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Alphatec Holdings Inc (ATEC) Q2 2019 Earnings Call Transcript

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Alphatec Holdings Inc (NASDAQ: ATEC)
Q2 2019 Earnings Call
Jul 24, 2019, 4:30 p.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

Operator

Good afternoon, everyone, and welcome to Alphatec's Second Quarter 2019 Conference Call. We would like to remind everyone that participants on the call will make forward-looking statements. These statements are based on current expectations and are subject to uncertainties that could cause actual results to differ materially. These uncertainties are detailed in documents filed regularly with the SEC.

During this call, you may hear the company refer to reported amounts, which are in accordance with U.S. GAAP as well as non-GAAP or pro forma measures. Reconciliations of non-GAAP measures to U.S. GAAP can be found in the supplemental financial tables included in the press release, which identify and quantify all excluded items and provide management's views of why this information is useful to investors. Joining us on the call today will be ATEC's Chairman and CEO, Pat Miles; and CFO, Jeff Black.

Now, I will turn the call over to Pat Miles.

Patrick S. Miles -- Chairman and Chief Executive Officer

Thank you very much, Sidney, and welcome, everybody to the Q2 conference call. When we pivoted this company, we knew that there are several things we had to do to make this a growth company. Really the first thing was to create a new team. And so, just to refresh everybody's memory, we turned over 100% of the executive team, 90% of the Board and 75% of the company. This truly is a new organization.

We also knew that if we're going to create this growth company, what we had to do is distinguish ourselves clinically, and hence create an organic innovation machine and realize that in the entire process that our focus had to be in the operating. And so, when you look back and say, gosh, did we do those things? I think yes, I look forward now and say, at 2019, how did we do? And how are we with regard to those commitments that we've made? And so, the commitments we made for 2019 included creating clinical distinction with 12 new products. So through the first half of the year were seven new products in, expanded new product revenue contribution from less than 10% a year ago to 30% this year or 27% of the way in, in terms of reflecting revenue from new products.

Also, how do we start to drive revenue growth of approximately 30% with the strategic part of our sales network? We're at 40%. And then how do we increase revenue per case was another commitment. And so, we've increased revenue per case by 14%.

So based upon that performance, we really went back and reevaluated our guidance. And so, what we're doing is, we're upping our overall revenue guidance from $98 million to $103 million, up to $104 million to $109 million, and that's total revenue. From a domestic perspective, what we're doing is going from a $94 million to $98 million previous guidance to $100 million to $104 million. And so when you look at the growth of the marketplace, the domestic marketplace, that's over 20% top-line growth for our U.S. business, and that's in lieu of the headwinds that exist with regard to our continuing to translate some of our distribution out of the company.

And so, going on to the next slide, what I'd like to do is really kind of focus on Q2 and what the performance looked like in Q2. So, the financial reflection looked like this: We grew 28% year-over-year. Our ADS, our average daily sales, grew 28% as well. That's the largest or highest rate of U.S. quarterly revenue growth in 10 years for this company. Our sequential growth was 14% Q1 to Q2, and it's the third consecutive quarter of double-digit growth. And so, I would tell you that I believe our progress to be solid.

And so, when you start to think about what our priorities are, we started 2019 with really three core priorities. One of them was to create clinical distinction, one was to compel surgeon adoption and the third one was to revitalize our sales channel. And so we really like to delve more deeply in that and look at how we performed within our core priorities.

And so if you say 2019, what we deemed to be successful is 12 products, we're seven in. Also, we said if we do 12 products, what percentage of the revenue will be attributed to those new products. And we said, we thought 30% would be successful. And so, we're going to elevate that to 35% based upon the quarterly contribution of 32% of our revenue being from new products in the second quarter.

So there's a picture, if you're if you're looking at this from a presentation standpoint of the seven new products that we launched which we'll go into, and then we also continue the evaluation of our SafeOp platform moving forward.

