Orthofix Medical Inc (OFIX) 2018 Q3 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the Orthofix Third Quarter 2018 Earnings Results Conference Call. (Operator Instructions) As a reminder, today's conference is being recorded for replay purposes.

It is now my pleasure to turn the conference over to your host, Mr. Mark Quick, Director of Business Development and Investor Relations. Please go ahead.

Thank you, operator, and good afternoon, everyone. Welcome to the Orthofix Third Quarter 2018 Earnings Call. Joining me on the call today are: President and Chief Executive Officer, Brad Mason; and Chief Financial Officer, Doug Rice. I'll start with our safe harbor statement, then pass it over to Brad.

During this call we will be making forward-looking statements that involve risks and uncertainties. All statements other than those of historical facts are forward-looking statements, including any earnings guidance we provide and any statements about our plans, beliefs, strategies, expectations, goals or objectives. Investors are cautioned not to place undue reliance on such forward-looking statements, as there is no assurance that the matters containing such statements will occur.

The forward-looking statements we make on today's call are based on our beliefs and expectations as of today, October 29, 2018. We do not undertake any obligation to revise or update such forward-looking statements. Some factors that could cause actual results to be materially different from the forward-looking statements made by us on the call include the risks disclosed under the heading Risk Factors in our Form 10-K for the year ended December 31, 2017, as well as additional SEC filings we make in the future. If you need copies of these documents, please contact my office at Orthofix in Lewisville, Texas.

In addition, on today's call we will refer to various non-GAAP financial measures. We believe that in order to properly understand our short-term and long-term financial trends, investors may wish to review these matters as a supplement to financial measures determined in accordance with U.S. GAAP. Please refer to today's press release announcing our third quarter 2018 results for reconciliations of these non-GAAP financial measures to our U.S. GAAP financial results.

At this point, I will turn the call over to Brad.

Thanks, Mark, and good afternoon, everyone. I'll start by giving you a summary of our third quarter 2018 performance, after which Doug will discuss the financial results that we reported today. I will then follow up with our outlook for the remainder of 2018 before taking questions.

In the quarter we not had solid comp and adjusted bottom line performance, but also made great strides in aligning our Orthofix supplying business. Starting with the top line, we reported net sales of $111.7 million, representing a year-over-year increase of 6.1% as reported and 6.6% in constant currency. As announced in June, we are aligning our business unit structure around 2 pillars: spine and extremities. Within Orthofix Spine, there are 3 reported segments. The first is Bone Growth Therapy, formally called BioStim. This segment consists of spinal fusion therapy, which includes our Spinal-Stim and Cervical-Stim products, and bone healing therapy, which is our Physio-Stim product.

The second segment is Spinal Implants, which includes Spine Fixation, our legacy fusion implant products, and spine motion preservation, the Spinal Kinetics M6 discs. The third segment is Biologics, which includes our various Biologics tissue forms. This alignment of our spine product lines under a single Orthofix Spine organization is intended to drive both organic and inorganic growth.

A platform of market-leading, differentiated technologies, coupled with both an improved product development pipeline and continued business development execution, put Orthofix Spine in a position for accelerating and sustainable growth.

In total, Orthofix Spine including Bone Growth Therapy, Spinal Implants, Biologics and Spinal Kinetics produced $84.8 million in reported sales in the third quarter, which was a 6.3% increase over prior year.

Now beginning with the Bone Growth Therapy's reported segment, we reported net sales that grew 8.2% in Q3 over prior year. As expected, and as I discussed on our Q2 call, we benefited from a larger than normal open order volume at the end of Q2 that translated into sales in Q3. Even when normalized for this impact, sales increased 5.9% over prior year. In Spinal Implants, we reported a year-over-year increase of 9.7% overall, with a decrease in sales of 4.5% in Spine Fixations for the quarter, with Spinal Kinetics contributing net sales of $2.9 million. The primary driver of the decrease in Spine Fixation was expected international softness that we commented on in our last earnings call and to a lesser extent, the normal disruption that comes with the business reorganization and leadership transition that I also spoke about on our last call. We expect this to be a short-term issue, as the benefits of the Orthofix Spine alignment comes together in the next few quarters.

