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Executives

Patrick Williams - VP, Strategy and IR

Alexis Lukianov - Chairman and CEO

Michael Lambert - EVP and CFO

Keith Valentine - President and COO

Analysts

Matt Miksic - Piper Jaffray

Robert Hopkins - Bank of America/Merrill Lynch

Matthew O’Brien - William Blair & Company

John Putnam - Capstone Investments

Bill Plovanic - Cannacord Genuity

Michael Matson - Mizuho Securities

Richard Newitter - Leerink Swan

Matthew Taylor - Barclays Capital

Larry Biegelsen - Wells Fargo Securities

David Roman - Goldman Sachs

Jason Wittes - Brean Capital

Jeff Johnson - Robert W. Baird

Dennis Keller - Cowen and Company

NuVasive, Inc. (NUVA) Q3 2012 Earnings Conference Call October 24, 2012 8:00 AM ET

Operator

Greetings and welcome to the NuVasive, Inc. Third Quarter 2012 Earnings Release Conference Call. At this time all participants are in a listen-only mode. (Operator Instructions) As a reminder this conference is being recorded.

It is now my pleasure to introduce your host Patrick Williams, Vice President of Strategy and Investor Relations for NuVasive. Thank you, Mr. Williams you may begin.

Patrick Williams

Thanks operator. Welcome to NuVasive’s third quarter 2012 earnings conference call. NuVasive’s senior management on the call today will be Alexis Lukianov, Chairman and Chief Executive Officer; Keith Valentine, President and Chief Operating Officer; and Michael Lambert, Executive Vice President and Chief Financial Officer.

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

Finally, please try to limit the number of questions from each person and keep the conference call to a manageable time that allow everyone an opportunity.

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

Alexis Lukianov

Good morning from Dallas, Texas. We are hosting this call from Dallas, home of this year's NAS conference. We will be spending the remainder of the week meeting with certain customers to reinforce that there is absolutely no substitute for the years of experience with minimally invasive solutions that NuVasive has accumulated.

Competitive product portfolios do not come close to the safety and reproducibility that surgeons achieve with our comprehensive product portfolio. Our fully integrated innovative approach to spine surgery and our procedural sophistication will drive palpable excitement at the NuVasive booth. We encourage you to stop by to experience it for yourself.

On today’s call I will address our results for the third quarter, provide updated guidance for 2012 and offer general outlook for 2013.

Revenue in the third quarter grew 12% to $148.3 million. Non-GAAP operating margin was approximately 15% in the quarter. As I mentioned a few weeks ago, revenue fell short of our expectations due to a heightened level of account churn in the limited number of U.S. regions the impact of which accelerated late in the quarter. This was a result of both aggressive competitive tactics targeting our sales force and certain customers and continue surgeon adoption of the physician owned distributorships or POD model. These dynamics had a direct impact on our U.S. lumbar business which experienced flattish sales in the third quarter but are up 5% year-to-date.

The challenges also impacted the pull-through of our U.S. biologic solutions which were roughly flat in the quarter but are up 9% year-to-date. Our U.S. cervical and international business were both very strong growing about 15% and just over 40% respectively in the quarter.

Finally, our monitoring service revenue was approximately 9.6 million in the quarter which was shy of our expectations. So, first I want to talk about sales force and aggressive competitive tactics. So, let me provide some additional perspective around the current dynamics we are facing and offer a view of the outlook for each of them.

On the sales force front, we ended the third quarter 2012 with 310 quota carrying sales representatives globally, which was down on a net basis by 15 people from the previous quarter. The third quarter marked the first time that we have ever gone backwards in terms of the net number of reps. Some of these sales rep hold large accounts which will have a material impact on revenue in the short-term. Several reps went to various smaller competitors that are utilizing aggressive tactics to poach our industry leading sales team in three of our 12 geographies. In geographies where we did not experienced churn related to sales force departures, performance in the quarter was very strong. We believe that the strategy of offering huge and guaranteed compensation to poach our reps is unsustainable and we are taking steps to curtail this competitive threats as quickly as possible.

So, what are we doing about it? Well, first, the executive team is reengaging with our sales force at a much deeper level to best attract, retain and develop the face of NuVasive in the field. We have accelerated the pace of hiring with the intent of more than compensating for losses in the third quarter. We have already made progress adding six reps since the end of the quarter with the majority of the new hires in key regions. We are currently recruiting an additional 35 representatives and are making strong progress and obtaining top talent.

We continue to envision a team of 500 representatives globally as we approach $1 billion in revenue and despite the challenges of materialized in Q3, the efficiency of our sales reps continues to make excellent progress. In the third quarter, average annualized sales per representative was about $12 million up 13% compared to the same quarter of last year. Secondly, we are increasing our legal efforts to ensure that non-compete agreements are adhere to and we are pursuing those individuals (inaudible) companies that violate them. The market will clearly understand that we will aggressively protect the investments and agreements we have made to develop our industry leading sales force.

A couple of weeks ago we announced a decision of our President of Global Sales, Jeff Rydin to make the transition from his role at NuVasive. Jeff has been a very important member of the senior executive team and we are all supporting him in his decision. I thank him for his hard work and dedication throughout the years to build our global sales force. I’m excited that Jeff has agreed to a long-term consulting position and will continue to be a member of the NuVasive family working with members of the executive team. We have already begun the search and are also evaluating internal candidates for just replacement. In the interim I will assume U.S. sales responsibilities.

As you may know I have many years of experience executing sales strategies and leading sales forces in previous roles. We have made several changes already to better retain our top performers and I’m eagerly addressing the challenges we face head on.

Moving forward all international responsibilities will be led by our newly promoted Executive Vice President of International, Russell Powers who reports to me. Russell is very well verses in all international markets from his time at Medtronic. He has several years of experience leading international sales, marketing, development and global operations in spine and orthopedics. In just three weeks Russell has already set in motion high growth initiatives along with expense reductions. I’m really thrilled to be working alongside Russell to build our international business beyond a 10% of revenue that it is today.

Now with regard to surgeons and aggressive competitive tactics, we are also experiencing an increase in existing surgeon customers being heavily pursued by smaller companies in an effort to gain their business. These surgeons are being lured away with tactics that are not necessarily based on innovative product portfolio or responsive customer service. We have dramatically increased our communication efforts over the last month. I’ve personally reached out to over 350 surgeons thus far and the entire executive team has been assigned a surgeon list. I have received very positive feedback on these efforts. This is the basis of NUVATouch an executive program designed to increase face-to-face interactions with our top 300 accounts.

The effort continues to be fully active and has being expanded upon. NUVATouch has always differentiated us and we are (inaudible) in a big way. We are also increasing our focus on driving the influence and membership of our Solus group of surgeons. Our data shows a much higher level of engagement among Solus numbers. And according to the surgeons coming to Solus meetings in record numbers it is the most meaningful group focused on advancing spine surgery through scientific exchange. Those are not my words but theirs.

We are increasing efforts through our sales force and our clinical research team to communicate the benefit of Solus and will rely on key Solus numbers to expand the organization in the U.S. and internationally.

