Conformis, Inc.

Good afternoon, and welcome to the second quarter 2021 earnings conference call for Conformis, Inc. My name is Sarah, and I will be your conference operator today. All lines have been placed on mute to prevent background noise. After management's remarks, there will be a question and answer session. Before we begin, I would like to remind you that this call will include forward-looking statements within the meaning of federal securities law, which are made pursuant to the Safe Harbor provisions of the Private Security Litigation Reform Act of 1995. Any statements made during this call that are not statements of historical facts should be considered forward-looking statements. These statements involve material risks and uncertainties that could cause actual results or events to materially differ from those anticipated or implied by these forward-looking statements, including those discussed in the Risk Factor Section of Conformist Public Violence with the U.S. Securities and Exchange Commission. you should not place undue reliance on these forward-looking statements. Conformance disclaims any obligation, except as required by law, to update or revise any financial projections or forward-looking statements, whether because of new information, future events, or otherwise. This conference call will include time-sensitive information and is accurate only as of the live broadcast today, August 4, 2021. I will now turn the call over to Mark Auguste, President and Chief Executive Officer of Conformis.

Thank you, and welcome to our second quarter earnings call. With me today is our CFO, Bob Howe. We appreciate you joining us for an update on Conformis. The second quarter was solid for us on nearly every level. We closed the gap to getting back to 2019 levels of performance, and we made significant progress on the development of our key new products. From a macro perspective, we are seeing similar trends on procedure levels and customer behaviors as other medical device players, especially when compared to companies with a less diversified product portfolio. Like all companies, we are carefully monitoring COVID trends and vaccination rates and trying to assess how they will play out over the coming quarters. The environment for orthopedic surgical procedures continues to improve, but it's not without challenges. Like you, we take it in the news every day, and there are several complicated factors such as several areas of the world experiencing spikes in COVID-19 cases, the rise of the Delta variant, nursing and critical support staff shortages, medical facilities reconsidering how to handle elective procedures, and changing mask guidelines. So although the environment has not yet stabilized, we remain encouraged that the arthroplasty market is showing some level of resilience as it tracks back towards pre-COVID levels. Our current thinking is that we will attain a normalized medical procedure environment both in the U.S. and internationally by the end of this year or in early 2022 at the latest. This timing works well from our perspective because we have a number of growth initiatives that we expect to be well in the ramp right at the time the broader market is nearing full recovery. To that end, we remain cautiously optimistic that we are on track to get back to our pre-COVID operating levels by the fourth quarter. I would like now to provide you with an update on each element of our current growth strategy. Number one is to grow our core need business. Improved procedure levels were the main driver for our revenue performance in the quarter. Importantly, we saw a sequential improvement in our core products, which is a great indicator for our expanded product portfolio. We believe this will become even more pronounced in the relative near term as we add our imprint offering to our product portfolio. Although a smaller part of our business, we are moving forward with efforts to strengthen our presence in key international markets. The latest example of this is our recent announcement about our plans to expand Conformance's footprint into China. We are doing this through an exclusive distribution relationship, which will initially focus on the International Medical Tourism Zone in Henan Province. While it will take until the end of 2021 or early 2022 before the first cases are performed, we're excited about the commercial potential of this relationship. Number two is to grow our hip business. During the second quarter, we generated $900,000 of hip revenue, which was 62% growth over the second quarter of 2020. We are seeing continued interest in our Cadera Match hip system from current and new surgeons. The new system is designed to allow surgeons the flexibility to use either an anterior or posterior surgical approach, and given the demand for reduced sterilization costs, our surgeon-in-a-box model is gaining traction in both hospital and ASCs. We have more work to do as we build out our HIP portfolio and our software capability, but we're committed to expand our HIP franchise. Number three is to continue to drive R&D efforts and to launch new and differentiated products. Although we have many projects in the pipeline, three are expected to be particularly impactful to our overall growth. First is the identity or imprint project. We received regulatory clearance in May and have been busy preparing our commercial team and training the surgeons that will participate in our limited market release. We're excited about Identity Imprint's potential because it integrates the best of personalized knee design with the convenience and flexibility of an off-the-shelf system. We're very pleased with the end product, both in terms of attractiveness to customers and patients, and in its higher margin profile. Our target market for this system is, of course, the ASC and outpatient segment. Based on discussions today, customers recognize the delivery model efficiencies product features, and sterilization savings. We expect the first imprint procedure to be completed later this quarter. Another important R&D project is our cementless knee. While we continue to make progress, we are currently reevaluating if we should focus on applying the cementless technology first to our tentative imprint, given the increasing interest we are hearing from customers regarding this product. And then third is our plan to introduce an additional hip stem. That will complement our HIP portfolio. As we've mentioned in the past, we continue to be on track to add an additional stem to our portfolio by mid-2022. Our final strategic pillar is to continue to protect and monetize our intellectual property. We have a strong quarter on this front. Early in the quarter, we announced a non-exclusive license for a subset of our patents to Paragon 28 so that they can use our patient-specific instrumentation IP with their new total ankle replacement system. we will receive $1.5 million from Paragon 28. More recently, we resolved the open litigation we had previously filed against Wright Medical and Tournier by entering into a favorable settlement agreement with those companies and with Stryker, which acquired them in November of 2020. Lastly, we had a lot of positive activity during the quarter on our patient-specific instrumentation project for Stryker's Triathlon Total Knee Replacement System. In late April, we received 510 clearance, which triggered the final milestone payment of $11 million. The limited market release began shortly thereafter, and the first procedures using our patient-specific instrumentation, with strikers trapped on knee implant, were recently performed successfully. Although material product revenue ramp is not expected until 2022, we have the necessary manufacturing plans in place to support the sales ramp as ASC customers accelerate their adoption of this solution. We feel good about our strategy and the steady progress we continue to make. Let me now turn the call over to Bob for a more detailed financial review of the quarter. Bob?