Reported sales decreased in our Biologics business compared to prior year by 3.8%. The sales in this business continued to be negatively impacted by the contractual reduction in the marketing service fee percentage or the fixed-rate fee from MTF Biologics. When normalized for this change, which occurred in March of this year, sales increased by 3.7% in the period, with Trinity volumes increasing 4.6%, offset by a slight ASP decline. We are seeing a nice recovery in the previously underperforming region that I spoke about, and we remain optimistic about the additional opportunities the realignment of our spine businesses will create for Biologics in the future.

Turning to our Orthofix Extremities business, formally Extremity Fixation, reported and constant currency net sales increased 5.8% and 7.5% respectively in the third quarter over prior year. Both OUS and U.S. performed well in the period. As in our Bone Growth Therapies business, Orthofix Extremities also benefited from a carryover of an unusually large number of open orders at the end of the second quarter that were fulfilled in this period.

Now moving on to nonsales metrics. We are very pleased with our performance in the quarter. Adjusted earnings per share was $0.43 compared to $0.42 in Q3 of 2017. Excluding the dilution of Spinal Kinetics, adjusted EPS was $0.50 per share or 19% increase over prior year. Adjusted EBITDA as a percentage of net sales, excluding Spinal Kinetics, was 21.1% compared to 20.1% in the prior year period, a 100 basis point increase. Free cash flow was $11.7 million for the third quarter, which was a $2.6 million improvement over prior year. Adjusted trailing 12-month ROIC was 11.6% compared to 10.7% in 2017, and when excluding Spinal Kinetics, adjusted ROIC was 14.6% in the period.

And lastly, we had a total cash balance of $56.2 million as of September 30, 2018. I'll now spend a few minutes giving you more color on the important initiative we are undertaking in our spine businesses. In June, we announced the formation of Orthofix Spine, which is the alignment of the Bone Growth Therapies, Spinal Implants and Biologics reporting segments. In the third quarter, we made significant strides in optimizing the organization through a unified approach of strategy, leadership, marketing, operations, R&D and sales logistics. This work has been essential in preparing us to more fully leverage our market-leading Bone Growth Therapy and Biologic technologies, and upon U.S. FDA approval of the M6 discs. Orthofix has a unique combination of products that we believe differentiates us in the spine market and will be the platform for future accelerated growth. And more specifically, with the M6 disc in our current cervical spine product offerings, we believe that Orthofix will have the most complete and differentiated cervical spine solutions of any company worldwide, including the only FDA-approved osteogenesis device for use in the fusion of the cervical spine. Regarding the M6 disc approval process, we still anticipate the mid-2019 approval and limited market release, but this could be earlier or later in the year depending on the timing of the FDA approval process.

In summary, we have a very good top line and adjusted bottom line results in the quarter, made significant headway in aligning the Orthofix spine businesses, we finalized the redomicile of the company to Delaware, and overall are very pleased with our positioning heading into 2019 and beyond.

Doug will now give you the financial details. Doug?

Thanks, Brad, and good afternoon, everyone. Our financial results had many highlights this quarter, including strong top line growth, margin expansion within our organic business, a lower effective tax rate and increased cash flow. I'll start by providing some additional details into our net sales and earnings results and then discuss some of our other financial measures. As Brad noted, total net sales in the quarter were $111.7 million, up 6.1% on a reported basis and 6.6% on a constant currency basis when compared with the third quarter of 2017. When adjusting for Spinal Kinetics sales and the MTF Biologics contractual fee change, net sales were up 5% over prior year in constant currency. The growth from the quarter was primarily driven by our Bone Growth Therapies and extremities businesses, with stabilization in Biologics. Under the new ASC 606 revenue recognition standard, that we were required to adopt at the beginning of 2018, we generally recognized revenue at the time of invoice and no longer on receipt of cash for certain of our OUS net sales to stocking distributors. As I had previously mentioned, the differences between the current and historical methods may vary on a quarterly basis, but over time, we believe that the differences will not be significant. When comparing our Q3 2018 growth to the prior year period using the newly adopted revenue recognition methodology for both periods, our constant currency growth rate was 6.0%.

