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Edited Transcript of ATEC earnings conference call or presentation 24-Jul-19 8:30pm GMT

Q2 2019 Alphatec Holdings Inc Earnings Call

CARLSBAD Jul 26, 2019 (Thomson StreetEvents) -- Edited Transcript of Alphatec Holdings Inc earnings conference call or presentation Wednesday, July 24, 2019 at 8:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Jeffrey G. Black

Alphatec Holdings, Inc. - Executive VP & CFO

* Patrick S. Miles

Alphatec Holdings, Inc. - Executive Chairman, CEO & President

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Conference Call Participants

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* Brooks Gregory O'Neil

Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst

* Swayampakula Ramakanth

H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Healthcare Analyst

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Presentation

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Operator [1]

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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 view 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'll turn the call over to Pat Miles.

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Patrick S. Miles, Alphatec Holdings, Inc. - Executive Chairman, CEO & President [2]

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Thank you very much, Jenny, and welcome, everybody, to the Q2 conference call. When we pivoted this company, we knew that there were 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 memories, 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 have 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 growth.

And so when you look back and say, gosh, did we do those things? I think you have to 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, we're 7 new products in. Expand the new product revenue contribution from less than 10% a year ago to 30% this year. We're 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, are continuing to translate some of our distribution out of the company.

And so going on to the next slide, what I would 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 3 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'd really like to delve more deeply in that and look at how we performed within the -- within our core priorities. And so if you say 2019, what we deemed to be success was 12 products; we're 7 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 is a picture, if you're looking at this from a presentation standpoint, of the 7 new products that we launched, which we will 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 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 sell 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 IdentiTi 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 for -- to better facilitate fusion, a similar stiffness to bone, there's a reduced density so that it images better. And are made out of -- they're made via a subtractive manufacturing process, which ultimately begets greater predictability. And so we launched since Q1 both the IdentiTi TLIF and IdentiTi ALIF implant systems.

Next, we've also launched and it's 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 they're hackneyed terms. I'll 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. Often times, 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 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? 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 you look at 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 often times 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'd say, when we got here, there was substantial work to be done in terms of revitalizing really a broken sales channel. And I'm really excited about what's going on, especially from a leadership perspective. I think Dave Sponsel, Emory Rooney, we hired a -- another Stryker guy, Wyatt Stanfield, and Greg Rhinehart are all prolific in their right. And I think, I'm extremely 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 are we moving a lot of distributors, we're adding a lot of distributors, so there is a lot of activity going on. And then you look at what the contribution is from our strategic network. And this strategic -- 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 nonstrategic relationships. Because this is such an important element and to continue to delve in a little bit more deeply, as stated, we see a continued significant contribution from the strategic network. And that -- this is ultimately 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 nonstrategic channel, and you start to look, we continue to wind down these relationships. If you look at it numerically, we've eliminated $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 would have to appreciate the significance of that. Also what we're finding is some of the nonstrategic guys 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.

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Jeffrey G. Black, Alphatec Holdings, Inc. - Executive VP & CFO [3]

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Great. Thank you, Pat. Good afternoon, everybody. I'll spend just a few minutes reviewing, again, the 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 surgeon 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 of 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.

Our revenue from our international supply agreement continued to decline, consistent with our expectations, as our supply relationship with Globus winds down over the next 1 to 2 years. Overall, Q2 revenue results above expectations. We're continuing to be encouraged by the performance of our strategic distribution channel. We'll 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 a 39% or 39%, 40% decrease -- I'm sorry, a 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, on U.S. gross margin or gross profit of $18.8 million. It's 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 360 basis points to about 72% compared to Q1 of 2018. However, on a non-GAAP basis, excluding noncash 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 introductions.

As we reported in Q4 and in Q1, we saw margin pressure, much like we did in Q2, from noncash obsolescence related to our legacy products. We expect to see continued margin pressure over the midterm as we introduce new products and obsolete these legacy products. So we think a non-GAAP view of gross margin is a valuable 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, we present 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 nonrecurring or onetime charges or gains. And 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 a continued investment to support new product launches and longer-term product development.

As well, our SG&A increased 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 is included in SG&A, have actually remained relatively flat over the past 6 quarters, still well below where we exited 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 in the transformation of ATEC, we thought it would 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 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 nonstrategic channel. We've walked away from legacy, unpredictable, nonstrategic 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 is coming -- has come to fruition. It's been lumpy, and at times painful, but it's a decision that set us up to for growth in the right strategic long-term partners.

And finally, we have 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 been able to grow the trajectory we're seeing today.

And finally, on the balance sheet, before I turn the call over to Pat, we ended the quarter with just over $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 on our credit facility with Squadron, and we have $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 solutions more strategically and opportunistically.

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

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Patrick S. Miles, Alphatec Holdings, Inc. - Executive Chairman, CEO & President [4]

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Thanks much, Jeff. I think as much as anything, I think you are 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, as being commoditized. We believe that they are 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're making solid progress on our priorities. I think the innovation, the organic innovation machine continues to reflect success in all 3 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 would welcome questions.

