Michael Beaulieu - Integra LifeSciences Holdings Corp. Peter J. Arduini - Integra LifeSciences Holdings Corp. Glenn G. Coleman - Integra LifeSciences Holdings Corp. Sravan Emany - Integra LifeSciences Holdings Corp..

David L. Turkaly - JMP Securities LLC Jonathan Demchick - Morgan Stanley & Co. LLC J.P. McKim - Piper Jaffray & Co. Robbie J. Marcus - JPMorgan Securities LLC Shagun Singh - Wells Fargo Securities LLC Jayson T. Bedford - Raymond James & Associates, Inc.

Raj Denhoy - Jefferies LLC Craig William Bijou - Cantor Fitzgerald Securities Travis Steed - Bank of America Merrill Lynch Steven Lichtman - Oppenheimer & Co., Inc. Ryan Zimmerman - BTIG LLC.

Good day everyone and welcome to the Integra LifeSciences First Quarter 2018 Financial Results Conference Call. As a reminder, today's call is being recorded. At this time, I would like to turn the conference over to Mike Beaulieu, Director of Investor Relations. Please go ahead, sir..

Thank you, Brei. Good morning and thank you for joining Integra LifeSciences first quarter 2018 earnings conference call.

Joining me on the call are Peter Arduini, President and Chief Executive Officer; Glenn Coleman, Chief Financial Officer and Corporate Vice President of International; and Sravan Emany, Vice President, Treasurer and Investor Relations. Earlier this morning, we issued a press release announcing our first quarter 2018 financial results.

The release and corresponding earnings presentation, which we will reference during the call, are available at integralife.com under Investors, Events & Presentations, in the file named first quarter 2018 earnings call presentation.

Before we begin, I'd like to remind you that many of the statements made during this call may be considered forward-looking statements. Factors that could cause actual results to differ materially are discussed in the company's most recent filings with the SEC and in the release. Also the discussions will include certain non-GAAP financial measures.

Reconciliations of any non-GAAP financial measures can be found in today's press release, which is an exhibit to Integra's current report on Form 8-K filed today with the SEC. I will now turn the call over to Pete.

Thank you, Mike, and good morning, everyone. If you'll turn to slide 4 in the earnings presentation – let me start by sharing a few highlights from the quarter. 2018 is off to a strong start with first quarter sales of $357 million, an increase of 38% on a reported basis and 3% on an organic basis over the prior year.

Adjusted earnings per share increased 49% to $0.58. These results were better than expected and give us confidence to raise our full year guidance for revenue by $10 million and earnings per share by $0.08. Before Glenn discusses our financial performance, I'd like to provide an update on our channel expansion strategy and Codman integration.

Last December, we announced plans within our Orthopedics and Tissue Technologies segment to expand our sales channel, improve our focus and competitiveness and better align our product portfolio with our clinical customers.

Since then, we've established dedicated channels for our extremity orthopedics and inpatient wound reconstruction franchises, in addition to our surgical reconstruction and advanced wound care businesses. As a result of these additions, we now have four dedicated channels that are aligned with our primary clinical call points.

We've added approximately 30 new account managers in the first quarter and expect to add a similar number of positions in the second quarter. Taken together, these additions will substantially complete the commercial expansion plan for the year.

In the first quarter, the reduced selling time resulting from territory realignments and classroom-based training was in line with our expectations. We expect to see a positive impact on our organic growth from these activities beginning in late second quarter and accelerating in the second half of the year.

We're also very encouraged about our R&D and new product investments, which will begin to deliver sales growth later this year and position us well for 2019.

Within our regenerative franchise, we'll introduce new products including AmnioExcel Plus, an enhanced version of our amniotic product, and we also expect European approvals for our IDRT meshed and SurgiMend macroporous products for use in wound and surgical reconstructive procedures.

In extremity orthopedics, we'll be launching a new fusion nail in 2018 called the Panta II for ankle fixation.

And within our ankle arthroplasty portfolio, we will introduce a new total ankle revision system in the U.S., which will enable the revision of many competitive ankle systems and position Integra as with one of the broadest and most comprehensive ankle arthroplasty product lines.

I'm pleased with the progress that we've made to date within the OTT segments, specifically how well the teams navigated through the channel expansion in the first quarter.

As we look forward to the rest of the year and begin to benefit from the channel investments and new products, we feel confident in our ability to achieve 8% to 10% organic growth in this segment for the full year. Our performance in Codman Specialty Surgical segment exceeded our expectations in the first quarter.

Similar to OTT, we experienced reduced selling time in the first quarter as our commercial teams were training on the combined portfolio and taking on new territory assignments. Our careful management of this process and the commitment of our teams resulted in both the legacy and acquired Codman businesses performing ahead of plan.

We also successfully completed the transition of the Codman business in China, which represents the country with the largest revenue base that was not part of the closing in October 2017.

As we enter the second quarter, it's important to note that we integrated sales territories associated with over 90% of the Codman revenue globally by the end of the first quarter. And I'm pleased that the low turnover we faced in the process helped to preserve the combined talent pool.

We also opened a new campus in Mansfield, Massachusetts, which will serve as the home of the conveying Codman teammates. This facility is located near the legacy J&J campus.

With the commercial integration nearing completion, the next significant step will be to exit the transition services agreements that we have with J&J, with the first exits occurring in the third quarter. As previously discussed, given the size and complexity of the integration, we will continue to roll off additional TSAs through 2019.

After those exits, the most significant remaining step will be the eventual transfer of manufacturing to our Mansfield location. In the first quarter, we integrated the R&D organizations and have prioritized a new pipeline of registrations and product introductions that will accelerate growth in 2019 and beyond.

We recently received approval to sell CUSA Clarity in Japan, and we're on track to receive approval for DuraGen there later this year.

As a reminder, our direct sales channel in Japan is substantially larger than it was a year ago, allowing us to sell directly to customers and to drive increased growth and profitability when compared to the indirect model we had in place prior to the acquisition.

So if you turn to slide 5, when we announced our plan to acquire the Codman business from Johnson & Johnson over a year ago, we highlighted the strategic fit and how we plan to generate significant shareholder value.

On left-hand side of the page is a picture of that slide that we used to describe the strategic rationale for the Codman acquisition when we announced it in February 2017. Today, we're even more confident that when we signed the deal about the shareholder value to be created.

