NuVasive Inc (NUVA) 2013 Q1 法說會逐字稿

Greetings and welcome to the NuVasive Inc first-quarter 2013 earnings release conference call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation.

(Operator Instructions)

As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Quentin Blackford, Senior Vice President, Finance and Treasury for NuVasive. Thank you, Mr. Blackford, you may now begin.

Thanks, operator. Welcome to NuVasive's first-quarter 2013 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 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 10Q and 10K 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.

Thank you. NuVasive kicked off 2013 nicely, executing solidly against our full-year strategy to take market share.

Revenue in our first quarter was in line with our expectations growing about 5% to $160 million. The performance of each of our major product categories was strong in the quarter placing us squarely on track to execute to the full-year growth expectations we guided to at the start of the year.

Operating profit translation was also strong. We generated a non-GAAP operating margin of approximately 13.5%.

As I mentioned last quarter and will reiterate again, we run our business based on a multi-year plan emphasizing one full year at a time. We believe that aligning external guidance with that full-year focus will enable us to demonstrate execution against our long-term strategy. As such, we anticipate that revenue for the full-year 2013 will grow 6% to $655 million. We also expect non-GAAP operating margin to come in at 14%, with non-GAAP earnings-per-share of approximately $1.

Today, I will provide an updated view of the spinal market, where there has been some positive news recently, then I'll spend a moment on the top drivers of NuVasive's future growth toward $1 billion in revenue and a greatly improved profitability profile. Lastly, I will provide a legal update and then turn the call over to Michael to cover financial results and detailed guidance.

So, let's begin with an overview of the spine market. We estimate that the US spine market was down fractionally in 2012. The slight acceleration that materialized in year-over-year growth in the fourth quarter of 2012 was against the easiest growth comparison of 2011. So, while the improvement in growth late in 2012 is a positive, we do not believe that it is enough to suggest a significant change in market trend.

We continue to expect US market growth in 2013 will be in line with last year, very similar. That said, I am pleased to report several development on some of the issues that have pressured market growth for the last few years in the US. As you know, the US spine market growth has been negatively impacted by pushback from insurers. In spite of substantial evidence in support of spine fusion, there has never been a formal summary or review of the available literature to demonstrate a consensus of outcomes in efficacy.

Commercial insurance payers have been exploiting the lack of conclusive clinical data relying on actuarial data and financially-based judgments to dictate patient treatment. The ensuing difficulties that spine surgeons faced in obtaining pre-approval for surgery lead to a dramatic slowdown in the volume growth of spine procedures. In response, NuVasive marshaled the members of the surgical societies to formulate a cohesive collection of data that will educate payers and help ensure patient access to the care that they need. On April 1, the Spine Journal, published the outcome of that massive undertaking.

In a systematic review, the first of its kind, the authors evaluated the literature related to fusion for degenerative disc disease, or DDD, which included more than 3000 patients across 26 studies. They concluded that the literature as a whole is in support of fusion surgery as a viable treatment for reducing pain and improving function in selected patients with chronic lower back pain. The study found that lumbar fusion surgery for DDD patients delivers 45% to 50% improvements in back pain, disability scores, quality-of-life metrics, as well as patient satisfaction rates of over 70%. The degree of clinical improvement that was comparable to that seen in other common well accepted orthopedic procedures like total knee reconstruction, hip revision, spinal decompression and so forth are very similar.

I commend the authors and outstanding researchers for the mammoth effort involved in collecting, reviewing, and summarizing the data so that our industry can begin a scientific fight against insurer pushback. On a case-by-case basis, spine surgeons will now be able to use the review to facilitate medically indicated patient access to care, but the work is not done. We will continue to support the surgical community in the next step of the process, which will require the collaboration of several spine societies to establish a set of clinically supported guidelines for spine fusion. The final set of guidelines will demonstrate clinical agreement within the spine community and will dramatically strengthen the industry's argument as we work to execute the last step of the process, encouraging insurers to adopt clinically supported guidelines written by clinicians as policy.

Our industry is validating that spine surgeons, not insurers or consultants, understand what is best for spine patients. The process I described aligns well with what is unfolding in medicine on a grand scale. Medical coverage and health care decisions are increasingly being driven by data.

NuVasive is helping the spine industry demonstrate that there are copious data for the payers to utilize to ensure the best patient care. As insurer pushback reduced spine market volumes over the last few years surgical practice incomes decline. That lead in some cases to an accelerated adoption of physician owned distributorships, or PODs, which we estimate represent close to 15% of the US market, up significantly from a few years ago.

In another positive development for the long-term growth of our spine market, the Office of the Inspector General, or OIG, recently issued a strong recent fraud alert regarding PODs which may help to slow their adoption. We expect it may encourage those surgeons contemplating PODs and those hospitals who are doing business with them to reconsider. The alert specifically says that PODs are inherently suspect under the anti- kickback law and that hospitals or ambulatory surgery centers who do business with PODs are also at risk.

It is our understanding that the OIG's nationwide review of hospitals that bill Medicare for spine surgery is still underway. The timeline for a conclusion to that review is unknown. Whether the OIG will determine the additional guidance on PODs is necessary is also not certain. However, we view the fraud alert as a very positive step in the right direction and an affirmation that NuVasive chose the right correct action in choosing not to distribute through models that present such an ethical dilemma. We intend to continue to raise awareness of the ethical issues at stake, and it is our hope to insurers spine patients receive the best care available and that innovation in the spine market continues to thrive.

