OrthoPediatrics Corp.

Welcome to the quarter three 2020 Orthopediatrics Corporation earnings conference call. My name is Holly and I'll be your conference operator today. After the speaker's remarks, we will have a question and answer session. To ask a question, you will need to press star then one on your telephone keypad. To withdraw a question, press the pound key. Please note that this conference is being recorded. I will now turn the call over to John Medina. John, you may begin.

Thank you, Holly, and thank you, everyone, for joining today's call. With me from the company are Mark Throttall, Chief Executive Officer, Fred Haidt, Chief Operating Officer and Chief Financial Officer, and David Bailey, President. Before we begin, I would like to caution listeners that comments made by management during this conference call will include forward-looking statements within the meaning of federal securities laws, including the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve material risks and uncertainties, and the company's actual results may differ materially. For discussion of risk factors, including, among others, the risks related to COVID-19, the impact such a pandemic may have on the demand for the company's products and the company's ability to respond to the related challenges, I encourage you to review the company's most recent quarterly report on Form 10-Q, which will be filed with the Securities Exchange Commission soon. During the call today, management will also discuss certain non-GAAP financial measures, which are used as supplemental measures of performance. The company believes these measures provide useful information for investors in evaluating its operations period over period. For each non-GAAP financial measure referenced on this call, the company has included a reconciliation of the non-GAAP financial measures to the most directly comparable GAAP financial measures in its earnings release. Please note that non-GAAP financial measures have limitations as analytical tools and should not be considered in isolation or as a substitute for orthopediatrics financial results prepared in accordance with GAAP. In addition, the content of this conference call contains time-sensitive information that is accurate only as of the date of the live broadcast, November 5, 2020. Except as required by law, the company undertakes no obligation to revise or update any statements to reflect events or circumstances that take place after the date of this call. With that said, I'd like to turn the call over to Mark.

