K2M's (KTWO) CEO Eric Major on Q4 2016 Results - Earnings Call Transcript

| About: K2M Group (KTWO)

K2M Group Holdings, Inc. (NASDAQ:KTWO)

Q4 2016 Earnings Conference Call

March 6, 2017 17:00 ET

Executives

Eric Major - Chief Executive Officer

Greg Cole - Chief Financial Officer

Analysts

Matt Miksic - UBS

Matthew O’Brien - Piper Jaffray

Dave Turkaly - JMP Securities

Glenn Novarro - RBC Capital Markets

Kaila Krum - William Blair

Craig Bijou - Wells Fargo

Matt Taylor - Barclays

Steven Lichtman - Oppenheimer

Operator

Good evening, ladies and gentlemen and welcome to the K2M Group Holdings Inc. Fourth Quarter and Full Year 2016 Earnings Conference Call. [Operator Instructions] Please note that this conference is being recorded and that the recording will be available on the company’s website for replay shortly.

Before we begin, I would like to remind everyone that our remarks and our responses to your questions today may contain forward-looking statements that are based on current expectations of management and involve inherent risks and uncertainties that could cause actual results to differ materially from those indicated, including those identified in the Risk Factors and Management Discussion and Analysis of Financial Condition and Results of Operations section of our Form 10-K for the fiscal year ended December 31, 2015 filed on March 4, 2016, which is accessible on the SEC website at www.sec.gov and our most recent Form 10-Q which was filed on November 2, 2016 as such factors maybe updated from time-to-time in our periodic reports filed with the SEC, which are available on our website. Except as required by law, we assume no obligation to update our forward-looking statements.

In today’s remarks, we will refer to certain non-GAAP financial measures. Reconciliation of these non-GAAP financial measures to the most comparable measures calculated and presented in accordance with GAAP are available in the earnings press release and supplemental disclosure on the Investor Relations portion of our website.

I would now like to turn the call over to Mr. Eric Major, the company’s Chief Executive Officer. Please go ahead, sir.

Eric Major

Hello and welcome everyone to K2M’s fourth quarter 2016 earnings conference call. Let me begin with a brief agenda for today’s call. I will start off with a summary of our financial and operating performance for the fourth quarter and for fiscal year 2016, then I will discuss K2M’s exciting new platform, Balance ACS or BACS, which we announced a few weeks ago. The BACS platform represents the clearest example to-date of K2M’s leadership in spinal innovation as it offers the most comprehensive portfolio of products and services, applying three-dimensional solutions across the entire episodic care continuum to help drive quality outcomes for spine patients. Then I will turn the call over to Greg Cole, our Chief Financial Officer, who will discuss our financial results for both the quarter and fiscal year in greater detail and review our 2017 guidance, which we introduced in this afternoon’s press release. We will then open the call for your questions.

We are extremely pleased with the strong growth we experienced in our U.S. business. In the fourth quarter, we reported a sales increase of 21.5% year-over-year driven by solid growth trends across each of our three primary procedure categories: complex, MIS and degenerative, which posted year-over-year growth of 18%, 37% and 19%, respectively. Our Q4 U.S. revenue growth of $8.4 million year-over-year was not only the largest quarterly contributor to our full year 2016 growth results, but also was the largest quarter of growth in K2M’s history as a public company. In short, this was a great quarter for K2M and more importantly, our Q4 results were a continuation of the strong growth trends we have seen in the U.S. throughout 2016.

We told the investment community we are focusing our efforts on the U.S. business in 2016 and we believe the 17% U.S. revenue growth is a clear indication of the successful execution of our strategic growth plan. This plan was based on leveraging our strong portfolio of innovative technologies, specifically on the compelling new products we have introduced over the last 18 to 24 months and our increasing sales force productivity as we leverage the investments we made in our U.S. distribution network in recent years. Our results in 2016 not only demonstrate our ability to execute against our stated growth objectives, but also demonstrate that we continue to gain market share in the spinal implant market.

While we are extremely pleased with our U.S. growth in 2016, our revenue growth outside the U.S. was impacted by disruption in two of our international distributor markets, Australia and Japan, which resulted in our 2016 international sales declining 8.5% year-over-year on an as-reported basis or 7% year-over-year on a constant currency basis. These disruptions were both unexpected and difficult to navigate. But looking back over this year, I could not be more proud of the way our organization worked through these challenges. Simply stated, we resolved the issue in Japan earlier than originally expected, and despite lower-than-expected investments in new instrument sets in 2016, our partner in Australia stabilized its replenishment spending throughout the year. Importantly, we resolved these challenges without losing our focus on driving market leading growth in the U.S.

Turning to a high-level review of our operating performance in 2016, for those of you who are familiar with the K2M story, you know that our product innovation represents the company’s most important area of focus. We believe our execution against our goal of leading the industry in bringing new and innovative spine products to market remains extremely strong. Each year, we target introducing 5 to 8 significant 510(k) clearances for new products or product line extensions and we have established a proven track record of delivering against this important strategic objective each year. This innovation engine is the foundation for the company’s growth today and in the future. For example, in 2015, K2M received 14 510(k) clearances for 16 new products and product line extensions, many of which were key contributors to the 16.6% growth in U.S. revenue we reported this year.

