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Edited Transcript of CFMS earnings conference call or presentation 31-Oct-18 8:30pm GMT

Q3 2018 Conformis Inc Earnings Call

Bedford Nov 1, 2018 (Thomson StreetEvents) -- Edited Transcript of ConforMIS Inc earnings conference call or presentation Wednesday, October 31, 2018 at 8:30:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Mark A. Augusti

Conformis, Inc. - CEO, President & Director

* Paul S. Weiner

Conformis, Inc. - CFO & Treasurer

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Conference Call Participants

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* Bruce M. Nudell

SunTrust Robinson Humphrey, Inc., Research Division - MD

* Joshua Thomas Jennings

Cowen and Company, LLC, Research Division - MD and Senior Research Analyst

* K. Gong

JP Morgan Chase & Co, Research Division - Analyst

* Kyle William Rose

Canaccord Genuity Limited, Research Division - Senior Analyst

* Lawrence H. Biegelsen

Wells Fargo Securities, LLC, Research Division - Senior Analyst

* Ryan Benjamin Zimmerman

BTIG, LLC, Research Division - Research Analyst

* Steven Michael Lichtman

Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst

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Presentation

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Operator [1]

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Good afternoon. My name is Heather. I will be your conference operator today. At this time, I would like to welcome everyone to the Conformis Third Quarter 2018 Earnings Conference Call. (Operator Instructions)

Before we begin, I would like to remind you that management will make statements during this call that include forward-looking statements within the meaning of federal securities law which are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Any statements contained in this call that are not statements of historical facts should be considered to be forward-looking statements.

All forward-looking statements, including without limitation, statements about Conformis' strategy, future operations, future financial position and results, gross margin, product margin, operating trends, financial guidance, market growth, royalty revenue, total revenue, product revenue and revenue mix by product and geography, the anticipated timing of the limited launch of our hip product offering, the potential impact and advantages of using customized implants, business initiatives and transitions in our commercial operations are based upon current estimates and various assumptions. These statements involve material risks and uncertainties that could cause actual results or events to materially differ from those anticipated or implied by these forward-looking statements including those discussed in the Risk Factors section of Conformis' public filings with the Securities and Exchange Commission. Accordingly, you should not place undue reliance on these forward-looking statements.

While Conformis may elect to update these forward-looking statements at some point in the future, Conformis disclaims any obligation except as required by law to update or revise any financial projections or forward-looking statements whether because of new information, future events, or otherwise. This conference call contains time-sensitive information and is accurate only as of the live broadcast today, October 31, 2018.

I will now turn the call over to the Mark Augusti, the company's President and Chief Executive Officer. Mark?

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [2]

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Thank you, Operator, and welcome, everyone, to Conformis' Third Quarter 2018 Earnings Conference Call. With me on the call today is our CFO, Paul Weiner. During the call, Paul and I will share our prepared remarks on a variety of topics, including our third quarter financial and operating performance. Following the prepared remarks, Paul and I look forward to answering your questions.

From a commercial perspective, as noted last quarter, we continue to face headwinds in our OUS business, primarily reimbursement-related challenges in Germany. Our US growth performance of 5%, though general improvement over previous quarters, were not in line with our expectations. Fortunately, we had very good performance in many other aspects of our business. In the third quarter, we were able to successfully settle our patent disputes with Smith & Nephew resulting in a large one-time royalty revenue increase of $10.5 million. Our Conformis Hip System continues to progress in limited launch. We now have over 10 surgeons who have performed implantations with our hip. The surgeons are very pleased with the product and provided valuable feedback for our use in moving forward towards the full commercial launch anticipated next year. In addition, over the last few months we have had additional positive peer-reviewed clinical results published on our implants which contribute to the growing body of evidence for the benefits of our technology. In a study

Of our iDuo implant which allows surgeons to preserve both the ACL and the PCL while treating arthritic compartments of the knee, results showed a high survivorship out to 5 years and a satisfaction rate above 90% with patients who received this bi-cruciate retaining knee.

In addition, we continue to see positive results for iTotal CR. In a recently published peer reviewed study, data from 360 patients at 9 different centers demonstrated low postoperative manipulation rates, high Knee Society knee and functional scores, and a high level of patient satisfaction at one year. Importantly, at an average of just under 2 years, survivorship was at 99.2%, adding another data point to our existing data from the UK National Joint Registry which shows similar rates through this cohort.

