Earnings Call Transcript - ACH Q2 2023

Operator, Operator

Good day, and thank you for standing by. Welcome to the Owens & Minor Second Quarter 2023 Earnings Conference Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your first speaker today, Jackie Marcus, Investor Relations. Please go ahead.

Jacqueline Marcus, Investor Relations

Thank you, operator. Hello, everyone, and welcome to the Owens & Minor Second Quarter 2023 Earnings Call. Our comments on the call will be focused on the financial results for the second quarter of 2023 as well as our updated outlook for 2023, both of which are included in today's press release. The press release along with the supplemental slides are posted on the Investor Relations section of our website. Please note that during this call, we will make forward-looking statements. The matters addressed in these statements are subject to risks and uncertainties, which could cause actual results to differ materially from those projected or implied here today. Please refer to our SEC filings for a full description of these risks and uncertainties, including the Risk Factors section of our annual report on Form 10-K and quarterly reports on Form 10-Q. In our discussion today, we will reference certain non-GAAP financial measures, and information about these measures and reconciliations to the most comparable GAAP financial measures are included in our press release. Today, I'm joined by Edward Pesicka, President and Chief Executive Officer; and Alex Bruni, Executive Vice President and Chief Financial Officer. I will now turn the call over to Ed.

Edward Pesicka, President and Chief Executive Officer

Thank you, Jackie, and good morning, everyone, and thank you for joining us on the call today. The second quarter showed a continuation of positive momentum in many areas, including exceptionally strong cash flow, meaningful improvement in net debt, mid-single-digit organic growth in our Medical Distribution division and continued double-digit growth in our Patient Direct segment. However, we continue to see a slow recovery in our Global Products division as demand for our higher-margin Surgical & Infection Prevention (S&IP) products remains constrained. One of the objectives for 2023 is to significantly reduce debt to provide flexibility for the business. Our performance in Q2 has put us well on the way to achieving this objective. Strong execution and focus by the overall organization, combined with the operating model realignment program, has led to over $300 million in operating cash flow in the quarter, driven by the reduction of working capital, net proceeds from accounts receivable sales and disciplined capital deployment. After celebrating the 1-year anniversary of the acquisition of Apria at the end of the first quarter, Q2 marks the first quarter with a year-over-year comparison of the Patient Direct segment. After a year of double-digit pro forma growth in each of the previous four quarters, I am pleased to report that the segment continued to produce double-digit revenue growth with top line performance fueled by strong growth in most of our major product categories. In addition, we delivered year-over-year operating margin expansion of 25 basis points in the quarter. It is clear that the powerful brands of Byram and Apria are working well together with a broad offering to serve the patient in the home. We remain bullish on the outlook for the Patient Direct segment for the remainder of the year, as well as the long term as demand for chronic condition health care in the home continues to increase. Moving on to our Products and Healthcare Services segment. The results in this segment were mixed. In our Medical Distribution division, we saw year-over-year revenue growth accelerate to over 5%, driven by growth at our existing customers and the implementation of new wins, partially offset by the residual impact of previous losses. In addition, it should be noted that same-store sales, excluding PPE, showed growth of 10%. However, as we recognize the positive momentum in our Medical Distribution division, it is prudent to recognize headwinds we face elsewhere, specifically in our Global Products division, as demand for our higher-margin PPE products declined year-over-year. When combined with our fixed manufacturing costs, this means we must work much harder to control cost. With elevated supply levels and lower demand for PPE, we are remaining cautious on the balance of the year given these trends. We are working hard to navigate these uncertainties, recognizing what we can and cannot control and managing our business as closely as possible. One of the key elements to minimizing this headwind is our operating model realignment program. With our operating model realignment program well underway, we have already implemented cost-saving efforts while enhancing the processes to drive operational excellence as well as diligently reviewing each segment's opportunity for growth. First, within our sourcing and demand management work stream, the team has made significant strides to date with positive results already. Second, redesigning our organizational structure will allow us to invest and build teams and areas central to our growth opportunities in the coming quarters. Third, our focus on network rationalization and operational excellence will be critical in the ongoing management of our Products and Healthcare Services segment, particularly if the broad demand challenges continue in the coming quarters. And finally, we are having important conversations with customers and partners to improve our commercial excellence and product profitability. Everyone recognizes the difficult nature of an inflationary environment, but at the same time, our customers have come to rely on our proprietary distributed products as critical components of patient care. We are on a clear path to achieve the $30 million target for contribution to adjusted operating income in 2023 from this program, with the vast majority of the benefits in the coming months. Many of the actions have already taken place, and we are confident in the value provided by the operating model realignment program for the remainder of the year. When I look at the back half of the year, I like the opportunities presented by the operating model realignment program, the continued strength of our Patient Direct segment and the revenue growth in our Medical Distribution division. However, the previously mentioned caution around the outlook of S&IP products has resulted in slightly adjusting our full year expectations. Finally, the team and I hope you will join us for our 2023 Investor Day in early December in Boston, at which we will share our vision for the future of Owens & Minor. I will now turn the call over to our Chief Financial Officer, Alex Bruni, to discuss our second quarter financial performance and our guidance for the full year. Alex?

