Good day. Welcome to the Integra LifeSciences second quarter 2020 financial results call. At this time, I'd like to turn the conference over to Mike Beaulieu. Please go ahead, sir.
Thank you, Eduardo. Good afternoon, and thank you for joining the Integra LifeSciences second quarter 2020 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. Earlier today, we issued a press release announcing our second quarter 2020 financial results. The release and corresponding earnings presentation, which we will reference during the call, are available at integralife.com under Investors, Events and Presentations, in the file named second quarter 2020 earnings call presentation. Before we begin, I'd like to remind you that many of the statements made during this call may be considered forward-looking statements. Factors that could cause actual results to differ materially are discussed in the company's Exchange Act reports filed with the SEC and in the release.
In light of the ongoing COVID-19 uncertainty, we are disclosing more information today for investors about recent, current, and anticipated future business performance than we would during a typical quarterly earnings call. In particular, we will refer at times to our June 2020 revenue performance. When we do so, in all cases, our June 2020 average daily sales rate is being compared to the average daily sales rate for the entirety of the second quarter of 2019. This comparison provides a meaningful mechanism for understanding our actual business performance toward the end of the second quarter in 2020 versus 2019 by normalizing year-over-year sales activity to account for differences in monthly customer buying patterns and selling days. Lastly, our comments today will include certain non-GAAP financial measures.
Reconciliations of any non-GAAP financial measures can be found in today's press release, which is an exhibit to Integra's current report on Form 8-K filed today with the SEC. With that, I'll now turn the call over to Pete.
Thank you, Mike. Good afternoon, everyone. Thank you for joining the call. I hope you and your families are staying safe and healthy during these difficult times. If you turn to slide four, I'll begin the presentation. The second quarter was one of the most extraordinary periods in our company's history. Beginning in February and continuing through the second quarter, healthcare providers around the world moved quickly to manage the effects of the global pandemic. Surgical procedure volumes across the industry declined materially as essential resources were reallocated to treat COVID patients. Integra quickly adapted by taking actions to safeguard employees, ensure continuity of our supply chain and manufacturing capabilities, and contain costs to protect liquidity and profitability. These efforts were vital to our performance during the second quarter, and I'm proud of the resiliency of our global colleagues and their commitment to supporting customers and patients.
Looking at the second quarter, total sales were down 31% on an organic basis. However, looking at the monthly sequential trends, sales in June improved to a decline of approximately 13% from the prior year's average daily rate for the second quarter. In our global neurosurgery business, sales in each of our major franchises increased on a monthly sequential basis during the second quarter. Consistent with the outlook we provided on our last earnings call, products used to treat underlying conditions that are considered more urgent, such as neuromonitoring, CSF management, and dural access and repair, led the improvement in the second quarter. Second quarter performance outside the U.S., while highly variable, was slightly better than the U.S. and was led by our business in Japan, where sales increased double digits over the prior year.
While this performance can be attributed in part to effective government policies in Japan that mitigated the impact of COVID-19, the growth is also unquestionably a result of the investments that we have made in our commercial organization and successful launch of DuraGen. Within Orthopedics and Tissue Technologies, the most significant recovery came from the orthopedics franchise, which was down more than 80% in April, but improved to a decline of less than 10% in June. Wound reconstruction also improved on a monthly basis sequentially during the quarter. Looking at the company as a whole, we're confident that our businesses and competitive positions remain strong and our underlying markets will return to growth over time. During the second quarter, we continued to invest in critical parts of the business and launched new digital training and educational programs.
In neurosurgery, we are leveraging our comprehensive portfolio, global leadership position, and brand recognition. We recently announced the FDA clearance of a neurosurgery-specific indication for CUSA Clarity, making it the first and only ultrasonic tissue ablation system cleared to treat malignant and benign tumors. This approval was founded upon the abundance of clinical evidence and peer-reviewed publications that will allow our commercial teams to engage in a more detailed and focused conversation about the benefits of CUSA Clarity. Additionally, we launched new digital programs and resources that provide healthcare professionals quick access to product setup, training, and education through our new Codman's Got You Covered customer resource hub. In addition to training and education, these programs feature clinical and economic evidence that show fewer complications, reduced risk and more predictable outcomes associated with key products within our neurosurgery portfolio. These digital tools are enabling and accelerating our business recovery.
In wound reconstruction, we've rolled out national education webinars and interactive roundtables to highlight and differentiate our proven product solutions. We've also launched educational portals and micro sites that leverage social media. Taken together, we've developed a suite of virtual tools that enhance our interactions with customers. As we look toward the third quarter, we had a good start in July, showing a sequential improvement over June. Our business recovery is clearly well underway, and we're closely monitoring the scope and location of new COVID surges to determine any associated impact on surgical procedure volumes. Since April, hospital systems have adapted by expanding ICU bed capacity and creating zones that can be modified quickly to meet COVID surges. We remain optimistic that these measures, which preserve the capacity of hospitals to complete elective surgical procedures, will continue to bode well for our business recovery through the end of the year.
