SeaSpine's (SPNE) CEO Keith Valentine on Q3 2017 Results - Earnings Call Transcript

SeaSpine Holdings Corporation (SPNE) Q3 2017 Earnings Conference Call November 2, 2017 4:30 PM ET

Executives

Carrie Mendivil – Investor Relations

Keith Valentine – President, Chief Executive Officer and Director

John Bostjancic – Chief Financial Officer and Treasurer

Analysts

Matthew O'Brien – Piper Jaffray

Ryan Zimmerman – BTIG

Operator

Welcome to SeaSpine's 2017 Third Quarter Financial Results Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded today, November 2, 2017.

I would now like to turn the conference call over to Carrie Mendivil, Investor Relations. Please go ahead.

Carrie Mendivil

Thank you, Crystal, and thank you for participating in today's call. Joining me from SeaSpine is CEO, Keith Valentine; and CFO, John Bostjancic. Earlier today, SeaSpine released full financial results for the quarter ended September 30, 2017.

During this conference call, we will make forward-looking statements within the meaning of federal securities laws in regard to our business strategy, expectations and plans, our objectives for future operations and our future financial results and condition. All statements other than statements of historical fact are forward-looking statements. Such statements may include words such as believe, could, would, will, plan, intend and similar expressions. You are cautioned not to place undue reliance on forward-looking statements, which are only predictions and reflect our belief based on current information and speak only as of today, November 2, 2017. For a description of risks and uncertainties that could cause material differences between our actual results and those stated or implied by the forward-looking statements, please see our annual report on Form 10-K filed with the Securities and Exchange Commission on March 3, 2017, which is available on our corporate website, www.seaspine.com, and at www.sec.gov.

I will now turn the call over to Keith Valentine.

Keith Valentine

Thank you, Carrie. Good afternoon, and thank you all for joining us. We are pleased with our third quarter results, which reflect ongoing execution driving revenue performance while focusing on cash conservation.

Our third quarter revenues totaled $31.7 million, which was unchanged versus the year-ago period. We did incur some revenue disruption due to the hurricanes in Texas in the Southeast states, and John will provide more details in the financial section. I want to take a moment to acknowledge all of those who have been directly impacted by these storms as well as the fires in Northern California.

Geographically, U.S. revenue decreased approximately 1% to $28.2 million, with spinal implants revenue down 3.9% to $13.3 million and Orthobiologics revenue up 2% to $14.9 million. International revenue was 7.4% to $3.5 million, largely on the strength of the recently added distribution.

In the U.S., we are continuing to gain traction from our recently launched products. In the third quarter, these new products contributed more than 30% of U.S. spinal implants revenue. We look forward to the revenue growth that our Shoreline TruProfile Anterior Cervical fixation system and our Mariner pedicle screw system are expected to deliver as they pick up further traction following their recent full commercial launches. We remain confident that we have built a solid foundation for growth through more loyal and exclusive distributor relationships and by investing in product development and launching more innovative new products that focus on our surgeon customers' needs.

Last week, our confidence in our business and platform were reaffirmed at the recent North American Spine Society, or NASS, Annual Meeting in Orlando, which was an overwhelming success. We hosted a Surgeon Symposium and Investor Meeting with – which highlighted data from a preclinical study demonstrating the benefits of our NanoMetalene technology. Professor Bill Walsh, who runs the surgical and orthopedic research laboratories at Prince of Wales Clinical School in Sydney, Australia, conducted a study that compared the bone formation of NanoMetalene and PEEK implants in a sheep model. NanoMetalene is a submicron thick layer of commercially pure titanium, which molecularly bonds to the entire PEEK implant surface. The results show that NanoMetalene supports faster and better bone formation compared to PEEK and that the benefits were apparent even inside the graft aperture in the sheep model.

