NuVasive Inc (NUVA) 2012 Q3 法說會逐字稿

Greetings and welcome to the NuVasive Inc., third quarter 2012, earnings release conference call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation.

(Operator Instructions)

As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Patrick Williams, Vice President of Strategy and Investor Relations for NuVasive. Thank you Mr. Williams, you may begin.

Thanks, operator. Welcome to NuVasive's third quarter 2012, earnings conference call. NuVasive's senior management on the call today will be Alex Lukianov, Chairman and Chief Executive Officer; Keith Valentine, President and Chief Operating Officer and Michael Lambert, Executive Vice President and Chief Financial Officer.

During our management comments and our responses to your questions, certain items may be discussed which are not based entirely on historical facts. Any such items should be considered forward-looking statements that involve risks, uncertainties, assumptions. And other factors which if they do not materialize or prove correct, could cause NuVasive's results to differ materially from those expressed or implied by such forward-looking statements. These and other risks and uncertainties are more completely described in today's press release, and NuVasive's most recent 10-Q and 10-K forms filed with the Securities and Exchange Commission. Finally, please try to limit the number of questions from each person so that we can keep the conference call to a manageable time and allow everyone an opportunity. With that, I would like to turn the call over to Alex.

Good morning, from Dallas, Texas. We are hosting this call from Dallas, home of this year's NAS conference. We will be spending the remainder of the week meeting with surgeon customers to reinforce that there is absolutely no substitute for the years of experience with minimally invasive solutions, that NuVasive has accumulated. Competitor's product portfolios do not come close to the safety and reproduce ability that surgeons achieve with our comprehensive product portfolio. Our fully integrated, innovative approach to spine surgery, and our procedural sophistication, will drive palpable excitement at the NuVasive booth. We encourage you to stop by to experience it for yourself.

On today's call, I will address our results for the third quarter, provide updated guidance for 2012, and offer a general outlook for 2013. Revenue in the third quarter grew 12%, to $148.3 million. Non-GAAP operating margin was approximately 15% in the quarter. As I mentioned a few weeks ago, revenue fell short of our expectations due to a heightened level of account churn, in a limited number of US regions, the impact of which accelerated late in the quarter. This was a result of both aggressive competitive tactics, targeting our sales force and surgeon customers, and continued surgeon adoption of the physician-owned distributorship, or pod model. These dynamics had a direct impact on our US lumbar business, which experienced flattish sales in the third quarter, but are up 5% year-to-date.

The challenges also impacted the pull-through of our US biologic's solutions, which were roughly flat in the quarter, but are up 9% year-to-date. Our US cervical and international business were both very strong, growing about 15% and just over 40% respectively, in the quarter. Finally, our monitoring service revenue was approximately $9.6 million in the quarter, which was shy of our expectations.

So first, I want to talk about sales force, and aggressive competitive tactics. So let me provide some additional perspective around the current dynamics we're facing, and offer a view of the outlook for each of them. On the sales force front, we ended the third quarter, 2012 with 310 quota carrying sales representatives globally, which was down on a net basis by 15 people from the previous quarter. The third quarter marked the first time that we have ever gone backwards in terms of the net number of reps. Some of these sales reps held large accounts, which will have a material impact on revenue in the short term.

Several reps went to various smaller competitors, that are utilizing aggressive tactics to poach our industry-leading sales team, in three of our 12 geographies. In geographies where we did not experience churn-related to sales force departures, performance in the quarter was very strong. We believe that the strategy of offering huge and guaranteed compensation to poach our reps, is unsustainable. And we are taking steps to curtail these competitive threats as quickly as possible. So what are we doing about it?

Well, first, the executive team is reengaging with our sales force at a much deeper level, to best attract, retain and develop the face of NuVasive in the field. We have accelerated the pace of hiring with the intent of more than compensating for losses in the third quarter. We have already made progress adding six reps since the end of the quarter, with the majority of the new hires in key regions. We are currently recruiting an additional 35 representatives, and are making strong progress in obtaining top talent. We continue to envision a team of 500 representatives globally, as we approach $1 billion in revenue. And despite the challenges that materialized in Q3, the efficiency of our sales reps continues to make excellent progress.

In the third quarter, average annualized sales per representative was about $2 million, up 13%, compared to the same quarter of last year. Secondly, we are increasing our legal efforts to ensure that non-compete agreements are adhered to, and we are pursuing those individuals and or companies that violate them. The market will clearly understand that we will aggressively protect the investments and agreements we have made to develop our industry-leading sales force.

A couple of weeks ago, we announced a decision of our President of Global Sales, Jeff Riden, to make the transition from his role at NuVasive. Jeff has been a very important member of the senior executive team, and we are all supporting him in his decision. I thank him for his hard work and dedication throughout the years, to build our global sales force. I am excited that Jeff has agreed to a long-term consulting position, and will continue to be a member of the NuVasive family, working with members of the executive team. We have already begun the search, and are also evaluating internal candidates for Jeff's replacement. In the interim, I will assume US sales responsibilities.

As you may know, I have many years of experience executing sales strategies, and leading sales forces in previous roles. We have made several changes already, to better retain our top performers, and I am eagerly addressing the challenges we face head-on. Moving forward, all international responsibilities will be led by our newly-promoted Executive Vice President of International, Russell Powers, who reports to me. Russell is very well versed in all international markets, from his time at Medtronics Sofamor Danek. He has several years of experience leading international sales, marketing, development and global operations, in spine and orthopedics. In just three weeks, Russell has already set in motion high growth initiatives, along with expense reductions. I am really thrilled to be working alongside Russell to build our international business, beyond the 10% of revenue that it is today.

Now, with regard to surgeons and aggressive competitive tactics. We are also experiencing an increase in existing surgeon customers being heavily pursued by smaller companies, in an effort to gain their business. These surgeons are being lured away with tactics that are not necessarily based on innovative product portfolios or responsive customer service. We have dramatically increased our communication efforts over the last month. I have personally reached out to over 350 surgeons thus far, and the entire executive team has been assigned a surgeon list. I have received very positive feedback on these efforts. This is the basis of NUVA Touch, an executive program designed to increase face-to-face interactions with our top 300 accounts.

The effort continues to be fully active and is being expanded upon. NUVA Touch has always differentiated us, and we are rekindling it in a big way. We are also increasing our focus on driving the influence and membership of our Solus group of surgeons. Our data shows a much higher level of engagement among Solus members. And according to the surgeons coming to Solus meetings in record numbers, it is the most meaningful group focused on advancing spine surgery through scientific exchange. Those are not my words, but theirs. We are increasing efforts through our sales force, and our clinical research team, to communicate the benefits of Solus and will rely on key Solus members to expand the organization in the US and internationally. Now, let me talk about pods.

In some situations, there is little we can do, or even want to do, to keep a surgeon, who makes decisions to adopt a new business model, that is not based on better clinical outcomes. Nowhere is this more evident than in the steady increase of physician owned distributorships or pods. We do not believe that the impact of pods on the overall market suddenly accelerated in the third quarter. However, the impact of pods on our business did accelerate late in the third quarter, as we abruptly lost a few major customers to that model. Pods have been a negative force within the spine market for several years. We estimate that they now represent as much as 15% of the US market. They are generally set up as follows.

