a sense for how much longer we think that potentially could be weak. And then what the new NASS guidelines on allograft or DBM may do either positively or negatively for that business?

You bet. Let me say a few words on January and February, and then I'll have Quentin take the Biologics. But we spent a fair amount of time looking at the analytics in the U.S. business and trying to understand what we were seeing in the industry. And whether it was our own sale of implants or we're able to see actually the industry in a broader base given our service business, we believe the volumes that were somewhat depressed in January and February were industry-related. In terms of the cause of it, we then followed up in talking to a few administrators of hospital systems and the like. And at least one theory of the case is high-deductible plans, and it just takes some time for those to start to work through as you begin a new calendar year. And that's somewhat validated by the fact that March came back into real strength. Certainly, at our expectation is continued now onto in April. So that's our best guess of what we're seeing. And in terms of our results, I think we continue to grow above market in the U.S., and you can see us doing very well internationally. So we think the company is doing fine. We think we're just experiencing a temporal kind of restart of the year that may be a new reality given high-deductible plans. Quentin, on the Biologics?

Yes. Matt, with respect to the Biologics, sad to say we expected that to be flat to slightly down over the course of the year, certainly coming in at 6% for the quarter. It was a bit disappointing relative to where we thought that we might see that come in. I think a couple of things. One, price has been under a bit more pressured there. I noted price of 1.5% decline in my prepared remarks. Biologics is closer to 3% right now. You see a little bit of price pressure there, but I would also tell you there's a tremendous amount of opportunity in this business with respect to that Biologics portfolio that we haven't got after yet. I think there's a real opportunity to see incremental growth come from that. Our full year expectation is to be relatively flat here, and I think you'll start to see that as we get into the back half of the year and start to explore some of these things that can drive incremental growth for us. So I think it's more of a temporal impact despite the fact that it's been negative for several quarters now, but I think you'll start to see that turn.

Our next question comes from the line of Richard Newitter with Leerink Partners.

I'll also try to put 2 in 1 here. So just on -- the first one is just on your trauma strategy. You have the ReLine launch, and also you have UNYTE. That's going to be -- it sounds like coming in the back half. I would just love to hear kind of how you're envisioning either a sales force build-out here on the non-spine trauma side. And then the second question is just on the cadence for the year. You gave some color on margin expansion. I was just thinking from a gross margin standpoint, do we think of gross margin tracking similarly to operating margin expansion? Is there anything to call out there?

Why don't we take the last part first? And Quentin, gross margins?

Yes. So Rich, with respect to both gross margin and operating margin, I gave you some color around Q2, and sequentially, we expect operating margin to increase roughly 140 basis points. You're going to see all of that improvement in Q2 really coming from the leverage of our selling, marketing, administrative expenses. I would expect gross margin in Q2 as relatively flat with where you saw it in Q1. You got the headwinds coming out of the Biologics -- or sorry, the Biotronics business that has lower gross margin profile. And keep in mind, we didn't have that in Q2 of last year. So you have one more quarter of headwind with a gross margin profile. But at the time you get to Q3 and Q4, we will have annualized that. You no longer have it, so you're not going to see a sequential change from it. And then you're going to start to get the benefit of the in-house manufacturing starting to roll through with what we're doing in Dayton, and that's more of a Q3, Q4 benefit. So I think you'll certainly see the gross margin start to improve in the back half of the year. You're not going to quite see it in Q2 just yet. You're going to see more of that improvement coming out of SM&A.

And the first part of your question on UNYTE, a little bit more context. So our PRECICE business, which does limb lengthening or the opposite of the UNYTE technology, which does compression and, as you say, fracture healing, we've experienced very fast growth with that business. That's all done through third-party distributors at present, and they're doing a very effective job. We're in the process, as we speak, of taking through the right distribution approach for the UNYTE technology. We believe it will probably entail more third-party distribution that's augmented by investment on our side for further managerial help as well as some sales specialists to bring in that extra understanding of the technology, but we're trying to do this in a lighter investment way just as we continue to build out that business and get to scale.

Our next question comes from Kaila Krum with William Blair.

