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

Robert J. Marcus - JPMorgan Securities LLC Craig William Bijou - Cantor Fitzgerald Securities Ryan Zimmerman - BTIG LLC J. P. McKim - Piper Jaffray & Co. Jonathan Demchick - Morgan Stanley & Co. LLC Steven Lichtman - Oppenheimer & Co., Inc. Travis Steed - Bank of America Merrill Lynch.

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

Thank you, Katie. Good morning, and thank you for joining the Integra LifeSciences second quarter 2018 Earnings 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 second 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 second 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 turn to slide 4 in the earnings presentation, let me start by sharing a few highlights from the quarter. Second quarter sales were $366 million an increase of nearly 30% on a reported basis and 3.4% on an organic basis over the prior year. Adjusted earnings per share increased 33% to $0.60.

Our performance through the first half of the year was in line with our plans and we are reiterating our organic revenue growth guidance of 5% and raising the low-end of our full year 2018 total revenues and earnings per share guidance. During the second quarter, we completed the expansion of our OTT commercial channel.

Throughout the first half of the year, we added approximately 60 sales positions and today, we have four fully dedicated channels in the areas of extremity orthopedics, acute wound reconstruction, outpatient wound care and surgical reconstruction.

As a result of our larger channels and improved focus, we achieved broad-based strength in regenerative technologies, which was up close to 10% in the second quarter excluding the private label business.

Many of our key products including the Integra skin portfolio, nerve and tendon and our amniotics portfolio PriMatrix had a strong quarter growing high single or double digits. We had many success stories during the quarter. One bright spot was the performance of our acute wound reconstruction business.

The channel investments we made over the last nine months increased the capacity of our reps and enabled them to have more in depth clinical discussions which ultimately translates to higher sales. We also continue to make progress with our R&D pipeline and have launched AmnioExcel Plus, our next generation amniotic tissue product.

AmnioExcel Plus is a three layer amniotic tissue product with an expanded five year shelf life is easy to handle and contains a broad array of growth factors. These characteristics differentiate AmnioExcel Plus from the leading amniotic products currently in the marketplace.

In extremities orthopedics, we launched our Integra XT Ankle Revision System at the American Orthopaedic Foot & Ankle Society Meeting earlier this month. Surgeons expressed their excitement for the XT system and our approach to ankle revision surgery.

This system features bone sparing characteristics and a streamlined instrumentation set and complements Integra's broad line of ankle arthroplasty products. We also remain on track to launch the Panta II, a new fusion nail use in ankle fixation and believe that this product will help the performance of our lower extremities business later this year.

Taken together these products will give Integra a comprehensive set of solutions for ankle fixation and arthroplasty further differentiating us from the competition. And finally, I've spoken in the past about enterprise contracting and our ability to leverage our increasing scale and breadth.

We've recently signed agreement for Integra's regenerative product portfolios that will provide us with preferred access to hundreds of facilities in the U.S. Our expanded and comprehensive portfolios will provide us with additional opportunities for enterprise contracts.

We're still in the early days of seeing the results of our channel expansion efforts but are encouraged by what we've seen to-date. The clinical and commercial investments that we've made over the last nine months have positioned us well to accelerate organic growth in the second half of the year.

Before providing you an update on our Codman transition services agreement, I'd like to discuss our second quarter operational and strategic accomplishments for the CSS segment.

Integration efforts remain on track as evidenced by the strong performance in the first half of the year, we're benefiting from the larger integrated neurosurgery organization. As a reminder, we have expanded our U.S. sales team by 30%, increased our commercial footprint outside the U.S. by 50% and completed our global territory alignment.

With the commercial integration complete, the combined sales teams delivered accelerated year-over-year organic growth in a number of franchises including Dural Repair, Advanced Energy and Neuro Monitoring. Also as we mentioned on our earnings call in April, we're excited about the CSS neurosurgery pipeline.

During the second quarter, we advanced our commercialization plans for a number of products and just last week, we launched the CUSA Clarity platform in Japan.

We look forward to a steady flow of product launches in late 2018 and early 2019, which include the introductions electrosurgery generator, a next-generation ICP monitor platform and an innovative customer-centric toolkit for our Certas valve along with additional shunt configurations.

If you please turn to slide 5, I would now like to provide some additional details related to the Codman transition services agreements, or TSAs. All of you know, we integrated the U.S. Codman sales force into Integra in the fourth quarter of 2017, but had remained dependent on J&J for certain customer support services.

On July 2, we assumed full operational control of all commercial support services and functions including; order management and customer service, distribution and inventory management, IT services and infrastructure, credit management and cash collections.

Members of the integration teams created detailed plans and worked diligently adding up to thousands of employee hours to transition these services into Integra in line with our original timetable. This was all completed on the same weekend as the quarter closed.

We're now running the entire business independently in the United States, Canada, Australia and New Zealand. Importantly, during the second quarter, we also transitioned the Codman China business one year ahead of schedule. Collectively, this wave of TSAs represents roughly 60% of the global revenues associated with the acquired Codman business.

During the first three weeks of July, we processed several thousand orders on Integra's platform and I'm pleased to report that we've had a smooth transition with no significant issues, and our preliminary cost assessments to perform these services is consistent with our guidance for the full year.