So, next I'd like to talk about what are the top five future growth drivers. Well, positive market developments are very encouraging for the future of the US spine market. They alone will not return our market to the growth rates experienced a few years ago, but they are giant steps in the right direction.

With the positive news as a backdrop, we will continue to focus on crisp execution of our market share taking strategy to drive industry-leading growth. Our vision for growth extends to $1 billion in revenue and beyond with unmatched opportunity for operating margin expansion. The top five drivers of our long-term top line growth line will be, one, spine market shift toward more MIS solutions; two, even more XLIF focused clinical evidence including XLIF for L4-L5 surgery; three, broadening surgeon adoption of our comprehensive offering; four, launching innovative new solutions and cultivating an exciting pipeline; and five, our massive opportunity outside of the United States. I'll spend a brief moment on each of these then walk through the opportunity for operating margin expansion in front of us.

First and foremost, we believe the global shift toward minimally invasive spine surgery will continue to provide a very healthy backdrop of growth for innovative spine companies like NuVasive. Minimally invasive solutions now represent close to an estimated 25% of the spine market. And we believe that a superior patient outcomes and clinical evidence continue to drive surgeon adoption, less invasive solutions will become the standard of care in spine growing towards 80% of the market. It is an evolution that happened years ago elsewhere in ortho and general surgery, and it is definitely unfolding in spine.

Another top growth driver for NuVasive will be XLIF focused clinical evidence. We are using clinical evidence to differentiate XLIF from traditional fusion procedures. Relative to traditional fusion XLIF produces superior outcomes and saves money for the system, and we are using data to communicate that to hospital decision-makers.

We are also using data to distinguish XLIF from other lateral products. It warrants repeating that there have been 116 journal articles published on the XLIF procedure. Competitive lateral approaches have yet to publish results in peer-reviewed literature.

We are distinguishing XLIF from other lateral products at L4-L5 where the majority of spine fusion procedures happen. Over 3500 XLIF L4-L5 cases have been reported in the literature, and the research shows that complication rates with XLIF are consistently lower. Years of experience have afforded a wealth of evidence to confirm that our solutions are clinically proven and differentiated.

The third growth driver for NuVasive will be increased surgeon adoption of our comprehensive offering. We use XLIF as the door opener and practice changer with new surgeons globally. And, as our relationships with new surgeons mature, we have an incredible opportunity to introduce them to the rest of our comprehensive portfolio of over 80 procedurally integrated, minimally invasive and traditional spine solutions that are differentiated from anything else in spine. Our state-of-the-art surgeon training facilities and programs drive adoption of our solutions and help surgeons appreciate the comprehensiveness of our portfolio. We hosted a record number of surgeons and training sessions last year and are focused on creating greater impact going forward.

Our sales force is also critical to broadening adoption of our solutions. We responded to sales force churn issues in the third quarter of last year and have now expanded the size of our sales team to an ideal level. We have an exceptional pipeline of qualified candidates to support continued progress toward the 500 member team that we envision a $1 billion-dollar company.

Our fourth top growth driver will be new solutions. Surgeons expect NuVasive to be at the forefront of innovation, and we execute to that expectation every year adding at least 10 unique products or line extensions to our portfolio. Today, our new product momentum is especially strong. We continue to rollout Precept, NuVasive's best in class offering in the massive roughly $1.5 billion market for posterior fixation.

We are also rolling out MAS PLIF, a less disruptive approach for a conventional surgery, and we are actively training surgeons on our recently approved PCM device for the cervical spine. PCM enters NuVasive into a $100 million plus market, and its differentiated low profile design enables it to be minimally disruptive to adjacent anatomy and a viable treatment option for levels adjacent to prior fusions. The depth of innovation within the NuVasive product pipeline is also as strong as ever, with several new products rolling out at MAS later this year. We will continue to lay the groundwork to drive sustainable future growth with innovation that improves spine surgery and patient outcomes.

The final top growth driver for NuVasive will be our expansion outside of the United States. We are looking to replicate the experience and successes that we achieved in the US throughout international markets. That means we are not simply selling product overseas.

We are establishing footholds to drive market leadership in new countries by making thoughtful investments into the optimal leadership teams, regulatory approvals, sales professionals, IT infrastructure and inventory support. It has been no small feat, but today we are beginning to reap the benefits of that effort with a growing presence in over 35 countries.

As you know, we just launched our commercial effort in Japan, an estimated $400 million market with attractive economics. Last week I was in Tokyo to officially open our office there. We are working to align NuVasive with thought leading surgeons and hospitals in Japan. And with the solid leadership that we have in place, we are making excellent progress selling not just XLIF but our entire portfolio of spine solutions. The excitement in the Japanese market for NuVasive and its products is palpable.

And now, as far as an update on our expansion opportunities when it comes to margin, our growth would certainly be incomplete without mention of the substantial operating margin expansion opportunity in front of us. As we approach $1 billion in revenue, we anticipate a non-GAAP operating margin in the low 20%s which compares to the 14% that we expect in 2013. That's over 600 basis points of improvement.

Let me walk through a couple of the drivers of that opportunity. Increased international scale will be one of the greatest drivers of our future leverage. We are still investing to become a global spine company, but we have reached an exciting inflection point.