Good morning, everyone, and thank you for joining us today on our third quarter 2020 earnings conference call. I'd like to begin by recognizing all our orthopediatrics associates for their tremendous effort. which has produced the strong results during the recent quarter, including record revenue and improved EBITDA. The pandemic continues to pose challenges, particularly in some overseas markets, but our associates have been able to excel during these times of unprecedented difficulty. While the operating environment remains highly uncertain, the positive momentum we have seen since May accelerated during the recent quarter and has continued into October. We delivered accelerating growth in the United States, improved our gross margin, and produced improved EBITDA and positive adjusted EBITDA. This morning, I'll begin by providing an overview of our results by geography and product line, including our thinking on procedure recovery rates in the U.S. and abroad. I will then discuss our recent acquisitions, following which I'll comment on additional progress and factors driving our business. I'll then turn things over to Fred for a detailed financial review and guidance for the fourth quarter, and we'll then open the call up to your questions. The U.S. recovery, which began in the second quarter, continued to accelerate in the third, and we achieved domestic growth of 17% year over year, with trauma and deformity and scoliosis growing in line with total domestic sales, and scoliosis increasing total users 33% on a year-to-date basis over third quarter 2019. This was a tremendous improvement over the 12% decline seen during the previous quarter. Moreover, U.S. sales continued to accelerate monthly during the third quarter, and we have seen consistent increases in domestic sales every month since April's sharp decline. October domestic sales continued strong and confirm that we are clearly on an upward, although choppy, trajectory. However, we are concerned by the recent spike in COVID-19 cases nationally and cannot predict whether there will be another deferral of elective surgeries in this country. As we consider the final quarter of 2020, we believe we remain on a solid footing for continued strong domestic growth, which will be slightly improved over Q3's performance. The recovery overseas continues to lag that in the U.S. Most pediatric surgery abroad occurs in general hospitals, many of which also treat COVID cases. There remains a high degree of last-minute case cancellations which may be due to parental concerns over bringing their children to these hospitals. Additionally, given the low procedures, our stocking distributors have made little to no set purchases in Q3, and we expect the same in Q4. While international sales declined 34% year over year, EMEA and APAC were relative bright spots, Sales in EMEA grew 5% during Q3, driven in part by agency sales growth, while APAC was up 7%, driven in part by strong agency performance in Australia. Overall, agency sales grew 26% and accounted for half of third-quarter international sales compared to 25% historically. This helped drive strong gross profit performance in Q3. Despite the recent growth of COVID cases in many countries, so far we have seen only localized impact on elective surgeries. In addition to lagging the U.S. recovery, trends overseas are also more variable, geography by geography, notably in Latin America, which was the company's sole disappointing region in Q3. Continued challenges notwithstanding, we remain committed to the regions. and we are continuing our aggressive training programs and surgical society support. Moving on to revenue contribution by business, trauma and deformity sales increased 8% for the third quarter. Domestic sales were driven by very strong trauma growth and encouraging signs of recovery in elective deformity correction surgery, PNP femur, cannulated screws, and orthex all contributed substantially to domestic sales growth as well. Worldwide scoliosis sales increased 1%, with domestic growth in line with overall U.S. sales growth, driven by response and Firefly, as well as a 33% increase in total users year-to-date compared to prior year. Sports medicine and other grew 56%, reflecting contributions from Telos partners. Turning to acquisitions, while representing a small percentage of our sales, we remain pleased with the revenue impact of Telos, which won several multi-year consulting contracts with new medical technology clients. We acquired Telos in March to bring into the company state-of-the-art expertise on regulatory trends and clinical trials management. and this expertise is highly sought after in the COVID-19 environment. While we manage Telos on an arm's-length basis so its clients can be assured of confidentiality, we have benefited from Telos' knowledge that enables orthopediatrics to gather clinical data on our surgical systems and anticipate future regulations in a sure-footed manner. Orthex continued to deliver strong growth, with a number of new users and sales agencies performing their first cases. Fifty percent of our U.S. sales force is now actively supporting complex external fixation surgery. Orthex was recently approved in Australia, where we're now booking cases. We anticipate launching Orthex in Europe with the CE mark in Q1 2021. and in preparation are hiring a European Orthex sales director to handle the strong demand we are already seeing. It is clear that the Orthex acquisition, our first, is producing synergy with the extensive line of internally developed surgical systems we have launched since the IPO, thus increasing our credibility as the supplier of choice to pediatric hospitals. Acquired in April, Apifix represents another selective technology acquisition that can increase the scale of our scoliosis franchise, which has grown between 20 and 40% annually over the past years. Apifix is one of two recently approved non-fusion technologies and represents a revolutionary approach to how scoliosis is treated. As a reminder, Earlier this year, we received FDA approval to expand the label to 35 to 60 degrees for progressive curves from 40 to 60 degrees previously. This allows the Apifix system to compete head-to-head with spinal tethering, the only other non-fusion technology approved for use in skeletally immature patients. However, Apifix is a much simpler surgery than spinal tethering. which comes with a significant learning curve. As with Orthex, from a return on capital perspective, we anticipate benefiting from very high revenue contribution per dollar of