Tornier N.V. Management Discusses Q4 2013 Results - Earnings Call Transcript

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Tornier N.V. (NASDAQ:TRNX)

Q4 2013 Earnings Call

February 20, 2014 4:30 pm ET


Shawn T. McCormick - Chief Financial Officer and Principal Accounting Officer

David H. Mowry - Chief Executive Officer, President and Executive Director


Robert A. Hopkins - BofA Merrill Lynch, Research Division

Joanne K. Wuensch - BMO Capital Markets U.S.

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

Matthew S. Miksic - Piper Jaffray Companies, Research Division

Matthew O'Brien - William Blair & Company L.L.C., Research Division

Lawrence Biegelsen - Wells Fargo Securities, LLC, Research Division

Daniel Sollof - Barclays Capital, Research Division


Good day, ladies and gentlemen, and welcome to the Tornier Inc. Fourth Quarter 2013 Earnings Conference Call. [Operator Instructions] As a reminder, this call may be recorded. I'll now introduce your host for today's conference, Shawn McCormick, Tornier's CFO. You may begin.

Shawn T. McCormick

Good afternoon, and thank you for joining us today for Tornier's fourth quarter and fiscal year 2013 investor conference call. I am Shawn McCormick, Tornier's Chief Financial Officer, and with me today is Dave Mowry, our President and CEO.

Before we begin our detailed discussion of results for the fourth quarter and full year 2013, I'd like to remind you that during the course of this call, we will make forward-looking statements regarding our future financial and operating results, and our business plans, objectives and expectations. These forward-looking statements are covered under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995, and Tornier desires to avail itself of the protections of the Safe Harbor for these statements.

Please be advised that actual results could differ materially from those stated or implied by our forward-looking statements due to certain risks and uncertainties, including those described in our most recent annual report on Form 10-K and subsequent quarterly reports on Form 10-Q. We suggest that you read these risk factors and our SEC periodic reports and other future filings that we may make with the SEC. You should also know that Tornier disclaims any duties to update or revise our forward-looking statements.

On this call today, we will disclose certain non-GAAP financial measures. We use non-GAAP financial measures as supplemental measures of performance, and believe these measures provide useful information to investors in evaluating our operations period-over-period. For each non-GAAP financial measure that we use in this call, we have included, in our press release or on our website, a reconciliation of the non-GAAP financial measure to the most directly comparable GAAP financial measure. Please note that non-GAAP financial measures have limitations as analytical tools and should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP.

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

David H. Mowry

Thanks, Shawn. On today's call, I will briefly cover accomplishments associated with Phase I of our U.S. force -- U.S. sales force transition before providing an overview of our execution plans for Phase II.

Additionally, I will provide you with an update on key product introductions and developments within our product pipeline. After which, I will turn the call back over to Shawn, who will provide a financial review, an outline of key performance metrics that we will track through 2014, and our 2014 guidance. Following Shawn's update, I will return to provide closing comments before we open the lines for your questions.

I'd like to begin the fourth quarter earnings call by outlining our U.S. sales channel transition accomplishments. We made significant progress towards our goal of dedicated upper-extremities and dedicated lower-extremities sales representation. During the fourth quarter, we execute -- executed new agency agreements and further expansion of our direct sales team, which collectively increased our total of territories addressed to greater than 85% of total U.S. revenues.

Also, as a direct result, our direct sales reps now cover approximately 55% of our U.S. revenue. These achievements exceeded our original goals and create a stable sales platform upon which we will be building.

The successful completion of Phase I positions Tornier to focus our efforts on the work required to optimize our U.S. territories. Phase II of our U.S. sales channel transition will be a deliberate process over the course of 2014 and into 2015, which will move us closer to our goal of fielding competitively superior, dedicated upper and lower sales teams. I will outline the steps associated with Phase II in greater detail in a moment.

But first, let me provide you with additional background regarding the 2 distributor separations that occurred in late December 2013. One of the separations was a legacy Tornier distributor who carried both the upper-extremity line and the combined Tornier OrthoHelix lower-extremity lines. The second distributor separation involved a legacy OrthoHelix distributor who was focused on lower-extremities and carried the combined lower-extremity portfolio.

Given that these separations happened very late in the fourth quarter, we experienced less disruption during the quarter than was contemplated in our fourth quarter and full year guidance. However, we anticipate that the associated negative impact on revenue from these separations will shift into the first half of 2014.

Territories impacted by these 2 distributor separations, along with the previous distributor separation from the third quarter, represent approximately 10% of Tornier's total U.S. revenue. We expect that the impact from these 3 separations, in addition to the disruption experienced at the rep level in the third and fourth quarters, will begin to subside in the second half of 2014 as new territory coverage is established and new sales rep performance ramps.

Looking back, Phase I of our U.S. sales channel transition was a difficult challenge for the business. I am pleased with the way our sales management, field sales reps and agency partners came together to deliver results that exceeded our initial transition goals. The resulting groundwork from this process becomes the foundation from which we will intend to build a stronger, higher-potential U.S. sales organization. We are committed to elevating their capabilities to deliver strong return on the company's future investments in both sales channel and new product development. None of these results could have been achieved without great teamwork and engagement from our internal support team, as well as our agency partners.

Turning to Phase II. This will represent the U.S. sales transition addressing our individual sales rep alignment and territory optimization work necessary to deliver against our goal. Accordingly, we anticipate the pace of our U.S. investments into specific territory and sales rep development will increase during this time. We expect our Phase II efforts will extend over 2014 and into 2015, during which time, we intend to execute against a disciplined alignment and optimization process on a territory-by-territory basis.

The U.S. sales management team is focused on separating the channels, improving our coverage and arming our sales reps with the training, tools and support necessary to become highly effective and capable of delivering sustained, above-market growth. Our goal remains unchanged in our U.S. sales force transition, fielding competitively superior, dedicated upper- and dedicated lower-extremities sales teams.

We have already begun making progress against our Phase II plans. In the 3 territories disrupted by distributor separations mentioned earlier, efforts to rebuild our sales representation is already underway. Specifically, we have finalized a revised coverage plan for each of these impacted territories, initiated sales management and sales rep recruitment. We have hired our sales leadership teams, as well as many of the new sales reps required to staff these areas. We have also conducted some of the initial sales training for the reps already in place.

Across other U.S. territories, we still have sales reps selling both upper- and lower-extremity product lines. Our Phase II plan outlines the work necessary to reallocate our sales reps, methodically separating the business into 2 dedicated channels.

The U.S. sales management team will focus first on the newly established direct territories, splitting the channels where we have exclusive representation. This process is expected to take some time to fully execute, as many areas will require the addition of new reps to cover cases and support the channel alignment.

As we enter Phase II, it is important to understand the current composition of our U.S. sales force. Tornier currently fields approximately 400 U.S. sales reps, of which approximately 145 are direct.

Throughout 2014, we expect to add between 15 to 20 new direct sales reps in support of splitting the upper- and lower-extremity channels. Our 145 direct reps, approximately -- of the 145 direct reps, approximately 60% have been identified and transitioned or are in the process of transitioning to either the dedicated upper- or lower-extremity sales teams. For our distributor reps, nearly 80% represent only our upper or lower product lines as a result of our Phase I negotiations.