In 2013, our international revenue will exceed our international investment. And, as we approach $1 billion with international representing close to 20% of revenue, we expect our international operating margin to be more in line with that of our core business. That is a huge opportunity when you compare it to a near zero contribution just last year. Another lever for us will come from shifting portions of our manufacturing in-house. Today all of our manufacturing is outsourced, but we are taking steps to integrate vertically and expect profitability improvement as that shift unfolds.

Royalty accruals related to our patent infringement litigation are an additional lever. The majority of the royalty expense that we accrue is related to the assertive patent infringement of sales of our current line of implants. The Medtronic patent in dispute will expire in less than two years. That is February of 2015.

Additional leverage opportunity will come from improving the scale and profitability of our IOM offering. We made significant investments to integrate and extend the footprint of Impulse last year as, and, as we work through the challenge rate environment, we are working to increase the efficiency of those investments. I trust you can appreciate why we are so excited about the prospects for long-term sustainable growth at NuVasive. We have substantial opportunities to drive both top and bottom line growth toward $1 billion and beyond, and we have an established proven strategy to get us there.

Before I turn the call over to Michael, let me provide some detail on the settlement we agreed upon with Medtronic pertaining to what we have called Phase II of our litigation with Medtronic. As part of the settlement, we resolve all disputes relating to cervical plate happens and gain access to virtually all of Medtronic's cervical plate patents. In exchange, we will pay $7.5 million up front, all of which will be offset against any damage award we may ultimately have to pay in connection with Phase I of the litigation. Going forward, we will also assume an effective royalty rate of about 3% on certain cervical plates that rely on the patents we licensed.

Since the upfront payment is fully offset against future liability, and the royalty is a modest 3%, this is a very good financial arrangement for us. It also provides is great us great flexibility in the development of cervical plate technology. There are well in excess of 150 cervical plates on the market today, so the license affords us greater innovative creativity in a crowded space.

The settlement also eliminates the need for Phase II of the litigation, which will save us millions in legal fees and will simplify the appellate process. We can now focus squarely on our immediate goal of pushing forward with the appellate process in Phase I, addressing the core issues related to lateral implants, and reducing the outstanding damage award.

With that, I will turn the call over to Michael.

Thank you, Alex, and good afternoon, everyone. As Alex mentioned, our revenue for the first quarter 2013 was $159.5 million, a 5.2% increase over the first quarter of 2012. We continue to expect full-year revenue growth of approximately 6% with the second quarter of 2013 expected to be flat in dollar terms when compared to Q1.

Revenue guidance contemplates market share gains and solid contribution from new procedural solutions and new geographies offset by the continued risk from the market related challenges that surfaced mid last year. Let may be very clear, we believe that the market issues like PODs as well as aggressive competitor tactics still have the potential to have lumpy and abrupt impacts on the US spine market overall. We are optimistic that the host of initiatives that we've put in place to reestablish momentum late last year will support continued solid execution. Our full-year guidance reflects these combination of items.

Let me provide some insight into the drivers of growth in the first quarter. Year-over-year revenue growth for US lumbar was just over 1% while US biologics declined about 2%. We continue to expect full-year 2013 US lumbar and US biologics revenue growth of about 2% as new products and geographies ramp over the course of the year. US cervical revenue grew about 16% in the first quarter. We expect the continued penetration of our cervical portfolio combined with gradual surgeon training and adoption of our PCM device to drive revenue growth of about 14% for the full-year of 2013.

The services revenue from our US monitoring business grew almost 3% in the first quarter. We continue to expect full-year 2013 growth to be about flat with solid volume growth offset by continued monitoring reimbursement challenges.

International revenue, which includes Puerto Rico and the biologics component of our international business, grew approximately 47% in the quarter. While international revenue growth was slightly ahead of our expectations in the quarter, we are not changing guidance for the full-year 2013. Our performance in Japan has been solid, and our expectations for procedural volumes and product sales into that market are unchanged. However, the significant weakening of the Yen relative to the US dollar year-to-date suggests an approximate $8 million contribution from Japan compared to the up to $10 million that we had previously expected.

As a result, we continue to expect international revenue growth of about 35% for the full-year 2013. All of this detail is provided for your reference in the supplementary financial information posted on our website in the investor relations section. Gross margin in the first quarter was 75.5% compared to 75.7% in Q1 2012 and 74.6% in Q4 2012. The year-over-year gross margin was pressured by 130 basis points from the combination of med device tax and international mix.

Offsetting that impact in the quarter was the reversal of some past royalty accruals related to the cervical legal settlement. The settlement eliminated the need for any royalty payments up to the date of its enforcement. So we were able to reverse approximately $600,000 of past royalty accruals aiding gross margin by about 40 basis points in the quarter. Operational improvements to minimize cost related to scrapped or damage product drove the remainder of the year-over-year gross margin delta.

Hospital pricing pressure was largely immaterial in the quarter. We continue to anticipate a full-year 2013 gross margin of approximately 74%, which contemplates a roughly 150 basis point impact from the med device tax.