So first is just on company priorities and where you expect to invest in both organic and inorganic growth opportunities going forward. Because obviously, you guys have a lot going on here. So I mean, is it still deformity? Is it expendable? Is it more in trauma and expanding the portfolio there, less where you're building on capital sales force? And I guess, if it's all of the above, then how do we think about prioritizing those initiatives relative to one or another over the next 12 to 18 months?

Sure. I'd say we have 3 major priorities, and then obviously, there's more being done in the company. But at the highest level, there are 3 things we're trying to get done. One, we're evolving the company from purely degen to degen and deformity, and you're seeing that happen as we speak through '16, '17 and '18. Second, on the innovation side, you're seeing us go from a world leader in proceduralization to also becoming a world leader in the systems around spine surgery and there's a whole host of products coming out again over the next couple of years that will drive that. And then the last priority is a very meaningful investment that has not produced any drama, thank God, and that's becoming self-manufactured in Ohio in what will become the largest spine factory in the world. So all of that is taking place, and I think we're doing it in a way with minimal disruption and pretty good execution.

Okay. That's helpful. And then just a question real quick for Jason on international. Can you just talk a little bit more about your efforts internationally? And specifically, I guess the progress that you've made in Japan thus far, where we're at in terms of getting back to the historical run rate there?

Sure. So we laid out a strategy for international almost 2 years ago now that was really focused on going deeper in our markets, the biggest, our most direct markets: the U.K., Germany, Italy, Australia, Japan and then ultimately, Brazil, which we've done. Of the success you're seeing is really just execution of that strategy. It's primarily coming from the markets where we're direct to the biggest opportunities. We have made investments in our direct teams and in product launches and all those markets. So that strategy is playing out over the last couple of years, and obviously, well in the first quarter. With respect to Japan, it's reintroduced. There's significant interest from Japanese surgeons who truly believe in the procedure. Those procedural volumes are coming back quickly. We would expect to be nearing historical run rates where we were the middle of 2016 by the summer, maybe the late summer into the fall. It's going to come back pretty quickly because there's significant interest.

Our next question comes from the line of Matt Miksic with UBS.

So I wanted to -- and I -- bouncing back and forth between calls here, so I hope this question hasn't been asked. But I wanted to ask a little bit about your sort of initial response to demand analysis, I guess, if you will. What -- how interested are hospitals and docs in Lessray? And kind of where are you in terms of the business model for rolling that out?

Yes. So Jason and I will frick and frack on that one. As I said in the script, we've now done the beta launch. We're finalizing the complete system, and we'll be on market in a big way here in May. And Jason can give you more color commentary on the initial channel reaction. So Jason?

Sure. So the initial reaction has been very positive. As you can imagine, we acquired technology. We're in the process of truly productizing it, meaning that's the alpha beta process we're going through, putting it on a package that actually makes it work functionally and from an industrial design perspective in the hospital. The response to the way the technology works, the level of radiation reduction it can provide and its ability to be integrated into our future capital platform have all been extremely good. And so we are going back now, and we start to build the units. We will place a good number of Lessray units stand-alone that will reduce radiation in the operating room by themselves, and that will then be followed by the inclusion of that technology into our capital platform that come later in 2018. So significant interest. The understanding that this is one of those topics that is on the front of mind of every surgeon and should be with respect to patients as well, and you have something that is rarely talked about sufficiently because people didn't believe there was a sufficient answer to it or a sufficient solution. So it's got great interest from obviously surgeons, from practice management, from hospitals. So we look forward to try and meet the demand.

And just to understand the business model, I guess how are you -- I guess for the lack of a better way of asking the question, how are you pricing it? How do you anticipate being paid for delivery of this -- of the technology?

Jason?

Yes. So we're starting to build a bit of a capital sales force that will manage the Lessray opportunity as well as ultimately our capital platform in 2018. Obviously, a different sales cycle and a bit of a different call pattern when you're starting to sell capital, so we will do that. It will be priced with options essentially, either a straight capital purchase or we'll provide a leasing opportunity to the hospital. And that pays the way for us ultimately to build the capacity as well as the coverage to then be selling a larger capital unit, like I said, towards the end of 2018. So pricing options supported by a capital sales team.

