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NuVasive, Inc. (NASDAQ:NUVA)

Q4 2013 Earnings Conference Call

March 3, 2014 5:30 p.m. ET

Executives

Tina Jacobsen – Director of IR

Alex Lukianov – Chairman and CEO

Michael Lambert – EVP, CFO

Quentin Blackford – SVP, Finance & IR

Keith Valentine – President, COO

Analysts

Matt Miksic – Piper Jaffray

Matthew O'Brien – William Blair & Co.

Bill Plovanic – Canaccord Genuity

Richard Newitter – Leerink Partners

Bob Hopkins – Bank of America-Merrill Lynch

Chris Pasquale – JPMorgan

Raj Denhoy – Jefferies & Co.

David Roman – Goldman Sachs

Mike Matson – Needham & Co.

Matt Taylor – Barclays

Glenn Navarro – RBC Capital

Jeff Johnson – Robert W. Baird

Larry Biegelsen – Wells Fargo

Operator

Greetings and welcome to the NuVasive Fourth Quarter 2013 Earnings Release Conference Call.

[Operator Instructions] As a reminder, this conference is being recorded.

I would now like to turn the conference over to Ms. Tina Jacobsen, Director of Investor Relations. Thank you. Ms. Jacobsen, you may begin.

Tina Jacobsen

Welcome to NuVasive's fourth quarter 2013 earnings conference call. NuVasive's senior management on the call today will be Alex Lukianov, Chairman and Chief Executive Officer; Keith Valentine, President and Chief Operating Officer; Michael Lambert, Executive Vice President and Chief Financial Officer; and Quentin Blackford, Executive Vice President of Finance and Investor Relations.

During our comments and responses to your questions, certain items may be discussed which are not based entirely on historical facts. Any such items should be considered forward-looking statements that are based on current expectations and involve risks, uncertainties, assumptions and other factors which, if they do not materialize or prove correct, could cause NuVasive's results to differ materially from those expressed or implied by such forward-looking statements. These and other risks and uncertainties are more completely described in today's press release and in NuVasive's most recent 10-Q and 10-K forms filed with the SEC.

This call will also include a discussion of several financial measures that are not calculated in accordance with Generally Accepted Accounting Principles. We generally refer to these as non-GAAP financial measures. These measures include our gross margin, sales, marketing and administrative expenses, research and development expenses, operating margin, and non-GAAP earnings per share. We believe this information is useful to investors because it provides important financial information regarding earnings generation at NuVasive and is helpful for measuring our progress.

We use these non-GAAP financial measures along with the most directly comparable GAAP financial measures in evaluating our actual and forecasted operating performance, capital resources and cash flow. The most directly comparable GAAP financial measures and information reconciling these non-GAAP financial measures to our financial results prepared in accordance with GAAP are included in the press release and in the supplementary financial information file, both of which are accessible from the Investor Relations section of our website.

With that, I would like to turn the call over to Alex.

Alex Lukianov

Thank you, Tina. The fourth quarter of 2013 marked a fantastic close to a year of solid execution. NuVa is on a mission to change spine surgery and our market share taking strategy clearly continues to fuel industry-leading growth.

Revenue in the fourth quarter exceeded our expectations, growing 15% to $191 million. The strength is broad-based. Each major product group outperformed their targets. Operating profit translation was also strong. We generated a non-GAAP operating margin of 16.3% and non-GAAP EPS of $0.37. For the full year 2013, revenue grew 10% to $685 million, and we generated a non-GAAP operating margin of 15% and non-GAAP EPS of $1.23.

With the strong 2013 in the rearview, I will focus my comments this afternoon on NuVasive's future. First I will update you on our outlook for the U.S. spine market, then I will detail the key pillars of our strategy to continue to take market share, which we believe will drive revenue to well beyond $1 billion. I will also address our commitment to improve profitability. Following my comments, Michael will walk through the fourth quarter results and provide detailed guidance for the full year 2014.

So let's start with an update of the U.S. spine market. As you know, both insurer pushback and physician-owned distributorships, or PODs, are forces that have negatively impacted market growth for the last few years. However, progress is being made. With respect to insure pushback, the health technology assessment or HTA was published in a peer-reviewed journal. This collection of clinical evidence in support of spine fusion for degenerative disc disease also demonstrated that lumbar surgery outcomes are consistent with outcomes for hip and knee replacements and is being used by surgical societies to develop consistent clinically supported guidelines for spine fusion.

Progress was also made against PODs. In a report that summarized their investigation, the OIG did not ban POD models. It did underscore that they have a propensity to drive higher procedural volume without less cost for the hospital. Overall scrutiny of PODs continues to grow. Adoption is decreasing and hospital networks are increasingly refusing to work with PODs. As well, we've just learned of the first enforcement action taken by the Department of Justice in an application filed for a civil investigation of a surgeon involved in a POD model. Clearly the prevalence of PODs should decline. That said, we do not expect the (POD res) to materially benefit U.S. growth in 2014.

Regarding Obamacare, we do not expect its implementation will be an incremental positive for spine, or purely anecdotal, our conversations in the field suggest that fourth quarter volumes did not benefit from the ongoing uncertainty and challenged implementation of Obamacare. With respect to 2014, we have seen research that speaks to spine patient volume growth; however, we do not see marked evidence of that being the case.

In consideration of all of these factors, we expect the market will continue to stabilize. In 2014, we anticipate U.S. market growth will be flat to up about 2%, similar to 2013. And regardless of U.S. market growth, we intend to continue to outgrow the industry by executing our strategy to take market share.

Let me now turn to a discussion of our share-taking strategy and the drivers of NuVa's continued industry-leading growth. We are focused on executing to the full year expectations that Michael will outline in a moment, but our vision extends well beyond 2014. NuVasive is evolving into an increasingly profitable spine powerhouse capable of generating well over $1 billion in revenue. And we are doing that with the commitment to change spine surgery.

We talk a lot about culture at NuVasive. At our sales meeting a month ago, our focus was on developing ways to evolve our culture to expand our dominance of innovation in spine in the decades to come. To achieve that, we are incenting share owners at every level of the organization to rethink processes and team architecture in order to best achieve our mission. We didn't get to where we are today with replication. So we are challenging the entire organization to inject innovation on a major scale and drive strategic execution by being champions of change, thinking creatively, and being inventive in everything that we do in operations, manufacturing, IT, marketing, and development.