Research and development to R&D expenses adjusted to exclude stock-based compensation and acquisition related items totaled $7 million in Q1 2013 compared to $9.5 million in Q1 2012 and $7.9 million in Q4 2012. R&D expense as adjusted was 4.4% of revenue for Q1 2013 versus 6.3% in Q1 2012 and 4.8% in Q4 2012. Relative to last year, the decrease in R&D, both as a percent of revenue and in aggregate dollars, was caused by lower spending on clinical trials, several projects reaching completion and active management of discretionary expenses. We continue to expect non-GAAP R&D expense as a percent of sales to ramp in the second half of the year approximating 5% for the full-year 2013.

Sales, marketing and administrative, or SM&A, expenses adjusted to exclude stock based compensation, certain intellectual property litigation expenses and acquisition related items totaled $92 million in Q1 2013 compared to $87.6 million in Q1 2012 and $90.8 million in Q4 2012. SM&A expense as a percent of revenue was 57.7% in Q1 2013 versus 57.7% in Q1 2012 and 54.8% in Q4 2012. Relative to last year, flattish SM&A performance as a percent of revenue was due to investments made to support international expansion, especially in Japan. The investments were partly offset by sales force productivity and leverage in freight and G&A.

On an absolute dollar basis the year-over-year growth in SM&A expense is primarily attributable to investment activity to support future domestic and international growth and to higher legal spend partly offset by G&A leverage. For the full-year 2013 we continue to expect non-GAAP SM&A expense as a percent of revenue to approximate 55%. Non-cash stock-based compensation in the first quarter was $6.8 million. Both year-to-date stock price appreciation as well as the recently finalized details of our 2013 long-term incentive plan resulted in increased expectation for stock-based compensation.

We now expect full-year 2013 stock-based compensation of approximately $35 million compared to our prior $30 million guidance. First-quarter non-GAAP operating margin was 13.5% compared to 11.7% in Q1 2012 and 15% in Q4 2012. In the quarter, the med device tax pressured non-GAAP operating margin by roughly 100 basis points, and the legal settlement benefited us by about 40 basis points. Adjusting for these two items we demonstrated roughly 240 basis points of operating leverage, compared to Q1 2012.

For the full-year 2013 we continue to expect non-GAAP operating margin, including the negative impact of med device tax and the slight positive impact of legal settlements, to approximate 14%, which compares to the 14.5% reported for full-year 2012. Investments to support future growth have been mapped more heavily toward the first half of this year. As a result, we anticipate that non-GAAP operating margin in the second quarter of 2013 will be down some compared to the first quarter with the greatest degree of operating leverage in the fourth quarter.

Excluding the expected full-year med device tax impact of 150 basis points, we anticipate generating about 100 basis points of operating leverage in 2013 demonstrating continued steady progress against our goal to improve NuVasive's profitability profile. Interest and other expense net totaled $6.6 million in the first quarter compared to $6.2 million in Q1 2012 and $5.9 million in Q4 2012. For the full-year 2013 we continue to expect interest and other expense to approximate $26.5 million.

We booked a GAAP tax benefit in the first quarter of $764,000, driven by the roughly $1 million benefit from the 2012 R&D tax credit. We will continue to actively manage our tax line, and we expect to make gradual progress. But this year will be a bit of an anomaly in terms of taxes given that we now anticipate GAAP pretax book income to land around breakeven driven by our increased expectation for non-cash stock-based compensation.

The most important item to focus on here is that in absolute dollar terms, we now expect our full-year tax expense to be down from about $4 million previously to roughly $1 million. The updated view of stock-based compensation changes our projected full-year 2013 GAAP effective tax rate from the 60% we anticipated previously to just over 80% which assumes a roughly 120% effective tax rate in each of the remaining quarters of 2013. We continue to expect non-GAAP adjustments to be tax affected at approximately 40% for the full-year 2013.

Our Q1 2013 GAAP net income was approximately $596,000 or earnings-per-share of $0.02. With the increased expectation for full-year stock-based compensation, we now expect full-year 2013 GAAP EPS of about $0.02 compared to $0.07 previously. Excluding an aggregate adjustment of approximately $11 million net of tax for the adjustments detailed in today's press release, first-quarter non-GAAP earnings were approximately $11.9 million or $0.26 per share.

We continue to expect full-year 2013 non-GAAP earnings-per-share of approximately $1 which contemplates the following adjustments -- non-cash stock-based compensation of $35 million, certain intellectual property litigation expenses of approximately $5 million, amortization of intangible assets of approximately $21 million, acquisition related items of approximately $2.5 million and as incurred additional items and non-cash interest expense associated with the 2717 convertible notes of approximately $13.7 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.

For the first quarter, cash provided by operating activities came in at just over $24 million compared to an adjusted $28.5 million last year. We generated nearly $15 million in free cash flow in Q1 2013 which compares to an adjusted $14 million in Q1 of last year. As a reminder, while we are focused on continuing to enhance our cash generation capabilities, we expect the magnitude of 2013's cash generation to be somewhat below what we achieved last year as we transition to being a cash taxpayer, as we faced the impact of the med device tax and as we anniversary 2012 significant working capital improvements.

Our cash and investments balance at the end of the first quarter was approximately $281 million which is down about $65 million from $346 million at the end of 2012. During the first quarter we redeemed the approximately $74 million remaining on our March 2013 convertible notes upon their maturity. At the end of Q1 2013, inventory was roughly 20% of annualized first-quarter revenue compared to about 20% at the end of Q1 2012 and roughly 19% at the end of Q4 2012.