Please refer to today's earnings release and the footnote in the 10-Q for further analysis. Gross margin in the third quarter 2018 was 78.5% compared to 77.5% in the prior year period. The 100 basis point increase was driven by continued improvement in our inventory management initiatives and cost savings resulting from our U.S. restructuring in late 2017. These improvements more than offset the noncash purchase-accounting related inventory of fair market value adjustments related to the Spinal Kinetics acquisition. For the full year 2018, we now expect gross margins to be between 78.5% and 79.0%. Sales and marketing expenses were 44.7% of net sales in the third quarter of 2018, down from 45.1% of net sales in the third quarter of 2017, primarily as the result of lower commissions. We continue to expect sales and marketing expense as a percentage of sales for the full year to approximately track with 2017's results. Non-GAAP net margin in the quarter was 33.8% of net sales, which was up 150 basis points from 32.3% of net sales in the third quarter of 2017. This improvement was due to the improvement in both gross margin and sales and marketing expenses as a percentage of sales over the prior year.

G&A expenses were 20.3% of net sales in the third quarter of 2018, which were up from 17.2% in the prior year period. This increase is due primarily to higher share-based compensation as well as higher strategic investment spending, which includes costs from the integration of Spinal Kinetics and our corporate redomicile to the U.S.

R&D expenses were 8.6% of net sales in the third quarter, which were up from 6.6% in the prior year, primarily due to costs pertaining to regulatory efforts associated with the FDA premarket approval of the M6 cervical disc. We now expect R&D spending to be between 7% and 7.5% for the full year.

Adjusted EBITDA, including the expected dilution from Spinal Kinetics during the third quarter, decreased to 19.2% of net sales from 20.1% of net sales in the prior year. The decrease was primarily driven by the increased R&D spending from the M6 disc PMA process that I just mentioned and previously discussed in our guidance. However, as Brad mentioned, excluding Spinal Kinetics, our organic margin expansion during the quarter was 100 basis points, which was primarily driven by the improvements in gross margin. Other expense was $5.2 million during the third quarter as compared to other income of $500,000 in the prior year period. This increase in expense in Q3 was primarily driven by a noncash $4.4 million impairment charge related to our investment in Bone Biologics, a development-stage public company focused on a proprietary recombinant human protein growth factor that promotes bone regeneration. Together with MTF Biologics, since 2013, we have made a series of equity investments in Bone Biologics common stock that totaled $3.3 million of cost basis.

Following this charge, the previous book value of $4.7 million is now valued at $200,000.

Now turning to tax, we have income tax benefit for the quarter of $115,000 or 9% of loss before income taxes as compared to income tax expense of $6.2 million or 65% of income before income taxes in the same period of 2017. This year-over-year decrease in our quarter tax provision was driven by the benefit of our recent redomicile and the lower U.S. tax rate, offset by a certain unbenefited or nondeductible expenses, including the write-down of our investment in Bone Biologics. As a reminder, based largely on the expected benefits of our redomicile, effective with the third quarter, we have lowered our non-GAAP long-term tax rate from 35% to 29%. For the third quarter 2018, we reported GAAP net loss from continuing operations of $0.07 per share as compared to net income of $0.18 per share for the third quarter 2017. After adjusting for certain items and when normalizing for tax using a non-GAAP long-term tax rate, adjusted EPS was $0.43 compared to $0.42 in the third quarter of 2017. As Brad mentioned, when excluding the inorganic operating losses associated with Spinal Kinetics, our organic adjusted EPS was $0.50 per share in Q3, which represents approximately 19% growth compared to the prior year period.

Moving on to the balance sheet highlights. Days sales outstanding or DSOs were 61 days at the end of the third quarter 2018, up from 53 days at the end of the third quarter 2017. As noted on the last call, this increase was due primarily to the increased receivables from our adoption of the new revenue recognition standard at the beginning of 2018. Our inventory turns at the end of the third quarter 2018 were 1.2x, flat to the third quarter of 2017, as inventory management improvements were offset by an $8 million increase in inventory related to the acquisition of Spinal Kinetics.

