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NuVasive (NASDAQ:NUVA)

Q3 2008 Earnings Call

October 22, 2008 5:30 pm

Executives

Nick Laudico - The Ruth Group

Alex Lukianov - Chairman and Chief Executive Officer

Keith Valentine - President and Chief Operating Officer

Kevin O’Boyle - Executive Vice President and Chief Financial Officer

Analysts

Matt Miksic - Piper Jaffray

Taylor Harris - JPMorgan

Raj Denhoy - Thomas Weisel Partners

Benjamin Andrew - William Blair & Company

Bob Hopkins - Banc of America

David Roman - Morgan Stanley

Joanne Wuensch - BMO Capital Markets.

Vincent Ricci - Wachovia

Vivian Cervantes - Rodman & Renshaw LLC

Ed Shenkan - Needham & Company

John Putnam - Dawson James Securities

Bill Plevenic - Kenicourt

Operator

Greetings and welcome to NuVasive Incorporated third quarter 2008 earnings conference call. (Operator Instructions)

It’s now my pleasure to introduce your host, Nick Laudico of The Ruth Group. Thank you, Mr. Laudico. You may begin.

Nick Laudico

Thanks, operator. Welcome to the NuVasive third quarter 2008 earnings conference call. NuVasive senior management joining us on the call today will be Alex Lukianov, Chairman and Chief Executive Officer; Keith Valentine, President and Chief Operating Officer; and Kevin O’Boyle, Executive Vice President and Chief Financial Officer.

During our management comments and in 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 proved correct could cause NuVasive 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.

With that I’d like to turn the call over to Alex Lukianov.

Alex Lukianov

Thank you Nick and thank you everyone for joining us this afternoon on our third quarter 2008 call. Our results in the third quarter provide continued evidence of strong market adoption of XLIF and the proficiency of our exclusive sales force in penetrating existing accounts with our full mixed innovative products.

And following our continued philosophy to stay ahead of the competitive curve, we are preparing to launch our newly-acquired biologic product Osteocel as the core of a $100 million biologics platform. The combination of these strategic initiatives provides what we believe to be a clear path to the robust revenue growth and sustained profitability we expect over the next several years.

Before outlining some of the details that drove our operational success this quarter, let me take a moment to briefly review our strong financial performance. Revenue in the quarter increased 73.7% year-over-year to $67 million.

On a sequential basis, this represents a 16.5% quarterly increase over the second quarter of 2008. Accordingly, we are increasing our revenue guidance for the full year 2008 to $245 million to $247 million.

Our exclusive sales force, which now stands at 300-strong, continue to gain momentum in the third quarter. Our most seasoned representatives who have been with the company for at least 18 to 24 months have been successful in achieving penetration of our full product offering into existing accounts while also developing new business.

On average, our commissioned representatives are currently producing $1.2 million in annual sales. In regions such as the west and the southeast, our most experienced representatives are producing annual sales well above the current corporate average in an excess of $2 million.

This demonstrates the potential we envision for our entire organization as our exclusive sales force becomes more expert in selling our full mix of products and expands their relationships with both current and new spine surgeon customers.

Our growing product offering has strengthened our ability to address the majority of procedures in the lumbar, thoracic and cervical spine allowing our sales force to compete for the majority of the spine surgeon’s business and expanding our established competitive advantage in XLIF. Our most important new product introduction was at NASS was NeuroVision M5, our next generation nerve avoidance system.

M5 builds on the innovation behind our original NeuroVision products and represents a significant step forward in nerve monitoring technology, strengthening XLIF in the MAS platform as the only safe and reproducible lateral approach to spine surgery.

M5 brings the total number of NeuroVision monitoring modalities from three to five, extending monitoring coverage to the entire spine. The addition of SSEP mode or somatosensory evoked potential broadens NeuroVision coverage for thoracic surgical procedures and offers a faster set-up with intuitive plug and play connections. Navigated guidance mode offers surgeons a user-friendly approach to pedicle screw placement using precision trajectory feedback to help align the proper approach angle, while dramatically reducing fluoroscopy exposure.

These two new modes are in addition to our pre-existing modalities of stimulated EMG or electromyography, free run EMG and MEP or motor-evoked potentials. The next generation NeuroVision leverages NuVasive’s five years of experience in nearly 100,000 cases of surgeon-directed neuro-monitoring and will create even greater distance between us and our competitors.

In addition to these enhancements to the NeuroVision platform, we have introduced CoRoent interbody device extensions to address the specific demand for unique sizes and shapes in the lumbar spine from the surgeon community. We also believe there is considerable opportunity for XLIF to address failed TDRs or failed traditional fusions. At NAS, we introduced instrumentations specifically designed to facilitate removal and reversion of these failed implant.

We have complemented the growing applications of our innovative lateral approach by devoting appropriate focus on the development of our traditional product lines. In addition to expanding options with XLIF, a surgeon can now use NuVasive products to perform anterior fusion procedures and address L5-S1 through our Halo system.

We also continue to expand our instrument and implant offerings for (inaudible 00:09:48) procedures.

In the cervical spine, we now have a comprehensive selection of products that address the various preferences among surgeons for fixation. Our recently introduced cervical products, the Helix Anterior Cervical Plate, Helix Miniplate and VuePoint posterior fixation system are allowing our sales force to steadily gain incremental cervical pull through business across our customer base.