The next steps in exiting the transition services agreements will include converting the Switzerland manufacturing facility to our ERP platform which will be followed by a TSA exit in Western Europe and Japan in the first half of 2019.

To summarize with the commercial channels in place, momentum building in both segments in the second quarter and the first TSA milestone successfully completed, we are well-positioned to accelerate our organic growth in the second half of the year.

Now I'll turn the call to Glenn to provide a more detailed review of our second quarter financial results.

Glenn?.

Thanks, Pete, and good morning, everyone. Total second quarter reported sales were $366.2 million, an increase of 29.8% compared to the second quarter of 2017 and 3.4% on an organic basis. The acquisition of Codman contributed $79.2 million in the quarter, a slight sequential increase from the first quarter.

Reported revenues in the second quarter would have been $368.4 million using foreign currency rates that were in effect when we provided our April guidance. However, the stronger dollar in the second quarter reduced our expected foreign currency benefit by $2.2 million.

Turning to slide 6, I'll begin with a review of the Codman Specialty Surgical segment. Reported sales for the segment grew 50% to $239.5 million. Organic sales grew 3.7% over the prior year, slightly ahead of our expectations. These results reflect sequential quarterly improvement and stronger than expected sales in our Advanced Energy franchise.

Moving to the performance of the franchises within CSS, Dural Access and Repair grew organically at 3% over the prior year's quarter. This growth was led by 6% increase in our U.S. DuraSeal business resulting in a record level of sales.

We attribute the strong performance to the contracting work we completed late last year as well as the 30% increase in the size of our U.S. commercial organization and its ability to spend more time in the operating room with clinical decision makers.

We continue to expect low- to mid-single digit growth for this franchise in the second half of the year. Organic sales in Advanced Energy increased 20% year-over-year driven by strong CUSA Clarity sales. We achieved double digit growth in both CUSA capital and disposables.

The consumable growth is an indicator of the success that we're seeing with the adoption of CUSA Clarity as disposable sales are a good measure of capital utilization. Looking forward, we have a strong funnel of opportunities and expect CUSA to drive double digit growth in this franchise for the remainder of 2018.

Sales at precision tools and instruments were flat compared to the prior year's quarter. Strong mid-single-digit growth in our acute instruments business was mostly offset by declines in Cranial Stabilization which achieved a record level of sales in the prior year's second quarter.

The remaining franchises within CSS, Neural Monitoring and Cerebral Spinal Fluid Management performed in line with our expectations. Total CSS international sales were flat in the second quarter compared to the prior year.

That said, we did achieve growth in our core neurosurgery business and continue to see strength in certain key markets such as Japan and Canada offset by slightly lower sales in Europe. Based on our CSS segment performance through the first half of the year, we are slightly raising our organic revenue growth guidance to be about 3% for the full year.

Let me now move to our Orthopedics and Tissue Technologies segment on slide 7. Second quarter sales were $126.7 million, representing an increase of 3.6% over the prior year or 3% on an organic basis.

During the second quarter, we saw progress on our commercial expansion plans which led to an increase in organic growth of 6% excluding the private label business. This was a nice sequential improvement from the first quarter where we had about 3% organic growth.

We expect to accelerate organic growth in the back half of the year with double-digit growth in both the third and fourth quarters. Sales of our regenerative products increased about 10% in the second quarter with broad-based strength across our portfolio.

With this momentum, we expect low double-digit growth in our regenerative products in the back half of the year. Sales in the private label business were down mid-single-digits from the same quarter last year because of the tough comparison resulting from a large order that occurred in the second quarter of 2017.

This result was consistent with the expectations that we had mentioned on our first quarter earnings call. As you look at the second half of 2018, we expect double-digit organic growth in the private label business starting in the third quarter based on a strong demand from existing customers and the addition of several new partners.

Second quarter organic sales in total extremities were down about 2%, driven by a decline in a lower fixation portfolio. This decline offset strong performances in both our ankle and shoulder businesses.

Overall, total extremities improved slightly on a sequential basis, but we expect an improvement in the second half of the year as we should benefit from new product launches and increases in productivity from a larger and more focused sales force.

International sales in OTT increased mid-single digits, driven by higher sales of regenerative technologies in Europe. For the OTT segment, we are reiterating our previous full year guidance for reported revenue to increase in the range of 10% to 12% and organic revenue to remain in the range of 8% to 10%.

Please turn to slide 8 where I'll review highlights from our second quarter P&L performance and provide full year 2018 guidance. We are raising the low end of our full year 2018 total revenue guidance by $5 million to $1.475 billion and keeping the upper end of our guidance range at $1.49 billion, representing year-over-year growth of about 25%.

This includes a foreign currency benefit of about $8 million which represents a reduction from the $15 million benefit we projected in April. Organic growth for the full year 2018 remains unchanged at about 5%.

For the third quarter of 2018, we expect a sequential improvement in total reported revenue and are projecting revenue to be between $367 million and $372 million which represents growth of 32% to 33% over the prior year on a reported basis with organic growth expected to be above 6%.

Let me now move to some of the profitability metrics in the second quarter. Adjusted gross margin was 67.4%, a decline of 100 basis points compared to the prior year, largely due to the mix of acquired Codman business.