Surgeons purchase products from medical device companies, resell those products at a marked up price to hospitals, where the surgeon performs surgery, and typically prescribe or use those products in the surgeries they perform, to obtain profits. It is our belief that the financial motivation of pods can distort the marketplace for medical devices, through disinter mediation, and stifle beneficial research and development. However, without some concerted effort by hospitals, surgeon societies, and government legislation, it is possible that pods will continue to be a formidable market dynamic for the foreseeable future. We believe that by raising awareness and educating these key groups on the pod issue, is a sound way to proceed. Our efforts on the legislative side, have been encouraging, but the speed at which things progress has been somewhat disappointing. We will continue to focus some efforts in this area, but the biggest impact will likely come from the surgeons and the hospitals.

We have been in contact with many of our surgeon customers to understand what steps are being taken at the society level, to formulate self policing guidelines. While there are very vocal supporters to stop pods, the likelihood of legislative guidelines in the near term is uncertain. Thus we are now focusing our efforts largely on educating hospitals about the ethical issues at stake. We have seen some good progress here, with more hospitals enacting policies that prohibit the use of pod sourced implants. These actions appear to be quite effective, in eliminating the buying of pod products, and in deterring surgeons from joining pods.

We operate under the presumption that better medicine is what motivates the surgical community. We focus on doing what is best to earn a surgeon's trust and confidence. This will remain our measure, in increasing our business, and we will not enter the fray in any other manner. We will, however, protect and defend the people, innovation, and intellectual property that we have worked so hard to develop in pioneering procedures, to provide the very best results for patients. We intend to continue building our business purely on our commitment to change spine surgery, through absolute responsiveness, speed of innovation, and superior clinical outcomes. We will forge ahead and fight the battle against pods head-on. We took on a similarly nebulous task in marshaling the surgical community, to address insurer push-back. Like our experience with insurer push-back, we anticipate that progress made to stem the increasing penetration of pods will be at a measured pace and will require patience.

Now, let's talk about insurer push-back more specifically. So in terms of what we're experiencing with regard to push-back, when we pre-released third quarter revenue results, I mentioned that we were hearing from surgeon customers of continued insurer delays or outright denials of coverage for patients in need of any spine fusion procedures. In September, we received unsolicited feedback about the continued prevalence of insurance payer push-back at our Solus East meeting and more at the SMISS meeting, Society of Minimally Invasive Spine Surgery, and we were not alone. Before our pre-release call, an industry report observed that conversations about payer push-back were more prevalent. We have since learned that some insurers are now pushing back in spite of being challenged with the overwhelming body of evidence in support of fusion. And we have heard of insurer push-back in geographies that were previously unscathed. It's difficult to quantify what impact if any, insurer push-back had if any on our third quarter.

Let me be clear. We believe that our shortfall in the quarter was overwhelmingly driven by account churn, not reimbursement. However, we also believe that insurer push-back continues to pressure US growth, and does not appear to be easing. We supported the surgical societies in developing the Health Technology Assessment or HTA. It is now complete, and awaiting publication. The collection of clinical data provides evidence in support of spine fusion, that surgeons and societies can use in dialogue with insurers, and it is a giant step in the right direction.

However, the industry needs to quell the challenge of insurer push-back through broader insurer adoption of a clinically supported consistent set of guidelines for spine fusion. We will continue to do what we can to aid in the development of those guidelines, but understand that drafting them is an immense undertaking, that entails the collaboration of several surgical societies. While the process is under way, it is progressing at a measured pace. A few NUVA executives and I are actively spurring this process. All right. So now let's move to guidance.

As I just outlined, we are taking steps to address the challenges that impacted us in the third quarter. We have developed and implemented tactics to address what are both macro and Company-specific issues. That said, our mission at NuVasive, which is to change spine surgery as a $1 billion startup, will not change. We transformed the spine industry with innovative approaches, and we will perpetuate that creative startup edge with our speed of innovation, superior clinical outcomes and absolute responsiveness culture. As we reassess our strategic plans in light of new challenge, you can be assured the decisions made, will continue to reinforce our market share taking strategy. And as we work through this process, we intend to set realistic expectations for our growth. The account churn related to aggressive competitive tactics, and the loss of a few accounts to the pod model, accelerated late in third quarter.

We anticipate that the impact to the fourth quarter may be greater than what we experienced in the third quarter. We are therefore adjusting full-year 2012 revenue guidance to $601 million to $606 million, compared to $625 million previously. The account churn is having the greatest impact on our US lumbar business. As a result, we now anticipate US lumbar growth to approximately 2% for the full year down from about 7%. We continue to expect US biologic's of approximately 5%, US cervical growth of about 15%, and international growth of about 40%. As a reminder, our monitoring business is dependent on direct billing to payers.

Case volumes are growing very well and as planned. But we continue to experience difficult reimbursement trends. As a result, we anticipate our US monitoring service revenue to approximate $40 million for the full year, versus our previous $42 million estimate. Impulse's clinical execution has been outstanding, and we look forward to continued growth in our monitoring platform. The significant decrease in revenue guidance, and the abruptness of the slowdown in the third quarter, will make it difficult to materially alter investment and spending decisions in the near term. Still, we have taken additional steps to ensure strong profitability translation. We now expect full-year 2012 non-GAAP operating margin to be approximately 14%, down from 14.5% previously, on $625 million in revenue. Let me repeat that any additional cost savings initiatives, will not be related to the core drivers of our revenue growth, such as sales force hiring and training, and surgeon training, along with Solus.

Over the long term, our goal is to grow our top line at a double digit rate. However, assuming the market dynamics that materialized in the third quarter persist through 2013, we anticipate mid single digit percent revenue growth. As well, exclusive of the impact of the medical device tax, we intend to show meaningful non-GAAP operating margin improvement over each of the next several years. We will of course provide more detail on the outlook for our future, during an analyst lunch at our NUVA East headquarters in New Jersey, on November 7. The agenda will include a strategic update, with further discussion of the competitive landscape, pods, and insurer push-back. We will cover our future revenue growth drivers and catalysts, and provide additional color on the decisions we are making to expand profitability, using revised assumptions for revenue growth. There will be a surgeon panel. And ample time for audience Q&A with executive management and the surgeons. We hope to see you there.

So now I would like to talk about market share taking strategy, growth catalysts, and also NAS. In spite of the market challenges we face, our market share taking strategy and the spirit of innovation at NuVasive, is very much alive and well. Nowhere does that ring more truly than in the buzz around the NuVasive booth at NAS this year. We are showcasing a number of key growth catalysts that will drive market penetration. The booth features a vast array of innovative solutions, like our new indications specific implants for XLIF sagittal alignment, new lateral fixation options, expansions of MAS TLIF, the new maXis c-retractor for the cervical spine, and a new post exterior fixation approach known as MAS PLIF, we believe that MAS PLIF will redefine the traditional posterior approach, with a less invasive medialized procedure, for posterior pathology that requires direct decompression.

Our precept posterior fixation system, simplifies procedures by offering more practical MIS or open instrumentation for even the most advanced constructs. The full launch is underway, which we believe will be a substantial contributor to new account growth and deeper penetration. We also have a section of the booth dedicated to impulse monitoring and NeuroVision, demonstrating to surgeons the power of integrative neuromonitoring, and the technical superiority of our many monitoring solutions. In addition, our booth will highlight our patient advocacy efforts, dedicated to improving patient access to care. Better way back, designed to build a community of support for individuals, suffering from chronic back, neck, or leg pain, will be featured prominently. That effort has been a tremendous success, and today boasts over 750 XLIF active patient ambassadors, which will be more than 1,000 strong by year end. And spine care alliance, for patients who have exhausted the appellate process for medically indicated spine surgery, will also be highlighted.