Our progress in bringing new products to market continued again in 2016, with 10 different 510(k) product clearances and following 7 of which we highlighted in press releases given their significance. RHINE Cervical Disc, MESA Mini and DENALI Mini, our Growing Spine Application and three additions to our CASCADIA family of Lamellar 3D Titanium Technology products, specifically CASCADIA AN Lordotic Oblique, CASCADIA Cervical and CASCADIA Lateral line extensions for MIS. While we are proud of the collective progress we made during 2016 in bringing new and innovative spine products to market, we are especially proud of the success we have had in the area of 3D printed applications in spine.

We believe our success with 3D printed spine technology demonstrates our ability to leverage our differentiated R&D capabilities to introduce new and innovative products. Since debuting the CASCADIA family of products featuring Lamellar 3D Titanium Technology at the 2015 North American Spine Society Meeting, K2M has established a leadership position in this innovative and rapidly growing area of the spinal implant market as evidenced by our growing portfolio of FDA cleared 3D-printed interbodies. We are delivering comprehensive 3D solutions by offering the largest portfolio of FDA cleared 3D interbodies in the market today among leading companies, with 8 different implant designs cleared for use. We are proud of our leadership position in this important area of the industry. We built this leadership position by focusing our R&D team on creating complex geometries designed specifically to support potential bony integration that would have been highly impractical to create through traditional subtractive machining methods.

Our CASCADIA Lamellar 3D Titanium Technologies are currently being used in 13 countries worldwide and we continue to see strong growth in surgeon users. Roughly half of which are new users of K2M’s interbodies business. After over a year on the market, we continue to receive positive surgeon feedback on CASCADIA. Importantly, our surgeon customers want to see our Lamellar 3D Titanium Technology contemplated across our entire portfolio and we look forward to offering new 3D solutions to fill the unmet clinical needs of our spine surgeon customers going forward.

By way of background, our comprehensive 3D solutions approach with CASCADIA was the direct result of K2M identifying an unmet opportunity in the spine market to focus on our leading R&D team on a differentiated process to deliver a disruptive technology. While the broader spine competitors have been focused on enabling technologies across navigation, imaging and robotics, we believe it was important to first gain a leading market mover position in the implant segment of the business. Our comprehensive 3D solutions approach with CASCADIA has positioned us as a leader in the next generation of implant technologies.

As a leader in both deformity correction and in 3D printing, we believe K2M is uniquely positioned to meet the changing dynamics in the complex spine market and we also believe that providing services at various points throughout the episodic continuum of care is invaluable to both surgeons and their patients. I would like to take a minute to discuss how we are positioning K2M to address the surgeon’s focus on patient outcomes across the full episodic continuum of care.

K2M has leveraged our knowledge of surgeon needs and our expertise in developing innovative spine products to create a new and revolutionary platform, balance, axial coronal, sagittal, or BACS, which we announced a few weeks ago. BACS is a comprehensive platform of products, services and research to help surgeons achieve three-dimensional spinal balance across the axial, coronal and sagittal planes of the spine with the goal of supporting the full continuum of care to facilitate quality patient outcomes. This platform represents the clearest example of K2M’s leadership in spine innovation as it is the most comprehensive portfolio of products and services applying three-dimensional spinal solutions across the entire episodic care continuum.

More specifically, BACS provides the spine surgeons a holistic approach to achieving, validating and predicting enhanced patient outcomes through 3D balance of the spine. The BACS platform provides products and services from preauthorization tools and preoperative planning to 3D anatomical modeling and postoperative reporting. An integral part of the BACS platform is the advancement of new capabilities to complement our leadership as an innovator of spinal products. To further enhance the platform, we recently announced a partnership with 3D Systems Corporation, the originator of 3D printing. K2M and 3D Systems have entered in a comprehensive development agreement that includes an exclusive software solutions partnership as part of the BACS platform to aid in balancing the spine across all three planes. As part of the BACS platform, we also acquired the e-Fellow service-based technology that provides automated solutions to surgeons and healthcare systems to effectively collect real-time data and monitor patient outcomes. We believe the BACS platform is truly unique in the spine market and we are the first to provide a platform of spinal products and services to manage the entire patient experience with the ultimate goal of achieving total body balance in all three planes.

We look forward to sharing more about this exciting platform in the coming months and plan to host an event at our corporate headquarters in Leesburg, Virginia later this year. We believe this event will be a great opportunity for analysts and investors to not only learn more about the BACS platform, but also to experience the platform’s features and benefits in our BACS lab, a state-of-the-art hands-on bio-skills lab, which is already being visited by surgeons from around the world for cadaveric research, product development and procedural technique validation.

So, we are pleased with our financial and operating performance in 2016 and we believe the 17% growth in the U.S. for the year represents clear evidence of our ability to gain market share in the spine market. Building on the strong momentum we built over the course of 2016, our year is off to an exciting start fueled by the recent introduction of our Balance ACS platform.

With that, I will turn it over to Greg for a more in-depth review of our financial performance during the quarter as well as a review of our guidance for fiscal year 2017. Greg?

Greg Cole

Thank you, Eric. Total revenue for the fourth quarter 2016 increased $7.6 million or 14% to $61.8 million. Total revenue increased 14.9% year-over-year on a constant currency basis. This increase in revenue was driven primarily by greater sales volume from new surgeon users and newer product offerings offset by decreases in both international direct and distributor revenue compared to last year. Our U.S. revenue increased $8.4 million or 21.5% year-over-year to $47.7 million and represented 77% of total company revenue in the period. Fourth quarter U.S. revenue growth is driven primarily by the addition of new surgeon users. By procedure category, complex spine, MIS and degenerative represented 38%, 17% and 45% of U.S. revenue respectively, in the fourth quarter.