To that end, we remain confident in a sequential revenue improvement in third quarter, but still expect to be below 2019 levels. We also continue to model a scenario that has revenue returning to 2019 levels in fourth quarter, but this will depend largely on recovery rates in our capital and instruments businesses, which rely upon the availability of capital funds at hospitals and healthcare systems. As I mentioned in my opening comments, our recovery is being driven in part by the resiliency and commitment of our colleagues around the world. Given our increased confidence in a recovery path, we recently took steps to ease some of the cost containment programs we implemented in April that impacted our colleagues. For example, we recently reinstated a 40-hour workweek for all employees and restored wages accordingly.
Also, while we continue to tightly control discretionary spending, such as travel and conference expenditures, we're also increasing investments in certain clinical R&D and marketing programs that will deliver growth for years to come. As we begin the third quarter, our priorities for the balance of 2020 remain clear and consistent with the same priorities that have guided us since the onset of this global crisis. First, safeguarding our employees, customers, and patients. Second, ensuring continuity of our supply chain and manufacturing capabilities. Third, managing the business for the long term by making critical investments in clinical and R&D programs. With that, I'd like to turn the call over to Carrie for a more detailed review of our second quarter performance. Carrie?
Thanks, Pete. Good afternoon. Second quarter revenues for the total company were $259 million, representing a decline of 33% on a reported basis and 31% on an organic basis compared to the second quarter of 2019. Our performance was above the high end of our preliminary range communicated on July 9th. Adjusted earnings per share were $0.33 compared to $0.73 last year. While revenue and EPS declined on a year-over-year basis due to the adverse impact of COVID-19, both came in at the high end of our internal models. If you turn to slide five, I'll start with a review of our CSS segment. Second quarter CSS revenues were $170 million, a decrease of 30% on an organic basis. We saw steady monthly improvement throughout the quarter, with sales in June down 13%.
Global neurosurgery sales performed better than the segment average, with a decline of approximately 26% in the second quarter, with each franchise showing sequential monthly improvement off of the April lows. For the month of June, neurosurgery sales were down mid-single digits, led by a strong recovery in neuromonitoring, CSF management, and dural access and repair, as these products are used in more urgent procedures. Performance in advanced energy was mixed as capital sales, which are tied to hospital budgets, did not see as strong of a bounce back as compared to our consumable sales, which are largely correlated to CUSA procedures and showed very nice sequential monthly improvement. Sales in our instrument franchise declined 46% on an organic basis, and while we did see monthly improvement throughout the quarter, the month of June was still down approximately 35%.
As we discussed last quarter, the instrument business includes more capital and instruments sold to alternate site settings, which are less correlated to the pace of surgical procedures. International sales in CSS were down low double digits in the quarter. International did better than the segment average due to the strong performance in Japan. As Pete mentioned, our revenues in Japan grew double digits year-over-year due to a more moderate impact from COVID, as well as investments we have made in the market over the past year, including the successful 2019 launch of DuraGen. Moving to our Orthopedics and Tissue Technologies or OTT segment on slide seven. Second quarter revenues were $89 million, representing a decline of 54% on an organic basis. We saw steady improvement throughout the quarter in this segment as well, with sales in the month of June down 13%.
Second quarter sales in wound reconstruction declined 31% compared to the prior year. For the month of June, sales in wound reconstruction improved to a decline of approximately 10%. Recovery rates were particularly strong in our chronic wound product line as well as our nerve repair business. Sales in surgical reconstruction were the slowest to recover, as breast reconstruction and hernia repair procedures proved more deferrable compared to other tissue repair procedures. Sales in private label were down approximately 29% in the second quarter. Performance was more balanced on a monthly basis. As we previously discussed on our Q1 earnings call, COVID had a minimal impact on first quarter private label sales as the bulk of orders were received in January and February. As such, we did anticipate a larger impact in the second quarter.
We continued to work with our private label partners and have been encouraged by a broad recovery in procedures. We saw positive momentum late in the second quarter and expect orders to improve in elective areas such as spine and dental cases into the third quarter. Orthopedic sales declined 49% in the quarter, but as Pete indicated, showed the strongest improvement off of the April lows among our franchises. Recall that ortho sales were down over 80% in April, whereas in June, sales recovered to mid-single-digit decline rates. Sales of our shoulder solutions led the recovery, and both upper and lower extremities improved on a monthly basis during the quarter. Turning to slide seven, I'll now review our second quarter performance of our key P&L components and cash flow. Our performance across the P&L in the second quarter was negatively impacted by COVID and the associated reduction in surgical procedures.
However, as mentioned earlier, our financial results were better than original expectations. Second quarter adjusted gross margins were 66.2% compared to 67.4% in the prior year. Gross margins came in stronger than expected, in part due to the higher-than-expected revenues, also due to the great execution of the cost savings measures identified by our global manufacturing teams. Our adjusted EBITDA margin was 20.4% compared to 25.5% in the prior year. Although EBITDA margins were down year-over-year, the decline was greatly mitigated by our stronger-than-expected gross margin results as well as significant reductions in operating expenses. The enterprise-wide cost containment measures we initiated in the second quarter contributed to a 28% reduction in operating costs from prior year levels. Second quarter GAAP EPS was $0.00 compared to $0.34 in the prior year.