With a backbone of our truly differentiated culture, we have our 1,600 NuVa family members focused on one mission: to change spine surgery and take market share. This mission will be driven by three key pillars. First, we are driving the shift in spine for minimally invasive surgery. Secondly, we are introducing innovation to the traditional or open spine market. And third, we are launching our market share taking strategy internationally. So now let's walk through each one of these.

NuVasive is at the forefront of the shift for minimally invasive solutions or MIS which continues to unfold in spine. We estimate that less invasive solutions represented about 27% of the global market at the close of 2013. As better patient outcomes, superior economic evidence and the growth in the number of key institutions teaching MIS and fellowship programs continue to drive adoption, we believe MIS solutions will become the standard of care in spine. So how is NuVasive championing that shift?

First, with economic evidence. We are a market share leader within the $2 billion MIS market. We have an unrivalled 10 years of experience pioneering the lateral solution for spine fusion. That market leadership and that experience give us a unique ability to educate decision-makers on the cost-effectiveness of our MIS solutions. We have evidence that asserts 10% to 14% reductions in overall cost to the hospital when a surgeon performs an XLIF instead of a traditional open fusion procedure. And we have evidence that MIS surgeries results in lower complication rates and readmissions which can otherwise erode hospital profit margins by as much as 23%. These are incredibly powerful arguments in an increasingly cost-focused environment.

We are also championing the shift toward MIS by expanding internationally, introducing new surgeons to the superior clinical outcomes and procedural reproducibility of our MIS platform. The U.S. market is over 30% MIS today, but international markets are still under 10%. NuVasive is building new markets for MIS overseas, much as we began to do here in the U.S. a decade based on our development mantra of providing technology to make spine procedures faster, better and cheaper.

Lastly, we are driving the shift toward MIS with constant innovation. Our experience in research affords us an unrivalled understanding of the unmet clinical needs in MIS and where NuVasive can create additional value in the operating room.

For example, we are rolling out Bendini -- I love that name -- rod bending software designed to minimize the most time-consuming, most difficult and least reproducible step and long posterior constructs. Bendini can dramatically reduce the amount of time in the OR, resulting in less exposure to fluoroscopy and less anesthesia time. We are also launching the decade lateral plate which enables single approach lateral surgery. Surgeons can work through their original incision to achieve nearly the standard way of stability without needing to reposition the patient. This can save a great deal of time in the OR and reduce the risk of complications.

And we are launching XLIF for anterior column realignment or ACR, an MIS technique that can restore lumbar lordosis. Compared to the traditional treatment, XLIF ACR is designed to further reduce time in the OR, the length of hospital stay, and the amount of blood loss.

Innovation is at the heart of our continued ability to take share and drive spine market conversion towards MIS. And importantly, I am more excited about the direction of our current pipeline than I had been at any point in our past. We are making more R&D investments to bring innovation to fruition over the next few years, developing solutions that will expand MIS surgical capabilities. We have new systems planned for clinical evaluation this year that will change the way spine surgery is being done. We will tell you more about that platform in 2015.

Our focus on innovation is a great segue into the second major driver of our path towards $1 billion in revenue. We are introducing more innovation in the traditional or open spine market, which is over $6 billion globally, nearly three times the size of the global MIS market. As we continue to introduce innovative ways to perform traditional open procedures, we are not just capturing share of the traditional market, we are also establishing relationships with new surgeons who will gradually convert to MIS.

Surgeon demand for our recent product launches that address traditional procedures like Precept, MAS TLIF, and all of the innovation within our surgical portfolio validate that there is definitely a place for NuVasive in the traditional market. Precept, our posterior fixation solution that can be used both in MIS and in open procedures, rolled out over the course of 2013 and became our all-time fastest-growing product. The second generation of VuePoint, a posterior surgical solution, achieved $1 million in sales more quickly than any product in our history.

These successes demonstrate that our drive to change spine surgery really isn't about MIS or open. Our success comes from architecting both new and better procedures to achieve improved patient outcomes in reproducible way. Again, faster, better, cheaper. NuVasive has a unique ability to deliver on that development mantra.

Looking forward, the momentum behind our procedurally integrated innovations will enable us to marshal the market shift toward MIS and to increase our penetration of the $6 billion traditional market by modernizing traditional posterior procedures. We had strong success driving that in 2013 and we expect to expand upon it with our robust new product line.

The third major driver of our long-term revenue growth will be launching our market share taking strategy internationally. We estimate the international spine market to be over $2.5 billion and growing at about a mid-single-digit pace. In 2013 we generated over $70 million in revenue internationally, just a 3% share. Compare that to the roughly 10% share we have achieved in the U.S., and you can appreciate the long runway for growth in front of us. As we drive towards $1 billion, we expect the revenue we generate internationally to almost triple, approaching $200 million.

Let me update you on our strategy for expansion. We are increasing penetration across the EMEA, a $1.1 billion market. We built upon the executive leadership changes of last year, with additional highly-experienced country leaders to effectively drive share gains in the most important markets: Germany, the U.K., Italy and Spain, and to develop new and emerging market opportunities.

In the $1.2 billion Asia Pacific market, we are ramping aggressively. We have strong momentum in Japan where the demands for surgeon training and the adoption rates in our inaugural year have been fantastic. We also are cultivating our leadership position in Australia and growing strategically in China.

In the $350 million Latin America market, efforts are underway to further develop our position in Brazil and in Mexico. We also just appointed a new exclusive distributor in Argentina, which will improve our ability to service customers across the region.

We have exceptional, seasoned international leadership and subsidiaries in 80 market countries, plus 20 dedicated distributors in 20 countries. The numbers of our international NuVa family are extremely excited and well-positioned to replicate our share taking strategy globally.

So assuming consistent market dynamics, we believe that those three pillars of growth can support mid-single-digit revenue growth for the foreseeable future. In addition to that top-line growth, we are also committed to operating margin expansion from the 15% level reported for the full year 2013 to at least 20% as we approach $1 billion. That is a growth opportunity of over 500 basis points that we have a clear line of sight to achieve.