set inventory. To date, Apifix sales have not been material to the company, but we anticipate this changing next year. Apifix has achieved significant milestones in its short time with Orthopediatrics, The system is now in various phases of IRB approval at 20 sites in the U.S. Of these 20 IRB sites, seven are now fully approved to conduct surgery, having received both IRB and registry approvals. We anticipate that the balance of the sites will be fully approved by year end or early 2021. Nine surgeries have occurred at four sites, and each case has been an unqualified success. The other three recently approved sites have scheduled cases which will be completed very soon. Surgeons are responding enthusiastically to the results they can achieve with Epifix. Correction is comparable to fusion but with a much simpler surgery and reduced procedure times. Cases are completed within several hours or less. Surgeons also like the short hospital stays for patients which range from 24 to 48 hours as well as the fast post-op recovery times. We expect IRB sites to continue their internal approval process with surgeries commencing in most of the 20 hospitals by year end or early 2021. We have agreed with FDA that the first 200 patients in the U.S. will be included in a registry, and we anticipate that these cases will be completed by mid to late 2021. Switching gears to factors enhancing our competitive advantage, the pandemic has thus far proven to be an excellent opportunity for strengthening our industry-leading position in pediatric orthopedics. The company has remained committed to supporting our patients and surgeons with no reductions in financial support of important surgical societies in stark contrast to other industry sponsors. In Q3, this included maintaining our gold-level support of the Scoliosis Research Society, our platinum-level support of the American Academy for Cerebral Palsy and Developmental Medicine, and our diamond-level sponsorship of the 30th Annual Baltimore Limb Deformity Course. We grew the domestic sales organization headcount by 5% over the third quarter 2019 to 166 sales representatives. Given the uncertain environment, we are proud that our domestic sales agencies continue to make personnel investments that will drive future growth, a tangible indicator of their confidence in orthopediatrics and the market we serve. As the U.S. market continues to normalize, we expect an increased number of new sales associates to be hired in Q4. While our international business remains more significantly affected by the pandemic, and we cannot predict when consistent OUS growth will return, there are a number of tailwinds that can significantly impact growth in 2021. These include significant numbers of new regulatory approvals completed in foreign jurisdictions, the launch of Orthex with the CE mark in Europe, the launch of individually packaged sterile configurations of most orthopediatrics products that are now in demand by many European hospitals, and the upcoming conversion of multiple stocking distributors to sales agencies. Distributor conversion discussions are in an advanced stage in three EMEA markets, and conversion should be completed by year-end 2020 or the first quarter 2021. As a reminder, our sales agencies here and around the world do not take title to product. Instead, they are paid a commission on sales generated, but Orthopediatrics decides on the pace of consignment of said inventories, which remain on our books. Converting a stocking distributor to a sales agency allows us to bill customers directly at full hospital prices, thus doubling our revenues and gross margins. More importantly, it allows us to accelerate the pace of organic growth in the market. Regarding inventory investment and operations, we largely maintain instrument implant set deployments, with $13.1 million in investments during the first nine months of 2020 versus $13.7 million in the same period last year. We have made significant progress consolidating the number of our contract manufacturing suppliers. Several years ago, we embarked on a strategy to consolidate 80% of our implant volume in the hands of a single supplier in northern Indiana, that was equally dependent on orthopediatrics. This strategy has largely been implemented in 2020, giving us lower costs, greater control over quality, and increased responsiveness. Here in Warsaw, we are now constructing a 20,000 square foot warehouse, nearly three times the size of the warehouse expansion completed only 18 months ago. We anticipate that the new facility will be completed in Q1 of 2021. Longer term, the current warehouse will be converted to office space for new personnel. We also expect the beta launch this year of a new mobile app that is now well along in development. This app will allow surgeons and sales consultants to access all OP's training videos, surgeon technique guides, and other information on the company's 35 surgical systems, both before and during surgery. We view ourselves as the market leader in pediatric orthopedics. We have recently seen a few companies announce initiatives in our market, and we welcome the wider commitment of industry to the well-being of children. However, being the market leader is more than just cherry-picking one or two lucrative pediatric products. It is more than just bundling several old products together under a new marketing banner It is more than so-called entrepreneurial initiatives to cobble together a company that seeks a quick sale to a strategic or financial buyer. Being the market leader requires a long-term, multidimensional commitment to innovative product development, selective acquisition of complementary technologies, investing in non-commercial clinical education, and leading the financial support of pediatric orthopedic surgical societies. Being the market leader requires a built-to-last strategy of steady execution that balances growth with profitability. We believe that Orthopediatrics has continued to exercise market leadership and resiliency, even in the pandemic environment, both during its shutdown earlier this year and during the improved operating environment that has followed. In the process, Nearly all of our 2020 corporate objectives have tracked to plan thus far. As we consider the last quarter of the year and prospects for 2021, we believe that our market leadership and resiliency will continue to benefit our customers and our shareholders. With that, let me now turn the call over to Fred to review our financial results and provide an outlook for Q4. Fred.