So, to delve a little bit more into the SafeOp platform, when we think of clinical distinction, clearly the SafeOp platform comes top of mind. And so, all indications ***Part 4*** ***Part 5*** all indications are that we are creating safe and reproducible surgery through this platform. So we're providing, as a reminder, objection or objective actionable feedback integrated into surgery. We're doing that through automating EMG and automating SSEP. A key to the success of SafeOp is the workflow in terms of how we integrate it. We talk about convoyed sales, meaning you saw multiple products in the surgery. And so, a key to the success of this product is that we have these things work together. The peripherals for SafeOp will not be available until Q4. So we've decided to launch the entire platform in Q4.

Next is, in addition to the SafeOp platform, we also launched approach specific identity implant systems. These are the currency of our product portfolio. And so, these implants are porous titanium. They are made of a proprietary porous structure to better facilitate fusion, a similar stiffness to bone. There is a reduced density so that it images better and are made out -- they're made via a subtractive manufacturing process which ultimately begets greater predictability. And so we launched since Q1 both the IdentiTi TLIF and the IdentiTi ALIF implant systems.

Next, we've also launched in as literally just this week really a foundational product in InVictus. What this is, is a comprehensive thoracolumbar fixation system. I think so often people use terms like best-in-class and there are hackneyed terms. I will tell you this is more than best-in-class and this is also created by a group of people who have done this multiple times.

And so they -- one, they did it in a record amount of time but also they created literally a best-in-class solution. It's designed to treat a wider range of pathologies from an MIS, open and hybrid. It all works together and it fully integrates with our SafeOp EMG technology for objective, actionable, real-time feedback. So cannot be more excited.

Oftentimes, these are a proxy for the sophistication that will be reflected across the entire portfolio and really can't say enough about literally the suppliers, the design team, the surgeon who help -- the surgeons who helped us on this. The entire effort was a family affair, and I just can't be more enthusiastic about the launch of InVictus. And so, really, congratulations to the organization.

So, we talked a little bit about clinical distinction, and now really you start to say, are we compelling surgeons or are they moving over to us and what does success look like? And I would say success looks like traction, meaning what's the number of products used and revenue as an indication of how we're doing.

And so you look at the revenue growth from the top 20 surgeons was approximately 80%. You look at the number of people who are wanting to come into the company and better understand what we're doing and participate in educational programs, grew by -- was about 43% growth. And then the increased revenue per case of 15%, which is oftentimes an indication of confidence. Are we doing more complex surgery with them, and then are they using more products per surgery? And so, these are all confidence drivers that ultimately give us an indication that we are compelling surgeon adoption.

And also, the last one, I think is really kind of a proxy for our approach strategy, which is how many products per surgery, and we're up to 1.5 products per surgery. And so the next really key priority is revitalizing the sales channel I'll tell you when we got here, there was substantial work to be done in terms of revitalizing really a broken sales channel. And I'm very excited about what's going on, especially from a leadership perspective. I think Dave Sponsel, Emory Rooney, we hired another striker guy, Wyatt Stanfield and Greg Rhinehart are all prolific in their right. And I think I'm exceedingly bullish in terms of our ability to really create traction in the marketplace.

And so, I would tell you this is still a work in progress, but we're seeing success being enjoyed. And so, we're seeing 45% revenue growth from our top 20 distributors. Also, we're seeing 45% growth year-over-year from all distributors. And that's when you start to look at where we're moving a lot of distributors, we're adding a lot of distributors. So, there's a lot of activity going on.

And then you look at what the contribution is from our strategic network, in the strategic net -- that network is the one that we believe that will ultimately march to exclusivity with us. And there, we're growing at around 41%. And so when you look at what's going on and you start to say, what's functioning well. What's functioning well is, we're starting to assemble a sales network that is growing at a very rapid rate and we continue to discontinue legacy and non-strategic relationships.

Because this is such an important element and I'll continue to delve in a little bit more deeply, as stated, we see a continued significant contribution from the strategic network. And this is also who we're building the company around. And what we're finding is really we're earning really increased contribution. And you really start to see, gosh, as we increase the contribution, these guys start to gain more confidence in us. There really becomes a much more direct route to exclusivity.