Now let me talk about PODs. In some situations there is little we can do or even want to do to keep a surgeon who makes decisions to adopt the new business model that is not based on better clinical outcomes. Nowhere is this more evident than in the steady increase of physicians owned distributorships or PODs. We do not believe that the impact of PODs on the overall market suddenly accelerated in the third quarter. However, the impact of PODs on our business did accelerate late in the third quarter as we are roughly lost a few major customers to that model. PODs have been a negative force within the spine market for several years. We estimate that they now represent as much as 15% of the U.S. market.

They are generally setup as follows. Surgeons purchase products from medical device companies, we sell those products at a marked up price to hospitals where the surgeon perform surgery and typically prescriber use those products in the surgeries they perform to obtain profits.

It's our belief that the financial motivation of PODs can distort the marketplace for medical devices through disintermediation and stifle beneficial research and development. However, without some concerted effort by hospitals surgeon societies and government legislation it is possible that PODs will continue to be a formidable market dynamic for the foreseeable future.

We believe that by raising awareness and educating these key groups on the POD issue is a sound way to proceed. Our efforts on the legislative side have been encouraging with the speed at which things progress has been somewhat disappointing. We will continue to focus some efforts in this area but the biggest impact will likely come from the surgeons and the hospitals. We have been in contact with many of our surgeon customers to understand what steps are being taken at the society level to formulate self policing guidelines. Well there are very vocal supportive to stop PODs the likelihood of legislative guidelines in the near-term is uncertain. Thus we are now focusing our efforts largely on educating hospitals about the ethical issues at stake. We have seen some good progress here with more hospitals enacting policies that prohibit the use of PODs sourced implants. These actions appear to be quite effective and eliminating the buying of POD products and (inaudible) from joining PODs.

We operate under the presumption that better medicine is what motivates the surgical community. We focused on doing what is best to earn a surgeons trust and confidence. This will remain our measure in increasing our business and we will not enter the fray in any other manner. We will however, protect and defend the people, innovation and intellectual property that we have worked so hard to develop in pioneering procedures to provide a very best results for patients. We intend to continue building our business purely on our commitment to changed spine surgery through absolute responsiveness feet of innovation and superior clinical outcomes. We will forged ahead and fight the battle against PODs head on. We took on a similarly nebulous task in marshalling the surgical community to address insurer push back. Our experience was insurer push back, we anticipate that progress made to stem the increasing penetration of PODs will be at a measured pace and will require patience.

Now let’s talk about insurer push back more specifically. So, in terms of what we are experiencing with regard to push back, when we prerelease third quarter revenue results, I mentioned that we were hearing from surgeon customers of continued and short delays or outright denials of coverage for patients in need of any spine infusion procedures.

In September, we received unsolicited feedback about the continued prevalence of insurance payer push back at our Solus meeting and more at the SMISS meeting, Society of Minimally Invasive Spine Surgery. And we were not alone, before our prerelease call an industry report observed that conversations about payer push back were more prevalent. We have since learned that some insurers are now pushing back in spite of being challenged with the overwhelming body of evidence in support of fusion. And we have heard of insurer push back in geographies that were previously (inaudible).

It is difficult to quantify what impact if any insurer push back had on our third quarter. Let me be clear, we believe that our shortfall in the quarter was overwhelmingly driven by a account churn not reimbursement. However, we also believe that insurer push back continues to pressure U.S. growth and does not appear to be easing. We supported a surgical societies and developing the health technology assessment or HTA. It is now complete and awaiting publication.

The collection of clinical data provides evidence in support of spine infusion that surgeons and societies can use in dialogue with insurers and it is a giant step in the right direction. However, the industry needs to (inaudible) the challenge of insurer push back through broader insurer adoption of a clinically supported consistent set of guidelines for spine infusion. We will continue to do what we can to aid in the development of those guidelines but understand that grafting them is an immense undertaking then [hails] the collaboration of several surgical societies. While the process is underway it is progressing at a measured pace. A few new executives and I are actively spurring this process.

Now let’s move to guidance. As I just outlined, we are taking steps to address the challenges that impacted us in the third quarter. We have developed and implemented tactics to (inaudible) macro and company specific issues. That said our mission at NuVasive which is to change spine surgery as a $1 billion startup will not change. We transform the spine industry with innovative approaches and we will perpetually that creative start a badge with our speed of innovation, superior clinical outcomes and absolute responsiveness culture.

As we reassess our strategic plans in light on new challenges, you can be assured the decisions made will continue to reinforce our market share taking strategy. And as we work through this process we intend to set realistic expectations for our growth. The account chart related to aggressive competitive tactics and a loss of a few accounts to the POD model accelerated late in third quarter. We anticipate that the impact to the fourth quarter may be greater than what we experienced in the third quarter. We are therefore, adjusting full-year 2012 revenue guidance to 601 to $606 million compared to 625 million previously.

The account churn is having the greatest impact on our U.S. lumbar business. As a result we now anticipate U.S. lumbar growth to approximate 2% for the full-year down from about 7%. We continue to expect U.S. biologics of approximately 5% U.S. surgical growth of about 15% and international growth of about 40%.

As a reminder or monitoring business is dependent on direct billing to payers. Case volumes were growing very well and as planned but we continue to experience difficult reimbursement trends, as a result we anticipate our U.S. monitoring service revenue to approximate $40 million for the full-year versus our previous $42 million estimate. Impulses clinical execution has been outstanding, when we look forward to continued growth in our monitoring platform.

The significant decrease in revenue guidance and the abruptness of the slowdown in the third quarter will make it difficult to materially alter investment and spending decisions in the near-term. Still we have taken additional steps to ensure strong profitability translation. We now expect full-year 2012 non-GAAP operating margin to be approximately 14% down from 14.5% previously on $625 million in revenue. Let me repeat that any additional cost savings initiatives will not be related to the core drivers of our revenue growth such as sales force hiring and training and surgeon training along with Solus.

Over the long-term, our goal is to grow our top line at a double-digit rate. However, assuming the market dynamics to materialize in the third quarter persist through 2013, we anticipate mid single-digit percent revenue growth. As well exclusive of the impact of the medical device [pacts], we intend to show meaningful non-GAAP operating margin improvement over each of the next several years.

We will of course provide more detail on the outlook for our future during an analyst lunch at our NUVA East headquarters in New Jersey on November 7. The agenda will include a strategic update with further discussion of the competitive landscape, PODs and insurer push back. We will cover our future revenue growth drivers and catalyst and provide additional color on the decisions we are making to expand profitability using revised assumptions for revenue growth. There will be a surgeon panel and ample time for audience Q&A with the executive management and the surgeons. We hope to see you there.

So, now I’d like to talk about market share, taking strategies, growth catalyst and also NAS. In spite of the market challenges we face, our market share taking strategy and the spirit of innovation at NuVasive is very much alight and well. Nowhere does that ring more truly than in the buzz around the NuVasive booth at NAS this year. We are showcasing a number of key growth catalyst that will drive market penetration. The booth features a vast array of innovative solutions like our new indications specific implants for XLIF sagittal alignment, new lateral fixation options, expansions of MAS TLIF, the new maXis c-retractor for the cervical spine, and a new posterior fixation approach known as MAS TLIF. We believe that MAS TLIF will redefine the traditional posterior approach with a less invasive (inaudible) procedure for posterior pathology that requires direct decompression.

