Integra Lifesciences Holdings Corp Q2 FY2021 Earnings Call

Good day, and welcome to the Integra LifeSciences Second Quarter 2021 Financial Results Call. Today's call is being recorded. At this time, I'd like to turn the call over to Mike Beaulieu, Director of Investor Relations. Please go ahead.

Thank you, Stephanie. Good morning, and thank you for joining the Integra LifeSciences Second Quarter 2021 Earnings Conference Call. Joining me on the call are Peter Arduini, President and Chief Executive Officer; Glenn Coleman, Chief Operating Officer; and Carrie Anderson, Chief Financial Officer.

Thank you, Mike, and good morning, everyone. I'm pleased to report strong results this morning, reflecting the continued momentum in the business, which enabled us to raise our full year guidance. If you'll turn to Slide 5 in the deck, I'll begin with a review of our second quarter performance. Total revenues were $390 million, representing reported growth of 51% and organic growth of 49% compared to the prior year. Our growth rates were above the high end of the guidance we provided in April and represent organic growth of approximately 3.7% compared to 2019. The gradual recovery in our business, coupled with growth acceleration in products launched over the last 18 months drove much of our strong performance in the second quarter. Sales were particularly robust across a vast majority of our franchises in both segments. Sales of capital equipment and products in some of our indirect markets are still early in their recovery and showing encouraging trends. Based on feedback from our commercial teams, we expect year-over-year improvement in the second half, especially with respect to capital. Profitability was also very strong in the second quarter with EBITDA margins of nearly 26% and adjusted earnings per share of $0.79. Higher revenue, favorable mix and integration savings drove much of our performance, offset somewhat by normalization of our expenses.

Thanks, Pete. Good morning, everyone. Please turn to Slide 8. As Pete indicated, our second quarter operating performance was better than expected. I'd like to highlight a few of the factors that contributed to our results and some of the progress we made during the quarter, including an update to the catalysts we discussed at our May Investor Day. Our performance in the second quarter sequentially increased $30 million or 8%. It was led by a recovery in our core portfolio of products in neurosurgery, instruments, burn trauma and surgical reconstruction.

Thanks, Glenn, and good morning, everyone. I'd like to start with a summary of our second quarter highlights on Slide 10. Second quarter total revenues were $390 million, representing an increase of 51% on a reported basis and 49% on an organic basis compared to the prior year. Compared to 2019, organic growth was 3.7% in the quarter and was broad-based, including positive organic growth in both segments as well as in both our U.S. and international markets. Revenues were approximately $12 million above the high end of the guidance range. Adjusted gross margins in the second quarter was 68.1%, an improvement of 190 basis points compared to 2020 and an improvement of 70 basis points compared to 2019. These gains were driven by a better-than-expected recovery in our revenues and favorable U.S. product mix, including the addition of ACell. Our Q2 adjusted gross margins came in slightly better than expectations. But as mentioned on our Q1 earnings call, our adjusted gross margins in the first half were impacted by higher manufacturing costs related to tight labor supply. We are also experiencing longer lead times for select sourced materials, resulting in some increases in freight. These labor and supply chain challenges will likely persist into the second half, and will keep us near the lower end of our full year adjusted gross margin range of 68.2% to 68.5% that was provided during our Investor Day meeting. Consistent with this outlook, though, second half adjusted gross margin should be modestly higher than the first half. We are closely watching material cost inflation and have supply contracts to largely reduce near-term exposure.

Thanks, Carrie. If you turn to Slide 15, I’d like to summarize a few of the takeaways. Our first half performance in COVID recovery was very strong. And when coupled with our outlook for the second half, gives us confidence to raise our full year outlook on both the top and bottom line. We had all hoped that the pandemic would be completely behind us as we begin the second half of the year. But it's now clear that the lingering effects are going to be with us globally for the coming months. That said, we're seeing very healthy recovery trends across all our businesses and geographies, and we remain optimistic about a strong second half of the year and full recovery in 2022. Our teams are adapting to a hybrid environment. And while we're returning to more in-person meetings, we'll continue to leverage all the digital tools that we've implemented over the last 16 months. In the second quarter, growth in many parts of our business exceeded pre-pandemic levels. Our new products will drive growth in '21 and beyond, and we believe many of these products in both neuro and regenerative tissue business represent breakthrough technologies that will deliver better patient outcomes through innovative therapeutic advances. We look forward to the launches of CereLink, our neuro critical care monitor, and the Aurora scope, the first product from our minimally invasive surgical platform. Each of these products raises the bar in their respective markets and advances our leadership position within neurosurgery. For the second half of the year, we remain focused on execution. We've sharpened our strategy and put in place the operational capabilities and leadership team to drive faster growth and greater value for shareholders in '21 and into the future. So that concludes our prepared remarks. Thanks for listening. And operator, if you wouldn't mind, please open up the lines for questions.

Our first question comes from Steve Lichtman with Oppenheimer & Company.