Diving deeper into our U.S. results. Our complex spine and degenerative spine categories were the largest drivers of our U.S. growth in Q4. Complex spine sales increased $2.7 million or 18% year-over-year to $17.9 million and degenerative revenue increased $3.5 million or 19% year-over-year to $21.7 million. Sales growth in complex spine was driven primarily by increased surgeon usage of our EVEREST Deformity System, while degenerative sales growth was fueled by our CASCADIA 3D printed titanium interbody devices. In addition, sales in our MIS category increased by $2.2 million or 37% year-over-year to $8.1 million, driven primarily by increased surgeon usage of our CASCADIA and our EVEREST minimally invasive product lines.

Wrapping up the review of our U.S. revenue results. Our same-store same-product price decline continued to be in the low to mid single-digits, consistent with the pricing trends we have experienced in our U.S. business since 2014. Regarding revenue results outside the U.S., international revenue decreased $862,000 or 5.8% year-over-year to $14.1 million, representing 23% of total company sales in the period. International sales declined 2.4% year-over-year on a constant currency basis. Performance in our direct subsidiary markets, those markets where we invoice and collect in local currency, increased 14% on a constant currency basis in Q4.

Turning to our financial performance through the rest of the P&L in the fourth quarter. Excluding the benefit of a $694,000 medical device tax recovery in 2015, GAAP gross margin was 62.1% compared to a GAAP gross margin of 65% last year. Gross margin declined as a result of the year end increases to our inventory reserves as well as product sales mix. Gross profit includes amortization expense on investments in surgical instruments of $3.6 million or 5.8% of sales in fourth quarter of 2016 compared to $3.2 million or 5.9% of sales in the same period last year. Excluding the impact of amortization expense on investments in surgical instruments of $3.6 million in Q4 of 2016 and $3.2 million in 2015 and the impacts of the medical device excise tax of $12,000 in 2016 and a credit of $694,000 in 2015, our non-GAAP adjusted gross margin was approximately 67.9% in 2016 compared to the non-GAAP adjusted gross margin of 70.9% in 2015.

GAAP operating expenses increased $4.2 million or 9.7% year-over-year to $47.7 million. The increase in operating expenses was driven primarily by a $2.5 million increase in general and administrative expenses, a $1.2 million increase in sales and marketing expenses, and to a lesser extent, a $498,000 increase in research and development expenses compared to last year.

Our GAAP operating expenses, specifically our G&A expenses, included the impact of intangible amortization of approximately $2.6 million in the fourth quarters of 2016 and ‘15 respectively. GAAP net loss was $12.5 million or $0.30 per share compared to a loss of $8.5 million or $0.21 per share last year. Our GAAP net loss includes the impact of non-cash foreign currency transaction gains and losses, which was a loss of $1.3 million in the fourth quarter of 2016 compared to a loss of $261,000 last year. The difference was driven by an impact of fluctuating foreign currencies against the U.S. dollar on our intercompany subsidiary payable balances. Our fourth quarter adjusted EBITDA loss was $829,000 compared to income of $1.3 million last year.

For the 12 months ended December 31, 2016, total revenue increased $20.6 million or 9.5% to $236.6 million compared to $216 million last year. Total revenue increased 10.2% year-over-year on a constant currency basis. U.S. revenue increased $25.8 million or 17% to $181.1 million in fiscal 2016 compared to $155.3 million last year. International revenue decreased $5.1 million or 9% to $55.6 million in fiscal 2016 compared to $60.7 million last year. International revenue decreased 6.6% year-over-year on a constant currency basis.

As of December 31, 2016, we had cash and cash equivalents of $45.5 million compared to $34.6 million as of December 31, 2015. We had working capital of $115.9 million as of December 31 compared to $107.4 million as of December 31, 2015. At December 2016, outstanding long-term indebtedness included the carrying value of the convertible senior notes of $36.9 million and the capital lease obligation related to our headquarters facility of $34.9 million. We have an untapped revolving line of credit of an additional $45 million.

Finally, turning to our full year 2017 guidance expectations, which we updated in this afternoon’s release, we expect total revenue on an as-reported basis for fiscal year 2017 in the range of $263 million to $270 million, representing growth of 11% to 14% year-over-year. Total net loss for fiscal year 2017 of approximately $34 million to $31 million and adjusted EBITDA for fiscal year 2017 in the range of $6 million to $10 million. Finally, for modeling purposes, the midpoint of our fiscal 2017 total revenue guidance assumes mid-teens growth in the United States and low single-digit growth in our international business.

Our international growth guidance for 2017 includes the following expectations in our international distributor markets of Australia and Japan. In Australia, our guidance assumes we continue to service the replenishment demands of our partner, LifeHealthcare, consistent with the trends in the most recent quarters. We have excluded investments by the distributor in new surgical systems. In Japan, our guidance assumes a full 12 months contribution at the historical revenue replenishment run-rate that we have experienced in that market. Remember, our replenishment activity last year was limited by an approximately 4-month voluntary suspension of our distributor’s product registrations.

Finally, while our guidance assumes revenue growth of 11% to 14% for the full year 2017 period, our growth in the first quarter of 2017 will be challenged by difficult comparison in both the U.S., where we posted over 20% growth and in Australia and Japan, where our issues in 2016 did not present themselves last year until April. We have provided a reconciliation of expected 2017 GAAP net loss to adjusted EBITDA in our press release to assist in understanding the impact of certain non-cash items on our outlook for adjusted EBITDA. We continue to target GAAP net income for profitability in Q4 of 2018. For the full year 2017, we expect the weighted average share count for earnings purposes to approximate 43 million to 43.5 million shares.

