Hello, and welcome to the Q2 2019 SeaSpine Holdings Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to introduce your host for today’s call, Leigh Salvo, Investor Relations. You may begin..

Thank you. And thank you for participating in today’s call. Joining me from SeaSpine is CEO, Keith Valentine; and CFO, John Bostjancic. Earlier today, SeaSpine released full financial results for the second quarter ended June 30, 2019.

During this conference call, we’ll make forward-looking statements within the meaning of federal securities laws in regard to our business strategy, expectations and plans, our objectives for future operations and our future financial results and conditions. All statements other than statements of historical fact are forward-looking statements.

Such statements may include words such as believe, could, would, will, plan, intend and similar expressions. You are cautioned not to place undue reliance on forward-looking statements, which are only predictions, and reflect our beliefs based on current information and speak only as of today, August 1, 2019.

For a description of risks and uncertainties that could cause material differences between our actual results and those stated or implied by the forward-looking statements, please see our news releases and periodic filings with the SEC, which are available on our corporate website at www.seaspine.com and at www.sec.gov.

I’ll now turn the call over to Keith Valentine.

Keith?.

interbody device that incorporate the NanoMetalene and Reef Topography I’ve just mentioned, including a boarded interbody for PLIF and TLIF approaches that accommodates both straight impaction and insert-and-rotate techniques; an articulating TLIF interbody designed to maximize endplate contact and sagittal correction; and a no-profile anterior lumbar interbody device with an optional modular plate and that includes both a screw and an in-line fixation option.

We also plan limited launches of a minimally invasive, pedicle-based TLIF retractor that will be compatible with our Mariner modular screw sets; and a newly designed comprehensive anterior decompression and disc preparation instrument system to better support our existing Vu aPOD Prime NanoMetalene anterior lumbar interbody franchise and the next-generation A-list implants.

We’ve also taken a new direction with respect to our Expandable Interbody strategy and the technology we acquired from NLT Spine. We continue to move forward with the development and commercialization efforts for the NLT lordotic expandable implant.

However, due to market trends and new features necessary to be competitive in the expandable market, we have identified a faster and more cost-effective internal development initiative to launch an even more robust and personal parallel expanding interbody compared to what the NLT technology enable.

We expect to make the launch for both the parallel and lordotic expanding devices in the first half of 2020. I also want to address plans with respect to our complex spine and deformity franchise.

While our degenerative franchise once again posted strong growth in the second quarter, our complex and deformity franchise posted lower revenue compared to last year, though we did see a nice rebound in July’s sales.

A significant step in the advancement of our deformity franchise will be the development and introduction of improved Mariner reduction instrumentation as well as expanded implant options, both of which we expect to introduce in the second half of 2019.

Those enhancements, combined with our recent commercialization of the Mariner Outrigger System, and all in-licensed SeaSpine-branded version of implant with its market-leading Jazz brand, will further our deformity capabilities and allow us to take on more complex cases that address significant deformities.

These additions will proceed a larger and more extensive development efforts to further extend the Mariner platform into deformities that we expect to launch in the second half of 2020.

Based on the success so far of this foundational platform, we have a great deal of confidence that these Mariner advancements will produce similar revenue growth in our deformity franchise as we have experienced in our degenerative portfolio. As you can see, we have aggressive development and commercialization plans.

But I have great confidence in the talent and capability of our product development and marketing teams to deliver quality launches on time and that meet the demanding needs of our surgeon customers. I’ll now turn the call over to John to provide more detail on our financials and our financial outlook, then I will wrap up.

John?.

Thanks, Keith, and good afternoon, everyone. As Keith noted earlier, total revenue for the second quarter of 2019 was $39.3 million, an increase of 8% compared to the prior year. U.S. revenue increased 7.5% to $35.1 million, and international revenue grew 12.3% to $4.2 million, largely on the strength of spinal implant replenishment orders. U.S.

orthobiologics revenue in the second quarter increased 9.3% year-over-year to $18.2 million, driven by growth in recently launched DBM products, led by the OsteoStrand Plus product.

As we continue to ramp up production capacity of the fiber space DBM products and broaden our sales and marketing efforts, we’re starting to see more of the expected and desired cannibalization of our legacy particulate DBM products.