I guess first question I wanted to touch on with CereLink with the launch pending here in 3Q. Can you give us a sense of what the outlook on the rollout is? You've talked in the past about a lot of potential targets out there of both old Codman systems and competitive systems. How are you seeing CereLink potentially contributing to growth in the second half and then into 2022?

Steve, it's Glenn. I'll start off and maybe just first highlight some of the differentiating features of CereLink and why we're excited about it. First, it's more accurate than other products that are on the market as it has less microsensor drift. It's MR compatible. The sensor durability and flexibility is the best on the market. So it doesn't have kinking or bending because you can coil it, you can tunnel it, and surgeons really like that capability. And then it's got this advanced data presentation, which you can think of as a waveform on the actual product versus point-in-time reading. So you can measure ICP burden over time. And measuring that pressure and having some historical data can really inform clinical decisions, which is an important part of this new product rollout. Keep in mind, why we are excited about it, in addition to those features, is that we have the largest neuro sales force that will be rolling this out. In terms of the launch itself, we're going to do a controlled market release here in the third quarter, both in the U.S. and a handful of sites outside the U.S. So don't expect a lot of revenue in the third quarter associated with the controlled market release. We expect to then pivot to a full market release in the fourth quarter. We do have some pent-up demand, so we should see a nice uptick in revenues in the fourth quarter once we move to a full market release. What I really like about this product is we talk about hitting peak year sales 3 to 5 years out. And that's probably where we'll be in the U.S. market in 2025 or 2026. The nice thing is, though, we're going to be launching in China around that same time frame, which will drive additional growth for really the next 10 years when we look at CereLink. We see a real nice path here for a number of years relative to CereLink, the growth it's going to bring to us, not just on the upfront capital purchase, but also the disposable side of this as well. So hopefully, that gives you some color on how we're seeing it. But there's probably something close to 9,000 units out there that we could replace. Almost half of those are in China. So that's why we're excited about the longer-term aspects of not just the next 3 to 5 years but also the next 10 years; we have a real big opportunity here to upgrade the installed base and take market share from others that are currently in the market.

I think it's fair to say as well, I mean both our existing installed base and most of the competitive installed base is over 10 years old. I mean some of these items have been out for 15 to 18 years. And so there's clearly a need; I think a lot of you know that this idea of cerebral pressure, brain swelling is one of the most critical metrics. And so having the features Glenn talked about is a pretty big deal. So we're excited about what this can represent really over the next 3 or 5 years.

Got it. Great. And then just secondly, with the higher sales performance in the first half and the EBITDA coming in higher, that's translated, as Carrie mentioned, onto cash. Do you anticipate the use of cash in terms of M&A to pick up again here in the coming quarters? Are you comfortable now with the leverage ratio where we could see some more tuck-in M&A on the technology side?

Yes. I think, Steve, you're right on in terms of understanding that we've got a lot of flexibility on the balance sheet now. Our target leverage window is usually 2.5 to 3.5, and we're at 2.4x now. So really good flexibility to give us to be opportunistic on M&A. I'll let Glenn talk about some of the areas that we're focused on that side. But M&A has always prominently been part of our capital allocation strategy. We want to continue to be opportunistic in M&A and certainly can support that with the balance sheet. Glenn?

It's great to see the performance of the cash flows of the business over the past 6 months to 9 months, and Carrie and team have done a really nice job. And that does provide a lot of flexibility. We take a balanced approach to it. So what I mean by that is what investments are needed to fuel growth in the actual core business, including the catalysts that I walked through in some of my prepared remarks. And then, obviously, M&A is a big part of that as well. As we talked about during the Investor Day, acquisitions and integrations are a core competency for us as a company. And so as we look at the M&A landscape right now, we're focused on doing tuck-in acquisitions. I'd love to be able to get a couple done before the end of the year, but we'll have to see how that plays out. We're looking at adjacent opportunities in neurosurgery along with our regenerative business. And then still looking at international partnerships, so not necessarily going on acquiring technologies, but licensing deals where we can leverage our large commercial channels in places like Japan and China, to name two. But listen, we're going to remain very disciplined on M&A. We've got great cash flows, as we talked about during our prepared remarks. We've got a number of things that are in the pipeline. But expectations around valuations are quite high right now. So we'll have to see how some of that plays out. But we're in a really good position from a balance sheet and flexibility point of view.

Our next question comes from Dave Turkaly with JMP Securities.

Just to start with, you mentioned ACell, and I think you highlighted sort of restricted access in terms of the delta of the $13 million or so that we're looking for for the year now. And I'm just curious, should we think of it as like headcount turnover as well? I know there's a lot going on in the biologics space, but when you say that, are you talking about duplicative folks? Or how should we just kind of think about that specifically? Is it they can't get in, or is it that there's going to be fewer reps?