With that, I will turn the call back to Eric for a few closing comments. Eric?

Eric Major

Thanks, Greg. In closing, we believe we are well-positioned to achieve our full year 2017 growth objectives. Growth in the U.S. remains the key contributor to our total company revenue results and we expect mid-teens growth in the U.S., which clearly differentiates K2M as a market share gainer in the spine space. Outside the U.S., our guidance reflects measured expectations for international growth in 2017 as we continue to service the replenishment needs of our customers around the world. We continue to expect strong tailwinds to revenue performance from our continued focus on new product introductions and investments in our U.S. distribution infrastructure. Importantly, we are showing increasing profitability and cash flow performance, which bolsters our confidence and the ability to drive sustainable organic growth in both the top and bottom lines. And our success in this area should drive our long-term performance.

Tom, we will now open the call for questions.

Question-and-Answer Session

Operator

Thank you, sir. [Operator Instructions] And our first question comes from Matt Miksic with UBS.

Matt Miksic

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

Eric Major

Yes. How are you?

Greg Cole

Hi, Matt.

Matt Miksic

I am well. Thanks. So a couple of things and I guess first, I just wanted to get your sense, it sounds like the overseas distributor issues that everyone was kind of focused on last year are sort of – I don’t know sunset might be too strong a word, but it certainly feels that way. So first, is that the right way to think about where you are at? And then second and I want to just pushing on the tone as it come up quite often in terms of sales reps through competitive environment between you and your sort of midsized spine companies, pure-play spine companies around reps or interaction with larger sort of legacy players in spine around reps? And if I could, I do have one important question on the P&L, but I just didn’t want to start there. So, if you could add some color on those two quick subjects, I’d appreciate it?

Eric Major

Sure, Matt. First one on the international side, yes, I think your term around any of those issues starting to sunset, we feel like in Japan, we are back and up and running. I was very pleased with the team’s ability and our partner’s to resolve that last year ahead of what could have been a longer, protracted process. We are now back up and selling in the Japanese market. And we do have a lot of opportunity there, but first step is to be back up and fully operating in that market and we are pleased with that. In Australia, right now, you can see from the comments that we are looking to Australia, our partnership there, where we are looking at our replenishment levels, we see continued growth in that market to the point where we already were a – one of the top – with our partners, one of the top leaders in Australia. We think that that position will continue in Australia with LifeHealthcare. And I think when you look to your question about the U.S. business and our U.S. reps and distributor model, if you look where we ended up in 2016 versus 2015 between direct sales reps and managers we went from 124 to 140. We are very – on the agent side remained consistent with 85 with strong growth there of kind of churning the bottom performers and bringing on new performers. I think when you look at that U.S. growth and you look at our performance in Q4 of 21.5%, that’s really a result of the fact that a number of – or we continue to get interest from seasoned sales professionals that want to come to K2. So for us, it’s been a continued flow of I think people that recognized the innovation we are bringing to the market and the fact that we want to add those top performing people to drive that growth.

Matt Miksic

That’s helpful. And if I could just one specific question, I know you are sure to get some questions on profitability and EBITDA throughout the call, but I have just one on the fourth quarter gross margin. I think Greg, you had mentioned some offsets. It would be helpful if you could quantify some of those. And maybe just talk about the nature of the reserve and sort of what we can expect for those kinds of things heading forward?

Greg Cole

Sure. So the quarter did have what I would call typical year end review of our inventory reserves and we had about a 300 basis point impact of additional reserves that we took during the quarter. And we do that when we are evaluating products that are reaching sort of the end of their life so we will add reserves for those products or we will look at our physical inventories at the end of the year to reconcile the inventory on hand to the books on records. So, we took some charges there. I don’t see those as being recurring. I see those as typically something that we would see for the end of this year on a one-time basis and not something that we would be doing again next year. And again, we will do our own evaluation next year but not a recurring item.

Matt Miksic

Okay. So that sort of mid to upper – mid to upper is maybe pushing it a little bit, but sort of like north of mid-60s is still kind of where we should think about your trending in gross margin?

Greg Cole

Yes, that’s typically right. We don’t project big improvements in gross margin when we think about our business going forward. We do have a number of things that contribute positively to margins such as CASCADIA. That’s one of the reasons we are very bullish about CASCADIA. It’s a good contributor to positive margins. But again, just strategically as we talked about, the bigger opportunities to really call that the bigger pieces of margins are looking at our distribution relationships and looking at manufacturing as well at some point in the future when we have good scale.

Matt Miksic

Great. Thank you.

Greg Cole

You’re welcome.

Operator

We will take our next question from Matthew O’Brien with Piper Jaffray.

Matthew O’Brien

Good afternoon. Can you guys hear me okay?

Eric Major

Yes.

Matthew O’Brien

Thanks. Good evening. Thanks for taking the questions and sorry about the background noise. Eric or Greg, just to be clear on this, I think a few weeks ago you had mentioned thinking about your business as kind of a mid-teens grower. I want to be clear on this, are you talking about the U.S. business specifically or the overall business and if it’s the latter, why the guidance today in that 11% to 14% range?

Eric Major

So I will start and then Greg you can follow. When you look at our business for the year, the guidance for that 11% to 14%, I think the big thing is international. I think everyone is kind of watching to see what’s going to happen on the international front. When it comes to the U.S., we feel very strong about our ability to deliver mid-teens growth in the U.S. There is upside potential on the international side, but it’s going to depend on all the factors, I think everyone is kind of watching right now what happens in the international front. But on the U.S. side, we do feel that mid-teens growth is going to be just like last year, where we reported that our ability to deliver that growth in the U.S. at a rate that our competitors aren’t and we think we can continue to do that.

