ConforMIS' (CFMS) CEO Mark Augusti on Q4 2016 Results - Earnings Call Transcript

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ConforMIS, Inc. (NASDAQ:CFMS) Q4 2016 Results Earnings Conference Call February 15, 2017 4:30 PM ET

Executives

Mark Augusti - President and Chief Executive Officer

Paul Weiner - Chief Financial Officer

Analysts

Allen Gong - J.P. Morgan

Kristen Stewart - Deutsche Bank

Larry Biegelsen - Wells Fargo

Steven Lichtman - Oppenheimer

Bruce Nudell - SunTrust Robinson Humphrey

Operator

Good afternoon. My name is Terrence. I will be the conference operator today. At this time, I would like to welcome everyone to ConforMIS Fourth Quarter and Fiscal year 2016 Earnings Conference Call. All lines haves been placed on mute to prevent any background noise. After the speakers' remarks there will be a question-and-answer session.

Before we begin, I would like to remind you that management will make statements during this call that include forward-looking statements within the meaning of Federal Securities law, which are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Any statements contained in this call that are not statements of historical facts should be considered to be forward-looking statements. All forward-looking statements, including without limitation, statements about ConforMIS' strategy, future operations, future financial position and results, gross margin, operating trends, financial guidance, market growth, total revenue and revenue mix by product and geography, the potential impact and advantages of using customized implants, business initiatives, milestones and priorities, and potential new products are based upon based upon current estimates and various assumptions. These statements involve material risk and uncertainties that could cause actual results or events to materially differ from those anticipated or implied by these forward-looking statements, including those discussed in the Risk Factors section of the ConforMIS' public filings with the Securities and Exchange Commission. Accordingly, you should not place undue reliance on these forward-looking statements.

While ConforMIS may elect to update these forward-looking statements at some point in the future, ConforMIS disclaims any obligation, except as required by law, to update or revise any financial projections and forward-looking statements whether because of new information, future events or otherwise. This conference call contains time sensitive information and is accurate only as of the live broadcast today, February 15, 2017.

I will now turn the call over to Mark Augusti, the company's President and Chief Executive Officer. Mark?

Mark Augusti

Thank you, Terrence, and welcome everyone to ConforMIS' fourth quarter and year-end 2016 earnings conference call. With me on the call today is our CFO, Paul Weiner.

In terms of a brief agenda, Paul and I will share our prepared remarks on a variety of topics including of course our fourth quarter financial and operating performance, our financial outlook and guidance for 2017 which we introduced in this afternoon's press release, and the company's near-term strategic priorities and key milestones. Additionally, I thought it might would be helpful if I shared my thoughts on what attracted me to this position, where I have been spending my time and efforts since joining the company, and what I have learned in the first 12 weeks as CEO.

Following the prepared remarks, Paul and I look forward to answering your questions. We have a lot to cover this afternoon so let's dive in. Before turning to our fourth quarter and year-end results, I would like to briefly review my initial experiences since joining as CEO on November 14 and share my high level thoughts on our strategic roadmap going forward.

In my first few months I have been meeting with people throughout the organization and acquaint myself with the business. I have also spent a fair amount of time with customers and other stakeholders such as investors, suppliers, etcetera. Many of these discussions have highlighted areas of excellence and differentiating for the company, as well as certain areas where we have opportunities for improvement. I was attracted to this position for multiple reasons and these discussions have confirmed many of them.

First, ConforMIS has incredibly differentiated technology and capabilities that are making a difference to patient outcome. Second, our highly differentiated technology is supported by two important factors. Strong IP portfolio and a large and growing body of clinical evidence, which together give me confidence in our long-term growth opportunity. Our growing body of evidence demonstrates that ConforMIS implants can deliver significant economic savings over traditional implants.

Third, we have a solid customer clinician loyalty. I have connected with many of our customers. I am awed by the amazing stories they have related to me. Those I have spoken with are convinced that ConforMIS is enabling them to deliver better outcomes than they were getting with off the shelf technology.

And finally our patients. Our technology and business model is still easily marketable in today's digital enabled society. The ability for ConforMIS to speak directly to patients about the benefits of our iFit technology is so well aligned with today's active and informed community of healthcare consumers. There is no better example of this then the two new programs we are in the process of rolling out. Our patient ambassador program, which has the ability to connect prospective patients to ConforMIS with existing ConforMIS patients. And then our track the implant program where patients can track their implants being designed, manufactured and shipped to the OR.

In terms of some potential opportunities for the company, first, we want to strengthen and continuously improve our commercial execution. While we have done some things well was clear to me during my initial reviews but there are a few gaps and areas for improvement. We will continue to invest in our selling infrastructure and we are establishing clear strategic priorities. Our management team will be tasked with insuring that we execute our priorities and that resources are allocated to those highest priorities in our strategic plan.