Our goal is to complete rep transitions and increase the percentage of reps dedicated to either upper- or lower-extremities to 85% of our total rep count by year end, keeping in mind that not all territories warrant or can support 2 separate sales reps.

With regard to sales training, our process includes progressive levels of rep training for either upper- or lower-extremity specialties. Each channel will begin with a Level 1 training session on either upper- or lower-extremities, giving newly dedicated reps a platform proficiency in their respective lines.

Deeper specialist training will expand upon the initial training to increase proficiency and further rep sophistication in each channel, including in-depth cadaveric lab training and live case proctoring by our KOLs and in-house training team.

This comprehensive process will be critical to our long-term success, providing our sales force with the proper tools to become true export -- experts across their respective upper-extremity and lower-extremity product suites. We are excited about moving through this process of honing their knowledge and field skills, and we'll closely monitor our training progress throughout the year.

Moving through Phase II, we will also put significant effort into building and developing our coverage plans, identifying the appropriate rep mix within geographies, prioritizing and filling open territories and managing sales reps where performance improvement is needed. I am pleased with the progress we have made on the critical tasks and program development activities associated with Phase II, thus far. Nevertheless, our team realizes that there's still a great deal of work necessary to reach our goal.

Now let me shift your attention to our product portfolio. As I have mentioned in previous earning calls, we are pleased with our product portfolio and believe our recently launched and pipeline of products will play an important role in our long-term growth objectives. We have designed this product suite to increase our penetration with best-in-class products, expand our customer base through increased ease-of-use and expect to drive additional extremities market expansion through the introduction of early intervention and late-stage revision innovation.

Let me outline the products we believe will make significant contributions to this portfolio strategy. In upper-extremities, we believe the Aequalis Ascend Flex convertible shoulder system will allow us to grow market share, driving increased penetration into competitive accounts. Just 2 quarters into the full commercial launch, Ascend Flex continues to perform exceptionally well as surgeon -- several surgeon customers continue to migrate to the Flex product as a best-in-class shoulder solution.

Ascend Flex ease-of-use and simplicity over competing systems resonate well with the surgeon community. The Ascend Flex has also allowed us to regain some lost customers who had converted to competitive reversed shoulder products to access press-fit or convertible solutions.

With press-fit and cemented options, short and standard lengths, and anatomic to reverse convertibility with our proprietary eccentric trays, the Flex product not only fills the competitive gaps, but provides solutions to real clinical problems not previously addressed by existing prostheses.

We have seen great success in our targeted competitive conversions. And as of the end of the fourth quarter, we have trained more than 150 surgeons now using the Flex product. And we'll be providing broader access to the product with further deployment of additional instrument and implant sets through the first half of 2014.

The addition of a new threaded base plate to be used in conjunction with the Ascend Flex humeral stem is now in limited user release and serves to fortify our expanded shoulder offering. Our new base plate features a threaded center post to provide increased acute fixation, giving surgeons greater confidence in placement. Thus far, we are very pleased with the early clinical data and plan to introduce this product at this year's AAOS meeting.

Another important shoulder product in the Tornier portfolio is our PerFORM glenoid system. More than 90% of patients in need of total shoulder replacement require surgical intervention on their glenoid, in addition to the implantation of a humeral component. Although a great deal of work has been done to date to improve the humeral prosthesis, much less development has been done to improve glenoid implants and the resultant clinical outcomes.

Tornier's PerFORM glenoid offers the surgeon an improved ability to fit the glenoid implant to the patient. The PerFORM system was specifically designed to have multiple backside curvatures to match a variable patient anatomy and preserve subchondral bone, a critical factor in preventing the greatest complication in shoulder surgery: glenoid migration and loosening.

Additionally, our pyrolytic carbon humeral head is another innovative solution for shoulder replacement surgery. Leveraging the properties of pyrolytic carbon, we believe this novel humeral head, designed for both the Ascend Flex system and our soon-to-be introduced next-generation reversed fracture system, enables the surgeon to complete a shoulder replacement procedure without the need for glenoid replacement.

Beyond avoiding the largest cause of complication in shoulder replacement surgery, glenoid replacement, the pyrolytic carbon product has the promise to provide other significant advantages, including both the reduction of OR time and a shortened patient recovery cycle.

Initial clinical feedback outside of the U.S. also suggests that the inherent surface properties of pyrolytic carbon may reduce procedurally-related pain caused by cartilage and bone erosion.

The pyrolytic carbon humeral head is intended as a market expansion product, addressing the needs of younger patients where surgeons are looking to preserve future intervention options. We also believe that this product will draw attention from the generalist orthopedic surgeon that may wish to avoid the more difficult glenoid replacement procedure associated with total shoulder arthroplasty.

We will continue to support a limited user release in Europe with thought-leading positions building our clinical experience, while we work with the FDA toward defining a regulatory pathway to U.S. commercialization.

As we've mentioned in previous calls, we are well along the clinical study pathway needed to secure a U.S. FDA 510(k) approval for the Simpliciti Stemless Shoulder. The Simpliciti is an innovative surgical option that allows a shoulder replacement procedure without significant bone removal from the humerus. We believe that the bone-preserving or conserving and less-invasive characteristics of this product may lead to market expansion with younger patients opting for surgery, given the nature of a stemless approach.

Based upon our clinical study timing, we anticipate filing for U.S. approval early in 2015, with a 510(k) approval late in the first half of 2015. Our early clinical study work, preceding the competitors by 18 months, will provide Tornier with first-mover access to the U.S. market.

Now moving to lower-extremities. The CannuLink and angled CannuLink Plus continue to grow rapidly, showing significant quarter-over-quarter sequential growth. We believe that this novel family of products will allow the Tornier to increase our market share in the greater-than-$200 million hammertoe correction market.

The primary benefits of this product family include reduced patient rehab and the elimination of uncomfortable patient recovery using K-wires long-term, while retaining the option to stabilize the adjacent joints through the implant. The newly introduced angle line provides support for surgeons looking to eliminate adverse outcomes that can accompany overuse of K-wires.

While the Salto-Talaris is an ankle revision system, we view it as a market expansion product as well, and as a catalyst to increased penetration on primary ankle replacement. We believe a reliable revision system will give physicians greater confidence in performing total ankle replacement. This surgeon confidence will be critical to driving increased conversion rates from ankle fusion to total ankle replacement.

The current limited user release of the Salto Talaris XT continues to go exceptionally well, and we have already begun to witness the desired effect gaining access to competitive accounts.

Coupled with our sales training initiatives, we believe the introduction of the Salto Talaris XT will further improve our lower-extremities sales reps ability to convert a competitive ankle business to the Salto-Talaris family of products.

Similar to upper extremities, we are also applying our proprietary pyrocarbon technology to lower-extremity innovation, with the development of the pyrolytic carbon metatarsal arthroplasty device.

This product is designed to leverage the unique surface and wear resistance properties of pyrolytic carbon to provide a joint replacement option for the big toe, as opposed to the current option of fusion. We are currently in a very limited market introduction in select European centers, which will provide us with a baseline of data and experience to potentially move forward with a broader European regulatory approval and launch the necessary steps to design and develop a U.S. clinical study plan that brings this novel technology to the U.S. market.