This controlled cannibalization will have a beneficial impact on our longer-term gross margins and cash flow management as we scale down production of the legacy products over time.

Sales of our Mozaik collagen ceramic matrix product line stabilized in the second quarter, and with the addition of the recently launched OsteoCurrent product in May, we expect to generate growth in our synthetic bone graft substitute franchise in the second half of 2019. U.S.

spinal implant revenue in the second quarter increased 5.5% year-over-year to $16.9 million and was once again driven by growth in recently launched products, led primarily by the Shoreline and Mariner systems and by our expanded NanoMetalene portfolio.

Spinal implant surgery case volumes increased more than 10% but were somewhat offset by low single-digit price declines and procedural mix, more specifically the lower complex spine and deformity revenue, as Keith mentioned earlier. Gross margin for the second quarter was 63.6% compared to 60% for the same period in 2018.

This expansion reflects the benefits of our focused efforts to reduce the raw material and manufacturing costs of our orthobiologics products.

Throughout 2018, we implemented a series of process improvements at our Irvine, California manufacturing facility that increased manufacturing yields and lowered scrap rates, the benefit of which we are realizing in the P&L now as that lower-cost inventory is sold.

Operating expenses for the second quarter of 2019 totaled $37 million compared to $29 million for the same period of the prior year. The increase included a $5 million noncash impairment charge associated with intangible assets from our NLT Spine acquisition due to the shift in our Expandable Interbody commercialization strategy that Keith outlined.

The remaining increase was primarily the result of $2.2 million in higher selling, general and administrative expenses, including selling commissions, stock-based compensation related to timing of equity award grants and salaries and wages.

Research and development costs increased approximately $800,000 primarily due to increased headcount and higher costs related to clinical studies. Net loss was $12 million compared to a net loss of $7.4 million for the second quarter of 2018, reflecting the impact of the $5 million impairment charge I’d just noted.

Cash, cash equivalents and investments at June 30, 2019, totaled $36.4 million, and we had no amounts outstanding under our credit facility. Year-to-date in 2019, we did not sell any shares of common stock under our ATM program nor do we anticipate utilizing the ATM program in the near future.

Our free cash flow burn, which excludes financing inflows and outflows and purchases and sales of marketable securities, was $9.3 million for the second quarter of 2019 compared to $3.9 million in the prior year period.

The increase was driven primarily by higher purchases of inventory and instruments to support the full commercial launch of the Regatta system and in preparation for the numerous full launches Keith recapped above and to support full inventory levels for both the newer fibers-based DMB and the legacy particulate DBM portfolios.

As the expected cannibalization of the legacy DBM products increases, we expect to reduce orthobiologics’ raw material and finished goods levels in the second half of 2019. We remain focused on expanding our gross margin and continuing to reduce cash-based G&A expenses as a percentage of revenue.

However, in the short term, we plan to continue to redeploy much of that operating leverage towards the sales, marketing and R&D initiatives as well as the increased investments in spinal implant set builds in the inventory that are critical to building a scale and driving a sustained revenue growth that are needed to achieve sustained, positive free cash flow.

Accordingly, we expect our free cash flow burn for full year 2019 to be in the range of $25 million to $27 million.

With respect to investments in spinal implant set builds and inventory, we expect to spend in excess of $10 million of capital expenditures in 2019 to support all of the system launches discussed earlier and the deployment of additional sets of our flagship Mariner and Shoreline systems.

That represents nearly a 50% increase in capital spend compared to 2018. That will translate into meaningfully higher but much harder to quantify spend this year on the implant inventory that will go in those sets.

I wanted to give more color on this anticipated spend because it is an important factor that led us to increase the bottom and top end of our full year 2019 revenue guidance.

Based on a detailed analysis of the key spinal implant system launches and set deployments since the beginning of 2017, we identified a strong correlation between spinal implant set additions and increased revenue growth as measured by revenue generated per set.

We believe there is meaningful unmet demand for key systems, Mariner and Shoreline in particular. Accordingly, we believe deployment of additional sets of proven systems as well as aggressive investment in key new systems will drive greater revenue growth in the second half of 2019 compared to the first half of the year.