Our preset posterior fixation system simplifies procedures by offering more practical MIS or open instrumentation for even the most advanced constructs. The full launch is underway which we believe will be a substantial contributor to new account growth and deeper penetration. We also have a section of the booth dedicated to impulse monitoring and NeuroVision, demonstrating the surgeons the power of integrated neuro monitoring and the technical superiority of our many monitoring solutions. In addition, our booth will highlight our patient’s advocacy efforts dedicated to improving patient’s access to care. Better way back designed to build a community of support for individuals suffering from front and back, neck or leg pain will be featured prominently. That effort has been a tremendous success and today boast over 750 XLIF active patients ambassadors which will be more than 1,000 strong by year-end.

And spine care alliance for patients, who have exhausted the appellate process for medically indicated spine surgery, will also be highlighted. SCA has been very effective in helping to reverse fusion denials. By the end of this year, we expect our portfolio to boast over 80 innovative spine products with addressable minimally invasive and traditional procedures. Our commitment to expand our portfolio by developing more game changing products remains unchanged and will continue to distinguish NuVasive in the market. Our pipeline speaks to that commitment.

We continue to plan for eventual approval of our cervical TDR device PCF, this year however, we still do not know exactly when the FDA will give us approval. Launch of the device would mark our foray into motion preservation of the cervical spine, a very exciting segment of the MIS market still very much in its infancy. We will provide updates and general forecast once we gain clarity on the timing of this launch.

As well we continue to work for U.S. clearance of our synthetic biologic AttraX. But we have no further updates at this point. AttraX by way of reminder augment are existing portfolio of biologics solutions which we believe can compete head to head with the industry leader at a more economical price point. If all goes well with FDA and that is still a very big if AttraX could be cleared in the first quarter.

Our international opportunity remains very strong. We are now selling into Japan and should have approval to sell our XLIF implants in early 2013. We will be the clear leader in lateral procedures in this new market and anticipate strong adoption of our industry leading solutions around the globe.

Before I turn the call over to Michael, here is a quick update on our ongoing Medtronic patent litigation case. The district court still has not yet determined the royalty rates that will apply during the period of time from the verdict through the appeal. A few months ago we announced that the federal republic process for phase 1 has been put on hold until the district court has ruled on the post-verdict royalty which we expect by the end of the year. Regarding the appeal of the NeuroVision trademark case, the ninth circuit court of appeals reversed and vacated not only the original district courts judgment against us but also the injunction and the award of attorney fees and cost against us. The case has been remanded back to the district court for a new trial with a new judge and we are very optimistic that we will receive a more favorable resolution in the new trial along with removing the restricted $63 million from escrow with full access to that capital. Michael will outline our cash position and cash flow which are already very strong. We have taken a necessary steps of securing cash and incorporating the anticipated financial impacts into our guidance for these legal issues.

I will now turn it over to Michael for a further discussion of finance.

Michael Lambert

Thank you, Alex and good morning everyone. Our revenue for the third quarter 2012 was 148.4 million and 11.7% increase over the third quarter of 2011 and a 4.7% increase excluding IOM service revenue.

Year-over-year revenue growth in the third quarter for U.S. lumbar was flat with year-to-date growth of approximately 5%. U.S. biologics growth was roughly flat and year-to-date was up approximately 9%. U.S. cervical revenue grew about 12% and is up 16% year-to-date. The services revenue from our impulse monitoring business was 9.6 million and was 29.3 million year-to-date. Finally, international revenue including its biologics component grew over 45% just over 14 million with year-to-date growth of approximately 40%.

My number today reflect the reclassification of approximately 1.2 million of revenue which was classified in the second quarter as either U.S. lumbar or U.S. cervical revenue instead of as U.S. biologics revenue. Correcting this item affects only the bucketing of our revenues and does not impact our historical overall revenue results for Q2 nor does it significantly impact the historical growth rates that we have reported for our U.S. lumbar, U.S. cervical or U.S. biologics product offerings. All of this detail is provided for your reference in the supplementary financial information posted on our website in the investor relation section.

Our Q3 2012 GAAP net income was 2.4 million or earnings per share were $0.05. Excluding an aggregate adjustment of approximately 7.7 million net of tax for the adjustments detailed in our press release, third quarter non-GAAP earnings were approximately 10.1 million or $0.23 per share.

Gross margin in the third quarter was 74.6 million compared to 80.4% in Q3 2011 and 76.3% in Q2 2012. Year-over-year gross margin was primarily impacted by patent litigation royalty expense which drove 130 basis points of net impact and by the acquisition of impulse monitoring which drove 320 basis point of net impact. Most of the remaining gross margin delta was driven by international mix which has a lower gross margin then the rest of the business. Hospital pricing pressure was immaterial in the quarter.

Research and development or R&D expenses adjusted to exclude stock based compensation and acquisition related items totaled 7.4 million in Q3 2012 compared to 9.2 million in Q3 2011 and 8.7 million in Q2 2012. R&D expense as adjusted was 5% of revenue for the Q3 2012 versus 6.9% in Q3 2011 and 5.6% in Q2 2012.

Relative to last year the decrease in R&D as a percent of revenue was caused by the addition of impulse revenue which comes with the lighter R&D component to it and lower spending on clinical trials, FDA approvals and studies.

We continue to invest in our product pipeline through 510(k) applicable products. Sales, marketing and administrative or SM&A expenses adjusted to exclude stock based compensation, certain intellectual property litigation expenses and acquisition related items totaled 81.1 million in Q3 2012 compared to 75.3 million in Q3 2011 and 84.1 million in Q2 2012.

SM&A expense as a percent of revenue was 54.6 million in Q3 2012 versus 56.6% in Q3 2011 and 54.5% in Q2 2012. The year-over-year decrease in SM&A as a percent of revenue is primarily attributable to the addition of impulse which has a less intensive SM&A structure than the rest of NuVasive. On an absolute dollar basis the year-over-year growth in SM&A expense is primarily attributable to headcount and related compensation increases, continued international expansion and the addition of impulse.

As a result of the above mentioned gross margin, R&D and SM&A results, our third quarter non-GAAP operating margin was 15% compared to 16.8% in Q2 2011 when you exclude the 101.2 million litigation award expense and 16.3% in Q2 2012. Compared to Q3 last year, Q3 2012 results include a full quarter of impact from both the patent litigation royalty expense and from the impulse acquisition. Normalizing for the impact of these two items, Q3 2012 non-GAAP operating margin would have been 17.5% or in line with a similarly normalized view of Q3 2011.

Interest and other expense net totaled 6.4 million in the quarter compared to 5.3 million in Q3 2011 and 7.3 million in Q2 2012. For the third quarter, cash provided by operating activities came in at 33.7 million bringing us to nearly 100 million year-to-date. Excluding the refund received from Q4 overpayment made to a taxing authority, the year-to-date number is just over 88 million. A comparable year-to-date free cash flow number similarly excluding the Q4 overpayment is roughly 53 million. We are pleased to see this improving performance given our teams continued focus on enhancing our cash generation capabilities. We clearly continue to make progress.