Profitability improvements will be driven primarily by increased international scale as we lever years of investment; increased vertical integration as we work to triple the 15% of total implants that we currently produce internally; improved asset efficiency with operational initiatives to improve inventory positions and distribution methods while levering IT investments; improved sales force effectiveness of our new mobility platforms and revamped sales teams to drive deeper geographic penetration; and finally, the February 2015 expiration of the patent behind the majority of our royalty expense accruals.

Our vision for growth and the differentiated company culture at NuVasive position us exceptionally well to continue to take market share. We are laser-focused on continuing to drive both top and bottom-line growth as we move toward the next milestone of $1 billion in revenue.

Lastly, turning to the legal front, we are actively complying with the OIG's document request. We have nothing new to report on that front, but we'll provide further updates if and when they are needed.

With regard to our ongoing patent litigation with Medtronic, the appellate process related to phase one of the litigation is moving forward. Initial briefs have been filed by both sides and additional briefs will be filed in the coming months. We expect the appeals court to then schedule a hearing, with the potential decision by midway through 2015.

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

Michael Lambert

Thank you, Alex, and good afternoon everyone. Before we get started, let me remind you that when we cover gross margin, SM&A expenses, R&D expenses, operating margin and EPS numbers today, we will be speaking to non-GAAP results. Please refer to the supplementary financial information file on our website, in the Investor Relations section for all of the detail that will be covered on today's call to reconcile our non-GAAP items to their GAAP counterparts and to put the 2013 to 2014 EPS comparison into context.

Our revenue for the fourth quarter 2013 was $190.8 million, a 15% increase over the fourth quarter of 2012. Year-over-year revenue growth in the fourth quarter for both U.S. lumbar and U.S. biologics was about 12%. U.S. cervical revenue grew approximately 17% in the quarter. Services revenue from our impulse monitoring business grew about 15%. International revenue, which includes Puerto Rico, grew over 40% in the quarter.

Non-GAAP gross margin in the fourth quarter was 74.2%, down fractionally compared to 74.6% in Q4 2012 and 74.4% in Q3 2013. Year over year gross margin was pressured by 130 basis points from the combination of incremental royalty expense, to med device tax impacts. We offset most of that pressure with 90 basis points of benefits from operational and other improvements.

Non-GAAP sales, marketing and administrative or SM&A expenses totaled $103.3 million in Q4 2013 compared to $90.8 million in Q4 2012 and $93 million in Q3 2012. SM&A expense was 54.1% of revenue for Q4 2013 versus 54.8% in Q4 2012 and 55% in Q3 2013. The year-over-year improvement in SM&A expense came in spite of about 60 basis points of spend in the fourth quarter related to the OIG request. Excluding that, the magnitude of SM&A leverage demonstrated in Q4 would have been more significant at approximately 130 basis points.

Non-GAAP research and development or R&D expenses totaled $7.1 million in Q4 2013, compared to $7.9 million in Q4 2012 and $6.8 million in Q3 2013. R&D expense was 6.7% of revenues for Q4 2013 versus 4.8% in Q4 2012 and 4% in Q3 2013. Relative to last year, the decrease in R&D as a percent of revenue was primarily driven by the prioritization of R&D investments and a timing-related decrease in clinical spending.

Fourth quarter non-GAAP operating margin exceeded our expectations, totaling 16.3% compared to 15% in Q4 2012 and 15.4% in Q3 2013. Interest and other expense net totaled $6.4 million in the quarter compared to $5.9 million in Q4 2012 and $3.4 million in Q3 2013. Fourth quarter non-GAAP earnings were $17.8 million or $0.37 per share, which includes an approximately 5-point [ph] tax benefit related to the reversal of foreign tax valuation allowance.

Full year 2013 cash flow performance met our expectations for the full year. Cash flow from operating activities approached $98 million compared to an adjusted total of about $119 million last year. Free cash flow approach $50 million versus last year's adjusted total of about $78 million. While both of these numbers are below the 2012 totals, we did not anticipate repeating the magnitude of the working capital progress that we made in 2012. As well, in 2013 we absorbed the med device taxship [ph] and the cervical litigation settlement, and we also spent more on capital expenditures.

Our cash and investments balance at the end of the fourth quarter was approximately $326 million, down about $20 million from $346 million at the end of 2012. The decrease was primarily driven by our repayment of the remaining $74 million associated with our March 2013 convertible debt and by significant capital expenditures, both of which were partly offset by strong operating cash flow generation.

Now let's turn to detailed guidance for the full year 2014. As I mentioned earlier, please reference the tables in today's press release and the supplementary financial information posted on our website for additional guidance details.

We continued to anticipate full year 2014 revenue of approximately $725 million or 6% year over year. This year we anticipate our continued ability to take share within a still stabilizing spine market. Similar to 2013, our focus will be on achieving full year expectations not on results in any given quarter.

Let me walk through the expected composition of the various elements of our 2014 revenue growth profile. U.S. lumbar grew about 8% in 2013. We expect it to grow about 5% for the full year 2014, driven most heavily by continued progress from some of our new solutions like Precept and MAS TLIF within the context again of the still stabilizing U.S. market.

U.S. biologics grew about 5% in 2013. We expect that it will grow 1% for the full year 2014. Growth will continue to benefit somewhat from the pull-through of our U.S. lumbar solutions, but Osteocel Plus has likely reached its potential level of penetration.

U.S. cervical grew about 21% for the full year 2013. We expect it to grow about 12% in 2014 in consideration of the larger revenue base and as we anniversary a few major product rollouts.

U.S. monitoring service was flat for the full year 2013. We expect it to be down about 4% for the full year 2014 as strong volume growth continues to be offset by pushback from insurers.

Our international business grew over 30% in 2013. We expect it to grow just over 20% for the full year 2014 as our expansion into new geographies and our drive for leadership in existing markets continues to be offset to some degree by economic turmoil in various regions.

Turning to the rest of the P&L, we expect full year 2014 gross margin to be approximately 76% compared to the 74.8% recorded for full year 2013. The significant year-over-year improvement primarily reflects the initial impacts of our vertical integration efforts. We expect full year 2014 non-GAAP SM&A expense to approximate 54.5% compared to nearly 56% in 2013. SM&A leverage is a major focus for us with the numerous initiatives that Alex detailed in his remarks. The improvement in SM&A expense that we anticipate for 2014 reflects strong progress across many of the various areas.