Dave, it's Glenn. Let me take a shot at this one. So I think, first off, ACell is a great asset, and it has a really nice synergistic fit into our overall business. In terms of the integration itself, all the integration activities are on or ahead of schedule. All the functional areas are really running well. Think of that as 2 plants that we inherited, a quality organization, distribution, all the back office functions; that's all going really well. Let me take you back to the beginning of the year. One of the key assumptions that we had was we had to do a sales force integration in order to get this business to be profitable. As a standalone business, this was not a profitable business. And I would just tell you that, that sales force integration has actually gone really well. The short-term challenge that we're facing is as our reps are handing off the relationships and selling these new products, it's been more difficult to get face-to-face, in-person selling versus a virtual environment. I think as we start to see more and more access being lived and getting access into the hospital theater, that's going to really help to get the momentum we need for the ACell business. But it's been a challenge because we have had restricted access. The good news is, month-to-month, we are seeing improvement. Having said that, the sales will come. The sales growth will happen. And so we feel quite confident around the ACell business. Like I mentioned before, it's a great fit. One of the positive aspects around this is also the fact that it's enabled us to have new conversations with our existing portfolio in complex wound and surgical reconstruction. You saw that performance in our base business in the current quarter. If you just look at our U.S. sales performance, we grew over 20% in our PRS or plastic and reconstructive business, mid-single-digit growth in wound reconstruction in the U.S. So we are getting some positive benefits in the base business as well. So Carrie, I don't know if you want to add anything to it.

Yes. I would just say the way I look at it is everything that Glenn mentioned, but from a guidance perspective, I look at we derisk the second half. We had a slower start in ACell. The guidance reflects an improvement from the second quarter but a slower ramp for the rest of the year. It doesn't change my outlook for 2022 and hitting our accretion target. So everything is on track there. But we derisk the second half. And because of the fact that the rest of the business, the organic base of the business is really performing quite nicely. When you think about guidance, we took guidance up by $15 million. ACell came off a little bit, but the underlying base organic business was up $28 million to $29 million embedded in that guidance.

Great. I guess as a follow-up, neuro and instruments, your Codman side has been really strong, and I always thought of those as sort of lagging. But as you sort of look at the performance, some of the things you called out, CSF, dural access. I mean, do you think these markets are accelerating, or is it your portfolio? Or I guess just any thoughts around some of the strength there.

In the first quarter, the neuro aspect of our business experienced some weakness, primarily due to the surgeries affected during the winter and the storms in February. This negatively impacted our procedure-based operations. However, we anticipated improvement in the second quarter, particularly in the neuro segment, and we did see that improvement in burn, trauma, and surgical reconstruction areas. Our instruments, especially in doctor offices, also showed significant growth. While it’s difficult to determine the exact cause, such as whether it was due to deferred procedures or pent-up demand, we definitely benefited from it in the second quarter and observed a notable recovery. We believe this sets a positive tone for the second half of the year. Some parts of our business, like capital and indirect markets, are still not fully recovered. As we head into the latter half, we feel optimistic about our overall performance.

Dave, I would just add, keep in mind, in 2019, we've launched a number of new products coming out of the Codman portfolio that have a multiyear ramp to them, and then COVID hit. We never saw the benefit of that first and second year ramp, which we're starting to see now. So in addition to these procedures coming back, we look at our CSF portfolio, a number of the Certas valve enhancements that we rolled out, the toolkit, our surgical headlamp, DuraGen in Japan, all these products are really gaining momentum now that we're coming out of COVID. That is another driver of what you're seeing in terms of the stellar performance in our neurosurgery business.

Our next question comes from Kaila Krum with Truist Securities.

Great. So I guess just at the midpoint of your third quarter guidance, you're assuming a step down from Q2. And to me, that makes sense because of traditional seasonality, that you're also effectively assuming that Q3 is only up about 2% relative to the third quarter of 2019. And I think your goal has been to grow the business higher than that. So can you just walk me through sort of how you're thinking about your guidance specific to the third quarter and just some of the puts and takes there?

Yes, Kaila, I'll take that one. And I think you're thinking about it exactly correct. If you look at historical patterns of seasonality, typically, Q2 to Q3 is about flattish. Because of the European holidays, U.S. holiday, summer vacations that happen, and that's kind of comprehended within our guidance there. In addition, again, I do think that we benefited from some deferrals of pent-up demand in the second quarter as it relates to some of the performance, as I responded to Dave's question. And so as you normalize that, you kind of get to that flattish type of Q3 number. At the low end of our guidance, we do comprehend some variability related to recovery associated with the continuing Delta variant impacts potentially. It's the variability in the vaccination rates. At the same time, we did take down ACell a little bit within those numbers, which implies a 6% organic growth compared to 2020 on the base business. So we think Q3 is set up nicely, and certainly, the trends that we've seen thus far would support that. But overall, I think you're thinking about it correctly, Kaila.