The breadth of our product portfolio, the global leadership position that we now have in neurosurgery, the strong recognition of the Codman brand, and the scale that enables will help us improve our EBITDA margin profile and global growth.

In the first quarter, our commercial teams identified multiple opportunities for cross-selling, which resulted in increased sales.

Among them are clinicians who regularly use Integra products and are now excited to learn about Codman's leading products, electrosurgery and hydrocephalus management, likewise Codman customers who brought opportunities for legacy Integra product such as CUSA Clarity.

Outside the U.S., we're seeing similar benefits from the union of the product portfolios and sales expertise. As I mentioned on slide 4, we are ahead of our commercial integration plans and the remaining items are on track.

We've combined the R&D pipelines and see opportunities to generate a steady flow of new products over our five-year planning horizon. With these investments and a commercial channel that is 30% larger in the U.S.

and 50% larger internationally, were in a position not only to drive growth in our existing portfolio but also to launch new products through a larger, more effective channel.

The closure of the transition service agreements will represent a significant milestone for Integra and will correspond to the investments that we're making to stand up our own global organization. Exiting these agreements will signify that we have successfully built the necessary infrastructure to assume direct control of all operations.

At this point, we'll be running the business independently and be better positioned to manage our operating costs and drive leverage. Consistent with the strategic value that we discussed when we announced this transaction in February last year, Codman is accretive, it's accretive to our EBITDA margins.

It generates a positive effect on our tax rate, and provides avenues to drive organic growth through our rich R&D pipeline of core technologies. So based on two quarters of running the Codman business, we're pleased with how the team has come together and achieved above expectations.

Therefore, we're raising our full year revenue and earnings outlook for the whole company. And with that, I'll now turn the call over to Glenn to review the quarter in detail..

Thanks, Pete, and good morning, everyone. Total first quarter sales were $357 million, representing an increase of 38% on a reported basis and 3% on an organic basis. Sales exceeded the midpoint of our expectations by about $8 million.

This performance was driven by better organic growth in our Codman Specialty Surgical segment, higher than expected sales from the Codman acquisition, and a more favorable impact from foreign currency. Turning to slide 6, I'll begin with a review of the CSS segment. Reported sales for the first quarter grew 51% to $236 million.

Acquired revenues from Codman Neurosurgery were $78 million, exceeding our expectations while also improving sequentially over the fourth quarter, which is usually the quarter that experiences the highest sales in a given year.

Organic sales in the segment grew 2.5% over the prior year, which is also slightly better than expected, reflecting the progress of the integration around the globe. Looking at the franchises within CSS, organic sales and advanced energy increased double digits year-over-year driven by CUSA Clarity.

We continue to receive positive feedback for surgeons globally, resulting in strong CUSA sales worldwide. We're still in the early stages of this product launch and expect CUSA Clarity sales to be in the high single to low double-digit growth range for the balance of 2018.

Sales of DuraGen and DuraSeal were flat compared to the prior-year quarter, in line with our expectations. This performance was directly related to our sales reps having less time in the operating room as they are going through extensive product training and new territory assignments.

For the remainder of the year, we expect to see the benefit of our expanded commercial team and deliver a low to mid-single digit growth for DuraGen and DuraSeal. First quarter sales in precision tools and instruments grew over 2% compared to the prior year driven by growth in MAYFIELD, MicroFrance and specialty surgical instruments.

Turning to our CSS segment guidance for the full year, we're slightly increasing our expectations for reported revenue growth to a new range of 33% to 35% and organic growth to a range of 2% to 3%. We expect that acquired full year Codman revenue will be in the range of $325 million to $335 million, consistent with our prior guidance.

Let me now move to our Orthopedics and Tissue Technologies segment on slide 7. First quarter sales were $121 million representing an increase of 18% over the prior year on a reported basis and 3.6% on an organic basis, roughly in line with our plans. Sales of our regenerative products increased mid-single digits in the first quarter.

PriMatrix, which increased double digits, drove this growth as we continue to see increased usage and adoption of this product in both the inpatient and outpatient settings. Sales of our IDRT product line as well as private label also grew mid-single digits.

In our total extremities business, sales in both ankle and shoulder arthroplasty increased double digits continuing a consistent trend since last year. In aggregate, our total extremities sales decreased about 5% resulting from a decline in our lower fixation portfolio.

That said, the expansion and increased focus of our sales force are expected to deliver accelerated organic growth starting in the second half of the year. International sales in the segment increased mid-single digits, driven by strength in Europe.

With respect to the full year 2018 guidance for the Orthopedics and Tissue Technologies segment, we are reiterating our previous guidance for reported revenue to increase in the range of 10% to 12% and organic revenue to increase in the range of 8% to 10%. Please turn to slide 8 for a consolidated revenue guidance.

We are increasing our consolidated full year 2018 total revenue guidance by $10 million to a new range of $1.47 billion to $1.49 billion, representing growth of about 25%. The $10 million increase is based on a strong first quarter performance in CSS and also reflects a higher benefit expected from foreign currency exchange.

This guidance range implies organic growth of about 5%, which is consistent with our prior guidance. For the second quarter of 2018, we expect total reported revenue to be between $365 million and $370 million, which represents growth of 29% to 31% over the prior year.

With our first quarter organic growth of 3% slightly exceeding our expectations, I now will provide some direction for quarterly organic growth over the balance of the year.

As we continue to move forward with the Codman integration and the OTT channel expansion, we expect a slight sequential increase in organic growth in the second quarter, which will put us on track with our plans for the first half of the year.

We would then expect to see an acceleration in the third quarter, which represents the easiest year-over-year comparison and should be our highest organic growth quarter of the year. Please turn to slide 9 where I'll review highlights from our first quarter P&L performance.

Our adjusted EBITDA margin for the first quarter was 23.3%, an improvement of 200 basis points compared to the prior year.

This significant margin expansion resulted from better leverage on our operating expenses mainly in our G&A costs and was achieved despite the dilution to gross margin from the Codman products, which currently carry lower gross margins than our historical average.

Given the strong performance in the first quarter, we expect to be at the higher end of our full year adjusted EBITDA margin guidance range of 23% to 24%. We are fine-tuning the components of EBITDA margin guidance by slightly lowering our gross margin, offset by lower SG&A costs.