We are pleased with the initial success of our cervical business and remain on track to double our cervical revenue in 2008. These innovative product launches combined with the continued success of Thoracic XLIF to address multilevel degenerative scoliosis procedures supports our strategy of providing surgeons with a comprehensive product suite that addresses major applications in all regions of the spine.

In early August, we completed enrollment of our NeoDisc clinical trial. The trial protocol requires a successful two year follow-up period on all patients before submitting to the FDA for potential approval. In terms of our complete motion preservation platform, we remain focused on XLPTR or innovative disk replacement device with our unique lateral approach and plan to embark on a clinical study in 2009.

Osteocel, the most recent addition to our comprehensive product portfolio is part of our biologics unit that we expect to be a $100 million business over the next several years. As a reminder, we believe that Osteocel uniquely fills the product gap between DBM and BMP in the $1.5 billion U.S. biologics market and is complementary to our Formagraft product.

It is the only viable bone matrix product on the market that provides the three beneficial properties similar to Autograft of osteo-conduction, osteo-induction and osteogenesis.

As we have previously disclosed, we recently agreed on a plan with Orthofix, the current primary distributor of Osteocel to effect an easier and more rapid transition of distribution to our sales force. As a result, we now expect to begin limited direct commercial activity in late fourth quarter which should lead to a more robust 2009.

We are supporting our 2009 expectations with an aggressive ramp in pre-marketing activity in our biologics division designed to fully educate our sales representatives, identify key accounts for initial product penetration and commence clinical studies supporting the efficacy of the product. We are strategically aiming to complete and present the result of these studies in support of even stronger sales expectations in 2010.

Upon completion of our diligence and integration of the Osteocel business, we have confirmed there are no supply issues with Osteocel and expect to have ample inventory to support our expectations in 2009.

In order to support our robust revenue growth and profitability expectations, we recently completed two major improvements to our corporate infrastructure.

During the quarter, we completed the transition to our new corporate headquarters and strengthened our technology infrastructure with the implementation of our new ERP system. These are essential components of our growth strategy and our commitment to sustain and grow profitably.

The ERP system and our new corporate headquarters provide a strong base that will enhance operational efficiency and help support our expectation for rapid revenue growth in 2009.

I would now like to briefly address the complaint brought by Medtronics Sofamor Danek alleging patent infringement involving certain NuVasive products. As we indicated in our press release, we are assessing defense strategies as well as potential counter claims based on our own significant patent portfolio and intellectual property rights.

I would like to reiterate that we are prepared to vigorously defend ourselves in the court room and remain focused on building our business so that patients can continue to experience the innovations that NuVasive has brought to the field of spine care.

Our existing operations have not been disrupted whatsoever by this legal matter and we do not expect any significant disruption going forward. Although I do not plan to provide detailed updates of the procedural steps of this litigation, I will surely keep you apprised of all significant developments or changes.

Kevin will provide an overview of our expected legal costs for the next 15 months during his remarks. I would also like to provide a few comments on the current financial environment and the potential impact on spine procedures.

From a macro perspective, we have not seen a significant impact on elective spine procedures in the markets where NuVasive does business. And we do not expect the growth of our core business to slow in the current environment. However, hospitals may slow down upfront purchase arrangements such as capital purchases and stocking order.

As a result, we may see less of these large scale transactions in the fourth quarter. Nonetheless, on the strength of our core business, we anticipate robust growth in Q4 leading to our revised annual revenue guidance of 245 to $247 million.

Despite the current financial markets, we still believe our business can grow at rates consistent with past guidance.

Looking to 2009, with the addition of the Osteocel product line, we believe our overall revenue growth can approach 40% over our newly-revised 2008 revenue guidance range with steady improvements to profitability.

I would now like to turn it over to Kevin O’Boyle for a detailed review of our financial results and updated guidance.

Kevin O’Boyle

Thank you, Alex. Our revenue for the third quarter 2008 was 66.9 million, a 73.7% increase over Q3 2007 and a 16.5% increase over Q2 2008.

Osteocel revenue was 4.4 million versus our expectation of approximately 5 million for the third quarter. Excluding Osteocel revenue, the third quarter was 62.3% increase over Q3 2007 and an 8.9% over Q2 2008. International revenue remains on target with a 2% to 3% revenue contribution that we guided to for 2008.

As Alex mentioned, the lower Osteocel revenue was a result of the transition arrangement we worked out with the current primary distributor of the product. As a result of this arrangement, Orthofix will take less inventory so that they are able to transition away from the product. In exchange, we will begin limited sales in the late fourth quarter.

Gross margin for the third quarter was 81.8%, compared to gross margin in Q3 2007 of 82, and gross margin in Q2 2008 of 83.3. The lower gross margin in the third quarter primarily reflects the revenue contribution from sales of Osteocel through pre-existing distribution agreements with the gross margin of 36.4

Our Q3 2008 net loss was 23.1 million or a loss per share of $0.64 on a GAAP basis. On a non-GAAP basis, the company reported net income of $8 million or $0.21 per share.

Our non-GAAP net income calculation in the third quarter of 2008 excludes stock-based comp of $5.4 million, a charge for in-process R&D of $16.7 million related to the acquisition of the Osteocel biologics business, one-time leasehold charge of 4.8 million related to the company vacating our previous headquarters. A charge of 2.6 million related to short-term transitional support cost for the company’s ERP system, amortization of intangible assets of 900,000 and IP litigation expenses of $600,000.