We expect full year 2014 non-GAAP R&D expense to be approximately 5.5%, compared to about 4% in 2013. The increase will be driven by support of several large projects in our pipeline, including procedurally integrated computerized solutions being designed to enable surgeons to more precisely achieve spinal column realignment. The increase also contemplates accelerated efforts to design products for manufacturing as well as for distribution, also to achieve product approvals in overseas markets and to accommodate sterile packaging requirements.

To summarize, we expect to drive close to 250 basis points of efficiencies out of the combination of cost of goods sold and SM&A over the course of 2014. That progress will be balanced against about 140 basis points of greater R&D investment to maintain our innovative prowess and cultivate the future growth drivers of our business. As a result, we will translate over 100 basis points of operating margin expansion in 2014, resulting in an expected full year non-GAAP operating margin of approximately 16% compared to the 14.9% reported for the full year 2013.

Implied in our guidance is growth in non-GAAP operating profit dollars of about 14% in 2014. That represents operating profit growth that is roughly double the expected rate of revenue growth in 2014, a clear demonstration of our commitment to improve the operating profitability of our business.

In thinking about the progression of non-GAAP operating margin from quarter to quarter, please make sure that you are mindful of the historical seasonality it has demonstrated. The front-end-loaded nature of our normal spending pattern has led Q1 operating margin to be far and away the low point for the last few years. In addition, unlike Q1 2013, the first quarter of 2014 will also bear the impact of the incremental royalty expense and the incremental spend on the OIG request. As a result, Q1 2014 operating margin will likely be down compared to Q1 2013.

Continuing with the rest of the P&L, we anticipate full year 2014 other income and expense to be approximately $27.5 million, including roughly $14.7 million in non-cash interest expense. We anticipate a full year 2014 GAAP effective tax rate of approximately 80% compared to the roughly 29% reported in 2013. A portion of this increase can be attributed to the fact that 2013 benefited from several discrete items unique to that year, including the reversal of our foreign tax valuation allowance as well as the one-time double-up of the R&D tax credit.

The rest of the increase in our 2014 effective tax rate will be driven primarily by the impact of our globalization initiative which is designed to consolidate and standardize the management of our international business activities. Over the longer term we expect the initiative to drive operational, asset utilization, compliance and cost and tax-oriented benefits. As a result of this implementation, we expect to see a spike-up in U.S. tax expense and in the corresponding tax rate this year 2014. We expect our GAAP tax expense will be approximately $90 million [ph], which includes more than $9 million of impacts associated with implementing the initiative. Over the next several years, depending on the rate of growth of our international business compared to current expectations, as well as other factors, we anticipate that the various benefits of the initiative will materialize.

On the tax side, over the next several years, it should enable a steady improvement in our GAAP tax rate from its high point in 2014, down to a rate in the low to mid 30s. Under our new structure, once we reach the low to mid 30s, we expect our effective tax rate to remain at or around that level over the longer term. We expect non-GAAP adjustments for the full year 2014 will continue to be tax-effected in approximately 40%. As we transition to becoming a cash tax payer and as we implement our globalization initiative, we anticipate a significant impact on free cash flow in 2014. However, even with these impacts, we expect to manage free cash flow to be roughly flat with 2013's results.

Diluted shares outstanding for the full year 2014 will be approximately $50 million. We expect full year 2014 GAAP EPS to be approximately $0.11 and non-GAAP EPS to be approximately $1.06, down $0.17. In order to put the year-over-year EPS comparison in its proper context normalized for the discrete 2013 items, including the tax benefits and the legal settlement benefits in other income and expense, as well as for the 2014 tax rate impact of our globalization initiative. Those adjustments result in an expected 2014 non-GAAP EPS growth rate of about 14%, roughly twice the rate of revenue growth.

Non-GAAP operating margin and EPS guidance for 2014 excludes full year impact of non-cash stock-based compensation expense of approximately $36 million, certain intellectual property litigation expenses of approximately $5.5 million, amortization of intangible assets of approximately $16 million, one-time and acquisition-related items of approximately $7.5 million, which includes a real estate rationalization item and as-incurred additional items, and non-cash interest expense associated with the 2017 convertible notes of approximately $14.7 million.

I am really looking forward to what 2014 will bring. We are simultaneously executing a share taking strategy and driving operational improvements.

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

Alex Lukianov

Thank you. 2013 results clearly demonstrate that our market share taking strategy is thriving, and importantly, we're cultivating the drivers that will support top and bottom-line growth for many years to come.

In May of 2014 we will notch 10 years for NuVa as a public company. Over our first decade, we pioneered the lateral approach to spine fusion surgery. We developed an idea into a company because we engaged early adopter surgeons, drove broad penetration, and amassed the clinical evidence to build that idea into a procedural platform. In just 10 years we launched over 90 products, establishing a comprehensive portfolio that addresses every level and pathology of the spine, achieving better patient outcomes, surgical reproducibility and cost savings. We were able to do all of that by fostering a vibrant corporate culture with a collective will to succeed in changing spine surgery. And we did just that.

Some companies would be content to simply celebrate those achievements. But our deep desire and commitment to improve patients' lives by continuously evolving and changing spine surgery through speed of innovation means NuVa is just getting started. We are systematically converting the global market to MIS solutions and our dedication to innovation has conceived a pipeline that might even dwarf what we achieved in our first 10 years. Onward and upward indeed.

We will now take your questions.

Question-and-Answer Session

Operator

Thank you. We will now be conducting a question-and-answer session. [Operator Instructions]

Our first question is from Matt Miksic of Piper Jaffray. Please go ahead.

Matt Miksic – Piper Jaffray

Thanks. Can you hear me okay?

Alex Lukianov

Yes.

Matt Miksic – Piper Jaffray

I have a couple of quick questions here. Sort of bigger picture question here, because we just learned a great deal of your preannouncement. I apologize for the background noise in advance. But thinking about how you're positioning the product portfolio, Alex, you talked about extending into traditional spine and broadening the offering not just into MIS but beyond MIS. I guess what experience have you had so far or how soon do you expect us to see, you know, more often in some of these larger [indiscernible] where NuVasive has been able to take the leadership position with the breadth of your bag [ph], able to sort of not have some of the more traditional suppliers and give the surgeons and hospitals confidence that, you know, you have everything that you need. Is that a '14 event, is it happening already, is it a '15 event? And then I have one additional question. Thanks.