Booth activity at NASS was strong, driven largely by interest in our recently launched products. The surgeon response to these products further validates our confidence that we are offering innovative and cost-effective solutions. With the growing sophistication in spinal implant technology, we are committed to offering complementary, innovative and cost-effective orthobiologic products as payers and hospitals seek more economical orthobiologic solutions.

Looking to our Orthobiologics portfolio. We have some exciting new product introductions on the horizon, which mark the first launch of internally developed orthobiologics products since 2010. We recently announced the limited commercial launch and completion of initial surgeries for our OsteoStrand Demineralized Bone Fibers. OsteoStrand is a new product family for SeaSpine based upon fibers rather than standard demineralized bone matrix, or DBM, particulate. This platform builds upon our current DBM expertise and a product offering that is 100% human tissue with attractive handling properties and potential clinical advantages as we continue our mission to develop complete procedural solutions that integrate our spine and orthobiologics product offerings and to further leverage our Irvine manufacturing facility.

Additionally, we plan to launch the OsteoStrand Plus Demineralized Bone Fibers with our proprietary Accell Bone Matrix on a limited basis in early 2018. We believe these product offerings deliver clinical value as payers and hospitals seek more cost-effective orthobiologic solutions.

In April, we initiated an alpha launch of our reusable RAPID Graft Delivery System, which is designed to provide surgeons a cost-effective and controlled method to predictably deliver a broad range of orthobiologic grafts efficiently to the spine. We are incorporating design feedback from surgeons who participated during alpha to support a full commercial launch by January. This innovation was in part opportunistically derived from the intellectual property we acquired from NLT Spine.

Finally, we continued to expect the limited launch of our Resorbable Mesh DBM system in late 2017 or early 2018. This system, when cleared [ph], will be the only product to offer 100% DBM material within a resorbable mesh, which is made from a common suture material. The launch of this product reflects our focus on offering complete procedure solutions by helping to prevent graft migration during posterior – posterolateral fusion procedures.

Our recent launched products coupled with our pipeline across both portfolios address attractive commercial opportunities in the United States. As I have stated in the past, our surgeon-centric product development helps ensure our products meet the needs of surgeons and their patients. Our innovation strategy also seeks to drive complete procedural solutions that combine efficient spinal implant systems with our industry-leading orthobiologics to deliver clinical value to the surgeon, hospital and patient. We believe that the focus on innovation and clinical value and our investment in education and training will make us the spine company of choice among both surgeons and distributors. We are seeing progress in this regard, and we are optimistic that the increasing loyalty and exclusivity we see amongst our distribution network will translate into sustainable, long-term revenue growth.

In sum, we are continuing to launch differentiated products, strengthen our distribution network and execute on the innovation and commercialization strategy critical to fulfilling our mission to deliver cost-effective clinical value to the surgeon, hospital and patient.

I'll now turn the call over to John to provide more detail on our financials and our financial outlook, then I will wrap up. John?

John Bostjancic

Thanks, Keith, and good afternoon, everyone. As Keith noted earlier, total revenue for the third quarter 2017 was $31.7 million, unchanged compared to the prior year. The current quarter revenue was impacted by an estimated $500,000 to $600,000 of revenue disruption caused by the hurricanes in Texas and the Southeast and by one less selling day compared to the third quarter of 2016.

Geographically, U.S. revenue decreased approximately 1% or $240,000 to $28.2 million, while international revenue increased 7.4% to $3.5 million.

U.S. spinal implant revenue decreased 3.9% or $540,000 year-over-year to $13.4 million. Notwithstanding the impact of the hurricanes, low single-digit price declines and decreased usage of our legacy systems outpaced the solid revenue growth contributed by recently launched products.

Following the recent full launches of the Shoreline and Mariner systems, we anticipate this dynamic to shift as we exit 2017 and move into 2018, with growth from recently launched products and new and upgraded distribution outpacing any continuing declines in pricing usage of our legacy systems. However, for the remainder of 2017 and to the early part of 2018, we continue to expect this shift to be muted by further revenue declines from certain lower-performing legacy distributors that is a byproduct of the strategic and more committed distribution adds we've made in the past 18 months.