Second, improvement of the company's gross margin will be a point of emphasis. My early assessments suggest that we have identified the significant opportunities for margin improvement that are in the process of being resourced and implemented. Now we just need to execute on those. Over time we believe that we can steadily achieve significant higher gross margins. I will discuss thoughts on how we possibly execute with each of these as part of my commentary on strategic priorities later in the call.

Before turning the call over to Paul, I want to share a few considerations regarding our revenue guidance for 2017, which we introduced in the press release this afternoon.

There are a few considerations highly to investors as you evaluate those expectations for the year. First, 2017 will be a transition year for the commercial team. I anticipate many changes as we develop, communicate and execute a more targeted commercial strategy. While we don’t anticipate large changes to the existing selling team, I do anticipate additional adds both in employee and rest in agents and that we will manage these resources differently then we have in the past.

In order to capitalize on the opportunity in front of us and accelerate surgeon adoption, this will be an investment year with plans to accelerate spending on commercialization activities. However, the impact from these activities will not be immediate. The second item impacting our 2017 growth is an unexpected change in the reimbursement of our iUni and iDuo partial implants in Germany. In December it was announced that the reimbursement for customized partial knee procedures will be reimbursed at the same rate as the off the shelf partial knee procedures beginning January 2017. Through 2016, hospitals were receiving a premium reimbursement on our partial implant. We expect that this will adversely affect sales of our partial knee replacements in Germany.

With that, let me turn the call over to Paul for a detailed review of our fourth quarter and fiscal 2016 results and our 2017 guidance. Paul?

Paul Weiner

Thank you, Mark. Total revenue for the fourth quarter of 2016 increased $2.6 million to $21.7 million, or 14% year-over-year on a reported and constant currency basis as compared to the fourth quarter 2015. Total revenue in the fourth quarter of 2016 and 2015 includes royalty revenue of approximately $200,000 related to patent license agreements.

Fourth quarter product revenue increased $2.6 million to $21.4 million or 14% year-over-year on a reported and constant currency basis. U.S. product revenue increased $3.1 million to $17.7 million or 21% year-over-year. Rest of world product revenue decreased $478,000 to $3.7 million or 11% year-over-year on a reported basis and decreased 8% on a constant currency basis. This year-over-year decrease in rest of the world revenue was primarily due to fourth quarter 2015 being positively affected by rescheduled cases from the third quarter 2015 into the fourth quarter of '15 due to our recall in September of 2015.

As detailed in our press release this afternoon, fourth quarter product revenue from sales of iTotal CR, iDuo and iUni decreased $300,000 to $16.8 million or 2% year-over-year on a reported basis and decreased 1% on a constant currency basis. This year-over-year decrease in base business revenue was primarily due to fourth quarter 2015 being positively affected by rescheduled cases from the recall. Fourth quarter product revenue from sales of our iTotal PS increased $2.9 million to $4.6 million or 167% year-over-year on a reported and constant currency basis.

Fourth quarter U.S. product revenue represented 83% of total product revenue compared to 78% of total product revenue in the same quarter of 2015. Fourth quarter rest of the world product revenue represented 17% of total product revenue compared to 22% of total product revenue in the same quarter of 2015. Total fourth quarter revenue was impacted by approximately $124,000 due to changes in foreign exchange rates compared to the prior year.

Turning to a review of our results across the rest of the P&L. Fourth quarter gross margin was 37% of total revenue compared to 33% of total revenue in the same quarter of 2015. The increase in gross margin compared to the prior year was driven primarily by higher product revenue in the fourth quarter of 2016 as compared to the fourth quarter of 2015. Gross margin included $700,000 in unused product or 3% of product revenue in the fourth quarter of 2016 as compared to $700,000 in unused product or 4% of product revenue in the fourth quarter of 2015.

Historically the cost of unused product has averaged approximately 4% of product revenue with modest volatility in this item on a quarter-to-quarter basis over time. Fourth quarter operating expenses increased $874,000 to $22 million or 4.1% year-over-year. Sales and marketing expense accounted for $49,000 of that increase. R&D expense decreased $646,000 or 14% compared to last year and general and administrative expense increased $1.4 million or 23% year-over-year due primarily to patent litigation expense, [indiscernible] consultant expense and severance and other expenses related to the CEO transition.