SCA has been very effective in helping to reverse fusion denials. By the end of this year, we expect our portfolio to boast over 80 innovative spine products, which address both minimally invasive and traditional procedures. Our commitment to expand our portfolio by developing more game changing products, remains unchanged, and will continue to distinguish NuVasive in the market. Our pipeline speaks to that commitment. We continue to plan for eventual approval of our cervical TDR device, PCF, this year. However, we still do not know exactly when the FDA will give us approval. Launch of the device would mark our foray into motion preservation of the cervical spine, a very exciting segment of the MIS market, still very much in its infancy. We will provide updates and general forecasts once we gain clarity on the timing of this launch.

As well, we continue to work toward US clearance of our synthetic biologic AttraX. But we have no further updates at this point. AttraX, by way of reminder, augments our existing portfolio of biologic solutions, which we believe can compete head-to-head with the industry leader, at a more economical price point. If all goes well with FDA, and that is still a very big if, AttraX could be cleared in the first quarter. Our international opportunity remains very strong. We are now selling into Japan, and should have approval to sell our XLIF implants in early 2013. We will be the clear leader in lateral procedures in this new market, and anticipate strong adoption of our industry-leading solutions around the globe.

Before I turn the call over to Michael, here is a quick update on our ongoing Medtronic patent litigation case. The district court still has not yet determined the royalty rates that will apply during the period of time from the verdict, through the appeal. A few months ago we announced that the federal appellate process for Phase I has been put on hold until the district court has ruled on the post verdict royalty, which we expect by the end of the year. Regarding the appeal of the NeuroVision trademark case, the 9 circuit Court of Appeals reversed and vacated not only the original courts judgement against us, but also the injunction and the award of attorney's fees and costs against us. The case has been remanded back to the district court for a new trial with a new judge, and we are very optimistic that we will receive a more favorable resolution in the new trial, along with removing the restricted $63 million from escrow, with full access to that capital. Michael will outline our cash position and cash flow, which are already very strong. We have taken the necessary steps of securing cash and incorporating the anticipated financial impacts into our guidance for these legal issues. I will now turn it over to Michael for a further discussion of finance.

Thank you, Alex. And good morning, everyone. Our revenue for the third quarter 2012, was $148.4 million, an 11.7% increase over the third quarter of 2011, and a 4.7% increase, excluding IOM service revenue. Year over year revenue growth in the third quarter for US lumbar, was flat with year-to-date growth of approximately 5%. US biologic's growth was roughly flat, and year-to-date was up approximately 9%. US cervical revenue grew about 12% and is up 16% year-to-date. The services revenue from our impulse monitoring business, was $9.6 million, and was $29.3 million year-to-date.

Finally, international revenue, including its biologic's component, grew over 45%, to just over $14 million, with year-to-date growth of approximately 40%. Our numbers today reflect the reclassification of approximately $1.2 million of revenue, which was classified in the second quarter as either US lumbar or US cervical revenue, instead of as US biologic's revenue. Correcting this item affects only the bucketing of our revenues, and does not impact our historical overall revenue results for Q2. Nor does it significantly impact the historical growth rates that we have reported for our US lumbar, US cervical, or US biologic's product offerings. All of this detail is provided for your reference, in the supplementary financial information posted on our Website in the Investor Relations section.

Our Q3, 2012 GAAP net income was $2.4 million, our earnings per share of $0.05. Excluding an aggregate adjustment of approximately $7.7 million net of tax for the adjustments detailed in our press release, third quarter non-GAAP earnings were approximately $10.1 million, or $0.23 per share. Gross margin in the third quarter was $74.6 million, compared to 80.4% in Q3, 2011, and 76.3% in Q2, 2012. Year over year, gross margin was primarily impacted by patent litigation royalty expense, which drove 130 basis points of net impact, and by the acquisition of Impulse Monitoring, which drove 320 basis points of net impact. Most of the remaining gross margin Delta was driven by international mix, which has a lower gross margin than the rest of the business. Hospital pricing pressure was immaterial in the quarter.

Research and development, or R&D expenses, adjusted to exclude stock-based compensation, and acquisition-related items, totaled $7.4 million in Q3, 2012, compared to $9.2 million in Q3, 2011, and $8.7 million in Q2, 2012. R&D expense as adjusted was 5% of revenue, for Q3, 2012, versus 6.9% in Q3, 2011, and 5.6% in Q2, 2012. Relative to last year, the decrease in R&D as a percent of revenue was caused by the addition of impulse revenue which comes with a lighter R&D component to it and lower spending on clinical trials, FDA approvals, and studies. We continue to invest in our product pipeline through 510K applicable products. Sales, marketing and administrative or SM&A expenses adjusted to include stock-based compensation, certain intellectual property litigation expenses, and acquisition-related items, totaled $81.1 million, in Q3, 2012, compared to $75.3 million in Q3, 2011, and $84.1 million in Q2, 2012.

SM&A expense as a percent of revenue was 54.6% million in Q3, 2012, versus 56.6% in Q3, 2011, and 54.5% in Q2, 2012. The year over year decrease in SM&A as a percent of revenue is primarily attributable to the addition of impulse, which has a less intensive SM&A structure than the rest of NuVasive. On an absolute dollar basis, the year over year growth in SM&A expense, is primarily attributable to head count and related compensation increases, continued international expansion and the addition of impulse. As a result of the above-mentioned gross margin, R&D, and SM&A results, our third quarter non-GAAP operating margin was 15%, compared to 16.8% in Q3, 2011, when you exclude the $101.2 million litigation award expense, and 16.3% in Q2, 2012. Compared to Q3 last year, Q3, 2012 results include a full quarter of impact from both the patent litigation royalty expense and from the impulse acquisition. Normalizing for the impact of these two items, Q3, 2012 non-GAAP operating margin would have been 17.5%, or inline with a similarly normalized view of Q3, 2011. Interest and other expense net totaled $6.4 million in the quarter, compared to $5.3 million in Q3, 2011 and $7.3 million in Q2, 2012.

For the third quarter, cash provided by operating activities came in at $33.7 million, bringing us to nearly $100 million year-to-date. Excluding the refund received from a Q4 overpayment made to a taxing authority, the year-to-date number is just over $88 million. The comparable year-to-date free cash flow number, similarly excluding the Q4 overpayment, is roughly $53 million. We are pleased to see this improving performance, given our team's continued focus on enhancing our cash generation capabilities. We clearly continue to make progress. Our cash and investments balance at the end of the third quarter was approximately $285 million, which is up nearly $20 million from last quarter, and up $56 million from the end of last year, when normalized for the cash restriction associated with the patent litigation royalty. Our current cash and investment totals exclude approximately $175 million now restricted, for the patent litigation royalty, and for the NeuroVision trademark case.