U.S. Orthobiologics revenue increased 2% or $300,000 year-over-year to $14.9 million, driven by growth across multiple product lines generated from recently added distributors. Overall, pricing remains stable in the U.S. Orthobiologics portfolio. We are excited about the growth potential of the orthobiologics franchise going forward as we combine the benefits of the stronger distribution footprint with the innovation that we're bringing to market with the upcoming product launches that Keith discussed earlier.

We continue to generate the anticipated gross margin expansion that reflects the return on the substantial investments that we made at about Irvine, California manufacturing facility. For the third quarter of 2017, gross margin improved 530 basis points to 61.6% compared to 56.3% for the same period in 2016 and was the fourth consecutive sequential quarter of expansion. Consistent with recent quarters, the increase was mainly driven by lower manufacturing costs for orthobiologics products manufactured at our Irvine facility. This improvement was slightly offset by a $230,000 increase in noncash amortization for technology intangible assets related to the NLT acquisition.

Operating expenses for the third quarter of 2017 totaled $27.3 million, a slight decline compared to $27.4 million for the same period of the prior year.

R&D expenses increased by $234,000 to $2.8 million for the third quarter of 2017 or 8.9% of revenue and is in line with our expectations as we continue to invest in accelerating innovation in both the spinal implants and orthobiologics portfolios.

Selling, general and administrative expenses decreased $129,000 to $23.7 million for the third quarter of 2017. The net decrease was driven by a $1.2 million noncash benefit related to a decrease in the fair value of contingent consideration liabilities related to the NLT acquisition and a $1 million decrease in consulting and other expenses, primarily due to the completion in late 2016 of the outsourcing project to our third-party logistics provider. These decreases were mostly offset by a $1 million increase in selling commissions and a $1 million increase in accrued incentive-based competition related to SeaSpine's year-to-date financial performance. While we expect total SG&A expense in 2017 to decrease as a percentage of revenue compared to 2016, components within SG&A, specifically distributor commissions, are expected to continue to increase relative to 2016, both in absolute terms and as a percentage of revenue.

Net loss for the third quarter of 2017 was $7.5 million compared to a net loss of $9.5 million for the third quarter of 2016. Cash and cash equivalents at September 30, 2017, totaled $16.7 million, and we had no borrowings outstanding against our $30 million credit facility.

During the third quarter of 2017, we raised $11 million in net proceeds through the sale of approximately 1,023,000 shares of our common stock under our at-the-market equity offering program, a portion of which we use to fully pay down all outstanding borrowings and interest under the credit facility. We are very pleased with our improved liquidity position with a total cash balance of $4.4 million higher than at the end of June and all outstanding debt and interest paid down as of September 30, 2017.

Our year-to-date net cash burn, which excludes financing inflows and outflows, totaled $9.8 million through the end of the third quarter 2017. During the third quarter, our net cash burn was $2.7 million, a $2.9 million sequential quarter decrease. We continue to leverage the scalability and cost efficiencies associated with the favorable impacts of a variety of operating expense and inventory cost saving initiatives implemented in 2016. And we continue to increase our investment in the sales, marketing, R&D and spinal implant inventory in instruments to support the fully commercialized launches that are so critical to driving future revenue growth. Our strong liquidity position provides us the flexibility to continue to invest for long-term sustainable growth.

Turning to our financial outlook for 2017. We expect revenue to be in the range of $130 million to $132 million, reflecting growth of 1% to 2.5% over full year 2016.

We now expect gross margin for 2017 to be in the range of 59% to 60%, which includes the impact of approximately $900,000 more in annual noncash intangible asset amortization compared to 2016 because of the NLT technology acquisition; SG&A, excluding noncash equity-based compensation charges and noncash benefits or expenses related to changes in the fair value of NLT-contingent consideration liabilities, to approximate 69% to 71% of revenue; and R&D to approximate 9% to 10% of revenue.