Alexander Bruni, Executive Vice President and Chief Financial Officer

Thank you, Ed. Good morning, everyone. I'd like to start by reviewing our financial results and the key drivers of our performance in the second quarter of 2023. Following that, I'll briefly touch on our outlook for the remainder of the year and the cadence for the third and fourth quarters. Starting with our second quarter results, our revenue for the quarter was $2.6 billion, which represented growth of 2.5% and was driven by continued strong performance in our Patient Direct segment and growth in the Medical Distribution division of Products and Healthcare Services. For the quarter, Patient Direct revenue was up 10.5% versus the prior year with strong growth across most categories, especially in our largest categories of diabetes and obstructive sleep apnea. Products and Healthcare Services revenue was relatively flat compared to the second quarter of 2022, with growth in Medical Distribution of 5% offset by headwinds in our Global Products division. Second quarter gross margin was $519 million or 20.3% of revenue compared to $533 million or 21.3% of revenue in the second quarter of 2022. The gross margin contraction was driven by a change in product sales mix as less higher-margin PPE was sold, partially offset by a reduction of LIFO expense of $6.7 million versus the prior year, driven by a significant reduction in our Medical Distribution inventory. Our distribution, selling and administrative expense for the quarter was $455 million, making up 17.8% of revenue. This expense increased by $33 million versus the prior year, primarily due to variable expenses in Patient Direct to support revenue growth along with increased team member benefits expenses and inflationary pressures negatively impacting wages and occupancy costs, which affected both segments. GAAP operating income for the quarter was $10.8 million, and adjusted operating income was $62 million. Strong top line performance in our Patient Direct segment was critical to our margin performance during the quarter. Interest expense for the quarter was $41 million, which reflected an increase of $4.9 million as compared to the prior year, primarily due to interest rate increases. GAAP net loss for the quarter was $28 million or a loss of $0.37 per common share. Adjusted net income for the quarter amounted to $14.2 million or $0.18 per share. Adjusted EBITDA in the second quarter was $113 million with a margin of 4.4%. Additionally, and as Ed mentioned, our operating model realignment program continues to gain momentum, which improved our margin performance. We remain on track to achieve $30 million of contribution to adjusted operating income in 2023 from this program as well as exiting the year with a $100 million run rate. Let's now look at cash flow, the balance sheet and our capital structure. In the second quarter, we generated significant operating cash flow of $313 million, inclusive of $150 million in net proceeds from accounts receivable sales. During the quarter, it became economically attractive for us to enter into a program that allows us, from time to time, to sell receivables related to a handful of customers across the businesses. Also, as you've seen over the trailing few quarters, our business is capable of producing strong levels of operating cash flow, which is driven by margins within Patient Direct, followed by cash conversion and rigid working capital management across all business lines. Due to the level of cash from operations, we reduced total debt by $49 million and net debt by $269 million during the second quarter. We have built invested cash balances, much of which is earmarked toward our 2024 series notes. Presently, these investments are out-earning the coupon on much of our near-term and longer-dated debt. It's also worth noting that we have reduced total debt by $309 million since the finalization of the Apria acquisition. At the end of Q2, our total debt was $2.3 billion, and net debt was $2 billion. Delevering remains a top priority. With another quarter behind us, we are able to narrow our guidance for 2023. We are revising our revenue, adjusted EBITDA and adjusted EPS outlook to reflect our confidence in Patient Direct and the operating model realignment program, balanced against the lack of visibility and caution we have around S&IP product sales in the back half of the year. The new details are available in our press release from earlier this morning and in the supplemental slide on the Investor Relations portion of our website. As we think about the cadence for the second half of the year and consistent with our expectation that our earnings will be heavily weighted to the back end of the year, it's reasonable to expect that Q4 earnings could be roughly twice that of Q3 due to traditional seasonality and, moreover, timing of the realization of the operating model realignment benefits. We are heavily focused on delivering savings on time and in full as well as driving the performance of the business. Before turning the call over to the operator for Q&A, I'd like to thank all of our dedicated teammates for their efforts in enabling Owens & Minor to provide the highest quality of service to our customers. With that, I'll now turn the call over to the operator for questions. Operator?