Finally, once again, we are able to demonstrate good operational results in both our gross margin and expense management.

Let me turn the call over to Paul for a more detailed financial review. Paul?

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Paul S. Weiner, Conformis, Inc. - CFO & Treasurer [3]

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Thank you, Mark, and thank you all for joining us. We reported third quarter revenue of $29 million, representing an increase of 57% or $10.6 million year-over-year on a reported basis. Excluding the positive impact of changes in foreign currency exchange rates of $10,000, revenue increased 57% on a constant-currency basis. Revenue in the third quarter of 2018 and 2017 includes royalty revenue of $10.7 million and $249,000, respectively, related to the patent license agreements.

Royalty revenue in the third quarter of 2018 includes the Smith & Nephew royalty settlement of $10.5 million. Third quarter product revenue was $18.3 million, representing an increase of $157,000 or 1% year-over-year on a reported basis and constant-currency basis.

Sales of iTotal PS increased $804,000 to $6.1 million or 15% year-over-year on a reported and constant-currency basis. Sales of the iTotal CR, iDuo and iUni declined $867,000 to $12 million or 7% year-over-year on a reported and constant-currency basis. iTotal PS represented approximately 33% of total product revenue in the third quarter of 2018 compared to approximately 29% for the same quarter last year.

With the limited launch beginning in the third quarter, Conformis Hip System sales were $219,000. U.S. product revenue increased $753,000 to $16.3 million or 5% year-over-year. U.S. product revenue was driven by sales of our iTotal PS, which increased 17% year-over-year offset by a 3% year-over-year decrease in sales of the base business product lines. Third quarter U.S. product revenue represented 89% of total product revenue compared to 85% for the same quarter last year.

Rest of World product revenue was $2.1 million, a decline of $596,000 or 22% year-over-year on a reported basis and 23% on a constant-currency basis. Rest of World product revenue was affected primarily by sales of the base business product line including reimbursement challenges in Germany.

Turning to a review of our results across the rest of the P&L, third quarter gross margin was 68% of revenue compared to 40% of revenue last year, a 2,800-basis point increase. The increase in gross margin year-over-year includes the $10.5 million royalty settlement. Without the royalty settlement, the gross margin would have been 50%. Excluding the royalty settlement, the 1,000-basis point gross margin improvement was driven by cost reductions as a result of vertical integration, manufacturing efficiencies and material cost decreases. Gross margin improvement has been a point of emphasis and we continue to see the positive impact from the hard work that has gone into the cost reduction programs.

Total operating expenses increased $6 million to $26.2 million or 30% year-over-year. This increase in expenses was driven primarily by an increase in general and administrative expense due to a noncash write-off of $1.9 million of unused manufacturing equipment and a noncash write-off of $6.7 million related to an impairment of goodwill due to the company's market capitalization cash flow position. This was partially offset by $2.8 million of reductions in patent litigation expense, business insurance expense, personnel costs, and other administrative expenses.

Net loss was $7.4 million or $0.12 per share compared to net loss of $12.5 million or $0.29 per share for the same period last year. Net loss per basic share calculations assume weighted average basic shares outstanding of 60.2 million for the third quarter of 2018 compared to 43.5 million for the same period last year. Net loss in the third quarter included foreign exchange expense of $272,000 compared to foreign currency exchange income of $1.1 million in the same period last year.

As of September 30, 2018, we had cash and cash equivalents and investments totaling $36.9 million compared to $45.2 million as of December 31, 2017 and $46.6 million as of June 30, 2018. The $10.5 million related to the royalty settlement is not included in cash at the end of the third quarter 2018 as it was received in October.