Cash, cash equivalents and restricted cash at the end of the third quarter were $56.2 million compared to $81.2 million at the end of 2017. The decrease in cash was primarily related to the $45 million upfront payment for the acquisition of Spinal Kinetics. Cash flow from operations for the quarter was $15.8 million, up from $13.8 million in the third quarter 2017. This increase was due primarily to improvements in inventory management. Capital expenditures were down slightly in the quarter, $4.1 million from $4.7 million in the prior year. Free cash flow, defined as cash flow from operations minus capital expenditures, was $11.7 million during the quarter compared to $9.1 million in the prior year. This improvement primarily reflects the operating cash flow improvements that I just noted.

With that, I will now turn it back to Brad.

Thanks, Doug. I'll now finish my prepared remarks with our updated guidance. For the full year, the company is narrowing its expectations for reported net sales from $450 million to $456 million to $451 million to $455 million, which represents a year-over-year increase of 4.0% to 4.9%. This guidance is based on current foreign exchange rates and includes the impact of the MTS split change in the Spinal Kinetics acquisition. For the fourth quarter, we expect reported net sales to be in the range of $119 million to $123 million. At the midpoint of this range, this represents 3.5% reported and 4.1% in constant currency growth. When applying this year's new revenue accounting standard to prior year periods, year-over-year growth in the fourth quarter is expected to be 8.6% reported and 9.6% in constant currency. And for the full year, 5.5% reported and 5.8% in constant currency.

Please refer to the table in the earnings release for a reconciliation. Regarding the full year growth contribution from each reporting segment: We continue to expect Bone Growth Therapy business to grow in the 4% to 5% range. We now expect Spinal Implants growth, including Spinal Kinetics, to be in the range of 10% to 12%, which reflects our lower expectation for international spinal implant sales and some disruption in the U.S. business due to the realignment. Including the impact of Spinal Kinetics, we now expect to achieve adjusted EBITDA in the range of $85.5 million to $87 million for the full year 2018, and adjusting -- adjusted earnings per share to increase to $1.70 to $1.75 using weighted average shares of 18.9 million and a non-GAAP long-term tax rate of 35% for the first half of the year and 29% for the second half. For the fourth quarter, we expect adjusted EPS to be in the range of $0.46 to $0.51.

With that, operator, we are now ready to open up the lines for questions.

(Operator Instructions) Our first question comes from the line of Bruce Nudell of SunTrust Robinson Humphrey.

This is Stan Fediuk on the line for Bruce Nudell. Can you just quickly comment on the prospects for the rebound in Biologics and International Spine?

Sure. Sorry, I didn't catch the name?

Stan.

Stan, this is Brad. So in terms of Biologics, we had a nice quarter with 4.6% growth in volume. We're -- we expect the -- obviously, the MTF split change will come off -- that comp will come off in March of this next year and it should get back to some normal sorts of growth rates. But I think the big opportunity in the Biologics business is really the realignment of our overall spine businesses. In our Biologics business, we have many, many distributors out there that are smaller in nature. I think once we can attract larger, more influential distributors in addition to who we have out there today by -- through the attraction of our M6 disc and our Bone Growth Therapy products and those sort of things, I think we will see a nice uptick in the Biologics business over time. So I think maybe starting mid-next year we should start to see that sort of impact. I mentioned that before and we still have that same expectation.

In regards to the OUS Spinal Implants business, there is now under a new sales leadership. It's under Tom Afzal, who is the President of Spinal Kinetics business. All of their business is currently OUS. He has a great network setup worldwide, particularly in Germany where they're a very large player and other places around the world. So we're doing some hiring there, and I would give that another couple quarters before we see that start to pick up and that would be my expectation.

Okay. And my next question, can you just comment on the impact or if any increased focus on the larger competitors on closed robotics spinal systems to garner increased pull-through of their entire product lines? Is there any associated impact on your markets?

Not at this point, Stan, that we're seeing. I mean, overall, robotics is still less than 15% of the procedures out there. We do recognize that, that is going to be a significant part of the future. I know the estimates show the next 3 years that 15% could go to 30%. So as we think about our business development opportunities, that's certainly one of the areas where we will focus and making sure that we don't get left behind in whole wave of navigation and robotics.

Our next question comes from Raj Denhoy of Jefferies.