Our adjusted tax rate for the quarter was 18.4%, down from 25% in the prior year's first quarter because of the recent changes to the U.S. corporate tax laws and the impact from lower tax jurisdictions, such as Ireland and Switzerland.

For the full year 2018, we're reducing our adjusted tax rate guidance by 1 percentage point to 19% to reflect our expectation for higher profits in these countries. Adjusted earnings per share increased 49% to $0.58 compared to $0.39 in the same quarter of the prior year.

This adjusted earnings per share performance was $0.08 better than our expectations. Higher-than-expected revenues in CSS, better operating expense leverage and an improved tax rate drove this strong performance.

Based on our first quarter performance and our outlook for the remainder of 2018, we're increasing our guidance for GAAP earnings per share to a new range of $0.69 to $0.77 and increasing our guidance for adjusted earnings per share to a new range of $2.34 to $2.42.

In the second quarter of 2018, we expect adjusted earnings per share to increase approximately 30% year-over-year to a range of $0.58 to $0.62. This guidance includes incremental commercial investments that we plan to make in both segments as well as accelerate investments in clinical programs and new product development.

Please turn to slide 10 for a discussion of our cash flow performance. Our operating cash flow in the first quarter of 2018 was $41.5 million. This was a better-than-expected start to the year, driven by higher net income and effective working capital management and puts us on track to meet or exceed our cash flow expectations for the full year.

Our capital expenditures were $15.4 million in the first quarter, an increase of $6.2 million from the first quarter of 2017, largely resulting from higher spending to build out our new manufacturing site in Mansfield, Massachusetts.

Our trailing 12-month adjusted free cash flow conversion ratio as of March 31, 2018 was 46%, a decline from 85% in 2017. Significant one-time cash outlays associated with the two integrations contributed to this result. If we now turn to slide 11, I'll wrap up with a brief update on our capital structure as of March 31, 2018.

Our cash balance at the end of the first quarter was $189 million with net debt of about $1.7 billion. Our ratio of fixed to floating-rate debt remained at about 50% in the first quarter.

Our total consolidated leverage, as defined in our bank covenants, was just below four times at the end of the first quarter, representing a slight improvement from year-end. Our short-term priority is to continue to pay down our debt and reduce our leverage. And with that, turn the call back over to Pete..

Thanks, Glenn. If you'll turn to slide 12, I'll provide some closing thoughts. We executed well in many parts of the business during the first quarter, resulting in better-than-expected operating performance.

This strong start to the year combined with the benefits from the changes that we made to our commercial channels in both segments gives us confidence to raise our revenue guidance for 2018.

We remain on track to achieve our full year organic growth target of 5%, expand our adjusted EBITDA margins by about 100 basis points and grow adjusted earnings per share by over 20%. As I discussed earlier, Codman is a great deal and will serve as an important catalyst for Integra's global growth.

The benefits for shareholders that we communicated are on track or exceeding the expectations that we had when we signed the deal over a year ago. With the first quarter behind us, we're at an inflection point with our new commercial organizations substantially in place, a strong product pipeline and a team energized to move the company forward.

That concludes our prepared remarks.

And operator, would you please open up our lines for questions?.

Certainly, sir. We can now take our first question from Dave Turkaly with JMP Securities. Please go ahead, sir..

Thanks. Good morning, guys..

Good morning..

Just quickly, I realize it's early in the year, but obviously, the quarter was strong. Your SG&A was a little lower. Your taxes were a little lower. You got a bunch of new products and a bunch of new reps coming on board.

I guess I'd just like to at a high level ask you, why $10 million is sort of the right bump to the revenue target for the year and noting that $5 million of that is coming from FX?.

Dave, it's Pete. I would say if you think about how we started the year and we framed up from our – giving our guidance last call, and we had two major kind of risks as we entered the year. One is the channel integration and potential disruption.

So if you think about it, in the first quarter, we fundamentally kind of tweaked the dial so to speak, pretty much every channel around the world, China, Japan, all Western Europe, pretty much all of the United States except for some select focus channels.

And so we've come out for the most part in very good shape, had very low turnover, but we still have some adds and change in the second quarter, and hence that's reflective in the comments that Glenn made. And then the second part is tied to coming off the transition service agreements from Codman.

And realistically, about July is when the first one start coming off. And I would say as we look at things, we've actually been, I would say, one of the companies when it comes to integration and moving off, we've got pretty good system in place. Our teams know how to do it well.

I think the fact that we integrated the sales force and we're able to put up a beat demonstrates that. But the fact is we still have some risk that we have to work through here in the second quarter, and we think this is kind of the right place to be.

Based on that, if we're successful coming through that, do we have some opportunity towards the higher end of those ranges or better? I think there's that potential. But we want to be pretty pragmatic about – there's some pretty big TSAs that will be coming off in July. Glenn, I don't know if you want to add anything else to this..

No. Obviously, we're off to a good start to the year. Really the largest outperformance came in our CSS segment. We're quite enthusiastic about how we started off with the integration of the two teams, now becoming one team.

And to your point, we do have a number of products that are going to be launched, but I think the impact of those products is really going to be felt more in 2019....

Right..

...versus 2018. So we're going to be ramping up a lot of our spending around marketing to get these new products launched, but keep in mind, it's really a 2019 bump in our revenues. And so I would be – stay a little bit tempered on the expectations around new product contributions, especially those coming out of Codman portfolio late this year..

Great. And then I guess as a follow-up, you mentioned China and some approvals coming in Japan.

Can you just remind us sort of what your size is there today and how many of your products are actually being sold into those regions and like how many you plan to get out to those areas, let's say, in the next couple of years?.

Glenn, why don't you cover your international area..

Sure. I mean when we look at China and Japan, you can think of those as being roughly 3% to 4% of our total consolidated revenues, roughly to give you a sizing of those two. As Pete mentioned in his prepared remarks, we just got the approval for CUSA Clarity in Japan. So that's quite exciting. We're expecting DuraGen later this year.

And we're planning on adding more resources in China to further expand our footprint there. So all in all, those are the sizing of those markets.

We expect them to be pretty fast-growing markets for us as we launch the new products, when I say new products, existing flagship products within our portfolio that are being launched in new markets like Japan.

And so when we look at the growth rate in these markets, we think it's going to be a nice added benefit to our overall organic growth across the company.