Thank you, Mark, and good afternoon, everyone. I'll start with some details on a few non-recurring items in the quarter. We recognized $41 million of royalty and license revenue in the second quarter, almost all of which was one time in nature. This included the final milestone payment for the development of patient-specific instrumentation for Stryker. the resolution of the right medical litigation, and our agreement with Paragon 28, as Mark outlined. While this royalty and licensing revenue is non-recurring, it clearly demonstrates the strength of our IT portfolio. Specific to the Stryker PSI license and development agreement, we recognized 25 million of license revenue in the second quarter, which was triggered when we received FDA clearance in May. As Mark mentioned, we're now in the limited market release stage with Stryker. As a reminder, We do not expect material revenue ramp until 2022. We had $2.5 million of other income which related to the Stryker Development Agreement. This other income represents the difference between our direct R&D expense incurred to date and the contractual amount in the development agreement. Lastly, during the quarter, our PPP loan was officially forgiven. We had borrowed $4.7 million back in March 2020 and used the proceeds to maintain staffing during the pandemic. which allowed us to keep R&D and business operations moving forward. You will see the impact of the loan being forgiven and other income on our income statement. With that, I will now move to a review of our financial highlights. We reported second quarter revenue of $56.3 million, which included the royalty and license revenue I just mentioned. This makes comparisons to prior year or to 2019 tough due to the one-time nature of the royalty and license revenue. To be clear, our royalty and license efforts are a valuable component of our company, but these large settlements are non-recurring. The baseline recurring royalty and license activity is expected to be between $150,000 to $200,000 per quarter. Our focus and how we determine our long-term success is on product revenue performance. Second quarter product revenue was $15.2 million. representing growth at 56% year-over-year on a reported basis and 54% on a constant currency basis. The exceptional strong growth rates over 2020 were expected since the second quarter of 2020, with the quarter most severely impacted by COVID. As 2020 comparisons are less meaningful, we are more focused on how we are doing against 2019. Importantly, we saw sequential improvement from the first quarter growth rates when compared to 2019. We were down 33% to 2019 in the first quarter, and we were down 21% in the second quarter. We believe this trend will continue as reflected in the guidance I will discuss shortly. Sales of our new products were 14.3 million, representing a decrease of 24% versus 2019 on a reported basis. Sales of our conformance HIP system were approximately 900,000, an increase of 82% versus the second quarter of 2019. As a reminder, our HIP franchise is fairly new, and it's still in the early stages of growth. U.S. product revenue was $13.4 million, representing a decrease of 22% from 2019, which was also an improvement from the first quarter decline. Rest of world product revenue was $1.8 million, a decrease of 17% from 2019, but again, improvement from the first quarter. Our second quarter product gross margin was 42% of revenue, which was down 210 basis points from the first quarter. This was driven primarily by higher scrap, equipment repairs, manufacturing variances, and a decline in product sales price. Near term, we expect our gross margin rates to be in the mid-40s, growing over time as we ramp up imprint knee sales. Total operating expenses for the quarter were $16.6 million, which reflects the modest investment we are making in sales and marketing and R&D. It also reflects high G&A related to investment and professional fees we're making to protect our IP. We now have a well-established approach to protecting our IP and we remain confident of favorable outcomes in pending and future cases. Our expectations for operating expenses for 2021 year remain unchanged from what we communicated last quarter. We anticipate sales and marketing expense to be between 26 and 27 million for fiscal year 2021. R&D to be between 16 and 17 million, and G&A to be between 28 and 29 million. Moving to our bottom line performance, we generated net income of $38.0 million in the quarter, or 21 cents per share. The net income was driven by non-recurring items I listed at the beginning of my remarks, namely the 41 million of royalty and license revenue, 4.8 million of other income from the PPP loan forgiveness, and $2.5 million of other income related to R&D and the Stryker Development Agreement. The net income in the second quarter included foreign currency exchange income of $500,000 compared to foreign currency exchange income of $700,000 in the same period last year. Our balance sheet remained strong as we had cash and cash equivalents of $108.3 million, which was slightly higher than the $104.6 million as of March 31, 2021, and significantly higher than the $28.7 million as of the beginning of the year. Lastly, I would like to provide some thoughts on our outlook. Our practice of providing full-year guidance remains suspended due to the level of unpredictability caused by COVID. However, as we have done for the past several quarters, we are giving next quarter guidance with some thoughts on the rest of the year. Based on our performance through July and our forecast for August and September, we expect our total product revenue to be between $15.5 to $16.5 million. which at the midpoint is another strong move to further close the gap as compared to 2019. Another important note is that this guidance assumes sequential growth in product revenue when historically revenue goes down in the third quarter. In addition, as we exited the second quarter and through the month of July, activity levels in our weekly CT scans have kept us cautiously optimistic. But we are clearly not back to where we were in 2019, We do not expect to be until the fourth quarter of 2021 or the first quarter of 2022. We believe that office visits and elective procedures will continue to improve throughout the second half of this year, assuming, of course, there are no unanticipated complications with vaccinations or any setbacks from the rise of COVID cases due to the latest Delta variant, which appears to be the variant with the most disruption potential to date. Our goal for the fourth quarter remains the same. we'd like to see product revenue get back to what we generated in the fourth quarter of 2019. As a reminder, we typically experience a sequential bump in revenue in the fourth quarter as individuals complete procedures prior to the annual medical plan deductibles resetting on January 1st. While the sequential increase was fairly modest in the fourth quarter of 2020 due to COVID, our expectations for fourth quarter revenue of 2021 factors in a more normal sequential lift from the third quarter. With that, I'll turn the call back over to Mark.