Adjusted EPS were $0.33 compared to $0.73 in the second quarter last year. Diluted shares outstanding were down slightly in the second quarter as we completed the accelerated share repurchase program initiated in February. Based on revenue improvement trends over the last few months, we have eased several of our cost savings programs, including, as Pete mentioned, returning all employees to a 40-hour workweek. That said, given the ongoing uncertainty related to the pandemic, we will continue to manage discretionary spending closely. We do expect third quarter operating expenses to be higher than Q2 levels, but still lower than prior year spending by about 5%. Operating cash flow was $33 million in the second quarter, driven by lower earnings and higher inventory levels, both of which were impacted by COVID.
We did build additional safety stock of key product lines in the quarter, specifically some of our tissue regeneration products. If you turn to slide eight, I'll provide a brief update on our capital structure. We ended the quarter with net debt of approximately $1.3 billion, a slight improvement from March 31st, 2020. Our consolidated total leverage ratio was 3.4 x, well below our covenant maximum of 5.5 x. On July 14th, 2020, the company amended its credit agreement to temporarily increase its maximum consolidated total leverage ratio from 5 x to 5.5 x through June 30th of 2021. We did this purely on a proactive basis to increase financial flexibility in light of the unprecedented impact of COVID-19 and the remaining uncertainty surrounding the global economy.
The amendment provides us more optionality as our business improves and increases our confidence about expanding investments for long-term growth. Importantly, we have cash and cash equivalents of $361 million and $1.15 billion in undrawn revolver capacity. The company does not have any credit facility principal repayments due until June of 2021. Now I'd like to turn the call over to Glenn, who'll provide some additional insights into our international markets and how we're thinking about our second half recovery. Glenn?
Thanks, Carrie. Good afternoon, everyone. If you turn to slide nine, I'd like to provide further color on our international performance and cover some external factors to consider as we look at the second half of 2020. On the left side of this chart, we provide the revenue decline rates for each segment as well as splits for U.S. and OUS performance. We've included both the full second quarter and the month of June, which as Mike indicated, is a comparison to the average daily sales rate from the full second quarter of 2019. Sales outside the U.S. declined 30% in the second quarter compared to the prior year.
Our revenue recovery improved each month and in each region during the quarter, with June sales down 14%. By region, Asia Pacific was down less than the company average in the second quarter, and showed the strongest rates of revenue improvement led by Japan. As expected, revenue in China was down in the second quarter as distributors worked through deliveries taken in the first quarter. We're confident this decline was largely a matter of timing as China returned to growth in the month of June. Performance in Europe was down slightly more than the company average and varied significantly by country. Germany, Italy, and Benelux led the recovery, while France, Spain, and the U.K. lagged.
Turning to the rest of the world, we've seen mixed results, with Brazil being one of the hardest hit markets and Canada showing steady improvements in line with the company's monthly sequential recovery for the second quarter. With that, let me now turn on how we're looking at revenue recovery scenarios for the second half of 2020. There are still a number of factors that can vary widely and will determine the pacing of revenue improvement in the second half. As Pete discussed earlier, regional surges are likely to weigh on a patient's willingness to return to doctor offices or hospitals, and we have factored this into our second half revenue scenarios. Additionally, we are taking a conservative view in our outlook for recovery and capital and instruments, given the financial stress COVID has caused at many hospital systems.
Outside the U.S., we expect some seasonality in the third quarter as summer holidays reduce patient demand and staffing levels. We've also seen countries hold back to about 10%-20% of ICU bed capacity for potential surges in COVID cases. Given the ongoing uncertainty, we're not providing third quarter or full year guidance at the level we've traditionally provided. Directionally, if you take the factors I just discussed into consideration, we expect revenue in the third quarter to improve sequentially over the second quarter, but remaining between 5% and 15% below prior year levels. Consistent with our messaging last quarter, we continue to model multiple fourth quarter recovery scenarios, including those in which we return to fourth quarter 2019 revenue levels, depending on how the factors I just discussed unfold over the coming months. If you turn to slide 10, I'll provide some closing remarks.
As we move through the second half of 2020, we are adapting quickly to the new environment to capitalize on the recovery in surgical procedures. During the second quarter, we rolled out or supported many virtual training and education programs. Due to our global leadership position and brand recognition, these programs are reaching hundreds of practitioners along the care pathway, from surgeons to nurses, to patients and caregivers. Through these efforts, we are providing important clinical and product information in a timely and convenient manner to the people who need it most. Our supply chain and manufacturing facilities remain in a strong position and continue to operate efficiently. Where appropriate, planned maintenance was accelerated into the second quarter to better position the company for a second half recovery. We're closely monitoring demand and are prepared to allocate additional resources as needed. Our cash balance and credit availability remain strong.
We recently improved our flexibility by increasing our allowable leverage ratio, which further boosts our confidence as we resume some discretionary spending while continuing our disciplined approach to balancing investment with profitability. Finally, we continue to plan for long-term growth. We're taking advantage of the scale we've built over the last several years and leveraging our leadership position to emerge from this crisis in a stronger position. We are investing in critical R&D programs that will provide a pipeline of growth opportunity for years to come. That concludes our prepared remarks. Thank you for listening. Operator, would you please open the line for questions?
Thank you. If you'd like to ask a question, please signal by pressing star one on your telephone keypad. If you're using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, that is star one to ask a question. We'll pause for just a moment. We'll now take our first question from Matt Miksic at Credit Suisse. Please go ahead.