Turning to a discussion of the update to our 2018 financial guidance which we introduced in this afternoon's press release, for the full year 2018, the company expects total revenue in the range of $88.6 million to $89.1 million. Excluding the $10.5 million royalty settlement, the company expects total revenue in the range of $78.1 million to $78.6 million. This is updated from previous guidance in the range of $79.6 to $83.6 million. The company's 2018 guidance assumes the following. Product revenue in a range of $77.5 million to $78 million compared to previous guidance in the range of $79 million to $83 million. Royalty revenue of approximately $11.1 million including the $10.5 million royalty settlement. This is updated from previous guidance of approximately $600,000 related to ongoing patent license royalty payments. Excluding the $10.5 million royalty settlement, we believe we will finish the year ahead of our total gross margin guidance of 44% to 46% and well ahead of our 2017 gross margin of 37%.

With our hip system remaining in limited launch through the first half of 2019 and a transition to full commercial launch targeted sometime in the second half of 2019, we will be reviewing our guidance policy. In the meantime, directionally we are thinking that year-over-year total product revenue growth in 2019 will be in the 5% range.

With that, let me turn the call back over to Mark.

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [4]

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Thank you, Paul. Early in my tenure, I announced that we would have 4 imperatives at Conformis. Namely, commercial execution, gross margin improvement, innovation and investment in our people. As you can see in the third quarter, we had positive performances in many of these areas from financial metrics such as gross margin and expense management, and other areas such as clinical evidence publication and patent litigation resolution. However, as mentioned earlier, our commercial performance in Q3 did not meet our expectations. Though we anticipated OUS headwinds, we expected better performance in the US. As a result, we have lowered slightly our full year guidance. I mentioned in previous commentary that while we have seen some quarterly improvement in US revenue growth, future quarterly growth performance may not result in straight line year-over-year improvement. However, given the commercial investments we have made in sales, I believe we should be seeing better growth than we are realizing. As such, I made a change in our sales leadership. As of last week, US sales is reporting directly to me while we search for a new SVP Of Sales. This change will allow me to work even closer with the sales leadership team to ensure that we have good alignment with marketing to help support each and every representative in the field and thereby drive revenue growth.

To be fair, we have made good progress in certain US commercial activities including our national account contracting, direct to consumer activities and our market access programs. That said, our commercial performance on a regional basis has varied with some geographic regions delivering double digit percentage growth, but also with a few delivering offsetting declining growth. I believe we should have better consistency in performance among our geographies which has led to my decision to make a change in sales leadership.

Turning to gross margin improvement, we have previously detailed much of our gross margin activity. Our performance in this area in Q3 was excellent given that we had to turn on new operating processes in order to support our limited hip launch. In addition, I believe our expense control performance in Q3 demonstrates our ability to manage expenses going forward at a materially lower rate as we mentioned last quarter.

As for innovation, our next generation iTotal G3 knee replacement, as well as our cementless pressed foot program, continue to make progress. Our early results from the limited hip launch, while identifying a number of areas in need of improvement, give us confidence at this point that we should be able to achieve full commercial launch in the latter half of 2019.

That's all the comments I have for now. I look forward to answering any questions you may have about our Q3 results and any of the announcements we have made today. Thank you. And with that, I'll turn it back over to the Operator.

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Questions and Answers

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Operator [1]

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(Operator Instructions) Your first question comes from Bruce Nudell with SunTrust.

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Bruce M. Nudell, SunTrust Robinson Humphrey, Inc., Research Division - MD [2]

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Clearly, the unexpected headwinds in the US are going to be problematic for investors. Just given the toughness of the market, but as offset by some very unique technology, have you explored the idea of like a comarketing agreement with the majors to kind of provide a proof of concept? Or is that just an outlandish idea?

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [3]

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This is Mark. I'll take that question. I've been asked similar questions to that before and I'll respond as I have. From the moment I got here, I remained open to those types of discussions and would explore them. There's no doubt that while I feel we've done well given our limited product portfolio to take 2% of the overall primary mean share, and if you back out not having a press fit, it's actually a larger share than that. There's no doubt the big players, the incumbents have really great market power from training centers to the big luminaries and great distribution salesforces. So that's a long answer to say yes and it's the same answer I've given for a while, that I'm open to those types of opportunities. But as of to date, we have nothing further to announce on that

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Bruce M. Nudell, SunTrust Robinson Humphrey, Inc., Research Division - MD [4]

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And just to give some more color on the disparity between kind of high performing regions and low performing regions, what's the difference? I mean what elements are missing in the regions that are not successful? And what's the formula in the regions that are successful?