Net loss was $15.7 million or $0.37 per share compared to $15 million or $0.37 per share for the same period last year. For the 12 month period ended December 31, total revenue increased $13 million to $79.9 million or 19% year-over-year on a reported basis and 20% on a constant currency basis. This growth was driven by an increase in product revenue of $16.1 million or 26% on a reported basis and 27% on a constant currency basis, offset by a $3.1 million decrease in royalty revenue due to lump sum payments received upon the signing of patent license agreements in the second quarter of 2015.

U.S. product revenue increased $15.1 million to $62.3 million or 32% year-over-year. Rest of world product revenue increased $1 million to $16.6 million or 6% year-over-year on a reported basis and increased 10% on a constant currency basis. Total 2016 was impacted by approximately $535,000 due to changes in foreign exchange rates compared to the prior year. Gross margins for the 12 months of 2016 was 33% of total revenue compared to 33% of total revenue in the prior year. Prior year included 500 basis points in gross margin related to royalty revenue, resulting in product gross margin in 2016 of 33% compared to 28% in 2015.

Gross margin included $3.5 million in unused product while 4% of product revenue in 2016 as compared to $2.7 million in unused product or 4% of product revenue in 2015. Net loss from the 12 months period was $57.6 million or $1.39 per share for 2016 compared to a net loss of $57.2 million or $2.60 per share for 2015. Net loss per basic share calculations assume weighted average basic shares outstanding of $41.5 million for 2016 compared to $22 million in the same period last year. The increase in shares related to the issuance of shares in the 2015 initial public offering and the conversion of outstanding shares of preferred stock into shares of common stock.

Turning to a discussion of our 2017 financial guidance which we introduced in this afternoon's press release. For the full year 2017, the company expects total revenue in a range of $80 million to $84 million, representing year-over-year growth of zero to 5% on a reported basis and 1% to 6% on a constant currency basis. The company's 2017 revenue guidance assumes the following. Total revenue includes royalty revenue of approximately $800,000 related to ongoing patent license royalty revenue. Product revenue in a range of $79 million to $83 million representing year-over-year growth of zero to 5% on a reported basis and 1% to 6% on a constant currency basis.

Our product revenue constant currency growth of 1% to 6% assumes growth at the midpoint of our guidance in the high single digit percentage and a decline at the midpoint of our guidance, and the rest of the world in the high teens on a constant currency basis. Let me provide some additional color regarding our 2017 product revenue growth which is impacted from two items of note.

First, as discussed during our first quarter 2016 earnings call, those results benefitted from delayed surgeries due to the recall in 2015. We estimate that this is to be -- this is approximately $3.8 million in sales primarily related to the reduction of order lead times from 8 weeks to 6 weeks and to a lesser extent, the rescheduled cases, impacting our 2017 product revenue growth by approximately 500 basis points. Second, due to the change in the customized partial knee replacement reimbursement code in Germany effective January 2017, our 2017 expectations for product revenue in rest of the world have been lowered by approximately $3.4 million. We expect the change in the customized partial knee replacement reimbursement code in Germany to negatively impact our 2017 product revenue growth by approximately 400 basis points.

Absent these items, our guidance this year would be a 10% to 15% growth rate on a constant currency basis. For the full year 2017, the company expects total gross margin in the range of 36% to 38% as compared to 33% in 2016. For modeling purposes, for the full year 2017 we expect, as Mark mentioned earlier, this is an investment year with plans to accelerate spending on commercialization activities. We expect this additional investment to increase our sales and marketing expense by approximately 15% over 2016.

Patent litigation expense of approximately $5.7 million, an increase from $2.9 million in 2016. This increase is primarily related to the inter-parties review proceedings initiated in conjunction with our patent litigation against Smith & Nephew. [Staff] [ph] compensation expense of approximately $6 million and fully diluted weighted average shares outstanding with EPS purposes of approximately $43.5 million shares. Although we are not in the practice of providing quarterly revenue guidance, given the extent to which the first quarter of 2016 revenue was positively affected by the reduction in order lead times and rescheduled cases related to the recall, and the change in the customized partial knee replacement reimbursement code in Germany, we felt that it would be prudent for year-over-year comparative purposes to share our expectations for revenue in the first quarter of 2017 based on both the procedures that have already taken place and the visibility into orders we had in hand for the balance of the quarter.

Accordingly, we expect total revenue in the range of $17.7 million to $18.7 million, representing year-over-year total revenue decline of 13% to 8% on a reported basis and 12% to 7% on a constant currency basis. In conjunction with this year-over-year decline in revenue, we expect our first quarter gross margin to come in below the same period last year or up 33%. With that, I will turn the call back to Mark.

Mark Augusti

Thanks, Paul. While I am not in a position to provide a comprehensive strategic plan after only a few weeks, I would like to provide some early thoughts.