Operating expenses for Q3 2008 totaled $77.7 million compared to $35.2 million in Q3 2007 and $48.5 million in Q2 2008. The increase in operating expenses in the third quarter from the second quarter primarily reflects the in-process research and development costs, the traditional support cost for the company’s ERP system, the one-time leasehold charge related to vacating the company’s our previous headquarters and IP litigation.

Excluding these expenses, the operating expenses for Q3 2008 totaled 53 million.

Our legal expense related to the Medtronic’s lawsuit in the third quarter was approximately 600,000 and we anticipate spending $1 million in the fourth quarter.

For 2009, we are currently estimating the projected cost of our defense to be in the range of $4 million to $5 million. R&D expenses excluding stock-based comp for the quarter total $5.5 million versus $5.8 million in the second quarter. The decrease in R&D spend from Q2 was related to the completion of enrolment in the NeoDisc trial.

Excluding stock-based compensation, R&D as a percentage of revenues for Q3 2008 came in at 8.2% versus Q2 2008 at 10.1. Sales, marketing and administrative expenses excluding stock-based compensation for the quarter totaled 50.1 million versus 37.6 million in the second quarter.

Excluding stock-based compensation and other adjustments, the percent to revenue was 62.9% versus Q2 2008 at 65.4%. The increase in spend in absolute dollars from Q2 was related to typical selling expenses, related to higher revenue base, as well as a facility costs associated with the relocation of our corporate headquarters.

The interest and other expense cost for the quarter was 146,000. This reflects reduced yields on our cash investments due to current market conditions. With 222 million in cash, our primary focus in Q3 and going forward is safety of principal, which is why the majority of our cash is invested in securities backed by the U.S. government.

The stock-based compensation charge for the quarter was 5.4 million was recorded in our operating expenses and allocated as 920,000 in R&D with the balance of 4.5 million in sales, marketing and administrative expenses.

Our cash burn was 12.1 million for Q3 2008. Included our cash burn as a development of our MAS product pipeline, the national launch of new products and the build up of inventory in instruments to support future growth, cost related to leasehold improvements for our new corporate facility, cost associated with moving into our new corporate headquarters, and implementation cost for our ERP system. Our operating cash burn is defined as cash used for operating activities plus additions to fixed assets.

Our inventory position was 58.4 million at the end of Q3 or 21.8% of annualized third quarter revenue. We expect our inventory to sales ratio to average between 20 to 25% which may spike in a quarter, depending on how many and what type of products are launched.

Day sales outstanding or DSOs were 60 days in Q3 2008 compared to 50 days in Q2 2008. The fourth quarter sheet should see a meaningful decrease to the mid-50 day range and as we realize the benefits of our new ERP system, we should return back to the low 50s.

I would now like to turn to review of our 2008 financial guidance. For the full year 2008, we are increasing our revenue guidance to a range of 245 to 247 million, up from 238 to 240 million. This includes the contribution from Osteocel of 9 million in the second half of 2008 or approximately 4.6 million in the fourth quarter of 2008, which is down from our previous guidance of 15 million.

We’ve also increased our Osteocel guidance for 2009 from 25 million to 28 million based on introducing the product to our sales force on a limited basis in late fourth quarter. As Alex mentioned, the reduced sales to Orthofix will provide our sales force with the advantage of having more inventory to sell and reduced competition in 2009. We continue to expect Osteocel revenue contribution to be limited in the first two quarters of 2009, as we affect the transition to our sales force followed by a strong second half.

We expect the gross margins for the balance of 2008 should be in a range of 81 to 82% based on the effective selling Osteocel through existing distribution agreements at a mid-30% gross margin. We should realize a significant increase in Osteocel gross margin in 2009 to about 60% when we discontinue selling through distributors.

For the full year 2008, we have maintained our GAAP earnings per share guidance, excluding in-process R&D and other adjustments as detailed in the table of our earnings release at $0.05 to $0.07. We believe that excluding each of these costs provides information that reflects the company’s ongoing operating activities for 2008.

Our interest expense in Q3 of 146,000 continues to reflect the further reduction in yield on our invested cash due to current market conditions. We expect to incur greater interest expense levels on the fourth quarter and in 2009.

As Alex mentioned, we converted our entire company to the SAP Enterprise Software Platform in July. Although transitioning a new ERP system is never without challenges, our ability to report results in the third week following quarter end is a testimonial to our shareowners’ ability to adapt to a new system.

During the quarter, we realized that additional consulting time was important for successful transition and therefore incurred $2.6 million in Q3, which was incremental to our ongoing support costs. We also anticipate an additional charge of approximately $1.5 million in the fourth quarter.

These third and fourth quarter investments minimize the potential for a transitional risk of moving to a new SAP-based system and will assist in driving expected efficiencies in 2009. We expected to move to a more traditional and leverageable ongoing support model in 2009 without a significant incremental cost.

For 2009, we believe, our overall revenue growth can approach 40% of our newly revised 2008 revenue guidance range of $245 million to $247 million. In conjunction with a non-GAAP operating income percent of 11% to 13% which excludes stock-based compensation, amortization of intangibles and litigation fees associated with the Medtronic’s lawsuit.

We will provide a comprehensive guidance for 2009 on our fourth quarter earnings call.

I would now like to turn the call back over to Alex for closing comment.

Alex Lukianov

Thank you, Kevin. Overall, we are pleased with our third quarter results. We remained well-positioned to continue to strategically expand our geographic footprint, both in the U.S. and abroad, leveraging our innovative lateral approach, enhanced corporate infrastructure, and unique culture of absolute responsiveness to continue to take market share.