From the non-strategic channel and you start to look -- we continue to wind down these relationships. If you look at it numerically, we have limited $30 million in annualized revenue since 2017. So when we start to talk about the lumpiness of the top line and you start to see that type of revenue come out of this little company, I think that you'd have to appreciate the significance of that.

Also, what we're finding is some of the non-strategic -- as you want to stick around longer based upon the stickiness of the new products, but the point is we're winding that down. We're continuing to build on the strategic side and it just becomes a predictor of consistency which, in our effort to become a very, very predictable entity, that becomes a key component.

So, with that, let me turn it over to Jeff.

Jeff Black -- Executive Vice President And Chief Financial Officer

Great. Thank you, Pat. Good afternoon, everybody. I'll spend just a few minutes reviewing again revenue results, talk a little bit about gross margin, the P&L and then wrap up with the balance sheet.

On revenue, U.S. revenue growth from our strategic distribution channel, as Pat mentioned, was ahead of plan for the second quarter and for the first half of the year. We're seeing this growth on the strength of new product introductions, continued surge in adoption and increase in revenue per case. And while slower than anticipated, we did see a continued wind down of our legacy distribution revenue as part our planned transition of that channel. This headwind will continue in 2019. We still have about 12% of our U.S. revenue contribution coming from what we consider a highly unpredictable channel. Revenue from our international supply agreement continued to decline, consistent with our expectations as our supplier relationship with Globus winds down in the next one to three years.

Overall, Q2 revenue results above expectations. We're continuing to be encouraged by the performance of our strategic distribution channel. We will continue to see some lumpiness and unpredictability in our legacy distribution channel. But our revenue guidance updated $100 million to $104 million in U.S. revenue, represents up to 24% year-over-year growth from -- in product revenue and up to 39% -- or 39%, 40% decrease from -- I'm sorry -- 39% increase from our strategic distribution channel. So, encouraged by performance and encouraged by the outlook for the second half of the year.

On margin, U.S. gross margin or gross profit of $18.8 million in absolute dollars was our highest level of gross profit since 2016. Year-over-year, on a GAAP basis, our gross margin percentage decreased by about 260 basis points to about 72% compared to Q1 of 2018. However, on a non-GAAP basis, excluding non-cash obsolescence charges, our year-over-year gross margin improved by 310 basis points to nearly 81% and this is on the strength of new product introduction.

As we reported in Q4 and in Q1, we saw margin pressure much like we did in Q2 from non-cash obsolescence related to our legacy products. We expect to see continued margin pressure over the mid-term as we introduce new products and obsolete these legacy products. So we think a non-GAAP view of gross margin as a variable metric to track through this transition. At scale, we continue to believe that our gross margin will be in line with our peers in the mid-70% range.

On the P&L, a couple of highlights on operating expenses. Our operating expenses here represent on a non-GAAP basis to reflect what we consider normalized R&D and SG&A and it excludes stock-based compensation, litigation expenses, restructuring and other non-recurring or one-time charges or gains.

As we continue to talk about, we continue to invest in our product pipeline reflected in an increase in R&D expense in both absolute dollars and as a percentage of revenue in the second quarter compared to last year. And we do expect to continue investment to support new product launches and longer term product development.

As well our SG&A increase in absolute dollars, and as a percent in the first quarter as compared to last year most of this increase is driven by variable sales compensation which is tied directly to revenue increase. We've also made strategic investments in product marketing and the broader sales channel. In fact, our core G&A expenses which has included an SG&A have actually remained relatively flat over the past six quarters. Still well below where we are at in 2016 when we initiated the company's transformation.

So we'll continue to invest in the sales channel where we should start to see SG&A expense leverage in 2020 as we see continued revenue ramp from our 2019 product launches. So now that we're several quarters into the transformation of ATEC, we thought it'd be helpful to look back on where we began and where we are today. This historical look is a bit of an eye chart but a few relevant points to highlight. First is our commitment to drive revenue growth is coming to fruition now. In the first quarter 2019, we delivered our largest U.S. revenue quarter since the first quarter of 2017. Second, we're delivering on our commitment to transition the sales channel to scalable, committed strategic distribution partners. Revenue growth from this channel is now far outpacing declines from the non-strategic channel.