Turning to our financial outlook for 2019. As Keith mentioned earlier, we are raising the bottom and top end of our revenue expectations and now expect full year 2019 revenue to be in the range of $155 million to $157 million, reflecting growth of 8% to 9.5% over full year 2018 revenue.

This compares to previous revenue guidance of $154 million to $156 million. Moving down the P&L.

We continue to expect gross margin for 2019 to increase to within a range of 62% to 64% as we continue to realize the benefits of the process and yield improvements we’ve implemented in Irvine; and SG&A, excluding noncash stock-based compensation charges and any noncash gains or losses related to changes in the fair value of NLT-contingent consideration liabilities, to approximate 66% to 69% of revenue.

We expect R&D to approximate 9% to 10% of revenue to reflect the increased investment in clinical studies and product development headcount. At this point, I would like to turn the call back over to Keith for closing comments..

Thank you, John. We have tremendous opportunity ahead to significantly expand our share in the $10 billion-plus spine market as we remain relentlessly focusing on delivering clinically relevant, cost-effective procedural solutions that differentiate us with both surgeons and distributors in this competitive market.

We are committed to continuing to grow at a rate that is at least 40x faster than the overall spine market and are confident in our ability to execute. We are off to a solid start in 2019, but the second half of the year will be pivotal for SeaSpine.

We must continue to execute on the numerous product launches we discussed today as well as many others we have in the pipeline and continue to expand the reach and exclusivity of our global distributor network.

I am proud of the solid foundation for sustainable growth we have established, which is supported by our organization of nearly 400 energized employees who are committed to providing high-quality, differentiated and complementary technologies that leverage our core competencies in orthobiologics, interbody devices and modular spinal instrumentation systems.

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

Operator?.

[Operator Instructions] Our first question comes from the line of Matthew O’Brien with Piper Jaffray. Your line is open..

Thanks for taking the question and congrats on the quarter..

Good afternoon..

Good afternoon, guys. Would love to hear a little bit more about the back half confidence. Your comps are getting a lot tougher, which I’m sure you know, but you’ve got all these products coming and these new set deployments. Those typically take a little while to really ramp up.

So what gives you all that confidence? Is it existing accounts saying, hey, I’m really looking forward to this one or two systems or these one or two systems, or is it the additional sets? Or can you just talk a little bit more about that..

Yes. It’s a couple of things, Matt. It’s the set deployments, right? That analysis we looked at that said the revenue per set generated stays pretty much constant as we add additional sets. So we’re seeing an incremental increase in revenue.

We’ve onboarded a couple of more of the exclusive distributors this year, right? And they’re starting to hit their ramps, so they’re going to need to have those – more sets. So the timeliness of those deployment is really critical to the growth. And just the Mariner MIS kind of closing one of the big remaining portfolio gaps.

I think there’s a lot of folks who have been kind of on the sidelines ready to work with us but just needed that MIS solution, and I think that’s kind of the final piece of the puzzle to go in place. So it’s all of those factors that’s contributing to the optimism for the accelerated growth in the back half of the year..

Okay. And then….

One additional one, Matt. I think it’s important to note that we have progressively added to the Mariner system, as you know, and the midline cortical was an important part of entering into the MIS area. But the MIS – the full MIS launch really is very strategic. It’s becoming a bigger and bigger part of the market.

It does have – typically, it can often have a nice premium, but it also is probably the fastest-growing part of the market as well as more and more people think about MIS, whether it’s mini open or MIS.

It becomes a very important part of not only the excitement our distributors have of going after new accounts but also distributors that are coming through the door. And we have a different conversation with them about becoming part of our exclusive channel.

So we knew this was an important add, but I think it comes at a very strategic time as we get into the second half of 2019..

Interesting. Thanks, Keith. Sticking along those – the lines about the health of the business, especially on the hardware side. You mentioned this July strength, which is a little surprising just given that we’re in the summer months here and things tend to slow down a little bit.

So where are you seeing that strength come from? Is it new accounts going deeper in existing accounts? And then just generally speaking, in spine, it feels like the market generally – and I know you’re a smaller player, but is getting – is better. So I’m wondering if there’s a couple of things you can point to.