Thanks so much for taking the question. One question if I could. You've given some color in Q3 and this idea of down 5%- 15% year-over-year, which suggests there's improvement from the exit growth rates of June. Could you talk a little bit about how the pieces fit into that directionally? I know the last time we spoke, there was a question around ICU availability, and there were lots of questions around the Rebound and some of the elective procedure categories that seem like they're having a favorable impact on the recovery for orthopedics. Maybe if you could just check through the businesses and give a sense of, within that down 5% - 15%, where trajectory should lie across your major businesses. I have one follow-up.
Carrie, do you want to lead us off?
Sure. Again, I think generally, the slide that we had provided to you during our Q1 call that looked at the spectrum of our products and what we would think would be laggards and leaders of the recovery is largely intact. I think the things that we thought would lag, like capital, did lag, and I would expect those to continue to lag into the third quarter. The things that were more tied to more urgent procedures would lead the recovery. Certainly, a lot of our neuro, in our neurosurgical area did see a faster recovery as we exited June. I think largely that slide is still intact. I think there were a few surprises. Ortho really came back much stronger than what we expected. Certainly there was some pent-up demand that I would say that helped us in the second quarter on the ortho side.
Generally, we think the ortho side of the business will continue to show some nice recovery there. I would say the other surprise was maybe instruments kind of lagged a little bit more than what we expected it to be. It behaved more like a capital like. Again, we do have some parts of our instrument business that are tied to alternate site settings, those would lag instruments that are more in the surgical setting. Largely, I would say that's where we would largely stay, Mike, with in terms of how we would see Q3 kind of unfold.
That's helpful. As a follow-up, if I could, and maybe this is for Glenn, and just generally on the geographies that seem to be improving across the global Codman footprint. I guess what you mentioned monitoring some of the trends, looking for sort of flare-ups across the portfolio. I guess, given what's happened in the U.S. and what seems to be kind of maybe quieting back down in certain parts of the U.S., how confident are you at this point that we're looking at a series of sequential improvements or is there some sense that we're likely to see more flare-ups and steps back before we take the final steps forward in some of the other geographies like we've seen in the U.S.?
Hey, Matt, thanks for the question. I don't want to kind of predict where the flare-ups are going to happen and when they're going to happen. I would say, though, that from what we've seen so far, we've been very delighted with the results in Asia-Pacific, broadly speaking. Japan had a really strong growth quarter, even despite COVID-19. China, while we had some challenges early in the quarter, which we knew we were going to have because of how we ship into China. June was a strong month, we're expecting the third quarter to show growth in China. Even greater Asia has held up quite nicely when we look at the rest of Asia. Right now, we don't expect to have any setbacks in that part of the world. Australia didn't get as hard hit as many other places around the globe.
Australia continues to be pretty steady for us. Canada was hard hit in the second quarter. I'm expecting to show a nice improvement sequentially in the third quarter. Latin America is still a bit of a wild card for us. We're still seeing some laggards, as we use the term, relative to the Latin American market, and that's probably one market that we're keeping a closer eye on. I would just say, generally speaking, Europe has done kind of a mixed review. We mentioned some of the strength in Germany and in France and in Italy, but at the same time, we haven't seen the same level of recovery yet from the U.K., and Spain to name two. Bit of a mixed bag there, but we are seeing improvement in Europe.
In general, though, I would say we feel very good about the direction of our direct markets. Indirect, where we sell through distributors, I think is going to be a bit lagging in terms of some of the recovery. Again, that would be part of Latin America. All in all, I think that's how I would phrase it up. Obviously, I know your question was very focused on international. The U.S., we're seeing positive trends sequentially here in July, both for OTT and for CSS. Carrie hit on a lot of the points about what was going on there.
Yeah. The other thing I would add is certainly as we think about the guidance for Q3, we do have the summer holiday season to think about, broadly across the U.S., but particularly in Europe. Not sure that we'll see the same sequential month-to-month improvement. Definitely from Q2 to Q3, we expect sequential improvement, but it may have a different way it unfolds over the months just because of the normal European holidays.
That's great. Thanks so much, and I'll get back in queue.
Thanks, Matt.
All right, we'll now take our next question from Kaila Krum, Truist Securities. Please go ahead.
Hey, guys. Thanks for taking our questions and for all the detail this quarter. You mentioned that you're optimistic about the ability to return to pre-COVID revenue levels by the fourth quarter. I guess if fourth quarter revenue was flat this year versus last, is it fair to assume that earnings would also be flat relative to the fourth quarter of 2019? Or is there anything in particular we should consider that would weigh or benefit earnings this year as compared with last?
I'll take a side of it. Let me make a comment, Carrie, and then maybe you can frame up on the profitability side of it. Just to be clear, I don't say we think we're overly optimistic on getting to 2019 levels. We clearly are modeling scenarios that get us there. I think, and I would say we lean more towards that's a scenario that makes sense. That being said, how the flu season plays out, complementing that with COVID and the confidence really within our institutions. I would say our capital funnels are actually quite strong, but we need to have hospitals feel like they can see what a predictable multiple set of months looks like, that they could actually pull the trigger and make the acquisitions. That would clearly give us room to get to the next level.