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Questions and Answers

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Operator [1]

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(Operator Instructions) And our first question comes from the line of Brooks O'Neil with Lake Street Capital.

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Brooks Gregory O'Neil, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst [2]

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Congratulations on the terrific progress you are making. I have a couple of questions. Obviously, we're in the seventh month of 2019, and you, I think, introduced or launched formally 7 new products. Would you expect sort of the pace of additional new product introductions to get to 12 to kind of go along with that sort of 1 per month kind of pacing? And do you think there is any remaining products that might be particularly significant to Alphatec going forward?

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Patrick S. Miles, Alphatec Holdings, Inc. - Executive Chairman, CEO & President [3]

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Yes. Thanks, Brooks. And I would tell you that there is 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 will 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 room. And that's who we are as a company and that's what you will see reflected throughout the year.

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Brooks Gregory O'Neil, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst [4]

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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're prepared for and you are 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?

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Patrick S. Miles, Alphatec Holdings, Inc. - Executive Chairman, CEO & President [5]

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I think as far as the eye can see, our commitment is 8 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 all of these feed one another. And so as far as the eye can see, we'll do 8 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 you start to see an increase in the R&D spend, and then now what we're going to do is we're going to appreciate the requisite fruit.

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Brooks Gregory O'Neil, Lake Street Capital Markets, LLC, Research Division - Senior Research Analyst [6]

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Yes. Yes. It's good. And then just last question I had was, obviously, I understand the importance of SafeOp. 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 that you're producing today or innovating in the future to drive faster growth from ATEC going forward?

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Patrick S. Miles, Alphatec Holdings, Inc. - Executive Chairman, CEO & President [7]

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Yes. Thanks, Brooks. There's a bit of an interesting situation in spine in that implants are the currency items, and they are the ones that generate most of the currency. The challenges is a currency that's been defined and what the surgeon requires to do predictable surgery are not one and the same. And so what happens is, is 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, objectionable -- clear, excuse me, objective actionable information. And so the opportunity there is that you will see a vast minority in the contribution from the SafeOp platform, but it will be responsible for the revenue gained, if you will.

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Operator [8]

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And our following question comes from the line of Swayampakula Ramakanth with H.C. Wainwright.

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Swayampakula Ramakanth, H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Healthcare Analyst [9]

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Congratulations, Pat and Jeff. 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 up with $104 million to $109 million, obviously, higher than what it was on the previous guidance. But when you look at the 6-month revenue run it is basically kind of annualizing where you are at this point, at least on the bottom end of the range that you are 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 a $110 million or $112 million kind of a number, what needs to happen? And also what could be potential challenges even to get to $104 million, if we need to kind of think through that?

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Patrick S. Miles, Alphatec Holdings, Inc. - Executive Chairman, CEO & President [10]

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Yes, RK, I'm going to let Jeff speak to some of the numbers directly. But one of the interesting dynamics is this company has been historically one that I would suggest has not been as predictable as we would want it to be. So what we're trying to do is be extremely thoughtful with all of the -- trying to weigh the -- 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, that was reasonably aggressive. The other thing is, we still suffer from some of the uncertainty associated with the nonstrategic 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. 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, do you want to add?

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Jeffrey G. Black, Alphatec Holdings, Inc. - Executive VP & CFO [11]

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Yes. 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 to transition from shedding the legacy distribution and ramping up strategic distribution. So I think the baseline and 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 in our guidance, we're still projecting on the dedicated or I'm sorry, 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 continued headwind.

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Swayampakula Ramakanth, H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Healthcare Analyst [12]

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Okay. Thank you for that. So the other -- the longer outlook that we have been talking about is a 2022 outlook that we are talking about. So at this current growth rate, about, let's say, 17%, or middle of your range that you have provided us today. Obviously, that -- 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 ourselves looking at it as metrics going forward.

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Patrick S. Miles, Alphatec Holdings, Inc. - Executive Chairman, CEO & President [13]

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Yes, I think the key thing in what we're trying to really be clear about it is the contribution by new products. And what will happen to this company is we will continue to do new product developments and add products that are relevant to specific approaches that address specific pathology. And so what you will see is, is you will see us turn in from a new product company to an approach company. And what that will mean reflectively will be you will 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.

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Swayampakula Ramakanth, H.C. Wainwright & Co, LLC, Research Division - MD of Equity Research & Senior Healthcare Analyst [14]

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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, so -- but at the same time, you don't want to lose your sight on the bottom line. So is there anything that you are doing towards that end as well? Or would bundling some of these products help in improving the operating margins?

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Jeffrey G. Black, Alphatec Holdings, Inc. - Executive VP & CFO [15]

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Yes, RK, 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 pretty stable for the past really 7 or 8 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 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.

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Operator [16]

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(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.

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Patrick S. Miles, Alphatec Holdings, Inc. - Executive Chairman, CEO & President [17]

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

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Operator [18]

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