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [5]

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Well you know, it's multifactorial, but I'll -- there's a few things I'll just kind of contribute to it. At the end of the day, distribution really matters. And then distribution experience that can execute on the playbook around targeting surgeons and really being able to grow business. That being said, I mean some of the regions there's sometimes it's just on luck. I mean we have, we get buffeted by things that affect us in a more, bigger way when we lose surgeons due to various reasons. Health reasons and retirements and stuff like that. I feel like that hurts us more than frankly any type of competitive losses. But it is a disparity, Bruce. We have a number of regions that actually do quite well, but then we have a couple of areas where from a geographic standpoint, whether it be insurance, contracting changes, pricing, access to the references sites that are regional reference sites. It's been a challenge to get out of the starting gate there. So those are ones we have to get more aggressive on frankly.

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Bruce M. Nudell, SunTrust Robinson Humphrey, Inc., Research Division - MD [6]

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I guess this is a follow-up. Are those underperforming regions just structurally kind of impossible? Or would greater adherence to a proven playbook make those regions successful as well?

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [7]

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No, I don't think they're structurally impossible. They may be structurally more challenging, but not impossible. At the end of the day, as our clinical evidence shows, the technology is good. We do get barred. The biggest impediment to this is, you know it's a challenging market, is getting really good distribution that doesn't have noncompete issues and whatnot. And frankly, Conformis, Bruce, as you know, has been a little bit handicapped by being a one product company to really go get that next level of distributor. And that's why, as I've mentioned on previous calls, we're excited about our hip product. Because once we get that to full market launch, now we have the ability I think to more aggressively be able to find that next level of distributor. And that's, frankly speaking, probably some of the stuff that will help us get into some of these areas that are [attractive]. And it's a limited set, I can tell. Because we roughly sell, going forward we sell with like 10 regions, and I can absolutely tell you it's only 2 or 3 that are the ones that we need kind of a renewed focus on. The rest of them are all positive net contributors, some of them being actually very good net contributors. I know this is operational and every company has this, but when you're dealing at the revenue levels that we're at, these really do exacerbate themselves.

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Operator [8]

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Your next question comes from Larry Biegelsen with Wells Fargo.

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Lawrence H. Biegelsen, Wells Fargo Securities, LLC, Research Division - Senior Analyst [9]

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I'm sorry, I was jumping between calls, so I apologize if this was asked, but Paul, any color, commentary on 2019? I think the street is modeling about 12%. I mean at this point it seems a little aggressive. Is that fair?

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Paul S. Weiner, Conformis, Inc. - CFO & Treasurer [10]

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Yes. Since you missed the commentary, basically I gave direction on the main part of this call that we're thinking year-over-year total product revenue for next year somewhere in the range of about 5%. So yes, you're right on in line with our thinking.

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Lawrence H. Biegelsen, Wells Fargo Securities, LLC, Research Division - Senior Analyst [11]

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Okay. And then on the hip, Mark, I did hear your comments earlier about 10 surgeons used it. Can you talk about kind of what you've learned and how confident you are in the second half of 2019 launch and if you feel like you need to make any changes to the hip before you launch? And then I'll drop and follow-up with you guys offline.

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [12]

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As commented, and I'll put a little more color on that, we feel really good about where we are. I've had a number of people that have a longer history with Conformis than myself that have suggested we are at a much farther along place than say we were when we did our first partial and our first total knee. Having said that, I will tell you, the hip presents different challenges. And the bar is really high, as it should be, because we've done frankly such a good job on our knee, that the expectations for making sure this surgical technique is really dialed in, is important to us. I'm kind of trying to approach this with a religious fervor that would make Steve Jobs so to speak proud. I really want it to be right. And so what I will tell you, Larry, is that we've gotten more than a few things that need to be fixed, but they are tiny things that are not going to require invention, they're just going to require work that has to get done. There's a couple of things where we have some really good ideas for even further improvement and we have to balance our ability to get that in and get that approved from a regulatory standpoint and make some decisions about and approve the launch. I'm pretty confident we're going to hit second half of the year. Again, noting certain in this life, but I'm pretty confident around that. The thing that I have to balance is what that final, final package looks like and the tradeoff in time and also our ability to ramp that up. So there's some little few moving pieces there. But I can tell you we are bringing the most comprehensive set of guidance jigs to the market. We're dialed in on the femur, I feel really good about what we're doing. We have some work to do to make the (inaudible) a little easier to use, but when it's used it works. There's no doubt that we're giving surgeons more information than we have in the past. So I'm really, I'm actually really pleased about the opportunity we have with us on this.