As I mentioned previously 2017 will be a year for transition for ConforMIS as I look to reposition the company for longer term growth and profitability. While I am not yet ready to get very granular, I can identify four strategic priorities at ConforMIS. Early in the call I mentioned two of them. Namely, we have opportunities to strengthen our commercial execution and improve our gross margin. In addition, we will look to invest in our people through training and talent management and we will look to innovate into new markets with new products.

For every new product, I am reviewing various new product opportunities including the hip project. While we do not plan to confirm or give more detail about our new product pipeline I can confirm that we will continue to pursue the hip regulatory clearance. However, actual commercialization plans remain under review. Now let me provide a little more color on the first two priorities, namely strengthen our commercial execution and improve our gross margin.

First, I see a need for us to establish a ConforMIS commercial playbook. A playbook that better defines our commercial strategy, includes an enhanced focus around out-patient surgery, cost economics and consumer awareness. As we grow our business and increase market share, we have to develop plans for establishing better relations with the surgeon training community as we look to include ConforMIS surgical concepts in the training curriculum of the next generation of [indiscernible] surgeons. We will be looking to hire specific talent that will focus on these areas.

Second, we thought it would be helpful to provide some additional details on our gross margin initiative. While our iJig manufacturing process has been 100% vertically integrated for some time using 3D printing, most of our implant component manufacturing is outsourced. This is expected for companies of our size. However, it means that ConforMIS fares high material cost with or vendors limiting our gross margin expansion. We are making significant progress with our vertical integration strategy.

We completed the in-sourcing of metal tibial trays for iTotal CR and iTotal PS at the end of 2016. Moreover, our in-sourcing plans for the poly-inserts of iTotal CR are scheduled to take effect in 2017 with iTotal PS can follow in early 2018. We expect that this will yield a gross margin improvement in the second half of '17 and continue into 2018. We have also made significant progress with the development of new processes for the 3D printing of our patient specific iJig using 3D [nylon] [ph] printers. These programs are focused on 3D print cycle time reduction and powder utilization optimization which we believe will translate into additional gross margin improvement as well as enhance utilization of our existing fleet of 3D printers.

We believe this will reduce our capital outlays for 3D printers in 2017 and onwards. We have made additional progress with our design software programs in CAD automation which we believe will yield further gross margin expansion in '17 and '18. We are preparing for our multiyear plan to off shore some of our CAD design work starting in 2017, which will provide additional gross margin expansion due to reductions in labor cost.

Last but not least, volume in increased overhead absorption is the third driver of our gross margin expansion strategy in addition to reductions in material and labor cost. We believe volume in increased overhead absorption will continue to contribute to gross margin expansion over the next several years. In short, we are seeing steady progress in our operational programs which we believe will yield progressive improvements in gross margin in '17 and '18 and continue the incremental improvements in future years.

So in conclusion, we have a great team here at ConforMIS, both in the field and at headquarters that wakes up everyday looking to help our customers and our patients. We love talking about our value and telling our story. Our technology is slowing reaching out across orthopedics and touching many lives. We are into this business for the long haul and believe we have the vision that will result in improved outcome and an overall lower cost. Thank you. So back over to the operator, Terrence, and we will take questions.

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Allen Gong from J.P. Morgan. Your line is open.

Allen Gong

This is Allen on for Mike. So just to start off, a quick one, how much was the FX headwind in the quarter. I know you said it, but I missed it.

Paul Weiner

Yes. It was around $125,000, I believe. $125,000, yes.

Allen Gong

Okay. And also this was really kind of the first quarter where you broke out growth rates for your base, the CR, Duo, Uni business by geography. And it kind of, based on what I am calculating, kind of implies O-U.S. for your PS business of around $0.5 million. Would you say that was around, like flat with your third quarter results?

Mark Augusti

No, I think we had an increase in the PS O-U.S. as well. Certainly not to the extent that we have in U.S. but there is some growth in the O-U.S. business as well on the PS.

Allen Gong

Okay. And just to kind of close it up. So one of the goals that your really kind of outlined for the first time at the JP Morgan Healthcare Conference was really to improve the profitability of your business and you mentioned that again today, you are aiming for 38% by the end of next year. But you were really talking about a push to 60% gross margin over the next four to five years with the majority of improvement towards that, actually in 2017 to 2018. So do you think you are still on track with that or do you think that goal has kind of pushed out a bit further.

Mark Augusti

Yes. Allen, we definitely still have that as our target and we think we will be able to achieve it in that time frame.

Operator

Thank you. And our next question comes from Kristen Stewart from Deutsche Bank. Your line is open.