Days sales outstanding, or DSO, when run off of our net AR balance was 51 days in the quarter compared to 50 days for last year's Q1 and 48 days at the end of Q4 2012. We continue to work to more efficiently manage working capital. The first quarter was a testament to the continued successful execution of our share taking strategy and our focus on driving operational improvements. I am looking forward to what the rest of 2013 will bring.

Now I'll turn the back over to Alex for closing comments.

Thank you, Michael. Results in the first quarter demonstrate solid execution against our 2013 plan. Our dedication to being absolutely responsive by supporting the spine societies and advocating on behalf of our industry are beginning to make an impact.

The positive developments that have resulted have the potential to improve long-term US market growth. And regardless of what market growth ultimately looks like, we have massive opportunities to drive sustainable top and bottom line growth as I have outlined today. Our proven share taking strategy of superior outcomes, absolute responsiveness and speed of innovation will enable us to execute our plan for growth toward $1 billion in revenue with an improved profitability profile.

Onward and upward, ready for your questions.

Thank you.

(Operator Instructions)

Matt Miksic, Piper Jaffray.

One question, Alex, for you on the market and your view this year. And I know I don't want to push you to get more optimistic this early in the year in particular. But stepping back and looking at the growth last year, and your assessment that this year's growth will be like last year's growth, I'm wondering, is that for lack of visibility and it's a good business planning assumption?

It's just that with things like the OIG language and the assessment that you described, some of the other dynamics in the spine market, that seem to be removal of tailwinds that we faced last year that things ought not -- ought to be just a bit little bit better. So if there is anything else incrementally you're worried about I'd love to just get a sense of what they are, and then I have one follow-up.

Yes, I think, Matt, everything we just went through is reason for optimism. However, I don't think we can actually correlate that into a tailwind at this point in time.

So, we've got to wait for that to play out a little bit longer. I think these are all very positive signs. We are pleased with our execution for the first quarter. It is consistent with what we expected to see for the year.

So, I think that we are guardedly optimistic when it comes to these various improvements, but nothing has really happened yet. So all that has happened is things have been published. There is various things that have taken place in terms of alerts, but I think it's going to take a couple of quarters to play out, and if it picks up, all the better for all of us.

Great, and then the follow-up for Michael, if you are going through the detail of the litigation in the royalty accruals and that sort of thing. Looking back at some of the accrual rates in the past, the I believe the older language around the cervical plate patent was accruing at 2%, this looks like it set a rate for all cervical plate patent accruals at 3%. Understanding that was a pretty small part of the accruals before. Does that affect the rate at which we should be thinking about a full-year accrual this year and next until some of these things roll off?

Matt, it doesn't affect really how you ought to be thinking about the royalty expense for the full-year. While it's a slightly higher royalty rate on an effective basis, there is also some shifting in movement amongst the products that we think would be affected. And so we will still come out at about $11 million or so that we had guided everybody to at the start of the year.

Great. Thank you again for the color.

Matthew O'Brien, William Blair & Company.

Just to follow-up on Matt's question, with respect to the royalty settlement. I think, Alex, you had mentioned historically that this was something you didn't want to settle you kind of wanted to see all the way through.

I'm just curious as to why you decided to go ahead settle now? Was it something that was coming from Medtronic? Was it coming from you guys? And has there just been any more correspondence or chatter between the two of you on something broader for the retractor and the implants as well?

So, we settled on the cervical part, which is Phase II. And as you know because of the complexity of this case, there were a lot of patents that were involved. And so the court simplified it down to two phases.

So, we are all over Phase I. Phase I is the -- is really let's call it the XLIF patent situation. And so, our intension is not to settle on that unless Medtronic made us a fantastic offer. And so, I think really what we did is we went after the thing that made a lot of sense here which was the cervical piece. And I think we arrived at something that made sense to us from a business standpoint.

Okay but has there been any more correspondence as far as potentially looking at other areas of the litigation?

No.

Okay. And then Michael I'm just a little curious, and I understand the conservatism that you tend to provide us, but the operating -- adjusted operating margin performance in the quarter, 13.5% -- typically Q1 is your low-water mark in terms of that metric. Why would you stick with the 14% range if you should benefit a little bit also from the Medtronic settlement today? Why not go ahead and just boost that up a little bit higher? And then why on top of that is stock based compensation expected to be a bit higher?

Yes, so, we think op margin, as I mentioned, will ramp later in the year. We are sort of layering in a few investments in the Q2 and Q3 time frame to continue the momentum we have particularly in Japan as well as to hopefully start to stage us up for 2014. 2014 that is on the back of a strong Q1 start, right?

When you think about the guidance few -- and you think about how to characterize it, we would characterize it as realistic. We've got two quarters of solid execution behind us. So whether you're talking about top line or op margin, two quarters doesn't make a long-term trend.

Alex talked about some of the challenges that are still out there that we battle day-to-day and that we are trying to manage this thing really to a full-year instead of paying attention to the ups and downs of any one particular quarter. And then what was the last?

Stock-based comp.

Stock-based comp, for us the driver there was the stock has appreciated quite a bit year-to-date. So that combination combined with the final plan details of our long-term incentive plan, is really what drove the delta to the original guidance.

The thing to pay attention to on that is that it is essentially all stock price related because the plan move to a TSR, totals shareholder return, based metric in 2013. It was not that methodology last year.

Thank you.

Bill Plovanic, Canaccord Adams.