At the end of Q3, 2012, our inventory position was roughly 22% of annualized third quarter revenue, compared to about 23% at the end of Q3, 2011, and roughly 21% at the end of Q2, 2012. Days sales outstanding, or DSO, when run off of our net AR balance, was 47 days in the quarter, compared to 51 days for last year's Q3, and 50 days at the end of Q2, 2012. The AR team posted another solid quarter of cash collections, which helped us improve DSO year over year, even in spite of approximately 1.5 days worth of upward DSO pressure, due to the addition of impulse, and the outsized growth of our international revenues that generally have longer collection cycles.

Now, let me turn to our updated guidance for the full-year 2012. Please reference the tables in today's press release for additional detail. As Alex mentioned, we are updating full-year 2012 revenue guidance to a range of approximately $601 million to $606 million, compared to $625 million previously. Turning to the rest of the P&L, we now expect full-year 2012 gross margin to be approximately 75%, versus our prior guidance of 75.5%. With the biggest drivers being the lower impulse gross margin, and a heavier mix of international business.

We are lowering our full-year non-GAAP operating margin guidance to approximately 14%, compared to 14.5% previously. We have taken steps to mitigate the impact to operating margins in view of lower revenue growth assumptions. These efforts are demonstrated by only a 50 basis points reduction to our operating margin guidance, in spite of the significant change to top line guidance. However, the full impact of our efforts will take time to materialize, and is likely to be more meaningful to 2013 and beyond. We anticipate that the main driver of our future profitability improvements will be SM&A leverage.

Full-year 2012 other income and expense guidance, is unchanged at approximately $27 million, which will include about $12.5 million in non-cash interest expense. In view of lower expectations for pretax income, we now anticipate a full-year 2012 GAAP effective tax rate of approximately 60% compared to 55% previously. We generally expect our effective tax rate to improve some in future years, as our pretax income increases. However, more significant progress will be dependent on international revenues, becoming a more meaningful percentage of our total revenue mix. Non-GAAP adjustments continued to be tax effected, at approximately 40%, for the full-year 2012.

Diluted shares outstanding for the full-year 2012 remain at approximately 45 million, and finally, we now estimate full-year 2012 GAAP EPS to be approximately $0.11 to $0.13, and non-GAAP EPS to be approximately $0.88 to $0.90. As a reminder, non-GAAP operating margin and EPS guidance for 2012 excludes the full year impact of non-cash stock-based compensation of approximately $27 million, compared to $32 million previously, certain intellectual property, litigation expenses, of $3 million, compared to $2.5 million previously, amortization of intangible assets of approximately $12 million, acquisition-related items of approximately $2 million, and as incurred additional items, and non-cash interest expense associated with the convertible notes of approximately $12.5 million. We feel this non-GAAP EPS measure generally speaking most accurately portrays the operating earnings power of NuVasive and should be the basis for measuring our progress.

We plan to issue guidance for the full-year 2013 in conjunction with our Q4, 2012 earnings announcement. As Alex mentioned, we are taking what steps we can to bolster our market share taking strategy, and to drive double digit top line growth with meaningful improvements in profitability longer term. In light of current market challenges, however, we envision top line growth in the mid single digit range for 2013. We are working to close our 2013 budget during Q4, and we will get our arms around what changes need to be made, to ensure that we improve execution in 2013, despite the difficult environment. Now I will turn the call back over to Alex for closing comments.

Thanks Michael. We are making changes in the face of adversity. Account churn is not the biggest challenge NuVasive has ever faced. We have overcome much more difficult obstacles, and we intend to do so again. Look, we developed and pioneered XLIF. Years ago it was ridiculed for a lack of data, now there are nearly 100 publications and over 30 book chapters on XLIF. We developed Solus, which boasts over 600 active members. That didn't happen serendipitously. It was strategy and tactical execution, and we overcame the obstacle.

When payers stepped out against XLIF just a few years ago, what happened? Experts said we would be dead in the water for at least 12 months to 18 months. We marshaled our resources, drove laser focus, and worked with societies. In a matter of three months, it was resolved and payers retracted their XLIF denials. We overcame the obstacle. NuVasive filled the void for surgeon training in the spine industry, without which we would not have been able to proliferate XLIF.

We established world class training on the west and east coasts, to provide the only in-house cadaver program, for nearly the past decade. Why? Because there wasn't a comprehensive course in an operating room done with any consistency or frequency among the societies or surgeons. The result is what surgeons called the best one-on-one training they have ever received, in a one-day intensive program. We have overcome more obstacles than I have time to recount. And most importantly, we have and will continue to change spine surgery.

We developed MAS TLIF, which completely rethought an ages old procedure. Now we are launching MAS PLIF and precept for percutaneous or open posterior fixation. We are approaching hospitals with procedurally integrated monitoring for the lumbar, thoracic and cervical spine. We are changing the game in spine, and we are still just getting started. We have learned from the past, and we will take those lessons to overcome a very challenging spine market. We are driving change and I have no doubt that we have the management team to make it happen.

We talk a lot about our culture at NuVasive. Our culture is built upon the strength of character, upon belief in the ability to overcome obstacles, which is predicated upon our many successes in doing so, and upon a burning desire to make a difference, by consistently changing spine surgery to benefit patients. This is our purple koolaid and we drink it every day. And this is why we will again prevail and achieve our $1 billion startup goal. Our plan in the fourth quarter, and into 2013, is to reestablish sales momentum, by adding more new businesses than we have lost in three of 12 US regions. Rather than only focus on the three regions, we have implemented changes across the country.

In summary, here is the plan to address our third quarter challenges. Number one, broader sales force engagement and deeper penetration. Number two, significantly accelerate the pace of sales force hiring. And number three, reinvigorate and expand NUVA Touch along with Solus expansion. In terms of number one, we are implementing new initiatives for greater sales force interaction, with our exceptional leadership team. We are rolling out improved mobile resources to simplify the rep's jobs and putting together new asset management programs. We are providing additional incentives to gain new accounts, and sell more mix, into existing accounts. All fully underway for broader sales force engagement, and deeper penetration.

Back to number two, significantly accelerate the pace of sales force hiring. We are actively recruiting top talent, and have immediately opened the path for 35 new reps to join NuVasive. Interest is very high, including among key competitive reps also, fully underway. Three, reinvigorate and expand NUVA Touch along with Solus expansion. Increase executive engagement with our top 300 customers, and emphasize what most differentiates NUVA, which is personal involvement and interaction between us and our surgeons. It also means more surgeons being recruited to the NUVA family. We are expanding the reach of Solus and the membership to beyond the current 600 active members again, this, too, is underway.

Looking onward and upward, we anticipate the following five main catalysts will drive our growth. One, the continued spine market shift, from open procedures toward MIS procedures. Two, the increasing and overwhelmingly significant body of clinical data, generated by Solus, in support of XLIF, including thoracic, and other integrated procedures, patient outcomes and economic advantages. Three, the adoption of our new game-changing solutions, like MAS PLIS, precept impulse monitoring, PCM and AttraX, as well as deeper penetration in scoliosis, tumor and trauma. Four, the massive opportunity outside of the United States, both in new markets like Japan and Italy, and existing markets like Australia and Puerto Rico, where we are driving towards market-share leadership. And lastly, five, a commitment to rapid growth in a challenging market, with meaningful year over year improvement in profitability. We fully expect to deliver on our plans to build more accounts, and deeper penetration with our existing customers and sales force. And we are very excited about the many catalysts driving growth, with disciplined focus on profitability. We thank you for your support and patience. We will now take your questions.