Kristen Stewart

I was wondering if we could just go over the revenue and product sales guidance. And I appreciate the breakouts in terms of how much the estimated was the delay in surgery from the prior 1Q '16 and then the Germany impact. But even absent that, you are still looking at 10% to 15% growth in this year. Clearly, I guess I don’t know what the adjusted number would have been but it seems like it would have been a little bit better than that. Is this just kind of conservatism, I guess Mark, just kind of coming in and still getting kind of your feet wet? Or just kind of, because you are going to do some changes within the sales organization that that too might lead to some disruption. I am just trying to get an appreciation for what more is disruption or are we just seeing a little bit more of a softening of demand. Because it looks like PS did quite well in the quarter and just trying to understand what the dynamics are in terms of the guidance and how we should really interpret kind of the 10% to 15% on a constant currency basis, just because it seems a little soft relative to how you guys have been doing.

Mark Augusti

Thanks, Kristen. This is Mark. Appreciate the question. Yes, I mean it's important thing to [ease out] [ph] and it's not really just conservatism. I mean if you actually look at the last couple of quarters trends and we look out that, that’s really kind of where the business has been at. So it's compounded by this Germany effect which we have tried to provide the detail in there but the business kind of has softened to that level and one of the things I have got due coming in, as I have said, is kind of change the commercial execution. I think this has been a good rollout. We have a nice kind of ramp up, as I look back over the last few years, but we are going to be successful. We have to continue to do even that much better at our commercial execution. And it's just spotty right now. We have some places that are very good but we have got to be able to export that to other in the country and do well there as well.

Kristen Stewart

Okay. So should we look at 10% to 15% as kind of this base level, as the transition year and not something you will be targeting for the longer term?

Mark Augusti

Yes. I think that’s right. The issue is that it's going to take more than a year probably to kick it in. But I like your words, I think that’s kind of the base year for this transition year and then I certainly want to target north of 15% longer term and think we should be able to definitely achieve that with improved commercial performance.

Kristen Stewart

Okay. Then just a question for Paul. With that level of growth, it is pretty impressive that you are able to still see the gross margin expansion. Can you maybe just breakdown how you are able to achieve that in terms of different buckets? I don’t know how to bet quantify that in terms of just the vertical integration versus software changes. Anything that might be helpful to get us more confident in terms of being able to achieve that range.

Paul Weiner

Sure. The biggest thing we are doing as far as the biggest impact over the near term. That’s really towards the second half of this year and in 2018, it's a vertical integration. So as you know in the past we have been, from day 1 we have been doing all of the manufacturing of our patient's instruments. We have just completed the vertical integration of the tibial trays, metal tibial trays. So we will start to see that improving gross margins, lowering our cost in 2017. But above and beyond that, there is other projects like the poly-inserts that we are bringing in house and in 2017 we are going to make a lot of progress there. We will see that progress certainly in the second half of this year and then finishing up in the first half of '18.

So that all of the manufacturing for the most part of all the components other than the thermal component, will be done internally by the middle part of '18. So we do expect, certainly as we implement this vertical integration in the first half of this year and into beginning part of 2018, we expect the biggest part of the appreciation in gross margin in the second half of this year and throughout 2018, with incremental improvements in the outer years.

Operator

And our next question comes from Larry Biegelsen from Wells Fargo. Your line is open.

Larry Biegelsen

Mark, you talked about some execution gaps and I think you alluded to some changes in the sales force or the incentive structure. May be, could you provide a little bit of color on the gaps and how you plan to address those, please.

Mark Augusti

So I think the first thing I would say, Larry, is we kind of see an unevenness in performance, as you can expect, talent and geographically related. So I think there is bit of a talent gap we have to address. As well as we need to resource out the contracting and reimbursement piece. So one of the significant things we have done here in the last four weeks is we have added a key talent in reimbursement to support our contracting organization. We will also be looking to build out a couple of more SPEs which will be important for us to be able to handle the deal flow and contracting. I think those of us that follow the industry, contracting with the providers is just a big part of the day to day business that we have. But then even the thing that’s important to tease out here, these couple of other points I want to mention is. With the talent changes also how you train and you target and what we have to go after because there is a certain kind of psychology around performance, excuse me, around ConforMIS in converting surgeons. And we kind of export those best practices across the country and we are going to be looking to do that as we finalize and rollout the playbook.

I think that’s important. And then the other thing is we have done a little bit with the consumer awareness and I think a really good job to a certain point but I would say that in 2016, looking back at the numbers, we got more comfortable that we can do more there. And that if we do more there, that actually drives preferential interest in our products and we have to combine that better in the areas where we have the talent and the surgeons that can take advantage of that. So then we roll in kind of that coordinated approach out across the country.