Again, the sequential improvement comes down to the fact that everybody's getting smarter. I think all of the providers from where we were in April, you've heard this from other companies as well, how people are dealing with this has actually made a lot of differences. I remain confident that we're going to see, even if things get more challenging, just improved management of patients, which means more procedures. For us to get to a level of exiting at 2019, we need some capital, and we need instruments to be improving versus where we are, which we see that scenario. In that scenario, it also doesn't have us in October, November getting much worse with COVID and flu combined, meaning people kind of buckle down, and hence why we're not giving guidance at this point in time.
On the profit side, I'll let Carrie comment, but we clearly are keeping an eye on our overall expenses for the same reason and making sure that we funnel them to the most important longer-term projects, because we do have some big enablers in our hopper that could benefit us on the backside of 2021 and clearly in 2022. Keeping our thesis intact for the company, we want to make sure those are funded. Carrie, I'll turn it over to you. Any comments that you'd like to add?
Sure. As I think about the fourth quarter of last year, our adjusted EPS number was around $0.68. I don't think that's a bad place to think about a scenario that if we could get back to fourth quarter 2019 levels in the fourth quarter 2020, I think that's a general area that we could shoot for. The geography of the P&L may be slightly different. I would expect gross margins to be a little better this year compared to last year, just because, again, of our favorable mix as we continue to move on discontinued products and continue to look at new product introductions and the contributions of those to generate favorable mix changes. I would say, a higher tax rate this year compared to last year. We just don't have the stock comp expense deductibility that we had last year.
Maybe unfavorable on the tax rate year-over-year. Generally, I think operating expenses are going to be lower this year than last year. We're going to continue to control discretionary spending. I would definitely expect that operating expenses will be lighter than last year. The combination of maybe a little bit better gross margin, little bit less operating expenses offset with a higher tax rate largely would get us directionally in line with where we ended Q4 of 2019 for 2020.
That's great context and color. Then I know you guys mentioned on the call that you're investing in a pipeline of R&D programs, which is typical of you. If you guys could just remind us of any sort of upcoming product launches you're particularly excited about, any updates on Rebound or Arkis and product launches from those two acquisitions. Then assuming you guys are still sort of consistently evaluating M&A and inorganic opportunities at this time, can you just comment on what you're seeing on the M&A landscape and how you're thinking about supplementing some of those organic projects? Thank you.
That's a good question. That's a big one. I would say I'll frame a couple points up and then hand it over to Glenn. We clearly are active looking at opportunities in the M&A world. We think any type of disruption or change is obviously a good opportunity to take a look at scenarios and how they may play out for us. We will keep very active in keeping our eyes on things. At a high level, I'll let Glenn comment further about some of the other products in near term, I think of four big areas that we're focused on that have impact out into late 2021 and beyond. Rebound clearly is a big opportunity. To remind everyone, it brings two products for us. It brings a minimally invasive tool for neurosurgery to be able to do keyhole access for tumor resections and others.
It also brings us into the stroke market for intracerebral hemorrhage. Both of those areas have different timelines to those. As in late 2021 is when we start testing the water with some commercial capabilities with MIS and then ICH a little bit later. We have some ongoing dialogue with the FDA relative to building out our nerve portfolio, and we've been making good progress working and building our portfolio. We've been making sure that we've been able to fund that adequately during this time period.
Also in our plastic and reconstructive area, even though some of those businesses have taken probably a stronger hit during the COVID-19 window, we still see opportunities with our technologies and regenerative medicine to play a bigger, significant role. We're working with the agency as well as product development strategies to expand our indication portfolio there. Glenn, you may want to add some other comments as well.
Sure. I think first point to emphasize is during the cutbacks that we made from a cost reduction point of view, we did not really impact any of the long-term R&D programs. We wanted to make sure those were funded for the long-term viability of the company. All the things that Pete mentioned, obviously, we are funding. The other thing I'd add is we're still investing heavily in clinical studies as well to support reimbursement, to support differentiation of our product, and a lot of that is in the regenerative portfolio area. MicroMatrix, AmnioExcel, those are another areas of heavy investment that we've been making.
Great. Thank you, guys.
All right, we'll now take our next question from Shagun Singh at Wells Fargo. Please go ahead.
Thank you so much for taking the question. Peter, I was wondering if you're willing to share what the exit growth rate was in July versus the 13% that you called out in June, and if there were any differences by segment. It seems like it was pretty similar exiting June. I'm curious to get your thoughts on 2021. It looks like consensus is looking for about flattish growth in 2021 over 2019 levels. I'm just curious to know what your reaction is. I know it's a long way between now and then, but do you think that's a reasonable place to be, or could it be conservative if in fact you are able to approach normalized levels in Q4? Thank you for taking the questions.
Yeah. Thanks, Shagun. Unfortunately, I can't give you a whole lot right now. This is the reason that we're not actually giving guidance here even this year until we kind of see how the smoke clears in probably late October, early November. We'll have a better view. Our plans for 2021 guidance right now are kind of what we traditionally do, which would be out in early Q1. I'm not going to comment about that. I think when it comes to our June exit rates and our July, we've kind of given about what we want to give at this point in time. I would say, obviously, each of our product families and franchises has different levels of exit that bring that composite for the whole company.
I think we've given some views here where Orthopedics had the greatest recovery, but it also had the biggest impact, and more of things like wound reconstruction tended to be more steady throughout the quarter. I think that's really all the info on those two areas that we want to provide at this point in time.
Thank you.