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Operator [13]

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Your next question comes from Robert Marcus with JP Morgan.

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K. Gong, JP Morgan Chase & Co, Research Division - Analyst [14]

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This is actually Allen on for Robby. So I guess I just had my first question was just about

(technical difficulty)

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [15]

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Are we back? Who is that?

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K. Gong, JP Morgan Chase & Co, Research Division - Analyst [16]

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This is Allen on for Robby. Can you guys hear me?

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [17]

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Yes, Allen, thank you, this is Mark. We lost you or something went dead on our end. I don't know if that happened on your end. So could you repeat the question?

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K. Gong, JP Morgan Chase & Co, Research Division - Analyst [18]

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Yes, it was just on the new kind of like what you're looking for in your new SVP of Sales. What kind of qualifications are you going to be looking for and what kind of impact would you really want this new hire to have in like say the first 6 to 12 months of hire and then beyond that?

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [19]

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Yes, look, these are challenging jobs and I get that. I think first and foremost [audio difficulty) arthroplasty, and can bring kind of a level of energy and passion that I think is commensurate with the opportunity we have ahead of us. So there's a lot to it, Allen. It's a great question. I am not going to be in a rush to do this. I will tell you that this news is less than 2 weeks old and we've already had some inbound calls, so I think it shows there's still interest. But I want to make sure obviously that we get this right from that standpoint and so that's why I said I'm taking the opportunity. I love the 2 AVPs that we have, I like the region lineup that we've rolled out. But now we've got to kind of work with a different level of energy. Especially going forward in what's [audio difficulty). So it sounds like we're getting some feedback, Operator. I don't know if you can hear us, the call keeps dropping in and out. I'm not sure, so we'll try to soldier on as we can, but I want to apologize to those of you on the call. We're having the same technical difficulty. Operator?

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Operator [20]

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Your next question comes from Josh Jennings with Cowen.

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Joshua Thomas Jennings, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [21]

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I was hoping to just start off on the US business and just maybe get an update on just with the departure of sales leadership, just the bolting on of more sales reps in the quarter. I think you had 20% net adds in 2Q, if there's any update that you can provide there.

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [22]

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Yes, so first off, look, I know and rightly so, there should be a lot of focus on this. I mean in and of itself, the 5% given where the market is at wasn't necessarily horrible. It was a little under where we would have liked to have been and certainly I think from an expectation standpoint. My bigger concern is just around some of these problem areas and the energy going forward and the drag. So I hope there's an acknowledgement that we're trying to get ahead of this from that standpoint. To directly answer your question, we did indicate that we'd have 20% additional growth. And we're a little shy of that at the end of Q3, I want to say we're kind of in the 15% to 17% range. But we still have that as a target and the team still keeps working to find quality representation.

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Joshua Thomas Jennings, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [23]

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Should we be thinking about, I mean there's always attrition and addition, but was there net attrition in Q3? And did that impact the results in the quarter in the US?

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Paul S. Weiner, Conformis, Inc. - CFO & Treasurer [24]

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There was a little bit of attrition, you're talking a couple of percent from where we were looking to grow. But no, I would say that it wouldn't have any direct impact on it related to the adds as it does take a while for them to get really productive. So I don't think any changes in the salesforce would have had any effect on our topline in the third quarter.

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [25]

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That's exactly what I was going to say, more of an issue of just some other changes in dynamics from that standpoint.

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Joshua Thomas Jennings, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [26]

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Understood. Then just wanted to ask about the 2019 kind of target that you're setting. Can you help us just break that down a little bit just in terms of US versus international growth and just any outlook just in terms of how much iHip can add to the revenue growth as well?