Greg Cole

Yes, Matt. The only thing I would comment on the international side, I mean, we have talked about this a little bit before. We had a really fun year last year thinking through some of these investments in new sets with some of our distributor partners that didn’t come to fruition. So when we thought about building our plan this year, we just didn’t think it made a lot of sense for us to put incremental set investments out there for our distributors or distributor partners until we actually have them in hand. So, we do see opportunities obviously there, but we don’t think in terms of setting guidance for you guys that it made a lot of sense to do that, it’s more – we are really setting our guidance around what the replenishment business looks like. And then as we are able to sell new systems and launch new products, those would actually be upside or opportunities for us in the future. So I would say it’s a little more conservative of a position than we had taken in the past with respect to these kinds of set investments, but I think given the drama of last year for us, we really don’t want to do that again.

Matthew O’Brien

Okay. So just to maybe quantify it or frame it up a little bit, you are talking about going to 15% to maybe 30% for the year on the top line, couple of 100 basis points so talking about $5 million basically on the set side internationally, nothing has changed dramatically?

Greg Cole

Yes, yes. We still think about it as exactly that, mid-teens growth in the United States market with a replenishment-based forecast for our international business.

Matthew O’Brien

Okay. And then to follow-up on Matt’s question on the gross margin side, I appreciate the commentary, Greg, about the inventory adjustments. Can you quantify what that impact was? Is that included in the adjusted gross margin number or excluded? And then buried within there, I am a little surprised on the mixed commentary. With CASCADIA doing well, with the U.S. doing so well, why that metric would have contracted year-over-year? And then just real quick additional question on the EBITDA side, it’s below expectations I think and that’s probably more of a Street issue than anything, but are we still expecting profitability in 2018? Thank you.

Greg Cole

Yes. So first and foremost, yes, we are projecting our net income breakeven in the same place that we have. We are not moving off of that stance at all. And the other point really is we have talked about this with you guys before, we try to take every dollar of EBITDA savings that we can as appropriate and reinvest it into the growth rates for the business on a go-forward basis. So we have done that. The guidance that we have out there today going 6 to 10 is doing just that. We are trying to balance that mix of the right GAAP net income breakeven point and the right incremental investment to continue to drive our growth rates on a go-forward basis. So yes, we have thought about all these parameters and we are not changing sort of the end game here in terms of what we believe and when we expect to achieve that net income breakeven target. In terms of the Q4 itself and the margin, there is always pluses and minuses. We sell a very good biologics business, as you know and that biologics business is an example of something that works against the positives that you would have with an implant like CASCADIA. So, we balance those. And then also the countries in which we are selling internationally do in fact matter. There is pretty significant diversity there for using our wholesale distributor partners or if we are using our direct channels, there is a pretty big difference in terms of the mix of margin associated with those. The year end activity around the inventory is a one-time event like we mentioned. If you go back to your records, we had the same thing in 2014. So again, it shouldn’t be that big of a surprise at the end of the day. It’s just something that we don’t expect to recur, going into ‘17.

Matthew O’Brien

Very helpful. Thank you.

Operator

And we will take our next question from Dave Turkaly with JMP Securities.

Dave Turkaly

Thanks. Can you hear me?

Eric Major

Yes.

Dave Turkaly

Great. I know that in the past, we quantified sort of the impact of the distributors in Australia and Japan is sort of $10 million and $5 million. But I was wondering if you might just give us a little more color in terms of what’s baked into the total guidance for 2017 for those two territories? And just to be clear, I think you said in the past that you expected both to be back to growth and is that the case as we look at the 2017 guidance?

Eric Major

Yes, I can take that one. And absolutely, those two markets are back to growth. It is a good business. We talked about how that business – our partners in Australia had what we called a replenishment-based business and then they had what we typically would do with them in terms of investments. And so the replenishment based business is stable as we talked about and it will grow next year, so we are excited about that market and its opportunity. Japan, likewise, is going to see growth in the replenishment business, because they are going to have a full 12 months of activity with us this year, where last year they only had about 8 months during that period where the product registration was suspended. So yes, those markets are doing well and fine. And hopefully, to be really honest, I hope we don’t have to keep about talking about individual markets anymore. We hope to have our entire o-U.S. distribution base stabilized and doing well.

Dave Turkaly

Got it. And then as we look at sort of your three business lines from a margin standpoint, I imagine complex is your highest, but degen is becoming such a bigger part of what you guys do. I was just wondering if you would maybe put some color around it is very different as you look across those three business lines in terms of the gross margin profile and is there a way to quantify that at all, just to kind of get tighter control around what that’s going to look like moving forward? Thanks a lot.

Greg Cole

So yes, I mean, there are certainly opportunities on the degenerative side. We have talked about in the past that interbodies as a category is one of the best margin products in the portfolio of spine. So, the more we sell of those kinds of products, it’s a better story for us. MIS is equally strong and exciting, because the margins actually in the MIS category are quite good. So we are not shying away from having a good, robust degenerative business or MIS business. I think there are overall items that can be helpful to us on a go-forward basis.

Eric Major

And I guess what I would add to that is as we move towards 3D printing, we start to scale 3D printing, there are opportunities there also on the margin side, while it’s not what drives our innovation around 3D printing which was really a result of listening to the surgeons getting our feedback and providing a new alternative, there is opportunity there over time with scale.