Operator, Operator

Operator provides instructions to participants. We'll go first to Kevin Caliendo at UBS.

Kevin Caliendo, Analyst, UBS

A lot to unpack here. But I guess to start, sort of help us bridge first half to second half, third quarter to fourth quarter in terms of what is embedded and the expectations to go from, in essence, at the midpoint, $222 million of EBITDA to $333 million in the second half. Like what needs to happen in your opinion, to get there from now third quarter, fourth quarter. I get part of it is the cost savings plan, but operationally, ordering patterns, what needs to — what do you need to see to get comfortable that you can achieve this?

Edward Pesicka, President and Chief Executive Officer

Sure. Let me break it out in different components. Let me start first with Patient Direct. So Patient Direct has normal seasonality in their business, and that's historically shown. If you look at what the performance was last year in Patient Direct as patients hit their deductibles, the increase in the demand for products escalates at a pretty rapid pace in the back half of the year. In addition to that, just the traditional — the continued strong performance in our Patient Direct business. So that's the normal traditional ramp there, and we expect that to continue at the pace if not accelerate from where it's been historically. Then the second aspect of it is you're absolutely right in the operating model realignment and the four major work streams that we have. A lot of that work has already been done and locked in, it just needs to work its way through the system. So take sourcing, for example. While we've gone on and been able to source product and raw material at a lower price, those products and raw material are working their way through the inventory through the systems, and those will end up coming into place in the back half of the year. I think another example in that would be the way we've structured our organization and from our network optimization, those actions have taken place. So those are locked in and going into the marketplace. The next thing is really the continued reduction of debt. We've done a really good job on taking debt down which is actually going to help drive that impact, not so much on EBITDA but on the adjusted operating income. Then in our Medical Distribution segment, the continuation of the growth in that segment and the fixed costs leverage we're getting in it. And lastly, which is really the toughest one for us to predict in full transparency, is the expectation of improvement within the demand for our products within our Global Products division, specifically PPE. What I can't say is we have seen sequential or month-over-month improvement in the demand for those products as the year has progressed. But it's still difficult to put your finger exactly on it or put a pin on it because of what the customers have in safety stock. In addition to that, I don't want to miss the fact that you've got major distributors out there that carry our product and distribute them that have significant excess stock, both of our product as well as other brands in there. So that's why we're trying to be cautious on that last component. Look, the first three or four I talked about — they're pretty much locked in. We just need to continue to execute on those. And then the one at the end is the one that's really difficult to put a pin on, which is why we're trying to be a little bit more cautious on the back half.

Kevin Caliendo, Analyst, UBS

Can I ask a follow-up? When it comes to PPE, can you maybe talk about where the pricing is in the marketplace and maybe more importantly than pricing, how is your competitive positioning, in your opinion, changed, if at all, over the last 6 months or 9 months as these inventories have built and are now coming down. Are you seeing any additional competitive pressures from sourcing outside of the United States? Or anything else? Just help us sort of understand how the market dynamics are playing out for you in your opinion?

Edward Pesicka, President and Chief Executive Officer

Yes. In my view, I think we've seen prices stabilize. We saw a rapid decline in price in 2022, but through 2023 here, they have somewhat stabilized. And so that's where I would say they are right now.