It doesn’t it sound like pricing pressure is becoming less of a headwind.

Are there other things that are a little bit of a tailwind to the whole sector at the moment?.

Yes. We feel like we wanted to mention it, Matt, because specifically, we were being very transparent on the deformity challenges that went on in Q2. But interestingly enough, the deformity side of the business, so the traditional customers for deformity, it appears they just had a scheduling of patients in July instead of June.

And why exactly some of that went on, we’re not fully certain of, but it did show strength in July. When it comes to the other parts of July that we mentioned, I would categorize it as both. We’re seeing strength with new accounts and we’re seeing strength with existing accounts on the traditional degenerative business. So that’s a good sign.

Yes, I agree with you. I think if you look at the history of Q3, Q3 has always been a point of caution or concern. And I certainly like the fact that it’s kicking off strong..

Got it. And then, John, I may have missed this a little bit.

But the gross margin improvement that you saw this quarter, the durability of that as you’re adding new sets and more inventory, I mean, how does that metric trend with some of these process improvements that you’re doing as well?.

Yes. We expect the benefit of the process improvements in Irvine to continue to give us a lift on the margin.

I think as we work to balance the pullback of the inventory levels on the legacy DBM portfolio as the newer fiber-based DBM product sales ramp up – I don’t know, but I would expect more upside to it because that will create a little bit lower absorption in – of all the fixed costs in the plant because we’re trying to balance the increase in the gross margin but also with the right cash management because as that legacy portfolio continues to get cannibalized, we’ll be bringing those inventory levels down.

But we think it’s sustainable..

Got it. Thanks so much..

Thanks, Matt..

Thanks, Matt..

Our next question comes from the line of Ryan Zimmerman with BTIG. Your line is open..

Thanks. This is actually Sam on for Ryan.

How is it going guys?.

Good.

How’s it going, Sam?.

Good. Congrats on a good quarter. Just a question on industry generally.

With some of the consolidation we’ve been seeing in the market, how would you say your customer segments are responding? And what’s been the feedback you’ve seen in the market from your ability to work with new accounts and new customers?.

Yes. I still say it’s a strong opportunity for us. I think we’re all familiar with the biggest of big players that have already reported.

And it’s still a good opportunity not only for having strong conversations with new distribution, but I think also having conversations with surgeons who are a little frustrated just generally that any time there’s consolidation going on, there seems to be often a lack of communication or at least a lack of maybe their relationship base with the former company.

And so I think that’s been – our ability to kind of navigate through that and make sure they’re aware that we have not only very engaged marketing and development, we have a very engaged senior team in those conversations and understanding of the marketplace, in addition to the fact that we’re going to be aggressive going after the best of distribution and offering them a different, and I think, a more focused opportunity..

Great. And then just looking at the portfolio following the Mariner launch, that’s a big, big piece there.

But do you feel there’s anything else lacking in the portfolio that you’re looking at going forward? And where do you feel the development for that will be coming from, whether that be in-house or external at this point?.

Yes. So there’s a couple of things that would be organic-based, and the organic-based would be – we have a pretty elaborate and moving-forward project with posterior cervical. As you may be aware, we have two posterior cervical systems that came from each of the Theken and original SeaSpine acquisitions by Integra.

And so those are in need of updating, and we feel really good about the design team and the progress we’ve made on that system. We’ve already even done our first of a developmental cadaver lab with the early version of the system. So we feel good about the progress there.

The other area that we’re not in fully is the areas of the trauma, a more complex spine area, which would be the ability for a vertebral body replacement. And that’s an area that we’re trying to navigate in time and figure out when it’s best to put the investment forward. The good part about that is it is a well-paying procedure.

The difficulty with it is the set deployment because often, trauma has very short time lines for how quick the sets need to be there. So you need to basically have deployment in and around regions of the country that may sit for weeks and weeks until they’re requested. And so that’s a little bit – it’s not a challenge from an R&D perspective.

We have the horsepower to do it. It’s more of when do we want to deploy our capital for that particular area..

Great. Thank you..

Thank you. [Operator Instructions] Our next question comes from the line of Jeffrey Cohen with Ladenburg Thalmann. Your line is open..