Okay. Great. That makes sense. And then you guys are lifting guidance for the full year. But as you've mentioned, you're cutting the ACell contribution. The base business is doing a lot better than expected. But I mean, what is it that is performing so much better than you guys had expected in the organic business? And then what gives you confidence that you can recover those lost revenues in ACell over the next sort of 12 to 18 months?

Yes. So relative to the full year guidance numbers and why we are confident in our base business, we're really seeing it across the board in our disposables businesses. So outside of capital, we've seen really good strength in our nerve repair business. We've seen good strength in our CSF Management business. Instruments have come back very nicely. On the tissue side of the business, we're seeing some really strong growth, both on the wound reconstruction side as well as in our PRS side. I would just say, in general, all those areas are doing quite well. The two laggards are still the indirect markets piece that Carrie mentioned in capital, which both are actually showing positive trends but are still not where we'd like them to be in terms of a normal spending environment. Pete, I don't know if you want to add anything to that?

Yes. I would just think on the neuro bigger picture side, if you remember the charts Carrie showed last year about where it fits on the scale of elective versus emergent. It's obviously one of the first-in-line emergents. If you look at our two businesses, the first sales reps that really could get back into the hospital in the OR by far was our neuro team because those procedures had some level of pent-up necessity. Obviously, people only have a certain time to wait on many of these procedures. As things opened up, TBIs or traumatic brain injuries and those types of procedures have increased. So we think, again, with the breadth of our product portfolio, that's going to continue. With the addition of these new products, that's going to continue to fuel it. We’re actually in quite a good spot. But neuro, in some cases, had a 6-month running start over kind of TT as far as access from at least our perspective of the world.

Yes. And I would just say too, and why we're confident in raising our guidance is we are seeing better than expected in our direct markets outside the U.S., which have outperformed and we're expecting that to continue. Certain markets in Asia, such as Japan and China that we've talked about are performing really well. We expect that to continue. Certain direct markets in Europe are also outperforming. I would just highlight the international performance has been quite good, and we're expecting that to continue.

You also had a question about ACell. Can you just repeat that? Yes, sure. Just what gives you guys confidence that you can recover those lost revenues in ACell over the next sort of 12 to 18 months going into next year?

Yes. No. Listen, again, we think this is a great asset. The team has done a real nice job in terms of the integration work. The issue that we're facing at the moment is short-term just because of the rep access being challenging and not being able to do face-to-face selling in person. I think that will subside over the next few months, and we'll start to see better performance sequentially in the business. Moving into next year, you'll start to see the growth that we expect. We're very confident that this is a great asset and that we'll work through the short-term challenges that are really caused by COVID at the moment.

Our next question comes from Matt Miksic with Crédit Suisse.

Congratulations, Pete, on the opportunity, and good luck to the team with the succession planning. I look forward to seeing that develop. I have a couple of follow-up questions regarding the ACell changes and your comments about rep access. We haven't heard many similar challenges from others in the industry. To clarify, is there a distinction between the emergent and critical ICU cases for cranial surgery that you've mentioned, which were among the first cases to return? We often hear about representatives in orthopedics, spine, and cardiology also receiving access. Is the difference here about supporting acute care surgeries, while representatives and their access to sell new products or introduce new products at new call points operate under a different set of priorities? I don’t want to misinterpret your words, but I’m trying to grasp the difference.

Yes, Matt, it's a very good question. First of all, the emerging nature of neuro has definitely the need for a surgeon to ask for a rep to come in and be invited in more often in neurosurgery than the rest of our portfolio. So that's clearly some of it. But your other point is a really important one here. If you have a rep that's been in an account and you inherit a new product, either an NPI that we created or one that we buy, there needs to be some time for discussing with the doctor. There needs to be some time to get it on the shelf, particularly if it wasn't a stocked item, it was a carried-in item. That takes a little bit more time. In the case of ACell, we transitioned this in the midst of COVID. We knew that in the January time period, and we handed off in certain territories the product from a legacy ACell rep to an Integra rep. That Integra rep needs to get in and see those doctors that were using it, with access to those doctors reasonably limited for really most of the first quarter and most of the second. It's now opening up significantly. That is really at the core of it. I think it's equalized out now. But as Carrie said, our guidance reflects the increase in the second half, but we're also kind of positioning it such that we want to make sure that we come back appropriately. Longer term for this product, there's no reason why it won't be a wildly successful product in our portfolio. It complements everything we do. We had a slow start, but we'll get it fixed and be back up to where we expect to be as we head into '22.

That's great. I have a follow-up question about margins. Carrie, thank you for the details regarding the mix and progress on gross margins. It's encouraging to hear about the slightly better and expanding opportunities in EBITDA. Could you provide more information about the reduction in expectations for ACell? It seems like you mentioned this as a headwind to gross margins. Is there anything else occurring in the integration process that is coming in better, worse, or differently? This could relate to the pace, the slowness of access, or any other factors you can discuss in terms of EBITDA contribution specifically from ACell.