We've walked away from legacy, unpredictable, non-strategic channel relationships which has clearly been a revenue headwind. In fact, we exited the first quarter of 2017 with an annualized run rate of about $44 million from this channel, representing more than half of our U.S. revenue. And we exited Q1 of 2019 with about $12 million in annualized run rate, which represents less than 15% of our U.S. revenue. So, the transition has come to fruition. It's been lumpy and at times painful, but it's a decision that set us up for growth from the right strategic long-term partners.

And finally, we've invested for growth. R&D has grown from 5% of revenue in 2017 to about 12% today, and our SG&A growth has primarily been strategic investments in sales and product marketing. And all of these investments have enabled the growth trajectory we're seeing today.

And finally, on the balance sheet, before I turn the call over to Pat. We entered the quarter with just around $18.5 million in cash. Our operating burn decreased from $9.2 million in the first quarter to $8.5 million in the second quarter. We continue to hold the line on operating cash use, but we also continue to expect 2019 to be an investment year as we support new product launches with capex for new instrument and implant sets and expand our sales channel.

During the second quarter, we made a $10 million draw in our credit facility with Squadron, and we had $20 million remaining on that line. And while we realize we have some work to do on the balance sheet, we're well positioned now to execute on the business and approach financing solution more strategically and opportunistically.

And with that, I'd like to turn the call back over to Pat.

Patrick S. Miles -- Chairman and Chief Executive Officer

Thanks much, Jeffrey. I think as much as anything, I think you're seeing the resolution of the level of predictability that we're trying to bring to this company. And I think to step back for a second and look at the marketplace, I think, so often people see the spine market which is a big mistake is being commodities and we believe that they're misreading this marketplace. And certain items may appear within the context of spine devices as being commoditized, but spine surgery is far from predictable which creates an unbelievable opportunity for us to innovate. And that is why the spine market needs a new ATEC.

So Q2 would suggest that we are making solid progress on our priorities. I think the innovation -- the organic innovation machine continues to reflect success in all three of our core priorities for the organization which is creating clinical distinction, compelling surgeon adoption, and revitalizing the sales channel. And so we deem ourselves the most experienced students in spine and on our way to building a very formidable organization.

And so with that, that concludes the presentation and we'd welcome questions.

Questions and Answers:

Operator

Thank you. [Operator Instructions] And our first question comes from the line of Brooks O'Neil from Lake Street Capital. Your line is open.

Brooks O'Neil -- Lake Street Capital -- Analyst

Good afternoon, guys. Congratulations on the terrific progress you're making.

Patrick S. Miles -- Chairman and Chief Executive Officer

Thank you.

Brooks O'Neil -- Lake Street Capital -- Analyst

I have a couple questions. Obviously, we're in the seventh month of 2019 and you, I think, introduced or launched formally seven new products. Would you expect sort of the pace of additional new product productions to get to 12 to kind of go along with that sort of one per month kind of pacing? And do you think there's any remaining products that might be particularly significant to out the deck going forward?

Patrick S. Miles -- Chairman and Chief Executive Officer

Yeah. Thanks, Brooks. And I would say that there's not an insignificant product to ATEC. And so, I think the one that's going to most stand out is going to be the SafeOp platform and really start to integrate information into surgery. And so, we're so reliant upon building spine approaches, and so the ability to start to apply technology that integrates with each other such that we're architecting the approach which would be reflected in convoyed sales. And so, I would say that's a big one.

There's another one that is part of the InVictus system, and it's called single step, and that's about a month away. And that's another one that enables a technique within the confines of less invasive fixation that will really be a unique contributor to ATEC. And so when you start to integrate all of these things, what we're doing is we're making surgery better. And when you start to look at companies that I think that have grown over the past several years, it's the ones who have been profoundly focused on what's going on in the operating. And that's who we are as a company and that's what you'll see reflected throughout the year.