Concurrently, we are introducing new products to both protect our leadership in innovation and unlock new segments of the spine market. Together we believe that these initiatives strongly support our drive for interim sales goal of $500 million combined with the growing profitability.

We will now be willing to answer your questions.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, we will now be conducting a question and answer session. (Operator Instructions)

Our first question comes from the line of Matt Miksic with Piper Jaffray. Please go ahead.

Matt Miksic - Piper Jaffray

Hey, good evening. Thanks for taking the question. Can you hear me okay?

Alex Lukianov

Absolutely, yes.

Matt Miksic - Piper Jaffray

So one quick sort of clarification on Osteocel in the second half of the year. You were talking about marketing at late in the fourth quarter. You talked about data being important to marketing the product.

Can you talk about I guess how the strategy for going to market with that product now in the fourth quarter is going to change your step-up maybe throughout next year, just how would you think about that product and what you will be doing with it?

Alex Lukianov

Well, the strategy does not change from what we've talked about before, it just starts a little bit sooner as a result of the change in our arrangement with Orthofix. So we'll be rolling the product out on a limited basis beginning late this year and then expanding that in 2009.

What we planned to do, as we discussed before and many of these have already been initiated, is to conduct a series of pre-clinical as well as clinical studies that we think will further the efficacy of the product and give us a very strong case in order to reach the kind of sales levels that we're thinking about for 2010. So it's really no different than what we've talked about before. The only difference is that we're starting it a little bit earlier.

Matt Miksic - Piper Jaffray

Okay. Changing gears, a question on the sales force, numbers stepped up pretty significantly from last quarter and it looks like it puts you ahead of what was your former goal for growth in the year. Anything changed there?

I mean what caused you to sort of add, well, it looks like so many more people?

Alex Lukianov

Well, it's a combination of things. One is availability of excellent candidates and so we've certainly moved forward on that.

Additionally, it's been our exclusive distributors have been hiring at a faster pace than before. And I think that has a lot to do with their confidence in being able to really drive the products forward into 2009 and beyond and building the infrastructure for that growth now in 2008.

Matt Miksic - Piper Jaffray

Any of this falling out of any of the recent acquisitions or changes in distributorships here in the U.S.?

Alex Lukianov

No.

Matt Miksic - Piper Jaffray

Okay. So not yet, I guess maybe.

Alex Lukianov

Not at this point in time, no.

Matt Miksic - Piper Jaffray

So looking at the fourth quarter, should we continue to think about you adding more or are you sort of at where you need to be for the year?

Alex Lukianov

We'll probably increase, certainly a few more heads, that we have several in process. I can't give you an exact number right now, but it’s probably in the neighborhood of 10, approximately.

Matt Miksic - Piper Jaffray

Okay. And then, maybe just a general question coming out of last week at NASS, if you saw anything or came out of the meeting with any sort of realization of where docs are going? Or where the market's going or where reimbursement's going, sort of anything that you thought was particularly significant for your business?

Alex Lukianov

Well, I think there's been a very strong reception for minimally invasive spine surgery. We continue to see that with a very strong demand for lateral procedures, XLIF obviously, so we feel that that demand has been very robust.

We've not seen any kind of a fall off with regard to demand for elective spine procedures. And as I mentioned in my remarks, we feel that that's going to continue to be moving forward at a good pace just like the market has been growing right now as we see into 2009. So I think the environment is still very strong with regard to spine.

We anticipate a bit more pricing pressure because of our size as we move into next year. We anticipate being able to build into more larger accounts and have to bid aggressively to get that business.

So that means that some of our pricing will come down, but I don't think it's going to adversely affect our gross margins that we are used to seeing and we'll certainly talk about those some more on the fourth quarter call, but they'll be pretty consistent with prior levels.

Matt Miksic - Piper Jaffray

Okay, terrific. Well, thanks for taking the questions. I'll jump back in queue.

Alex Lukianov

Okay, appreciate it.

Operator

Thank you. Our next question is from the line of Taylor Harris with JP Morgan. Please go ahead.

Taylor Harris - JP Morgan

Thanks a lot. Hey, guys.

Alex Lukianov

Hi.

Taylor Harris - JP Morgan

Kevin, I wanted to make sure I heard your guidance for 2009 correctly. Did you say on the operating margin range, 11 to 13% on a non-GAAP basis?

Kevin O’Boyle

I did.

Taylor Harris - JP Morgan

Okay. And should we expect most of the leverage coming on the SG&A line?

Kevin O’Boyle

Yes.

Taylor Harris - JP Morgan

Okay, great. And for the full year 2008, you're obviously taking up your sales range and you're taking up non-GAAP EPS, GAAP EPS is staying the same. What are the moving parts there that's not allowing you to take up the GAAP EPS range?

Kevin O’Boyle

The GAAP EPS range, we have stock-based comp that's in that table is listed I think at $0.56 for the year I believe. That's one reason and as it relates to just managing the overall business given SAP transitional cost.

Another cost that we have in getting Osteocel out of the gates appropriately is the reason why.

Taylor Harris - JP Morgan

Okay. And I also assume interest rates on your cash have moved against you as well. Is that—

Kevin O’Boyle

That's fair because obviously with investing most of our cash in U.S. Treasuries, our effective yields sit close to 2%.

Taylor Harris - JP Morgan

Okay, great. And then the last question and I apologize I had to miss the beginning part of this call, but I guess, Alex, within the product portfolio, is there anything in particular, is the cervical business still growing faster than the rest that is really super charging revenue growth?