Hi, Keith and John.

How are you?.

Good.

How are you?.

Hi, Jeff..

Just fine.

So firstly, have you done any cases with the Jazz system since the announcement in the spring?.

So the Jazz system, there’s a couple components to it. It’s been a matter of, a, integrating. There’s been some – there’s a couple of different versions that we are working on. There’s one that’s traditional that I think people have seen in the marketplace. There’s one that will be proprietary to our own Mariner system.

So there’s a couple different pieces to that. But in light of the traditional system, yes. But the proprietary system, that connection with Mariner, that’s not fully launched yet..

Okay.

And when do you expect some sets of those to be out?.

I’m sorry, when do you expect some what?.

Some sets of those to be out? When do you expect that to be available with Mariner that’s compatible?.

Yes. Yes. We are placing bets on fourth quarter of 2019, and a number of things need to get in place between approvals and our clearances and also a buildout. But we feel good that everything should be on schedule.

It’s – they’ve already shown previous track record of success with integration with a screw system, so we don’t feel like there should be any major hangups..

Okay. Got it. And can you talk about any changes over the past quarter or two at the Irvine facility as the pickup in biologics kind of takes hold? I know you’re running probably half-ish as far as max capacity and throughput there.

What’s changed? And is that going a little bit higher? How are you seeing things?.

No. It’s materially the same. I think we’re just being more efficient with the process improvements that we’ve made because now, we’re at full bore production on both the fibers-based DBM and the legacy particulate.

But overall, capacity-wise, just because of the efficiencies, we haven’t really moved up much from around 50% to 60% of the plant’s capacity..

Yes. I think, too, Jeff, you should know that between the development team and our manufacturing and engineering team, they’ve done a really good job. The first – kind of first task we put them out to was let’s make sure as we launch Strand that we’re really refining the process.

And we’ve mentioned on previous calls that we feel our Strand is really differentiated because we have looked at every step of the manufacturing process to really maximize the product’s efficacy. And that’s an important first step. And now, the same folks are able to spend energy now making the process more efficient.

And the first goal was let’s make it the best product in the marketplace with the right steps. Next part is let’s really take a look at the way we manufacture, that goes back two decades for some products, and let’s really evaluate how we make it more efficient in light of these process improvements we’ve made to make it more efficacious.

And so that’s probably the most exciting part as we get in the second half of ‘19. We’re really starting to see some gains in both of those areas..

Okay. Got it. Could you talk a little bit lastly about case volumes and metrics that you’ve been seeing as far as number of surgeons, number of facilities, et cetera? And then also talk about any cross-selling synergies that you’ve seen.

Any pickup on there with the past few months?.

Yes. Year-to-date, case volumes are up about 12%. It was 10% in the first quarter. As we’d outlined in the script, there is a little bit of a mix shift. So volume’s up low single-digit, pricing declines. And then just the mix with deformity was down because of the decrease in the revenue there.

But I think as we move into the back half of the year, we feel good that we’ll stay in that mid-double digits procedural volume growth with the new distribution that we’re adding and all the new sets that we’re deploying over the back half of the year..

Okay. Got it.

And any commentary on cross-selling between the biologics and the hardware?.

Yes. Actually, the cross-selling opportunity, we have a number of, I think, significant examples now of – we continue to see strength in the exclusive distributors, especially strength with the newer products. And that trend continues, which, I think, is extremely important.

We’re also seeing an increased interest from more and more groups, especially new groups coming aboard, comparing our NanoMetalene technology – and now even NanoMetalene with reef with stranded technology.

So that is, to us, the ultimate in cross-selling because it demonstrates not only – we feel strongly that having a orthobiologically friendly implant along with a better DBM will create a strong result as any other combination at a much better economic opportunity..

Perfect. Okay, that does it for me. Thanks for taking the questions..

Yes, thank you..

Thanks, Jeff..

I’m showing no further questions in the queue. I would now like to turn the call back over to Keith Valentine for closing..

So thank you, everyone, for joining us for this call, and I hope you all have a great evening. Cheers..

Ladies and gentlemen, that concludes today’s call. Thank you for participating. You may now disconnect. Everyone, have a wonderful day..