(Operator Instructions)

Matt Miksic with Piper Jaffray.

The one, Alex, I guess on the top line expectations for the back half of the year, and your high level comments for next year, as we look at that, is that assuming -- what is that assuming in terms of further impact from pods? That would be my first.

Well, so as far as pods are concerned, we expect to see some continued erosion in the entire market. But we expect to add more accounts than we could potentially be losing. We don't know of any additional accounts that we might lose. So our focus is on building stronger relationships with our existing base, and expanding rapidly. As you know, from our discussions a few weeks ago, we said that the annualized impact of what took place in the third quarter in terms of poaching was between $15 million and $25 million on an annualized basis. So that is what we're taking into account, with regard to our guidance assuming relatively worst case scenario. And moving from there.

But just to be clear, if I'm hearing you correctly, it would be whatever further impact there is going to be, you would expect to be able to offset that, with the steps you're taking.

Exactly right.

And then a question for Mike. The impact on the bottom line, you talked about some of the cost cutting, or cost controls, I should say, measures you put in place. I guess I was a little surprised that the drop-through was not more significant for the fourth quarter. Maybe if you could -- I know you're not giving 2013 guidance here, but talk about maybe the sustainability of some of the operating margin level given -- when you lose this top line revenue, it is quite profitable and it doesn't sound like you're pulling back on your SG&A, and your sales force, and your customer facing that expense, so I guess the question is, how do you sustain that kind of step-down and still maintain the same kind of margin trajectory?

So Matt, I mean I think I got it. You're a little bit clipped off, but let me talk a little bit about Q4, so Q4 we do expect to be down sequentially. It will be down in the '13 somewhere, given year-to-date, we're sitting at 14.3%. And what is going on underneath that is Q4 will be down on a lower gross margin. We've got a couple things going on there. International mix weighing in a bit more heavily because of the weaknesses, mostly domestic. There will be a lower impulse gross margin. Given both Q3 and Q4 FX in that business which is essentially fixed costs in the cost of goods sold arena, so not a lot of variable cost and leverage with any change.

On the OpEx side, we are making a few investments as Alex alluded to, incremental sales heads, and we will continue to build and drive out OUS, especially Japan, with the ramp in sales and marketing there. And we do expect a little bit higher legal spend in Q4. And so those are really the drivers on the change as you move from Q3 to Q4. If you think about the guidance old to new, essentially down 50 basis points, and that's really coming out of gross margin, Matt. It is really essentially a flat OpEx E to R at about 61%, which implies a substantial amount of OpEx reduction has moved out of the P&L. Some of that of course is variable costs, freight and commissions, things like that. But there is also a lot of active management of things like headcount, P&E, bad debt expense with the improvements in DSO, and some adjustments to performance-based comp. So those are all the moving parts. I hope it gives you the color you're looking for.

That does help. Thank you.

Robert Hopkins with Bank of America Merrill Lynch.

So two quick things. First very quickly for Michael, when you kind of think about all of the things that you guys have just articulated, do you think you can grow adjusted EPS in 2013 off of this $0.88 to $0.90 base from where you sit right now? When you think about all of the moving parts including the tax, the Medtech tax?

Certainly, when you think about Med device tax, everything we will talk about, Bob, will be ex-Med device tax, I think, but 2013 guidance, we will wait to provide on the Q4 call.

I appreciate that. But just generally, do you think you can grow, including the Medtech tax off of $0.88, $0.90 or not?

In the overall scheme of things, there is -- we would expect it to be able to improve. Think about some of the those moving parts. We will get rid of the March 2013 converts which will save a little bit on interest expense, and then with improvements operationally, the answer should be okay.

Okay. And then just for Alex, I appreciate all your commentary and explanations. But if you just sort of take a step back and look at the numbers, and what we're seeing from some of your competitors, I mean J&J is not putting up great spine numbers but they didn't get worse in Q3. And Medtronic looks like they're getting a little bit better. And Stryker looks like it is getting a little bit better. And you guys are getting a little bit worse. So, my question is, how confident are you that part of what is going on with your business right now is just from share loss to the bigger competitors, as they start to pay more attention to spine?

It is absolutely not share loss to the biggest competitors. And I will tell you that in terms of the new reps that we are hiring, that's exactly where they're coming from. And we've hired quite a few this year overall. And they are coming from the major players. So I think as you kind of frame where we are, on the quarter, essentially we were down $5.5 million, over our own expected outcome. And so I think as you consider the fact that across the United States, for example, the western half of the United States performed actually to quota, which is higher certainly than internal budgets and so forth.

Where we had weakness was actually in just three regions. More in the mid-south, mid-atlantic part of the country, and so I think what we're seeing, clearly, is a bigger impact from smaller competitors. We are doing our best to isolate that. We are doing our best to move forward with adding additional accounts in the event that we get broad sided again. But clearly, I can tell you that it is not going in the direction of larger players. That I'm certain of. And I believe that our growth thesis is still very much in tact longer term. Right now we just need to be very cautious with regard to where we're at and so that's the position that we're taking.

Thank you.

Matthew O'Brien with William Blair.

I was just hoping that you could provide a little bit more color around Japan, in 2013. I know you've gotten approval for some products at this point, but help us think about how the revenue outlook would look in that region, with and without XLIF products next year?

So what we're assuming right now is generally in the $10 million range for revenue next year, predicated upon an early launch of XLIF, first part of the quarter, literally January. We expect that to grow at a robust pace for the next several years.

Okay. And then here is a follow-up question with a lot of numbers to it, but just as I think about the revenue guidance for next year, call it around $600 million in revenue this year, growing that at about 5%, that's about $30 million absolute next year, and when you layer in Japan, as well as the strength you're seeing internationally, as well as cervical strength, that is something around $23 million, $24 million bucks, then you add in AttraX and PCM, maybe that is something around $4 million bucks, and then on top of that, all of these new reps, it is just -- is using something like a 5% growth rate a little bit too conservative? Or is there something else that I'm missing where using that mid single digit number like 5% would probably be too conservative?

I don't think you're missing anything. I think what you're hearing from us is, being prudent with regard to guidance. And I think that we believe that we can certainly build from what we're talking about. But at this point in time, we don't care to venture out beyond that. I think a lot of your assumptions are reasonable, we could certainly go back and forth on the exact numbers. But generally speaking, yes, those are the catalysts that are going to make a big difference in '13 and into '14.

But just to follow up on that a little bit more, it would assume kind of flat performance in lumbar, as well as in monitoring, and then your core biologic business. Is that accurate?

Generally speaking, yes, but again, we will give you some exact guidance on our next call.

Okay, great. Thank you.

John Putnam with Capstone Investments.

Two questions. Alex, the pod activity, where has it picked up? Is it the East Coast really that has picked up?

It is actually Southeast and Atlantic regions where we've seen the pickups in activity. The pods came out of the West Coast essentially. And so even though they've been there for quite some time, they are somewhat stagnating with regard to their development out there. And I think that's why we saw strong performance on the West Coast. So we're optimistic about overcoming what has been taking place in our market. And been very forthright with regard to where we've had the sensitivities with regard to revenue performance.

And have you seen any hospitals who may have used pods before, now rejecting them and going back to a direct distribution?

Yes, absolutely. We've seen quite a few. I'm hesitant to name them. But I can tell you that there is quite a few on the West Coast. There's also a large buying group, which has also banned pods, and has that in writing in their documents.