Yeah. You can say it's evident, but just to put a finer point on it, our initial plans to introduce something like CUSA Clarity in Japan through an indirect channel might have generated something in the lower single digits in millions of dollars of revenue. And with a direct channel, that automatically is doubled with its potential to go direct.

And I think we're just starting to learn after really four to five months being together what the scale change is. Again, we had about seven direct people, and now, we have a team of 75 to 80. China, we had about 25 and now, we're up into the 100 range.

So we're really finding even – I'd say, organically, we're finding new ways to open up markets that we wouldn't have really kind of dreamed of before the deal, so quite optimistic.

And again, I think culturally, the Codman team and the Integra team have been a really good fit around the world, which has reduced the amount of turnover that we would typically expect on a deal like this..

Thank you..

Sure..

Thank you. We can now take our next question from Jon Demchick from Morgan Stanley. Please go ahead, sir..

Good morning. Thanks..

Good Morning, Jon..

Good morning. Thanks for taking the questions. Wanted to start off a little bit on earnings guidance on the raise there. Organically, it doesn't look like much has changed. I mean that said, guidance wasn't really moved last quarter outside of directionally pointing towards the upper ends.

And I mean the two main things that I see from the initial guidance to now that have really changed is the tax rate and the 1Q beat. And understanding these overlap a bit but they contribute, at least by my math, to maybe $0.15 to $0.20 upside versus the initial guidance. So guidance went up by about half that much.

Are there any offsets we should be thinking about or is this more just a reflection of it being very early in the year and there's still some integration efforts moving on, so it just adds a bit of variability? How should we be thinking about the difference there?.

Yeah, Jon. It's Glenn. What I would say is, to your point, it's early in the year. We're one month past the first month of team's full time back in the field, so early in the year. We still haven't come off one TSA with J&J, as Pete had mentioned, so we want to see how that goes. We'll have a better indication in the early part of Q3.

But having said that, we are off to a great start to the year as it relates to earnings, almost 50% increase in earnings per share. We raised our guidance by $0.08, which really reflects the higher revenues. I would say better operating leverage, as you heard in my prepared remarks.

EBITDA margins for the quarter came in quite strong, above 23%, and this is usually the lowest quarter of the year for us, so we feel quite good around our margin expansion in Q1 and the opportunity for the rest of the year, coupled with the lower tax rate.

And those are really the drivers behind the increase in our earnings per share guidance by $0.08. But to your point, it's early in the year, and if things go well, obviously, we think there's potential for more upside but, right now, we want to get through the mid-way plan of the year before calling any further upside to our numbers..

No, very clear. Just two quick follow-ups. One, the Codman accretion is $0.25.

Is that still the right number? And second, on TSAs, as they start rolling off, should we be thinking about any large financial shifts in cost structure related to those or are those largely going to be relatively smooth?.

So, Jon, yeah, I mean $0.25 is the number that we haven't moved off of.

We've talked about that improving in outer years and some of that kind of correlates to the question you asked, which is if you think about – and we had a good cash performance for the quarter but even within that, we're already starting to add resources to, we use this term, stand-up capabilities, which means we're actually hiring people and putting structures in place.

We had some pretty good capital outlays that are tied to this Mansfield location. And effectively we're also paying a charge markup on a TSA fee to Johnson & Johnson. So in some ways, we've got not a full duplicate, but we clearly have added cost.

So as we come off of these TSAs, some of those costs will come out immediately, some of those will be latent as we take control of certain product families. And as we've already looked at them, we know that we can make them at lower cost than what J&J is charging us to make them.

So that's an ongoing level of potential productivity that will happen but the fact is for this year, the impact probably just starts happening in the late, late end of the year and, kind of as Glenn said with the NPIs, has more of an effect in 2019.

Glenn, what else did I miss?.

No, I think you hit all the key points. The only thing I'd say is as the Codman business outperforms on the top line, there was a little bit of an outperformance. Obviously, that's going to help at least get higher than the 25% if that continues later in the year.

And so that's a positive from my perspective and some potential upside if we continue to see the momentum that we saw in Q1. I think that business continues to give us more optimism around the EBITDA margin expansion opportunities, and I'll just leave it at that, especially after we unwind the TSAs.

And then third I would say, the tax rate improvement is coming really from the Codman business and the fact that we're seeing higher profits being generated out of Switzerland, which is a low tax jurisdiction.

So we're holding $0.25, but I think all indications are that we're moving in a positive direction and that number could be higher if we get past the midpoint of the year and things go well exiting these TSAs..

Very clear. Thank you very much..

Thank you. We can now take our next question from Matt O'Brien from Piper Jaffray. Please go ahead. Your line is open..

Hi. Good morning. This is J.P. on for Matt. Thanks for taking the question. I wanted to focus on OTT a bit. Obviously in Q1, you had a lot of moving pieces with the whole sales force channel change. And the organic growth is 3.6%.

I'm just trying to figure out, in your view, how has it been the first month out and what would be a successful number organic wise in Q2? And is there more risks in that business from the orthopedic side or the tissue side or what are you more focused on in terms of making sure you hit that 8% to 10% guidance for the full year?.

Yeah, J.P. Look, good question. I would just say, look, I was actually delighted with how we ended up with OTT in the first quarter and the main reason is this, I mean you guys listen to a lot of companies that do channel changes. This channel has fundamentally worked the same way for a decade.

And so when you start actually adding and splitting territories, the amount of cross-training alone, time out in the field was over two weeks. So that alone is a very big impact within the quarter.

And so the fact that we're – put up the numbers that we did have minimal turnover and feel quite good that the territories are clear, the data to the territories, the compensation we're paying folks, all that's working, that's a big check for us exiting Q1.

That being said, as we come into the second quarter, we still have 30-some territories that we're filling. We still have some added training. I mentioned some new products are going to be coming out. So we still expect this to be a much bigger ramp for OTT in the second half than the first half.

I would say CSS is more of a gradual continual ramp, mainly because the majority of those channel changes are done, whereas OTT, there's still some added resources. But the key point is the big disruption. I find out that my territory split in half. I'm the metal guy, you're the tissue guy.

That's all behind us, and we feel very good about how folks are doing their new territory opportunities..

Got it. And then just one for me on the TSAs. I think the first wave is in July. Is that going to be more on the U.S.

or international side? Is it sales force or manufacturing? And then when it comes to thinking about guidance later this year when you give updates, is it fair you'd want to wait to see how things go after the TSAs roll off, so you won't really know that until Q3?.