This is Anthony in for Raj. So couple -- start on the top line, just high level. I'm just wondering if we reconcile for ASC 606, our math is telling us just from the numbers in the Q that it would be around 4%. I'm just wondering if that's the correct way to look at it? Then the top line one also would be -- what was the contribution from Spinal Kinetics in the quarter in dollars if you have that? And I have a couple of follow-ups.

Sure. Spinal Kinetics in the quarter was $2.9 million. And in terms of -- we have a little bit different numbers in terms of the 606, but Doug can speak to that.

Yes, on -- for -- we've got a lot of different things going on with revenue this year with the Biologics split change and the rev rec change in Spinal Kinetics. But on a new-to-new basis, which we covered, our reported growth would have been 5.5% and on a new-to-new basis, which we think is more appropriate at 6% for the quarter in constant currency. Constant currency, thank you, yes.

All right, I can follow-up on that as well. But maybe a couple of follow-ups, one would be in Extremity, obviously the rebound there. I'm just wondering, Brad, you mentioned the catch-up orders. So should we interpret it that the entire $1.4 million was sort of recognized in the quarter and that some of that some of that could carry into the fourth quarter? And then also does that include, and I'm not sure if it does, but the launch of RIVAL foot & ankle? I think that's still to come.

So it was not quite the full $1.4 million, but it was pretty close to it for the quarter. I expect to see whatever was left to come through in Q4. But say 90% of it came through in Q3. And it does not include anything for RIVAL. We -- RIVAL we don't anticipate to be relaunched until probably mid-next year at this point.

Okay. And then the last one for me would just be maybe high-level comments as we think about margins next year, maybe directionally, what do you think in terms of overall margins from the realignment of bone growth spine Biologics in '19. Will it take longer than next year realized? Do you expect an impact at the adjusted EBITDA line? And then maybe also Spinal Kinetics, how -- will that be margin accretive as well in 2019?

Sure, Anthony. So the realignment or the alignment of the businesses that we're doing in spine is really not about cost savings. I think ultimately, as we get into 2020 probably, we will see some there would be my expectation. That's really about driving top line more than anything else. So we do have -- I have committed to 100 basis points per year for 3 years or sooner on our organic business. And I'm happy to say that on our organic business year-to-date, we're 100 -- when we adjust out stock-based comp and other adjustments that have EBITDA, were up 192 basis points. We made very, very good progress. Expect that to continue into 2019. Not sure we'll get all the way to the 300, but hopefully we will on our organic business.

Now the Spinal Kinetics business will be a little bit dilutive to that because of spending that we're going to launch to products, as well as the R&D spending to get the product approved from the regulatory agencies. So I hope that answers. And if not, I'm happy to follow up further.

Our next question comes from Jeffrey Cohen with Ladenburg Thalmann.

Could you give us a little further color on the fixation and the softness? More specifically, could you give us a little deeper color as far as some specific geographies, where they were light, kind of some of the ancillary commentary from the field as far as turnaround, both specifically on geographies outside U.S. as well as U.S.?

Sure. So outside the U.S. is where the majority of our shortfall was in the quarter. It was down 19% over the prior year, where our U.S. business was pretty close to flat, but down about 1.5%. But outside the U.S., it really is in -- the shortfall was in Germany and Australia, couple of places that we know the issues. Germany is a place where we expect to kind of realign our business there overall, not just in spine products, but also in Extremity. And Tom Afzal, who's the General Manager of Spinal Kinetics for us, who's the CEO there, he has very strong connections in Germany, and we're hopeful that he can have a pretty significant impact there, as well as Australia, but other territories as well.

So I would give that a few more quarters before we -- we'll give him a little bit of time to ramp up and work his magic. And then in the U.S., it was pretty broad-based, a little shortfall to what we would have normally expected for the quarter. Any time you make leadership changes, Ray Fujikawa and Bob Goodwin were both presidents. One of Spine Fixation, one of Biologics. They're transitioning out of the company. That makes distributors -- sales agents a little bit nervous. But as we bring everything together under Brad Niemann with the talent that he has on his team in both leading sales, although we have -- we're keeping the same sales management in each of these businesses or each of these product lines. But also on the marketing side and R&D and other areas, we think that they will pretty quickly see the benefit of all of that and realize the benefit of that and will recover in the U.S. business in the next few quarters as well. So it would be my expectation.