Thanks, Mark. Total revenue for the third quarter of 2020 was a record-setting $22.2 million and a 7 percent increase compared to $20.7 million for the same period last year. U.S. revenue for the third quarter of 2020 was $19.6 million, a 17 percent increase compared to $16.8 million for the same period last year, representing 88 percent of total revenue. International revenue for the third quarter of 2020 was $2.6 million, a 34 percent decrease compared to $4.8 million for the same period last year, representing 12 percent of total revenue. With domestic sales growth accelerating during the third quarter, we are very encouraged that we could build on the momentum we carried from earlier in the summer. Outside of the U.S., as Mark mentioned, With fewer standalone pediatric hospitals, the ex-U.S. procedure trends are taking longer to normalize, and recovery in the international market continues to lag the recovery we've seen in the U.S., which also has resulted in little to no set sales to our stocking distributors outside of the U.S. That being said, international performance was strongest in EMEA and Asia Pacific, particularly with the sales of our sales agencies. The recovery overseas is also more variable, with Latin America a lagging performer for OP during the third quarter. Our third quarter revenue breakdown by product category was as follows. Trauma and deformity revenue was $15.0 million, an 8% increase compared to $13.8 million in the same period last year. Strong growth in trauma continued to drive domestic sales with encouraging signs of recovery seen in elective deformity surgeries. Scoliosis revenue in the third quarter of 2020 was $6.6 million, a 1.3% increase compared to $6.5 million in the same period last year. And as Mark mentioned, our domestic scoliosis business showed improvement during the latest quarter. Lastly, sports medicine other revenue in the third quarter of 2020 was $0.7 million, representing a 56% increase over the $0.4 million in the same period last year. TELUS continues to perform very strongly. As mentioned earlier, the U.S. growth rate of trauma and deformity and scoliosis grew in line with our overall domestic growth of 17%. Moving down the income statement, Gross profit for the third quarter of 2020 was $17.6 million, an 11 percent increase compared to $15.9 million for the same period last year. Gross profit margin for the third quarter of 2020 was 79.4 percent compared to 76.6 percent for the same period last year. The strength in gross margin was driven by a large percentage of domestic and OUS agency sales with little to no set sales to our OUS stocking distributors as a result of COVID. Sales and marketing expenses in the third quarter of 2020 increased 5% to $9.2 million, compared to $8.8 million in the same period last year. This was driven by an increase in unit volume sold and associated commissions in the U.S. and international markets with sales agencies. General and administrative expenses in the third quarter of 2020 were $9.8 million, an increase of 35% over $7.3 million in the third quarter of 2019. The increase in expense was primarily driven by the increased non-cash stock compensation, depreciation, and amortization expenses, as well as the addition of Appifix and Telos G&A. Research and development expense of $1.1 million in the third quarter of 2020, a decrease of 23 percent from $1.4 million in the third quarter of 2019. Total operating expenses in the third quarter of 2020 were $20.1 million compared to $17.4 million for the same period last year. Operating loss in the third quarter of 2020 was $2.5 million compared to a loss of $1.5 million in the third quarter of 2019. Adjusted EBITDA for the third quarter of 2020 was a record-setting $1.1 million compared to $0.7 million for the third quarter of 2019. This performance was achieved in the middle of a global pandemic with single-digit overall sales growth and was a result of effective cost containment across all aspects of our business, combined with continued strategic investments in the business, which will drive future growth. Interest expense in the third quarter was $1.0 million, compared to $1.3 million in the same period last year. The $1 million expense in the current quarter includes $0.8 million for the accretion of the AppyFix acquisition installment payments. Effectively, this is the difference between the net present value of the liability and the total anticipated value expected to be paid in the future. Separately from interest expense, we also had a non-cash charge and other expense for the fair value adjustments of contingent considerations of $900,000 associated with the APIFIX year four payment, which is based on sales performance. Net loss from continued operations for the third quarter of 2020 was $4.5 million compared to a net loss of $2.9 million in the same period last year. Net loss per share in the third quarter of 2020 was $0.24 per basic and diluted share compared to $0.18 per basic and diluted share in the same period last year. Turning to our balance sheet. As of September 30, 2020, our cash and restricted cash was $89.7 million, compared to $114.4 million as of June 30, 2020. Related to our debt, on July 15, 2020, we repaid our $20 million principal amount outstanding under our term loan agreement, together with all unpaid interest and other related amounts payable. And currently, we have no outstanding long-term debt. We also expanded our $15 million revolving credit facility up to $25 million and extended the expiration date from January of 2023 to January of 2024 at a 10% interest rate with the full $25 million currently available to us. The change in property and equipment during the third quarter of 2020 was $1.3 million, which compares to $2.0 million during the same period last year, reflecting a decrease in construction and process, which includes partial sets waiting to be deployed. Including implants, $4.0 million of consigned sets were deployed during the quarter, compared to $1.7 million during the third quarter of 2019. Year to date, we have now deployed $13.1 million of sets compared to $13.7 million in 2019. We now turn to our outlook. Regarding our performance during the last quarter of 2020, the company expects overall sales growth in the fourth quarter to be similar to the third quarter of 2020. Fourth quarter sales growth in the U.S. is expected to accelerate slightly while the international sales decline in the fourth quarter should be similar to that of the third quarter. As we discussed, the recovery overseas is lagging the domestic market, and performance by geography is uneven, particularly in Latin America. As we continue into the remainder of the fall and either winter months, there's also the continued dynamic of the pandemic to consider both in the U.S. and abroad. As we continue to advance our strategic review and planning sessions, we see a number of tailwinds benefiting growth in 2021. These include robust AppyFix growth that will start to have a significant impact on our revenue. We expect Orthex conversions will continue to accelerate both here and in Europe. Individually packaged sterile products will be launched in Europe. We will convert at least three EMEA stocking distributors to sales agencies with a doubling of revenue and gross margins in those countries. And the company expects to continue to gain share OUS as well as within the major pediatric centers in the U.S. Consequently, while the pandemic environment will continue to evolve and potentially in unexpected ways, our proven business model consistent and strong execution, continued focus on cost containment, and our strong balance sheet all combined to provide us confidence in the future. Let me now turn the call over to Mark for some final comments.