Yes, Matt, from a gross margin perspective, it actually contributed positively, coming in at a strong, high gross margin within our portfolio. This supports a beneficial mix as it continues to grow. As we transition from the second quarter and begin to see an increase, we expect to get back on track in 2022, which will further enhance the mix. In this regard, it is adding to our gross margin. Regarding the overall SG&A synergies, we have accelerated our efforts and are making good progress. We have already seen some benefits in the second quarter, so it is ahead of schedule in terms of realizing these synergies. Remember, when we acquired that business, it was at breakeven, and part of our strategy was to rightsize it, particularly focusing on the sales channel. We have successfully achieved those synergies. As Glenn mentioned, we are on target, and I have observed the benefits in our second quarter results. While there is a slight dollar impact from not meeting the revenue targets, the overall margin mix remains favorable.

Our next question comes from Anthony Petrone with Jefferies.

I want to second, Peter, congratulations on the move. Good luck to the team as the transition gets underway. Maybe one, just on the broader strategy. It sounds like from the prepared remarks, Peter, as it relates to your transition to the Board really has a mindset where the strategy that has been in place over the last several years, which has largely been a portfolio reshuffle sort of strategy is going to remain intact. But as you look ahead, does that accelerate? Does it slow down? Maybe anything from the Board level as they're thinking about this transition? And I'll have a couple of follow-ups.

Yes, Anthony, I think I've communicated pretty much everything I can relative from that standpoint. From a Board standpoint, obviously, we have a very active integrated Board; they're heavily involved with our strategy. A big part of what we've been trying to do over the last several years was to bring assets in or only keep assets where we know we can be a strong player. The reason for that is because as hospitals continue to consolidate, competition consolidates, having areas where you can have a leadership position, we think, is the way that future growth, both top and bottom, is going to come. I think we've been able to demonstrate that. The Board is obviously very much aligned. On a future standpoint, we have adjacency areas to neurosurgery. You can argue that from the neck up, we have expertise at some level. There are lots of interesting scenarios there. And on TT now, as we mentioned at the Investor Day, moving broader than wound care is a big opportunity. We've talked about breast; we talked about nerve; we talked about hernia; we talked about other areas within plastics. All of those have accretive margins and growth rates. I think whoever comes into the role, I think they'll have plenty of opportunities with the base business to continue to grow and a pretty nice palette to expand into other faster-growing areas. That's kind of how I see it. I can't speak for the Board, but I think the Board is very much aligned with what we've laid out at this point in time.

And again, congratulations to you and the team, and good luck on the transition. The follow-up would be on margins. Just going back to the LRP target, the 28% to 30% adjusted EBITDA margin for 2023. Just trying to get a handle on that just given the ACell revision here. Where does the ACell margin profile sit in that LRP target? Perhaps in the near term as a headwind. The offset, certainly, Pete, you mentioned the new product categories, Aurora, SurgiMend, breast, CereLink, of course, those all seem to be set as margin tailwinds. So just maybe the complexion and mix as you approach that 28% to 30%. Where does ACell now sit in that equation and where do the new products contribute in that equation?

Yes, Anthony, I'll take that one. As we mentioned, ACell, our expectation is that we will be back on track in 2022. That's our expectation for our accretion being additive in year 2. There's nothing that would suggest that we will not hit that target in terms of additive from an EPS perspective. It favorably contributes to our margin profile, both in gross margin as well as the SG&A cost savings that we've been able to achieve. As I think about the long-term 28% EBITDA margin, 70% gross margins, all of those levers are still intact. Just to remind you of what those levers are, starting with gross margins, there are a number of things that continue to be tailwinds for us in gross margins. Let's start with the mix piece of those pieces. First of all, you think about revenue recovery, as we mentioned, not all of our portfolio is yet at 100% in direct capital. Still has positive growth opportunity for them. As Glenn mentioned, CereLink should be a very nice lift for us in 2022 regarding revenue as well as margin opportunity. You have, overall, the TT side of the business, which has higher margins than CSS, and so as that business continues to recover, including ACell, bringing strong favorable mix to that. Again, as we wind down from those discontinued products that carry lower margins, all of that is helping. One last lever on the gross margin side is around manufacturing. Productivity efficiency, we've got two big initiatives there. One is exiting the TSA agreement with the Codman integration at the end of the year that will provide some gross margin lift. We're closing a facility in France by the end of 2022, which should help as well. Overall, just SG&A leverage as our revenue recovers, productivity improvement, all of that allows us to stay on the path of a 28% type of EBITDA margin.

Yes. I would just highlight that these new product introductions and these key catalysts that I walked through in some of the prepared remarks are all accretive to the company average. When you look at those growth drivers in the short to midterm, those are all going to be nice tailwinds for us relative to our margins.

Our next question comes from Ryan Zimmerman with BTIG.