Yeah. J.P., this is Glenn. I would say when we think about the first cutover of the TSAs in the early part of the third quarter, it's the U.S., Canada and Australia. So those are the major markets that will cut over.

The next step after that will be in the fourth quarter, where we'll fully move off of TSAs or, I should say, TMA with respect to Le Locle in Switzerland. And then obviously, the TMAs for the other facility in Massachusetts are much more long lead time TMAs. So that goes out multiple years.

I think we have a very good indication of how things are going on the TSAs so far and they're going quite well. But again, until we get to that point of Q2 and cutting those over, we really won't know for sure how things go.

But I think we left ourself enough leeway and cushion in our numbers, both top line and EPS wise to compensate for any potential disruption that would take place. But as we go right today and look forward to the next few months, we feel quite good about how things are going..

Yeah. The only other add I would put on there, J.P., is the fact that obviously the big commercial component of customer service and order processing, that is this July date. As we go through their coming late into Q3, we're going to have pretty good indications of how we're doing. I would say look, we're pretty good at this.

We've done over 60 deals of all types of size and magnitude. Biting the bullet, so to speak, and implementing this Oracle system we put in place a few years ago is a big deal, because we are a big neuro company.

So if you think about this type of an acquisition, if neuro was completely new to you, you'd have to build out new customer list, all types of things. For the most part this is plugging it into our system. I don't want to undersize it. It's an important – it's a big deal.

But at the same time, unlike other deals where it might be a private equity company or a company that this is completely foreign business to them coming in, we believe we've just got a better handle on the things that actually have to happen for a successful neurosurgery integration. And we're well aligned.

But as Glenn said, we're also pragmatic that things can go wrong, and we want to have the appropriate hedges, if you will, to make sure that we succeed at the date and succeed at the outcome. And if all that happens at the cost we estimated, then there is clearly some benefit that can come through the P&L.

If not, we'll achieve our dates and be able to manage it that way. So that's how we think about coming off transition service agreements..

Got it. That makes total sense. Thank you..

Yeah..

Thank you. We can now take our next question from Robbie Marcus from JPMorgan. Please go ahead..

Hi, Robbie..

Hi, guys. And congrats on the good quarter..

Thank you..

Glenn, as I look at your commentary for the cadence of organic growth for the rest of the year, that's a really helpful starting place. But I thought it'd be great for people if you'd be able to put a little more meat on the bones and put some numerical ranges around it.

So I was coming up with something like 3% to 4% in second quarter, 7% in third and 5-plus percent in fourth quarter.

Is that sort of the way to be thinking about the cadence for the rest of the year?.

Yeah, Robbie, let me give you a little more color on some of my prepared remarks, and I'll kind of lay out how I see the year playing out here. So I said slightly faster organic growth in the second quarter versus the first quarter. So that's obviously above 3% within the range that you just quoted.

I would say CSS should see a gradual improvement in the second quarter. OTT also a slight improvement. I would just highlight though in the second quarter for OTT, we're expecting the private label business to be down mid-single digits, which is really a function of the significant Q2 of 2017 private label.

Remember we had a large order with one of our existing private label partners. So we're still expecting some acceleration of OTT growth in the second quarter, but it's going to be tempered by a decline in private label. So I just want you to be aware of that.

As we exit the second quarter, a good reference point for you to have going into the third quarter is if we hold our organic growth dollars flat from Q2 to Q3, as a company that will generate over 5% organic growth, and for OTT, it'll be double-digit growth by just holding the organic growth dollars flat from Q2 to Q3.

And so obviously, with our plans with the additional investments that Pete walked through on the commercial channel, we're expecting to see a ramp from Q2 to Q3. So the numbers that you quoted seem to be pretty reasonable as it relates to Q3. And then we'd wrap up the year with Q4 being a little bit lower than Q3, but certainly above the 5% range.

So that's how we see the year playing out. Hopefully, that's a little bit of color.

And clearly, we recognize the back half of the year looks like it's back-end loaded, but just given my comments you can see why we're very confident in our Q3 numbers as well, very easy comp, the ramp we're seeing in both channels, and the progress that we've made coming out of Q1..

No, that's really helpful. Thanks.

And maybe just to follow up on that private label commentary, maybe I missed it in the prepared remarks, but did you say exactly how much of the benefit you got in private label from hurricane restocking? And then maybe if you think about private label as a business going forward, is that something that you think can still grow double digits? I know you were saying a couple quarters ago.

Or is that now more of like a low to mid-single digit business going forward? Thanks, guys..

Yeah. No, good question. So when we exited Q3 of last year, we thought there was going to be about $5 million of private label business that was going to spill over into the first half of 2018. As we mentioned on our fourth quarter earnings call, we got about half of that back in 2017.

So we were able to accelerate some of the shipments given the progress we made of getting that plant up and running in Puerto Rico. So there's still a couple million dollars that spilled over, if you will, into 2018 but less than what we thought, I'll say, as we exited Q3.

The good news in the private label business is we are still expecting a very good year in 2018, a year that should generate double-digit growth. We just recently closed three new private label deals with our regenerative products, so that's going to help the back half of the year.

In addition, we have two or three more that I'm expecting to close in a positive manner probably in the early part of Q3 realistically. So we're winning new business. In addition, we're seeing very good end demand from our existing private label partners.

And I think the combination of those two gives us very good line of sight to double-digit growth in our private label business in 2018. So while Q2 is going to be down, we feel really good about our private label business right now and that should deliver very healthy growth in 2018..

And just to put a finer point on it operationally, it's obviously for everyone, it's a B2B business. We sign contracts. When they start, when they change creates lumpiness but to the three deals that Glenn mentioned, they'll be made in our regenerative plants which have benefits as well for productivity.

But once you get those orders signed, there's usually initial orders to get that started, and those initial orders will really start in Q3 and Q4. Hence, that gives us more confidence and the lift that private label will have in the second half..

Thanks a lot..

Yes..

Thank you. We can now take our next question from Larry Biegelsen from Wells Fargo. Please go ahead..

And this is Shagun in for Larry.

Can you guys hear me okay?.

We can..

I just wanted to circle back on your EPS guidance. Your EPS guidance for 2Q, it implies lower year-over-year growth rates in the second half versus the first half. I was just wondering if you can comment on that. It appears conservative given that you'll have better sales ramp, you'll have TSAs rolling off and you have better visibility.