Gross margins improved sequentially by 80 basis points and we would expect to see a continued gradual improvement in the second half of 2018 towards the low end of our current guidance range. Our adjusted EBITDA margin for the second quarter was 23.5%, an improvement of 130 basis points compared to the prior year.

This margin improvement resulted from operating expense leverage primarily from SG&A costs. For the full year, our guidance for EBITDA margin remains in the range of 23% to 24%. Our adjusted tax rate for the quarter was 18%, an improvement from 24.4% in the prior year, primarily driven by the changes to the U.S.

corporate tax laws as well as the benefit of higher income being generated in low tax jurisdictions such as Ireland and Switzerland. As a result, we now expect a slightly lower tax rate for the full year versus our prior guidance. Adjusted earnings per share increased 33% to $0.60 compared to $0.45 in the same quarter of the prior year.

This increase was driven by higher sales, EBITDA margin expansion and a lower tax rate. We have also updated guidance to reflect lower interest expense associated with a credit facility amendment and expansion and a higher share count related to the recent equity offering.

As a reminder, these two transactions had a neutral effect on our full year EPS guidance.

Based on our performance in the first half of 2018 and our outlook for the remainder of the year, we remain confident in our ability to achieve or exceed our guidance and are therefore raising the low end of our earnings per share guidance by $0.02 with a new GAAP EPS range of $0.71 to $0.77 and adjusted earnings per share of $2.36 to $2.42.

In the third quarter of 2018, we expect adjusted earnings per share to increase approximately 30% year-over-year and are guiding to an adjusted EPS range of $0.58 to $0.62. Please turn to slide 9 for a discussion of our cash flow performance. Our operating cash flow in the second quarter of 2018 was $36 million.

Based on a strong performance in the first half of the year, we remain on track to meet or exceed our cash flow expectations for the full year. Our capital expenditures were $20 million in the second quarter, an increase of $7.2 million over the prior year primarily related to our new manufacturing site in Massachusetts.

We expect an elevated level of capital expenditures through early 2019 as we build out this new manufacturing site and expand infrastructure outside the United States. If you turn to slide 10, I will wrap up with a brief update on our capital structure. Our cash balance as of June 30, 2018, was $184 million with net debt of about $1.35 billion.

Proceeds from our recent equity offering were used to pay down debt and resulted in a reduction of our consolidated leverage ratio has defined in our bank covenants from 4.0 times at the end of the first quarter to less than 3.2 times at the end of the second quarter.

Our fixed rate debt now represents 60% of our total debt, up from 50% at the end of the first quarter. And with that, I'll turn the call back over to Pete..

Thanks, Glenn. If you turn to slide 11, I'll provide a few closing comments. Our performance through the first half of the year was in line with our expectations and we're confident that we'll accelerate organic growth in the second half. At the beginning of the year, I had mentioned that we had two primary risks for the company.

The first risk was the sales force in the CSS segment and the integration and our significant channel expansion within OTT. The second risk was the completion of the exit from the largest of our transition services agreements which represent 60% of the Codman acquired revenue.

And based on our execution for the first half of the year, we are on plan with both and as a result, on path to achieve our full year guidance. That concludes our prepared remarks. Thanks for listening and operator if you would please open up our lines for questions..

Thank you, sir. Our first question will come from Robbie Marcus of JPMorgan..

Good morning, Robbie..

Oh. Good morning, guys. Thanks for taking the question. I wanted to start off on the OTT business.

And maybe you could just give us a bit more clarity into how the year-to-date progress on your sales force restructuring has gone? How that's tracking? And then should we expect any second-half bumps along the way? Or do you think you've really started to get your footing here?.

Yeah, Robbie. Look, thanks for the question. I would say OTT overall had a solid quarter for what we expected to achieve. We added, as we talked about, 30 reps within the quarter.

A lot of those were on the orthopedics channel, the other channels on outpatient wound, the inpatient advanced wound care and the surgical reconstruction, for the most part had their channels filled, there's a few puts and takes.

So the biggest piece was in that area and that was probably our softest area within the quarter, the lower extremities area. I would say ankle was a little lighter. We had really good performance in Cadence. A little bit lighter in Salto, but at the recent meeting in Boston I referenced really good feedback on XT and a really nice pipeline.

But I think getting all of those territories filled in ortho is a big deal and that's why we see growth coming back to that total segment that we haven't seen in some time starting here in the second half of the year. If you look broadly, the thing that I'm most energized by is the lift that we're seeing in the whole regenerative portfolio.

So on the inpatient wound side, which touches burn, altered types of trauma cases, we had a really good quarter. Our SurgiMend product outside the United States performed well. PriMatrix inpatient and outpatient performed well.

And we really saw, I'd say, our first substantial lift in amniotic tissue products, so all of that kind of says to us as we move into Q3 and Q4 that the lift is there. The only other part that was light in the quarter, which we've talked about and predicted, was private label. Glenn mentioned in his remarks that we had a bigger order last year.

We also have a few orders that we had in-house in Q2 that we won't ship product until Q3 and Q4 based on new customers. And so double-digit growth out of private label in the second half, we have a really good beat on and feel good about it. But I think it's positioned well where we'd like it.