With that, I would like to turn the call over to Shawn for his comments.

Shawn T. McCormick

Thank you, Dave. I will begin with a review of our top line performance by product line. Total revenue for the fourth quarter of 2013 reached $83.4 million compared to the fourth quarter of 2012 revenue of $79 million, an increase of 5.5% as reported.

On a constant currency basis, our fourth quarter revenue grew 4.4% over the prior year quarter. Fourth quarter revenue generated by extremity products totaled $68.1 million compared to $64.7 million for the same quarter last year, an increase of 5.2% as reported, and 4.8% on a constant currency basis.

Giving pro forma effect for the OrthoHelix acquisition to include OrthoHelix revenue in the full prior year quarter, our fourth quarter 2013 constant currency revenue growth was 4% over the same quarter last year, and extremities constant currency revenue increased 4.3%.

For the fourth quarter of 2013, extremities revenue represented 82% of reported global revenue. Revenue from our upper-extremities, joints and trauma category was $48.2 million, an increase of 4.7% in constant currency over the same quarter 1 year ago.

This growth was primarily led by the Aequalis Ascend family of products, which continue to gain worldwide recognition among upper-extremity specialists. This includes the second full quarter of commercial launch for the Ascend Flex, which was initially launched in the third quarter of 2013.

Growth was also driven by continued success of the Latitude EV elbow prosthesis, which drove growth in elbows in excess of 30% constant currency over the prior year quarter.

Fourth quarter revenues of our lower-extremity joints and trauma category increased 9.9% in constant currency to $16.2 million, driven by strong contributions from our broad platform of fixation products, along with the initial international expansion of our lower-extremities product offering.

Fourth quarter revenue from sports medicine and biologics were $3.7 million, a decrease of 11.9% in constant currency compared to the fourth quarter of 2012. This was due primarily to a decline in the company's anchor products.

This decline in anchor products was partially offset by growth in the company's suture and BioFiber products, including the Insite bio anchor and early launch of our unique Phantom Fiber high-strength resorbable suture, which provides surgeons with a completely resorbable construct to treat rotator cuff or Achilles tendon repair.

Revenues from our large joints and other product category totaled $15.3 million, an increase of 2.5% on a constant currency basis, reflecting strong growth in hip products in Europe, and particularly in France. New product introductions in both knees and hips have enabled some recovery from the negative growth experienced earlier in 2013.

Our international business continued to perform well overall, led by continued success of our broad shoulder offering, including the Aequalis Reversed and Ascend family of products. Lower-extremities also showed solid growth, led by foot arthrodesis products.

Several of our geographies made solid contributions in the fourth quarter, most notably the Netherlands, France and Scandinavia, in addition to our newest direct markets, the United Kingdom, Canada and lower-extremities in Australia.

Our adjusted EBITDA for the fourth quarter of 2013 was $9.2 million compared to $11 million in the fourth quarter of last year. As a percent of revenue, our adjusted EBITDA was 11% compared to 13.9% for the fourth quarter of 2012. The decrease in our adjusted EBITDA margin was primarily attributable to investments in our U.S. sales organization and the U.S. medical device tax.

During the fourth quarter of 2013, we saw increased costs associated with the buyout [ph] of our distributors and conversion of reps to direct employees. In addition, our investments in our sales and training organization, IT infrastructure and our international distribution channels increased over the prior year period.

We began to make these investments in late 2012, and they continued throughout 2013. We also expect SG&A as a percent of revenue to increase in 2014 over 2013, primarily as a result of our expanded direct U.S. sales representation and transition Phase II training and education.

Gross margin in the fourth quarter of 2013 was 74.5%, as reported, compared to 65.9% in the fourth quarter of 2012. Excluding approximately $0.5 million of inventory step-up charges relating to acquisitions, our non-GAAP adjusted gross margin expanded to 75.1%, an increase of 350 basis points over non-GAAP gross margin in the fourth quarter of 2012. This improvement in non-GAAP adjusted gross margin was driven by continued improvements in production costs and efficiencies. We expect to continue to achieve improvements in gross margin through a combination of manufacturing efficiencies, additional in-sourcing activities and our product mix.

Non-GAAP operating expenses in the fourth quarter of 2013, which excludes special charges and intangible amortization, increased 19% to $62.4 million or 74.9% of reported revenue. This compares to non-GAAP operating expenses of $52.5 million or 66.4% of reported revenue in the fourth quarter of 2012.

As I mentioned, and as discussed during previous calls, this increase in operating expenses as a percent of revenue was driven by strategic investments in our U.S. sales organization, including sales leadership and training personnel; going direct in certain U.S. territories; product training and education programs; expansion in Japan; conversion to a direct distribution channel in Canada, the U.K. and Australia for lower extremities; investments in a new IT ERP system; and the medical device tax.

These investments in SG&A were partially offset by a decline in R&D as a percent of revenue. We do continue to expect R&D spending to remain in the range of 7% of revenue over time.

Fourth quarter 2013 operating expenses as reported on a GAAP basis were impacted by $2.7 million of special charges related to acquisition, integration and U.S. distribution channel transition costs.

In the fourth quarter of 2013, our interest expense totaled $1.5 million compared to $2.3 million during the prior year quarter. This decrease was attributable to the repayment of our long-term debt -- of a portion of our long-term debt following our equity offering in the second quarter of 2013.

We ended the fourth quarter of 2013 with cash and available credit of $86.8 million, consisting of $56.8 million of cash and cash equivalents and $30 million available under our revolving line of credit. Our outstanding long-term debt totaled $67.6 million at the end of the fourth quarter.

During the fourth quarter of 2013, our non-GAAP adjusted free cash flow was negative $3.9 million, driven by $7.2 million of investments in implant instruments and $3.3 million of additional property, plant and equipment.

Looking ahead, as we move through Phase II of the transition process of our U.S. extremities sales force, we are using the following metrics to track our progress. As Dave said, we currently have approximately 400 reps carrying Tornier products, 145 of which are direct. Many of these reps currently carry both upper-extremity and lower-extremity products or carry non-Tornier products.

As of today, approximately 60% of our direct reps and 80% of our distributors are identified and are transitioned or in the process of transitioning to either dedicated upper- or lower-extremities. Our goal is to complete the transition of sales reps to either dedicated upper- or lower-extremities by year end. As we have previously discussed, we expect to become 85% dedicated upper or lower, as not all territories warrant 2 separate sales reps.

In terms of training, we expect to train an average of 50 reps per quarter for a total of 200 reps by the end of 2014. We expect this will complete the necessary Level 1 training for the reps newly dedicated to upper- and lower-extremities. We believe this will be an important milestone because it is an indication all our reps have the requisite pathology, procedural and product knowledge and skills to communicate the key aspects of their product lines and to support and guide surgeons during cases.

Looking ahead, as reps complete Level 1 training, we will continue their training through more advanced programs, ultimately resulting in advanced training certification. As we get further into 2014 and our transition Phase II, we will begin to report on the percentage of our sales force that has received training certification.