Operator, Operator

We'll take our next question from Michael Cherny at Bank of America.

Michael Cherny, Analyst, Bank of America

Maybe if I can follow up a bit there. Obviously, a lot of moving pieces, both within your control and without. Can you maybe just give us some sense on risk weighting the various components as you build that back half ramp? I know you've been adamant about the ramp over the course of the year. It seems like relative to at least where consensus is that the three to four jump up a little steeper, so curious how we think about where you have the highest degree of visibility, where you think there's still items that are out of your control that you're waiting to make sure come through, especially maybe on PPE pricing for one?

Edward Pesicka, President and Chief Executive Officer

Sure. Yes. I think the clearest line of visibility is in our operating model realignment savings. Like I said, those are completely locked in. And then I think there's a high level of confidence also in the seasonality — and this is the continued strong performance across all the segments in Patient Direct where I believe we continue to win business and continue to generate operating leverage in that business. I think in our Medical Distribution business, we continue to have momentum with growth, so higher level of confidence there. And I think I was trying to be clear that the one area that's still difficult to put an exact pin on is when destocking happens — and when I say destocking, not just at a customer, but other distributors that sell our product because they bought a tremendous amount of ours as well as other products in the market — and that flushing through. That's the one variable that we don't have complete control over as well as 100% visibility on. So I'd put that as the risk factor; the other four or so are pretty high confidence.

Michael Cherny, Analyst, Bank of America

And I guess on that last risk factor, sorry to harp just on the most negative part, but how do you think about the proof points you're looking for just because no one could have predicted the pandemic. No one had predicted the roller coaster that we've seen on demand on PPE. You went out of your way to service your customers incredibly well in terms of delivering what was needed. We've all been wondering to figure out when are we going to get to the new normal and what that is. And so especially with your look into not just your direct customers, but also the distribution side, what are the proof points you're looking for to call success or victory there?

Edward Pesicka, President and Chief Executive Officer

Yes. So the proof points we're looking at are comparisons back to 2019 demand, and that was kind of called the steady-state program. Within our existing customers, we're starting to see some customers where we distribute to them and they use our products — we're measuring those customers — and we're starting to see some of those customers back to pre-COVID levels of ordering, so that's telling us that they burned through that level of inventory. And then the other side is really taking a hard look at tracings to other distributors of what they're doing. So those are some of the key factors. And again, we have seen improvement month-over-month, but to get it overall back to that level, the improvements have fluctuated from month to month. They haven't been at a steady state, I'll put it that way.

Operator, Operator

We'll take our next question from A.J. Rice at Credit Suisse.

Jonathan Yong, Analyst (on behalf of A.J. Rice), Credit Suisse

I guess if we think about the range of your EBITDA guidance and obviously the big risk factor is the destocking component. How much more does it need to improve for you to come to the midpoint? And then at the bottom end of the range, what is kind of assumed there in terms of what happens on the destocking trend? Is it similar to what you're experiencing now? Or is there some improvement? Just trying to get a flavor of the risk factor from the bottom and top end of that EBITDA guidance.

Edward Pesicka, President and Chief Executive Officer

Sure. From a risk factor standpoint, the material significant majority of our EBITDA for this year is coming out of the Patient Direct segment. If you look back at the first and second quarter of the adjusted EBITDA generated in our Patient Direct segment and expect the ramp in the back half of the year, that's where the bulk of that EBITDA is going to be coming from for the full year. Then you think about just the small amount of the operating model that's been in the first quarter and then in the first and second quarter with the bulk of that coming in the third and fourth quarter — that will hit more in the Products and Healthcare Services side. So from a risk factor on that, it is heavily weighted, significantly weighted towards Patient Direct with the bulk of the stuff in Products and Healthcare Services coming from some seasonality, but the true benefit of the operating model realignment. So I guess the short answer to derisk it is there's a little of it coming from the Products and Healthcare Services in the back half of the year compared to what's coming from the other parts of the business. I would say to a lesser extent, we do think that LIFO and stock-based compensation will be factors in terms of where we land within that range.