Okay. And then just on the sales side, have you done any tweaking of the compensation situation for sales people to try to either retain them or attract new people?

Yes. Our compensation is strong. It is not much different than what everybody else is paying, but we've provided added incentives for new account growth. And for next year, we're in the process of redoing our compensation, in order to further the growth opportunities with our sales force. So right now, we've put into motion a number of different things. We did that immediately starting into the fourth quarter. And we plan to make some additional positive changes, as we move into '13 and '14. Which we think will help us to recruit faster. And also further solidify our sales force base.

Thanks very much.

Bill Plovanic with Canaccord Genuity.

If you were a smaller company with 5% of the lumbar market and you were growing, it is obviously a much easier task. As you become a bigger player at 10% to 15% of the lumbar market, obviously that becomes a much more challenging task. And you also become a target for the smaller people, players, to take your sales reps, so you say as you continue to try to grow the business, you're going to run into two challenges. One is the smaller companies are going to continue to pilfer your reps. And two, is as you have a bigger piece of the market, it becomes that much more challenging. How do you overcome those two challenges as you continue to march forward towards that $1 billion revenue goal?

I think you overcome them the way that I described for Q4. You overcome them by having better differentiation. Not only in products but in services and engagement. And all the things that I've talked about just now with John, relative to compensation. So I believe that there is a lot of things that you can do about that. Look, it is not like we haven't had competition since day one. I mean when we started out, we were just looking at the big gorillas out there, and doing our best to be able to come through with products.

Now we're on the other side of that, and we believe that we can still grow very effectively for years to come with the approach that we've taken. And I think the proof is going to be in the pudding obviously, but we feel very confident that we have established the right strategy, reinforced the right aspects of it, and frankly, made a series of deletions of things that we think are less effective. And so uncluttering and clarifying our position and expectations of the salesforce is as important as anything we might possibly do, and so we have done all of those things, and we will do more of them as we move into '13. But we think we've done what we need to do for Q4 growth and we expect to do a lot more with regard to '14 and '15.

I want to clarify, though, that we continue to get top talent moving in our direction. I don't want to name specific companies, with regard to how much of that talent has come from where. But I can tell you we are getting very, very much the top performers who want to come to NuVasive, because they want the full bag of all the things that we have, and they're very much aware of how many other new products we're going to launch. The big advantage that we have, we're not copycats. We don't sit there and just produce a whole bunch of stuff the same as everybody else. We're pioneers. And we're putting forward new platforms. The surgeons respect that. And certainly our sales reps respect that and want to be a part of that growth.

And Alex, if I could ask a follow up question.

Sure.

One of the comments you made was the rep compensations can hold on to those reps, but it creates a circular challenge, in that if you have to keep the rep compensation high, it keeps your operating expenses high, and you can't get that leverage in the model in the future. You can help me with that?

So to be clear, Bill, what is happening is that when somebody poaches a rep and at least in some of the instances, what they've done is they've put forward what we think is outrageous compensation to attract that person for let's say a year. There's numbers out there like $800,000 for a rep. We have no intention of competing with that. We think it is absurd and it is unsustainable. And we understand that, that is part of their poaching process. But companies doing that are going to find themselves in a very difficult position with regard to cash. So what we're doing is we're making sure that we have comparable incentive programs for our salesforce, and then doing the kind of things on top of that, that spur growth with adding accounts, and set sales, and things of that nature.

Thank you.

Michael Matson with Mizuho Securities.

Yes, I guess a question for Michael, just regarding where you're kind of focusing your cost control efforts, because just looking at what happened, or what you're guiding for the remainder of the year, R&D looks like it is getting hit maybe a little disproportionately relative to sales and marketing. And just maybe walk me through your thinking in terms of balancing the areas of where you're looking to rein in spending, and what gives you the confidence that R&D is really the right area to be a little more aggressive, if that's the case?

So a couple of thoughts. I mean part of the R&D reductions over the last 12 months to 18 months have been things like clinical trials ended or ending, right? And so that's been a significant contributor to the change in expense to revenue ratio there. It is not the place that we want to really look for long-term improvement in OpEx management. In fact, we do expect it to sort of flatten and maybe rise a little bit going forward. Which really leaves us with SM&A and I mentioned that in the script that, that will be the focus for us. Alex mentioned the productivity of the salesforce. And through that, naturally increasing productivity, which has continued to go up, we certainly do get some leverage.

We are slowing and have already substantially slowed the growth in non sales head count that brings with it both salary, benefit savings, as well as T&E and other things. And we're doing that through things like automation, and some of the productivity focus we have talked about in the past. We have redone some of our -- we will focus on some of our major contracts, freight and areas like that. We have also done a pretty good job actually and we will continue this activity, insourcing some activities that were buy before, make versus buy, and by bringing those things in-house, we're saving money. And then we're looking at all of our old habits that we built up as a Company over the last five to 10 years. And changing a lot of those spending habits. Whether it is on Company meetings and events, or promotional materials, and things like that. We're navigating those.

In fact if you go -- the people who come see the booth at NAS, you will see that the booth size a year ago was shrunk down significantly, which generated savings. I think it is the same size roughly this year, give or take. But it is really crawling through all of those different pockets of the Company, to make sure that we're scrutinizing all of the decisions and choices that get made, in order to make sure we're squeezing profit out, when we can. And as we mentioned on the call, we do expect to deliver meaningful operating margin improvement, even in light of or in spite of the slower revenue growth. And really trying to stay focused on the most important things, which is driving investments in our core areas, innovation and clinical outcomes.

Okay. And then just one additional question, on the mid-single-digit rough guidance for next year, for revenue growth. What are your assumptions around PCM and AttraX? Does that include those products or not?

At this point, it does not.

Okay. That's all I have. Thank you.

Richard Newitter with Leerink Swann.

Alex, maybe, I just wanted to ask, it sounds like one of the growth catalysts or the steps to improvement is going to be a focus on innovation and you're going to be exhibiting some of that innovation at your NAS booth today and over the next few days. I'm just -- compared to where you were several years ago, or even a decade ago, with respect to lateral, and how new and truly different that product category was, can you maybe tell us the level of revolutionary-ness of products that we will be seeing at NAS and whether they can in fact elicit or solicit a similar type of following from surgeons, enough so that people could gain increased confidence that newer products still do have the potential to win over a surgeon base?

So one of the things, first of all, with regard to XLIF, is that XLIF is going to continue to grow at a good clip. And there's a number of reasons for that. One of the things that nobody seems to be picking up on among the analysts, is a very simple fact, and that is that our competitors are actually making comments. And even I would say so much as guiding surgeons away from doing the four, five level in lateral. See, we built our entire business upon doing four, five and up the spine. That's the difference with NeuroVision and our monitoring approach.

Other companies are saying well you can't really do four, five. No, they can't do four, five. It is not that you can't do four, five. We do four, five and they cannot. And so we still have a very big advantage. And what we're dealing with now is effectively the marketing machines that are trying to move us or trying to create a cloud over four, five. We have a huge amount of data with regard to Solus. We have a lots of things that we are putting forward that mitigate all of that. But it is very interesting trend to us, watching what the other competitors are trying to do in this regard. So that's one thing. So that means there is still a lot of growth for XLIF. Obviously the same with moving into the thoracic spine. With lateral type of approaches, single incision type of approaches, and then of course, doing a lot more with trauma, tumor, and scoliosis.