Congrats, Pete, and the team. I just want to ask on the margin side a little bit. Carrie, you mentioned just some of the inflationary pressures that you're seeing and higher freight costs. And you talked a little bit about just adding potential for price. Wondering where you could specify kind of where you can pass that along, specifically within the product category versus maybe other areas where you intend to absorb some of those inflationary pressures?

Yes. Right now, I'd say the biggest impact is around the tight labor market. Certainly, a couple of different things. We have open positions in our factories. We have open positions in our SG&A areas where it's happening in our factories, that creates some idle capacity cost because you don't have a full team as you're trying to ramp up production. However, it helps on the SG&A side because you don't have all your positions filled. The second area on the labor side is that we are seeing some select wage pressure at certain sites where we're trying to ramp up. As we think about Boston, as an example, that's an important side as we're trying to ramp up and seeing some wage pressure there. In terms of the supply side, it's really right now limited to just longer lead times as it relates to select sourced materials that create some amount of expedited freight costs that we're dealing with. For the most part, I think we've been successful. We’ve got long-term contracts. We have opportunities to offset some of that internally with initiatives. So we haven't seen a lot of what I'd call material inflation yet. It's something we're watching very carefully. We do have the opportunity to price. We have been successful there, and I'll have Glenn maybe talk a little bit about our approach to price. We've got some longer-term contracts where we can offset some of the short-term headwinds around this. I would anticipate that in certain cases, we'll have some select price increases to also mitigate the effect on both sides of the portfolio.

Yes. The only thing I'd add is, first, on the cost side, yes, we are seeing some, obviously, headwinds as it relates to cost pressures. But I want to recognize our global operations and procurement teams. They've done a real nice job to identify a number of cost-savings initiatives over the last 12 months to offset some of these cost pressures. I want to recognize the team that's been working hard to minimize the impact of what you're seeing. As it relates to pricing, again, there's opportunity for some limited price increases given the increase in the materials that we're seeing coming into our sites. Carrie mentioned that we're fortunate that we've got some longer-term contracts where we can offset some of the short-term headwinds around this. I would anticipate that in certain cases, we'll have some select price increases to also mitigate the effect on both sides of the portfolio.

Got it. And then, Glenn, for you, as a follow-up. Can you give us the state of the PriMatrix just following that study? I mean, in terms of covered lives and where you're at and where you need to get to and how to think about your reimbursement strategy with PriMatrix given the study?

Yes. So keep in mind, we had pretty good reimbursement prior to the study. I think of that as over 100 million covered lives, but we really didn't have a lot of covered lives with the commercial payers. What this does for us, with this clinically and statistically differentiated data that is significant and the results are showing significant improvement in DFU closure in 12 weeks versus standard of care, enables us to now go to the commercial payers over the next 6 to 12 months and increase the amount of reimbursement. You could think of it as doubling the amount of covered lives from what I just said as a rough order of magnitude. So that's obviously going to open up more sales opportunities and more revenue growth for PriMatrix. It's been a product that's been very well received, both inpatient and outpatient. This should be a real nice opportunity for us as we move forward. Again, think of it as doubling the amount of covered lives once we get through going to all these commercial payers and getting reimbursement.

And just to put a finer point on that as the last, Glenn. I mean doubling over what period in your mind?

So the base number of covered lives today is over 100 million, so going over 200 million. Over, call it, 12 months. I think it's fair to say in 12 months, we'll have whatever we're going to have from a reimbursement perspective in place.

Our next question comes from Robbie Marcus with JPMorgan.

Two for me. Maybe first, Carrie, we've touched on it a bit, but I wanted to just dig into it a little further, particularly as it relates to the guidance raise and what's implied for third and fourth quarter here. The beat was a very nice beat, but we're now looking at third quarter guidance that captures the street at the high end. What's implied for fourth quarter is also capturing the street, but at the high end. I was trying to get a better sense of exactly what's going into it, how much is conservatism versus lowered thoughts on second half. How much of the impact is from lower ACell? If FX or anything else played into the decision here?

Yes. Foreign exchange did not influence any changes in our perspective. We're not expecting significant foreign exchange benefits in the second half of the year. To reiterate, I mentioned a $15 million increase, of which $13 million to $14 million is related to ACell, suggesting that our core business is growing by $28 million to $29 million. We have reduced risks associated with ACell and had a slower start, as Glenn and Pete have mentioned. I wouldn't describe it as conservative; rather, it's a balanced approach. We are observing positive trends in the core business and still see potential for additional growth in indirect and capital areas as we finish the year and enter 2022. Overall, I view it as a matter of timing. I addressed Kaila's question regarding Q3, noting that the $382 million to $389 million includes typical seasonal patterns for the third quarter plus some pent-up demand from the second quarter. The core business shows 6% organic growth compared to 2020. We believe Q3 is positioned well, and the trends we have seen so far back that up. Overall, we are very satisfied with the business's performance to date.

Sorry, maybe I should have been a little clear. I meant more focused on the bottom line.