I'm sure this is still primarily an XLIF story, but just wondering if there is anything outside of that that you would point to?

Alex Lukianov

It's really the XLIF story with regard to the cervical. I talked about how we're doubling our business from last year, but it is very much an XLIF story. Sorry, I have a cold. It's a little hard for me to enunciate. It's very much an XLIF story as well as the launch of M5 for NeuroVision which came out at NASS and we think that's just a huge step forward.

We are already well ahead of our competitors by at least a couple of years, excluding our IP position. And I think this puts us another three years ahead of everybody else at the very least. So that's going to give us a lot of momentum going into the fourth quarter and into 2009.

Taylor Harris - JP Morgan

Great. Thank you, guys.

Alex Lukianov

Thank you.

Operator

Thank you. Our next question is from the line of Raj Denhoy with Thomas Weisel Partners. Please go ahead.

Raj Denhoy - Thomas Weisel Partners

Good afternoon, guys.

Alex Lukianov

Hey, Raj.

Raj Denhoy - Thomas Weisel Partners

You mentioned the momentum of the business. It's pretty clear you guys have seen the underlying revenue growth accelerate for the last three quarters. But if you look at your guidance for the full year, the upper end of your full year guidance, and you back out what you think you're going to do on Osteocel in the fourth quarter, it kind of implies a low 40% kind of growth rate for the underlying business.

And I'm curious why you think you'd see that much of a slowdown for the fourth quarter just given the momentum we've seen so far?

Alex Lukianov

Well, I don't see that as a big slowdown and I think what we talked about during my remarks really has to do with sort of some limited upside in the fourth quarter that we're used to normally seeing. Capital purchases typically make up anywhere between 1 and 2% of the fourth quarter number for us.

We think because of our size right now as I mentioned before, we're now bidding for larger businesses at hospitals so the capital component could be more along the lines of 5%. So if you take a look at a 5% upside that may not be there in the fourth quarter, that's really what’s changing and that doesn't change our base business.

It simply changes the fact that hospitals are less willing to purchase out in front and purchase big steps and so we hope that some will still do that, but we're hesitant to rely on those steps until and if they come through.

Raj Denhoy - Thomas Weisel Partners

So you're really just being prudent at this point. It's not that you're seeing that 5%, which is usually where that 1 to 4%, which could be 5% now not coming in. Are you just being prudent in front of maybe it not coming in, I guess.

Alex Lukianov

Exactly, that would be the top side. So that would be not the top side of our guidance, that would be the upside above our guidance that now I'm just not sure that it's going to be there.

Raj Denhoy - Thomas Weisel Partners

Okay. Fair enough. I may have to just ask on the gross margin.

Again, if you kind of back out what you implied the Osteocel gross margins were in the quarter, I think the underlying business approached something like 85%. Is that correct? And if that is, that's a pretty big jump up from what we've seen in the last couple of quarters?

Kevin O’Boyle

It is correct and it really comes to product mix, what got sold. You know Formagraft was a great product for us in the quarter. XLIF continues to drive a lot of additional implants for us which gave us another 150 basis points in the quarter over what we had experienced in the past.

Raj Denhoy - Thomas Weisel Partners

Okay, fair enough. Nice quarter.

Alex Lukianov

Thank you very much.

Operator

Thank you. Our next question is from the line of Ben Andrew with William Blair. Please go ahead.

Ben Andrew - William Blair

I just wanted to catch up on a couple of details on Osteocel. What's your capacity for manufacturing next year. I know you can support the levels that your guiding to.

But I mean I think Orthofix was selling upwards of 15 million in the second quarter to end users. So that would imply some upside if you could generate that level of demand.

Alex Lukianov

The capacity is probably closer to about $50 million in revenue next year. But obviously we have to seed the market. We have to establish consignment levels, so we feel that $28 million is good guidance at this point in time. But from a supply perspective, we don't believe we're constrained.

Ben Andrew - William Blair

Okay, and then as you work with the different vial sizes and kind of the long lead time for that product, could we see inventory jump up as we go through '09 kind of as you position for that and make sure you don't run short on any particular vial sizes?

Alex Lukianov

Yes.

Ben Andrew - William Blair

Okay, and then breaking out the legal in the non-GAAP numbers, you're going to do that consistently over the course of 2008?

Alex Lukianov

Yes, we are with regard to this particular litigation, yes.

Ben Andrew - William Blair

Okay. And then I guess the last question I had is as you think about the customer base and kind of some of the stresses that they're seeing, are there any other potential areas beyond some of these large bidding contracts where you're seeing stresses in the system or increased hesitancy on the part of customers to position in front of this environment?

Alex Lukianov

Not in the least. Obviously had a lot of face time with customers at NASS and I asked that question of pretty much everyone I saw. And I would say that the enthusiasm is very high.

Surgeons in fact talk about how XLIF gives them an opportunity to grow their business beyond just maintaining growth in a pretty robust market. So I think pulling into the thoracic spine, doing multiple levels, all of those things are a huge positive for the surgeons. And so we continue to see a lot of excitement and a lot of uptake.

Ben Andrew - William Blair

I guess one last question, one of the things that impressed me at NASS was the navigating guidance mode on the new M5. How do you see that being used and is that a significant share-taking opportunity or is it just sort of more incremental to the sales guys?

Alex Lukianov

We think that's a way for us to really shore up the diversity of NeuroVision and give us another reason to be in there in front of doctors and in front of accounts. So at this point, we really don't have an exact impact number to give for 2009.

