Surgalign Holdings, Inc. (NASDAQ:SRGA) Q3 2022 Earnings Conference Call November 2, 2022 4:30 PM ET
Company Participants
Terry Rich – Chief Executive Officer
David Lyle – Chief Financial Officer
Chris Thunander – Chief Accounting Officer
Conference Call Participants
Matthew Hewitt – Craig-Hallum Capital Group
Operator
Greetings, and welcome to the Surgalign Holdings 2022 Third Quarter Earnings Call. It is now my pleasure to introduce your host, David Lyle. Please sir, you may begin.
David Lyle
Thank you, and good afternoon. I’ll start today with our customary forward-looking statement disclaimer and then turn the call over to Terry Rich, our CEO, who will provide updates on our business operations and key milestones. I will then review our third quarter financial results and outlook followed by closing remarks from Terry. We will then open the call for questions.
Additionally, Chris Thunander, our Chief Accounting Officer is with us today and will be available during the Q&A portion of our call. I’d like to remind everyone that on today’s call and webcast, management will be making forward-looking statements about future events, Surgalign’s business strategy and future financial and operating performance. Actual results could differ materially from those stated or implied by these forward-looking statements due to risks and uncertainties associated with the company’s business.
These forward-looking statements are qualified by the cautionary statements contained in today’s earnings release and Surgalign’s SEC filings. This conference call contains time-sensitive information that is accurate only as of the date of this live broadcast, November 2, 2022. Surgalign undertakes no obligation to revise or update any forward-looking statements to reflect events or circumstances after the date of this conference call.
In addition, this conference call may include a discussion of non-GAAP financial measures. Please see today’s earnings release for further details, including a reconciliation of the GAAP to non-GAAP results. With that said, I’ll now turn the call over to Terry.
Terry Rich
Thank you, Dave, and good afternoon, everyone. During my remarks today, I’ll focus on three areas: our progress during Q3, our business outlook through the remainder of 2022 and what we’re looking to build in the years ahead. While our third quarter revenue was in line with Q2, and we believe Q4 will grow sequentially but be softer than previously anticipated for reasons I’ll discuss shortly, our long-term positioning has not changed.
We have opportunities for growth through both our Spine and Biologics product portfolios and significant growth prospects for our HOLO AI platform, and we have the team to get the job done. Our highest priority near-term is to ensure we have the financial resources in place to execute our strategy and generate sustained and long-term value for our customers, partners, and shareholders.
As for third quarter revenue was a little lighter than we had previously expected, mainly due to a softer international market as economic pressure around the world continues and as the strengthening U.S. dollar works against us. Q3 revenue in the U.S. was in line with Q2. We are still seeing low procedural volumes or rather inconsistency throughout the summer months, but no worse than previous quarters. We remain excited about finally turning the corner with our revenue going into the fourth quarter. We are already seeing strength in October as it came in as our third strongest revenue month of the year.
Why do we believe Q4 is the turning point? During Q3, we continued to launch new products, including our new pedicle screw system. We expanded our reach and partnerships and perform more procedures utilizing our HOLO Portal surgical guidance system with more planned in the months ahead. That’s the high-level snapshot, and Dave will provide further details in his remarks shortly.
On the innovation front, we had a number of milestones. We received FDA 510(k) for our Cortera’s Spinal Fixation System, the first ever organically designed product at Surgalign. This was a major initiative for us, expanding our offering in the $2.2 billion posterior fixation market.
Cortera was internally developed by our engineering team and was designed, leveraging our network of medical advisers who provided invaluable insights into surgical needs, competitive offerings and market gaps. The Cortera system is comprised of an open and minimally invasive pedicle screw system and will be integrated with HOLO portal to enhance pedicle screw navigation.
We will continue to expand the Cortera system with other implants and instruments while simultaneously advancing HOLO Portal into the cervicothoracic spine to expand system applications. Surgeons will have two innovative technologies packaged together to perform spinal fusion procedures, and we believe this will be a great solution based on medical adviser insights and discussions with health care professionals since 510(k).
The Cortera Alpha launch was toward the end of Q3 and to date, we have already performed over 50 cases at multiple accounts. Our plan is for a limited market release in Q4 and a broader launch in 2023, and I will add that Cortera generated revenue in October that was more than 2x greater than September. Two other launches were addressed on our Q2 call, but were Q3 events. The first, the launch of our Fortilink product portfolio with TiPlus technology. This product suite is used for Anterior Lumbar Interbody Fusion or ALIF procedures. And as I noted, is the first in the family of 3D-printed titanium interbody cages and marks our entry into the 3D-printed titanium interbody market.