All right, we'll now take our next question from Robbie Marcus at JP Morgan. Please go ahead.
Yeah, thanks. Appreciate the question. You touched on this before, but how do we think about the impact on forward growth from capital equipment? CUSA had been a pretty big driver of growth. I know it's a capital, but then a disposable component afterwards. How should we think about this environment where maybe capital units aren't getting placed as much, having an impact on forward growth?
Yeah, Robbie, I'll take a shot, and then Carrie, if you want to, or Glenn add to it. I think, again, about half of our portfolio, when you think of something like CUSA, again, which is typically used in tumor resections or broadly in liver surgery around the world, is in consuming of the actual tips, tubing, the whole cassettes that are used. We're seeing that surge quite a bit. Some of this, as you know, as an incumbent in an area where there isn't a lot of new equipment being brought in, an incumbent in a given area, which we tend to be a significant one in neurosurgery, you tend to benefit from added cases. We're seeing that come through.
I think, again, capital has to be framed up in the look of CUSA, because we're not talking that this is a linear accelerator or an MRI that may cost multiple million dollars. These are $200,000 devices. I think we believe as the uncertainty settles, they are products that clearly enable procedures to be done that are still very profitable for institutions around the U.S. and obviously very necessary in markets outside the U.S. We are seeing reasonable transactions take place outside the U.S. in markets that start improving. As we see a market get better, this level of capital purchase, which some companies may describe as smaller cap or mid-size capital expenditures, we think are going to be some of the first ones coming back.
I think, Robbie, the long or the short of the question is, I think our funnel hasn't decreased. Our funnel's actually been growing, and I don't see people saying in six months if it's even challenging, "Well, I don't need this product anymore." I think they're going to buy it when they can afford to buy it, and we're going to be able to see that have an impact at that point in time. I don't know, Glenn, if you want to comment or Carrie, if you have some other comments to add.
Yeah, maybe I'll add just a couple of things. Capital is only about 10% of our total revenue. I would say, as Pete mentioned, the funnel is still quite healthy. I would say we're obviously working with our customers as they have the financial wherewithal on different options, whether it's an outright purchase, whether it's different financing models, rent-to-own, leasing models as well, to facilitate that capital purchase on how it makes sense to them. Generally, I haven't seen any change in competitive landscape either. I think it largely has stayed the same, which is good. Glenn, anything else?
Yeah, I was just going to say, don't forget, Robbie, we also just got a neuro indication for CUSA, which we think is a differentiator. There's significant savings to hospitals in using our CUSA device with significant reduction in the OR theater. The fact that we are precision cutting and only cutting out the tissue, that's the bad tissue, the hard to remove tissue. We believe there's differentiation in the product. We've just got a new indication for CUSA. Again, the funnel's strong. We think it'll come back once the actual hospitals get some dollars freed up.
That's really great color. Maybe just a follow-up, Carrie, this was one of your better free cash flow conversion quarters. Obviously, it was a little unusual. Did you undertake anything in the quarter that can increase free cash flow conversion going forward? How do we think about that, maybe as the top line and some of the expenses come back in? Thanks.
I would expect second half cash flow to improve sequentially from the first half, as revenue continues to increase. One of the levers, we did see some inventory build in the second quarter. I would expect as revenue continues to recover, we'll be able to work through some of that inventory, which will incrementally help cash flow. In addition, from a free cash flow perspective, capital expenditures will still be an area that we will manage tightly. If you think about our first quarter CapEx, it was around $16 million, $17 million. We obviously controlled that very tightly in the second quarter. The CapEx in Q2 was only about $7 million.
Largely, I think if you think about the second half, I would say incrementally will be higher than where we ended in Q2 on CapEx in each of the quarters in the second half, but certainly probably not at the levels we were at Q1. I think CapEx will continue to be a source of free cash flow conversion to us, along with just generally working some inventory levels down and improved EBITDA associated with higher sequential revenue.
Great. Thanks a lot.
All right, we'll now take our next question from Raj Denhoy at Jefferies. Please go ahead.
Hi, good afternoon. Wondered maybe I could ask a couple on the expense lines. I think you noted that the gross margin was quite good in the quarter, quite a bit better than I think most people were modeling. It sounds like you're comfortable with that continuing for the balance of the year. One, if that's in fact correct. The second question was really around the other operating expenses. I think you mentioned, you expect operating expenses to only be down about 5% in the third quarter. The second question, is that correct? What's the outlook really for spending on those lines? The roll-up of all that is when one thinks about your EBITDA, your leverage ratio here and where it ultimately peaks out in a sense, because your EBITDA is probably going to be a little lower for the next several quarters.
How much capacity do you truly have when you think about doing deals over the next few quarters here?
Yeah. Let me take that question in different parts. Let's start with the gross margin question. I'd expect Q3 likely to be in a gross margin neighborhood that's somewhere in between Q1 and Q2. Obviously Q3 revenue, where likely in the range we provide, it'll be lower than Q2, but higher than Q2 but lower than Q1. I'd expect gross margins to be somewhere in between Q1 and Q2 actuals for Q3. That bodes well. In terms of the operating expenses, we gave guidance in my prepared remarks that Q3 operating expenses will be down about 5% from last year. I think it's more interesting to compare it to our Q4 of 2019 run rate. We didn't have Arkis and Rebound really in our run rate numbers until Q4 of 2019.