As far as new products are concerned, we really believe, and this is based upon surgeon feedback obviously, but we believe that MAS, PLIF is one of the best systems that has been released in a long time in solving a lot of what are really the challenges of a very old procedure. And so the surgeon adoption has been very strong. One of the ways you can measure surgeon adoption is kind of what we call, do you have a one and out, meaning they do one surgery and that's it, they're not interested in doing anymore, or do you have a situation where they adopt and do additional cases? What we've seen consistently with all of the training that we've done on MAS, PLIF is people doing the first case, really liking it, and of course, after they get the training at our cadaver facility, and then booking additional cases.

So we feel that we have a whole host of some significant products that really I think, differentiate us in terms of our scope, precept is another example, I think if you ask any surgeon that has used precept, they will tell you it is the best instrumentation that they have seen on the market, it is the simplest, they love it. And it works for percutaneous, which is MIS, as well as it works for open procedures. So without running through the whole list of products again, they're all going to be on display at the booth, I think we have clearly a very strong armamentarium that a lot of surgeons still don't know about, because it has just been launching in small pieces over the past few months. So I think you're just going to see a continued process of both revolution and evolution of products and procedures from us.

Okay. And then maybe on kind of the same kind of topic, it sounds like just generally, the market on some level is telling the industry where it has used the level of importance of the amount of money that a hospital or physician wants to spend on a given level of service, or innovation. And while maybe a product or a new product is perceived as more innovative, the question is, does that benefit outweigh the cost, and by physicians moving to pods on some level, that is the market telling you that it is not important enough. Can you maybe just --?

I totally disagree with that in terms of the pods. I think the pods are being caused by reimbursement pressure on the surgeon, and I think that -- I mean there's been some very well known surgeons who got up at a various number of meetings and said yes this is our last chance to make some real money here. Those are sad statements, and I think that the pod model has nothing to do with service and providing products. It has to do with essentially becoming the new intermediary without any focus on innovation, without absorbing any of the expense associated with what it takes to move the products forward. So, to me it is a really poor model. I think it is being driven to some degree just out of all of the pressure that the surgeons feel. Did I answer your question completely?

You did.

Matthew Taylor with Barclays.

My first question, you expressed a lot of confidence that you are going to gain some new accounts here and I'm wondering if that's because --?

And we already have.

Got you. Can you help me with the source of that? Are the new accounts coming with the reps that you've hired from some of these large competitors?

No.

Or are you now identifying new surgeons that haven't used NuVasive before are surgeons coming back? Just any color around the confidence that you have around these new accounts would be helpful.

It is a combination of all of those things. We have had some surgeons that over the years have gone to smaller players, and now are quite unhappy with the way things have gone for them, and so I guess in sort of a simplified manner, they are in play. Meaning that they are more than willing to consider coming back and working with another company. And so I think it is important for us to be able to do the best, to do what we can to recruit them. But at the same time, we're not going to do it the way some of the other companies have done it, in a relative kind of pay for play approach that some have utilized. We're not doing that.

Our approach is different, we continue to build on the basis of our credibility, sound ethics, our products and so forth. And that attracts a lot more people than you might realize. I think there is obviously bad apples out there, and bad actors. But the majority of people are very straightforward, honest and easy to work with. So if you look at the reps that are coming, they're coming from a number of larger companies. We do get occasionally some from smaller, but for the most part, coming from larger companies. And even though we don't expect them to drag business across like the flick of a mouse, but clearly, they have an impact quickly, and they're able to start to obtain sales faster than perhaps somebody without any experience. So it is an across the board process, that is working well for us in all areas of recruiting additional sales people as well as attracting surgeons.

Great. You talked a couple times on the call about how your compensation is relatively comparable to a lot of the large players, and you mentioned $800,000 as the number that some smaller players have used to draw people away. Can you just help us in terms of what the median or the range or the high end of your compensation is, in terms of the work that we're doing in comparing the groups?

Sure. I mean the normal compensation for a rep is approximately 10%, in terms of commission. We have incentives for our reps to exceed 10%, we always have, that's always been part of our model. And what we're trying to do now is to not just apply a straightforward simple -- you get an added commission. What we're doing is to make sure that it is tied in to getting new business, it is tied into further penetration, which means selling more mix. And so our compensation, the variable piece, which is driven by over performance, I think is very attractive to the reps, and it has been our model for quite some time. We don't expect changing it, but we do expect making a number of I think quality, as well as quantity changes with regard to how we're approaching it in '13. But the sum of it is, we have very attractive compensation which allows us to compete with both small and large companies. And if you look at Synthes for example which is now combined with Depew, they have for years had 10% and higher commission rates with really stable businesses.

Okay. Thank you very much.

Larry Biegelsen with Wells Fargo.

Alex, you could talk about the Paradigm coflex and the potential impact it might have on fusion procedures? Their data looks impressive.

Okay. Well actually I will turn that over to Keith to talk about coflex. Because he knows those guys intimately.

I think that their recent approval and also the way they approach their clinical study is going to give them a leg up probably on two fronts, from a decompressive perspective, because they're going to be ahead of the reimbursement curve, with how they manage that study. So I fully think that they're going to have an expanded indication, that is really going to expand spine procedures themselves. Because it is a decompressive procedure, and I think they're going to have a pretty wide influence on age of patient as well. So I think it is going to be a good thing for all of us.

Thanks. And Alex, can you talk a little bit about the neuromonitoring reimbursement issues you touched upon? I think your original guidance is $45 million. And now it is $40 million. What is going on there? What has changed since the Impulse acquisition and what is the outlook there? Thanks.

It is really not a reimbursement issue per se. In fact reimbursement is strong. It is more of a collections issue that. That is the primary one that we're facing. So overall, I think in terms of payment, in most areas, the payment is actually gone up. And we've seen that effectively move across various regions. Of course, it is mostly set up on the East Coast, so it has a pretty small footprint, and we're in the process of expanding that.

So I think as I talked about on my call, we're happy with the case volumes, but we're really working through collection type challenges, and that's been one of the most challenging aspects of this. You know, there's kind of more to this in terms of the fact that what we're reporting is pure monitoring service. And that's the way that we should be doing it. There is also quite a few disposable's that get sold that are not part of that number that are completely associated with that case. And the same thing with NeuroVision cases.

So that number is actually a bit higher. And we're satisfied with that than if you look at the pure service side. We do expect it to grow, moving into next year, consistent with how the rest of the Company is growing, if not even faster than that, and I think as we move into '13, what you will see is much more integration from us, and to the salesforce.

Thank you.

With several people still in the queue, we do ask that you please try to limit the number of questions asked. David Roman with Goldman Sachs.

In your prepared remarks, Michael, you talked about R&D as a percentage of revenue coming down given the relative component of Impulse. And I think this was sort of touched on earlier, but the absolute dollar number came down materially both sequentially and year-over-year and I know there is some neo disk comps in here that make it a little bit difficult. But how do we think about the pacing of R&D going forward? And then maybe Alex, you could put that into the context of the growth drivers, is it really sales force that is going to push the top line or is it new products? And is that skew now coming more about marketing than it is about technology?