Larry Biegelsen

That’s very helpful. And just two more from me. One, on Germany, just looking at it on the surface, it seems like a pretty big impact relative to your sales for that product line outside the U.S. And the reimbursement is just being cut to the same as of the shelf partial procedures. We are just in similar to the United States. So what am I missing here? Does it seem like -- to what percent, your Uni business are you assuming goes away in 2017. And I will just throw in my third question here. Paul, just let me push back a little bit more or ask a little more color on the gross margin.

The guidance is only for about 400 basis point year-over-year improvement. The 60% goal was by 2020. It sounds like and I thought we were going to get the most improvement in 2017 and '18. I know earlier you got asked the same question but you said the goal hasn’t been pushed out. But it does seem like it's got to ramp a lot in '18, '19, '20, to get to that 60%. Thanks for taking the questions guys.

Mark Augusti

So, Larry, let me do the Germany piece and I can give some color around that, and then I will let Paul follow up with the gross margin. So I just got back from Germany to really try to asses to make sure I felt comfortable about kind of what's going forward and I will put the appropriate caveat on anything, you can't plan or predict the future but you kind of do the best to be able to understand it and project what's happening. What actually happened, to be clear, in Germany is they -- in Germany there was one code that the ConforMIS technology fell into for partials and totals. And it was reimbursement at a certain rate.

They decided to create a new and separate for partials. So that’s what actually happened. And then they had to set the rates for that code. And because they didn’t have data into the code because there is a lot of other products being reimbursement in that code from before that were more than just ConforMIS. They didn’t know what to do for the partial. So what they decided to do was set it equivalent, and this is for custom partials, it's got its own code now but it's set equivalent to off the shelf. And then the idea is after two years, the way it works in Germany, so for the years of '17 and '18, they will look at whatever utilization and pricing is in that code and if they think it needs to be adjusted, there is actually chance they could adjust it up. Or depending on what's been occurring, then they keep it the same. And this is what they do in Germany when they look at the DRGs every year, every few years.

So that’s actually what happened. Importantly, it didn’t affect our total business and I don’t anticipate it any code changes going forward, which I got comfortable with that. Again, the appropriate caveat is, as you can imagine, healthcare bodies and governmental bodies are going to do what they want to do, but I feel better about that. So that’s actually what happened to us. And that changed the profitability profile as you can imagine, for our customers, because they are getting a price advantage versus off the shelf partial. And so we do anticipate this will be a significant impact. In '17, one time impact on our partial business in Germany. Then, Paul, you want to address the gross margin question.

Paul Weiner

Sure. Let me give you a little bit of a cadence as far as some of the numbers. So as we have said, first quarter because of the revenue levels in the first quarter that we are expecting in the first quarter, as well as some additional vertical integration costs we have in the first quarter, we are expecting our gross margins to come in certainly below 33%, which is what we were a year ago. Leaving 2017, we expect gross margins to be in the 40s, the low to mid-40 range. So that will get us an average of somewhere between 36% to 38% gross margins for the year. So that marketable improvement from certainly last year and there is more from the beginning of this year to the end of the year, the average.

So leaving this year we are looking at, again, low to mid 40s. Again, we expect material increases in our gross margin in 2018 as we complete the vertical integration of the rest of the implant components. As well as we will be further on in the expansion of the off shoring of CAD as well as some software automation equipment and increasing efficiency in the machines. So 2018 we expect a big improvement and then that will lead us incremental improvements in those future years to get us to in or around 60%.

Operator

And our next question comes from Steven Lichtman from Oppenheimer and Co. Your line is open.

Steven Lichtman

So just my two questions are on the U.S. Mark, mentioned a couple of initiatives specifically would help economics in outpatient surgery. Can you flesh that out a little bit? What is the type or work that you anticipate going on there to help drive acceleration in the medium to long-term?

Mark Augusti

So first off, the other initiatives apply broader which is around the commercial execution and the consumer awareness. But specifically, our early results on health economics, Steve, I think are very compelling. And so we have to do a good job in getting those published. We also have to do a good job at reproducing them at other centers. So we will be working on both those front in 2017 and beyond to do that. And then in particular around outpatient knee surgery, right now there is a lot of discussion in there and there is various estimates. But we will say it's early days in outpatient total knee surgery.

But we believe that our model with the reduced sets and all the infrastructure that comes around that with that doesn’t come with us, that does exist with the off the shelf though, will allow sites to enable through outpatient knee surgery. We have got early data that shows we have got a higher rate of discharge within 24 hours and we have got a higher rate of discharge to home versus a step down facility. We think those are big things. So we are looking to identifying qualified sites in places where they want to do this. And who knows where CMS will go on the reimbursement but we want to be in a position to capture that because we believe this will be a growing of importance in the marketplace and when you combine this with consumer awareness and I think the brand allegiance that we can command around ConforMIS, I just view it where I am sitting today, early days, as a big opportunity for us. And we have to put ourselves out there as the best solution for customers around outpatient knee surgery.