Glenn, what else would you like to add?.

No. I think we tried to highlight the progress we actually made in the second quarter around the channel investments we've made. And the headline number of 3% organic growth includes the headwind in private label and overshadows the performance and the progress we're making in our direct channels.

If you exclude private label in the second quarter, we grew organically 6% versus 3% in the first quarter. So we're seeing really nice progress sequentially. And as we look at the back half of the year, we are expecting to see double-digit growth in both Q3 and Q4 in the OTT channel..

Okay. And maybe just to follow up on that. I know you gave a number of pointers, but can you help lay out some of your key drivers and the confidence and reacceleration and growth in the back half of the year, whether it's key products that will be contributing or tangible lines of progress....

Sure..

...we've seen on the sales force and OTT, just to really help us get a better sense for the confidence? Thanks, guys..

Well, I mean, just the first one, to Glenn's point, the 3% growth excluding private label would've been 6% in Q2. That private label contributing at a double-digit level will actually be a driver of growth. So that portfolio – number one.

All the Integra's skin products, the larger products for use on broader reconstruction, whether it'd be burn or other tissue areas, I think I'd love to see that. PriMatrix in outpatient for chronic wounds as well as acute, we expect that to see – and also, amniotic. I would say those are on the tissue side. Shoulder had a good quarter.

We expect that to continue and based on the feedback that we've received at the Ankle Meeting in Boston, we would expect that the ankle, particularly with the XT and the Cadence product will pick up. So I think it's reasonably broad-based that we expect to see the growth coming out of the portfolio in the second half of the year.

And as Glenn said, double digits, but we are roughly in the 11%, 12% range growth that we feel quite confident about it. And just to remind you, again, all you guys are aware of the circumstances that hit the industry in Q3 last year, where we had the hurricanes, three of them.

Just coming flat kind of quarter-to-quarter for OTT into Q3 of 2018 roughly gives us close to 10% growth. So we feel quite good, particularly about where we are with the orders we have in house for private label and the momentum that we saw on the new channel growth for regenerative..

Yeah. And then, Robbie, keep in mind on the CSS side, we've got great momentum on Advanced Energy in CUSA. We are seeing really strong double-digit growth rates. We mentioned 20% in the second quarter, expecting double-digit growth year-over-year in the back half of the year with sequential improvements in that part of our business.

And Dural Repair, in particular, DuraSeal, has gotten to a really good place overall versus where we were last year given the contracting efforts that we put in place.

And so when we look at the back half of the year, while some of the numbers look like they are significant in terms of a step-up between the easier comps, the momentum we've got at both segments, we feel quite confident that we'll get to the overall 5% organic growth for the full year..

Very clear, guys. Thanks a lot.

Thank you. Our next question comes from Craig Bijou from Cantor Fitzgerald..

Morning, Craig..

Good morning. Thanks for taking the questions. Let me start with the TSAs and rolling those off. And I appreciate, Pete, your comments on that you haven't seen any hiccups in the first couple of weeks.

But I did want to ask, where does potential disruption risk lie in those agreements? And I guess when will you be at a point to basically say that you're past any potential significant disruption from the transition?.

Yeah. So, Craig, good question. So again, just to remind everybody, the 60% of the global revenues we just converted from J&J to our systems. And again, it happened at the end of the quarter. So people told you why would you do it then? Well you typically don't do it mid-month, there's a lot of reasons for how you look at your financials.

So that Friday, Saturday at the end of the quarter, we also were in the midst of doing the transition and it's not a transition where you kind of start turning orders on slow. It's a cold turkey cut over on the first.

And so we literally had probably a day and a half of business that we kind of shut down to make the transition as effective as possible, but because it's such on/off and once you get a reasonable amount of orders through the system, we feel very confident right now that for that 60% we have it fundamentally behind us.

And again, we're already shipping and managing logistics. We're handling all the customer service. We're already collecting – at this point with shipments that went out at the end of the year, 30 days in, we're already collecting the AP on that and feel good about all of those processes.

So from that part of it, I feel very good, and again, when you think about closing the quarter as well as then having a significant amount of folks turning on a new system and slowing down some of the transactions that we probably could have taken in Q2 to go into Q3 mainly so that we had a smooth transition, I feel good about it.

The next milestone, I'm not that concerned about the Switzerland plant conversion from SAP to Oracle. We've done that multiple times. That happens in the fourth quarter. It's really in the first half of 2019 which Western Europe kind of doing what we just did in the United States.

So one could argue we got one under our belt, the rest of the 40% of the revenue will take place late Q1 through Q2, and then by midyear fundamentally be completed with all of the substantial TSA work..

Great. That's helpful. Next question, I wanted to just ask about Dural Repair. So you guys obviously called out strong U.S. growth in DuraSeal, 6% growth, but overall Dural Repair was low-single-digits, so just wanted to get a little bit more color on some of the offsets to that strong U.S. DuraSeal growth.

And then maybe your thoughts on the case – you lost the case with Adherus and HyperBranch, so just maybe the thoughts on competitive environment for the rest of the year?.