So if you can comment on that, that would be helpful..

Thanks for the question. And if we look at the first half of the year and EPS we're expecting based upon our Q2 guidance, we're not expecting a big ramp on EPS in the back half of the year. In fact, it's probably pretty equivalent to the first half of the year, despite the higher revenues as you mentioned.

The main reason for that is we're going to increase our spending in a number of R&D areas, advancing several clinical programs, launching new products, which obviously – pulling those forward in the pipeline is one thing but also there are significant marketing efforts attached to that.

And so we're going to be increasing our marketing spend in a pretty meaningful manner. And so if you look at our spending profile in the back half of the year, it's going to ramp up pretty significantly, and that's why you don't see the significant increases in EPS in Q3 and Q4. And just keep in mind in Q4 we lap Codman as well.

So Codman is now going to be year-over-year in both quarters, and so you don't get the significant accretion from Codman in the fourth quarter that you're seeing in the first nine months of the year..

Thank you so much for that. And just as a follow-up, I was wondering if you can parse out the impact of the integration disruption from the underlying growth in 1Q and how should we be thinking about that in 2Q? Thank you..

Yeah, I would say it's difficult to parse it out. I'd say the thing to think about is the comment that we made for both of the key businesses, probably just under two weeks of disruption for the CSS group. And when I say disruption, it means that a rep is not selling.

Actually, they're getting trained in labs or they're helping hand off an account to a colleague. So that's probably the CSS side. And probably a little over two, under three, for the OTT group time away from selling mainly because there's more work in that channel. That's behind us now.

As you look at Q2, CSS fundamentally, all settled in place, roles filled. OTT still has about 30-some roles to fill, but territory alignments and comp and all that stuff is completed.

So we would expect to see CSS to continue to accelerate and, as our guidance implies, OTT to accelerate but to have a bigger impact in the second half since we still have some additions to make in Q2. Okay? Operator, next question..

Certainly. We can now take our next question from Jayson Bedford from Raymond James. Please go ahead..

Hi. Good morning.

Can you hear me okay, guys?.

Good morning..

We can, Jason. Good morning..

Okay. So nice quarter, but I wanted to ask about gross margins, which was lower than our model. You trimmed the expectations for 2018. I imagine Codman is impacting this, but there's no real change to the Codman revenue contribution.

So can you just comment on the relative gross margin weakness and maybe a broad commentary on pricing?.

Yes. Jason, this is Glenn. I'll answer your question on gross margins. Of course, margins did come in a little bit lower in the first quarter than we were expecting. It really is coming out of the Codman portfolio. But let me give you a little color on the first quarter and then how we see the rest of the year.

First, I would say we're seeing higher TMA costs from J&J coming out of the Raynham, Massachusetts plant. We're working with J&J to reduce those costs going forward, but that was one of the drivers for lower gross margins in the first quarter. We're also at the same time incurring costs in our Mansfield plant that we're just starting up.

So keep that in mind when you look at the first quarter gross margins. In addition, when you look at the product mix, it's probably the most unfavorable in the first quarter versus the rest of the year. So you think about our regenerative products, both dural repair, which was flat.

That should improve the rest of the year, it's very high gross margins. Same thing with our tissue business as we now work through those changes. So the mix, you get a lot better the rest of the year, but that was obviously a bit of a headwind on our first quarter gross margins.

And then finally FX had a slight impact that was negative as well on gross margins in the quarter. As we look forward though, we feel quite good around the sequencing of gross margins.

I'm expecting at least 100 basis point improvement in gross margins in the second quarter, a combination of those regenerative products doing better in terms of growth rates, continuing to say a ramp on CUSA Clarity. CUSA product has obviously got higher gross margins. New product launches that we've launched in 2017 should help.

And as I think through our plan, we've talked about a lot of the work we've done in our collagen plants, and we're seeing better productivity coming out of those collagen plants, which is going to help our gross margins in Q2 as well as the rest of the year.

And just a final point, as revenues ramp up, we should get better leverage on our fixed costs, our fixed overhead costs in our plants. So that's going to help. And then as the Codman business sequentially improves outside the U.S., in places like Japan and certain key countries in Europe, those are markets that carry higher gross margins.

So that will help from a mix perspective as well. And so while Q1 was a bit lower really coming from the Codman portfolio, I would just say look for a nice rebound in Q2. We've got good line of sight to that. And then that would get us to our full year numbers of 67.5% to 68.5% as we roll out the rest of the year. But Q1 was a little bit lower.

We're not concerned about it. We have plans in place, and I feel quite good you're going to see a nice improvement in Q2, and that will get us to our full year numbers..

Okay. That's very helpful color, Glenn. And just as a quick follow-up, you mentioned the CUSA Clarity sales will be in the – I think you said high single to low double digits for the year. That's in reference to the total advanced energy bucket.

I forget when you launched the device, but is that the kind of read-through there? Is that advanced energy will be up high single, low double for the year?.

Yes. And again, that's an organic number, right? So I would say organically advanced energy, yes, will be up high single to low double digit with CUSA being the biggest component of it..

Okay. Thank you..

You're welcome..

Thank you. We can now take our next question from Raj Denhoy from Jefferies. Please go ahead..

Good morning, Raj..

Hi. Good morning. So I appreciate that a lot of the story right now is what you guys are doing internally with Codman integration, the sales force hires. But I'm curious if there's anything you can offer in terms of the markets. You mentioned that that dural repair was flat in the quarter, and that's been a area of contention in the last year or so.

And then also, you mentioned lower extremity fixation. It looks like that declined double digits as opposed to single digits before.

And again, I appreciate that there is a lot going on internally, but is there anything in the broader market that might be influencing those results as well?.

So Raj, I would say the short answer is no. I mean, clearly, the biggest influences right now is when pretty much every market in the world that you're in, you've had a sales change. That's caused the most impact.

But if I just go around the horn, broad neurosurgery product lines – obviously, we're number two, bought number three, become number one in the world, extended reach. We really are a key player, obviously, throughout that market. We see it. We haven't seen price shifts up or down. I mean the market's quite stable from that standpoint.