We'll talk about that some more in the fourth quarter in terms of what we think it'll contribute. But what we think it largely does is just allows us to continue to build the NeuroVision base in a very solid fashion.

Ben Andrew - William Blair

Thanks, Alex.

Alex Lukianov

Okay, you're welcome.

Operator

Thank you. Our next question is from the line of Bob Hopkins with Banc of America. Please go ahead.

Bob Hopkins - Banc of America

Thank you and I'm sorry if you already addressed this. I've been bobbing around on a few calls tonight, but, Alex, I was wondering if you could give us an update on the M&A outlook.

You guys articulated a while ago when you did the fundraising that you'd have several things that you'd potentially be doing over the course of the next 12 months. And one of those I think included potentially purchasing distributors outside the U.S. And I was wondering if you could just give us an update on where you are with that and when we might see some activity.

Alex Lukianov

Well, we don't have anything really to report at this point other than what I've talked about before, Bob, which is that we're looking at those sort of opportunities outside the United States. They're pretty hard to find.

We are also looking at ways to expand our biologics business. And I've talked about that before that we think there are some other things we can do more on the synthetic side, I guess if you want to call it of the business.

Now that we've moved into stem cells and we're very excited about what that'll do for us. And then we're going to continue to evaluate opportunities with regard to strengthening our position in trauma as well as scoliosis.

We are developing a scoliosis system organically and we'll talk about that some more next year. But we're also looking at some other things that we might do that'll move us forward with regard to trauma scoliosis as well as the VCF space.

We're very interested in the VCF space and trying to figure out an innovative way to get into that. And so we continue to evaluate companies and technology that will bring us closer to that goal.

Bob Hopkins - Banc of America

Thanks for that. And then I'm sorry if you might've talked about this as well, but in the preliminary 2009 revenue thoughts that you've provided, what kind of contribution do you have from outside the United States?

Alex Lukianov

Well, we haven’t really talked about that, Bob, haven't really given guidance on that so I'm not really prepared to make the comment there. Right now we're really at 2 to 3% of revenue and I'll give guidance specifically with regard to OUS on the fourth quarter call.

Bob Hopkins - Banc of America

Okay, thank you.

Alex Lukianov

Alright, you're welcome.

Operator

Thank you. Our next question is from the line of David Roman with Morgan Stanley. Please go ahead.

David Roman - Morgan Stanley

Thank you. Good evening everyone. Just two quick questions, on the sales reps you hired this quarter, was there any particular reason in which they were concentrated? I think we've talked a lot in the past about the northeast being sort of an under penetrated region for you guys. Was there anything to note on the sales forefront?

Alex Lukianov

Yes. We have made some advances in those territories. Also some additional hires in the southeast and really a peppering across the nation. But I think if there's a concentration to talk about, it's kind of in the right upper quadrant of the United States, as well as the southeast.

David Roman - Morgan Stanley

And does that sort of square out your comment as well on addressing sort of large area accounts potentially academic centers which are also largely concentrated in the northeast?

Alex Lukianov

No, that actually is more of a national issue.

David Roman - Morgan Stanley

Okay.

Alex Lukianov

There are plenty of large accounts obviously around the country, so we're into quite a few different scenarios with regard to moving into a bidding process.

David Roman - Morgan Stanley

And then one thing I think that came up in NASS was the number of your competitors who are also introducing lateral systems. They obviously in the numbers that you're reporting.

We're not seeing any impact from that, but maybe if you can talk just a little bit about are you getting any feedback from your sales force on some of the other players out there and what your expectations are in 2009?

Alex Lukianov

Well, our expectations are to continue to grow our excellent business at a very robust pace. I can go through the reasons for why we feel that there's no competition relative to what we're doing, but I think clearly you have to look at NeuroVision, M5 in particular as another reason why we're going to advance beyond everybody else.

And I'm sure as you know from speaking with the surgeons, they'll tell you that it’s not just NeuroVision or just MaXcess or the implants, it's everything. It's the entire thoughtfulness behind the suite of products. It's the surgeon expertise. It's the support. It’s the technique. It's all of the things that really go into spending five years on developing this area and continuing to stay at the forefront of innovation.

So I don't really see anything out there that we feel is a direct threat to what we're doing. We by no means minimize the efforts of our competitors, but we really feel confident in our ability to drive XLIF and to drive XLIF up the spine in 2009 and beyond.

David Roman - Morgan Stanley

Okay. And then just one quick housekeeping question for Kevin. On the $0.05 to $0.07 guidance for the full year, that was your comparator to 1.6 million in that income in $0.04 per share for this quarter?

Kevin O’Boyle

Repeat that one more time, please.

David Roman - Morgan Stanley

The $0.05 to $0.07 for the full year, if you were to count that to what that equates to this quarter to 1.612 million earnings per share excluding IP, R&D and other adjustments to the $0.04?

Kevin O’Boyle

Yes.

David Roman - Morgan Stanley

Okay. Thank you.

Alex Lukianov

Okay, thanks.

Operator

Thank you. Our next question comes is from the line of Joanne Wuensch with BMO Capital Markets. Please go ahead.

Joanne Wuensch - BMO Capital Markets

Thank you very much for taking my question. I apologize if I missed this, I've been bobbing around on calls.

Alex Lukianov

Everybody's bobbing today, don’t worry about it.

Joanne Wuensch - BMO Capital Markets

It's a bobbing day.