Thanks, Fred. In conclusion, the past nine months have been a strong reminder of how fortunate we are to serve the surgeons and healthcare providers we're proud to call our customers. We have unbounded admiration for their sacrifices as they put their lives on the line to improve the lives of children. I would also like to thank our associates throughout the world for their personal leadership that has allowed us to treat more than 188,000 children since 2008. I'm confident that our consistent execution will continue strengthening orthopediatrics' leading market position in pediatric orthopedics. And I'm confident that we will emerge from the COVID pandemic even stronger than when we entered it. With that, let's turn the call over to your questions, please.

Thank you. And as a reminder, if you would like to ask a question, please press star then one on your telephone keypad. And our first question is going to come from the line of Ryan Zimmerman, BTIG.

Thank you. Good morning, everyone. Hey, Ryan. How are you doing? Good, thank you. I just want to follow up on a couple of dynamics that you've talked about. One, I think at our recent investor meetings, you talked about a dynamic in the fall where the scoliosis season was extending into the fall a little bit, typically done in summer. And so I'm wondering, Mark, if you can give some commentary and thoughts around how that is playing out and what that says maybe about the durability or the seasonality you expect going forward here and what it could suggest for fourth quarter season. around scoliosis, and then I have a follow-up.

Certainly, Ryan. Dave Bailey has actually been talking to a number of our scoliosis surgeons personally on this issue. Dave?

Hey, Ryan. How are you? I think what we are seeing is a bit of a tail on the summer scoliosis season. We started to see that tail kind of continue to pick up through the balance of the end of summer and early into the fall. While it's too early to determine what the long-term ramifications are of COVID in terms of the seasonality of our business, I think what we can say is that we're very pleased with the rate of surge in adoption of our products in the scoliosis space, and we are starting to see a bit of a ramp into the back few months of the year here that would probably signal that we're picking up some of those cases that weren't done during the normal scoliosis season in the summer.

helpful. And then, you know, on this initiative to offer individually packed sterile products, you know, is there something competitively that changed that triggered your interest in pursuing kind of that individual packaged sterile product portfolio? I'm just curious, kind of, you know, we've seen that in some other markets, we've seen that with some other competitors. I'm just wondering if that's something you're now pursuing more aggressively, particularly in the European market, and maybe what the driving force is behind that.

I think Dave and I can both comment on that very quickly. My observation has been this is something we've been working on three years and has been an enormous undertaking in terms of finding the appropriate people who can sterilize and configuring products and gaining regulatory approval to make that happen. This has been something that has been in demand in Europe for some time.

Yeah, Ryan, this is, at least at this stage, is an entirely European phenomenon for us. And as Mark said, it's something we've been working on for a number of years. A number of accounts, and even in some countries right now, that are demanding our products or wanting our products require the products to be individually sterile packed. And while I'm not certain that the surgeons specifically are interested in that, I do believe the regulations are mandating that in the future. And so we wanted to be ahead of that curve when it was demanded of us in Europe And so that's why we've invested in that, and we're very pleased with the fact that we're near the completion of our capacity to sterilize these products and get them to our customers in Europe. We see no demand in the United States for individually sterile packaged products beyond the fact that in certain ones of our systems, we will probably benefit in terms of our asset utilization metrics with the ability to have just the implant sterile for certain of our larger kits. And so you may see over the coming years diversification of a portfolio whereby some of our instrument sets might be non-sterile, but some of the implants might be sterile, which is very common in industry. But certainly internationally we see a demand. Domestically we see little to no demand for that within the children's hospitals.

Got it. Okay, and then just squeezing one more for Fred. I don't want to leave him out. The gross margins certainly were driven. It's very clear in the lack of set purchases internationally, and it sounds like that should continue at least into the fourth quarter. But following that, Fred, should we expect gross margins to revert back to maybe more normalized levels closer to the mid-70s in 2021 as you do expect stock distributors to purchase sets potentially at lower margins in 2021? Thanks for taking the questions, guys.

Yeah, Ryan, thanks for including me. The third quarter is always our highest gross margin when you look back in history because the revenue is always the highest in the third quarter, and then traditionally the fourth quarter revenue is always a little softer, and so the margins will come down a little bit in the fourth quarter. With that being said, we do anticipate that in 2021, we will get the benefits of the more sales coming from our agencies outside of the U.S. So while 2020 has been a little unusual with limited set sales, we do think that we can continue kind of the 76%-ish plus or minus gross margin next year, which is similar to what we're going to see this year. as we do increase agency sales and at the same time start to sell sets at the zero margin that we've done historically.

Understood. Thank you. Thank you, Ryan.

And our next question will come from the line of Dave Turkley, J&P Securities.

Great. Good morning, guys. Congrats on the domestic rebound. I just wanted to get your thoughts quickly, Ryan, Obviously, you did mention some concern over some COVID hotspots. Are you seeing anything recently that gives you any more pause domestically? What are your sort of assumptions as we move into now that we're in 4Q about do you think elective procedures and hospital shutdowns may occur again or any areas where that might be happening?