We’re starting to gain traction, and we expect growth in 2023 with recent enhancements facilitating both TiPlus and TC adoption. The second, the commercial launch of our CervAlign Anterior Cervical Plate system designed for anterior cervical discectomy and fusion procedures. This is one of our flagship products and was one of our best sellers when it was first introduced into the market.
We’ve been working to source product and now have over half of our anticipated CervAlign sets redeployed. We see — foresee growth in the ACP category in 2023 and will focus on ramping up product supply throughout Q4. An update on our partnership with PRIA Healthcare and on the Surgalign patient access program. This program launched earlier this year is about improving patient access to two of our key product offerings, the Coflex Interlaminar Stabilization device and the SImmetry SI Joint Fusion System.
Coflex is a minimally-invasive posterior lumbar motion preservation solution that maintains stability in the spine. SImmetry is a minimally invasive SI Joint Fusion system that addresses arthrodesis, which is the surgical and mobilization of a joint by fusion of the adjacent bones. With SImmetry, we are the only company in the industry that decorticates the joint, a standard orthopedic principle and achieving fusion.
Since we launched the patient access program, we have enrolled over 70 accounts and close to a 100 surgeons and these figures continue to grow, leading to optimism around future growth. Moving on to HOLO, we’ve become even more excited about HOLO’s growth prospects and believe we have differentiated and very valuable technology that can change the way surgical procedures are performed, starting with the spine.
HOLO Portal is FDA cleared and in early stages of commercialization, we have secured four sites since receipt of 510(k) with the fourth site in Richmond, Virginia, and cases are being performed by Dr. Josh Herzog, a board-certified orthopedic spine surgeon with OrthoVirginia. We will be issuing a release shortly on this along with Dr. Herzog’s testimonial, which test mirrors our belief in the HOLO Portal and what it can do.
As Dr. Herzog said, I am confident that the increased precision and ability of this enabling technology will improve the recovery and outcome for my patients. This is really what it comes down to. Improving patient outcomes, that is our mission. And we believe the technology and its use in cases will only be enhanced as we train the AI and ML algorithms on additional pathologies and anatomy.
With regard to growth expectations for HOLO, we anticipated we close out 2022 somewhere between 10 and 15 sites up and running. Due to the long nature of review and approval cycles, including continued staffing issues, we are extending by one quarter, our goal is to have 10 to 15 sites up and running. The interest continues to be very high, and we are currently working on over 10 sites that could close this year. But we need to be conservative given the environment. Our pipeline of interested accounts has more than doubled since last quarter, growing from over 20 sites to more than 40 today, and this is a testament to the technology and its ability to improve patient outcomes.
An update on my remarks from last quarter regarding future applications. In Q1 of 2023, we expect to release a research version of our HOLO AI platform with stenosis and disc degeneration. This version will allow our clinical partners to use the technology to analyze diagnostic MRIs and apply the results for clinical research. We see great promise for this type of application and plan to pursue regulatory approvals in the second half of the year, which would open up new avenues to assist in patient treatment and new revenue streams.
The longer opportunities for the HOLO AI platform are very much in front of us and attainable. Though again, we will require capital to fund future development initiatives and support commercialization plans. Two other quick points on HOLO. Just a few weeks ago, HOLO Portal won the 2022 Best New Spine Technology Award presented by Orthopedics this week. This was a big achievement for Surgalign as HOLO Portal was recognized by the most widely read publication in our industry as the next generation of innovative technologies to improve spine care.
Equally, if not more important, HOLO Portal was voted as the unanimous winner by a panel of leading surgeons with clinical and research experience in our field. We received this award at NASS Annual Meeting on October 13, where we exhibited our Spine and Biologics products in addition to the HOLO Portal. At our booth at NASS, we also featured live hands-on demonstrations of the HOLO Portal system.
Just a few weeks prior, we exhibited at SMISS in Las Vegas and participated on the MISS Track Cadaveric Lab featuring HOLO Portal for the first time ever in an industry event. We had very positive receptions at both events, interactions with both current and potential customers and forge many new relationships to build our pipeline. Beyond the business momentum during the third quarter, we successfully addressed two of the bigger legacy issues that have remained overhang for our company and our shareholders.
In August, we announced a global settlement agreement with RTI. The past litigation stemmed from the sale of the OEM business to RTI in July of 2020, and the business relationship we had since. All litigation has been settled. Both parties have been released from potential claims and new agreements have been reached extending our relationship for an additional two years with updated supply chain provisions.