Brooks O'Neil -- Lake Street Capital -- Analyst

Great. So then, I'm curious, you didn't talk about it and I know it's sort of forward-looking but given that you prepared for and you're on track to launch 12 new products in 2019, can you say generally or with any degree of specificity what the outlook might be for 2020? Should we expect continued organic innovation from ATEC next year?

Patrick S. Miles -- Chairman and Chief Executive Officer

I think as far as the eye can see our commitment is eight to 10 products a year. And so when you start to think about what that does to the priorities, what happens is those salespeople who are profoundly interested in providing innovative solutions to their surgeons start to come our way. And so, with all of these feed one another and so as far as the eye can see we'll do eight to 10 new products per year.

And that's why you start to see, and it's fun to see the reflection of that in the financial metrics that Jeff presented is when you start to see an increase IND spend and then now what we're going to do is, we're going to appreciate the requisite for it.

Brooks O'Neil -- Lake Street Capital -- Analyst

Yeah. That's good. And then, just last question I had was, obviously I understand the importance of SafeOp. And I have some sense that it's not going to be a tremendous revenue generator. So, can you talk just a little bit about SafeOp specifically in terms of revenue and contribution then how you see SafeOp driving revenue growth from other products driving revenue growth for other products that you're producing today or innovating in the future to drive faster growth from ATEC going forward?

Jeff Black -- Executive Vice President And Chief Financial Officer

Yeah. Thanks, Brooks. There's a bit of a interesting situation in Spine in that implants are the currency items, and they are the ones that generate most of the currency. The challenge is that currently that's been defined and what the surgeon requires to do predictable surgery are not one and the same. And so what happens is, there's a lot of companies won't create the requirements of surgery because financially they don't appear as viable.

But I think as you look at things with regard to a procedure and the integration of the tools being used to fulfill a specific surgical need, what you see is you see the expanse of the currency items based upon the ability to deliver clear, objective, actionable information. And so, the opportunity there is that you'll see a vast minority in the contribution from the SafeOp platform, but it will be responsible for the revenue gained, if you will.

Brooks O'Neil -- Lake Street Capital -- Analyst

Yeah. Okay. Great. I've got it. Congratulations. Keep up all the good work.

Patrick S. Miles -- Chairman and Chief Executive Officer

Thanks a lot .

Jeff Black -- Executive Vice President And Chief Financial Officer

Thank you, Brooks.

Operator

Thank you. And our following question comes from the line of Swayampakula Ramakanth with H.C. Wainwright. Your line is open.

Swayampakula Ramakanth -- H.C. Wainwright & Co, LLC -- Analyst

Thank you. Congratulations, Pat and Jeff. A couple of quick questions. So, obviously this quarter, the growth is quite interesting. Not only that, you also updated your outlook -- financial outlook for the year-end coming out with $104 million to $109 million obviously, higher than what it was in the previous guidance. But when you look at the six-month revenue run, it is basically at kind of annualizing where you are at this point, much less on the bottom end of the range that you're giving us. So, what are the pushes and pulls for that number to be north of that range if it can, what needs to get done so that we can see that kind of a year-end number? So, I'm talking more like $110 million or $112 million kind of a number.

Now, what needs to happen, and also what could be potential challenges even to get to $104 million if you need to kind of think to that.

Patrick S. Miles -- Chairman and Chief Executive Officer

Yeah, OK. I'm going to let Jeff speak to some of the numbers directly. But one of the interesting dynamics in is this company has been historically one that I would suggest has not been as predictable as we'd want it to be. And so what we're trying to do is be exceedingly thoughtful with all of the trend or ways at all of the headwinds and all of the tailwinds. And so, we feel like growing at 20% to 24% in the U.S. marketplace is meaningful growth.

And so as we start to look at what's transpired in the first half of the year and where we are, we felt like that was reasonably aggressive. The other thing is we still suffer from some of the uncertainty associated with the non-strategic legacy distribution. And so where it's probably done a little bit more than we expected in the front half of the year. Candidly, that's the part that creates some unpredictability forward. And so our desire is to be thoughtful stewards of our growth. And since we're going to be at this for a long time, we just want to be methodical. Jeff, you want to add?