Yes. Regarding the bottom line, Robbie, it's important to note that we will likely see some additional normalization of operating expenses in the third quarter. As I consider the second half, we have several investments planned for new product launches. Glenn mentioned CereLink, and we're also exploring opportunities in breast health. We want to keep investing in Aurora. There are numerous new product opportunities we want to pursue for growth through clinical studies. The third quarter will include additional investments we intend to make. We believe we have ample capacity for these investments as they are a priority for us. In terms of gross margin, I anticipate that the second half will be slightly higher than the first half. However, manufacturing challenges related to labor shortages and extended lead times are likely to continue into the second half. Despite these pressures, I believe we will see modest improvements in gross margin in the second half compared to the first half.

Robbie, I would just add that Glenn mentioned this earlier, and we talked about it at the Investor Day, the five big kind of breakthrough technology opportunities that we have are all on track. What that means is the ramp of their spend will begin here in the second half, which is great news because all of those have the opportunity for significant growth profiles, everything from being in a position to file a PMA for breast to the discussion on Aurora. The work with clinicians on all the big names that you've heard in neuro institutes doing work on that, how we customize our instruments, including CUSA and other things, that's going to generate some added tweaks and work, which we want so that we can create this really differentiated custom set. In the case of that, no other player out in the marketplace will have something like that. A lot of that work to optimize it starts here within Q3 for all of those.

Great. And maybe just one last one. On R&D, you guided at the Analyst Day to get that up to 6% of sales in the next few years. It came in lower than expected or at least we expect in the second quarter. How do we think about when we start to see that tick up? And really what projects are going to be focused on?

Yes, Robbie. I believe it aligns with Pete's remarks that we should start seeing an increase in R&D investments during the second half of the year as we continue to pursue some of those new product opportunities. My expectation is that this will be part of the overall increase in spending related to R&D.

Our next question comes from Matthew O'Brien with Piper Sandler.

I only have one question. I apologize for revisiting ACell. It seems there has been a shift in focus from extremities to ACell, which has garnered significant attention. This is why I want to inquire further. Back in 2019, it was a $101 million business, and I understand the impact of the pandemic and access to accounts now. However, we are currently down about 30% compared to 2019. As investors are increasingly focused on this asset, could you provide additional insights on sales rep attrition and account attrition compared to your expectations? Are those metrics performing better than anticipated? Additionally, is there anything on the accretion side that is contributing to this? It appears things are moving faster, possibly leading to quicker adjustments that could be impacting the top line. When do you expect to return to around $100 million in sales for that business? Is that timeline looking like 2023 or beyond?

Yes, Matt, thanks for the question. Just to set some of the groundwork on the $101 million reference point for ACell. A couple of things to keep in mind. We had about one month less of sales this year. When you look at that 30% reduction, obviously, you should factor that in. There are certain accounting for GPO fees that are different within Integra versus how they were treating it. Those are two factors. Relatively speaking to the business itself, listen, I think the attrition has been as expected. We've taken the necessary actions around synergizing the sales force. For us, it's really just around access. I think once we start getting better access in these face-to-face meetings in the second half of this year, we'll start to see the pickup in the business. It will come. I'm very confident in that. When we get back to something close to $100 million, we'll have to talk about that as we get into 2022. I don't think we're ready to commit to anything other than expect to see a sequential improvement in the business, and we expect long term for this business to grow in line with the overall Tissue Tech business, which is in the 7% to 9% range.

Okay, Glenn. But just to be clear, you're not seeing anything from an attrition perspective on the sales force side or account side; is competition getting a little bit more elevated here? I don't know if TEI is an analog you can use as well as far as how you did on the integration side there, but I think that went pretty well.

Yes. No, just normal attrition. So nothing abnormal that we've seen in the first five months that we've owned the asset.

Yes, and I would further say as you look at Q1 to Q2, I mean, they're not comparable periods because we didn't own ACell for the full quarter. But as you look at it kind of on a daily run rate, we didn't see any deterioration in the business. We just didn't see the growth that we expected. There wasn't any deterioration from the first quarter to the second quarter. It's just that we just have had more limited access, and it just didn't allow us to ramp as fast as we expected to.

Our next question comes from Joanne Wuensch with Citi.

Many of the questions have already been addressed. However, I would like to know what type of CEO you believe would be suitable for the next stage, considering the progress made during your tenure. Additionally, I apologize for the repetition, but it seems we are all asking similar questions. If you reduce ACell but increase total revenue, what gives you the confidence in raising the lower revenue estimate? Is it due to new products or momentum in recovery? Any insights on this would be appreciated.