If I could just leverage off some of the other questions asked. You have talked about in 2012 international was breakeven and 2013 we will see that leverage, but then you also talked about investments. Should we really think about 2013 almost being breakeven and 2014 really being the year of operating leverage for the international business?

Well, let me just -- before Michael jumps in here, so as far as international is concerned, I think it is exactly as we stated. We expect this to have a positive contribution when it comes to 2013. What we have done though is, because Japan is such an important market, we have made sure that we've expended appropriate resources in that market.

So, we've probably done a little bit more than we probably would have otherwise contemplated a couple of years ago. We've put more time and more emphasis on having surgeons go over there for XLIF training. We are extremely pleased with what we are seeing. We think that is going to bear fruit for us with regard to the kind of revenues we see, especially next year.

Michael made some adjustments with regard to the impact of the Yen. So, that notwithstanding, we do believe that those are some relatively small investments that we have made. So when we say international we are really talking about Japan and talking about some ways to further accelerate that growth plan for 2014.

Yes, and so I will jump in on the back of that. So, we talk about this 2012 was essentially roughly a breakeven year for us. Oh, you asked as Alex mentioned we certainly do expect international to be positive in aggregate in 2013 and then to be improving every year beyond that. So, we will make the contribution to some of the leverage we expect to drive in 2013.

Now, all that said, Japan is still in investment mode from that perspective. We just got our last quarter to our earliest revenue dollars. But the race will be for us to ramp that up as fast as we can and take advantage of what is an incredible opportunity in the second largest spine market in the world, $400 million or so.

And then on the cervical settlement with Medtronic, will that royalty expire in 2015 with the rest of the royalties, or would back go on for longer?

I think it is 2017 or 2018.

Yes, it is February 2018.

2018.

And then if I could the medtech tax just what was that actual dollar amount for you in the quarter?

It was over -- a bit over $1.6 million, Bill.

Great, that's all I have. Thanks.

Bob Hopkins, Bank of America.

So to start I just want to make sure that I have got a handle on your organic growth in the quarter. I understand you in the press release said this slightly above 5% number, but I think I recall you saying earlier in the year that you have fewer selling days this quarter. Is that correct?

Yes, three fewer selling days.

Three fewer selling days, so then organically the growth rate was more like --?

Two or three, whatever it is.

So let me jump in on that. Essentially -- Two or three.

Two fewer official selling days. The third day Alex is mentioning is the fact that we take our sales force essentially out for a day when we have our national -- our NuVasive sales kickoff meeting at the beginning of the year. So you have two official holidays moving around, but when you think about what that means or implies, for selling day adjusted growth rate, here's how I would suggest that you look at it.

The impact of that is not the most easy to quantify. The reason for that is we've gone out and we've surveyed a few of the hospitals and really I think truly the hospital operating days are probably the biggest driver. We actually heard a bunch of hospitals were actually doing surgeries on some of the holidays. So probably the days lost were not officially two, maybe a little bit less somewhere between one and two.

You could adjust for selling days. You could adjust the growth rates up. The way to think about that is probably 200 to 300 basis points to each bucket for most of the categories. And then international would adjust up by a bit higher even probably 400 or 500 basis points, if you are making that full two day adjustment.

Okay, that is great. Thank you, that is very helpful.

And then on the gross margin this quarter, was that number that you gave for the medical device tax less than you expected? And then as we go through the year, why should it come down from here? I know you had sort of a one-time benefit, but that still left you over 75%. What are the things that will take it down over the course of the year?

Yes, at 100 basis point, it did come in a bit below. I think we had guided to and the range of about 150 basis points at the beginning of the year.

There are a couple of drivers underneath that, international mix was obviously strong in Q1, given the growth rates of that business in the mid to high 40%s. That mix will be different over the rest of the year and given the exemption of the OUS revenues. That's a piece of the picture.

The other piece of the picture is that it still not perfectly clear how to apply the guidance that came out of the IRS. Probably the best example of that is with instruments. Dependent on what you read those, could be exempt from the tax or not exempt for the tax. And so we've got to wait a little bit to see how all of that plays out.

Just in terms of what is really driving it down from the current level, though, I guess I'd still don't really understand.

Sorry say the last part again, you what?

So just from the 75%, you reported 75.5%. There was a one-time item in there that takes it down maybe closer to 75% I guess I'm still not clear from here maybe it's just the incremental medtech tax. What gets you down to 74%, what the drivers are taking you from 75% to 74%? Is it just a little bit of medtech tax?

No, under the total gross margin percent, the Medtronic agreement, the operational items that we have that affect the gross margin in the quarter. We talked about the positives, which were the benefits on damaged and scrap product. Those items may not continue. That may be what you are trying to struggle with on the gross margin line.

For us we want to make sure that those are in place and sustainable quarter-to-quarter before we think about that in terms of forward guidance.

Great. Thank you.

Chris Pasquale, JPMorgan Securities Inc.

Alex, you see the FDA warning letter in March. Can you comment on what impact if any that letter has on your business? And obviously AttraX has held up anyway, but does it preclude you from getting any PMA products approved until it's resolved?

It had no connection with AttraX whatsoever, and it has had no commercial impact whatsoever. So, it's a very straightforward process. It's effectively been resolved administratively. There are some final details, but we really see it as a non-event.