Alex Lukianov

So that already started to happen in '13, Matt. And I think that's what you really saw in terms of driving our lumbar growth, was the success that we had with posterior fixation. Products like Precept performed exceptionally well, as I discussed in my prepared remarks. The same with MAS TLIF and TLIF and so forth. So that's where we are now. We will be adding more products to the fold to give us more tools in the posterior fixation market over the course of this and next year. And we're just in the process of rolling out the products that I also mentioned like Bendini, ACR and so forth. So we believe that that will give us more opportunities to come at both the open and the MIS market this year. So we're in a very strong position and already there.

Matt Miksic – Piper Jaffray

Excellent. And then just wanted to follow up on what we're seeing as growth for the [indiscernible] spine, the use of greater technology in the OR, whether it's guidance [ph], robotics, implanting software. It sounds like you're working on extending your technology offering from what has been the markedly leading Takeda [ph] neuro monitoring technology to more the implanting, alignment. Give us your thoughts on how you see greater use of technology in the OR going forward. Is this, you know, does robotics make sense? Do you expect this to be a greater part of the market in the next two, three, five years? Thanks.

Alex Lukianov

So our approach is to really help the surgeons to plan the procedure earlier on in the process. So we're putting forward a series of different products and software options over the course of this year and into next as we continue to move down that pathway. So our approach is exactly as you described, providing a more comprehensive approach to being able to do a procedure.

It's not especially reliant on robotics in terms of our thinking right now. I do believe there is ultimately perhaps a place for robotics down the road, but that's not what we're relying on at this point in time. We will continue to expand our neurophysiology monitoring capabilities, and that will be a big part of how we get there, together with some of the things we're doing on the software side for planning.

Matt Miksic – Piper Jaffray

Thanks, Alex.

Alex Lukianov

Sure.

Operator

Thank you. [Operator Instructions]

We'll go ahead and take the next question from Matthew O'Brien of William Blair. Please go ahead.

Matthew O'Brien – William Blair & Co.

Good afternoon. Thanks for taking the question. Hopefully you can hear me okay.

I was hoping to dig in a little bit more on the lumbar side of things. Alex was just saying about share taking and, you know, when you look at your growth in '14 versus '13, kind of decelerating a little bit, again off a little bit tougher comp. Are you seeing something specifically about your opportunity with Precept or MAS TLIF or is there something else going on competitively that would cause that slight slowdown in [indiscernible] lumbar given all the momentum that you're seeing?

Alex Lukianov

So what we've done is really considered the current state of the U.S. market in providing our guidance and forecast for 2014. We are certainly pleased with the success that we had last year in achieving double-digit growth overall as a company, and we certainly expect to have very strong performance over the course of '14. But as we've considered still some of the pushback issues relative to insurance, the fact that PODs still are in the way of growth, we've actually opted to go with the guidance that we've put forward as a result. So we'll see how the year progresses. We'll see where we end up. But we think we're forecasting appropriately for this point in time.

Matthew O'Brien – William Blair & Co.

Okay. And then my follow-up is on Japan. You discussed a lot of momentum in that country. Can you just be a little bit more specific as far as what it is that have you so optimistic there? Is it number of surgeons that you're training, number of accounts that you've opened or going deeper within those accounts? And then I figure I'd give it a shot anyway, can you give us the revenue run rate on that in Q4, from Japan alone?

Alex Lukianov

So I just heard the first part of your question. And as far as Japan is concerned, I think what we've really seen is that the uptake for XLIF in particular as well as utilization of some of our products has been very robust. And what I think has been especially pleasing to us is seeing the surgeons continue to utilize the products and look for more and more applications. So I think the success and the stickiness, so to speak, of our penetration, has been excellent. So we expect very strong growth in Japan this year. I'm sure it will be higher than our overall average growth for international given the strong platform we already set up in '13.

Matthew O'Brien – William Blair & Co.

Great. Thank you.

Alex Lukianov

You bet.

Operator

Thank you. The next question is from Bill Plovanic of Canaccord. Please go ahead.

Bill Plovanic – Canaccord Genuity

Great. Thanks. Good evening.

Just curious on -- if you could provide more color on the globalization initiative and what exactly that entails.

Michael Lambert

Okay, Bill. Yeah, I'll try and give you an overview. So the globalization initiative for us is essentially, as I mentioned, trying to secure the benefits of consolidation, read that as scale, and standardization, read that as commonality and repeatability in the management of our o-U.S. business activities. And that includes our assets.

As I mentioned, you know, we think the benefits of that are operational in nature. We'll get some asset utilization benefits out of it too, compliance oriented, and cost and tax oriented.

What is involved for us is essentially setting up an operational hub, in this case in Ireland. They've got a great workforce there. They've got operational, logistics and even manufacturing skills. And as a country, they've also got some attractive incentives. They've also, as you know, got one of the lowest corporate income tax rates in the world. So those are the key structural items underneath it.

Bill Plovanic – Canaccord Genuity

And what's the timing and costs associated with this?

Michael Lambert

Yeah. The timing is it will take multiple years to sort of get through it. But I think the way to think about it from a tax rate standpoint is that we'll go from the high that you'll see in 2014, that 80% or so we have in our guidance, steadily down to the low to mid-30s over the course of several years. And the other thing to keep in mind about it is, essentially after 2014, it should become an EPS, you know, a future EPS lever for us off of the 2014 result.

Bill Plovanic – Canaccord Genuity

Okay.

Alex Lukianov

Just to be clear, Bill, this is underway and this was started in the fourth quarter and it's fully in effect now in terms of our offices and what we're doing internationally.

Bill Plovanic – Canaccord Genuity

Okay. And then just on that same kind of topic, the cadence of the gross margin improvements, what should we expect in 2014?

Quentin Blackford

Yes. So in the guidance, and this is Quentin here, Bill, you could expect roughly 100 basis points of improvement in the gross margin in the guidance that we set forth, because really the benefit of the manufacturing facility that we acquired back in 2013 is starting to play through, so about 100 basis points.