I think we're quite optimistic in some of the more aging markets in Western Europe, in a market like Japan where there tends to be a higher level of opportunity for neurosurgery cases, either because of the elderly population or because of falls that the opportunity to grow and be a key player in that market is very good for us and again, markets where we're probably understaffed.

So that would be the representation there. I would say as you look at on the OTT side, orthopedics, we're doing extremely well in ankle and shoulder. They're still small businesses for us, but our hope is as those markets continue to grow in high single to low double digits, we're going to be one of the top players that can participate in it.

This ankle fixation product as well as our new ankle product that's going to be coming out later this year for doing revisions, we're really excited about. And the fact is that market wise I think in the most competitive market we're in is probably mid to forefoot so there is some price pressure there but nothing significant; I think a few points.

And I think our focus sales channel is going to be able to ultimately turn that around for us. On the tissue side, just a lot of good things going on. We're seeing more and more adoption of scaffold such as the products that we make in IDRT. PriMatrix, as we commented, had a great quarter.

And outpatient allowed our advanced wound care business to grow double digits. Inpatient continues to do well. And I think now, we have a focus channel.

The time to spend with plastic surgeon and reconstructive surgeons to help them think through about how they can use our multiple matrix in different applications to drive growth, we think that's a big opportunity. In the past, we just didn't have the time to do it because the guys were selling orthopedics and tissue.

That's one of the bigger long-term benefits. But I would describe the markets as stable. We're not seeing any big price shifts one way or the other. We're not seeing any major competitive shifts either at this point in time..

No, that's helpful. And maybe just, I could follow up on the leverage ratio, I guess still roughly 4%. I also appreciate that the cash flow in the first part of the year is going to be a little bit depressed given the spending.

Can you remind us what your targets are for that leverage ratio this year and next year, when you think you can get that number back down to where you can start to be perhaps a bit more dynamic again on the acquisition side?.

Sravan, you want to take the question?.

Sure. So yeah, Raj, I think we're targeting about a half turn of deleveraging over the course of this year. So I think the end of this year, we want to exit this year around 3.7 times, according to our bank covenants, and then probably another half a turn over the course of 2019, as we still have a lot of one-time costs next year as well..

Yeah, but Raj, to the point – Raj, let me just add to the point, if we can continue to generate EBITDA dollars, if we continue to generate more cash flow, that could even be faster. And as you heard in my prepared remarks, margin expansion is probably higher than we thought coming into the year.

Cash flows are probably at the high end of our guidance range. So as that continues to progress, we could even delever faster. But I think Sravan's comments are appropriate in terms of how we see the year laying out for now. We'll see how the rest of the year progresses..

Yeah. I mean the add that I'd make, Raj, is that our focus obviously is getting Codman integrated. It's really our top focus and sales channel integration is the second. And so all of the cash we generate, the vast majority is going into paying down the debt. We have some opportunities for a few small tuck-ins and partnership deals this year.

But to do a large deal like a Derma or something in 2018, we don't see that happening. At the same time, part of our strategy to be a $2 billion-plus company is to acquire some reasonable size businesses in the outer years. And so being able to get that debt structure in line to reload the balance sheet for outer years is a big part of our strategy.

But this year, it's heavily focused on integration and good execution..

Great. Yes. Thank you very much..

Thank you. We can now take our next question from Craig Bijou from Cantor Fitzgerald. Please go ahead..

Good morning, guys. Thanks for taking the questions. I want to start with just following up on CSS guidance for the year.

I appreciate that you raised it slightly but with the 2% growth in Q1 and given that Q1 was supposed to have the biggest headwind due to the Codman integration and then some of the CUSA Clarity momentum, dural repair is supposed to accelerate throughout the year and obviously less disruption in Q2 and then the second half, is there anything else that we should be thinking about that may be is a potential headwind or is it relative conservatism to start the year?.

Craig, I would just say we're off to a good start to the year. We did raise our guidance, but keep in mind that Codman business, when that becomes organic in the fourth quarter is a low single-digit growth business. Until we launch some new products, we're probably going to see that level of growth as it relates to the Codman business.

So the Q4 numbers obviously would be in line with the guidance range that we provided for the full year. And again, as a reminder, we haven't come off of any of the TSAs, and so that could have obviously an impact on cost but also on revenue with customer service being transitioned over, with orders being transitioned over.

And so, again, early in the year until we get past some of these milestones, I think we're continuing to be somewhat cautious around the guidance for CSS, but those would be my comments around it.

But we feel quite good around how we started the year, and I agree with many of your comments that if things go well, we could be talking about a higher set of numbers. But for now, we're quite confident in raising our guidance to the 2% to 3% range..

Okay. Helpful. And then I wanted to follow up on the ankle and shoulder double-digit growth. I know you guys, I think, in the script said that it was consistent and it has been consistent in the double digits.

But is there any way to maybe parse out some color ankle versus shoulder? I know they're smaller businesses and you launched the ankle product or your ankle last year.

So maybe any color on growth acceleration in each of those specifically?.

I would just say, again, on the ankle side (00:58:07) businesswise, the ankle is north of – it's about $20 million, in that range, and the shoulder is probably closer in the $15 million range. So, again, they're still small businesses but they're growing at a good clip. I think if I take shoulder, we've got an indirect channel that owns that.

I would say the distributor structure or leadership team has done a really nice job there. And we're starting to kind of get our pace here with some new adds and things that will be coming out. So we think that we're going to be able to continue the growth and get that up to a scale where it makes a difference.

I think on the ankle side, the focus channel that we actually have created, if you think about the gem or the jewel that they're selling is the ankle arthroplasty products. So I would say in the past, most of our reps, a vast majority had not really sold ankle.

They were selling more basic fixation plates, bunions, toe repair, things of that nature, and hand and wrist. And now, this channel allows them to put a significant – more focus on ankle. So you could almost argue that our focus on ankle will double with the changes that we've made.

And so with the Salto product lineup, with the Cadence, both of those are doing well. We're getting really good feedback on Cadence for the time to get a case done and the simplicity and the elegance of the instrumentation.

And then with the revision system – and again, the key on the revision system, this isn't just a revision system that can work on Cadence or Salto, this is a revision system designed such that when someone after 15, 20 years needs to have their ankle redone, there are very few products in the marketplace that can offer a revision.

We can offer a revision on a host of other competitive systems. And so doing an ankle on a younger patient, choosing us as a primary knowing that we have a good revision, or using our revision system and then opening up the rest of your cases to our portfolio, we hope will be very good as a catalyst for us.