Alex Lukianov

It is a bobbing day.

Joanne Wuensch - BMO Capital Markets

How many sales reps did you hire in the quarter?

Alex Lukianov

Well, we went from 269 to 331.

Joanne Wuensch - BMO Capital Markets

Okay. And my second question is you made a comment about aggressively ramping Osteocel throughout the year. If I had to think about spreading 28 million throughout next year, how do you define aggressive?

Alex Lukianov

I don't remember if I said aggressively ramping, but I think what we talked about is—I think we're talking about the second half of the year with regard to aggressive ramping. We said the first half would essentially be the seeding process which starts late in the fourth quarter and then it would be an aggressive ramp in the second half of the year.

Joanne Wuensch - BMO Capital Markets

Okay. Over time, do you target what level of SG&A as a percentage of revenue you're trying to get to and if so, can you share that with us?

Kevin O’Boyle

Over time, Joanne, what we're looking at and we've been consistent on this is on a non-GAAP basis at 500 million we're looking for 20% operating margins on a non-GAAP basis. So that's where we’re headed, we're laser focused on that.

We've done a strategic planning around that and given 2009 guidance puts us on the right path to get there.

Joanne Wuensch - BMO Capital Markets

Okay. And then final question, what did inventory days look like during the quarter?

Kevin O’Boyle

Well, what we do is we don't do inventory days. What we do is we give the percent of inventory to our third quarter annualized revenue number. And it was just over 21%.

And in my prepared comments I mentioned that we'll traditionally be between 20 and 25, depending on how many different products we may launch in a particular quarter. So we're right in that range and feel comfortable there given where we think the business is going and what we need to bring in to make sure we don't interrupt the ramp.

Joanne Wuensch - BMO Capital Markets

Terrific. Thank you very much.

Kevin O’Boyle

Welcome.

Operator

Thank you. Our next question is from the line of Vincent Ricci (ph 00:47:24) with Wachovia. Please go head.

Vincent Ricci - Wachovia

Hey guys. Just a piggy back up on that inventory question. You guys have been building inventory for a while, you launch a lot of products throughout the year and most of those end up as a mix benefit. But is there is a chance that you obsolete yourself and eventually have some inventory you have to write down?

Kevin O’Boyle

We take a look at that all the time as we come out with new products and line extensions and things like that. And we are good stewards of looking at that information and making sure the products that we're buying are for next generation products.

As well as feeding the if you will the popular sizes that get used more often than others. And we are comfortable with out inventory balance in that we're appropriately managing any obsolescence that may come about as part of building our inventory.

Vincent Ricci - Wachovia

Okay, great. And then on the gross margins particularly the core gross margins if you kind of back out Osteocel, they continue to go up which is great for us. But we also tend to think of international diluting your gross margins.

Is it possible you guys are actually getting good pricing power international or is it just that it's not that significant part of your revenues right now that we're not seeing them as a drag?

Alex Lukianov

It's just not significant at this point in time.

Vincent Ricci - Wachovia

Okay, great. And then last question would be, you guys described this at the analysts today, but could you talk a little bit about the sensory signal and how that benefits the surgeon.

Alex Lukianov

I'll actually get Keith to jump in here and answer that technical question.

Keith Valentine

There's two items to SSEP, obviously we have expanded XLIF into the thoracic spine. And so as you do that there's two modalities that are typically used in the thoracic spine, MEP and SSEP, with SSEP being largely the preferred for a deformity correction especially in the thoracic spine.

And so what we've introduced with M5 is the ability to have a unit that not only does EMG and MEP, but also SSEP. And as we move forward, there's going to be a proprietary way that the SSEP is automated. And it's that automization and the ability for a surgeon to direct it that gives them full flexibility in the OR to use any one of those modalities for their XLIF cases or the deformity cases.

Vincent Ricci - Wachovia

Okay, great. Thanks for taking my questions.

Operator

Thank you. Our next question is from the line of Vivian Cervantes with Rodman & Renshaw LLC. Please go ahead.

Vivian Cervantes - Rodman & Renshaw LLC

Great, thank you for taking the question. You've talked to some length about the macro (inaudible 00:50:07) environment and what you guys are finding out there. But if I may, are there any changes in sales cycle? Or are you seeing that it takes longer to sell and then maybe sort of contrast that between what you expect this will be if you enter big accounts versus some of the more current accounts that you're currently marketing to at this point?

Alex Lukianov

The selling cycle has not changed and I think what we've talked about before is it has everything to do with sales force tenure. So as we build our relationships, we see the most effective sales representatives being those that have been with us for 18 to 24 months.

It obviously takes longer to go through a bidding process and to secure the larger accounts. Those are ongoing efforts. And I think if you take a look at how they tend to stack up, it provides us with the constant flow of new business on a quarterly basis.

So if we were just starting that today, you could probably anticipate a lag time of three to six months. But because we're already midstream on it, I think it's going to be a pretty consistent flow.

Vivian Cervantes - Rodman & Renshaw LLC

Okay, that's helpful. So that said, when we look into '09, should we look at big ramps in sales rep hires similar to what we've seen this quarter or we stay consistent to what we've seen in the last couple of years?

Alex Lukianov

I think it's going to be pretty consistent. We just try to give a general idea as to how the sales force is going to grow, a lot of it has to do with just the overall momentum in various territories and our ability to add as a result of that.

So that's just a general guideline. But our goal is to get the sales force to the range of 450 representatives, even as much as 500 representatives over the next few years. And if we can do that faster, we will, but we are going to keep an eye on the profitability as we continue to ramp.