So far we're not seeing that occurring, and I think that we're simply guarded as to what the future might bring. I think we would agree with others who observe that hospital stays generally are now shorter, treatment is more robust for COVID patients, and we continue to, of course, see the majority of our business occurring in pediatric hospitals that would be unaffected. Internationally, it is a different story. In the U.K., there has begun yesterday a lockdown, a circuit breaker for the situation, and that will impact surgeries in non-pediatric centers. Italy, France, Spain are not quite as bad, but that is occurring there as well. So internationally, we're much more guarded with regard to the impact of deferral of elective surgeries.

Got it, and you mentioned the three conversions that are likely to happen. I was just wondering if you would comment on, you know, how many others are there that you could look to do, let's say, over the next couple of years?

Yeah, Dave, this is Dave Bailey. I think that there are others. I think these three are probably the big ones for us at the moment, and so we've really focused our attention on ensuring that we can get these accomplished, been in the works all year, and as you can imagine, this isn't a simple process, and it isn't aided, frankly, by a COVID environment where traveling to outside of the United States has been very difficult. So the great majority of our focus has been on getting these three done, and I think we'll be very pleased to have that accomplished here by year end or end of the first quarter. and I think those three markets will have a substantially larger impact than any of the other markets, at least in the short term, that we may choose to take towards the agency model. That said, there are others. Those would primarily be other substantial markets in Western Europe, and we are in early discussions with a few others. We may see the opportunity to do this with one or two Middle Eastern markets, But at this time, our heavy focus is really on these three markets in Europe that I think will substantially benefit us in 2021. Thank you. Thanks, Dave.

Thank you. Our next question is going to come from the line of Mike Mattson with Needham & Company.

Good morning. Thanks for taking my questions. I guess I wanted to start with the international business, the decline that you saw there last Obviously, there's some procedural impact, but I was wondering if you could quantify or have a feel for the difference in the kind of destocking slash set sales impact versus the actual procedure decline that happened there, or maybe you just don't have visibility to that.

Yeah, I think what I would say is we're very pleased by the growth that we did see in our agency sales So, those that are selling direct to the hospital of 26 percent is very encouraging for us. And really, the large majority of the production year over year came from the lack of set sales that we have traditionally experienced as our small independent stocking distributors historically would be purchasing those sets to grow and continue to expand their marketplace And given COVID, they're still trying to get their feet underneath them and catch up on a cash basis before they're willing to reinvest more cash into their overall business. So the demand, we do think the overall demand is less than what we're seeing in the U.S. because there are so many hot spots where things have slowed down. But clearly, the reduction year over year is driven by the lack of set sales. In addition to that, I would point out that the currency fluctuations in Brazil has continued to have an impact on the business. The real is about 5.7, 5.5 in that range. It was about 3.5 about this time last year. So it's had a significant change in the overall cost of U.S. products being sold into Brazil.

Okay, thanks. That was helpful. And then this move to this supplier, the 80% of your manufacturing, has that helped your gross margin or do you expect it to help your gross margin and can you quantify what the impact of that is expected to be?

I think it would be my perspective that we're not doing this to improve gross margin as much as we're doing this to improve responsiveness and control over quality, because this is a supplier that's 40 minutes from our facility here in Warsaw, Indiana. Fred, do you have any sense, though, as to whether there is a material gross margin impact here?

Yes, I completely agree. The main focus here is speed and getting product, particularly around our launches. But with that being said, our overall dramatic increase in volume to where we were, you know, three years ago has earned us volume discounts, particularly with this one supplier, which has helped our gross margin a little bit. But more importantly, it's reduced the amount of capital needed to deploy new sets into the marketplace. So, for example, that $13 million that we deployed this year maybe cost us, you know, $14 million three years ago if you look at the cost we're paying today to what we've paid historically.

Okay, that makes sense. And then just in terms of the M&A pipeline, I didn't hear as much commentary on that. I know you've done a few deals, so maybe you're going to digest those. But, you know, what's the outlook there? Has the pandemic helped or hurt the M&A prospects? companies out there that are willing to sell and pricing, things like that. Thanks.