But I would say channel focus and time with both of these, as we think, is going to be the biggest component for accelerating the growth in both of these areas..

And the timing on the revision? I know you said later this year but just what's the – any more specificity?.

Yeah. I would say we'll probably make a splash of it later in fourth quarter but as Glenn commented on relative to Cadence, as you know, this is trialing and starting the activity. This will be a bigger benefit in 2019..

Okay. Very helpful. Thanks, guys..

Yes..

Thank you. We can now take our next question from Travis Steed from Bank of America. Please go ahead..

Good morning, Travis..

Thanks for squeezing me in here. Good morning. So in dural repair, I guess with some of the success you've had with contracts in health economic study, I would think you could do better than a low to mid-single digit growth you're guiding to for the rest of the year.

And kind of prior to the rep disruption in Q4, you were at 5%, and now, you've got more reps selling that product. Just maybe how you think about the rest of the year would be helpful..

Yes. So I don't think we have any other comments to add other than what we've said, which is we expect the rest of the year to be in the low to mid-single digit range for dural repair. I would say I'd expect those growth rates for both our dural graft and our dural sealant, and we feel quite good around our recovery plans exiting 2017.

But I think that's a modest expectation. It's probably a point or two faster than the overall market growth, and so I would keep that in mind as well. This is not a fast-growing area of the market. So from my perspective I think it's a reasonable expectation for the rest of the year..

And the only two other items that I would add with it are we locked in a significant amount of business into longer term contracts for dural repair, which is DuraGen and also DuraSeal, took some of those at some slightly lower prices.

There will be some price opportunities as we go out into late 2018 into 2019, but that's some of the first half component. And the other one is we've talked about this before, internationally, we were growing double digits and continue to be in many cases on the repair side as we grow.

But we picked up a large DURAFORM base of business as well, which isn't counted as organic growth obviously until we lap the business. And so for the next few quarters, particularly on DURAFORM, there's markets where we're driving DURAFORM over DuraGen because of the recognition.

So there is some level of noise between the acquisition in there, but no doubt with the 50% larger OUS sales force, a launch in Japan and a 30% larger U.S. sales force, we feel quite good that we'll continue to grow and move this forward.

The biggest catalyst for us is can we continue to put up data that shows that a product like a plasma-based product or other products to close the dura is inferior to polyethylene glycol, DuraSeal, or that suturing alone is just not adequate to the risk.

And I'd say that's where a lot of our focus is going into, and the more that we convert, that opens up still over half of the market for use of a more advanced closure product for the dura..

Okay. That's helpful. And then you're talking a lot about new products more for 2019. Just curious if you could kind of go over maybe the top two to three most impactful ones and how we should think about quantifying the impact of revenue growth.

Are they mostly singles or are there any doubles in there?.

Well, I think the ankle revision system is a double ultimately because of its effect not only for the sales itself but the door opener that it ultimately creates for us.

I think when you think about the SurgiMend products outside of the United States and Western Europe, there's a prepectoral breast reconstruction procedure, which we think is going to enable us to expand our Tissue Technologies business quite a bit in those areas. And then again, I think there's new to Integra and there's new to geographies.

I think the good news is there's a lot of things here that are new to geographies. And why is that important is the risk of R&D execution, the risk of manufacturing execution is eliminated and you're down focusing on commercial. And so things like DuraGen and CUSA Clarity in Japan, we think, are going to be double to triple.

So those would be examples that I would put out there. I will tell you that the CSS pipeline that we combined between our legacy neuro and the Codman pipeline, we're really excited about. We're not ready to talk about it.

But I would say over the next few quarters beginning in Q3 into 2020 or 2021, we have a very good lineup of new products that will actually move the needle within neurosurgery. And it's very similar to the play we ran maybe five, six years ago starting within our own legacy portfolio of product enhancements and just good execution.

So that's kind of the lineup set that I would articulate at this point in time..

All right. That's helpful. Thanks for taking the questions..

Sure..

Thank you. We can now take our next question from Steven Lichtman from Oppenheimer & Company. Please go ahead..

Hi, Steve..

Thanks. Hi, guys. Most of my questions have been answered. There's just one from me. You've obviously made a couple of positive changes for lower extremity outlook as you think about the focus sales force and maybe some cross-selling now, as you mentioned earlier, Pete, with ankle.

I'm wondering to what extent you think also product enhancements and/or additions are going to be needed as well to fill any gaps to accelerate growth in that broader lower extremity business for you..

Yeah. Steve, in short, I would say through 2018 into early 2019, I think we can get positive growth without any product changes. Beyond that, we need to bring in some updated plating and locking systems which the teams are working on currently..

Okay. Great. Thanks, guys..

Thanks..

We can now take our next question from Ryan Zimmerman from BTIG. Please go ahead..

Great. Thanks for squeezing me in. A lot of questions have been answered already. But your comments around China, you went from, I think, 25 reps to over 100 and you also mentioned that you may be adding some more in the second quarter.

So what's the right number for the Chinese sales force given that you've really accelerated your sales force size? And is there opportunity to expand further just to go deeper into the Chinese market?.

Ryan, just to clarify our head count in China, it's probably 35 pre-Codman, 70-plus post-Codman, and we're probably going to be adding 10 plus resources there in 2018. So think of it as exiting 2018 with about 85 total commercial resources in China. But we see China as a best growth market for us.

If you've followed the story for the past few years, China has been a market where we've put up 20%-plus growth on a pretty consistent basis, and we're quite excited about the opportunity now with having our combined sales forces coming together and driving growth in that market.

And so that's the reason why we've been investing very heavily in China..

But I think as we've dealt with other markets, we don't try to get too far out of our ski tips. I think as we see the growth of the combined portfolio pick up, we primarily cover the coast and so as other provinces and systems develop, yeah, I think this will be a market that we will add.

We're big importers as far as products into the market, how we kind of build out that market for larger sustainability is a big part of our strategic plans. But as Glenn said, I think with the structure we have right now, we've got the capabilities for continued high growth coming out of China..

Got it. All right. Thanks for taking the questions, guys..

Yeah. Thank you..

Thank you..

Thank you. That will conclude today's Q&A and our conference call for today. Thank you for your participation, ladies and gentlemen. You may now disconnect..

Thank you..