Operator

Thank you. The next question is from Richard Newitter of Leerink Partners. Please go ahead.

Richard Newitter – Leerink Partners

Hi. Thanks for taking the questions. Can you hear me okay?

Alex Lukianov

Yes.

Richard Newitter – Leerink Partners

That's great. Thank you. I just wanted to ask one, Alex, in your opening remarks you specifically talked about kind of the 4Q trends and 1Q trend is the market level and you mentioned ACA [ph]. I was just wondering, you said you're not seeing anything, you had a particularly strong fourth quarter, is there anything that was unique to the fourth quarter that we shouldn't kind of think about as trying to, and then also what about weather-related impact in the first quarter of '14, anything there?

Alex Lukianov

So for us, I think the fourth quarter, and really '13 is an execution story, and our ability to take share. I mean it's essentially that. We did not expect or see a lot of help coming from Obamacare in any way. So there were I guess - there's a fair amount of chatter about that, but we didn't actually see that take place in the marketplace.

As far as weather is concerned, we expected this to be winter and we thought it would snow, so there's nothing really in particular that has happened that's offset our planning or expectations.

Richard Newitter – Leerink Partners

Okay. Thanks, that's helpful.

And then just what I was hoping to get a better understanding on, with respect to your -- it sounds like you're not just a minimally-invasive company, you're broadening the breadth of your product offering, you're pulling through a more traditional portfolio. Can you talk about some of the benefits of products like Precept or MAS TLIF for example offering relative to traditional types of instrumentation? Like why is your solution in penetrating the traditional market different than competitors' solutions in the traditional market?

Keith Valentine

Yes, a couple of things. This is Keith. There's a couple of things I think you have to consider, is, one, the open instrumentation often works seamless with the less invasive instrumentation. So as you're learning a particular technique, you're also able to do both, both open and less invasive. And I think Alex mentioned nicely in the comments we started, that as you build the relationship, that as you build the relationship with some of these key institutions and those surgeons, you're able to then change and move them towards less invasive solutions. And so you're able to build a deeper relationship with them and really guide them to that less invasive course. And the good news is the instrumentation that they're using has lots of similarities as they move to the MIS/MAS platform. So it really is a simple transition process for them because of the way they're designed.

Alex Lukianov

I think what we've really tried to do is, for example, to make TLIF better, to make TLIF better, to address how to do these traditional procedures in ways that surgeons are actually excited and get some of the benefits, like Keith just said, of minimally invasive spine surgery actually immediately.

So what starts to happen is they start reducing the length of incisions because even big open surgeons, I mean they're thinking now about, how do we do this in another way? Even though they're still doing a large incision, I think it's starting to shrink. And so it gives us a very strong position to be able to keep improving our position in the counters [ph] as Keith outlined.

Operator

Thank you. The next question is from Bob Hopkins of Bank of America-Merrill Lynch. Please go ahead.

Bob Hopkins – Bank of America-Merrill Lynch

Thanks. Can you hear me okay?

Alex Lukianov

Yes.

Bob Hopkins – Bank of America-Merrill Lynch

Great. Good afternoon. Thanks for taking the questions.

First, Michael, just one for you on the tax rate to make sure I understand the moving parts here. If you look at the, you know, your non-GAAP EPS guidance versus where consensus is, it looks like the main difference is really tax rate and share count. And on the tax rate, could you just, in simple terms, why the tax rate going up in 2014? And I know you've run through it a little bit, but I just want to make sure I understand that.

And then more importantly, you gave some longer-term guidance on tax rate, how much progress can you make towards that in 2015? How long is it going to take to get down to those kinds of levels?

Michael Lambert

Hi, Bob. So if you think about that 80% GAAP tax rate, which equates, I think as I mentioned, to about $19 million in GAAP tax expense. That includes within it, Bob, about actually over $9 million of unfavorable 2014 impact as a result of implementing the globalization initiative. So while it benefits future years, it certainly has its impact on 2014.

If you exclude out those roughly greater than $9 million of unfavorable impacts, our actual GAAP tax rate in 2014 would have been in the 40% to 45% range, what looked probably quite a bit more normal in that sense.

If you think about how long it takes to get there, I mentioned it's over -- it'll take over several years. You know, that's really a function of how fast our o-U.S. business continues to grow, obviously, as well as a host of other factors. But we expect to be back at or around that sort of statutory federal stake rate of about 40% probably by 2016, and then, underneath that, post.

Bob Hopkins – Bank of America-Merrill Lynch

Okay. And then Alex, as a follow-up, your comment on PODs and things starting to loosen a bit there, but then you guys aren't guiding to any real benefit from that in 2014. Is that just you being conservative as you wait and see how you want to -- see how it might play out? It would seem to me that, you know, there's some growing momentum here in that NuVasive may be better positioned than others to benefit given that you have higher market share in some of the areas that the PODs are concentrated. So I'm just wondering, is this conservatism on your part or is there some sort of structural reason why this is going to grow slowly?

Alex Lukianov

Bob, I think we are very well-positioned to benefit from that. What we haven't seen though is just surgeons immediately jumping away from PODs. So I think that as this evolves over the course of '14, and hopefully they go away or for a large -- at least large part of it goes away, then I think we can start to factor that into our guidance.

Right now it simply hasn't happened. And whatever has happened has been pretty minor in terms of impact. So as we start to see that accelerate, then we can talk about that further. But right now in terms of our crystal ball, it hasn't happened yet.

Operator

Thank you. The next question is from Chris Pasquale of JPMorgan. Please go ahead.

Chris Pasquale – JPMorgan

Thanks. Start off with just a quick one on the interoperative monitoring business. The segment has been struggling. Your guidance for '14 reflects a modest decline, but this quarter's result was obviously quite good. What happened there?

Alex Lukianov

So we caught on some of the collections, but largely it continues to, for us, to be a headwind with regard to reimbursement. And so if you still -- if you look at last year versus prior year, relatively flat. This year, I think as we look at the year, it could be flat, but we've actually forecasted it's probably going to be down a little bit. If things go better than we expect, then hopefully we'll get back to being flat. But we don't see that at the moment.

Michael Lambert

Just a quick follow-on to that. As Alex mentioned, reimbursement, he's sort of talking about insurer pushback, not the, you know, not the quoting challenges that we negotiated at the beginning of last year.