In addition to sales rep training, we are also focused on continuing comprehensive physician training through regional training, as well as leveraging our in-house cadaveric lab. In 2014, we plan to complete training of over 200 physicians, including continued training on the Ascend Flex and Salto products. Our training programs are developed as in-depth, hands-on programs with a focus on creating high conversion to and utilization of Tornier products.

These metrics are closely aligned with our goals to optimize sales rep alignment and proficiency in all of our territories, and to continue to invest in medical education. We believe that as we move through Phase II, our reps will be in a stronger position to represent Tornier and increase their productivity. This, combined with our medical education, is expected to move us toward our goal of delivering above-market revenue growth.

Now let me provide our financial outlook for fiscal 2014. In addition to our operating plans and expectations, our guidance also accounts for anticipated U.S. and international market dynamics, seasonality, the timing of holidays and the number of selling days, and recent currency exchange rates.

As seen from our past results, with a meaningful percentage of our business based in international markets, currency exchange rate fluctuations can create significant differences between our reported and constant currency growth rates. For this reason, we continue to focus on communicating the revenue of our business on a constant currency basis.

In calculating our reported estimates, when it comes to predicting the value of the dollar versus foreign currencies, we assume exchange rates similar to the current levels. We do, however, expect to see continued fluctuations in currencies during the remainder of 2014.

In the first quarter, we expect revenue -- first quarter of 2014, we expect revenue to be in the range of $78 million to $82 million, representing negative constant currency growth of 5.7% to 0.8%.

Based on recent currency exchange rates, first quarter 2014 reported revenue is projected to be in the range of $78.5 million to $82.5 million, representing negative growth of 5.1% to 0.3% over the first quarter of 2013 revenue.

Revenue from the Tornier extremities product categories in the first quarter 2014 is expected to be in the range of $63.4 million to $66.7 million, representing negative growth of 5.9% to 1.0% in constant currency over the same period last year.

We expect first quarter 2014 adjusted EBITDA to be in the range of $4 million to $6 million or 5.1% to 7.3% of reported revenue.

Turning to the full year 2014. We expect full year 2014 revenue to be in the range of $302 million to $317 million, representing constant currency growth between negative 2.9% to positive 1.9% compared to 2013 revenue.

Based on recent currency exchange rates, full year 2014 reported revenue is projected to be in the range of $304.2 million to $319.1 million, representing reported growth of negative 2.2% to positive 2.6% over 2013 revenue.

Revenue from our extremities product categories in 2014 is expected to be between $252.6 million and $265.5 million, representing constant currency growth of negative 2.1% to positive 2.9%. We expect full year 2014 adjusted EBITDA to be in the range of $22.5 million to $27.5 million or 7.4% to 8.6% of reported revenue.

This guidance takes into account the expected ongoing impact of our U.S. sales transition efforts, including the impact of distributor separations in the third and fourth quarters of 2013, and ongoing Phase II efforts in territory optimization and rep training. We expect to see gradual improvement to revenues in the second half of the year as we move further along in the U.S. sales force transition.

As we have discussed, adjusted EBITDA guidance reflects the increase in SG&A, relating primarily to our U.S. sales transitions, including conversion to a higher percentage of direct reps, and increased training and education, as well as IT investments.

Getting into a little bit more detail. Amortization expenses are estimated to be approximately $17.3 million to $18 million in 2014 compared to $15.9 million in 2013.

We anticipate interest expense for fiscal 2014 to be in the range of $6.4 million to $7.4 million, including anticipated interest accretion charges of $2.1 million to $2.6 million, relating to contingent consideration payments for the OrthoHelix and certain distributor acquisitions.

In 2014, we expect to continue to record special charges relating to sales transition activities and distributor acquisitions, which occurred in 2013. In addition, we have initiated the process of integrating OrthoHelix customer service, warehouse and certain G&A activities into our Bloomington operations. Special charges are expected to total $3.9 million to $5.6 million in 2014, of which $1.9 million to $2.8 million are anticipated in the first quarter.

We also expect to record approximately $500,000 to $700,000 of inventory step-up charges in cost of goods sold during 2014, of which approximately $200,000 to $300,000 is expected to occur in the first quarter.

I will now turn the call back to Dave for closing remarks before opening the call for questions.

David H. Mowry

Thanks, Shawn. In closing, we are excited about the outlook for the company. We operate in attractive, high-growth markets. We have a comprehensive product portfolio with a deep pipeline, and we are building a dedicated, competitive U.S. sales force to match our existing channel-focused and highly successful international sales organization.

We are pleased with the completion of Phase I of our U.S. sales force transition, and are confident we have a robust, structured plan to execute Phase II.

The entire organization is focused on moving Tornier toward expanded market share, deeper surgeon relationships and a broader customer base, with an ultimate goal of reaching and sustaining above-market extremities revenue growth.

With that, I'd like to open the call to your questions. Operator?

Question-and-Answer Session


[Operator Instructions] Our first question comes from Bob Hopkins of Bank of America.

Robert A. Hopkins - BofA Merrill Lynch, Research Division

So just -- I want to start out with a question on kind of the near-term guidance for Q1 revenues. Because frankly, we expected you guys to be just a little bit more conservative. So first of all, do you have extra selling days in Q1?

Shawn T. McCormick

No, we do not.

Robert A. Hopkins - BofA Merrill Lynch, Research Division

Okay. So the reason I phrased the question that way is, again, I thought the guidance was going to be a little bit lower for Q1. Was that -- a lot of the orthopedic companies have seen greater-than-normal seasonality in Q4. You had those distributor issues, separations happened at the end of the quarter. And also, I assume, weather had to be at least a little bit disruptive, thus far, into Q1. So could you just comment on those -- couple of those issues and your confidence in that Q1 number and how you came up with it?

David H. Mowry

Yes. So Bob, I think, the first point, I guess, I would want to make is in talking about the separations with the distributors. And I think it's important to understand the separation process and the timing in particular. Both of those separations, I think, although not desirable, were somewhat amicable. And when you have a separation agreement with amicable coverage and plans, you're able to establish a 30- to 45-day case coverage plan, which both the distributor and the company agreed to. So in many ways, that delayed the initial step-down of some of the loss, if you will. But likely, most of the cases will run as planned under that coverage. However, after that separation occurs, both sides start ramping and competing, and I think what really had taken place in the first quarter is somewhat of a delayed effect of that distributor disruption. And I think some of that is probably reflected in our guidance.

Robert A. Hopkins - BofA Merrill Lynch, Research Division

And then what are you seeing on weather?

David H. Mowry

Well, it's snowing outside here right now. All kidding aside, what we see is we've seen it to be very spotty. I think that there is some, obviously, impact on utilization. But as we've seen in most of our cases, we've got patients -- we don't deal with a great deal of trauma. We're dealing more specifically with arthroplasty. And as a result, those patients queue up and surgeries get rescheduled versus being pushed out and delayed. People are actually having to deal with this chronic pain. So we anticipate it to be a little bit more lumpy, perhaps, but we don't necessarily anticipate it to be significantly off it's utilization rate.