Operator

We will take our next question from Glenn Novarro with RBC Capital Markets.

Glenn Novarro

Hi, good afternoon guys. First, for Eric, I wonder if you could talk a little bit about the competitive landscape. At last year’s NASS, we are all there and Medtronic talked about the business starting to stabilize to improve. J&J did an Analyst Meeting talking about reinvesting in the business. Obviously, you guys had a great fourth quarter and continue to take market share. But I wonder if you can talk about what the competitive landscape is right now as we start 2017 given that your two major competitors, Medtronic and J&J, continue to talk about reinvesting in the business? And then I had a follow-up.

Eric Major

Sure, Glenn. I guess to start off, the numbers speak, I think, are the best way to look at how we are performing. So we have heard peer group and some of the other companies speak to their investment or focus in spine, but I think the numbers speak best and that is we have been able to continue to attract the leading sales professionals. They have been coming to us from Medtronic, J&J, Stryker that hasn’t changed. And the best way to really understand that, are the numbers. And you look at our 16.6% growth for the year on our domestic, the accelerated growth of the 21.5% in the U.S., those come from having the best people on the Street and having fantastic products with a focus on the customer. I mean, while it seems obvious, I think the numbers backup the mission of that focus as an organization. So, I can’t really speak to what the other companies are doing or saying, but I can say that it hasn’t had an impact in our ability to continue to attract people and drive new products to the market. Now one of the things that we have done recently and we are very excited about is the introduction of BACS. That’s an example of I think why sales reps are looking to leave and come to K2, why surgeons are looking to K2. They are looking to us for innovation. And when we bring a platform like BACS that really looks at the whole continuum of care and moves beyond looking at the spine in one plane, but starts to bring a whole suite of solutions to think about the spine in all three planes, the axial, the coronal and the sagittal plane, now that just speaks to where K2 has been in taking that experience, along with our new experience of 3D printing and roll that up into a new platform like BACS. So, those are all the things I think that are rolling up to why, when we listen to what other people are saying, but we continue to be able to perform based on our ability to attract our customers and our sales professionals.

Glenn Novarro

And then just to follow-up on that, in 2016, you went from 124 direct reps to 140, can you – and the number of agents stayed constant at 85. Can you talk about the level invested in distribution you are playing for 2017? Thank you.

Eric Major

Sure. So, I think the best way to think of that is that we are guiding this year on top line growth of 11% to 14%, but we are guiding our U.S. growth in mid-teens. That’s going to be driven by leveraging the existing team, but also continuing to bring on the top people and attracting the top people and we need to do that in a balanced environment. So we are going to be making investments. So we are going to – our objective is to deliver $6 million to $10 million in positive EBITDA next year to get to profitability in ‘18 and continue to deliver 5 to 8 new products a year. But in light of all that, we are going to be bringing on new people, so that’s the balance, right, but we definitely have dollars in our plan this year to continue to invest in that field force.

Glenn Novarro

Do you want to quantify the add? Can you at least say is it going to be more than what you added in 2016? Thank you.

Greg Cole

Yes. We don’t typically just quantify it. We do tend to target this opportunistically. What we talked about very candidly is when there is an opportunity to hire an agent versus a direct employee we strongly evaluate that because we are not carrying the cost of that direct employee on the P&L, where an agent is in eat what you feel approach and it’s a very efficient model for us. So, we do look at them on a situation by situation basis. I would say if you looked over the last 3 years, we have hired on average about 10 direct reps and in minimum each of those years. And we are not changing our strategy by any stretch, but we also see plenty of opportunity in hiring agents, which is the piece I think you guys forget about. Agents are by far the biggest contributor to domestic revenue that we have.

Glenn Novarro

Okay, great. Thanks.

Operator

We’ll take our next question from Kaila Krum with William Blair.

Kaila Krum

Hey, guys. Thanks for taking my questions. So, just a couple of follow-ups on the Australian comments. I mean, it sounds like you are being fairly conservative there. I guess, I mean first when have you typically seen LifeHealthcare initiate larger product launches in the past? I think last year, they revised their purchasing plan in late April. So what’s the likelihood that we might hear an update as far as how things are trending again at that time?

Eric Major

Yes, no. Kaila, we don’t give seasonal direction around our distributor investments. But what we can say is in the plan that we have put together here going into ‘17 is that on the replenishment side, we do expect to see continued growth. In Australia, we will have Deformity Down Under again this year typically, it’s around Q3. We will continue to have collaboration across both of our organizations. The Australian team continues to send sales reps up to K2 and we send our team down to Australia on a regular basis. So we are excited about the future. As far as investments into new sets, that will come down to a number of different factors, but I think overall we feel that LifeHealthcare is prepared to continue to invest in growth to maintain a lead position in spine.

Kaila Krum

Okay, great. And then I know you mentioned a little bit about BACS but I would love to hear just a little bit more. What prompted the product development? And then just any detail on the anticipated rollout, how we should think about the sales model potential contribution would be helpful?