Chris Pasquale – JPMorgan

Okay. So the growth this quarter was driven by collections -- catch-up in collections from prior periods?

Alex Lukianov

Yes. The volume has been strong as well, and so overall the volume has been good the last couple of years, and it's been increasing. But we've not been able to really get a pull-through with regard to revenue from that.

Operator

Thank you. The next question is from Raj Denhoy of Jefferies. Please go ahead.

Raj Denhoy – Jefferies & Co.

Hi, good afternoon. Wonder if I can ask a little bit about the sales force. With the strong results in the last couple of quarters, has there been any changes to the complexion of the sales organization?

Alex Lukianov

Well, we've made a number of changes going into '13 with regard to leadership. We also made changes with regard to the vice presidents running things. And we've been adding, with regard to new sales directors and so forth. Everything else is effectively the same, even though we've put together, as I think we've talked about over a year ago, we put together I think some very strong incentive packages for our sales reps to outperform. Those are in place this year as well.

Raj Denhoy – Jefferies & Co.

But in terms of the actual number of sales reps in the U.S. market this year or the fourth quarter versus a year ago, has it changed dramatically?

Alex Lukianov

No, not dramatically. It's up a bit, but not dramatically.

Raj Denhoy – Jefferies & Co.

And maybe if I could just ask, you know, a follow-up in terms of the margin expansion potential, particularly on the gross margin line, I know you're citing the move to internal manufacturing, mentioned 15% now but growing over time. Do you have any sort of rough gauges in terms of how much you save on a product when you start to manufacture internally in order to sort of gape the magnitude at which you could see the gross margin expense from that over time?

Quentin Blackford

Hi, Rod, this is Quentin. Certainly I'm not going to give color with respect to the cost different down to the product level. But if you go back to our analyst day, you kind of roll that forward to today, we've talked about the opportunity being the 250-basis-point range. So as we come in to 2014, we see roughly 100 basis points of improvement in the gross margin coming primarily from the opportunity in the manufacturing space, and 250 being the longer term gives you a sense of the opportunity that's still out there.

Operator

Thank you. The next question is from David Roman of Goldman Sachs. Please go ahead.

David Roman – Goldman Sachs

Thank you. Good afternoon. Michael, I wanted just to back to your comments regarding operating leverage where you made a tremendous amount of progress. And I just -- if I look at the fourth quarter 2013 as an example, it looks like you're dropping to about 25% of every incremental dollar of sales, and that's with the headwinds of the medical device tax and the OIG year over year. Is it -- if I sort of normalize those two factors, is it fair to think about your business as 35% plus incremental operating margin business over time?

Michael Lambert

David, we will never really put out there our translational sell-through statistics to tracked and reported and monitored. The reason for that is we make investment decisions and choices around those things all the time. We actually made some of those even here in Q4, and so would have translated even stronger had we not invested a bit more in domestic sales, o-U.S. sales, Japan and in surg and training.

But I do understand your comment, and I guess I've thought about it more from a full-year perspective. If you look at 2013 on a full year basis, we come in at 49, but if you exclude those items, med device tax, the new royalty and the OIG, we actually would have been up in the mid-16, 16.6% or so, which essentially is 210 basis points of year-over-year improvement from 2012's 14.5%. And so we view that as very strong execution on the leverage story.

David Roman – Goldman Sachs

Okay, that's a nice level of perspective. And then maybe just a follow-up on the sales and marketing side. I think one of the topics that a lot of us had been monitoring is the disruption from consolidation at some of the larger players, and it actually seems not to have come up as of late, but maybe you could just talk a little bit about what benefits you might be seeing out there as it relates to the change since this integration and now that we're I think 16 to 18 months post the closing of that transaction, whether there are even more opportunities, some of the non-competes start to roll off?

Alex Lukianov

I guess the best way to think about it is what's happening with regard to market share. And most -- the companies that are larger than us really are not taking any share, and so they're losing share. They're not necessarily investing much as far as we can tell into R&D and new product rollouts. So that's not a great environment for sales reps who are really incented to put forward new products and to go deeper into accounts.

And so I think the best way to summarize it is that over the course of the last really year and a half, we've continued to attract and be able to secure some of the top reps in the business, coming really from the major players. And so that's been very consistent, keeps taking place on just about daily basis. So I think we have benefited really by the lack of those companies being able to take any significant market share, if any at all.

Operator

Thank you. The next question is from Mike Matson of Needham & Co. Please go ahead.

Mike Matson – Needham & Co.

Thanks. I know you probably can't say a whole lot about the new products that you're planning for the 2015 timeframe, but I was just wondering if you could give us some sense of whether this is some sort of a new MIS procedure or just new instruments and implants to use with existing procedures? Anything you can say, you know, about those products would be helpful.

Alex Lukianov

Sure. We can't go into a lot of detail at this point, we'd like to go through our clinical just to exactly see where we are. But effectively what it is, it's new implant systems and it's a different way of approaching the spine. And I'll kind of leave it at that. And we will be delighted to provide more color after we get through our round of clinical evaluations later this year.

Mike Matson – Needham & Co.

All right, thanks. And I was just wondering, with regard to acquisitions, are you still out there looking for acquisitions? And if so, do you see opportunities? And would these be more for scale and/or technology? Because it just doesn't seem like there's a lot of new technologies out there right on the spine market and you're already pretty big and pretty broad from a scale perspective.

Alex Lukianov

Yes. So I think that what you have to factor in is that we have a very strong organic growth machine. And we have the ability to produce products at a very robust cliff, and we can do it faster, better, cheaper than anybody else can. And so I think that we've been really leveraging that as much as possible.

We are always on the lookout for things that would make sense. I would hope that we can do some things internationally over the course of the next couple of years, things that would really be positive for us, and allow us to either increase distribution or to do things more in that general direction. But at the same time, we'd be looking for things to be accretive.

Operator

Thank you. The next question is from Matt Taylor, Barclays. Please go ahead.

Matt Taylor – Barclays

Hi. Thanks for taking the question. I guess firstly I wanted to just ask if you could help parse out your expectation in terms of the lumbar growth and how much of that is going to come from what's called new products versus legacy products or some of the ones that you launched last year versus some legacy products. I guess I'm just trying to figure out how much of the growth here is going to be affected by some of the comps next year.

