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Edited Transcript of KTWO earnings conference call or presentation 2-May-17 9:00pm GMT

Thomson Reuters StreetEvents

Q1 2017 K2M Group Holdings Inc Earnings Call

New York May 4, 2017 (Thomson StreetEvents) -- Edited Transcript of K2M Group Holdings Inc earnings conference call or presentation Tuesday, May 2, 2017 at 9:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Eric D. Major

K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director

* Gregory S. Cole

K2M Group Holdings, Inc. - CFO

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Conference Call Participants

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* Craig William Bijou

Wells Fargo Securities, LLC, Research Division - Senior Analyst

* David Louis Turkaly

JMP Securities LLC, Research Division - MD and Senior Analyst

* Glenn J. Novarro

RBC Capital Markets, LLC, Research Division - Analyst

* Joshua Thomas Jennings

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

* Kaila Paige Krum

William Blair & Company L.L.C., Research Division - Research Analyst

* Matthew Charles Taylor

Barclays PLC, Research Division - Director

* Matthew Oliver O'Brien

Piper Jaffray Companies, Research Division - MD and Senior Research Analyst

* Matthew Stephan Miksic

UBS Investment Bank, Research Division - Executive Director and Senior Research Analyst

* Michael Matson

Needham & Company, LLC, Research Division - Senior Analyst of Medical Technologies and Diagnostics

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Presentation

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Operator [1]

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Good evening, ladies and gentlemen, and welcome to the K2M Group Holdings, Inc. First Quarter of 2017 Earnings Conference Call. (Operator Instructions) Please note that this conference is being recorded and that the recording will be available on the company's website for replay shortly.

Before we begin, I would like to remind everyone that our remarks and our responses to your questions today may contain forward-looking statements that are based on the current expectations of the management and involve inherent risks and uncertainties that could cause actual results to differ materially from those indicated, including those identified in the Risk Factors and Management Discussion and Analysis of Financial Condition and Results of Operations section of the Form 10-K for fiscal year ended December 31, 2016, filed on March 7, 2017, which is accessible on the SEC website at www.sec.gov. Except as required by law, we assume no obligation to update our forward-looking statements.

In today's remarks, we will refer to certain non-GAAP financial measures. Reconciliations of these non-GAAP financial measures to the most comparable measures calculated and presented in the accordance with GAAP are available in our earnings press release and supplemental disclosure on the Investor Relations portion of our website.

I will now like to turn the call over to Eric Major, the company's Chief Executive Officer.

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [2]

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Hello, and welcome to K2M's first quarter 2017 earnings conference call. Let me begin with a brief agenda for today's call. I'll start off with a summary of our financial performance for the first quarter of 2017, then I will discuss K2M's operating progress in the first quarter and thus far in Q2. We have updates on our progress in a number of areas, including product innovation, international distribution and surgeon education as we increase awareness of K2M's innovative technologies with the spine surgeon community. I'll turn the call over to Greg Cole, our Chief Financial Officer, who will discuss our financial results in greater detail and review our 2017 guidance which we reaffirmed in this afternoon's press release. We will then open the call for your questions.

We are off to a strong start to fiscal year 2017 with first quarter constant currency revenue growth of 10.7% year-over-year. First quarter total revenue growth was driven by a combination of 10% growth in the U.S. and 14.4% constant currency growth internationally. We are pleased with this growth performance in light of the difficult comparison to both the U.S., where we posted 20% growth in Q1 last year, and Australia and Japan, where, as a reminder, the challenges we discussed in 2016 presented themselves in April of last year.

Our first quarter growth in the U.S. was driven by growth in each of our major procedure categories: Complex, MIS and Degenerative, which increased 8%, 14% and 9%, respectively, compared to last year.

Our growth continued to be driven by our innovative portfolio of technologies and techniques, specifically the compelling new products we have introduced over the past 18 to 24 months, highlighted by our leadership in 3D printing, as well as increases in the sales force productivity as we leverage the investments we have made in our U.S. distribution network. We also continue to evaluate inorganic growth opportunities that represent the appropriate mix of incremental growth and potential return on invested capital.

Regarding our 2017 outlook, we have reaffirmed our guidance in this afternoon's press release. Our performance during the first quarter continues to support our expectations that we will drive U.S. growth in the mid-teens and show improving growth trends internationally.

Building on our solid top line performance, we have reported improvement in profitability as measured by both operating loss and by adjusted EBITDA loss, which improved approximately $900,000 and $800,000, respectively, year-over-year. We remain committed to improving our profitability performance throughout 2017.

As part of our stated goal of achieving GAAP net income profitability in late 2018 and expect to generate adjusted EBITDA of $6 million to $10 million this year compared to reporting approximately $600,000 of adjusted EBITDA in fiscal 2016.

With respect to our operating progress in the first quarter and thus far in Q2, we have made progress on many fronts which we believe enhance our foundation for growth in the years to come. I'll share a few updates on our progress in the areas of product innovation, international growth and our efforts to support surgeon education and increase awareness within the spine surgeon community.

Starting with product innovation. In February, we entered into the alpha launch phase of our comprehensive Balance ACS, or BACS platform, which features products and services that apply three-dimensional solutions across the full continuum of care with the goal of facilitating quality outcomes for patients undergoing spinal surgery.

BACS provides solutions focused on achieving balance of the spine by addressing each anatomical vertebral segment with a 360-degree approach of the axial, coronal and sagittal planes, emphasizing total body balance as an important component to surgical success.

The BACS platform includes BACS preauthorization, an easy-to-follow insurance documentation tool that displays payer and patient-specific requirements; BACS surgical planner; a surgical imaging -- image measuring technology to assist in planning and preoperative implant selection; BACS anatomical models, 3D-printed anatomical models to aid in visualization of patient anatomy for surgical planning and intraoperative use; BACS data management, software for data collection and postoperative data tracking of patient quality metrics.