Also in August, we reached a settlement with the SEC, which has allowed us to move forward without this uncertainty and put the issue behind us. As a reminder, the case related to the investigation into former executives of RTI. This stems from business activities dating back to 2015 through 2019 and again deals with prior management, not our current team. These two matters are now in the past, which frees up not only capital resources, but also human capital to form on transforming the business at hand.
I’m going to turn the call over to Dave to review our financials and give an update on financing activities, then I’ll come back with a few closing comments.
David Lyle
Thanks, Terry. Similar to the past quarter, I’m going to provide sequential comparisons Q3 versus Q2. We can find our year-over-year comparisons for the third quarter and year-to-date and our 10-Q as in today’s earnings press release.
We reported Q3 revenue of $20.2 million as compared to $20.6 million in Q2. U.S. sales were in line with Q2 despite some product availability issues and continued procedural volume pressure. International is where we experienced the most softness as a result of current macroeconomic issues and market conditions, resulting in fewer procedures and lower sales volumes.
Within the U.S., we saw a sequential improvements within our biomaterial product lines with the biggest sequential increase in ViBone, which was one of our late 2021 new innovations. Product sales for CervAlign, our anterior cervical plate for anterior cervical discectomy infusions were up modestly on a sequential basis following its relaunch, and we expect better contributions in the quarters ahead. Sales of Cortera products, our new pedicle screw system, which was just launched, went very well, and we believe will contribute to sequential growth in Q4 and beyond.
I covered these products in particular as they are the new innovations from Surgalign and a sign that we have the opportunity to grow from here. Non-GAAP gross margin in Q3 was 74.9% as compared to 73.5% in the second quarter, an improvement of 140 basis points and primarily related to a favorable product mix shift and a decrease in excess and obsolete expense incurred. GAAP gross margin for the third quarter was 72.8% as compared to 68.9%, an improvement of 390 basis points sequentially. Excluded from Q3 non-GAAP gross profit was a $431,000 inventory purchase price accounting adjustment.
Moving on to operating expense. Q3 non-GAAP operating expense was $26.5 million as compared to $27.5 million in Q2, a $1 million improvement. On a non-GAAP basis, excluded from Q3 operating expense was a gain of approximately $6.7 million for accounting adjustments to the fair value of milestones, asset impairment, and abandonment in expense of $2.3 million, $1.2 million of noncash stock-based compensation expense and transaction and integration expense of $214,000.
Adjusted EBITDA in Q3 was a loss of $11.2 million as compared to an adjusted EBITDA loss of $11.7 million in Q2, a $500,000 improvement primarily due to higher non-GAAP gross margin and lower operating expense. To put this in perspective, our Q3 financial results were roughly in line with Q2 with slightly lower revenue, offset by higher gross margins and lower operating expense on a non-GAAP basis, impacting our ability to grow in Q3 was product availability, hospital staffing shortages, lower procedural volumes and contract delays, but most impactful with the macro environmental issues in Europe.
We expect sequential revenue growth in Q4 with U.S. hardware implant revenue stabilizing and growth expected from new products just launched but more muted growth than previously expected as procedural volumes still remain at lower levels. Internationally, we anticipate some minor growth over Q3. For HOLO, we expect to grow sequentially in Q4, but at less than previously expected, given longer lead times to close contracts. These factors are leading to our revised 2022 revenue outlook in the range of $82 million to $84 million.
We expect non-GAAP gross margin in Q4 to remain in the low 70% range as we grow higher gross margin HOLO Portal revenue, corporate gross margins could trend higher longer-term. U.S. gross margins tend to be higher than international gross margins. And if weakness continues and international declines as percent of revenue, there is some upside for improvement as well. We remain laser-focused on lowering our capital outlays, both expenses and nonrevenue-generating CapEx to both conserve capital and free up resources to support commercialization and product development.
Looking at our G&A expenses, we have lowered our quarterly expenses in each period of this year and through a series of organizational efficiency enhancements, coupled with more stringent expense policies, we expect to lower our Q4 expenses further and be in a position to operate on a lower cost basis moving into 2023. We have now developed additional optimization plans to streamline operations, improve efficiencies and lower expenses further with the majority of programs anticipated to begin in Q1 of 2023, depending on our financial position at that time.