Robert A. Hopkins - BofA Merrill Lynch, Research Division

Okay. And then, I guess, the other thing I wanted to ask about is, where are you on the transition to upper versus lower, in terms of dedicated reps, relative to the guidance that you gave on the Q3 call? Are you kind of in line with where you thought you'd be or a little bit behind? And does your 2014 revenue guidance anticipate any further distributor separations?

David H. Mowry

Bob, thank you very much for that question. I think it's an important one. I think we're actually further ahead than we anticipated in terms of establishing the agreements and creating a game plan to move us to those dedicated channels. As Shawn, I think, indicated in some of his dialogue, we've actually gotten to a position where now we have 60% of our dedicated or direct sales reps that are now aligned. And we have a much higher percentage in our agencies that are aligned to those dedicated channels. We think there's still quite a bit of work to do to split the dedicated channels up, or the direct channels up, and fill the open and vacant positions that are created through that process. But frankly, it's not about disruption anymore. It's really about building the potential to grow revenue back.

Robert A. Hopkins - BofA Merrill Lynch, Research Division

So do you -- does your guidance contemplate further separate -- distributor separations or stability?

David H. Mowry

No. So just to be direct to that question, there's no additional disruption that we anticipate. We've established agreements with all of the agencies that are still in play, that have very clear delineation of non-competes and expectations both for the distributor to the company and the company on the distributor if we're to go through those transitions. So I think we have effectively mitigated that long-term risk issue that we had throughout 2013.

Robert A. Hopkins - BofA Merrill Lynch, Research Division

And then just last really quickly. What percentage of direct did you end up at '13? And where do you expect your percentage of direct to be at the end of '14?

David H. Mowry

Yes. We ended at 55%, and I think there's 2 different numbers that people can get confused with. We say 55% of U.S. revenues are covered by direct. We also talked about 145 reps of 400, or approximately 400. So there's a very different component, as you would imagine, in the productivity of a direct rep versus the agency reps. We have plans to add 15 to 20 reps over the course of this year that would be direct, that would enable us to continue to split out territories and get further dedication of upper and lower. But frankly, over the course of the year, we'd expect our total number of sales reps to probably decline a little bit as we become more optimized and more productive in many of those territories.


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

Joanne K. Wuensch - BMO Capital Markets U.S.

One of the things which came up in the last call and that we've talked about is that it looked like you were losing some market share during the sales rep reorganization. What are your thoughts in terms of trying to get that share back? And over what period of time do think it may take?

David H. Mowry

Yes, Joanne, that's another great question, and thank you. I think we are putting the company in a position to be competitive against regaining a significant portion of any share lost. Not only with the sales rep training, but the products that we're putting into the portfolio, specifically in the upper-extremity side, where we're probably most impacted. And I think we can be competitive in all geographies. As you lose sales reps or become competitive with your old sales reps, physicians or customers have the choice to stay with the rep who gives them the service that they've become accustomed to or to stay aligned with the company, with the product that they are used to and have knowledge of. Our goal, ultimately, is to provide a sales rep that is more adequately capable of being trained and providing better service while we continue to build out this portfolio. So I think purely and very clearly, we're building both the best product line and the best sales team, and that's our goal. I think -- what kind of timeline? We've said that we will complete Level 1 training of all our sales -- all our Level 1 training efforts will be complete by the end of this year. And with the Ascend Flex additional rollout and then the addition of not only the threaded base plate but some of the other competitive products that we're pushing through our pipeline, I think, frankly, we're in a very, very strong position to go after that business aggressively in the latter half of 2014.

Joanne K. Wuensch - BMO Capital Markets U.S.

Okay. One of the things which, versus our model, at least, there's a difference is the adjusted EBITDA guidance for 2014. And even in the first quarter, it stepped down a little bit. Can you talk about how that progresses throughout the year? And how do you think about moving this company towards profitability?

David H. Mowry

Yes, Joanne. I'd say, I mean, if you look at the annual guidance versus the Q1 guidance, you can see that the adjusted EBITDA as a percent of revenue moves up for the full year. So we are going to -- we will have an increase in the investments related to the sales transition, training and education throughout the year. And then as -- we expect to make progress in the second half on building towards that above-market revenue ramp. And with revenue growth, that's when we'll begin to see the leverage in the SG&A line start to come through.


Our next question comes from Mike Weinstein of JPMorgan.

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

I want to start by diving into the rep productivity discussion. And maybe, Dave, you want to spend a minute on the 36% of your reps that are generating 55% of your revenues, I think those were the numbers you gave, that are direct. Maybe just comment on the direct rep productivity versus indirect rep. And I seem to recall, if my recollection is correct, that, that total number of reps has gone up over the last couple of years. And so maybe you can just talk to where they came from and the thought process there.

David H. Mowry

Yes. So 2 great questions. And I'd start by saying, Mike, our goal over the course of this year is to continue to build that kind of processes that are necessary to drive rep productivity. And that comes from not only having the right coverage and the right management team in place, but also having the training and the capability of supporting those reps in the field. And that's really where our focus will continue to be throughout 2014. The process, from my perspective, will continue to be kind of a twofold process. One is in reviewing the coverage plans and building a prioritization of backfilling -- splitting the channel and backfilling open territories with qualified candidates. And then almost independently, working through the entire sales organization through a standardization of training levels and proficiencies that allow them to not only carry the full bag that they carry, but to provide what we consider to be competitively superior support to their customers. So those are the kind of the 2 processes. I think the thing you've highlighted in terms of the productivity of a direct model versus the agency model is, I think it's a little -- can be a little misleading on twofold. I think we certainly believe that a dedicated sales channel who is either upper-focused and exclusively carrying and covering those cases can be -- much more productive for the company just because they're covering those cases and have full-bag coverage. In many cases, the number of reps has increased for us through not only the acquisition of the OrthoHelix distribution channel, but the fact that there are some people, as you would imagine, in a continuum that are providing some revenue because they're carrying a small percentage of their total bag is the Tornier product. Our efforts over the course of this year will be in driving that productivity by consolidating territories and working with our agents, as well as with our direct management -- direct sales management to drive productivity in both of those models.

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

I want to make sure -- I want to focus on the independent reps. So it feels to me like the independent distributors that are still there are carrying more products outside of Tornier than the independent reps were 1 year or 2 ago. Is that fair? Or is that -- am I getting a wrong sense from that?

Shawn T. McCormick

Yes, Mike, honestly, you are correct. We have -- within -- I mean, if you look at the numbers we gave, and you identified the number, 145 out of 200 (sic) [ 400 ] total reps carrying our product, that yield 55% of the U.S. revenue. We do have -- through our distributors, we still believe we have agents that are either not yet focused as much as they should be, upper or lower. And we believe they're carrying additional products, especially on the OrthoHelix side. If you think about the OrthoHelix model, that was -- they had over 50 distributors or distributor agents within OrthoHelix, a much smaller revenue base. And so that sales channel absolutely was carrying more than just the OrthoHelix product line.