We also unveiled a BACS app, which serves as a convenient portal for surgeons to access the BACS platform and has been designed as an intuitive interface that can be used on Android and Apple iOS devices, including iPhone and iPad.

Since its February launch, we have debuted Balance ACS at several leading spine meetings in the U.S. and abroad, including the AANS/CNS in Las Vegas, the AAOS in San Diego, the British Association of Spine Surgeons Annual Meeting in the United Kingdom and the ISASS Annual Meeting in Boca Raton, Florida.

During the meetings, we hosted several workshops featuring prominent spine surgeons on techniques to optimize spinal balance. These workshops were well-attended and well-received. The alpha launch is proceeding well, and we continue to receive strong feedback from both surgeon customers and from non-surgeon users as well. We are encouraged that our unique and compelling platform is resonating across the entire continuum of care in spine surgery.

Our Balance ACS platform offers value, not just to spine surgeons, but also to constituents focused on improving the results in these areas of planning, preauthorization, patient follow-up and costs.

We look forward to sharing more about Balance ACS as we approach full commercialization. We plan to host an event at our corporate headquarters in Leesburg, Virginia, later this year. We believe this will be a great opportunity for analysts and investors to not only learn more about the BACS platform, but also to experience the platform's features and benefits in our BACS lab, a state-of-the-art hands-on bioskills lab, which is being visited by surgeons from around the world for categoric research, product development and procedural technique validation.

Additionally, on the product innovation front, I want to emphasize that 3D printing remains a strategic priority for K2M, and we are committed to maintaining our market leadership in the 3D-printing of innovative spinal devices.

As evidenced by our growing portfolio of FDA-cleared 3D-printed interbodies, since we introduced the technology at the 2015 NASS Meeting, we are delivering comprehensive 3D solutions by offering the largest portfolio of FDA-cleared 3D interbodies in the market today among leading companies, with 8 different implant designs cleared for use.

Our CASCADIA Lamellar 3D Titanium Technologies are currently being used in 14 countries worldwide, and we continue to see strong growth in the surgeon users, roughly half of which are new users of K2M's interbody business. We continue to receive positive surgeon feedback on CASCADIA. Importantly, we have heard from a number of our surgeon customers who want to see our Lamellar 3D Titanium Technology applied across our entire portfolio, and we are focused on identifying novel applications of this technology in the form of new spinal implant products.

To this end, we plan to expand our portfolio of 3D-printed interbody products with additional product announcements throughout the year beginning in the second quarter.

I'll now provide an update on our progress in enhancing the company's foundation for growth in Australia and Japan.

On April 6, we announced a new 5-year supply agreement with our distribution partner in Australia, LifeHealthcare, for K2M's innovative spinal technologies. The K2M-LifeHealthcare distribution partnership which dates back to 2010 has yielded strong growth and a significant spine market position in the Australia and New Zealand market. Our long relationship has been fueled by an entrepreneurial culture inside both organizations focused on surgeon responsiveness.

Looking to build on this success, K2M and LifeHealthcare have entered into this long-term agreement with the shared goal of becoming the market share leader in Australia. We believe this new long-term announcement allows us to fully engage in discussions around the timing and long-term strategy for growth.

Turning to Japan. We are pleased to report that we recently received key product registrations from the PMDA, which now under our control. These registrations include important product lines such as MESA and EVEREST. As we discussed in the past, these registrations provide us with an opportunity to implement a new distribution strategy in the Japanese spine market.

Finally, with respect to our core focus in complex spine and our ongoing efforts to support surgeon education and increased awareness within the global spine surgeon community of K2M innovative spinal technologies, last weekend, we hosted 110 internationally recognized spine surgeons for our Annual Meeting of Minds in Lisbon, Portugal. As a reminder, Meeting of Minds is our premier world-class curriculum in the latest approaches, techniques and three-dimensional solutions for the operative treatment of complex spine disorders.

During this 2-day course, we also demonstrated our Balance ACS platform. Our Meeting of Minds is the largest of K2M's many medical education programs. And this year's event featured more than 60 interactive discussions, case presentations and hands-on product training demonstrations on key deformity topics in areas as diverse as adult, adolescent and cervical deformity, revision surgery, minimally invasive surgery, proximal junctional kyphosis as well as transformative solutions for achieving three-dimensional Total Body Balance in spine patients.

The course was chaired by distinguished leaders and spine surgeons, including Dr. Oheneba Boachie-Adjei from Accra, Ghana, and formerly Chief of Spine at the Hospital for Special Surgery; Dr. René Castelein from the Netherlands; Dr. Martin Gehrchen from Denmark; Dr. Kan Min from Switzerland; and Dr. John Kostuik, the Chief Medical Officer and Co-Founder of K2M and Professor Emeritus at Johns Hopkins University.

Over the last several days, we have received great feedback on this year's Meeting of Minds from both our faculty and attendees. I was particularly pleased to hear Dr. Harry Shufflebarger, Director of Division of Spinal Surgery at Nicklaus Children's Hospital and former President of the Scoliosis Research Society, say that he rates Meeting of Minds as a top-level educational event.

So to summarize, we are very pleased with our financial and operating performance so far. And we remain confident in our 2017 financial guidance which we reaffirmed in this afternoon's press release.

With that, I'll turn it over to Greg for a more in-depth review of our financial performance during the quarter as well as a review of our guidance for fiscal year 2017. Greg?