Steven Lichtman

Thanks for that Mark. And then just my second question is, you mentioned in terms of some of the investments, adding some people in this area also on the reimbursement front. Will you also be adding to the direct sales force in the U.S.? I wasn’t clear on that and if so, about how much you would think you would expand here this year?

Mark Augusti

Well, as you know we don’t give the specific numbers but I can tell you absolutely, we do plan to add direct reps in the U.S. in 2017 and we are well on our way of identifying geographies and where we are going to do that.

Operator

And our next question comes from Bruce Nudell from SunTrust. Your line is open.

Bruce Nudell

Mark, the investor expectations for the company was only 1.5% market share in the U.S. and a lot of that disproportionately Uni. We are probably north of 20% at this stage of the company. And one of the things that investors are going to be worried about is, are there market frictions that the company didn’t anticipate. So for instance, over half of patients in the U.S. who get primary knees are Medicare. And they are reimbursed at half the commercial rates and hence -- and there is demand matching that goes on in a lot of hospitals. Hence the price point of the ConforMIS implant could be problematic. Are there like specific market frictions that the company didn’t realize fully until you showed up and how could you speak to that investors concerns that this really has broad-base appeal. And then I have a follow up.

Mark Augusti

Sure. Bruce, that’s a great question and obviously well aware, as I said earlier, I also have those expectations and I think we need to get it there. But having said that, look it's a competitive market. I will say this, and I have said this before, I mean there are good strong competitors that we go up against. We happen to believe we think we have got a better technology and there is a real compelling interest in it. Given our gross margin of product standpoint, we do maintain a firm line on price and we do a pretty good job on that. And so that doesn’t mean that there is some business that we turned down. That we can't compete everywhere and we are not going to be able to compete there until we solve for the gross margins. That’s why it's critical that we do both of these simultaneously. And I will say, Bruce, there are plenty of areas where we still are able to really create an economic story around our product. And so there is still an opportunity to grow there. But there is no doubt that it's a market dynamic that we have to take into account.

Bruce Nudell

And then I guess just given the slower growth rate and you mentioned the TBG with regards to commercialization of the hip. What is the anticipated cash burn over the next several years and what are the measures you could take to conserve cash and basically provide the proof of principle in the U.S. primary knee market which is key for the investment hypothesis. For instance, do you really need Europe? I mean, why bother?

Mark Augusti

Let me give you the dollar amount and then Mark can follow up with certainly some of the things that we can look at during the year and the upcoming year. The cash burn that we would, ignoring the fact that we obviously have the $50 million debt financing that we can borrow off of, you are looking at cash used from operations as well as capital equipment in 2017 of somewhere in the neighborhood of $60 million or a little bit south of that number. That’s based on you know on where it stands today before Mark obviously completes his evaluation.

And then moving forward, certainly as our revenues increase and we tighten up our operating expenses, that number we expect to decrease. One of the things that we should look at and consider is the capital equipment needs is as we do the vertical integration. So in the past here in 2016 and 2017, what we did invest in new equipment to do this vertical integration. In the future years we would expect our capital equipment needs to decrease substantially relative to that.

Mark Augusti

And I guess I would just say, look there is no doubt that there is areas we could change the expense trajectory to conserve cash if we wanted to. I am more interested in making sure we got the right growth plans in place and looking about and making sure we can continue to execute on the profitability in the COG. Your point about Europe is well taken and that’s one of the reasons why you don’t hear me talking a lot about going into other international markets and certainly we will be very preferential to any opportunity around there around the right price point because I think as you all know, again it's due to the industry pricing is really challenged in the international markets, especially in Europe.

So it's something to look at. Having said that, you know Bruce, I am loathe to want to do anything to kind of impact that business at this point because once you have entered the market you have built that infrastructure, you have got that customer loyalty, it's hard to get back. I would rather work on product profitability and some other stuff to make that business more profitable and kind of keep it where it is. But that’s just me being very transparent in my early days about how I think about that. So I don’t think we are in a stage yet where we have to make drastic actions around our Germany and U.K. business.

Operator

And we have a follow up question from Kristen Stewart from Deutsche Bank. Your line is open.

Kristen Stewart

I was wondering if you would be willing to share just some more anecdotal comments just around your discussion with physicians in the quarter, just with the launch or roll out of PS, and just more on the order flows and how things are tracking or taking out of it just kind of the lumpiness on a year to year basis. Just kind of the underlying trends of the business. Have you, I guess, lost a number of physicians, are you thinking about adding. I guess, lost a number of sales people, just kind of more trends like that rather than to kind of talking more contextually about the guidance and cash flow trends, more subjective measures that you can share with us.