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [27]

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We might be able to give you a little flavor for US and OUS, but I don't want to get too deep into, Josh. I appreciate it, this is the earliest we've ever signaled, but one of the challenges we have obviously is trying to help you guys model out the hip and how we think about hip. This quarter, it was only about $200,000, the next quarter it's going to be a little bigger and we don't want to get into arguments about materiality and stuff. But it does pose a little bit of challenge for us from a management standpoint because we don't know exactly when we're going to turn the full commercial launch on. I don't want to be in a position where I feel like I have to do something ahead of time. I really want to get this right. And it's going to introduce a lot of variability in there. And then like I said, part of the challenge, the reason why I made a change is the go forward in the US knee growth around some of these, I liked the previous questioner's comment about these retractable or structurally challenging geographies we have and how we can change some of that.

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Paul S. Weiner, Conformis, Inc. - CFO & Treasurer [28]

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Again, directionally, since we're not giving guidance for 2019, I want to be clear about that, but as far as directionally, our thinking around the 5%, one, yes it does include hip. But really, that revenue relates to the limited launch. Because even if we hit our target in the second half of 2019 related to the full commercial launch, it still takes a while to onboard surgeons and penetrate their accounts such that it is anything meaningful on the topline. So again, if we're successful at hitting our second half target and depending on when we hit it in the second half, we wouldn't expect the topline really to be positively affected by the full commercial launch until the beginning, first half of 2020. As far as directionally on US versus OUS, if we're talking about 5% overall, we're talking a little bit above that 5% in the US and we're probably talking continued negative growth OUS as Germany is the biggest part of our OUS business, while we continue to add on other countries and resolve the reimbursement issue in Germany.

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Joshua Thomas Jennings, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [29]

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Great, that's helpful. And then just lastly, I know you guys have ramped up to a degree in your direct patient outreach, social media programs, etc. Any update in terms of the progress there or how you're tracking it and whether or not you feel like you're having some incremental success as we're moving through this year?

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [30]

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Yes, Josh, that's right. So we're getting much better at putting the analytics behind that. I think just being very candid, in the test markets that we've done, one there's been actually good feedback that suggests that we're moving the needle. Another one, it's kind of still questionable for us. And when I look personally at the difference in those markets, I feel like the one successful market we have more of a concentration of Conformis surgeons that really like the technology and are on our locator and really espouse the patient marketing from that standpoint. The digital marketing. The other is a little more sparse, so I think it's harder work for us to get the patients to that. So there's a learning there that we're kind of processing to put into our 2019 plans around that spend. But we continue to do that and that's part of our efforts.

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Operator [31]

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Your next question comes from Kyle Rose with Canaccord.

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Kyle William Rose, Canaccord Genuity Limited, Research Division - Senior Analyst [32]

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So I just wanted to kind of build on some of Josh's questions about the commercial business and the reps you were talking about hiring this year. Help us understand, is it taking longer than you expected for them to become productive? I guess I'm just trying to really understand the dynamics of what's slowing down the US business or seemingly slowing the momentum that we were seeing in some of the previous quarters.

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [33]

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Yes, that's the hardest thing to tease out. I think there is some of that, but like I said, I think there is just kind of a miss in a couple of geographies around the funnel and executing the right surgeons and making sure that onboarding process goes well. So you've got to get in the weeds. I don't think, I don't believe that it's about the adds, which I believe was being asked about before. There is a question of getting them kind of up and productive and that does take a while, but I feel like we've got some programs in there. We're not going to win every one, but we've done well. We just continue to struggle in a couple of areas where through some surgeon departures and some distribution challenges, that's kind of the hardest thing is to rebuild off of that.

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Kyle William Rose, Canaccord Genuity Limited, Research Division - Senior Analyst [34]

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Okay. Then Paul, when you put together guidance, or not guidance, your directional thoughts on what 2019 looks like, can you just help us understand, I got the comments as far as US and OUS thoughts there, but just when I think about hip potentially growing off of these levels, even if it is small, it seems to imply a continued slowdown in the US business in 2019. I guess am I interpreting that appropriately? Because at the same time, you've got, hired some this year that should become more productive, you've got some of the previous marketing and national accounts initiatives that should become increasingly productive and then you'll potentially bring on new leadership to hopefully turnaround some of the commercial issues. I guess just what's included in that 5% and how much of that is conservatism versus this is our first shot?