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [3]

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Thank you, Eric. Our total revenue for the first quarter of 2017 increased $5.6 million or 9.9% to $61.9 million. Total revenue increased 10.7% year-over-year on a constant currency basis. This increase in revenue was driven primarily by greater sales volume from new surgeon users and newer product offerings, offset partially by lower sales in certain international distributor markets, including Japan as compared to last year. Our U.S. revenue increased $4 million or 9.5% year-over-year to $46.2 million and represented 75% of total revenue in the period. First quarter U.S. revenue growth was driven primarily by the addition of new surgeon users. By procedure category, Complex Spine, MIS and Degenerative represented 37%, 17% and 46% of U.S. revenue, respectively, in the first quarter. Our Complex Spine and Degenerative spine categories were the largest drivers of our U.S. growth in Q1. Complex Spine sales increased $1.2 million or 8% year-over-year to $17.1 million, and Degenerative revenue increased $1.8 million or 9% year-over-year to $21.2 million. Sales growth in Complex Spine was driven primarily by increased surgeon usage of our EVEREST Deformity system, while Degenerative sales growth was fueled by our CASCADIA 3D-printed titanium interbody products. In addition, sales in our MIS category increased by $1 million or 14.4% year-over-year to $7.9 million, driven primarily by increased surgeon usage of our EVEREST MI and CASCADIA minimally invasive product lines.

Our Q1 same-store same product pricing headwind was at the higher end of the low to mid-single digit range that we have experienced since 2014. We also noted an impact from mix by procedure category, where Degenerative categories represent approximately 46% of U.S. sales in Q1 versus a lower percentage of sales during deformity season, where our mix shifts to complex spine procedures in quarters 2 and 3. Our success in driving growth with our CASCADIA 3D product lines in the accounts in which we sell it had a mixed impact of about 100 basis points during the quarter.

Regarding revenue results outside the U.S., international revenue increased $1.6 million or 11.1% year-over-year to $15.7 million, representing 25% of total company sales in the period. International sales increased 14.4% year-over-year on a constant currency basis. International growth was driven by the combination of 14% constant currency growth in our direct subsidiary markets, those markets where we invoice and collect in local currency, and modestly stronger replenishment demand in Australia. Our revenue results in Australia also included approximately 300,000 in set purchases of EVEREST MI XT and CASCADIA lateral systems. These set purchases were growth-focused investments from our Australian distributor partner that were not included in our original guidance.

Turning to our financial performance throughout the rest of the P&L in the first quarter. GAAP gross margin was 65.3% compared to GAAP gross margin of 65.2% last year. GAAP -- the gross profit margin includes amortization expense on investments in surgical instruments of $3.5 million or 5.6% of sales in the first quarter of 2017 compared to $3.3 million or 5.8% of sales in the same period last year. Excluding the impact of amortization expense on investments in surgical instruments, our non-GAAP adjusted gross margin was approximately 70.9% in 2017 compared to non-GAAP adjusted gross margin of 71% in 2016.

GAAP operating expenses increased $2.9 million or 6% year-over-year to $49.5 million. The increase in operating expenses was driven primarily by a $2.7 million increase in sales and marketing expenses compared to last year, primarily reflecting higher payroll and commission costs on our increased revenue.

Our GAAP operating expenses, specifically our G&A expenses, include the impact of intangible amortization of approximately $2.4 million and $2.6 million in the first quarters of 2017 and 2016, respectively.

GAAP net loss was $10.9 million or $0.26 per share compared to a loss of $10.2 million or $0.25 per share last year. Our GAAP net loss includes the impact of noncash foreign currency transaction gains and losses which was immaterial to net loss performance this year compared to a gain of $400,000 in the first quarter of 2016. The difference was driven by the impact of fluctuations in foreign currencies against the U.S. dollar on our intercompany subsidiary payable balances.

This year's net loss also reflects the interest expense in our convertible senior notes placed in August of last year in the capital lease for our headquarters.

Our first quarter adjusted EBITDA loss was $336,000 compared to $1.1 million last year. As of March 31, 2017, we had cash and cash equivalents of $38.6 million as compared to $45.5 million as of December 31, 2016. We had working capital of $110.4 million as of March 31, 2017, as compared to $115.9 million as of December 31, 2016.

At March 31, outstanding long-term indebtedness, included the carrying value of the convertible senior notes of $37.4 million and the capital lease obligation of $34.7 million. We have unused borrowing capacity under our line of credit of approximately $45 million.

Turning to our full year 2017 guidance expectations which we reaffirmed in this afternoon's release. We expect total revenue on an as-reported basis for fiscal year 2017 in the range of $263 million to $270 million, representing growth of 11% to 14% year-over-year. Total revenue on a constant currency basis is expected to increase to 12% -- to 15% year-over-year in 2017.

The company continues to expect mid-teens growth in its U.S. business in 2017. Total net loss for fiscal year 2017 of approximately $34 million to $31 million. Adjusted EBITDA for the fiscal year 2017 in a range of $6 million to $10 million.

We have provided a reconciliation of expected 2017 GAAP net loss to adjusted EBITDA in our earnings press release to assist in understanding the impact of certain noncash items on our outlook for adjusted EBITDA.

Finally, for modeling purposes, the midpoint of our fiscal 2017 total revenue guidance assumes mid-teens growth in the United States and low single-digit growth in our international business. Our international growth guidance for 2017 includes the following expectations in our international distributor markets of Australia and Japan. In Australia, our guidance assumes we continue to service the replenishment demand of our partner LifeHealthcare. In Japan, our guidance assumes a full 12-month contribution at the historical revenue replenishment run rate we have experienced in that market. We continue to target GAAP net income profitability in Q4 of 2018. For the full year 2017, we expect the weighted average share count for earnings purposes to approximate 42.5 million to 43 million shares.

With that, I'll turn the call back to Eric for a few closing comments. Eric?

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [4]

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Thanks, Greg. In closing, we remain committed to being a global leader in Complex Spine and our continued focus on providing minimally invasive solutions that help surgeons to achieve three-dimensional Total Body Balance.

As we look forward, we are well-positioned to achieve our full year 2017 growth objectives. Growth in the U.S. remains the key contributor to our total company revenue results, and we expect mid-teens growth in the U.S., which clearly differentiates K2M as a market share gainer in the spine space.

Outside the U.S., while our guidance reflects measured expectations for international growth in 2017, we are encouraged about the longer-term growth outlook in both Australia and Japan following the progress we have made in those regions in recent months.