Our cash and investments balance at the end of the third quarter was approximately 285 million which is up nearly 20 million from last quarter and up 56 million from the end of last year when normalized for the cash restriction associated with the patent litigation royalty. Our current cash and investment totals excludes approximately 175 million now restricted for the patent litigation royalty and for the NeuroVision trademark case.

At the end of Q3 2012, our inventory position was roughly 22% of annualized third quarter revenue compared to about 23% at the end of Q3 2011 and roughly 21% at the end of Q2 2012. Days sales outstanding, or DSO when run off of our net AR balance was 47 days in the quarter compared to 51 days for last year's Q3 and 50 days at the end of Q2 2012. The AR team posted another solid quarter of cash collections which helped us improve DSO year-over-year even in spite of approximately 1.5 days worth of upward DSO pressure due to the addition of impulse and outsized growth of our international revenues that generally have longer collection cycles.

Now let me turn to our updated guidance for the full-year 2012, please reference the tables in today’s press release for additional detail. As Alex mentioned we are updating full-year 2012 revenue guidance to a range of approximately 601 to 606 million. Our efforts will take time to materialize and is likely to be more meaningful to 2013 and beyond.

We anticipate that the main driver of our future profitability improvements will be SM&A leverage. Full-year 2012 other income and expense guidance is unchanged at approximately 27 million which will include about 12.5 million in non-cash interest expense. In view of lower expectations for pretax income we now anticipate a full-year 2012 GAAP effective tax rate of approximately 60% compared to 55% previously. We generally expect our effective tax rate to improve some in future years as our pretax income increases. However, more significant progress will be dependent on international revenues becoming a more meaningful percentage of our total revenue mix. Non-GAAP adjustments continued to be tax affected or approximately 40% for the follow-up 2012.

Diluted shares outstanding for the full-year 2012 remain at approximately 45 million and finally we now estimate full-year 2012 GAAP EPS to be approximately $0.11 to $0.13 and non-GAAP EPS to be approximately $0.88 to $0.90.

As a reminder non-GAAP operating margin and EPS guidance for 2012 excludes the full-year impacts of non-cash stock-based compensation of approximately 27 million compared to 32 million previously. Certain intellectual property, litigation expenses of 3 million compared to 2.5 million previously, amortization of intangible assets of approximately 12 million, acquisition related items of approximately 2 million and as incurred additional items and non-cash interest expense associated with the convertible notes of approximately 12.5 million. We feel this non-GAAP EPS measure generally speaking most accurately portrays the operating earnings power of NuVasive and should be the basis for measuring our progress.

We plan to issue guidance for a full-year 2013 in conjunction with our Q4 2012 earnings announcement. As Alex mentioned we are taking less steps we can to bolster our market share, taking strategy and to drive double-digit top line growth with meaningful improvements in profitability for longer term.

In light of current market challenges, however, we envisioned top line growth in the mid single-digit range for 2013. We are working to close our 2013 budget during Q4 and we will get our arms around what changes need to be made to ensure that we improve execution in 2013 despite the difficult environment.

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

Alexis Lukianov

Thanks Michael. We are making changes in the face of adversity. Account churn is not the biggest challenge NuVasive has ever faced. We have overcome much more difficult obstacles and we intend to do so again.

Look we developed and pioneered XLIF, years ago it was ridiculed for a lack of data, now there are nearly 100 publications and over 30 book chapters on XLIF. We developed Solus, which boast over 600 active members, that didn’t happen serendipitously. It was strategy and tactical execution and we overcame the obstacle. When payers stepped out against XLIF just a few years ago what happened, expert said we will be dead in the water for at least 12 to 18 months. We marshaled our resources, drove laser focus and worked with societies. In a matter of three months it was resolved and payers retracted their XLIF denials. We overcame the obstacle.

NuVasive filled the void for surgeon training in the spine industry without which we would not have been able to proliferate XLIF. We established world class training on the west and east coast to provide the only in house program for nearly the past decade. Why? Because there wasn’t a comprehensive course in an operating room done with any consistency or frequency among the societies or surgeons. The result is what surgeons call the best one-on-one training they have ever received in a one day intensive program.

We have overcome more obstacles than I have time to recount, and most importantly we have and will continue to change spine surgery. We developed MAS TLIF which completely rethought an ages old procedure, now we are launching MAS PLIF and precept for percutaneous or open posterior fixation. We are approaching hospitals with procedurally integrated monitoring for the lumbar, thoracic and cervical spine. We are changing the game in spine and we are still just getting started. We have learned from the past and we will take those lessons to overcome a very challenging spine market. We are driving change and I have no doubt that we have the management teams to make it happen.

We talk a lot about our culture at NuVasive. Our culture is built upon the strength of character upon belief and the ability to overcome obstacles which is predicated upon our many successes in doing so and upon a burning desire to make the difference by consistently changing spine surgery to benefit patients. This is our purple koolaid and we drink it every day. And this is why we will again prevail and achieve our $1 billion startup goal.

Our plan in the fourth quarter and into 2013 is to reestablish sales momentum by adding more new businesses than we have lost in three of 12 U.S. regions. For other than only focus on the three regions, we have implemented changes across the country.

In summary, here is the plan to address our third quarter challenges. Number one, sales force engagement and deeper penetration. Number two, significantly accelerate the pace of sales force hiring. And number three, reinvigorate and expand NUVATouch along with Solus expansion.

In terms of number one, we are implementing new initiatives for greater sales force interaction with our exceptional leadership team. We are rolling out improved mobile resources to simplify the reps jobs and putting together new asset management programs. We are providing additional incentives to gain new accounts and so more mix into existing accounts. All fully underway for broader sales force engagement and deeper penetration.

Factor number two, significantly accelerate the pace of sales force hiring. We are actively recruiting top talent and have immediately opened the path for 35 new reps to join NuVasive. Interest is very high including among key competitive reps, also fully underway.

Three, we invigorate and expand NUVATouch along with Solus, increased executive engagement with our top 300 customers and emphasize what most differentiates Nuva which is personal involvement and interaction between us and our surgeons. It also means more surgeons being recruited to the Nuva family. We are expanding the reach of Solus and the membership to beyond the current 600 active numbers again this too is underway.

Looking onward and upward, we anticipate the following five main catalyst will drive our growth. One, the continued spine market shift from open procedures toward MIS procedures. Two, the increasing and overwhelmingly significant body of clinical data generated by Solus and support of XLIF including thoracic and other integrated procedures, patient’s outcomes and economic advantages. Three, the adoption of our new game changing solutions, like MAS PLIS, precept impulse monitoring, PCM and AttraX as well as deeper penetration in scoliosis, tumor and trauma. Four, the massive opportunity outside of the United States both the new markets like Japan and Italy and existing markets like Australia and Puerto Rico where we are driving towards market share leadership. And lastly, five, a commitment to rapid growth and a challenging market with meaningful year-over-year improvement in profitability.