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Paul S. Weiner, Conformis, Inc. - CFO & Treasurer [35]

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Yes, so you're talking about primarily US. Keep in mind, the OUS business, we are looking for one thing as far as the reimbursement issue. We knew that we had the partial issue which we thought we would anniversary out of this year which we did. But then a bigger issue came in with this group called MDK, and we talked about this last quarter, pushing back on this higher reimbursement that the hospitals do get when they put in our customized implants. So that affected even a larger part of our business this year and is expected to continue into next year. We are working on ways to resolve that issue, but we certainly can't count on resolving it at this point in time. So we do expect those headwinds to continue into next year. As far as the US is concerned, we do have higher growth rates in these numbers in the United States than we've had in 2018. So we are looking for a step up in 2019 over 2018. It's just too early at this point in time to see, to be able to estimate the productivity of the new reps and some of the new surgeon onboarding programs to determine when that growth rate will get to that next level. Like I said, regarding the hip, as far as the revenue we expect from the hip, whether we do the full commercial launch or not in the second half of the year, the revenue will be coming from the limited launch and the commercial launch won't be positively impacting our revenue we wouldn't envision until the first half of 2020.

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Operator [36]

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Your next question comes from Steven Lichtman with Oppenheimer.

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Steven Michael Lichtman, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [37]

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Just wanted to follow-up on Germany. What's your line of sight in terms of stabilization there? When does this issue anniversary? And what are the types of initiatives you're working on to help improve the situation? I know last quarter you talked about bringing on some new personnel in international to help that.

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [38]

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Yes, so that's different, that's a person that's actually been helping grow slightly businesses outside of Germany. In Germany, there's really 2 specific things and this is just a challenge. First is on the partial, which we've already anniversaried out, it was a big issue, a significant issue, it cost us $3 million to $3.5 million in revenue headwind for the better part of 2017 going into 2018. The issue is the strategy that we put in place when this happened to work through certain surgeons in Germany and to work with the reimbursement body, we're going to know in Q4 if that was successful, because they will issue their new guidelines going forward. So we'll have more information when we do our Q4 announcement. But where we are today, it's just an uncertainty and we don't know. And if something doesn't change, then we clearly won't see partial business coming back from that standpoint. On the MDK issue, which is the Total business, what we've done is working with various customers, we've put in place a proactive strategy where we can give them templates of their patients' knee to justify a Conformis personalized knee versus an off the shelf knee. And then use that proactively to hopefully defend against these reimbursement denials which are what's affecting our business. It's too early in that process to know how successful we are. So it's hard for us to gauge where that is. And that is the challenge. But hopefully through Q4, as we get more experience with understanding where that stands, we'll see the willingness of customers that have historically been supportive of Conformis to continue to work with us.

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Paul S. Weiner, Conformis, Inc. - CFO & Treasurer [39]

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Right, and Steve, just to follow-up on the part of the question you asked about when do we anniversary out, so as Mark said, we anniversaried out and as we've talked about before regarding the partial implant, out there first quarter. With the total implant, however, there isn't necessarily an anniversary date. Because it is impacting negatively our revenues and until we resolve this issue, it could potentially continue to negatively impact our revenues that much more as the pushback continues from this MDK reimbursement group. So there's no specific anniversary date for the totals, but we are working on different strategies to alleviate these issues and hopefully turn these around. But it's still too early to tell when that, if or when that might happen.

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Steven Michael Lichtman, Oppenheimer & Co. Inc., Research Division - MD and Senior Analyst [40]

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Got it. Then Paul, on gross margin, the benefits that we're seeing here (technical difficulty). Can you remind us what are the primary initiatives that have driven that and what are sort of the next waves of things that you're working on to continue to expand gross margin looking ahead?

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Paul S. Weiner, Conformis, Inc. - CFO & Treasurer [41]

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Without getting to the specific details on a part by part basis, the vertical integration is a big thing, we've been doing that for a while and we're still in that mode as far as some of the final components, with integrating that into our manufacturing this year. For instance, the poly inserts for the PS were done, we're working on the partial inserts and there's a few other items that we're vertically integrating into our process which will help drive the costs down. And even decrease the time that it takes to deliver implants. We might be able to deliver implants even faster than we have in the past. So those are some of the main areas on the vertical integration. And then the other area is just really Lean Manufacturing throughout our plant. We have dedicated resources working solely on leaning out the facility and that's also driving the costs down. So those are a couple of the main initiatives.