We continue to expect strong tailwinds to revenue performance from our focus on new product introductions and investments in our U.S. distribution infrastructure. Importantly, we are showing improving profitability which bolsters our confidence and the ability to drive sustainable organic growth in both the top and bottom lines, and our success in this area should drive our long-term performance.

Denise, we'll now open the call for 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 Matthew O'Brien with Piper Jaffray.

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Matthew Oliver O'Brien, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [2]

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Just to start on the complex side a little bit, I know it's a seasonally soft quarter for you there. It's just -- this is kind of a lower level of growth that we've seen, still pretty good, but over the last couple of years there. So I guess the question would be, just I'm sure investors are wondering, if you're starting to see the impact of any ratchet up competition from your newer entrants into the market or just a little bit better ability of some of the bigger players to hold onto market share.

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [3]

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Yes -- no, I think when you look at our comps last year, we had 20% growth in the United States. I appreciate the question. We feel really the opposite. We feel like we are in a very good position going into Q2 and Q3 deformity season. Our growth in Complex Spine, every Q1, like you said, it's not a Complex Spine season for us. We're well-positioned, we believe, with MESA 2 in some of the new components of MESA 2 that we've been bringing to market through our team here in Q1 coming out of the global sales meeting. So we think that we are very well-positioned going into deformity season. We also think that the BACS launch, the BACS platform with kind of everything rolled up together in this comprehensive approach of the continuum of care. Inside of that is providing some interesting things for the complex spine surgeons, one of which is the preop planning and kind of this more cohesive environment that you can now -- the surgeons are then able to roll in and have access to 3D modeling. So these really tough cases, they can order a 3D model that they can hold and bring into the OR environment with them and use that to really see and understand the anatomy they're dealing with in these tough cases. So I think we're set up well, and I think the only thing you're seeing there on the comp is given last year's 20% growth in the U.S.

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Matthew Oliver O'Brien, Piper Jaffray Companies, Research Division - MD and Senior Research Analyst [4]

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Okay. So then, I guess, sticking within the U.S., Eric or Greg, comps are going to get a little bit more challenging as we go throughout the course of the year, not that they weren't tough in Q1 last year. So I guess the question is, we're seeing very good growth in MIS and Degen, obviously, is doing quite well, also. So can you just help kind of frame up where some of this growth is going to come from in those 2 segments specifically, be it some of these 3D-printed products with a presence of other competitors there or just maybe some of the pull-through opportunity that you're going to see with more and more new surgeons that are getting access to your products to start with the 3D-printing side and moving to the rest of your portfolio?

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [5]

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Sure. This is Eric. So good question. When you look at our portfolio, let me just go through the 3 categories quickly. Complex Spine, I think, we're very well set up. I think some of the continued additions that we've been making to our technology. So, for example, in the EVEREST MI XT space, that's our minimally invasive options in EVEREST that are being used also in the deformity space. We think that combined with MESA 2 sets us up very nice going into the complex spine season. On the MIS side, EVEREST MI is growing and really driving that number for us, combined with the interbodies there being used in the minimally invasive environment in that 3D interbody space. And so I talked about it on previous calls, I think it's really important to reinforce that when we think about 3D printing, 3D printing is a manufacturing process. When we've said this repeatedly, it's a manufacturing process where we learned having launched this in NASS of 2015. We really have gone through lessons learned. We've understood the process. I believe that our partnership that we've announced last quarter with 3D systems is very important to what we're doing in the 3D space. And what we're bringing to market is new innovative designs that we could not make previously with traditional manufacturing. So 3D manufacturing essentially allows our engineers now to think differently about the things that they can make and how they make them. And with that, we were able to introduce the Lamellar 3D Titanium Technology. Remember we talked about the fact that, that porous technology was optimized, we work towards optimization, towards enhancing -- working to enhance fusions and visualization, imaging, those components of the implant. So that's fueling our growth. The 3D printing is clearly really crossing the MIS, Degen space. And you should expect and we mentioned it on the prepared remarks, continued introduction of 3D-printed technologies that are uniquely different from anything else in the market as we go into the year, specifically here in Q2, and then we go into the rest of the year. So we're really excited about that. That's driving the MIS and Degen component of our business. And again, I think we are well set up for the Complex Spine season.

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Operator [6]

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Our next question comes from Glenn Novarro with RBC Capital Markets.

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Glenn J. Novarro, RBC Capital Markets, LLC, Research Division - Analyst [7]

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Two questions. One, Eric, if you could maybe talk a little bit about more about the Japan strategy. So you've got 2 products approved in Japan. You've got a distributor there, but I believe your distributor's (inaudible) 1 city, so there's opportunities to go direct broader in Japan. So maybe talk about how you see your Japan strategy playing out over the next couple of years.

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [8]

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Yes, so obviously, you could imagine, we are pretty excited around here and we got that information just in the last couple of days. After last year, in Q2, having closed with the Australian partnership with LifeHealthcare, which we're very excited about, and then receiving that information just a couple of days ago, really, we think, positions ourselves well and it truly, I think, a testament to the management team. The team really rallied and executed over the last couple of quarters to kind of pull things together as we look to APAC going forward. And now, with these PMDA clearances in Japan that we control, it really puts us in a new place to now execute on some of the things that we were exploring. And I want to emphasize there. So we noted MESA and EVEREST, but it actually was not just MESA and EVEREST, we said key products, it's all of our pedicle screws as well as some other products that were also cleared. So it really puts us in a great place from a clearance perspective. And is now allowing us, because we've been doing a lot of research into Japan, a lot of looking at assessing how best to expand that footprint in Japan and going from the partners that we've had there with limited coverage, but some well-recognized key opinion leaders serving as almost think of it as a proof of concept in Japan to get going. We think now what we are looking at for the future positions us well as we look to kind of get that relationship going in '17 and then really fuels that growth going into '18 and going forward.

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Glenn J. Novarro, RBC Capital Markets, LLC, Research Division - Analyst [9]

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So...