Vivian Cervantes - Rodman & Renshaw LLC

That's helpful. Thank you.

Alex Lukianov

Good.

Operator

Thank you. Our next question is from the line of Ed Shenkan with Needham & Company. Please go ahead.

Ed Shenkan - Needham & Company

Yes, a couple of questions on the international side of the business. Could you just recap for us what countries you're direct in, where you've got distributors and what future expansion plans are?

Alex Lukianov

We're direct in Germany and the UK. As far as distributors at the moment, in Europe we have Greece, we have Spain and we have Italy. Greece, we've been in now for over a year. The other two countries we're just really starting in.

We've established some distributor relationships in Latin and South America. And so the future really bodes for a greater focus on European opportunities as well as the Far East.

So next for us will be Japan over the next couple of years as well as Australia, New Zealand next year.

Ed Shenkan - Needham & Company

What kind of gross margins do you get in Germany and the UK? And what is it as distributor countries? And put that in perspective how that'll affect the overall gross margin going forward?

Alex Lukianov

Well, generally speaking those will range anywhere between 65 and 75% just depending upon the particular market and the product mix.

Ed Shenkan - Needham & Company

Okay. So when your direct in Germany and the UK, 65 to 75 also?

Alex Lukianov

That's correct.

Ed Shenkan - Needham & Company

And in the Greece, Spain and Italy, probably less than 65 I guess?

Alex Lukianov

That would be the typical model for a distributor, yes, that would be less.

Ed Shenkan - Needham & Company

And is it local currency or do you sell in U.S. dollars to those distributors.

Alex Lukianov

It's all in U.S. dollars at this point in time.

Ed Shenkan - Needham & Company

Except Germany, obviously and UK, correct?

Alex Lukianov

That's right, that's right.

Ed Shenkan - Needham & Company

Great. And that's all. Thank you.

Alex Lukianov

Okay.

Operator

Thank you. Our next question is from the line of John Putnam with Dawson James Securities. Please go ahead.

John Putnam - Dawson James Securities

Thanks, my question just got asked and answered.

Alex Lukianov

Alright then, next question. Go ahead, John. That is it then?

Operator

We have another question from the line of Bill Plevenic with Kenicourt (ph 00:54:07). Please go ahead.

Alex Lukianov

Alright. I was just kidding, John, you could have asked another question.

Bill Plevenic

Alright, thank you. Good evening.

Alex Lukianov

Hi.

Bill Plevenic - Kenicourt

Hi. Hopefully it's the last question here. So, Alex, it's very interesting you've been in this business a long time. We all just got back from NASS last week, we saw just a bunch of little companies kind of grow up over the last couple of years and now it seems like not a lot of the new players at this year's spine show.

Just give us your view on kind of what's going to happen to all these little guys especially with the funding that's dried up and how does NuVasive capitalize on that?

Alex Lukianov

Well, from my perspective there were a lot of companies at NASS this year and I think what I saw was that there were a lot of companies that did not have anything unique to talk about or anything unique to show. It was anther pedicle screw or a plate or some kind of a peak product.

So I really believe that there are going to be some issues for companies like that as they try to ramp because as you already pointed out, there is no well to turn to with regard to building these companies. And I don't think that there's much of an interest with regard to the larger players in acquiring them.

So I know that in actually even talking to surgeons, they expect to see a fair amount of carnage with regard to the smaller companies. I think we're going to continue to look at opportunities whether it is to buy some interesting IP, parts of a particular technology that are of interest to us. We'll certainly keep our eyes open for that.

But we don't see much in the way of many small companies that were of great interest to us. And I don't mean to dismiss anybody that has a great product idea and there were certainly some companies out there that did that. But there were more me too, copy type companies than any other sort.

Bill Plevenic - Kenicourt

Do you think we've started to see or have you seen or picked up customers that maybe been at some of those small me-too companies or is that a shift that is probably coming in the next call it six to 18 months?

Alex Lukianov

I don't think I fully understand your question about those that have invented the—say that again, I'm sorry.

Bill Plevenic - Kenicourt

No, no, the me-too companies. So as the surgeons that were dealing with the me-too companies kind of look at this and understand the liquidity is not there for them. That they don't have capital to fund it. That they can't grow.

How long do you think it takes for you to take those customers or those surgeons and bring them into NuVasive for the first time and make them a customer of yours because you have something differentiated and you know?

Alex Lukianov

Yes, sorry, yes, I understand your question. I think that happens right away for us and in fact I was just on a call today talking about this with regard to our cervical business. That it is very diversified now compared to where we were before. And how much easier it is for us to sell our full line of cervical products versus competing with a company that only has a cervical plate.

And so in talking to some of the folks on the sales force today, they've had very good success in doing just that and that's just on the cervical side of the front. So I think overall, NuVasive is in a very strong position right now.

We've got approximately 45 different product lines so we're in a terrific position to come in and diversify and show what we've got that's different in terms of our offering.

Bill Plevenic - Kenicourt

Alright, that's all I have. Thank you.

Alex Lukianov

You're welcome.

Operator

We have no further questions in the queue at this time.

Alex Lukianov

Alright then, well, thank you everybody for bobbing with us today and we will speak with you in another quarter. Thank you.

Operator

Thank you, ladies and gentlemen. This does conclude today's teleconference. (Operator Instructions)

Thank you for your participation.

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Source: NuVasive Q3 2008 Earnings Call Transcript
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