Okay. And then I think Michael made a comment about Q2 revenues. I just want to make sure that I heard you correctly. Did you say that you expect sales to be flat sequentially?

Yes, flattish Q2 revenue sequentially.

Your 2Q sales historically have been up sequentially from 1Q virtually every year, and you had that fewer selling days in 1Q, so why should we expect it to be flat this year?

Well we have talked about new product launches playing out over the course of the year, that's PCM backend loaded, MAS PLIF just getting started. Japan and the other country impacts were mentioned are going to take some time to ramp. Always the drivers on surgeon training and adoption for new products and new geographies just take some time to build momentum.

And then also you could look at the two selling days shifting out of Q1. Those are all contributors. To us, those days land towards the back half of the year. Those are all really the drivers that support probably a flattish Q2.

It is pretty consistent with last year. If you look at the contribution of the first quarter relative to last year is about 24.5%. It's the same this year. It is what we anticipated when we set our guidance. I think what Michael is talking about is we anticipate a similar type of process as took place in the first half of last year taking place again the first half of this year.

Okay I guess I could see how some of those factors would make the second half of the year stronger than the first half. But wouldn't necessarily make the first quarter stronger than it would be normally relative to the second quarter. Was there anything else in the first quarter that you viewed as somewhat one-time and that would lead to 2Q being flattish instead of up?

No.

Okay.

Matt Taylor, Barclays Capital.

So, I guess first question was you called out a couple of things in the beginning of the call that are potential positives for you longer-term. I was wondering when you thought the Spine Journal article could actually translate into those guidelines that you mentioned? And then on the PODs you mentioned you think it could be an inhibitor to more PODs forming. Do you think that fraud alert could actually cause people to want to drop out of PODs in the near-term?

So, I think as far as how long it's going to take to develop clinical guidelines, I don't think it's going to happen faster than about a year. I think it could be anywhere between 12 and 18 months. It just depends how fast the societies are able to move. It is not an unwillingness to move, there is just a lot of societies, and they are trying to come to an agreement.

As far as the PODs are concerned, I do believe it will be a deterrent with regard to I think physicians joining PODs. Now whether or not PODs start to or members drop out of their PODs as a result, I think they should, whether or not they will, we just don't know. This is a pretty recent development.

We do think that the hospitals will take this very seriously, because it has potential ramifications for them. And so I think we are going to expect to see a lot more scrutiny on the part of hospitals when it comes to any physicians out there that are -- have formed PODs and are either doing or trying to do business with the hospital.

Okay great and then just on Phase I, I know a couple quarters ago you said you are still waiting for the District Court. Is that still the case? Do you have any visibility on timing there?

You mean with regard to the royalty rates or what do you mean?

Yes, just in the next court date or any kind of guidepost for us?

Yes, no, we are still -- don't have anything. That is what still really preventing us from moving forward here with regard to the appellate process. So that is the same. We've -- as we have talked about settled our Phase II on the cervical side, but Phase I remained in the same status that it was before.

David Roman, Goldman Sachs.

Michael, I know you made some comments regarding free cash flow when you gave the $15 million number for the quarter and some of the moving parts that impact 2013. But can you maybe just help us think about the cash flow characteristics of the business and the context of Alex's long-term trajectory on margins? And when do you think we can start to see a more material inflection point in that segment of the financials?

Yes, David, conceptually I think the way to think about it as is as op margin improves, right, and as we continue to drive the growth that we are driving, we absolutely should expect generally speaking the cash flow situation to improve from an operating cash flow standpoint. We also expect over time to try and drive a more efficient base on the capital expenditure side. And we are making progress on that so far this year, which will contribute to a more favorable view on the free cash flow side.

So, conceptually, I think that is right. This is one of those years where we are running into a catch-up point associated with becoming a cash taxpayer essentially for the first time, the med the device tax coming in and impacting us and then I forget what the third one was, but there is another big item. It is really trying to anniversary the working capital improvements which were significant that we made in 2012. All those things will affect us in 2013, but as those get anniversaried, that we should see the growth you're looking for.

Okay, that is helpful. And then Alex when you were working through the long-term market opportunity, one of the data points you gave was I think the number of cases of XLIF done in L4-L5. But that is till the majority of spine procedures.

Can you maybe just put that into specific it from a penetration standpoint? If you look at your overall -- how does your share compare -- your overall share versus where it is in that segment of the market? And should we think about that converging or maybe just help us think little bit more about that opportunity.

Yes, Dave, I wasn't talking about the number of cases being done, what I was talking about was that there were over 3000 L4-L5 cases reported in the literature. And that, that is a lot of data that is out there. And that is what I was referring to. And so that, as you are well aware, I think that our competitors make the argument that you can't safely access L 4-L5, and we would generally concur with that assessment given their technology.

We believe that our technology does allow you to safely and reproducibly access L4-L5. L4-L5 is the lion share the market. We've talked about that before. It's depending upon which estimate you go by, it is certainly 50%. It could be even as high as 60% of the market. So I think it is a very important point of anatomy to be able to access with lateral.

Okay, that make sense. Thank you.

Richard Newitter, Leerink Swann.

Just quickly just to go back to the gross margin. Michael, could you just quickly say what the precise benefits were this quarter? And then what is going to get a little bit worse going forward and what isn't, just to clarify on Bob's question earlier?