David H. Mowry

I think the other point, if I could just pile on for a second, Mike, is as you think about what we went through in 2013, it was about establishing a pathway to get to dedicated upper and lower. But inclusive in that was establishing agreements with all of the agencies that give us the ability to work collaboratively with them to get the right alignment and the product mix in their bags. That's going to take some time as we work through a lot of these agencies, especially the ones that are -- came over from OrthoHelix because they were supporting a broader array of products. Our goal is to continue to expand our product offering and gain more and more wallet share of the procedures by putting more products into the hands of those reps through our own product development cycles.

Michael N. Weinstein - JP Morgan Chase & Co, Research Division

So let me ask you one more question, just thinking about 2014. So you've got to go through this Phase II, where you've got to basically draw the line and say, "Okay, you're going to be a lower-extremity rep. You're going to be an upper-extremity rep." And you're part of the way through that process, although you actually haven't separated out the business. How do you -- as you gave the guidance -- you came up with your guidance for this year, how did you think about that disruption as a rep is currently covering both sides of the bag, switches as over and carries just one side, while someone else picks up that slack?

David H. Mowry

Yes, I think the point I would make you is, first of all, in the distributor side, we're at a much high percentage. So it's a lot less disruptive, if you will, with our agents. On the direct side, where we have a smaller number and we're going to have to do some work to split the channel, we already have installed sales management and a greater kind of, if you will, support system through the company. So we've gone through a very granular approach to establishing our guidance for the year. However, we don't believe that it is significant disruption as we move through this process. It's really about adding people, and then as we add people into those territories, helping convert and move the business over to the new rep, while we have a -- the old rep is still in place and on our team, and the new sales management is there, as well as the internal support structure. So it's going to be a very, I guess, a thoughtful process. I told you during my comments that it was going to take some time, and the intent of that time is that we can be very thoughtful and not hasty in those processes.

Shawn T. McCormick

Yes, I think, just to summarize -- I'd just add, kind of, I guess, pile on a little bit, it's really much more about the timing of getting through the process and building the ramp than it is about creating additional disruption.

David H. Mowry



Our next question comes from Matt Miksic of Piper Jaffray.

Matthew S. Miksic - Piper Jaffray Companies, Research Division

I wanted to follow up on something you mentioned, Dave, about these contracts' exclusivity and so on. I think you've mentioned before also that the new contracts you have in place will give you some greater visibility into sort of what's happening into these independently managed regions. And I'd love to understand just to kind of maybe contrast the last few years and the experience that you had in trying to sort of manage productivity, get visibility, obviously negotiate these arrangements. Contrast where you were and maybe what -- maybe more specifically, what these contracts do for you now. How would that visibility help? What do these things do for you, especially the independent contracts? And then I have a couple of follow-ups.

David H. Mowry

Okay. So Matt, that's a pretty deep question, and I appreciate it because I think it's important that the investment community understands that there's a couple of things that it generates for us. As I indicated during a previous earnings call, the contracts are really designed to do 2 things. I think, first and foremost, establish an appropriate balance between the company and the agents in terms of expectations for how the business will be run, what access we would have to rep-level performance, giving them the support they need to continue to drive and grow their business, while we have greater visibility and access to standardization of expectations at the rep level. So that's really kind of what we tried to achieve. I think, in addition to that, what we established was rep-level, non-compete protection of the revenue. So I think beyond just the visibility, control and ability to set a standard for rep-level performance, we also established with the agencies the ability for us to establish kind of a non-compete provision that gives us the ability to invest aggressively in their territories and support them without fear of creating a competitor. So that's really, I think, fundamentally what we achieved in '13, and I'm very pleased with where we ended up. I think what I'm equally excited about is the way in which the agents are embracing this agreement and signing up for and engaging with us in driving their sales reps through the same training that the direct reps are going through. So I'm very, very encouraged that we've established a relationship, we've mitigated our long-term risks, we've created a relationship at the rep level, even through the agencies, but now, even more importantly, we've got the agents aggressively engaging with us to establish the right investments to drive the growth that we need.

Matthew S. Miksic - Piper Jaffray Companies, Research Division

That's helpful. And then the mix, you mentioned 200 reps. Is that mix skewed more towards direct, more towards indirect?

David H. Mowry

Yes. So just to be clear. We said there are approximately 400 reps that we have completely, and 145 of which are direct reps. And I think that's where...

Matthew S. Miksic - Piper Jaffray Companies, Research Division

I'm asking about the -- I'm sorry. [indiscernible] I'm sorry to interrupt. I meant the training that Shawn had laid out [indiscernible].

David H. Mowry

Oh, yes. I'm sorry. Shawn, do you want to run through the training?

Shawn T. McCormick

Yes, Matt, what I would tell you on the training is if there is a skewing, that would just by default probably be to the direct because they are much more focused and dedicated to Tornier. But overall, our intent is to have our entire field organization trained at least to Level 1 by year end. Now as was talked a little bit earlier in Mike's questions, the distributor reps, we have a lot more distributor reps who are not making necessarily a living off of Tornier, their Tornier revenue. We will be less focused on getting somebody trained who isn't going to be dedicated in yielding a significant amount of their revenue from Tornier product. And additionally, I'd add, if you take the 200 versus a grand total of 400, we did initiate some of this training last year, so we're not starting from 0. And we do have some more experienced reps that will be able to test out of certain aspects of this training, which will also help us move through this a little bit faster as well.

Matthew S. Miksic - Piper Jaffray Companies, Research Division

That's helpful. Just a couple other follow-ups. On the sort of rebuilding, if you will, of some of these territories that you -- I think you mentioned 15 to 20 additional direct reps or whatever other contracting or hiring that you need to do. I guess, when will you be -- is it at the end of the first quarter, do you think you'll have sort of the feet on the ground to sort of cover the distributor separations that you suffered in the fourth quarter? Is it by the end of the first half? When can we sort of start thinking of your distributor field force in the U.S. as being kind of relatively in place?

David H. Mowry

Yes, I would kind of take you back to the comments I shared and maybe somewhat embedded into the dialogue. But what I said, Matt, and I'll reiterate, is the fact that we expect that the distributor disruptions, because of some of the case coverage and established relationships, maybe rolled out a little bit. But we still expect a negative impact from those 3 distributor disruptions. In the third quarter, we've pretty much mostly hired and completed and done the training. The 2 that happened more recently at the end of the fourth quarter, we've already got the management team in place. We've got many of the reps in place, although we have some hiring left to do. And we'll do the training and continue that. But all of those, we think, will subside in the second half. And we should be back into a position in the second half of '14 in those 3 territories with full staffing and, at least, baseline early training of those reps.

Matthew S. Miksic - Piper Jaffray Companies, Research Division

Okay. And then the final, just on some of the product categories. I think you had mentioned before that there is a nuance -- there's a couple of developments on the shoulder side, and I think I asked about this before. I'd just like to get a sense of where you are. It seems like some of the folks in the space are rolling out, I do know to what degree they're having success with some of these custom cutting and positioning glenoid systems, similar to what we've seen in the knee, and disposable instruments for better targeting. I'd love to get a sense on where you are on that? And I'd also like understand how you're thinking about the ramp-up of training that's required to kind of get the foot and ankle folks not just to focus on foot and ankle but really on total ankle and how we should think about that in terms of growth this year on the lower end of the extremities business.