Yeah, Craig. It's Glenn. I'll take the Dural Repair question. So we called out DuraSeal as kind of a stellar performer in the U.S. in the quarter. We did see good growth as well in DuraGen. So I would say the U.S. business did quite well.

It was offset by some slight declines in the graft business with DuraGen outside the U.S., and a big part of our strategy outside the U.S. is looking at the combined portfolio of DuraGen along with DURAFORM, which is the product that we got from Codman.

And so when we look at it in total, we're seeing some conversions and some more focus on DURAFORM in certain markets, which is, I'll say, dampering some of the effective organic growth, but the overall growth within Dural Repair outside the U.S. is quite healthy and quite strong. But you're just not seeing it in the organic growth rate.

But that's the reason why when we talk about dural grafts organically, it's a bit down outside the U.S. which brought the overall Dural Repair number down to 3% for the quarter. Going forward, obviously you won't get the Q4. This will all be organic growth for us, so it will be a discussion of our total portfolio including DURAFORM outside the U.S..

And then, Craig, relative to the HyperBranch case, look, we were disappointed that the ruling came down the way it did on some of the near-term patents that we had that are primarily associated with the actual material matter and some of the characteristics. We don't agree with it, so we're well-positioned I think for appeal.

But I just would remind you as well, we have a second set of patents that we believe are being infringed that run out to 2029 and those are on the delivery mechanism and associated approaches to that. And we're going to press forward.

And then those may not even come up for trial such for a couple years, but those are a patent portfolio as I said that run out pretty late. So we still see this as the game that we're going to still stay focused on. We believe that we're being infringed, and so we'll continue to kind of defend our portfolio vigorously.

The last point I'd point to is the obvious one that Glenn discussed. I think the breadth of our organization, the size now that we have and really the desire for customers to come to us and want to contract our wider set of products, is becoming more evident.

And I think from DuraSeal moving from a smaller percentage on contract and now a larger percentage, I think, we're starting just to see the benefit of that contracting kick in.

And that's some of the uptick that you're seeing here we had in the quarter and we would continue to believe that we'll see that here as we enter into the second half of the year..

Great. Thanks for taking the questions again..

Sure..

Thank you. Our next question comes from Ryan Zimmerman of BTIG..

Great. Thanks for taking the questions. So you called out wound care opportunity, namely some contracting agreements that give you the license to hunt, as I understand it, going forward in the rest of the year.

Just given the disruption we're seeing with some of the competitors in the wound care space, just maybe talk a little bit more about some of those opportunities to win business in large health systems and wound care clinics? And what we should expect going forward into 2019 as well?.

Yeah, Ryan. Thanks for your question. Look.

I think we've taken a pretty methodical approach and I think our channel split that we have right now that again doubling the inpatient channel, having the outpatient group at a healthy high-80s, low-90s group that's exclusively calling there and then a contracting strategy that could actually contract the quantity of products that are at 90s and may be used in outpatient/inpatient is what we've been focused on.

And we're starting to get some good traction. So amniotic obviously is part of your question. We're seeing with some of the disruption or questions in the marketplace, people assessing where they're going for supply, I think, everything from the VA to independent hospitals.

I don't see major mass exodus or changes taking place, but I think the fact that people are taking a step back and say, let's evaluate this, is a really good thing for Integra. And the AmnioExcel Plus, which I just talked about we're introducing now, is a very competitive product.

Some of the leaders out there have a two-ply product with a chorion and amnion. This three-ply we think makes a more simplified application. It's a much more interesting pliability structure to it. And it also, we believe, will demonstrate that it's got some higher capabilities over the long run when we do some of the studies.

So we're well-positioned with the product portfolio. The contracts in enterprising areas that I've mentioned really are happening on both sides of the house, with the expanded Codman Integra portfolio, more coming to us.

And not just license to hunt but compliance contracts where it's one or two of us, or only one of us, and if they don't comply to that level of buying, there's actually price implications to the IDN. That's a change for us where we've had more license to hunt contracts.

And I can't give you the specific names for a lot of reasons, but I think in the second half you'll probably hear us talk more about this growth and this trend. I would say on the front for outpatient wound care, our channel has really settled down as well. It's taken us a good year to kind of make sure we have the right folks in the right roles.

The positioning of the products, whether it'd be PriMatrix, the selective use right now in the fee-for-service model with Omnigraft, but I think we're really starting to get a good structure around how we think about AmnioExcel and our new product, AmnioExcel Plus, two different amniotic products within the marketplace.

So more to come, but we had a good quarter on it, some good tailwinds. And I would leave you with this.

I'd say our funnel of opportunities going into Q3 and Q4 has been the strongest it's ever been, in some cases up significantly, and the question will be how well can we convert those? So it's one of the reasons I remain optimistic about wound reconstruction, both inpatient and outpatient for the second half of the year..

Very helpful, Pete. And then just my follow-up question, CUSA Clarity was very strong in this quarter. And just commenting on the strength, you called out just a larger neuro sales force.

But where are we in the upgrade cycle of CUSA Clarity? And kind of the cadence of what we can expect maybe looking through the rest of the year? Thank you for taking the questions..

Yeah. Thanks, Ryan. So we are one year post-launch. If you think about the launch of CUSA Clarity, we launched in March of last year, so we're just lapping now the first full year. It's a multiyear upgrade cycle.