Looking ahead, two to three years beyond 2017, as we build scale to the business and achieve anticipated longer-term, double-digit revenue growth and leverage the exiting infrastructure in which we have invested so heavily, we expect to generate gross margins in the mid- to upper 60% range; to invest 7% to 8% of revenue in R&D; and to reduce SG&A, excluding stock-based compensation and noncash benefits or charges related to NLT contingent liabilities, to between 60% and 64% of revenue. We plan to end 2017 with at least two years of liquidity, as measured by cash on hand and availability under our credit facility.

At this point, I'd like to turn the call back over to Keith for closing comments.

Keith Valentine

Thank you, John. Our strategy to reposition SeaSpine for growth is on track. As we move into the final months of 2017, our momentum continues across both product portfolios. Looking ahead to 2018, progress will be defined by continued execution and consistent investment in new products and market development efforts, which, we believe, will further fuel financial results throughout the year and provide plenty of momentum as we head into 2019. We look forward to updating you on our progress on future calls.

With that, we will now open it up to questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from Matthew O'Brien from Piper Jaffray.

Matthew O'Brien

Just to start off on the new product side, there's a lot coming – there's a lot you've been introducing. It's exciting stuff, but when do some of the legacy headwinds start to abate? Is it the end of this year? Is it the first half of next year or even later than that? And then as you're launching all these new products, they've expensive as far as the instrument sets that go along with them. Is that going to be a gating factor for you?

Keith Valentine

Yes. I'll answer the first part, Matt, and I'll let John give some insight to the second part of that question. So from the first part, I think as we discussed in here – and I think it's a reasonable question of how the legacy products continue to have an impact on the future outlook and our revenue, of course. I think we've been pretty predictive and we're moving towards the execution that as we exit 2018, we'll be greater than 50% of our revenue coming from products four years or younger, right?

And I think that's when you really start to see another significant shift, where we have – just by definition, we'll start having less and less reliance on the legacy products and more reliance on continued fueling growth of the new product introduction. That said, I think that there's a number of things that we've done over the past year or two that continue to give new life to some of the legacy opportunities by giving them greater application in less invasive surgery, greater application in even open surgery. So there's still some legacy products that we think still have a good deal of future ahead of them, thanks to some of the new advancements we've incorporated within those sets.

John Bostjancic

Yes. And on the cash question, Matt, the goal of ending 2017 with at least two years of liquidity, obviously, reflects the benefits we've seen from the year-to-date cash rates under the ATM program. But it also masks out and contemplates the cadence of new product launches. I think Q4 is going to look a lot like Q2, and we've got a lot of spinal implant systems being launched, but also for the first time, as Keith mentioned, in many years, new orthobiologics products being launched. So I think Q4 will look a little bit more like Q2 in terms of cash burn because of the investments we're making in inventory to fully support these launches. But we do contemplate that continued investment in inventory now with both portfolios going forward when we make the statement about the liquidity position that we expect to hit at the end of the year.

Matthew O'Brien

Fair enough. And then just two for me. On the gross margin side, the pop in the quarter that we saw, which is good to see, that's just more of a mix benefit that you saw that should come down as orthobiologics sits back up here in Q4? And then that metric – I guess how do we think about that as we head into 2018 as you get a little bit more scale, a little bit more revenue coming from some of these hardware products?

John Bostjancic

Yes, we've seen a nice trend in the gross margins. As I said, it's four sequential quarters in a row that we've seen it increase. The mix issue comes into play – as the hardware business starts to turn towards growth, you get a better gross margin contribution from that portfolio. But also, the volume that we're adding and plan to add with the launch of the fibers products to the Irvine manufacturing facility, it's anticipated to continue to generate more leverage on the gross margin line. And I think looking backward, the ability to take cost out of the orthobiologics production process that's been driving this sequential expansion in gross margin, we'd expect to continue. So we're looking at similar patterns of the improvements being drawn – driven by the deleverage in the orthobiologics facility, and then it could be complemented by a shift in mix as the hardware starts to grow.