We did those two acquisitions very late in the third quarter. When you compare it to more of a Q4 2019 operating expense run rate, our Q3 2020 operating expenses are probably more down like 10% as a rough magnitude. We'll likely continue to increase that in Q4 as long as revenue continues to recover. We'll obviously manage that quite a bit. Then, what was your last question, Raj? I missed that one.
Yep, sorry. Just when one thinks about your debt ratio right now.
Oh, yeah.
How expenses are going to trend, just where do you think that peaks out before it starts to improve?
Well, remember the way that the total consolidated leverage works, it's based on a trailing 12-month EBITDA number. It's a bank EBITDA number, slightly different than the adjusted EBITDA number that we report. It's trailing. The second quarter will see more of a peak because you're losing the last two quarters of 2019 as the other quarters kind of roll on into that formula. Certainly, I would expect that ratio to peak a little bit more in the third quarter and fourth quarter. However, we still have lots of capacity. As you think about this amendment we did on July 14th, 2020. We got a temporary amendment to bring us up to 5.5 x. In Q2, we were only at 3.4 x.
We have an ample opportunity there to be confident of putting spending back in as our revenue recovers and making sure that we're thinking about long-term growth and investments there. We still have lots of ample room on our debt, our revolver as well. I'll maybe let Pete comment on thinking through M&A opportunities. Pete, you want to shed a little bit of light on that?
Yeah, just to the fact that, Raj, again, as I mentioned earlier, in these times, there's all types of opportunities that come up. I would say we're keeping an eye on opportunities within the tissue portfolio. We've clearly got opportunities that could start to build out further some of the missing puzzle pieces within our broader neuro portfolio. Those could be small plug-ins that are profitable, singles and doubles. I don't think of any large kind of transactional work that we're thinking of, but there's lots of interesting opportunities to plug in to keep building out the portfolio. Again, a big part of what we've been focused on during this time period is thinking about our portfolio and how we continually optimize it.
Obviously, SKU rationalization has been a big part of it, but thinking about other things that we can plug into it and keeping the dialogue moving forward. Most of the deals we do, we probably have entertained or engaged in some dialogue with a partner or an opportunity years in advance. We're using this time period as well to make sure that we advance those relationships, so when the time's right, we'll be in a good position to add key assets.
Yeah, that's very helpful. Thank you.
Thanks.
All right, we'll now take our next question from Steven Lichtman at Oppenheimer. Please go ahead.
Hey, thank you for taking the questions. This is actually David on for Steve. I know it's probably difficult to parse out, but could you provide any color on the recovery during 2Q as to how much of it was from previously deferred procedures versus new patient growth? Thanks for having me.
I would say honestly, I don't have it all broken out, nor do we have a perfect handle on it ourselves. Clearly, there was a recovery component that was built into it. If you think about orthopedics as an example, that would probably be the clearest example where we know shoulder procedures were delayed, and we saw that come back much more strongly. Across the board, we clearly had some recovery that was built in there. I would say, I don't think we're in a position to really characterize exactly how much that was worth within second half of May or within June.
Okay, that's fair. I just had one question on your 3Q estimate of down 5%-15% year-over-year. Is that an organic basis or a reported number? What should we be factoring in for FX and discontinued products for 3Q and the full year? Thank you.
Carrie, you want to take that?
Yeah. That's more on a reported basis. I don't have the breakout between FX and discontinued products, but that's more on a reported basis.
Okay, thanks.
Thank you.
All right. We'll now take our next question from Matthew O'Brien at Piper Sandler. Please go ahead.
Afternoon, thanks for taking my questions. Pete, sorry to push a little bit here, but everybody's trying to get their head around backlog versus new patient growth. Was July better than June as far as the overall growth rate goes for the company?
Maybe, Pete, I'll take a stab at that. Again, in Pete's prepared remarks, we talked about July being sequentially stronger than June. I do think, and Shagun kind of asked a little bit about this as well, that certainly, I still think there is some pent-up demand, some backlog we're working through as we go through the recovery. Remember also, there's parts of our business related to traumatic injuries that are really not tied to pent-up demand. You either have the injury or you don't. You don't have a backlog of those. As shelter-in-place restrictions ease and people are out and about a bit more than they were in Q2, you will start to see some more recovery in those areas.
I would say we've started generally to see some, as I think about our wound reconstruction, our area that performed the best for us was our chronic wounds. As we move into the third quarter, I do think with some of the shelter-in-place restrictions down, we'll see the continued recovery of our acute burn and wound area as, again, those are tied to maybe more traumatic things happening. The same thing with our neurosurgery, TBI type of brain injuries that will benefit from shelter-in-place restrictions being eased.
Yeah, I think, Matt, Carrie covered it. The only piece that I would add to it is the fact that when we take a look here coming into the fall or as we're exiting right now, there's only so much you can delay certain procedures in everything that we do outside of the items that Carrie commented on. We're seeing a continual ticking along of those. There's offset by, as you know, many hospitals still reserving some ICU bed capacity. That's one of the things that's clearly tempering some of our recovery in neurosurgery because they're being cautious. I do think as states get through and continually see a window when they're going to have cases below 5%, as an example that's been used in the media, we do see correlations with procedures growing.