And what's encouraging for me is not only we're seeing the significant growth in capital but also the disposables or consumables part of the business now. And so we're seeing a really high attach rate, shows more usage and utilization of our product and that's very encouraging.

We've been seeing some really strong indications that capital was going really well, but now the disposables pull-through is coming through as well, which drove 20% year-over-year increase. And keep in mind, this is a global product launch, and so this growth is in the U.S.

as well as outside the U.S., so plenty of opportunity to go for the next several years to see very healthy growth. I would just say, over the next couple of years as we exit 2018, we would still expect this to grow high-single to low-double-digits.

So this year will be stronger than that, just given where we are through the half-year, given what we expect for the back half of the year. But think of 2019 and 2020 as a high-single, low-double-digit growth for Advanced Energy. And Pete, maybe you want to add any additional comments..

Yeah. The only comment I'd make is it's kind of a metaphor using CUSA for the pipeline we talked about in neurosurgery. Dan and his broader team, Mike Tracy, the group we brought together, is a really stellar team. And I think the really interesting opportunity – if you look at CUSA, it was a very well executed launch.

It's a scalable platform that can meet the cost and future needs in a China or Japan and more of the broader needs it can be meet in the United States.

And whilst doing that brings a significant step-up in gross margin versus its predecessor products and all the launches we're talking about in the second half of the year whether it'd be we think about the monitoring platform, we think about the generator, that's probably one of the most important CTQs or critical to quality parameters that we have.

And so we get a lot of questions about stepping up the growth rate of the previous Codman assets as well as the margins.

This mentality that we've applied to the CUSA product, we're applying to all the forward R&D products and think that there's some significant value going to be associated with those launches by doing fundamentally what we did with CUSA.

Very helpful. Thank you.

Thank you. Our next question will come from Matt O'Brien from Piper Jaffray..

Hi, Matt (sic) [J. P.]..

Good morning. This is J. P. on for Matt.

How's it going, everybody?.

Good. Good morning..

So I just wanted to touch upon some questions earlier asked about just your confidence in the reacceleration in the back half. And really, I wanted to dig into – it sounds like it's more around operational and commercial execution than it is about new products.

Is that how you characterize it? Is it fair to say that three-fourth of the reacceleration is just you've got your sales channel intact an OTT and the Codman integration moves on further? But you do have some new products? It's not like you're banking on these new products to really take off to get to your number, I guess, is the question I'm getting at it's more about your commercial organization is in much better position than it was in the first half..

Yeah. J. P., it's Glenn. I would say certainly having the commercial teams in place, having all the roles filled in the U.S. and outside the U.S., moving past the changes we made early in the year and having more focused channels is the bigger part of the growth. And so it's a better execution. It's about capitalizing on the market opportunities.

New products do play a role in that, so I know there are certain new products we're launching now. Those are not going to have a significant impact in the back half of the year.

But those launched in the last 12 months such as the CUSA Clarity product, Cadence, those are all will be considered to be new product launches that will contribute in the back half of the year.

But relative to things we're going to be launching now, like our XT Ankle and those types of products, Panta II, which is for ankle fixation, the AmnioExcel Plus that Pete mentioned earlier, they'll have a big contribution, but it's a much smaller contribution versus the actual channel expansion that we expect in the back half of the year.

Pete, maybe you want to add to that?.

Yeah, I would just say, J. P., in a word, it's productivity, so you think about first quarter all of our global sales organizations except for maybe 15%, 20% of them were having territory changes all through Q1. Q2 a good 60%, 70% of them were in their roles but they were still learning their products.

We've built the rest of those roles in the second quarter. And so the second half now is about a stable organization that's well-trained that has more time to sell and can increase their commercial productivity.

So to Glenn's point, yeah, there's products that can help that but I would argue like on the Codman side, both of our teams that are now integrated learning the other's portfolio to a level that you can convert customers, we're just getting there.

On the orthopedic and tissue side after all the territory changes which we all know can be really disruptive, the fact that we've come out of Q2, we're stable the focus now can be on just growth.

And a day, a week where you had to spend helping your counterpart or following up on data now can be spent selling, that's where we're going to see the biggest lift in the second half of the year..

That's helpful. And then on the TSAs, I recognize none of these are easy, but it sounds like the original 60% was probably tougher than the remaining 40%. Is that fair and then on the decision to integrate China a year early, was that your decision or was that some sort of regulatory decision that got accelerated? That'd be helpful..

Yeah, it was our decision based on we took a look at our initial plans and understanding how stable that group was, there was some considerations of how we thought about our distribution structure and so we felt it was prudent to pull it in, so it was our plan initially and was our plan to pull it in because we felt better about doing that.

I would say the way to think about this is they're probably reasonably equal as far as the TSA is coming off. The U.S.

had the benefit of having a lot of the systems in place, but those larger and more complex, the international one isn't as larger volume, just based on the numbers I represented but it brings complexity of multi-currencies, multi-languages, and we also have more work to do on ERP system. So that's how you would think about it.

But I would say we're well on our plans, ahead of our plans really as far as getting a system structures and capabilities in place to be able to manage it. But I think they are relatively equal as far as the scope and scale.