We fully expect to deliver on our plans to build more accounts and deeper penetration with our existing customers and sales force. And we are very excited about the many catalyst driving growth with disciplined focus on profitability. We thank you for your support and patience. We will now take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is coming from the line of Matt Miksic with Piper Jaffray. Please state your question.

Matt Miksic - Piper Jaffray

Just one follow-up, the one, Alex I guess on the top line expectations to the back half of the year and [pile of] accounts for next year. As we look at that, what is that assuming in terms of further impact from PODs?

Alexis Lukianov

So, as far as PODs are concerned we expect to see some continued erosion in the entire market, but we expect to add more accounts than we could potentially be losing. We don't know of any additional accounts that we might lose, so our focus is on building stronger relationships with our existing base and expanding rapidly. As you know from our discussions a few weeks ago we said that the annualized impact of what took place in the third quarter in terms of poaching was between 15 and $25 million on an annualized basis. So, that’s what we are taking into account with regard to our guidance assuming relatively worst case scenario and moving from there.

Matt Miksic - Piper Jaffray

But just to be clear if I’m hearing you correct whatever further impact there is going to be you expect to be able to offset that (inaudible).

Alexis Lukianov

Exactly right.

Matt Miksic - Piper Jaffray

And then question for Mike. I think the impact on the bottom-line you talked about some of the cost cutting or cost control measures you put in place. I was little surprised that the drop was not more significant for the fourth quarter. Maybe you could I know you are not getting 2013 guidance here but talk about inability of some of the operating margin level given when you lose the top line revenue and it's like profitable and it doesn’t sound like you are pulling back on your SG&A and your sales force and customer spacing expense. So I guess the question is how do you sustain that kind of debt down and still maintain the same kind of margin trajectory.

Michael Lambert

Let me talk a little bit about Q4, so Q4 we do expect to be down sequentially. It will be down in a 13 somewhere given year-to-date was sitting at 14.3% and what’s going on underneath that is Q4 will be down on a lower gross margin. We have got couple of things going on there. International mix swing in a bit more heavily because the weaknesses mostly domestic there will be a lower impulse gross margin given both Q3 and Q4 FX in that business which is essentially fixed cost in the cost of goods sold arena. So, not a lot of variable cost and leverage with any change.

On the OpEx side we are making a few investments as Alex alluded to incremental sales heads and we will continue to build and drive out OUS especially Japan with the ramp in sales and marketing there. And we do expect a little bit higher legal spend in Q4. And so those are really the drivers on the change as you move from Q3 to Q4. If you think about the guidance old to new, essentially down 50 basis points and that’s really coming out of gross margin. It's really essentially a flat OpEx at about 61% which implies a substantial amount of OpEx reduction has moved out of the P&L. Some of that of course is variable costs, freight and commissions things like that, but there is also a lot of active management, things like headcount, T&E, bad debt expense with the improvements in DSO and some adjustments to performance based comp. So, those are all the moving parts, I will get you the color you are looking for.

Operator

Our next question is coming from the line of Robert Hopkins with Bank of America/Merrill Lynch. Please state your question.

Robert Hopkins - Bank of America/Merrill Lynch

First very quickly for Michael, when you kind of think about all the things you guys have just articulated do you think you can grow adjusted EPS in 2013 off of this $0.88 to $0.90 basis. Can you think about all of the moving pats including the tax and net of tax?

Michael Lambert

Certainly, when you think about Med device tax everything we will talk about will be ex-Med device tax I think, but 2013 guidance relate we will provide on the Q4 call.

Robert Hopkins - Bank of America/Merrill Lynch

But just generally, do you think you can grow including the Medtech tax off of 88, $0.90 or not?

Michael Lambert

In the overall scheme of things there is, we would expect it to be able to improve. Think about some of those moving parts will get rid of the March 2013 converts which will save a little bit on interest expense and then with improvements operationally the answer should be okay.

Robert Hopkins - Bank of America/Merrill Lynch

And then just for Alex, I appreciate all your commentary and explanations, if you just sort of take a step back and look at the numbers and what we are seeing from some of your competitors, J&J is not putting up great spine number but they didn’t get worse in Q3 and Medtronic looks like they are getting a little bit better and Stryker it looks like it's getting little bit better and you guys are getting a little bit worse. So, my question is how confident are you that what’s going on with your business right now is just from share loss to the bigger competitors as they start to pay more attention to spine?

Alexis Lukianov

Yes, it is absolutely not share loss to the biggest competitors and I will tell you that in terms of the new reps that we are hiring that’s exactly where they are coming from and we have hired quite a few this year overall and they are coming from the major players. So, I think as you kind of framed where we are on the quarter essentially we were down $5.5 million over our own expected outcome. And so I think as you consider the fact that across the United States, for example, the western half of the United States performed actually to quota which is higher certainly than internal budgets and so forth. Where we had weakness was actually in just three regions more in the mid south, mid Atlantic part of the country. And so I think what we are seeing clearly is a bigger impact from smaller competitors, we are doing our best to isolate that, we are doing our best to move forward with adding additional accounts in the event that we get broad sided again, but clearly I can tell you that it is not going in the direction of larger players. That I’m certain of and I believe that our growth thesis is still very much intact longer term. Right now we just need to be very cautious with regard to what we are at and so that’s the position that we are taking.

Operator

Our next question is coming from the line of Matthew O’Brien with William Blair. Please state your question.

Matthew O’Brien - William Blair & Company

I was just hoping that you can provide a little bit more color around Japan in 2013. I know you got an approval for some products at this point but help us think about how the revenue outlook will look in that region with and without XLIF products next year.

Alexis Lukianov

We are assuming right now is generally in the $10 million range for revenue next year predicated upon an early launch of XLIF first part of the quarter literally January. We expect that to grow at a robust pace for the next several years.

Matthew O’Brien - William Blair & Company

Here is a follow-up question with a lot of numbers to it. As I think about the revenue guidance for next year, call it about 600 million in revenue this year growing at about 5% that’s about $30 million in absolute next year when you layer in Japan as well as existing internationally. As well as cervical strength that’s something around 23, 24 million bucks, then you add in AttraX and PCM and maybe that’s something around 4 million bucks on top of that. All these new reps, is using something like 5% growth rate a little bit too conservative or something else that I’m missing where using that mid single-digit number like 5% will help biologics business. Is that accurate?

Alexis Lukianov

Generally speaking yes, but again we will give this some exact guidance on our next call.

Operator

Our next question is coming from the line of John Putnam with Capstone Investments. Please state your question.

John Putnam - Capstone Investments

Two questions, Alex the POD activity, where is it picked up, is it the east coast really that’s picked up?

Alexis Lukianov

It's actually southeast and Atlantic regions where we have seen the pickups in activity. The PODs came out of the west coast essentially. And so even though they have been there for quite some time they are somewhat stagnating with regard to their development out there. And I think that’s why we saw strong performance on the west coast, so we are optimistic about overcoming what’s been taking place in our market and been very forthright with regard to where we’ve had the sensitivities with regard to revenue performance.