If we were to look at New Jersey and New York now, our procedures growth versus Florida or Arizona, you would see a big difference just based on what the hotspots are. Part of our crystal ball discussion we have internally is what's going to happen in September, October, November with masks, with better protocols that are taking place, and honestly, how well the seasonal flu is managed, not because it has the specific effect, but because it causes so-called false positives or loads on the institution, which may actually have folks be continually cautious. We are optimistic that there's opportunity to actually see more upside. Again, much of it we have to see, I think, with a consistent result state by state, rather for the United States, that the COVID's being managed consistently.
Okay. That's very helpful, and I appreciate that color. As a follow-up, I'm curious about what's under the hood that we can't see, investors can't see at the moment that you could kind of benefit coming out of this dynamic. What's kind of being masked? It sounds like the OpEx side of things is somewhat durable. Are your competitors less focused right now? Are they going to be unable to invest in their inventory channels, their sales forces? Are you doing more virtual training? Are there a couple of things, Peter or Glenn, or Carrie, you can point to? That are just kind of under the hood you can't see that could be some meaningful tailwinds for the business as we head into 2021?
I'll comment and have Glenn then add to it. Look, we were behind in inventory. Glenn and his broader team have done a great job using this window of less demand to get our inventory status on all of our products where they need to be. That's a big deal, an Integra-specific item, particularly in regenerative medicine. Second item is, like everybody, we found how to do things differently that otherwise were thought maybe you couldn't do them that way. Many of those things have the potential to give us greater flexibility or agility, but they also have the opportunity to do it in a more cost-effective way. We're thinking about those things longer term, about what they mean from the impact of the company.
I would say the third one is that from day one of the reasons that we actually pulled back on hours and reduced wages and cut expenses are we wanted to preserve the critical programs that really around our growth thesis for the next multiple years. I mentioned some of them earlier around Rebound, some of the broader indications, and I think we've done a very good job being able to focus on those, having R&D people coming into environments, advancing those programs while we've been in the midst of the COVID-19. Again, as we come out of this towards the end of the year into next year, I think we'll be able to talk more about those specific programs and how we did, again, to feed our future growth. Glenn, what else would you add?
I would just say, obviously, we're being much more efficient with our expenses. Virtual selling, big thing for us now. Virtual marketing. We've set up a number of microsites across all of our key products, doing virtual professional education. Our sales meetings and our sales trainings are all going to be done virtual. These are all big cost savings for us. Obviously, we want to reinvest some of that in other parts of the business. You look at those things coupled with, even in the R&D area, how you can do clinical studies virtually to a certain extent, and these are all things we think will help benefit our cost structure over the long term.
Got it. Thank you.
Thanks.
We will now take our next question from Matt Taylor at UBS. Please go ahead.
Hey, thanks. I'll follow up that with a conceptual question. I was hoping you could help us understand, if you do get to, let's say, the exact same number of dollars in 2021 versus 2019, are these changes that you're talking about on discretionary spending and the virtual training, are those enough to make a material difference in the margins that you would see on the same sales in 2021 versus 2019, or is it more incremental?
I'll comment, and Carrie, you could jump in because I think you've been giving some really good thoughts to how we think about stuff. I would say, we'll see. We've laid out our longer-term goals a few years back, around 5%-7% longer-term growth. We don't think that that's changing. We've talked about EBITDA margins of 28%-30%. We still see that as a very viable goal. The question is: how long has COVID impacted our ability to get there? That will be part of our focus area around that. We've looked at programs and areas that we're talking about that could be incremental adds, obviously. But there are some things that could have bigger impact. I mentioned some of them are on the R&D front, which could help accelerate growth at a faster level.
Many of those are thinking about our cost structure differently and how we might be able to leverage those things in ways that we weren't in the past, whether it be how we have customers be able to service and help themselves more because the investments we've made into customer portals and tools, as an example, to actually having the capabilities to share resources around the globe more effectively between countries, which today we're rather binary. Glenn and the team are looking at those examples as well. Carrie, you may want to frame up your thoughts on how you think about incremental versus w e clearly have some things that could make a bigger difference for sure.
Yeah, I still believe that our opportunity, our biggest lever, is on the gross margin line. It has to do with our continued portfolio shift on growing our higher margin, faster-growing products that are really led by our new product introduction, and then continuing our discontinued product SKU rationalization. That still will have a large majority of what drives our margin expansion. Don't forget, we still have the TMA agreement with J&J that will come off of at the end of 2021, which will drive margin expansion as well. I think on the operating model questions, the opportunity for COVID to accelerate different thinking about how we drive expenses and manage expenses, I think that does become incremental. To Glenn's point, it gives us maybe the opportunity to reinvest in other areas of the business that maybe we didn't have enough room for.
We'll utilize the opportunity to maybe trim in some of these more traditional expense areas, like travel and entertainment and conferences and things, to think about potentially what else do we want to add in R&D and clinical to drive long-term growth. I look at that piece as more incremental and really where some of the big movement is will continue to be in the gross margin line.
Okay, great. Thanks very much for the call.
There appears to be no further questions as of right now. I'll turn it back to the speakers for any additional or closing remarks. Please go ahead.
Thank you for joining the call today, and we look forward to updating you here on our future updates. Thanks again for joining. Have a nice evening.
This concludes today's call. Thank you for your participation. You may now disconnect.