Yes. Joanne, I'll take the second part of your question, and I'll defer to Pete on the first part. But I think in terms of the underlying business, it's very broad-based. I think with the exception of the indirect markets and capital, that isn't yet at full recovery, most of the other parts of the business have recovered very, very nicely. The procedure-based pieces of our business in neurosurgery, as Glenn mentioned, the disposable, the consumable pieces of the business, our IDRT skin products, SurgiMend products have all seen some really nice rebound in growth. Even instruments, as I mentioned in my second quarter prepared remarks here, 4% organic growth compared to 2019 when that's a business that would probably grow low single digits. Very nice performance there. As we think about going into the second half, I go back to some of those comments that Glenn made about products that we launched in the middle of 2019. We had about seven products that we launched in the middle of 2019. COVID interrupted that opportunity to really see that nice ramp on them. What you're seeing is you're seeing a lot of those products really taking hold as the recovery comes back. It's the combination of international growth and some NPIs as well. Certainly some pent-up demand and deferred procedures kept some of that recovery handcuffed in the second half helping us in the first half as well. Glenn, anything else you want to add?

Yes. The only other thing I’d highlight is why we feel more confident in the second half of the year is that capital has lagged, but the actual capital funnels themselves are really strong right now. We've got a lot of things going on relative to trialing and advancing our capital through the selling cycles. I believe once we start to see that open up, we're going to see a really nice windfall on the capital front in the second half of the year. Again, that lagged in the first half of the year. But when I look at the activity, I look at the progress in terms of the funnel, it's the strongest I've seen in a very long time. That's why we're also confident.

Joanne, regarding your point, I would emphasize that the company is in excellent condition. For those who have followed us, everything from our systems to data access speed to our product pipeline is solid. It's important to find someone who can enhance what we have while also envisioning new growth opportunities. We refer to this moment as an inflection point for a reason. The balance has shifted towards more opportunities for growth rather than just internal fixes. We discussed this at the Investor Day, and finding the right leader who can navigate both aspects is what I hope for. Ultimately, it's the Board's responsibility to make this decision. There is considerable interest and enthusiasm about the company, and I believe we will identify the right leader before the year concludes.

Our next question comes from Shagun Singh with Wells Fargo.

So you indicated that the base business was up about $28 million, $29 million. How much benefit did you see from backlog in Q2? What are your expectations for the second half? And then with respect to U.S. capital, can you give us the growth rate, and I'm sorry if I missed it, relative to the double-digit pace of decline that you had posted within advanced energy in Q1?

Yes, Shagun, I'll take that. In terms of the $28 million to $29 million, the backlog, I think there was a piece of that. It's hard to quantify how much of the $12 million beat the upside of our high-end guidance range came from deferrals or pent-up demand. Certainly, a portion of that did as we think about the surgical reconstruction side of our business was down in the first quarter year-over-year, and it came back really nicely in the second quarter. Instruments saw a really nice recovery in the second quarter. There was some elements of that pent-up demand that benefitted in the second quarter. As we think about the third quarter, we tended to try to normalize that in our guidance there. Overall, we’re just seeing some nice recovery in most parts of the business. As Glenn mentioned, we think the opportunity in the second half will be seeing more normalization of capital and seeing a really full pipeline, which gives us some nice comfort that capital will rebound nicely in the second half, coupled with the clinical launch of CereLink into Q3 and then following full market release in Q4.

Our final question comes from Jayson Bedford with Raymond James.

Congrats, Pete. I'll just—just a couple of questions that require, I think, pretty quick answers. You mentioned restricted access. Is this restricted access dynamic negatively impacting sales in your base tissue technology business?

No, because again, they have the existing relationships. So it's much easier to do the sale with our existing portfolio. We haven't seen that impact our base business. It's really around new products and obviously the transition of the relationships from the ACell portfolio. So the answer is no.

Okay. What is the level of discontinued revenue implied in the organic growth guidance for the year? What's the assumption for FX in '21?

For FX, let me start with that. We saw probably $11 million to $12 million of benefit of FX in the first half. We're not assuming a tailwind or a headwind in FX in the second half of the year. So depending on where rates go, we're not really counting on FX to be a benefit in the second half. About $11 million to $12 million was the FX for the first half of the year. For discontinued products, discontinued product revenue has been a little bit higher, again, as people continue to do some last-time buys there. So probably about a $10 million to $11 million type of year-over-year change in the discontinued revenue. About $20 million of revenue in discontinued products in 2020 and about $10 million to $11 million in 2019. Essentially, that year-over-year delta is probably about $10 million to $11 million.

This concludes our question-and-answer session. I would like to now turn it back to Peter Arduini for closing remarks.

Thanks, Stephanie, and thanks, everyone, for your questions. Look, I'll just close by saying that there's never been a more exciting time at Integra. We're clearly at an inflection point to accelerate scale and growth and really market leadership. We're now aligned to faster growth markets with the changes we've made and the discussions we've had on the pipeline. Hopefully, you can see that not only do we have a lineup of products with faster growth but higher margins, which will drop through. Thank you for your continued interest in Integra. Look forward to speaking with many of you here in the near future and providing an update on our progress at the next quarter. In the meantime, please enjoy your summer, and that concludes our call. Thank you.

Thank you, ladies and gentlemen. This concludes today's presentation. You may now disconnect.