Okay, got it. Doug, can you clarify the $4.4 million impairment piece. I have $5.2 million from Bone Biologics. You expect a couple of hundred thousand follow-on for Q4. And is there anything else expected in the fourth quarter?

No other changes expected at this time. We're still very hopeful about the technologies that the company is developing. Just $200,000 is our net remaining exposure that will remain on our books until we get further information.

Okay. And another quick one on taxes, for modeling purposes, for the balance of this year as well as for 2019, you said you use 35% for the front half of '19 and 29% for the back half? Is that correct?

Just for 2018, we use 35% in the first half of the year and effective July 1 in the third quarter, we lowered it to 29%. So short of any changes that's the right -- that's what we're using to adjust our -- for our long-term rates.

Okay. And you said that was for 2018 or 2019?

Well, first half of '18 was different at 35%, and we lowered it. This quarter, for Q3, the 29% and that will stay in place until we get -- until we reevaluate, so I would expect that rate to stay at or near that level into 2019.

Okay, perfect. And one more, if I may. You talked about guidance on percentage increase for Spinal Implants. I think you said 10% to 12%. Were you indicating that for the fourth quarter or for the full year '18?

That was for the full year '18.

10% to 12% for the full year?

Right. And I think I missed something in my prepared remarks here, too, just to let you know, Jeff. We continue to expect Biologics sales to decrease in the mid-single digits for the full year, primarily due to the MTF fee reduction. And we now expect Orthofix Extremity sales to grow in the mid-single digits for the full year.

Our next question comes from Brian Zimmerman (sic) [Ryan Zimmerman] of BTIG.

So a lot of questions have been asked. But I just want to check, how are you guys thinking about the commercial launch of the M6 disc in the midst of all these changes in the spine segment. I mean, how do we know that all the issues will be resolved and the launch of M6 won't be delayed in spine because of what you're going through right now with the leadership changes?

Well, they're -- Ryan, it's Brad. They're unrelated. So the team that has done all the work on the M6 disc in the U.S. is at Spinal Kinetics and still very actively engaged. There's no crossover, no risk of any kind of changes to our overall leadership affects that at all. They're certainly -- we don't know what to expect totally from the FDA, so our best guess is still July of next year. We've got a submission to make here in the very near future, and once we make that submission, they'll have some time to respond to that. And then depending on the response, we go from there. So that's the normal process that everybody goes through. And -- but there's nothing in the market. There's nothing that's with the FDA, nothing that's with our realignment that will affect that in any way at all.

Our next question comes from Jim Sidoti with Sidoti & Company.

So I understand the disruption outside the U.S. in the spinal -- for the spinal distribution with the changes made there. Can you remind me what the disruptions were in the U.S. for the spinal distribution?

Yes, just a change in leadership of that business. Remembering that the vast majority of our independent reps out there are not exclusive to us. So as the sea change, they tend to get nervous and back off a little bit and maybe sell some of their other lines a little bit more aggressively than ours. Once they see -- so it's a little bit of an engagement issue. Once they see the new structure, the people taking hold and things going well and giving them more opportunities, then that flips pretty quickly and they're -- we reengage. And again, this isn't huge numbers. We're talking about hundreds of thousand dollars, not millions of dollars here. So as you -- as we think about this, I want to keep it in perspective. So that -- we expect -- we're seeing good signs in October and hopefully that will continue. But I would give it another couple of quarters to kind of resolve itself as the new alignment takes hold.

Okay. And then my other question was, the charge for strategic investments in the quarter, is that related to new acquisitions or is that related to the integration of Spinal Kinetics?

Yes.

Yes, it's a both. Yes, it's a combination, Jim.

Ladies and gentlemen, this concludes today's question-and-answer session. I would now like to turn the call back over to Brad Mason, Chief Executive Officer, for any closing remarks.

Thank you, operator. And thank you all for joining us on the call today. I look forward to speaking to you again soon, and have a nice evening.

Ladies and gentlemen, thank you for participating in today's conference. This concludes today's program. You may all disconnect. Everyone, have a great day.