John Putnam - Capstone Investments

And have you seen any hospitals who may have used PODs before now rejecting them and going back to direct distribution?

Alexis Lukianov

Yes absolutely, we have seen quite a few. I’m hesitant to name them, but I can tell you that there is quite a few on the west coast. There is also a large buying group which is also bands PODs and has that in writing in their documents.

John Putnam - Capstone Investments

And then just out of sales side, have you done any tweaking of the compensation situation for sales people to try to either retain them or attract new people?

Alexis Lukianov

Our compensation is strong it's not much different than what everybody else is paying, but we have provided and added incentives for new account growth and for next year we are in the process of redoing our compensation in order to further the growth opportunities with our sales force. So, right now we have put into motion a number of different things. We did that immediately starting into the fourth quarter, and we plan to make some additional positive changes as we move into ‘13 and ‘14 which we think will help us to recruit faster and also further solidify our sales force base.

Operator

Our next question is coming from the line of Bill Plovanic with Cannacord Genuity. Please state your question.

Bill Plovanic - Cannacord Genuity

I just have one question and this is, you are a smaller company at 5% at the lumbar market and you are growing, it was obviously a much easier task. As you become a bigger player 10 to 15% of lumbar market, obviously that becomes a much more challenging task. And you also become a target from the smaller players to take your sales reps. So, you say as we continue to try to grow the business. You are going to run into (inaudible) one is the smaller companies are going to continue to fill for your reps and two, as you have a bigger pieces of market, it becomes that much more challenging. How do you overcome those details as you continue to march forward toward that $1 billion revenue goal?

Alexis Lukianov

I think the way that I described for Q4 you overcome them by having better differentiation not only in products but in services and in engagement and all the things that I have talked about just now with John relative to compensation. So, I believe that there is a lot of things you can do about that. Look, it's not like we haven’t had competitions since day one, I mean when we started out we were just looking at the big gorillas out there and doing our best to be able to come through with products. Now we are on the other side of that and we believe that we can still grow very effectively for years to come with the approach that we have taken and I think the proof is going to be in the putting obviously. But we feel very confident that we have established the right strategy, reinforced the right aspects of it. And frankly made a series of deletions of things that we think are less effective. So, unclutering and clarifying our position and expectations of the sales force is as important as anything we might possibly do. And so we have done all of those things and we will do more of them as we move into ’13. But we think we have done what we need to do for Q4 growth and we expect to do a lot more with regard to ’14 and ’15.

I want to clarify though that we continue to get top talent moving in our direction. I don't want to name specific companies with regard to how much of that talent has come from where, but I can tell you we are getting very much the top performers who want to come to NuVasive, because they want the full bag of all the things that we have and they are very much aware of how many other new products we are going to launch. The big advantage that we have, we are not copy cats, we don't sit there and just produce the whole bunch of stuff the same as everybody else. We are pioneers and we are putting forward new platforms. The surgeons respect that and certainly our sales reps respect that and want to be a part of that growth.

Bill Plovanic - Cannacord Genuity

One of the comments you made was the rep compensation then pulled on to those reps, but it creates a circular challenge in that if you have to keep direct compensation high, it keeps your operating expenses high and you can’t get that leverage in the model in the future.

Alexis Lukianov

To be clear, Bill, what’s happening is that when somebody poaches a rep, in at least in some of the instances, what they have done is they have put forward but we think it's outrageous compensation to attract that person for let say a year. There are numbers out there like $800,000 for a rep. We have no intention of competing with that, we think it's absurd and is unsustainable, and we understand that that’s part of their poaching process, but companies doing that are going to find themselves in a very difficult position with regard to cash. So, what we are doing is we are making sure that we have comparable incentive programs for our sales force and then doing the kind of things on top of that it's for growth with adding accounts and set sales and things of that nature.

Operator

Our next question is coming from the line of Michael Matson with Mizuho Securities. Please state your question.

Michael Matson - Mizuho Securities

Question for Michael, just regarding where you are kind of focusing your cost control efforts because just looking at what happened or what you are guiding for the remainder of the year. R&D it looks like its getting hit maybe a little disproportionately relative to sales and marketing. And just maybe walk me through your thinking in terms of your balancing areas of what you are looking to spending. What gives you the confidence that the R&D is only the right area to be little more aggressive? If that’s the case.

Michael Lambert

Couple of thoughts, I mean part of the R&D reductions over the last 12 to 18 months have been things like clinical trials ended or ending right. And so that’s been a significant contributor to the change in expense to revenue ratio there. It's not the place that we want to really look for long-term improvements in OpEx management, in fact we do expect it to sort of flatten and maybe rise a little bit going forward. Which really leaves us with SM&A and I mentioned that in the script but that will be the focus for us. Alex mentioned the productivity of the sales force and through that naturally increasing productivity which has continued to go up we certainly do get some leverage. We are slowing and have already substantially slowed the growth in non-sales headcount that brings with it both salary, benefit, savings as well as T&E and other things and we are doing that through things like automation and some of the productivity focus we have talked about in the past where we have done some of our major contracts, freight and areas like that.

We have also done a pretty good job actually and will continue this activity in-sourcing some activities that were buy before make (inaudible). And by bringing those things in-house we are saving money and then we are looking at all of our old habits that we built up as a company over the last 5 to 10 years and changing a lot of those spending habits whether it's on company meetings and events or promotional materials and things like that. We are navigating those. In fact if you go people will come see the booth at NAS, you will that the booth size a year ago was shrunk down significantly which generated savings, I think it's the same size roughly this year give or take, but it's really crawling through all of those different pockets of the company to make sure that we are scrutinizing all the decisions and choices that get made in order to make sure where what recent profit outward we can. And as we mentioned on the call we do expect to deliver a meaningful operating margin improvement even in light of or in spite of the slower revenue growth and really trying to stay focused on the most important things which is driving investments in our core areas, innovation and clinical outcomes.

Michael Matson - Mizuho Securities

One additional question on the mid single-digit, rough guidance for next year for revenue growth. What are assumptions around PCM and AttraX does that include those products or not?

Alexis Lukianov

At this point it does not.

Operator

Our next question is coming from the line of Richard Newitter with Leerink Swan. Please state your question.

Richard Newitter - Leerink Swan

Alex, I just wanted to ask it sounds like one of the growth catalyst or the steps to improvement is going to be a focus on innovation and you are going to be exhibiting some of the innovation at your NAS booth from today over the next few days. Compared to where you were several years ago or even a decade ago, with respect to lateral and how you and truly difference, that products category was, can you maybe tell us the level of revolutionary of products we will be seeing in NAS and whether they can inspect to solicit the similar breadth of modeling, so that people could gain increased confidence that newer products still do have the potential to win over?

Alexis Lukianov

So one other things first of all with regard to XLIF is that, XLIF is going to continue to grow at a good cliff and there is a number of reasons for that. (inaudible) so, that means that there is still a lot of growth for XLIF obviously the same of moving into the thoracic spine. With lateral type of approaches single incision type of approaches and then of course doing a lot more with trauma, tumor and scoliosis. As far as new products are concerned we really believe and this is based upon surgeon feedback obviously. What we believe that MAS PLIF is one of the best systems that has been released in a long time. In solving a lot of what are really the challenges of a very old procedure. And so the surgeon adoption has been very strong. One of the ways you can measure surgeon adoption is kind of what we call (inaudible), meaning they do want the surgery and that’s it, they are not interested in doing anymore or do you have a situation where they adopt and do additional cases.