Mark Augusti

Yes, I can, Kris. So first off there is not from my standpoint any anecdotal worrisome trend about two of the key things you mentioned, which is loss the U.S. knee surgeons or loss of reps. We clearly like all companies want to manage the performance and we will do that both at the rep level and the manager level. I think it is always a work for talent in finding good orthopedic talent, across the board is hard and you have to be really targeted about your market. Anecdotally my surgeons, what I have said in my prepared remarks, I will reiterate here, review anecdotally is you know what I love about ConforMIS is, people love the technology. I literally haven't had a single conversation with a surgeon that suggested somehow they were unhappy with our technology or somehow they couldn’t or wouldn’t incorporate their practice.

As a matter of fact, we have surgeons routinely coming through the office for headquarters visit. We continually do that add, and there is a lot of continued interest in the product both at the surgeon level and as I had mentioned at the consumer level. And those anecdotes are very strong. Now there is no doubt, we are a small company and we have a smaller group of, for us, high value surgeons. And if one of those surgeons takes two weeks to go on a ski vacation or runs into a health issue, that certainly can adversely affect us for the short time and we will see that. And I get, as a CEO, I get those stories anecdotally a lot. But no real challenges where core customers for whatever reason has decided to move away from ConforMIS.

Kristen Stewart

And just with respect to the iTotal PS launch. Are the incremental sales still truly of PS, so truly incremental or are you seeing any cannibalization from CR? I would imagine that they are incremental but checking.

Mark Augusti

Yes. No, that’s a really good question. Thanks. Because I actually wanted to point that out. I mean I think we have said it in the remarks. But PS will be still be an important areas of growth for us and it opens up a much larger market for us. I think it would probably -- it's obvious at some level there is a little bit of cannibalization from some guys that have been doing CR because they like ConforMIS and then want to go back to doing PS. I don’t think we have broken that out and I am not sure we actually nearly even could quantify that because as was detailed, that wouldn’t make sense and it's not materials. So we see PS as a big source of growth for us but we also believe we will continue to be an important player in CR. And that’s really the bigger business and clearly as a result, it's performance is, it's certainly not growing as fast as the PS. I don’t know if you want to comment more, Paul?

Paul Weiner

Yes. The other thing to look at, Kristen, is we have our sales reps spending their time, so there is one regarding some limited cannibalization amongst our surgeons. The other thing is, as far as where our reps, and we don’t incentivize them more to sell PS then the PR, but the PS is such a big opportunity and a new opportunity within the existing territories that the reps are already covering, that, yes, some of their time certainly that was spent before solely on PR and the partial, is now being spent on PS. So that begs the question, how do we expand our sales force to be able to cover the potential growth in PS and still pay attention and grow our base business.

Kristen Stewart

Okay. And then just going back, I guess, my original question, because I just want to make sure I completely understand as I am having a hard time just reconciling all. If it doesn’t seem like you have lost physicians and haven't lost reps and momentum still feels good and you have got sizable PS and all of that, I guess I am just having a hard time wrapping my head around this 10% to 15% growth.

Mark Augusti

So the way I think about it, and again it's hard to quantify this and think about it, but I think to process to acquiring the surgeon at ConforMIS is pretty lengthy if you think about it. Because we are getting in it about all the time upfront that we take to get them psychologically ready to want to make the change, Kristen, as then they got to put their first case and wait, of course, six weeks for the case. And let's be charitable and say maybe they even put a couple but then they want to leave another six weeks or so to see those patients in clinic to see how they are doing. So right there you are talking about 12 weeks which is 3 months. And when I really talk to people and think about -- and I hate to go back and do this because I don’t want to be forward looking, but what really happened to us with the recall that was more pernicious is, it threw that cadence of surgeon acquisition off. And it forced our reps to actually spend a lot of time homing on to the business, going with customer satisfaction issues all through kind of '16.

Then we start to get some of those guys back but then what's happened is that cadence of acquiring new surgeons really got hit. And part of what I think that effect is it's kind of through that misstep off and we have got to get that pipeline and that cadence back. So I don’t think about the growth. Our core surgeons are actually, for the most part still with us, I think for a large part still with us and that’s giving a growth. But what we are not really seeing is that next uptick of these new surgeons where you are going to then come in give us a significant part of the business and that rate has fallen off. And so that’s part of the work that we have to do with '17 and to build that back up and be smart about that and get new surgeons in the fold as it were.

Operator

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

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