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Operator [42]

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Your next question comes from Ryan Zimmerman with BTIG.

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Ryan Benjamin Zimmerman, BTIG, LLC, Research Division - Research Analyst [43]

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So just to begin, Paul, or excuse me, not Paul, Mark, just hearing your commentary around taking your time to find a new head of sales, what -- you're going to dedicate a lot of time I suspect to this role. What is it you feel that you can do differently from what we've seen multiple previous heads of sales? And given your other responsibilities, I mean can you dedicate the time necessary to work with the distributors and the salesforce at a 2-inch level as they say?

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Mark A. Augusti, Conformis, Inc. - CEO, President & Director [44]

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That's a great question, Ryan. And if you'd asked me that when I first started here, I would have said absolutely not because of the level of detail to be involved in some of the operational things. But because we've actually got the gross margin progressing, I've got such a good team I think in place on the inside, operational as well as of course the great contributions of our CFO, I feel like I can actually try to turn even more attention, and I'm going to have to, by that. Look, I'm not trying to suggest that I personally am going to be the answer to the issues, but I do feel good about the AVPs we have in place, I have a good relation with them, they know the business. I don't think it takes a lot for you to surmise that I would have liked the outcome of the first person that I got to choose to put in the chair. I don't know about all the people before, Ryan, you may have been following the company longer on that, but I go back to one of the questions earlier. There is an energy level, an amount of travel that needs to evolve, some others things. And I'm hoping that won't take a long time, but I'm also, I want to get the right person that's a fit for the company and where we're at and really, really can support. Because we -- the company is getting more complicated with the launch of the hip. We don't spend a lot of time on this, but in our knee, we don't need any physician approval. On the hip, just like other companies with their PSI work, there needs to be a feedback loop with the physicians and approval as Paul said. So that process is a little different, so we need to be thoughtful about how we train reps and physicians around that. We've got to build out the hip capability if you will, the technology about it. So there's a lot of things that go with this. And so there's just a lot of coordination and alignment with marketing and energy around kind of what the expectation setting for the field. I feel I can bring some of that by nature of the office, if you will. I feel comfortable that we'll be able to answer the question about leadership sooner rather than later. But I guess I just wanted to make the comment that I don't feel reactionary. I guess my point is, though disappointed, I really like all the other positive stuff that's going on with the company. I really like what the hip opportunity offers. I like what certain geographies are doing and all the other stuff. So I don't want to be overly reactionary. I want to really dig deep and get the right fit for the role.

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Ryan Benjamin Zimmerman, BTIG, LLC, Research Division - Research Analyst [45]

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Okay, appreciate the color there. You did manage your expenses better this quarter than I think we've seen in the past few quarters. So help me understand, or help investors understand kind of what you're pulling back on in your expense management and what that may pull back on going forward just given the expense management that you do need to do on the P&L.

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Paul S. Weiner, Conformis, Inc. - CFO & Treasurer [46]

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Yes, so as we talked about last quarter, we came together with a plan to really start reducing our operating spending starting in 2019. We weren't necessarily focused on 2018 as we were working on completing some projects before the end of this year. So we didn't think we'd be successful in starting to decrease those expenses this year. We did obviously, looking at Q3, we were successful actually starting to pull back on those expenses already. Some does relate to litigation expense and reducing that, so we're seeing that positive impact. Related to the settlement of the Smith & Nephew royalty litigation, we're already starting to see that in the third quarter and should continue to see that in the fourth quarter as well as continuing into the future quarters. As I said in the call, we were able to negotiate some lower rates than expected such as insurance and other areas that are already starting to take, we're starting to see a positive impact. But really, we're looking for a step up from that starting in 2019 as far as even further expense reductions to materially decrease our cash burn.

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Operator [47]

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Thank you. This concludes our question and answer session as well as today's conference. We thank you so much for your participation and you may now disconnect. Everyone, have a wonderful day.