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [10]

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Let me add one thing there, which is, I mean, our goal on the execution of our strategy is to do that as quickly as possible. It's not to sit around and wait on and evaluate and think about it. It really is to move as quickly as we can towards the execution phase of that.

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Glenn J. Novarro, RBC Capital Markets, LLC, Research Division - Analyst [11]

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Does that execution include some sort of hybrid sales force going forward? In other words, looking to hire more distributors as well direct reps in Japan?

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [12]

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So no comment on that as of yet. We explored a number of things. We have our game plan, and we're going to start executing on it, and we'll get you guys some feedback as we do that.

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [13]

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I'm just going to add, again, because it was in the press release, the fact that we got that notification walking into just in the last couple of days, it was very important and exciting to our strategy. I think we're positioned now and you should expect the information from us on that front.

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Glenn J. Novarro, RBC Capital Markets, LLC, Research Division - Analyst [14]

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Okay. And then just quickly, Eric, you used the word "inorganic growth". In other words, as you look at your cash position, to me, that sounds like you're thinking about certain acquisition targets over the coming years. So maybe can you talk about parts of the portfolio that you think you can augment via M&A?

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [15]

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Sure. So our balance sheet is strong right now. We -- combined with that, I'll use the word "however". We also have an extremely product fantastic product management and engineering team when it comes to innovation on the organic side. So I think we demonstrated, having done this for quite a while now that we are able to deliver innovation to the market space. So what we're going to look at in that is things that are really going to bolster our ability as an organization to continue to compete by bringing differentiation to the market and building scale. And so we're going to look at what makes sense for the organization both, for -- that makes sense on the balance sheet for the investors, shareholders in the company. And also maybe tuck-ins in areas that we are looking for technology that gets us there faster, things that we may not have an expertise in. We've talked in the past about whether how we think about imaging, robotics and navigation. And then things that allow us to continue to build out the portfolio. We have a pretty strong portfolio now. We continue to be able to win tenders and win major contracts against all the competitors. So we really are in a position with our portfolio that we can -- we're competing today. So now it's things that just become additive and really differentiation to the overall offering. Anything you'd add?

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [16]

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I think that's really right. We always talk about how we try to invest in areas where we don't have any internal expertise, and we feel that, that's exactly something that we're interested in. And we've also talked about how we would evaluate over time as we have cash and a P&L to support it, looking to try and improve our margins by focusing on maybe distribution areas that we can do -- that we can improve upon, et cetera. Those are still things that are important to our thought process.

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Operator [17]

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Moving along, our next question comes from Matt Miksic with UBS.

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Matthew Stephan Miksic, UBS Investment Bank, Research Division - Executive Director and Senior Research Analyst [18]

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So just a follow-up on Q1, I guess one of the other companies in this space talked a little bit about the tone throughout the quarter. I know you had your prior year pretty impressive U.S. comps to face in this quarter, but any color at all? And if I missed your comment, I apologize, but any color on sort of the ramp throughout the quarter, slow starts, strong finish, anything like that? And then I have a follow-up.

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [19]

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I think we both can take that. I'll just touch quickly on the fact that we continue to see procedural growth. We continue to see a lot of interest from a distribution perspective on people coming to K2M. So there was nothing material to report on the different months other than the fact that we had nice procedure growth and we did have a 20% comp versus the previous year. But overall growth in the U.S. business. Do you want to add to that?

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [20]

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Yes, there really wasn't much of a monthly notation to say there about the strength or weakness. Just -- it's been strong and continues to be strong. We see procedures being very, very good for us right now.

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Matthew Stephan Miksic, UBS Investment Bank, Research Division - Executive Director and Senior Research Analyst [21]

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Okay. And then I'd love to get your -- that's helpful, by the way. I'd love to get your updated thoughts on where you stand on robotic surgery. And that and I know there's folks moving forward with platforms. You've taken sort of a different route, if you could maybe give us an update of what, if anything, you're working on along the lines of, call it, advanced surgical technology that we can look forward to or just how you'd find yourself positioning against those companies in the field? Your viewpoint on that will be helpful.

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [22]

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Sure. So I think I've stated previously that we recognize that there is some aspect of spine surgery as it continues to move towards -- I think we have to roll them together, navigation, imaging and robotics, those are really, especially in today's robotics, you are looking at navigation and understanding where you are in the space. We continue to explore different opportunities. We think that the future, there's a role, but I think the most important takeaway is that we continue to believe that we'll be able to deliver mid-teens growth this year and continue the growth as an organization. We believe that there's a lot of interesting complexities around what -- how to bring those products to market and find a way to monetize those markets in today's health care environment. And so we're looking to -- we're kind of watching the market, and we're watching what the other companies are doing while we continue to deliver growth. I'll remind you that we took the decision to move in the direction to get leadership in 3D printing. Part of that strategic decision was forethought around the idea that we could gain a leadership role in 3D printing, and that there are a number of other companies exploring navigation, imaging and robotics, a lot of other companies have kind of made a decision, they're in full bore on a direction, and I think there's a lot of other exciting technologies out there that are startups and/or smaller companies that eventually a company like K2 and our scale are ideal for. So we think the timing for us is that we're still in the early innings of robotics and while that technology is continuing to progress through entrepreneurs and innovators in startup and midsize companies, we're taking advantage of 3D printing. And the other piece that ties all this together I'll finish with is obviously a big piece of this is utilizing AI and computers in the form of pre-op planning and deciding what we're going to do. And so you can kind of see where we're going with our whole BACS platform, by establishing that footprint with BACS and the whole continuum of care, as surgeons are looking to go to IT systems, as they're looking to go to apps and websites and systems to help them across all the different things we talked about in BACS, those are going to tie you into planning and utilization as we look to those pieces of capital equipment in the future.

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Operator [23]

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Our next question comes from Dave Turkaly with JMP Securities.