David H. Mowry

That was a pretty comprehensive question. Matt, I'm trying to split it into 2 and kind of take it. First, I'll talk a bit about the imaging, and then I'll come back to the ankle training. We're really excited about the relationship that we established with the third-party, working together to create an image-guided glenoid placement system. We've seen the early results of over 30 surgeries done using this procedure and using this tool. We know that even the best surgeons can improve their outcomes with this type of a tool, and we know that it will help facilitate not only better outcomes for these specialists, but more importantly, a sense of confidence with the generalists. And we think it is going to be an important consideration. We also think that this type of a tool can be used in a couple of different ways. It can get used by creating a patient-specific instrument or a placement guide for the more generalist. But we think equally important is the preoperative planning portion of this concept that allows surgeons to load and download to their own computer a graphic that comes from a simple scan and allows them to then do preoperative planning, placement of the glenoid, selection of the right implant, reaming directions, et cetera. That can happen in a matter of 10 to 15 minutes without intervention from a third party. In other words, they get the software, they get their own images, and they could do the work on their own laptop. And I think this is completely different than everyone out there that's using much more capital-intensive equipment and engaged with home offices having to do scans and replicate products. So we're excited about it. The timing of that will be really dependent on our ability to work effectively through the U.S. FDA office to get the appropriate regulatory clearance. We're intending for that to be in some sort of limited user release in the not-too-distant future. However, I think without going and getting a date in stone or etched in stone, I'm reluctant to kind of give it to you. I will tell you, our process will engage key physician leaders throughout the country to set centers of excellence, to help do the training and the evaluation, to help people get comfortable with this technology. The interest thing, though, is you don't really need to go far. All of the hardware you need is within everyone's current office, in most cases. And I think that's what makes it exciting. Moving to your second question, on the ankle, the training necessary. I think I've said repeatedly that the training is really critical to driving uptake. And I think equally critical is having this revision ankle that we talked about with the XT. I think these 2 things, coupled with physician training, the new product that we talked about and then also the rep training, is critical to bringing kind of a 1-2-3 punch to drive our lower-extremity sales, specifically, around the ankle. So we're going to continue to prioritize those activities and make them coupled by a territory-by-territory basis, rather than trying to broadly brushstroke across the entire U.S. So all I can tell you at this point is, our guidance is contemplative of the increase that we will see in the lower-extremities based upon that territory-by-territory investment in physician training, introduction of the XT and the sales rep training and getting them to the right level of certification to support an ankle replacement.


Our next question comes from Matthew O'Brien of William Blair.

Matthew O'Brien - William Blair & Company L.L.C., Research Division

Sorry to keep harping on the domestic extremities business, but you've talked about converting the whole sales force over to upper- and lower-extremity. But can you give us a sense for how we should think about the breakout between upper and lower overall? And then direct specifically, what percentage is going to be upper and what percentage is going to be lower?

David H. Mowry

So by the way, I appreciate that you're harping on this. Because I think there's a lot of questions around it, Matt, and I think getting clarity for the investment community is important. So we started by saying that we intend to get to 85% as a target. And remember, I think both Shawn said it and I said it, that there are certain geographies that do not warrant nor could support a singular person for upper and a singular person in lower. So full-line coverage is expected in those territories. And that's really more designed around the call point. You've got physicians in a lot of these outlier areas that are actually doing shoulders and ankles and knees. So we're really trying to align our reps to the case coverage that they have to support, okay? So I'll start by saying that. I think we have not provided the breakout of reps that are upper and lower. And I don't think we're intending to provide that at this time, Matt. Our intent is to continue to focus on getting reps that are aligned to those 2. And frankly, we need to look at, territory-by-territory, what's the best way to do that as we move through this process. We have a very generic plan, but until you break down and get into each of those areas -- those specific territories and the granular nature of the coverage, it could be a two-for-one deal, where you have 2 people doing upper and one doing lower. And in other places, it could be a one-on-one deal. So we're really not in a position to share that number at this point. But I will tell you, it's really about optimizing the revenue per rep as we move forward, and giving them the right skills and tools to be very productive.

Matthew O'Brien - William Blair & Company L.L.C., Research Division

Okay, that's fair. If I may ask another question I'm sure you're probably not going to answer. But in looking at your run rate right now in the direct reps that you have, it looks like they're running at about $750,000 annually per rep. And I know it's early days there. But just can you give us a sense for, once you get through the transition, once you get through the training, what kind of targets should we think about there? I know one of your competitors in lower-extremities just talked about $1 million per rep. And with the shoulders being much more expensive there, is this an opportunity for a rep to do, on average, across your group, something north of $2 million dollars, north of -- or around $3 million?

David H. Mowry

Yes, Matt. What I'd say is we're not yet -- we're not in a position or ready to put out what our ultimate goal and objective is. I mean, obviously, there's numbers out there and there's some industry standards. Our focus right now is ensuring that we move in a very disciplined, methodical process through the Phase II activities, clearly defining the right territories and the right coverage within those territories, ensuring that we get our reps moved through the training and the development programs that we have for them, first Level 1, and then progressing into the more advanced training. We, ourselves, are looking at productivity metrics and talking about what our goals and objectives should be. But we're going to hold off on communicating that and especially communicating ultimate goals and objectives, whether those are nearer-term or longer-term, until the appropriate time in our progress through Phase II.

Matthew O'Brien - William Blair & Company L.L.C., Research Division

I thought I would try. So one more, if I may. You've given some numbers in the past about growth rates in mature markets. Can you give us a sense for how that trended here in Q4? And then specifically, if you wouldn't mind breaking it down between your indirect and your direct sales forces.

David H. Mowry

Yes, I'll answer and I'll ask Shawn to kind of speak up as well here. We're not prepared to go into that, frankly, because what we're finding as we go through this is, even within a territory, as we've added a rep, it's hard to say that territory's mature when you've got a new rep we just added and you got 3 reps that are 2 years old. So it's kind of difficult, and it becomes very challenging to define mature versus not mature. But what I would tell you as we look at that data by territory then when we started the transition, and when we've kind of feel like we're mostly done with this transition, we're still feeling extreme confident that the process we've outlined, the need to define upper and separate upper to lower or split the channel and invest in training, yields excellent results. And we're committed to that process and we'll continue to march through that process over the course of next year, when we get to 85% into those dedicated channels, we have everyone through a Level 1 training, and in the second half we've said, we believe the impact of the disruptions will all have subsided through the rep ramp that we expect.

Shawn T. McCormick

Yes. I think that sums it up.


Our next question comes from Larry Biegelsen of Wells Fargo.

Lawrence Biegelsen - Wells Fargo Securities, LLC, Research Division

If I heard you correctly, you said that the 3 distributors you'd lost in 2013, one in the third quarter, the 2 in the fourth quarter, were about 10% of your U.S. sales or about $18 million. So rough math, the 2 that you lost in the fourth quarter, ballpark $12 million, plus or minus. And so I'm trying to understand. My questions really are a follow-up to Bob's earlier question. When I look at the Q1 guidance, it actually seems very conservative. You're normally -- your normal seasonality in Q1 is that you'd be 5% to 10% higher than Q4. But the midpoint of your Q1 guidance assumes about kind of $8 million below where you would normally come in quarter-over-quarter. And I guess I'm trying to understand -- that seems like a pretty big dropoff. I'm trying to understand what you're assuming for Q1 that makes you think it'll be that low, if I'm kind of going through all the math right.