Matthew O'Brien

Got it. Last one for me, just on the commentary about an extra $1 million. I think you said in the quarter of spend on the incentive side of things that, that should stay elevated going forward. Can you expand on that a little bit? I know you're getting access to some better – or some higher-end distributors than you've had historically. Is that investment in those types of distributors? And then can you characterize some of the revenue opportunities that some of the those distributors may bring?

John Bostjancic

Yes, it's exactly what you're talking about. It's the investments we're making in the new and more exclusive distribution that we feel is so critical to achieving the sustainable, long-term revenue growth. That's exactly what's driving the increase in the commissions at this point. But that does come down over time, right, as the longer-term agreements we strike. You may have an accelerated or fixed commission in the year 1, but then it comes down over time, so we'll get more leverage out of that line. But yes, that's exactly what's driving that.

Keith Valentine

And Matt, I think it's important to – it's consistent with the theme, right? The theme is that as long as new distribution or even existing distribution is willing to invest in their business, and part of that investment is in people, part of it is in how they're going to go after the territory, then we'll invest with them, right? And I think it needs to be consistent. We're investing in new products. We're investing in how we're going to deploy those products and commitments we've set. But we also have to give them the ability to also expand their territories. And as they expand their territories and bring aboard good reps, then we put them in a place of success. And that's how we've been approaching it for those exclusives and even those current distributors that want to become more exclusive.

Operator

[Operator Instructions] And our next question comes from Ryan Zimmerman from BTIG.

Ryan Zimmerman

So I just want to ask about the legacy products versus the new products. I appreciate all the color you guys have given about in '18, 50% of your products being four years or younger. When you think of the legacy products, you did mention that you've retooled a few of them to continue to provide some growth for you. And I'm just kind of curious how you characterize the broader legacy portfolio and whether there's other opportunities you can look to within that portfolio to retool those to still provide some of that growth.

Keith Valentine

There's – when you look at a couple interesting things over the history of the two spinal companies that came together, right, the original SeaSpine and Theken Spine, there's a lot of crossover. And there's been good opportunity to sit down and look at the best of the features and try to, a, expand on those features and new product development; but also, look at what subtle things we can do through more specific changes to the instrumentation that lead to a better, more seamless experience in the surgery.

So a lot of items that we're doing are not changes necessarily to the implant system, but designing kind of next steps or better instrumentation. And good example of that is for less invasive surgery, right, that sometimes, you need instrumentation that helps carry the day to make the surgery more seamless. And so we've done this evaluation with cervical systems as well as the lumbar portfolio. But I think the greatest result, or at least biggest market opportunity, has come from the evaluation of those lumbar – the lumbar portfolio.

Ryan Zimmerman

Appreciate that. And then just an update on feedback from the field in terms of Skipjack and kind of where your expandable cage sits in terms of launch.

Keith Valentine

Yes. So still in alpha launch. This particular alpha – every alpha launch has a little bit different progression. This particular alpha launch kind of defined that we need continue to refine the instrumentation. The instrumentation, it works obviously in surgery, but there's ways to make it more elegant and refine it. And so one thing clear with the surgeries that we've done to date is the implant is working very nicely and effectively. We just need to continue to advance the instrumentation.

So we fully anticipate that those changes will be made for full launch. Additionally, we're gaining additional insight into the differences and the need for a parallel distraction versus orthodontic distraction. And those are valuable learnings and will help shape not only how we launch this product in the full launch, but will also shape future product iterations with the same technology. Obviously, this is a family of products that will be coming out from an expandable perspective, whether it's expandable on height or expandable on width.

Operator

Thank you. And I am showing no further questions from our phone lines. I would now like to turn the conference back over to Keith Valentine for closing remarks.

Keith Valentine

Thank you, everyone, for joining us today, and have a great evening.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone, have a wonderful day.