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David Louis Turkaly, JMP Securities LLC, Research Division - MD and Senior Analyst [24]

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I was wondering could you possibly give us an update on sort of your sales force metrics, your direct guys and the agents. And then I was also wondering if you might comment quickly on sort of the mix from them and maybe what we should expect this year in terms of either adds or any change as you build out the direct side.

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [25]

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Sure. Yes, so when we put together our guidance and our forecasts, I mean, we're certainly anticipating sort of an aggressive approach at continuing our expansion activities, and we're doing that. As of recent, we've done a little more of the hiring of agents as opposed to direct employees, variety of expansion. And then some of that has to do with just the quality of the people that we're seeing out there, there's just a really good amount of high-quality, aggressive hunters out there to be had, and we've done a good job of being able to bring them onboard. We like them, as we've said, because they're more friendly to the P&L in the short term because they only get paid if they sell something. But it's been a good transition. We've also had a number of direct employees that, during the first quarter, that we've moved from their direct employee status over to agents to really light the fire underneath them and help them to transition and be more aggressive in their management of their businesses. So we continue to fine-tune and work and manage those businesses the way we always have and we see lots of opportunity there.

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David Louis Turkaly, JMP Securities LLC, Research Division - MD and Senior Analyst [26]

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Okay. And then I guess 1 quick follow-up. But I think you said in the past that Japan, that you're operating primarily in 1 city, I think even, but anything you could share that's sort of on the side of that market and maybe options that you have obviously with the approval? I imagine you can try a bunch of different things, but where you're coming from as a base of business today and where you might go over time given that you have those now.

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [27]

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Let me touch on some of that. Number one, it is a very large market, it's a market of about $300 million spine market. And within that market, we had limited access to the market and really 1 major, maybe 2 cities. But the interesting thing is we did not have a large-scale footprint there. However, we did have key opinion leader utilization. And so when there was a Japanese Scoliosis Society Meeting, the Japanese Spine Society Meeting, there was definitely visibility to K2M. But what we did not have is really a footprint to cover that very important and very large market. In fact, we think that our technology, specifically MESA, are ideal for that market, right? So MESA is a small stature-type product. We think that it is ideally suited for that market, and the feedback that we got from the key opinion leaders that have used the technology -- very, very favorable feedback. And so what we're looking at in a way of a plan going forward, one of the important steps was to receive that clearance which we just received and as now let's us execute. And I think what I'll say is that we're not beginning that process, we're ready now. So you should expect us to be speaking to this as we move forward from this earnings call. And any relationship is one that we are looking forward to have a very strong partner that can give us distribution across the entire country versus pocketed areas of the country.

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Operator [28]

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Moving along, our next question comes from Craig Bijou with Wells Fargo.

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Craig William Bijou, Wells Fargo Securities, LLC, Research Division - Senior Analyst [29]

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I wanted to start with the international growth of 14% in the quarter. Came in well above our expectations even when you back out the instrument set sales. So I just wanted to see how that compared to your plan? And if there were any surprises to you. And then if I'm doing the math correctly, it implies roughly flat growth for the rest of the year based on your guidance. So I just wanted to ask if there's any other concerns about the international markets or if it's just a matter of conservatism for the rest of the year?

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [30]

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Yes, I mean, I think it's a -- just as a general framework, when we think about because what you're really asking is about our thought process around guidance going forward in that market. And as a general comment, we don't really adjust for guidance until the third quarter. You know that about us. So with that backdrop, what we are though very, very pleased with the way we got out of the gates here in Q1. And it's fantastic, they did a great job. All across the board, the direct markets that we managed to control, very, very strong performance, and we're getting back to a more normal routine with our partners in Australia, LifeHealthcare. So we like that. Now 1 quarter, unfortunately, is just not enough to base a trend on because we use the heavy amount of independent distributors and they don't place orders every week on a routine normal fashion. They do pocket and place them. And we know this over time having worked with them. So we'll be watching that as well over the next couple of quarters, and the goal would be just to see them continue to perform well. And I'd love to be able to come back to you in the third quarter with more positive statements about it. I'd love to do that, but we're really, really pleased with the way they got out of the gates. It's really a good news for us.

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Craig William Bijou, Wells Fargo Securities, LLC, Research Division - Senior Analyst [31]

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Okay, that's helpful. And just as a follow-up. With the long-term agreement with LifeHealthcare, I guess I want to ask if -- does that give you more confidence that the investment sets would begin to pick up? And I guess, is there anything within the agreement that gives you, I don't know if it's a minimum or some additional assurance that they will be investing at a certain level going forward?

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [32]

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Yes, I mean, I can take that. I mean, certainly the agreement does have contractual minimums and amounts in it, but there's not requirements of any kind to force them to make purchases. What I will say is, we're working with them closely right now because we have a joint strategy of making the Australian market and K2M #1 in that country. We are very much deep in those dialogues and we're focused really on the timing of when the real investments will start occurring. Now in terms of expectations, I'm not sure if it's going to be in the form of 1 big investment or if they will, over time, do what those finance guys like to do and buy a little, spend a little and sell a little over time. So we're working on the timing exactly how that would occur, and that's important. But I think the key theme is, for the long term, they would not be placing these orders for continued growth if they didn't have confidence in a longer-term relationship to do that.

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [33]

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Yes, we're...

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [34]

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That's it.

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [35]

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I would just add, we're very pleased with -- this group has been with us since 2010. The feet on the street there, I think, are among some of the best when it comes to knowledge of spine and their ability to grow their business. And so to Greg's point, it's really more of timing and pace as we get there. We've gotten through where we were last year. They are engaged. This 5-year contract is very important to that relationship. And I think, again, I'll just add to the first part of that question. When we think about international so far in '17, that is really a replenishment-based focused number. And so as we move into 2H and forward second half of the year, we're going to be working closely with LifeHealthcare and our other partners to see what we can do to continue to grow. And the objective for us and LifeHealthcare is to be the #1 market share company in Australia, and we believe that's very achievable.