What we have seen consistently with all of the training that we have done on MAS PLIF is people doing the first case, really liking it and of course after they get the training at our cadaver facility, and then booking additional cases. So we feel that we have a whole host of some significant products that really I think differentiate us in terms of our scope. Precept is another example, I think if you ask surgeon that has used percept they will tell you it's the best instrumentation that they have seen on the market, it's the simplest, they love it and works for percutaneous which is MIS as well as it works for open procedures. So, without writing through the whole list of products again, they are all going to be on display at the booth. I think we have clearly a very strong armamentarium that a lot of surgeon still don't know about because it's been launching in small pieces over the last few months. So, I think you are just going to see a continued process of both revolution and evolution of products and procedures from us.

Richard Newitter - Leerink Swan

It sounds like just generally the market at some level is telling industry where to use the level of importance of the amount of money hospital or physician wants to spend on a given level of service or innovation. And maybe a product or a new product is perceived as more innovative. The question is benefit out way the cost and by physician growing the PODs and some of those, that’s the market telling you that it's not important enough.

Alexis Lukianov

I probably disagree with that in terms of the PODs. I think the PODs are being caused by reimbursement pressure on the surgeon and I think there has been some very well known surgeons who got up at various number of meetings and saying, this is our last chance to make some real money here. Those are sad statements, and I think that the POD model has nothing to do with service and providing products. It has to do with essentially becoming the new intermediary without any focus on innovation without absorbing any of the expense associated with what it takes to move the products forward. So, to me it's really a poor model, I think it's being driven to some degree out of all the pressure that the surgeons feel.

Operator

Our next question is coming from the line of Matthew Taylor with Barclays. Please state your question.

Matthew Taylor - Barclays Capital

My first question is you said on lot of conference that you are going to gain some new accounts here. I’m wondering if that’s because.

Alexis Lukianov

We already have.

Matthew Taylor - Barclays Capital

Can you help me with the source of that, I mean how many new accounts coming with the reps you hired from some of these large competitors or are you now identifying new surgeons and haven’t (inaudible) or surgeons coming back. So, any color around the confident that you have in these new accounts will be helpful.

Alexis Lukianov

It's a combination of all of those things. We had some surgeons that over the years have gone to smaller players and now we are quite unhappy with the way that things have gone for them and so I guess in sort of a simplified manner, they are in play, meaning that they are more than willing to consider coming back and working with another company. And so I think it's important for us to be able to do the best to do what we can to recruit them. But at the same time we are not going to do it the way some of the other companies have done it in a relative pay for play approach and some have utilized. We are not doing that and so our approach is different. We continue to build on the basis of our creditability, sound ethics, our products and so forth. And that attracts a lot more people than you might realize. I think there is obviously bad apples out there and bad actors, but the majority of people are very straight forward (inaudible) easy to work with them. So, if you look at the reps that are coming they are coming from a number of larger companies, we do get occasionally some from smaller but for the most part coming from larger companies and even though we don't expect them to drag business across like flick of a mouse, but clearly they have an impact quickly and they are able to start to obtain sales faster than perhaps somebody without any experience. So, it's in across the broad process, it's working well for us in all areas of recruiting additional sales people as well as attracting surgeons.

Matthew Taylor - Barclays Capital

You talked a couple of times on the call that how your competition is relative comparable to lot of the large players and 800 grand is the number that smaller players have used to drop them away. Can you just help us in terms of what the median or the range or the high end of your compensation is in terms of we are getting in comparing that differs.

Alexis Lukianov

I mean, the normal compensation for rep is approximately 10% in terms of commission. We have incentives for our reps to exceed 10%, we always have that’s always been part of our model and what we are trying to do now is to not just apply a straight forward simple, you get an added commission. What we are doing is to make sure that it's tied into getting new business, it's tied into further penetration which means selling more mix and so our compensation the variable piece which is driven by over performance. I think is very attractive to the reps and it's been our model for quite some time, we don't expect changing it, but we do expect making a number of quality as well as quantity changes with regard to how we are approaching it in ’13. But the sum of it is we have very attractive compensation which allows us to compete with both small and large companies. And if you look at (inaudible) for example, which is now of course combined with the few, they have for year's had 10% and higher commission rates with very stable businesses.

Operator

Our next question is coming from the line of Larry Biegelsen with Wells Fargo Securities. Please state your question.

Larry Biegelsen - Wells Fargo Securities

Alex can you talk about the Paradigm coflex and the potential impact that might have on fusion procedures there. The data looks impressive.

Keith Valentine

I think that there are recent approval and also the way they approach the clinical study is going to give them a leg up probably on two fronts from a decompressive perspective, because they are going to be a head of the reimbursement curve with how they manage that study. So, I fully think that they are going to have an expanded indication, that’s really going to expand spine procedures themselves, because it's a decompressive procedure and I think they are going to have a pretty wide influence on age of patient as well. So, I think it's going to be a good thing for all of us.

Larry Biegelsen - Wells Fargo Securities

Alex, could you talk a little bit about neuro monitoring reimbursement issues you touched upon. I think your original guidance is 45 million, now it's 40. What’s going on there and what’s changed since the impulse acquisition and what’s the outlook there.

Alexis Lukianov

It's really not a reimbursement issue per se, in fact reimbursement is strong as more of a collections issues. That’s the primary one that we are facing. So, overall I think in terms of payment, in those areas the payment is actually gone up and we have seen that effectively move across various regions. Of course it's mostly setup on the east coast, so it has a pretty small footprint and we are in the process of expanding that. So, I think as I talked about on my call we are happy with the case volumes, but we are really working through collection type challenges and that’s been one of the most challenging aspects of this. There is kind of more to this in terms of the fact that what we are reporting is pure monitoring service. And that’s the way that we should be doing it. There is also quite a few disposables that get sold that are not part of that number that are completely associated with that case and the same thing with NeuroVision cases. So, that number is actually a bit higher and we are satisfied with that. Then if you look at the pure service side. We do expect it to grow moving into next year, consistent with how the rest of the company is growing if not even faster than that. And I think as we move into ’13 what you will see is much more integration from us into the sales force.

Operator

(Operator Instructions) Our next question is coming from the line of David Roman with Goldman Sachs. Please state your question.

David Roman - Goldman Sachs

In your prepared remarks Michael, you talked about R&D as a percentage of revenue coming down given the relative component of impulse and I think this is sort of touched on earlier but the absolute dollar number came down materially both sequentially and year-over-year. How do we think about the pacing of R&D going forward? And maybe Alex you can put that into context of the growth drivers, is it really sales force that’s going to push us offline or is it new products. And is that skew now becoming more about marketing then it is about technology?