Okay so Q1 we landed at about 75.5%. That was down 20 basis points year-over-year. The drivers on that were med device tax, an impact unfavorable about 100 basis points a little bit over that.

We also had about 30 basis points unfavorable of international mix. Those things were offset by the benefits from cervical legal settlement of about 40 basis points. And then we had operational improvements on scrap and damaged product that was favorable about 70 basis point. That is how you net down to the 20 basis point unfavorable delta net-net.

As we think about progressing towards Q2, and beyond, certainly what I talked about a little bit earlier for gross margin in Q2, the drivers there are things like there will be a shift and change in product mix and some of the assumptions there. As I mentioned earlier, we also want to see that our Q1 operational progress on the loss and damage is sustainable before we think about continuing it out in guidance. And then as Q2, you also as an unfavorable thing, you won't get the benefit we saw in Q1 from the favorable cervical legal piece, that was 40 basis points. Those are the main drivers.

Okay, that is really helpful. That is all I have. Thank you.

Glenn Novarro, RBC Capital Markets.

On G&G's conference call a few weeks back, they talked about their business being down 10% in the US, and a lot of that was due to sales force disruption. So, two questions -- one, did any of that help you with your sales force hires here in the quarter? And, two, how much did that help just thinking in terms of volume and business the quarter? Thanks.

I don't think it has affected the quarter per se, but I think it has improved and have consistently improved the quality of candidates that we are getting. So, that has been an ongoing process for us. But, I would not see it as a business shift per se that we have seen. That's been an ongoing process for us, and I don't think that one event had really that much to do with it.

Okay, and then one quick follow-up, I jumped on late so you may have already responded or answer to this. But can you talk about pricing in the quarter if it changed at all? I know pricing has been somewhere down from most companies in the mid single-digit range.

We talked about it in our prepared remarks, I don't think we've actually taken a question, but Michael is dying to answer your question.

So, price in the quarter was about 20 basis points of impact. Essentially it represents about a 1% price erosion as we analyze it on a same-store basis.

Okay. Thank you.

Jeff Johnson, Robert W. Baird.

Wanted to start with a cervical question and maybe just a couple of clarifying questions. But on the cervical settlement with Medtronics, two questions, Alex. Does the 3% rate lend any additional credence to the 3% rate on that 933 patent or the 10% rate on 973? One of the questions I often get is what happens if the Court comes back and those rates are much higher? Did you and Medtronic agreeing that 3% lends some credence to these low mid single-digit royalty rates on products in the spine area?

No, it doesn't really have a direct impact. I think 3% is a reasonable royalty rate, and we made those comments during the course of our prepared remarks. So, I think what it is, is something I would say a customary royalty rate or in that range. So, no, it does not have any other impact.

And with that settlement, does that impact at all the angle fixed litigation that just came up, or can you maybe give us any thoughts on that new litigation?

It does not, no.

Any thoughts on that?

No, that is just something that was literally came up very recently, and we haven't even looked at that from a legal standpoint yet. That's just -- we are just getting our arms around that. We think that is a relatively minor situation to put it mildly.

Understood and then, Michael, just two questions. Any PCM update on the quarter or how you still think about it for the year and the same with Japan? Are you still thinking $10 million for the year may be any update on XLIF procedures in the quarter in Japan?

So PCM still anticipating that $3.5 million to $5 million. We did talk about on the call a reset in Japan essentially related to deterioration in the Yen, weakening of the Yen. And so where we had previously talked about Japan being up to $10 million or so, now we're talking to it is in the Yen change of about $8 million or so.

Okay, sorry, I must have missed that. I appreciate it. Thanks.

Michael Matson, Mizuho Securities.

I guess just given what we saw happen in the third quarter of last year, I know that you with your sales force -- I know that you have rebuilt and replaced a lot of those folks that left. But I was just curious if you made any changes to the compensation structure or anything to try to make it harder for competitors to poach reps? Or I guess you are pursuing legal action against some of those folks as well. So, just wondering what your strategy there is to try and increase your retention rate?

Well I think we have made a lot of changes that we talked about over the course of last year and going into this one. I think -- personally I don't want to keep anybody that doesn't want to be here. But, at the same time, if they break a covenant that they had with us, then we will certainly take legal actions.

So, I think we've done a number of very positive things. We've made a series of leadership changes as we've talked about. There is a lot of things we've done with regard to I think further improving our overall compensation program, which I think all of our reps really like. So, even though on a full out basis, it's not -- we are not paying more on the sales expense line per se, but the way that we've changed the mix is very favorable for the reps and how they are being compensated. So, we feel like we are in a stable position.

We were very satisfied with all of the sales managers that we have in place and their development. So I think we have done all the right things, so to speak. And just like every company that is out there on the planet, you're always at risk of something going wrong. But I think we have thought about every possible precaution you can think of and implemented it.

Okay and then, as a layperson here with regard to patents, I was just wondering on Medtronics spacer patent, you mentioned it expires in early in 2015. But I know in some cases companies can get patents extended. So I was just wondering if there's -- if that is a risk at all that Medtronic could somehow get that patent life extended?

No, we think that one is it. That's February 15, and it is over.

Okay. All right. That's all I have. Thanks.

Okay you are welcome. I think that is it for all of our questions. We thank everybody for being on the call today, and we will look forward to speaking with you in another quarter. Thank you. Goodbye.

Thank you, this does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.