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Operator [36]

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Our next question, it comes from Mike Matson with Needham & Company.

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Michael Matson, Needham & Company, LLC, Research Division - Senior Analyst of Medical Technologies and Diagnostics [37]

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Greg, you mentioned that there was 100 basis points of mixed benefits from CASCADIA. Was that on the revenue or the gross margin line? And then I also had a question about just the quarterly sequencing. Is there anything that you'd want to say about just for modeling purposes, the sequencing over the next few quarters?

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [38]

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Yes, the mix is really about the Degenerative category because we talked about, it's not really Complex Spine season. So we have a heavier weighting of the Degenerative business in the first quarter and MIS as well. And so the mix benefit, if you will, it's only about 100 basis points. It may vary, sometimes it's -- some quarters, it's 50 basis points. Sometimes it's 100 bps. But this quarter happened to be about 100 basis points related to the revenue. And the contribution of that weighted basket against the overall pool of the revenue that we have. So I hope that helps in terms of the pieces there.

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Michael Matson, Needham & Company, LLC, Research Division - Senior Analyst of Medical Technologies and Diagnostics [39]

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Yes, that does. And then just on the quarterly sequencing?

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [40]

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Yes. And then, just lastly, Q2 and Q3, when you think about those, I mean, that -- it could flip back around, right, because remember our seasonality for Complex Spine, you would expect a much higher contribution of the Complex Spine business in Q2 and 3 than what you saw in the first quarter just because of the seasonality. So again, that mix could flip around a little bit the other direction as well. So it's just one of those things that we found interesting looking at it this quarter. I think the key theme there, the reason we mentioned it is that the procedures are still very strong, we're seeing very good procedure level growth, and we're pretty happy with that. That's a really important message.

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Michael Matson, Needham & Company, LLC, Research Division - Senior Analyst of Medical Technologies and Diagnostics [41]

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Okay. Are you comfortable with us keeping kind of Q2 and Q3 sort of even from a revenue standpoint? Or would you prefer to come into Q2 with a little bit lower bar?

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [42]

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Yes. So again, I wish we could tell you for sure when the Complex Spine procedures are going to hit, right? It's a question of whether -- if they're going to be more in Q2 versus Q3. And I think the right way to model it is that we evaluate this season at the end of Q3 by adding the 2 components together. And I think the way to model it is you should have a more conservative approach in the Q2 modeling with the bigger weighting in Q3 because there's frankly more summer in Q3 than there is in Q2. And that's what we've been guiding towards for the last couple of years and I think that serves folks well as they've looked at it.

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Operator [43]

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We'll take our next question from Matt Taylor with Barclays.

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Matthew Charles Taylor, Barclays PLC, Research Division - Director [44]

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And so I just wanted to delineate between your comment on mix and your comment on price. You made a comment that pricing was at the higher end of the low to mid single-digit range that you've been seeing. So can you just talk about how different that has been from trend and what you think might be driving that?

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [45]

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Well, remember, we're in a -- especially in Q1, when you think about our business, Matt, we are seeing more utilization here in Q1 on the Degenerative space. But then Degenerative space, we're going to see a different mix than in Complex Spine where we have different ASPs. So I think that's been an interesting phenomena for us because in the past, as you know, from watching the company, Q2 and Q3 were really dramatically different. We didn't have the 3D printed technologies and the EVEREST MI XT technologies that we're starting to see that growth within MI and Degen. And So that's starting to add in a unique way to the mix now putting us in that Degen space.

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [46]

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Yes. And Matt, I would like to say when I think about the band that we trade in on price, it's a true low- to mid band. It's not a mid- to high band. I mean, it's really -- it's tight. It's a low- to mid band. And we typically have traded there over the last 4 years within that very tight range. And some quarters, it's up to the high end. Some quarters, it's to the low end. And we just happen to be towards the high end on that low- to mid-range this time.

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Matthew Charles Taylor, Barclays PLC, Research Division - Director [47]

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Okay. I just want to make sure I understand. So you're saying that the pricing is really linked to mix because with greater Degen mix, that's where you also have greater price pressure typically?

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [48]

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Yes, exactly. We try to break that out, that's right. And that was the purpose of talking a little bit about the weighting of the Degenerative piece. We try to do that mix piece really separate, so you can sort of see where we see that impact. I don't think we've done that before but it was something we looked at, and it wasn't very material, but I thought I'd mention it anyway.

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Matthew Charles Taylor, Barclays PLC, Research Division - Director [49]

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Okay. And just back on this international piece because it's a little bit more dynamic. I guess, you did come in better in the first quarter and I understand your conservatism, but can you just help us understand the range of what you're now forecasting, which is just replenishment growth and what the range would be if you saw a normalized growth? What's the magnitude of that difference? I mean, would you get back to the run rate that we were before because Life is clearly talking about some of the new products, so I think that you'd get some of that back.

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [50]

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So I appreciate that. I mean, I think we're focused on a purely replenishment-only business. And we have all kinds of distributors that tell us and talk to us about goals and objectives that sound really, really great. It's really translating those commentaries into actual purchases and real expansion plans. So for what it's worth, I mean, we still believe that the right way to model all of the markets is to focus on replenishments first. And overall, international is a low single-digit assumption right now overall. And we do see pockets of strength back and forth on these markets.

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [51]

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Yes. I mean, I'll add there, we're seeing -- I just got back from Europe where we just had our Meeting of Minds and I had noted that we had 110 leading deformity surgeons at that meeting. And had an opportunity while we were there to meet with the general managers of each of our regions, of the team running Italy and U.K. and Germany. And they're really performing quite well. The thing that hedge -- that when we think about our international number is not those replenishments and not those direct markets, it's those large set orders coming from these international partners that we just -- when you're modeling that, that becomes difficult obviously because it's hard for us to know exactly where they are until we sat down and they've spoken to us within a quarter around the new product launch that they want to introduce. So we think it's the right guidance to provide at this time, we think our -- we know that our direct and markets in the replenishments are looking very good to plan. And now, we'll wait and see how we going forward here into Q2 and Q3, especially given the Australia relationship and then the future where we think it can go here in Japan.