Alex Lukianov

So I guess we don't give that level of detail with regard to how things are really rolling out and the impact. I think the products that we showed in the fourth quarter of last year at NAS, those are just ramping. So those will have a very positive impact on this year overall. But typically new products for us have had an impact of adding a substantial amount of additional fuel and providing anywhere from 25% to even 30% pickup on the revenue side.

Matt Taylor – Barclays

Okay, thanks. And just to follow up on the comments on the insurance perspective, I guess you said in the earlier prepared comments that you're I guess more optimistic around the health technology assessment, but you're not really forecasting any change. Do you think this is just going to take a long time to evolve in terms of something that could be more positive?

Alex Lukianov

So we know that the societies are working on it. We don't know when they're going to complete their work and put something out there. We just can't give any more information than that, to be honest with you, with regard to [indiscernible]. I would certainly expect that something would happen over the course of this year. I believe they have been working on long enough for that to be a reasonable expectation. And they have I think done a good job in, NAS and ISAS in particular, of taking on some of the more individual issues and fighting some of the insurance companies head-on for various things that have come up that frankly just don't make very much sense, whether it's on the cervical side or on the biologic side.

Operator

Thank you. The next question is from Glenn Navarro of RBC Capital. Please go ahead.

Glenn Navarro – RBC Capital

Hi guys. Good afternoon. On 2014, just on the revenue ramp, gave us some guidance regarding operating margin, how that's going to play out in 2014. Can you give us any help with respect to the revenue ramp, for example? Are there any extra selling days we should be thinking about in 2014, if that will be a 2013 -- I didn't see much seasonality throughout 2013, but is there any seasonality we should be thinking about? Just any help with how we model 2014 and the revenue ramp. And then I had a follow-up on the pipeline.

Quentin Blackford

Yes. So this is Quentin here. I think if you think about modeling 2014, I don't expect seasonality would be any different than what we've really seen over the last couple of years. So I think seasonality is going to be in line with what we experienced.

In terms of selling days, there is an extra selling day in Q1, offset by one less selling day in Q2. So for the full year the selling days are even.

Glenn Navarro – RBC Capital

Okay. And then in years past you would give us an update or your outlook for PCM. Any update on PCM revenues for 2014 in your outlook for the cervical disc space, and any update on the tracts [ph]?

Quentin Blackford

Yes. On the PCM side, the motion preservation market continues to be a difficult market to navigate through with some of the reimbursement challenges. We gave some color on PCM in 2013 as it was in its first year of launch. We came in line with those revised expectations, and at this point we won't give further color with regard to that product specifically in 2014.

With regards to the tract [ph], it continues to sit with the FDA. We worked through that process with them in terms of some of the additional testing that's been required. I anticipate not hearing anything more until the fourth quarter of this year.

Operator

Thank you. The next question is from Jeff Johnson of Robert W. Baird. Please go ahead.

Jeff Johnson – Robert W. Baird

Thanks. Good evening guys. Hey, Alex, one more question on the 2015 pipeline, I know you're not going to talk about it a whole lot at this point, but I think one point, you mentioned potentially getting into the deformity market, that's about a $400 million opportunity I believe in the U.S. market anyway that you don't have a big exposure to at this point. Is that still something you'd be looking to beta test in 2014 as you move in more formally in 2015?

Alex Lukianov

Yes, that's definitely part of the plan.

Jeff Johnson – Robert W. Baird

Okay, thank you. And Michael, maybe I'm just slow on the uptake here, I've been accused of that in the past many times, but that $9 million 2014 impact on the tax side from the global initiative, what exactly is that $9 million? I know you've used that number, you've explained a couple of times. I still don't see what the $9 million in expenses --

Michael Lambert

Let me take a shot at it, Glenn, see if I can help. So the $9 million is essentially an increase in U.S. tax expense that will happen in 2014 on higher taxable pretax U.S. income. And it is essentially generated out of two things: the transfer of intellectual property rights outside the United States so they can be exploited by our Irish and related subsidiaries, and then also in these structures you also allocate out a fair share of U.S. costs that are there in support of the o-U.S. operation. Both of those factors essentially raise our U.S. taxable income in 2014 and generate that $9 million in higher tax expense.

Jeff Johnson – Robert W. Baird

Makes sense now. Thank you.

Michael Lambert

Sure. Glad to help.

Operator

Thank you. The next question is from Larry Biegelsen of Wells Fargo. Please go ahead.

Larry Biegelsen – Wells Fargo

Good afternoon. Thanks for taking the question. Back to the 2014 guidance, I'm just trying to reconcile here the comment in the release to note the historical seasonality for quarter-on-quarter modeling, and I'm trying to understand, is that -- does that apply to Q1 2014 over Q4 of 2013? Because that would, you know, that would imply about $183 million or so in revenue in the first quarter, or down 4% sequentially like the first quarter of '13, or does it imply like the 23% or so that you typically see for the first quarter, which would apply a very big step-down in Q1? I'm trying to understand those two things.

Michael Lambert

Yes. So when we speak to seasonality, we're speaking to it more in line with Q1 and the last couple of years has been between 23.5% to 24.5% of the full-year revenue contribution. So that's the way we speak to seasonality. You know, the sequential drop from Q4 into Q1, certainly in a situation where the growth is a bit slower, you're going to feel the impacts of that seasonality sequentially through a higher degree, and that's what you're seeing reflected in the number.

Larry Biegelsen – Wells Fargo

Understood. And then my follow-up question, on the OIG, I know you said there was no update on this call, but in the past I think you said you expected an update in April of this year. Is that still the case and could you refresh on kind of what you're expecting to hear next on the OIG? Thanks.

Alex Lukianov

So I'm not sure of what the timing will be, when we do hear back from them. I think it's fair to say that it should be somewhere by the middle of the year. But we have no way to control what that's going to look like.

Operator

Thank you. We have no further questions in queue at this time. I'd like to turn the floor back over to management for any closing remarks.

Alex Lukianov

Well, thanks everybody for being on the call. We're very excited about our progress and success in 2013 and equally enthused about 2014 and our ability to take share and drive more profitability. We'll talk to you in a couple of months. Thanks everybody.

Operator

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

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