Eric Major

Sure. I think for anybody on the call, if you go to our website or link through to bacs.com, it really gives you kind of an overview of the platform. And it’s – we are excited about it that we introduced it at the global sales meeting. And then subsequent to that, we have been having training – individual in-depth training with our sales partners around the country and that will start to expand around the world as well. And the platform really is intended to be – to look at the whole continuum of care. So, there is really four components to it. There is the preauthorization, pre-op planning where we are providing surgeons tools to help them determine ahead of time how they want to treat these patients intraoperatively. And in that pre-op planning, a lot of time spent on thinking about all three claims of the spine, not just the sagittal plane, right the axial plane and the coronal plane. And that’s how we got to developing BACS. So K2M, as everybody know, started in this area of deformity. And so from our inception, we really had been thinking about three dimensions of the spine in correction of the spine. And we felt like there was an opportunity to take that not only to the deformity market, but to bring that three-dimensional approach for surgeons that are doing multilevel degenerative cases as well.

Kaila Krum

Great. Thanks, guys.

Operator

We’ll take our next question from Larry Biegelsen with Wells Fargo.

Craig Bijou

Hi, guys. It’s actually Craig on for Larry. I wanted to start with the international business and not necessarily Japan or Australia. I understand you guys are going to see growth in the replenishment business there, but there were a couple of comments in your script. One about direct subsidiary markets were up 14% in Q4 and I think they have been up a good amount or a good percentage throughout the year? And then there was also a comment about international direct being down. So, I just want to understand the single-digit international growth in 2017 some of the components there, specifically the direct subsidiary and then international direct and are there bigger picture concerns in some other geographic locations?

Greg Cole

No, I appreciate the question. So, the story isn’t really any different, I think and I appreciate you guys pushing a little on the international topic. Our direct international businesses do very well. And they have been teams growers for the last what four quarters that we have talked about it with you guys and we don’t see that those markets changing. We are pretty excited about those opportunities. I think our – no different than what we talked about before, our distributor businesses do not place their – and I am excluding Australia and Japan for a minute, because we have talked about them ad nauseam. Our other distributor businesses, they do place their orders on a sporadic basis and they are not necessarily smooth throughout the year. We tend to focus on the replenishment businesses with them and these would be markets in Latin America, Europe and the other African markets, places like that. We are in 39 countries now. But it is interesting that what we try to do here is that we don’t want to be in a situation with Wall Street like we were in the past where we are projecting a significant investment order for some sets or an incremental launch and then have that – have something happen with the timing or have something happen that they choose not to purchase this any longer. It’s not a place we want to be. So, I think the more prudent approach is we know and have better visibility into the replenishment businesses for all of our distributor partners and so we are taking some conservatism as we think about the instrument side of the business on a go forward basis.

Craig Bijou

Okay, that’s helpful. And just to be clear, there is no – I mean – there is no, you don’t foresee any similar issues that you had in Japan, Australia, it’s just a matter of conservatism?

Greg Cole

There is no catchall. We are not hiding behind some issue that we all know about here that we don’t want to tell you. We are very happy with our businesses right now.

Craig Bijou

Okay, thanks. That’s helpful. And then if I could follow-up on the comment about Q1, I mean, you guys have had a relatively consistent cadence with some sales flipping back and forth between Q2 and Q3 depending on deformity season. So, I just – Q1 has typically been slightly higher than Q4, $1 million or less. So, just how should we think about the cadence throughout the year? I mean, do you expect Q1 to be higher than Q4?

Eric Major

I think the best way – I am going to start with the comment of our seasonality is Q2, Q3, it speaks to our focus as an organizations while we sell across all three components. Complex spine definitely drives seasonality for us in Q3 and Q2. I will let Greg add some color, but I will remind you that as we go into this Q1, as we look at Q1 versus last year’s Q1, for example, any of the disruption that we had in Japan and Australia last year, that was Q2. We had a strong U.S. quarter last year and we had kind of traditional international growth. So we are running off of a traditional comp versus a down comp like what we hit from Q2 and Q3 on the international side.

Greg Cole

Yes. I think the other things to think about it is you recall every year you guys ask us about rep hires and the buildup of our sales force, right. And so what we see is an upward to the right trajectory typically year-over-year in the U.S. and if you just looking at last year, you will see between the first half of the year and the second half of the year, there was about a 500 basis point difference in growth. We don’t actually see the business changing at all. But I would say what’s interesting about our business now is that as we are doing more in the degenerative space than we have, we are feeling a little bit of what I would call the degenerative seasonality, which is a much stronger Q4 on the degen piece of the business and typically a little bit lighter Q1, because elective procedures, the patients are maybe not yet through their deductibles or whatever the case maybe. I think that’s not something we are as experienced with that’s something that we certainly are believing to be the case with the degenerative business. So, I think it something that we are again trying to put some conservatism around and knowing how our sales force ramps kick in typically in the back half of the year against some tough comps that we have in Q1 already. I think it’s a pretty good approach to think about it that way.

Craig Bijou

Okay. Thanks for taking the questions.

Operator

We will take our next question from Matt Taylor with Barclays.

Matt Taylor

Hi, thanks for taking the question. Can you hear me okay?

Eric Major

Yes.

Greg Cole

Yes.

Matt Taylor

Great. So just wanted to ask a follow-up question on the international business, I guess firstly, I didn’t hear in the call if you gave a number for FX impact for ‘17 guidance. Can you just give us that quickly?

Eric Major

Yes. So I think the constant currency growth could be an additional $1 million in terms of overall impact. The numbers we gave were certainly as-reported figures. But there is about 50 to 100 basis point impact of additional constant currency lifter.

Matt Taylor

Okay, understood. And then this year is kind of a funky year with you coming off these issues internationally. But I guess now if you are looking forward over next 5 years or so, I mean, do you think that basically now that your international business is going to grow faster – or sorry slower than the U.S. business over a longer period of time, is that where you are looking to invest?