Okay. That's helpful. And if I could just one question on sort of the core MIS business. Your XLIF is obviously a leadership platform in lateral and also just generally, I think, in MIS, you could say in spine. And I'm just wondering, is there a place, if it's lower abdomen, if it's thoracic where you feel like there's an opportunity to expand that? And maybe any color on how you're looking at expanding that leadership franchise?

Jason?

So we have worked over the years. As you know, and many of you know, XLIF was initially a single-level degenerative application. And it's been expanded over the years, regularly used in the thoracic spine now from 4-5 way up the spine. And so we continue to try and improve on XLIF. We continue to try and minimize the disruption of thoracic surgery through XLIF, corpectomy through an XLIF approach. So its concept, I would say, we've done a fair amount in the thoracic spine already and continue to use our knowledge of the lateral anatomy. Get it 4-5, and ultimately hopefully, to get it 5-1 as well. So yes, we continue to try and expand that franchise.

Our next question comes from Andrew Hanover with JPMorgan.

Quentin, I just wanted to start with you quickly. On the second quarter guidance, I just wanted to make sure I actually heard $262 million. And one of the reasons I'm asking is I think that would be a slight sequential deceleration on an organic or pro forma growth basis and just wanted to understand what some of the underlying factors are within a $262 million guidance for the second quarter.

Yes. So Andrew, $262 million, that is correct. That's the number that we put out there. You've got to look at it on a constant currency basis. Certainly, when you look at it on a reported basis, you're right, it would be roughly 5%, 5.3%, somewhere there. But neutralizing for the impact of currency, it's actually up around 7%. So it's an increase coming off of Q1 on a pure constant currency basis when you neutralize that impact. So I think when you start to look at it that way, it makes a whole lot more sense.

Okay. And then as far as how to think about the contribution from these competitive surgeons or reps, obviously, there's like some non-competes that are going in the first half that probably lapse in the second half. But can you help tease through was there any contribution in the first quarter and how that sort of ramps throughout? And then on top of that, I'm just trying to understand the commentary, I think you were talking about giving second quarter guidance so that we could understand some of the cadence that's going to be a little bit different this year, does some of that have to do with the fact that you're launching this deformity system? And because deformity is bigger in the third quarter than it sort of plays out through the second, and third quarter might be bigger? Appreciate it.

Yes. Well, certainly, the seasonality of the different businesses whether it's NSO with deformity, where you've got different seasonality than the historic hardware business, where you've got Biotronic, that's a bit different as well, all of that's being contemplated in the numbers that we're giving you for Q2. The point is, when you're integrating these businesses that have a decent revenue stream to them, they don't all perform kind of from a seasonality perspective the same way that our old historic hardware business did. And that's what we're trying to give you guys visibility into and make sure that you're contemplating that correctly. With respect to the contribution coming from new surgeon conversions or surgeons working with the company or the sales reps hire, I think we've been pretty clear that we expect that to be more of a contribution late in the year, in 2017, certainly the back half and more into 2018. To the extent that we start to see benefits from that sooner, great. That'd be a great thing to see in the business, but that's not the way we're setting up the expectations with relative to those contributions. And though, we didn't see much of any impact in the first quarter coming from either one of those yet.

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

This is actually Matt Henriksson in for Joanne. My first question is following AOS and kind of the buzz surrounding robotics, has your view changed on spine robotics than you guys have commentated previously?

Our view remains unchanged. We fully appreciate that a shiny new object, an interesting piece of technology like a robotic arm might grab some attention and ultimately might grab some buyers, but that's not the path we're going to follow because we don't think it actually fundamentally addresses what drives the unpredictability aspect in spine surgery, and so we're confident of our path. We recognize it will be short-term kind of a chatter in the market, but we'll get through that. And we like where we're going with our whole concept of automation over the next couple of years.

Okay. Great. And then my follow-up question is you guys have commented on preplanning surgeries and how that's going to help with managing inventory levels. Are you guys starting to see that materialize? And then how important of that is a driver for your risk-sharing program with the hospitals and the payers?