Yeah, Mike. So I think it would be a good assessment that you made that we were going to have to digest some of the technologies that we've acquired here over the last few years. Obviously, you know, we have a huge ramp in the Orthex business and we're aggressively still launching and deploying sets and training the sales force to On the Apifix side, we're barely starting the first inning here on Apifix. While the Apifix acquisition wasn't complicated in terms of joining the organizations, certainly launching that product in the United States and around the world is consuming a lot of energy. So I don't expect that you – you can expect not to see anything major on the horizon, or at least short-term. You might see some small bolt-on stuff, particularly in the external fixation area. We really like our position with the Orthex Hexapod, but there are some add-on technologies and products there that I think could strengthen our market position, but those would be very small. And we continue to be interested in partnerships, as we've said in the past, around digitization of the OR, interoperative navigation solutions, preoperative planning solutions, And so, you know, we are always in discussions there with how we craft our strategy in pediatrics, which we feel is, frankly, very different than how the OR is being digitized in the adult space. But nothing major on the horizon, at least in the near term.

Okay. Thank you. Thanks, Mike.

Thank you. Our next question will come from the line of Matt O'Brien with Piper Sandler.

Well, thanks. Morning. Thanks for taking the questions. And I'll start with Fred to make sure he doesn't feel left out at all.

Excellent.

Thank you. Of course. Of course. Fred, so, you know, you made a lot of comments about your confidence in 21, you know, with, you know, the set deployments and new products and happy fix and conversions of, you know, distributors to direct. As I look at the street numbers for next year, essentially we're assuming that, you know, you get all the revenue you lost this year back, you know, next year, and then you also grow again around that 20%, you know, level for next year. So just, you know, not wanting to get too much into guidance for next year right now, but just, you know, from a set perspective and from a, from a personnel perspective, can you deliver that type of a performance next year where you're getting close to $100 million in sales?

Yeah, I think the message was just relaying how strong we feel about the confidence in our business and our business model. Obviously, we have to react, and our results will be based on COVID, both domestically and outside of the U.S., And we can't predict that. Nobody can. But regardless of COVID, we're very confident in our ability to continue to grow the business. We have many, many really positive growth drivers that we're going to be coming online here next year. And we're going to do very well to continue to take share, both domestically and outside of the U.S. You're right, I don't want to get into predicting next year's revenue at this time. But I think the message is just clear that we're very, very confident. We're very pleased with the progress we've made this year in moving the business forward and strengthening the business model. And that's going to continue to benefit us in the long term. And we'll really start to see some of that kick in next year in 2021.

Got it. Okay. And then just, I guess, another one for you, Fred. On the instrument set side, you seem to be the czar as far as the sets go. you know, what are your thoughts as far as set deployments, you know, are looking like into the future? Because I think, I know in Q3 you're up a ton, but I think, you know, year to date you're roughly flat. So should we see, are we expecting an acceleration in set deployment here in Q4 and then into next year versus what we've seen here in 2020? And then can you talk at all about the productivity of those sets? And then I do have one more follow-up for either Mark or Dave.

Thanks. Absolutely.

Yeah, so it's 13.1 versus 13.7. So it's similar to what it was at this time last year. We do anticipate to continue to roll out more sets here in the fourth quarter. as we continue to invest in these sets. A lot of it is focused on new products, products that have been developed or launched in the last couple of years and continuing to get more of those sets out there, which is very encouraging to see. Some of that is to our agency countries outside of the U.S., so we're investing and growing those locations as well. And we would fully expect that that will continue into next year at a similar pace The really encouraging part is that when we talk about AppyFix, for example, or Orthex, those systems are very, very capital efficient. And so as those two systems become larger and larger percentage of our sales, the need for capital deployment will go down. And we're encouraged by that and think that we'll continue to benefit from that starting next year a little bit, but definitely beyond that point. The return we're seeing obviously is a little skewed because we look at it on a trailing 12-month sales basis. And so with the second quarter sales softness, it skews the overall return. But the bottom line is we are absolutely pleased with the return we're getting on all the sets, in particular the new products that are being deployed and the adoption of those new products. Mark mentioned the PNP, the cannulated screw. PDFOOTS, all those systems are really, really having strong adoption. And so it's driving demand for more sets, which will continue to deploy here this year and next year.

Okay, well, that's really encouraging. And then I guess the last one, again, for either Mark or Dave. On those, you know, on AppEffect specifically, given how excited you are about that product, can you talk about those 20 IRB sites? are they all existing customers or any of them new customers to orthopediatrics because of ApiFix? And then if they're not, if they're all existing customers, are any of those, you know, historically they've been smaller customers, but because of ApiFix and the opportunity there, they could be much, much bigger customers for orthopediatrics going forward?

Thanks. It's a mix, Matt. There are some existing customers. There are a number of new customers. Most interesting to me is there are a number of new surgeons, who have never used orthopediatrics response system. And so we would expect over time that there would be a pull-through of our conventional scoliosis fusion technology as these surgeons get to know us as a supplier and they see the outstanding service that our sales representatives might provide them. Did you have any other comments, Dave, more specifically?