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [52]

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The last thing I'll say, Matt, which is, I wish we didn't in some -- for purposes of this call, I wish we didn't necessarily have more than 50% of our international business tied to international distributor partners but the truth is, it's much harder for us to manage that. For your comment around the direct piece, that's easy to flow through to project and trend and understand, but it is a much more challenging in our experience with the international distributors. Because they just don't flow through that procedure demand to purchases on a consistent basis because they don't buy -- their purchasing patterns just aren't even. So I would urge caution towards getting excited about doing something with that as of yet just because that's just not the business that we're in.

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Operator [53]

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We'll take our next question from Kaila Krum with William Blair.

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Kaila Paige Krum, William Blair & Company L.L.C., Research Division - Research Analyst [54]

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A follow-up on Japan, and then one on the U.S. and a quick one on cash usage this year. The first on Japan, I'd imagine there's some sort of transition process if you do choose to move away from your current distributor and start selling more direct. So I guess, how do we think about that transition process in the near term?

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [55]

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Yes, I only see Japan right now as opportunity. I see -- we had noted that we're back up and running in the market. We did have the period of time last year where we were not in the market, so when you think about our replenishment order, that run rate includes the 60 -- our 2016 period by which we had 4 months of volatility due to that voluntary suspension. Coming off of that and where we are today, I think that instead of thinking it as a downturn, it's opportunity to the upside, is the way I would think about that. So there's really no update now on those numbers, but I would say it's not a modeling of taking them down during the transition. I think that we would have the ability to transition in such a way that we could at least maintain where we are, and if not, see acceleration at some point.

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Kaila Paige Krum, William Blair & Company L.L.C., Research Division - Research Analyst [56]

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Okay, that makes sense. And then as it relates to your U.S. results and specifically in MIS and Degen, it looks like your growth actually accelerated on a 2-year stacked basis. And I know, at least on my end, I'd modeled a deceleration there with seasonality. So I know you mentioned your new surgeon users are driving this, but I guess what's the opportunity, in your opinion, to shift some of these new users in MIS and Degen to your deformity products over time?

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [57]

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Yes. So as you might imagine, we're -- we keep going back to the thing that's opening the door for us right now is the 3D printing technologies and it's the CASCADIA platform and so Lamellar 3D Titanium Technology and what we've been able to invent and work towards creating protected innovation around that. That is opening the door for us not just in Degen, but our lateral 3D-printed implants, so for the MIS space. And then also, we had talked about the fact that we wanted to deploy this technology across our broader platform, and then I discussed that in the prepared remarks. So think about in the Complex Spine space, tumor trauma, Complex Spine space, there's opportunity there, and we are expecting announcements as we go into the Q2 and the second half of the year to bring more of that 3D printing to market. And so it's doing what you asked, it's opening doors for us, the MIS and Degen. So we enter the accounts through MIS and Degen. We get access into those accounts very quickly because of unique products like our 3D printed products and CASCADIA. And then the longer sell process is always the Complex Spine, the longer selling process but they're also a much stickier market. And so as we open those accounts, we get access, we get interest from those Complex Spine doctors, which is kind of reversed from the old days where it was only Complex Spine and then we start to get Degen doctors interested. Now we're able to hit them from the top and the bottom because now with 3D printing, we're getting access into new accounts.

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Kaila Paige Krum, William Blair & Company L.L.C., Research Division - Research Analyst [58]

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Got it. Now, that makes sense. And then, I guess, just as it relates to cash, do you guys expect to generate or consume cash for the full year?

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [59]

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We'll be consumers of cash. We typically would spend, on an annual basis, about $20 million in excess of our EBITDA numbers each year. So I mean, we've budgeted a number somewhere in the $20 million, $25 million range for cash usage because -- and that really is the difference between EBITDA and cash flow for us is really focused on a little bit of working capital and the inventory that we purchase every year. So for us, that's -- we'll consume $20 million to $25 million, but I do think there's opportunities to see good cash flows around the corner. We're not that far away from our GAAP net income target in Q4 of 2018. And our hope is to see some good cash flows as we run right into that mark. We are well capitalized, I think, is the other point you were getting at. And to Eric's thought process around some of the strategic looking that we've done, we do have funds that we can deploy in that area.

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Operator [60]

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And we'll take our next question from Josh Jennings with Cowen and Company.

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Joshua Thomas Jennings, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [61]

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I was hoping to ask another question on the international business and just to clarify in terms of the strong Q1 results, was there any onetime benefits that you received or stocking orders or any pull-forward orders that drove that higher-than-expected international revenue number?

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [62]

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No, not really. I mean, it really is a replenishment-focused number on the international side. I mean, we don't see really big new country launches or things like that any longer. We're not -- we're already in the mainstream countries. The only thing that we mentioned here is that Australia did purchase $300,000 of what we call the EVEREST MI XT and CASCADIA lateral products which are part of our growth initiatives with them, and that's a unique item. It's really small, but it's a start, we're -- pretty excited that they did do that.

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Joshua Thomas Jennings, Cowen and Company, LLC, Research Division - MD and Senior Research Analyst [63]

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Great. And then that you wouldn't consider that a onetimer though?

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [64]

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It's one -- I would say, it's maybe, for the hospital that they're investing it for, it's onetime, but there may be hopefully other purchases along the same themes in the future. Those are the things that we're working on with them.

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Operator [65]

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Ladies and gentlemen, that does conclude our time for question-and-answers. And this also does conclude our conference for today. Those were all the prepared remarks we have for today. You may now disconnect.

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Gregory S. Cole, K2M Group Holdings, Inc. - CFO [66]

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Thank you, Denise.

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Eric D. Major, K2M Group Holdings, Inc. - Co-Founder, CEO, President and Director [67]

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Thank you, Denise.