Yes, great questions. There's a few pieces to ultimately creating more patient-specific implants, and you're seeing us put out, the key building blocks, here in time. So now we just have been able to finish out the iGA system for the entire cervical part of the spine, so now we have the whole spine covered. That's an important element. We're moving forward with sterile pack technology to allow us to be shipping products out in a sterilized way, so it can be more patient-specific. And unbeknownst, because we haven't talked about it to investors very much, we're radically revolutionizing the entire delivery process to the surgical suite. And so as we get all of that in place, it's then leading to the ability to do preplanning on the software system to then do a much tighter selection of the implants and bringing them into the OR. As we said before, that's more of a kind of late '18, '19 type of phenomena that builds on the back of the Ohio plant coming fully on line, which will give us a great economic boost.

Our next question comes from the line of Jonathan Demchick with Morgan Stanley.

International continues to be a great spot for the business, but was just wondering a little bit on the margin side there. Given the near-term benefits from manufacturing and asset management over the balance of this year and just the momentum that we've seen in international, is this an area where you're likely to, I guess, invest more for -- to kind of maintain this growth rather than start to really see any margin uptick in this business? Or have we already kind of seen some of the margins international start ticking higher?

Quentin, why don't you grab that one?

Yes. So Jon, I think great question. It is a great opportunity for the organization. When you think about our market position there, 4.5% of the overall market that we have today, and there's no reason we can't see that more than double over the next several years. It does take investment, but we've also committed ourselves to that investment strategy in plan and the broader margin goals that we've given to the investors. And so I would say we're tracking right in line with where we expect to be. You will see the profitability of that international business continue to ratchet up, but at the same time, balancing it with key investments that are needed in that area. For example, last year, we continue to invest in international in a pretty meaningful way despite the fact that we had to pull XLIF from the market for part of Q3 and all of Q4. We didn't look at that as a situation where we needed to reconsider the investment and pull back on investing in some of the initiatives that we had there. We continued with it. And so we're committed to investing for the long term in that business. I think there's tremendous potential, but we will balance it. There will be opportunities to drive profitability improvements, but at the same time, make the key investments necessary to get that to a 10% share position or better over time.

I just had a quick follow-up on, I guess, both the Ellipse and Biotronic acquisitions. Product pulled through from screws on Ellipse and disposables on Biotronic to be a substantial driver, where are we on the adoption there?

We're still very early stages. For example, with the Ellipse products in the MAGEC rod, we didn't have the smaller stature screw that even go with the smaller rod until here in Q1. We've now got a full suite of screws that can meet the requirements of the MAGEC rods of 5-5 and 4-5. And now we'd expect to start to see pull through take off, and it's probably more of a back part of the year type of opportunity for us. And the same with biotronics. If you look at what we've done in the IMI business, now we've been able to pull through nicely the M5 disposable onto that service line. Part of the value proposition with the Biotronic deal was the ability to do that as well. We knew it was going to take a bit of time. And again, we kind of model that as roughly a 12-month time frame before we start to see that really take off, which puts you in the back part of this year as well. And so I think you're focusing on and thinking about all the right potential levers to drive expedited growth for us, but you're bit too early yet. I think in the back half of the year, you start to see some of that benefit, and certainly, as we roll into the following year.

Our next question comes from the line of Kyle Rose with Canaccord Genuity.

Great. Just a couple of quick questions. First, you talked about Lessray with the building out capital sales force there but then also mentioned a larger capital strategy coming in 2018. I just wondered if you could give any additional color from that standpoint. And then on the other products, as far as the expandable cages, I mean, that's a pretty major product app that you guys are filling there. Just thoughts on that overall product opportunity near term and then how you think about the overall size of that market.

So Jason, why don't you give a commentary on the capital technology road map and then expandable cages as a category?

Sure. So on the capital, you know we have our NVM5 unit, which is our hub for neuromonitoring computer-assisted surgery multi-modality. When you think about that unit and then you start to -- you add in technology like Lessray, the combination of those things becomes our new capital platform. That platform then serves as a platform for patient image processing and the other things we do. So we talk about a capital strategy longer term, we're talking about the combination of all those technologies into a single platform. That's the direction, and that's the value of building the capital sales force so that we can manage those things going forward. With respect to expandables, they are a significant market opportunity. It's important to remember how we look at the market. We don't look at the market as individual implants that carries significant ASP, and therefore, a highly sought-after area for us. Instead, it's a procedural reality. We look at the entire procedure. And so the gap, the clinical gap that expandables fill is real. And you see it now with our launch in 2 different expandable cages in TLIF. We'll be doing the same thing from a lateral perspective and others as we work through the clinical that we're solving. And so they are a significant market opportunity, and you'll see us following these launches significantly in that space over the coming quarters.