Yeah, Matt, I think we're really bullish about the opportunity to pull through a number of response cases in the next few years from these accounts. I would say more than half of these accounts are not active users of the response system. And they're, as you know, very substantial accounts with very substantial well-known key opinion leaders. So while they may be using our trauma and limb deformity products, they haven't historically been active users of the response system. And even in some of these accounts, Matt, we have struggled historically to get our product or the response product approved. because of potential contracting obligations they have with another supplier like Medtronic or Depew. And we're in a good spot now in that circumstance, because if you remember correctly, the Apifix device requires the use of two response screws. And so to use the Apifix device within an IRB site, a site is also required to approve for use on contract the response system. And so this gives our sales force a very nice hunting license into some substantially large key accounts that have historically not, we have historically been shut out due to contracting. And so that was one, really one of the drivers short term for the acquisition of Appifix beyond, you know, how it's going to impact the lives of children through a non-fusion technique.

That's very helpful. Thank you so much.

Thank you. And our next question will come from the line of Kayla Crum with Truist Securities.

Hi, guys. Thanks for taking our questions. So you guys mentioned really strong growth in scoliosis users. So I'd love just to get your sense as to whether or not you're seeing new users grow due to excitement around mid-C or what specifically is driving that, and then just how you're thinking about that translating into stronger revenue growth in the coming quarters.

Yeah, so that's a great question. I think that it's a combination of things here. Certainly we are tracking new users of our scoliosis system and the response system as a result of their exposure to the spine portfolio through the mid-C. We are definitely seeing that. But I think what we are really seeing probably more broadly is just the permanence of orthopediatrics in the marketplace. As you know, this is really, I believe, only our sixth scoliosis season with a product, and we compete against companies that have been in the marketplace selling pedicle screws in these accounts for 20, 30 years. And so the fact that I think these accounts consistently see sales reps, we have extremely low turnover within our selling organization. They're being serviced across multiple different products by the same sales force. I think the trust that we're ultimately building with our customers is Now for six years of Scoliosis sales and, you know, 12 years of product sales to these accounts is a bit of a tidal wave that is every quarter, every year, attracting more and more customers to our company more broadly. And we have good technologies on the Scoliosis side, and I think it's bolstered by the add-on of technologies like Firefly as well as technologies like the Mid-C. And, you know, we're just seeing kind of all of those influences happening move customers to give our scoliosis systems a try. And when they do, I think that we're seeing a lot of stickiness in people adopting the product once they give it a go. So as we think about primary demand long-term, I know no other way to determine what things are going to look like in the future other than to look at the total number of people who are using your product, which are well in excess of 100 at this stage and growing rapidly. And to say that when we return to a completely normal or more normal environment post-COVID, having dramatically more customers, I think, points to a substantially, you know, increasing growth number or revenue number over the course of the long term.

Great. No, that makes a ton of sense. And then I guess, you know, just on Mid-C, I think you guys mentioned that you've now done nine surgeries at seven centers. Can you just give us a little bit more insight anecdotal commentary, what you're hearing from those cases. Did those happen kind of in the last month or two? Just would love to hear a little bit more detail there. Thank you.

Sure. So, yes, those cases have really happened over the last few months, and we're seeing an accelerating scheduling trend. So I believe we have that in many cases, if not more, scheduled between now and the end of the year already. And so as we see surgeons complete their first procedure, get comfortable with With the procedure, see that patient and their postoperative outcomes of that patient. You know, after a few weeks, obviously you start to see those customers who are trying a new thing for the first time. Those customers start to get more comfortable, and we're starting to see booking patterns that reflect that. So the outcomes here have been fantastic. We've been able to, again, very short term, but we've been able to get great correction with surgeries that, I would say right now are averaging less than two hours, which is drastically different than a tethering procedure and even more drastically different than a fusion procedure. And, you know, we have some of our first patients now that are a few months out, completely returning to normal activities. So the feedback from the customers has been extremely positive. More recently, we had a first user group discussion where we had a number of the surgeons in the IRB sites that are awaiting approval. And that was led by one of the surgeons who has done a few of these procedures. And there was very good, strong participation. And the surgeons were very proud to share the results and their experiences with the product after the first few months.

Thank you, guys.

Thanks, Kayla.

Thank you. And at this time, we have no further questions at this time.

Okay, very good. Well, let me just close by thanking all of you for joining us today. We appreciate your interest in orthopediatrics and, of course, your support for the cause of helping kids throughout the world. So we hope everyone has a safe and healthy holiday season, and we're looking very much forward to updating you on our future progress. So everyone, please have a good day.

Thank you, ladies and gentlemen. This does conclude today's conference. You may now disconnect.