They're different, but the fact that we are able to complete this U.S., Canada, Australia, New Zealand and China here on plan on time with really no disruption, I think is kind of emblematic of our approach and the approach that we'll apply to the European and Japan transfers that we'll do next year..

That's helpful, thank you..

Thank you. Our next question will come from Jonathan Demchick from Morgan Stanley.

Good morning and thanks for taking the questions. Wanted to start off on the refinancing that you guys did during the quarter. Obviously, it was a bit opportunistic but also opens the possibility for deals going forward.

Was just wondering how you're thinking about capital deployment and where you'll want to be net debt to EBITDA moving forward? And specifically there is any gaps you are looking to fill as you build the OTT sales channel up?.

Hey, Jon, this is Sravan. I'll answer the first part of that, which is the capital structure, a piece of it.

I don't think we stated publicly in the past what our targets are from a net leverage perspective? I think from a cash flow deployment for the near to midterm, we've got some one-time costs associated with Codman and we're still working through which will last through the middle of next year.

So any available and additional free cash flow, we'll likely use toward debt repayment. From a target perspective, I think we even like to be between 2.5 times and 3.5 times long-term so around 3 times, but right now we're continuing to drop that leverage down where we can..

In terms of the portfolio, we're looking at opportunities across our business whether it'd be tuck-in acquisitions for CSS or bolstering some of the parts of OTT that are not at scale today and I think we've been pretty evident where some of those are.

But as we mentioned earlier, nothing big planned for 2018, it's all about heads down, getting Codman integrated. They have some tuck-ins, licensing deals, strategic alliances, those types of things, but focus for the rest of this year is really ensuring that we get Codman integrated successfully. And that's going well, as Pete mentioned earlier..

Understood and just a quick follow-up on growth expectations into the back half of the year.

You guys commented guidance of at least 6% organic growth into 3Q and I think this is a little lower than investors would've thought just given some of the potential headwinds that were being removed with the Codman commercial integration and the OT sales build. Private label gets better.

You have easier comps, notably from the Huricade (49:06) and Dural Repair, stuff like that. I mean it seems when you add all those together there's 4 or so points of acceleration rather than the 3 points or so that you're kind of commenting on.

Is there anything that investors should be thinking about that pressures growth in 3Q? Or is this just potentially a little conservative as you look going forward?.

No. Listen. I think when we look at Q3 and Q4 we're expecting really robust quarters for organic growth. We have easier comp in Q3, to your point, and I mentioned on the last call in the first quarter that Q3 will likely be the highest quarter.

So I think at this point we're just seeing a really strong back half of the year and both quarters should be above 6%. Keep in mind we're still at 5% for the full year, although we've got some incremental momentum in the CSS business.

So we'll see what that means in terms of our ability to overachieve that number, but right now, we feel good about Q3 and Q4. Both quarters should be above 6%. And it's possible that Q3 could even be better, but right now that's what we are guiding to..

Yeah. The only addition that I would add to that is, as we've stated all year, we're trying to be quite balanced and prudent with as many changes we've had going on to the company.

Obviously with these two larger risks, the channel integration and the TSA component behind us, there's probably more upside in the second half than downside and we do have some wildcards. I think it's alluded to the outpatient wound care space. How that evolves, could be a positive wildcard. I think our channel productivity and how much we get.

We're not counting on a significant amount. Is there more that could come? Absolutely. So I think we've got quite a few levers that could help us drive growth higher, but at this point in time I think this is the right way to think about the numbers.

And again, our approach has been to be pretty conservative or pragmatic about how we think about what the growth expectations can be until we start driving some consistent trends around that. But I feel very good about where we exit Q2 and how we start Q3 and move into Q4..

Very clear. Thank you very much.

Thank you. Our next question comes from Steven Lichtman with Oppenheimer & Company..

Good morning, Steve..

Steven, your line is open. Please make sure you're not on mute..

Yes. I was on mute. I'm sorry about that. Good morning, guys. Private label looks to be set up well to expand given the capacity you have in the regen facility in New Jersey.

Can you remind us how big that business is today and broadly, what you see as the opportunities for expansion in that business looking ahead?.

one, existing customers that have long-term contracts that are seeing very strong end market growth; and then second, new partners that we're signing up. But the new partners are in different areas, but the dental collagen space would be what I'd highlight that we won a couple of recent deals on and an area of opportunity for us.

But all in all, between the existing customers growing nicely as well as the new partners we're signing up and we expect to have a couple more signed up in the not too distant future. We feel really good about our business and we have plenty of capacity to continue to focus on getting more productivity out of our collagen manufacturing plant.

It brings up a good point around gross margins and given where we are with gross margins, we see a nice path forward to getting to 70% in a number of different areas, one of which is filling that plant with more capacity. And so that would be a double benefit for us in terms of top-line growth as well as gross margin improvement..

Great. And then, Glenn, just a couple of quick follow-ups. The tax rate of 18%, is that a number that we could hold potentially into 2019 and beyond all else equal? And then lastly on FX, you mentioned obviously the reduced tailwind that you're absorbing on the top line.