Great. And then just one last question on the manufacturing side. I mean, you talked about your doubling the unit volume to 80,000 units in the Q1. Just can you kind of characterize how we should think about that volume as we exit the year? And just can you put that 80,000 and frame that for us as we think about Q1?

Yes. And right, and we're talking about on a unit basis, so I'll just give you a sense of how much we expect to put through that plant kind of around some time frame. So that we exited last year, roughly 40% of what we could produce we were capable of producing within that plant. We would expect that gets closer to 60% or so by the end of this year and then moving closer to 100% by the end of next year, so I think that will give you a sense of just the cadence of how quickly we move through there. It's also why we talked about 2018 being the year that will provide even a greater benefit to us from a manufacturing perspective than what you're going to see in '17. While we're ramping nicely this year, so much of the benefit gets caught up on the balance sheet, we're unable to release that back and so we turn to the inventory. So that's why you hear us talk about more in the back half of this year and then really '18 opportunity for us.

Our next question comes from the line of Jeff Johnson with Robert W. Baird.

Quentin, maybe I missed it, and I apologize if I did. But were there any selling day issues this quarter? Can you walk us through selling days the next few quarters?

Yes. Selling days were equal year-over-year in the first quarter. We expect them to be equal in the second quarter as well. But in Q3, we have 1 less day. And then Q4, they're equal. So...

Okay. That's helpful. And then on the sales force side, I think this question was already asked in one direction, but I kind of want to push it a little bit differently. You've talked about that big 15% increase in the end of '16. I know with some of the garden leaves up, that's not going to help until you get maybe deeper into '17, as you've already talked about. But you're doing some things a little bit differently here as you add those sales reps by putting them kind of into adjacent markets and then you're going to kind of flip the established rep in the adjacent market rep kind of back into their respective markets at the end of this year. That's a little bit different than we've heard other companies do things in the past. How is that going qualitatively at this point? Any hiccups with that? Or does that seem to be going on as planned?

Yes, I would say that we're right in line with how we expected them to be contributing to the organization. When you talk about taking them out of a particular territory, that's what you're dealing with when you have these non-competes. And rather than being able to put them on the sidelines and not have them produce any type of value for you over the course of whatever that non-compete might be, whether it's 12, 18, 24 months, we typically find ways to put them in adjacent territories or other territories that they can get out and compete in. And so that's what we do. And then once the noncompete is up, we look at putting them back into the territory that they can't compete within and so -- or that they came from. And that's why we talk about it. In the early stages of these type of opportunities, the revenue -- increased revenue opportunity isn't really there. It's more 12 to 18 months from the date of hire, and that's we can start to see the benefit. But in between that, you're working through navigating some of these noncompete issues that take them out of their local market.

Yes. And so I guess, my final question would just be, if that's going well, it sounds like the rest of the business is clicking along fairly well. I mean, you guys are closing enough to Street numbers. The 2Q guidance is maybe a few million dollars light of where the Street is at. 1Q was kind of more in line to maybe $500,000 below Street. But what's -- is it end markets that's just a tad softer maybe than you guys were thinking? Is it Street just got a little ahead of itself in the first couple of quarters? Just trying to bridge the gap maybe between kind of what you're calling for in 2Q and then where we were all sitting kind of going into tonight's call?

Yes. Well, I think there's no question Q1. The Street was a bit ahead of where we said we would be in the quarter, right? We had put out specific number, the $250 million, and the Street was a bit ahead of it. And I think Greg framed that up pretty well with respect to January and February, just being a bit soft is what we anticipated. We saw that rebound in March and feel good about where the volumes are at, at that point in time. I think what the Street doesn't fully appreciate is just the nuances in the business around seasonality when you're starting to integrate organizations that contribute $15 million to $20 million a quarter. They can have an impact on the way you look at seasonality. And so a lot of folks simply model the second, third, fourth quarter by looking at historic seasonality and say, "Hey, we dropped 24.5% of revenue into Q2 on an average basis over the last 3 years." Well, when you start to consider the fact that you've acquired NSO and now Biotronics, that might look a little bit differently. And so we need to get out on front and help educate you guys on exactly what that looks like, and that's why we're doing this. You could go back and look on a pro forma basis. This company historically over the last 3 years, we're going to put 24.2% to 25% of revenue into Q3. We're guiding kind of right down the middle of 24.5% roughly with that Q3, I meant Q2 with that Q2 guide that we gave you, right in the -- kind at this point out at 24.5%. So I think more than anything, it's just us trying to make sure you guys are thinking about this pro forma business that has all business lines combined now in the right way.