Let me just jump in first and say that it really has to do with both. It has to do with new technology in terms of our growth and we need to have a very strong pipeline, as well as I think more aggressive let's say tactics, but highly ethical tactics with regard to what we're doing. The one thing I want to just comment on before Michael answers is that, you have to look at what has changed for us over the last couple of years in terms of R&D. We are reluctant right now to spend big money on PMAs. The FDA uncertainty is so great surrounding those, that it is very hard for us to justify pouring $10 millions into a product that may not see the light of day for 10 years.

I mean look at how long things have gone on with PCM, for example. Many manufacturers have experienced the same thing. And so what you're really seeing is not a deceleration, with regard to R&D spending, what you're seeing is much more of an emphasis on 510K products. 510K products are generally much less expensive obviously than a full-fledged clinical trial. And so what we can do with the large number of 510Ks, is very effective in the way of launching more products quickly.

And David, just to give you a little bit of color then, if you look at it year-over-year, R&D as a percentage of revenue was down about 190 basis points. A couple of things going on under there and you alluded to one or two of them. Certainly the neo disk trial ending was a contributor. For us also XL TDR, as a clinical trial has essentially completed in terms of the surgeries. I mean those obviously are significant contributors to that 190 basis point reduction. Impulse also makes a contribution I think as you alluded to. And then the other thing going on, is for some time, and we've talked about this, we've been investing in various studies to build the clinical data set on the biologic's front, with osteo cell plus.

And as it happens this year, some number of those studies have essentially begun to wind down. And so through that process, there has been incremental reduction that you saw in the numbers. We do expect it to start to tick back up in absolute dollar terms and you will probably start to see that in Q4. And some of that is some new projects kicking in, and a little bit of head count and head count related too. But I think the point to leave with on it is, PMA dollars down, certainly as we mentioned on the wait and see attitude with the FDA, and continuing with 510K, applicable products, the whole idea there is to continue to build the product portfolio through innovation, in this case less expensive innovation, and continuing to invest in data that will provide superior clinical outcomes.

Okay. And then just to follow up to that, obviously you made some nice progress on cash flow this quarter. Can you maybe talk about next year how we should think about cash dynamics, I think you have a convert due and also how that affects the non-GAAP profile from an interest adjustment perspective?

When you think about cash flow, I think the way to think about it, and we will sort out whether we speak to it more formally on the Q4 call, but you can take our P&L and convert it via a cash flow proxy to an EBITDA SBC dollar and margin item, and then it is a relatively straightforward set of adjustments to look at the balance sheet items, so working capital, CapEx, equity proceeds and the like. And you can-- I think you guys can get relatively close to it, from a cash flow perspective, operating and free cash flow. Now, we will, as I said, we will sort out after we talk at more length about targets, as we head into 2013, but we are obviously pleased with the performance and improvements that we've seen, both operating cash flow-wise, almost $100 million now through nine months, and free cash flow-wise, over $50 million. That is a significant change to the trajectory from just a year or two ago.

Okay. Thank you very much.

Jason Wittes with Brean Capital.

Hi, thank you. Just a quick follow-up on Impulse Monitoring. In terms of collections, is that limiting the number of procedures that you're allowed to collect for? Or is it simply just the hospitals taking their time in reimbursing for these procedures?

It is mostly the latter.

Okay. And just related to that, your outlook for market growth, as well as pull-through, for other products in lumbar, has that changed, and specifically, on the pull-through, it sounds to me like you really haven't done enough integration to see it yet. Is that a fair characterization?

I think that is exactly right. I think we're behind on the integration process. We wanted to make sure that we stabilize impulse very well. We've done that. And so now, I think what we're trying to get our arms around is the fastest mode to integration. It is actually one of the things that I have Jeff Rydin working on, together with our head of the IMI and IOS group, is putting together the integration with the rest of our Company on the practical side, on the sales side, and then of course, to maintain clarity with what to expect on the clinical side. So what I'm saying is that as we move into next year, we expect to start to see more pull-through, and more of a bigger footprint as we expand that model throughout the US.

Okay. Great. Thank you.

Jeff Johnson with Robert W. Baird.

Thank you. Alex, just a question on some of the surgeon losses and that. Anecdotally just talking to a couple of spine sales reps here recently, it sounds like some of these guys thought they were going to get new accounts, now these aren't NUVA reps from other companies, thought they were going to get new accounts but the hospitals have actually shut them out, and signed some long term deals with other companies. So I'm wondering how much of your surgeon losses here recently, are the surgeons making this decision, and how much might may be hospitals making decisions going to some of the larger players on longer term deals?

I think it is largely the surgeons making the decision. And I think that in a couple of cases, and this is really only happened in about three, but they are good sized accounts, was that the surgeon and the rep ultimately, and we don't know which was the chicken or the egg, but we do believe that it was the surgeons, they effectively were in cahoots with each other to move ahead. And so that is really what we've seen. But it has only happened in a small number but it has been impactful, because it starts to -- it starts to accumulate. As you look at the impact of doing that in several areas, to more like the $15 million to $25 million impact that we spoke of. But we feel that we're very effectively adding new accounts. We know we've done that. We're literally, this week. So we believe that we can fully mitigate that issue.

Just one addition to that as well. I don't think the trend in the marketplace is going to exclusive providers. I think it is quite the contrary that more and more hospital accounts are losing the exclusive provision and opening it up to competitive usage. Often, it may only be two or three companies allowed in. And we have done quite well when those situations have come up. So I don't think it is an exclusive use being dictated by hospitals.

And Alex, just one follow-up, you keep referencing the $15 million to $20 million number and I look at the fourth quarter guidance, it is probably somewhere close to $15 million below what was initially implied, when 2Q guidance or coming out of the 2Q call. To me that is more of a $50 million, $60 million annualized impact from all these different issues. How do I reconcile your $15 million to $20 million and the more sizable cut to 4Q?

I think that essentially, what we're saying is that we don't see more than say $25 million at this point on an annualized basis. And regardless of that amount, what is most important is our ability to offset with new accounts. So I think it is important to appreciate that the impact of that is not clearly understood, but we don't believe it exceeds $25 million at this point.

Josh Jennings with Cowen and Company.

Hi, this is Dennis Keller in for Josh Jennings for Alex. Can you talk about maybe about the timing of the HTCA release and how you envision that being rolled out over the course of next year?

So we're hopeful that it is going to happen within the next several weeks. And I think that, that really, as I mentioned in my remarks, arms the surgeons and the societies, as well as us, to be able to do battle, so to speak, with the payers, in defense of very strong outcomes related to fusion. The other step that has to be taken, which they're working through and in fact, there is a NAS meeting today to talk about it. There's a number of other societies that are now discussing it. And we've been trying to spur that into faster action. And that has to do with the development of clinical guidelines that are ultimately agreed to by all of the societies.

Right now, everybody has kind of got their own. There is the middleman out there that everybody has discredited. But nonetheless, payers reference it because it serves their means. And so really, that's going to be the next critical step. First is HTA. I think that really does help to affect the landscape, because it is a clear document, along the ways that insurance companies look at it. And then from there, it is going to be the development of broadly accepted clinical guidelines.

Great. Thanks.

Okay. So we're all set. Thanks, everybody. We will see you on the NAS floor here in about less than an hour. Okay. Thank you. Talk to you soon.

Ladies and gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time. And we thank you for your participation.