Alexis Lukianov

It really has to do with both, it has to do with new technology in terms of our growth and we need to have a very strong pipeline as well as I think more aggressive let’s say tactics. But highly ethical tactics with regard to what we are doing. So, one thing I want to just comment on before Michael answers, is that you have to look at what’s changed for us over the last couple of years in terms of R&D. Are we looking right now to spend big money on PMAs. The FDA uncertainty is so great surrounding those that is very hard for us to justify tens of millions of dollars into a product that they may not see the light of day for 10 years. I mean look at how long things have gone on with PCM for example. Many manufacturers have experienced the same thing. So, what you are really seeing is not a deceleration with regard to R&D spending. What you are seeing is much more of an emphasis on 510(k) products. 510(k) products are generally much less expensive obviously than a full fledged clinical trial. And so what we can do with the large number of 510(k) is very effective in the way of launching more products quickly.

Michael Lambert

If you look at it year-over-year on (inaudible) percentage of revenue was down 190 basis points. Couple of things going on under there and you alluded to one or two of them, certainly the neo disk (inaudible) w as a contributor for us also, XLTDR as a clinical trial has essentially completed in terms of the surgeries. I mean those obviously are significant contributors to that 190 basis point reduction. Impulse also makes contribution, I think as you alluded to, and then the other thing going on is for some time we will talk about this, we have been investing in various studies to build the clinical data set on the biologics front with (inaudible). And as it happens this year some number of those studies have essentially begun wind down and so through that process there has been incremental reduction that you saw in the numbers. We do expect it to start to tick back up in absolute dollar terms and you probably start to see that in Q4 and some of that is some projects kicking in and a little bit of headcount and headcount related to. But I think the point to live with on it is PMA dollars down certainly as we mentioned on the wait and see attitude with the FDA and continuing with 510(k) applicable products the whole idea there is to continue to build the product portfolio through innovation in this case less expensive innovation and continuing investing data that will provide superior clinical outcomes.

David Roman - Goldman Sachs

Can you maybe talk about next year how we should think about cash dynamics, I think you have a convert to and also have an FX just non-GAAP profile from an interest adjustment perspective?

Michael Lambert

When you think about cash flow, I think the way to think about it and we will sort out whether we speak to it more formally on the Q4 call, but you can take our P&L and convert it by a cash flow proxy to an EBITDA SBC dollar and margin item and then it's a relatively straight forward adjustments to look at the balance sheet items. So, working capital CapEx, equity proceeds and the like. I think you guys can get relatively close to it from a cash flow perspective operating and free cash flow. Now as I said we will sort out after we talk at more length about targets as we head into 2013, but we are obviously pleased with the performance and improvements that we are seeing both operating cash flow wise almost a 100 million now through 9 months and free cash flow wise over 50 million, that is a significant change to the trajectory from just a year or two ago.

Operator

Our next question is coming from the line of Jason Wittes with Brean Capital. Please state your question.

Jason Wittes - Brean Capital

Just a quick follow-up on impulse monitoring. In terms of collections, is that limiting the number of procedures that you are allowed to collect for or is it simply just the hospitals taking their timing and reimbursing for these procedures?

Alexis Lukianov

It's mostly the latter.

Jason Wittes - Brean Capital

And related to that your outlook for market growth, as well as pull through for other products and lumbar, has that changed and specifically on the pull through it sounds to me like you really haven’t done enough integration to see it yet, is that a fair characterization?

Alexis Lukianov

Yes, I think that’s exactly right, I think we are behind on the integration process. We wanted to make sure that we stabilized impulse very well, we have done that and so now what we are trying to get our arms around is the fastest mode to integration. It's actually one of the things that I have Jeff Rydin working on together with our head of the IMI and IOS group is putting together the integration with the rest of our company on the practical side on the sales side and then of course to maintain clarity with what to expect on the clinical side. So, what I’m saying is that as we move into next year we expect to start to see more pull through and more of a bigger footprint as we expand that model throughout the U.S.

Operator

Our next question is coming from the line of Jeff Johnson with Robert W. Baird. Please state your question.

Jeff Johnson - Robert W. Baird

Alex just a question on some of the surgeon losses in that. Anecdotally talked about a couple of spine sales reps here recently. It sounds like some of these guys thought they were going to get new accounts, now these are newer reps, but some other companies thought they were going to get some new accounts, but the hospitals are actually shut them out, signing some long-term deals with other companies. So I’m wondering how much of your surgeon losses here recently or the surgeon taking this decision how much may be hospitals making decisions going to some of the larger players on longer term deals?

Alexis Lukianov

I think it's largely the surgeons making the decision and I think that in a couple of cases and this is really only happened in about 3, but they were good sized accounts was that the surgeon and the rep ultimately we don't know which was the chicken or the egg but we do believe that it was surgeons. And so that’s really what we have seen but if something happened in the small number but it's been impactful because it starts to accumulate as you look at the impact of doing that in a several areas to more like the 15 to $25 million impact that we spoke of. But we feel that we are very effectively adding new accounts, we have done that, we are literally this week. So, we believe that we can fully mitigate that issue.

Michael Lambert

I don't think the trend in the marketplace is going to exclusive providers, I think it's quite the contrary that more and more hospital accounts are losing the excusive provision and opening it up to competitive usage. Often it may only be two or three companies allowed in and we have done quite well when those situations have come up. I don't think it's an exclusive use being indicated by hospitals.

Jeff Johnson - Robert W. Baird

And Alex just one follow-up, you keep referencing 15 to $20 million number. When I look at fourth quarter guidance it's probably somewhere close to $15 million below what was initially implied when 2Q guidance coming out of the 2Q COGS. To me that’s more of a 50, $60 million kind of annualized impact from all of these different issues, how I reconcile kind of your 15 to 20 and then the more sizeable cut to 4Q?

Alexis Lukianov

I think that essentially what we are seeing is that we don't see more than say $25 million at this point on an annualized basis. And regardless of that amount what’s most important is our ability to offset with new accounts. So, I think it's important to appreciate that the impact of that is not clearly understood but we don't believe it exceeds 25 million at this point.

Operator

Our last question is coming from the line of Josh Jennings with Cowen and Company. Please state your question.

Dennis Keller - Cowen and Company

Can you talk about maybe the timing of the HTC, how you envision that being rolled out for next year?

Alexis Lukianov

We are hopeful that it's going to happen within the next several weeks. And I think that really as I mentioned in my remarks arms the surgeons and the societies as well as us to be able to do battle so to speak with the payers in defense of very strong outcomes related to fusion. The other step that has to be taken which they are working through and in fact there is a NAS meeting today to talk about it. There is a number of other societies that are now discussing it and we have been trying to spur that into faster action and that has to do with the development of clinical guidelines that are ultimately agreed to by all of the societies. Right now everybody has kind of got their own, there is (inaudible) out there that everybody has discredited but nonetheless payers reference it because it service their means and so really that’s going to be the next critical step versus HAD, I think that really does help to effect the landscape because it's a clear document along the way that that insurance companies look at it. And then from there it's going to be the development of broadly accepted clinical guidelines.

So, we are all set, thanks everybody we will see you on the NAS floor here in about less than an hour. Thank you, talk to you soon.

Operator

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

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