Our next question comes from the line of Glenn Novarro with RBC Capital Markets.

Two questions for Quentin. First, in -- for 2Q, Quentin, you gave us sales, you gave us operating margin. Can you give us tax rate? And I may have missed it. Did you give us any EPS range for 2Q?

It's in the prepared slides that we have on the website. Tax rate, 35%. We continue to think about it that way. We feel very good about where that's going to land at this point in time, and that's going to generate an EPS number of somewhere around $0.44 for you.

Okay. Great. And then as I'm looking at my model, you have 44s where I came out. The 17.1% operating margin, 2 questions on that. To get there, it looks like we need to have an operating margin in 3Q of somewhere around 18%, and then 4Q, somewhere around 20%. So is that in the ballpark? And maybe talk about what your confidence level is that you can go from 14% in 1Q to 18% in 3Q and 20% in 4Q?

Yes. Look, we haven't given specific guidance around what operating margins look like in each one of those quarters. I would just remind you, in Q3's got 1 less selling day. So you're going to have a bit of pressure on the operating margin from that perspective, and you're going to pick up or you'll see nice a ramp back into Q4 operating margins. But at the very highest level the way you've thrown those out there, I think directionally, you're thinking about it correctly. It's going to continue to improve over the course of the year each and every quarter now that we have NSO and Biotronic fully integrated. And then you've got XLIF coming back in a full way in Japan, so you're going to see some nice leverage over the course of the year for sure. So I think you're thinking about it the right way.

Okay. And I think you said that's one of the -- to earlier questions that, that gross margin would be a greater contributor in the second half of the year given that the comps anniversary on Biotronic and the Ohio facility starts to contribute more. Is that accurate?

Yes, you're thinking about it the right way. Whether you get the contributions from the manufacturing facility in Q3 and Q4, you're going to get a bit of them. But you're not going to have the headwinds of moving out of that like you have in Q1, and it's going to become normalized in Q2. But you're thinking about it correctly.

Our next question comes from the line of Josh Jennings with Cowen and Company.

I was hoping to just ask about surgical volume assumptions. I know that you called out some softness in January and February. And is Q2 guidance baked in a reacceleration of surgical volumes? And are you seeing some improvement thus far in the quarter?

So I think the right way to think about that is the pro forma growth, excluding any impact of currency, will see us accelerate a bit into Q2, roughly 7% versus the 6% that you saw in Q1. And so that's going to be primarily driven by volumes, and I think that answers the question for you. I think you'll continue to see that play out from what we saw exiting the quarter of Q1. January and February, we talked about a bit soft. March certainly rebounded and performed well, and we kind of look at Q2 as performing in line with Q1 as a whole. That's how we're thinking about it.

Great. And just a follow-up on Ellipse. I think you guys had called out on the acquisition expectations for accretion in the $0.18 range in 2017. I guess you guys are on track for the accretion target. And then also just on the NTAP decision that was positive, kicked in I believe in October, are you seeing any ramp in adoption rates for MAGEC rods since that was positive decision was made?

I would tell you that, that MAGEC business has performed in line, if not ahead of expectations, for us, particularly relative to the deal model. It's exactly where we would expect it to be on the top line. And from a profitability perspective, I would tell you it's a little bit ahead. We looked at that as an opportunity to accelerate the overall growth profile of the profit margins for the company, and we continue to believe that, that will be the case longer term for sure.

There are no further questions at this time. I would like to turn the floor back over to Greg Lucier, Chairman and CEO, to conclude today's call.

Operator, thank you very much, and thanks all of you for participating on the call today. We look forward to speaking with you at the end of the next quarter. Thanks very much.

This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation, and have a wonderful day.