Is that also an impact in the bottom line as well if you're absorbing some impact on EPS as well?.

Yes. So good question, Steve. I would say relative to the FX piece, I will start with that. When we look at the quarterly impact in Q2, if you use constant rates to our able guidance, we had about a $2.2 million negative impact and so I called it out in the script, we would've been at $368.4 million had rates held constant from April.

And then when we look at the full year now, it's going to have a reduction of about $7 million to our full year number, but we're absorbing that in our guidance through better operational performance in CSS. And so hopefully that point came across in my prepared remarks.

There is an impact on the bottom line as well and so we think of it as about a 15% to 20% impact on revenues. So if you think about a $7 million reduction, it's about a $0.01 or $0.02 negative impact on the bottom line versus our previous projections.

And again we're absorbing that while still raising the low end of our guidance range because of stronger operational performance first half of the year while we expect in the back half of the year. So there is an impact. There's probably a $0.01 or $0.02 given the recent strength in the U.S. dollar mainly versus the euro and the British pound for us.

But we're absorbing all that and we're absolutely more confident now given our first half of the year performance than what we expect in the second half..

And just on that tax rate looking forward, 18% a good number?.

Yeah. So listen, we're not going to give guidance, but I would say if you're modeling out multiple years, you would just hold the 18% in your models. I think I'm comfortable saying that..

Got it. Thanks, guys..

Thanks..

Thank you. Our next question comes from Travis Steed from Bank of America..

Hi. Good morning. Thanks for taking the question. Just wanted to talk more about the TSA with J&J. Can you comment how the process went in terms of spending? Your plan I think you mentioned was in line with guidance, but I think before you had said you left some cushion there, so there could be some upside to EPS if the process went on plan.

Is there still a possibility for that to flow through the second half?.

Yeah. So, Travis, when we think about – obviously when we take a look at the products I think overall I would say if you think longer-term over the next two to three years, we look at the opportunity to increase gross margin on all of these products with the right type of engineering on the existing products, the higher margins on the new products.

And then just the way we believe we can run the plant because we can focus on certain productivity levels. We feel more confident than we did when we bought the assets that we can do that. You mentioned as we come off the TSA, so we're paying a markup so there's clearly an initial benefit.

Those that are already being contemplated within our guidance for the second half of the year, so we don't see a substantial change to that. If volumes increased, things of that nature that could be a benefit, but I would say at this point in time we think they're right in line with what we expected.

And as we move into 2019 and 2020, I think Glenn's point about sequentially increasing, we think, that's clearly going to play out with the Codman portfolio as well.

I don't know, Glenn, if you want to add anything else to that?.

No, listen. When we look at the roll off of the first wave which was 60% of the revenues of the business, I would just tell you our costs are at or below that J&J was charging us. But it was reflected in our guidance. And one of the reasons why we are more confident in our EPS guidance as well, having that uncertainty now behind us.

We raised the low-end of our range. We still have more work to do outside the U.S.

But I feel very good once we come off these TSAs and the TMA later we're going to have pretty substantial improvements across our business getting us to our long-term goals that we outlined at the Investor Day which was 70% plus gross margins and 30% EBITDA margins by 2022.

The biggest part of getting there is doing this efficiently, doing it better than the cost that J&J is charging us today and so far so good..

All right. And maybe a couple questions on the gross margin. For this quarter and I think you originally were calling you're at the 100 basis point improvement sequentially and it was a little bit below that, not a lot, but a little bit, so maybe if you could provide more color on gross margin this quarter.

And also your full year guidance implies a decent wrap, 100 basis points, 200 basis points in the second half.

It sounds like a lot of that is going to come from mix, but just anything else you can provide more confidence on gross margins in the second half?.

Yeah. So I would say, first, we were expecting about 100 basis points of improvement sequentially from the first quarter. We had about a 80-basis-point improvement, so it was a little bit softer than we have expected. The main driver behind that is some of the favorable manufacturing variances in one particular plant outside the U.S.

shifted from Q2 to Q3, so it's just timing. As a result of that and then some of my prepared remarks I talked about a gradual improvement in Q3 and Q4. So we are expecting margins to continue to improve in the back half of the year getting us to what I would say as the low end of our guidance range.

If you look at our guidance range right now, I would expect we probably would be closer to the 67.5% range given our first half performance, but gross margin is improving. Year-over-year, just keep in mind, the reason why we are down is because of the dilution from Codman.

The Codman gross margins are lower than our base business and so we expect at least 100 basis points of dilution year-over-year from Codman. Having said all that, I'll go back to the longer-term view.

When I look at the cost we're being charged by J&J, which includes a markup and that will go way, coupled with improving the capacity in our collagen plant, we feel really good about the gross margins going out over the next several years.

But as we think about it in terms of the quarter, it was probably about 30 basis points or so light and it was really associated with some of the manufacturing variances shifting to Q3, so nothing of substance other than that. As Pete mentioned earlier, we're expecting a really strong back half of the year with our regenerative technologies.

And you know that's part of our portfolio that generates gross margins that are above 8%, so that will help with the improvement in the back half of the year as well..

Thank you for that..

We have now reached the duration for today's conference. Thank you, ladies and gentlemen, for joining us today. You may now disconnect..