Jeff Black -- Executive Vice President And Chief Financial Officer

Yeah. RK, look, I think when you think about first half last year versus this year, so admittedly last year, we bottomed out on revenue, right? And a lot of it, we were just really beginning the transition from shedding the legacy distribution and ramping up strategic distribution. So, I think, the baseline or the denominator in the first half was much -- a little easier than it would be in the second half.

I think, when you look at the second half on our guidance, we're still projecting on the dedicated or the strategic distribution 30% growth year-over-year. So we'll continue to see headwinds, but we still believe that there is a real opportunity to continue to ramp the strategic distribution. But at the same time, we're aware that there will be -- continue to be headwinds.

Swayampakula Ramakanth -- H.C. Wainwright & Co, LLC -- Analyst

Okay. Thank you for that. So the other -- the longer outlook that we have been talking about is the 2022 outlook that we are talking about. So, at this current growth rate of about, let's say, 17% or the middle of the range that you provided us today, obviously it has to be a little bit north of that just to get to that number. So for that to happen, what is -- how are you placing Alphatec in the marketplace such that you gain market share across the various product categories so that you can either maintain the 17% or actually go north of that 17% and what are the long-term strategies that you as a management have started and are trying to work through it so that we can kind of keep -- I was also looking at it as metrics going forward.

Patrick S. Miles -- Chairman and Chief Executive Officer

Yeah. I think the key thing in what we're trying to really be clear about is the contribution by new products. And what will happen to this company is, we will continue to do new product development and add products that are relevant to specific approaches that address specific pathology. And so what you'll see is you'll see a turn-in from a new product company to an approach company. And what that will mean reflectively will be, you'll start to see more and more products used within the context of a specific surgery. And so, we believe that we will compel people, and so we'll need the right sales force, and we'll need to compel the surgeons. But what we'll see is through this new technology, we will expand the opportunity not only from a number of products used, but also the number of cases done based upon the unique innovation that's created within the context of those assembled products.

Swayampakula Ramakanth -- H.C. Wainwright & Co, LLC -- Analyst

And also, are there any cost-cutting strategies being put forward or because, as you said, if you have to get to a certain growth rate, you also have to spend in terms of getting the right sales force in place and also get the right message out there. But at the same time, you don't want to lose your sight on the bottom line. So, is there anything that you're doing toward that end as well or would bundling some of these products help in improving the operating margins?

Jeff Black -- Executive Vice President And Chief Financial Officer

Yeah. Okay. This is Jeff. I'll answer that. So, I think just from a cost structure perspective, when you look at the G&A load on the company, that's remained been pretty stable for the past really seven or eight quarters. In fact, it's lower today than it was when we started this transformation. So, I would say, we've got G&A pretty dialed in. I would also say that keep in mind that a significant portion of our OpEx is variable selling, right? And so, we are going to continue to make investment in the sales channel and product marketing. We have to continue to make investments in R&D to keep the pipeline where it needs to be. And it really -- to us it's about ensuring that we are growing the top line and that we are controlling the fixed portion of costs that don't directly contribute to revenue.

Swayampakula Ramakanth -- H.C. Wainwright & Co, LLC -- Analyst

Okay. Thank you. Thanks for taking all my questions.

Jeff Black -- Executive Vice President And Chief Financial Officer

Thanks, RK.

Operator

Thank you. [Operator Instructions] And there are no further questions at this time. I would now like to turn the call back to Pat Miles for any further remarks.

Patrick S. Miles -- Chairman and Chief Executive Officer

I just wanted to say thanks to the level of interest out there on the ATEC. Clearly there is an undercurrent of enthusiasm about the company and I just want to thank everybody for their time. Take care.

Operator

[Operator Closing Remarks]

Duration: 36 minutes

Call participants:

Patrick S. Miles -- Chairman and Chief Executive Officer

Jeff Black -- Executive Vice President And Chief Financial Officer

Brooks O'Neil -- Lake Street Capital -- Analyst

Swayampakula Ramakanth -- H.C. Wainwright & Co, LLC -- Analyst

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