David H. Mowry

Yes. So a couple of things, Larry. First is that we talked about the distributor separations and that they represent 10%. I think the one thing I would add to that is, remember through the course of third quarter and fourth quarter, we had some additional disruptions at the rep level that I highlighted, but I want to make sure that we continue to reiterate. That lost business is business that we have to go back and regain. So the base business that was lost, not only from the distributors, but from the reps, was incremental to that 10%, okay? So it's much larger. I think from my perspective, I feel like we're being very granular in our assessment of the business that we have. And I think as we move through this process, I'm not necessarily feeling that we're being overly conservative, nor are we being aggressive. I think we're kind of looking at the business the right way, keeping in mind that the disruption from the fourth quarter may be pushed out a little bit from those 2 distributors. So I feel very confident that our guidance is appropriately calibrated to the disruption that we've seen historically, and what we continue to think is going to kind of, if you will, continue to leak as we go forward.

Lawrence Biegelsen - Wells Fargo Securities, LLC, Research Division

Okay. So and then -- that's helpful. And then my follow-up is actually a little bit -- it's a follow-up to Mike's earlier question, which is, if 60% of your direct reps have not -- have been identified or transitioned to either upper or lower, that still leaves 40% that haven't. And I guess, from what we understand is that a lot of these reps, specifically upper-extremity reps, are not interested in carrying -- transitioning to lower-extremity products because of the lower ASPs. And I know you talk about it earlier in the call, but I wanted to ask again if you're factoring in potential disruptions from reps that just are not interested in kind of what you guys want them to do, which is to focus on upper or lower, especially the upper guys who might not want to do that. But I just want understand if that's a source of additional disruptions.

David H. Mowry

Yes, I think there's a few places that we will -- we may see some disruption, and we factored that into the guidance. But I want to be really clear in just addressing one of the things you said, Larry, and that is that the upper folks in particular, we're not expecting to take somebody that is mainly an upper guy and move them to lower. So I think, just to make sure, I don't want you to believe or think leaving this call that we're going to be moving a qualified, talented rap that's generating a significant portion of their revenue in upper, moving them to lower. I think what we will see, though, is the ability to hire an additional rep and consolidate lower business from maybe 1 or 2 reps to that new rep that we add, okay? So I don't believe it will be disruptive, while that existing rep stays in place, providing case coverage and support and then, ultimately, transitioning it to the new rep that we add, giving them bandwidth, if you will, to further expand their upper extremities revenue.

Lawrence Biegelsen - Wells Fargo Securities, LLC, Research Division

Right. That's helpful. Let me just ask one last one for Shawn. Sorry, Dave, did I interrupt?

David H. Mowry

No, no, no.

Lawrence Biegelsen - Wells Fargo Securities, LLC, Research Division

Okay. Shawn, the gross margin has improved by an impressive amount over the past couple of years. I don't know if you mentioned what your expectation is for 2014, but just curious where you think it can go in 2014 and over the next 2 or 3 years. And then I'll drop.

Shawn T. McCormick

Yes, well, I think that over -- I'll start with the longer-term, and I'll back up to 2014. I do think that we have the continued opportunity with the in-sourcing and manufacturing efficiencies, increasing volumes, to keep moving our margins up. I've historically said to the mid-70s. I think I can say it's the mid- to upper-mid-70s at this point. I do think we have further runway over the next few years, not just a little bit. Specific to 2014, looking at the total annual margins, so not the 75% here in Q4, but if you look more at an annual gross margin adjusted for the step-ups, it's more about 74%. I would tell you that I believe, we can do in the range of 30 to 50 basis points improvement on an annual basis.


Our next question comes from Daniel Sollof of Barclays.

Daniel Sollof - Barclays Capital, Research Division

Just one on the Aequalis Ascend Flex. It's performing well

2 quarters into the launch. You guys are seeing the migration. And appreciating that you weren't in that segment of the market, have you or is there a level of confidence that you've penetrated competitive accounts, and that those accounts are there to stay versus just trialing? Or is it really still too early to see anything meaningfully there?

David H. Mowry

Well, I think -- and Dan, that's a great question. We're very pleased with the progress we've made with the Flex. Starting right out of the gate, I will tell you that we did have competitive users in our initial or expanded limited user release. And our intent in doing that was to not only just try to target competitive users, but more importantly, get early feedback from them on the product, the instrumentation, the procedures, and ensure that we weren't missing an opportunity on how to best present that product into competitive accounts. I can tell you and assure you that many of those initial users are still using the product. So we're very confident and comfortable to know that it presents itself well against the competitive product, at least in the hands of those surgeons. As we move through the ongoing approach of trying to convert competitive business, you see greater success with some companies than you will with others because of the product offering and the comparative. But we've had, I would tell you, success with each and every company that we've gone against to some lesser or less -- some greater or lesser extent. So we feel like the product compares favorably to all, but it presents probably more favorably to some. I hope that answers your question.

Daniel Sollof - Barclays Capital, Research Division

No, that's very helpful, guys. And I'm just shifting to lower-extremities for a minute. So how do you see the product portfolio there? You've got an ankle, which should pull through to the plates and the screws. CannuLink is doing very well for you guys. If I look at the overall mix of your extremity business, it's still is right now at 75-25, upper versus lower. As you guys kind of go forward with the realignment, do you see that kind of mix staying where it is or do you kind of see more of a ramp in lower? And then I'll drop.

David H. Mowry

So a couple of things, I think, that factor into that. We see great market growth on both upper and lower. Our intent is not to divert our attention away from upper to go to lower. However, we think that we probably have been underinvested in our lower. So that being the case, our intent is to continue to grow above market in both of those segments. I think we do have additional or greater headroom in lower, and some of our additional investments may track against going after that lower growth. So I can see this getting closer than the current breakout of upper to lower, but I also don't want anybody to think that we're diverting our attention away from upper. In fact, that was the sole reason of making sure that we create the dedicated channels and put the resources internal to our business into alignment with those 2 channels, so that one would not be stealing from the other.


I'm not showing any further questions in queue. I'd like to turn the call back over to management for any further remarks.

David H. Mowry

Okay. Thank you, operator. Well, for those of you still on the phone, I want to thank you for attending and listening to our conference call. We're very excited about where the company is and where we're going. I think we've made significant progress through 2013, and I'm very encouraged with the progress we're making towards our goals and initiatives in 2014. I want to assure you that our focus will continue to be on execution, U.S. sales channel transitions, our product launches and additional integration of OrthoHelix, as well as o-US expansion opportunities such as Japan's reverse shoulder, and our expansion of lower extremities into the U.K., Canada and Australia.

I think our future is very bright and I'm very bullish on the company. And I'm very, very excited about where we're going in the future. Thank you.


Ladies and gentlemen, this does conclude the conference for today. Thank you for your participation. You may all disconnect, and everyone, have a great day.

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