Eric Major

Well, we have been very clear recently – well, I’d say for the last year that we were going to focus on the U.S. investments. Remember that U.S. business drives better margin for us. We think there is tremendous opportunity still for us in the U.S. business across all three area or segments of our business, complex, MIS and degen. And on the international side, we will continue to support our international partners. We think there is growth opportunity on the international side. But in light of where – in light of last year, focusing if you think about modeling, you think about strategy, if you focus on what is the known which is the replenishment business and you say okay, you are going to get growth across the replenishment business, that means existing customers are continuing to use product and we are seeing growth of existing technologies, i.e., K2M Complex Spine technologies. As we launch new products, then we want to work with our international partners and see as we deploy those in each of the countries around the world. But yes, we are going to see continued performance in both the U.S. and in the o-U.S. business. But this year, we are confident in the mid-teens growth for the U.S. We know the investments we have made as we go into 2017. And on the international side, I think we have kind of gone over some of what happened in ‘16 and why we feel like the guidance that we are giving on international is what makes sense go into this year right now.

Matt Taylor

Sure. I know you want to be sort of once burnt twice shy there, but it would seem to be like assuming there is no set sales and no new product sales is a very conservative pact. I guess from your prior comments, can you just help us understand what it means when you talk about the replenishment rates that you saw in the back half of the year for Australia and Japan if you could quantify that?

Greg Cole

We are going to – this is no different than the – what we talked about on the last call. Our partner in Australia, we had what we call the investment business and the replenishment business when we talked about that guidance and that replenishment business could be anywhere from $8 million to $10 million. And so it really depends on the timing of this ordering and all those kinds of things. The Japanese business is a little bit smaller. It’s a sub $5 million kind of business in general. So again, as we think about what we are trying to do there is going to be a very modest amount of growth in our Australian business off that base I just described, consistent with the way they have made their public disclosures. They are a public company, so all that information us public. And in terms of Japan, really the way we think about Japan is we are going to see 12 months of business with them versus really what we saw last year was 8 months of business with them. And again, I mean, the law of small numbers there, it’s an increment in its growth, but it’s not exactly an overwhelmingly huge number there. But that’s all built into our forecast and our guidance. And the stocking distributors, they are all good performers, but again not different from what we have talked about in the past, they are traditionally single-digit growers, sometimes mid, sometimes low. It depends, because again they don’t place their orders on a monthly basis or a weekly basis, they place them as they manage against currency and just their current needs. So putting all of that together, the approach is not what I would say an unusual approach. It’s just making sure that you don’t get ahead of ourselves in terms of assuming investments in new systems and such that may not materialize.

Matt Taylor

Okay. Alright, thanks a lot for the color.

Operator

We will take our next question from Steven Lichtman with Oppenheimer.

Steven Lichtman

Thank you. Hi, guys. Eric, you mentioned during your prepared remarks that CASCADIA continues to be a door opener for you guys. Can you maybe elaborate a little bit more on how that maybe becoming a pull-through product if at all to the rest of the business in the U.S.?

Eric Major

Absolutely. So when we are – when we – we have a large portfolio, right, of over 80 products now. And when you think about that portfolio, our sales partners around the world and the U.S. are going to decide what to lead with. And what we are finding is that they are leading with CASCADIA. CASCADIA has just really brought us – or brought the surgeon a new way to think about interbody implants. We listened to the surgeons, and it has a tremendous amount of advantages, we believe or a lot of things that the physicians were looking for. So because of that, our reps are leading with that. So when they lead with that, the number of surgeons and surgeon users, more than half of our new users were CASCADIA users in this last quarter. So what we are seeing is that we are opening the door with CASCADIA. From there, it pulls through EVEREST, it pulls through our biologics and then with those, the surgeons start to see the differentiation of our technologies, and with that, they start to ask about our other technologies whether it’s MESA, our cervical technologies and/or our minimally invasive technologies. And so they clearly are using CASCADIA as the lead product. And as I had stated in the prepared remarks, what we are also going to be doing is continuing to develop new products utilizing that CASCADIA Lamellar 3D Titanium Technology.

Steven Lichtman

Great. And then just secondly, just on the long-term in Japan, you guys talked about in the past of pursuing your own registrations. Any update there and how you see that as a potential avenue for further growth in the long-term in that country?

GregCole

Yes. I mean, I think that market is an exciting market. It really is – we are – the progress as we talked about before, we haven’t changed at all our approach on getting our own shown in. I mean, we are expecting to receive our own product registrations in 2017. And as we talked about before, that really gives us the flexibility to make decisions around the distribution channel. Now in the meantime, before we have our shown-ins, we are going to try to work with our partner in Japan to improve the business there. But again, I don’t think our expectations are that we are going to grow it significantly. It’s a big market. We do see opportunities, but we may have to make some changes to really see that stuff come to fruition.

Eric Major

And I think what I might add to that is that we are in the process of receiving our own shown in. We think strategically it’s important. You also take away though for you guys to think about is it’s not a driver on our ability to continue to operate in Japan right now so we do have clearance in Japan. It is through our original partner, but we have approval through, clearance through the PMDA. And I think that’s a very important takeaway here, right. So, we can continue to explore what ways to grow in that market and we will be receiving those shown-ins as we continued to work through the process with the PMDA, but I just want you to note that we can continue to move forward today with our existing relationship in Japan.

Steven Lichtman

Sure, great. Thanks, guys.

Operator

And ladies and gentlemen, that does conclude our conference for today. Thank you for your participation.

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