I will note that R&D expense fluctuations have been minimal throughout the year, and we are continuing to invest in product innovation and our engineering and design capabilities, which brings me to the balance sheet and the status of our financing initiatives. First, the balance sheet. We ended the third quarter with $13.8 million in cash and cash equivalents compared to $29.3 million as of June 30, 2022, or a decline of $15.5 million.
Key cash outflows were $11.9 million in cash used from operations, $2.2 million in capital expenditures, $1.4 million for changes in working capital and $600,000 in other net cash inflows. We’ve stated throughout the year that additional financing would be required by around year-end, given our cash runway gets us into early Q1. We have been seeking the least dilutive path to financing, looking at debt instruments, debt and equity combinations as well as straight equity alternatives. We are working on multiple parallel paths with our board and advisers evaluating all options available to us.
Over the past few weeks, we have received indicative terms for a proposed transaction. But to date, we haven’t been able to progress to definitive documents. The greatest challenge has been market headwinds and volatility and the process has taken longer, removing a number of potential players as a result. In the interim, we remain laser-focused on reducing our cash spend and finding a path that leads to shareholder returns. On this front, and as I mentioned earlier, we have instituted a number of cash savings initiatives and have plans to do more.
Now I’ll turn the call back over to Terry.
Terry Rich
Thanks, Dave. And I’ll build off that last comment. We’ve accomplished a lot over the past two years and the value provided to our customers have been significant. Many of our new products have been developed with their support, we have strong distribution, growth opportunities both domestically and abroad, and then there is HOLO both the HOLO Portal and our HOLO AI platform, both of which hold great promise, not just for Surgalign, but for the medical community at large and patients they serve.
Our challenge right now is securing the resources we need to turn this vision into reality and realize the value we believe is in front of us. We know it’s been a tough few years for shareholders ourselves included and greatly appreciate the support we’ve received. We’re asking for more. We need time to explore all options as there is value in our assets and greater value to be realized.
Operator, we’re now ready to open the call for questions.
Question-and-Answer Session
Operator
Thank you. We will now begin the question-and-answer session. [Operator Instructions]. Our first question comes from Matt Hewitt with Craig-Hallum Capital Group. Please go ahead.
Matthew Hewitt
Good afternoon. Thank you for the update and for taking the questions. Maybe the first one, and I apologize if I missed this, but do you have a number of HOLO procedures that were completed during the quarter or how that’s trending?
Terry Rich
Hey Matt, yes, no, we have not reported on HOLO procedures at this point, just units. But we’re making great progress and are incredibly encouraged by the results and the surgeon excitement about the unit, both those surgeons having done cases as well as the reception we received at mass having had it in the booth for the first time, it was unbelievable.
Matthew Hewitt
That’s great. Regarding Cortera, has that been used in utilizing HOLO yet or when do you anticipate that could occur?
Terry Rich
Yes. We have not done that in conjunction with HOLO yet. We’re just doing the Alpha cases with Cortera. So as we get through the Alpha launch, then we’ll look to integrate with HOLO, I don’t think it should take an incredibly long time suggest in conjunction potentially with the full commercial release next year.
Matthew Hewitt
Got it. And then I know originally with HOLO, that the plan was to do a measured rollout. You’ve kind of set those targets on a number of sites that you expected to have up now it sounds like Q1. But I’m just curious, given the environment that we’re in, is there anything that you can do maybe to expedite the rollout a little bit, whether it’d be working with some of the existing foresights to maybe ramp up so that you can get the publications to drive incremental awareness and utilization? Or I’m just trying to think of ways that you could maybe ramp up a little bit quicker. And I get it, it’s a very challenging environment with all the reasons you mentioned, and we’re hearing that elsewhere. But I’m just trying to think of things that — what are the levers to drive a little bit faster growth, whether it’s here in Q4 or as we look at FY ’23? Thank you.
Terry Rich
Yes, of course. Thanks, Matt. And look, the engagement around HOLO has been huge. And in fact, a number of the sites we’re bringing on additional surgeons now, which is very exciting. The feedback has been huge. We believe that with the increased funnel that we’re seeing as a result of having put it in a number of these trade shows that we will be able to look to accelerate the placements through the back half of this year and into next.
Again, assuming we’ve got the ability to get through these hospital contracting processes. That’s been the number one issue delaying things. It absolutely has not been surgeon interest. We’ve got more there than we have units. So it’s just about getting through these contracting processes and we’re engaged in a bunch of them. So thank you.
Matthew Hewitt
Got it. All right. Thank you.
Operator
Ladies and gentlemen, as there are no further questions. This concludes today’s call. Thank you.
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