Jonathan Yong, Analyst (on behalf of A.J. Rice), Credit Suisse

Okay. That's helpful. And then you mentioned that some customers are improving their purchasing patterns. It sounds like they're burning through, but what about the distributor side? Do you have any sense of how much excess inventory they have? And then are they purchasing other competitor products? Or how is that trend looking? How many months of stock do they have on hand relative to what you would normally think?

Edward Pesicka, President and Chief Executive Officer

Yes. I think that's tough because getting that data is difficult. But we believe that — we look at ourselves as a proxy. We know we've done a really good job in the last quarter of taking inventory down, which turned around and helped us generate tremendous cash flow for the quarter. So we believe that if we're using ourselves as a proxy, they have similar, and we've probably been more highly focused on moving our inventory out specifically our products to get them to turn. So the short answer here is, we don't have direct visibility, but if we use ourselves as a proxy, we believe that across the board, whether it's the four, five or six distributors that are key distributors to us, they have similar, if not more, than what we would have in stock.

Operator, Operator

Next, we'll go to John Stansell at JPMorgan.

John Stansell, Analyst, JPMorgan

This is John on for Lisa. Just a question going back to some of the commentary around sourcing and demand management. It sounds like you're having positive impacts already, as you said. But I noticed you adjusted the commodity price assumptions in the guidance from kind of stable to improving just to stable. Is there anything more than just added visibility on the input side that's changed for you through the quarter? Or what's driving your cost outlook for the back half?

Alexander Bruni, Executive Vice President and Chief Financial Officer

Thanks, John. Obviously, in our Products Division, in particular, we keep a very close eye on commodities and how they impact things. I would say that the update here was just based on a broad look across trends and, I think, a judgment that it's probably more stable than stable to improving.

John Stansell, Analyst, JPMorgan

Okay. Great. And then just — I know we had some discussion last quarter around home respiratory potentially being a little below kind of the average within Patient Direct. How about trend during the quarter? And are you seeing any changes in patterns there?

Edward Pesicka, President and Chief Executive Officer

At a high level in the Patient Direct business, I can't be more pleased that we had double-digit growth overall in that segment, and that's coming off some pretty tough comps. The one category coming off of COVID that's still not growing at the rate we wanted to is home respiratory; it has improved sequentially quarter-over-quarter. Another aspect is the Philips recall on NIVs and other home respiratory products, which has caused us to actually have to spend more capital to get new machines that are qualified. The long-term benefit is that when Philips gets it fixed and machines are refurbished and ready to go, we won't need to spend the capital for replacements. So home respiratory is still not where we want it to be. It is improving as the year has progressed. But across all categories, two major ones — diabetes and CPAP — are both growing in the double-digit range. Overall the total segment is growing in double digits, and across the board whether it's ostomy and continence, wound care, urology, all those categories are continuing to do extremely well in the marketplace.

Operator, Operator

We'll go next to Daniel Grosslight at Citi.

Daniel Grosslight, Analyst, Citi

I want to go back to what's the topic of the year, the PPE stocking. Earlier this year, I think you mentioned in your conversations with health systems that around one-third of hospitals were working through their inventories, one-third still had access, and one-third had about a year's worth of stock. Wonder if there's been any change to that? And is there any way to quantify your conversations with hospitals and their PPE stocks right now?

Edward Pesicka, President and Chief Executive Officer

All I would say based on the conversations as well as some of the data we looked at, that has gotten slightly better. We've seen that get slightly better from Q1 to Q2, but it's that second bucket — the last two-thirds that have excess stock that's less than a year and up to a year on the other side of it. Those are the ones that are slow to come down. And again, that's just one component of it. That's just what hospitals have. We've seen that improve, but we also have to factor in other channels to the market where those other channels have excess stock. And that's another one that's tough to get arms around as you look at different data like sales tracings to try to get to where you need to get to on that.

Daniel Grosslight, Analyst, Citi

Okay. And then on the core distribution ex-PPE, it seems like that's trending nicely around 10% year-over-year growth this year versus mid-single digit last quarter. Just curious what's causing that acceleration in same-store sales growth?

Edward Pesicka, President and Chief Executive Officer

I think there are a couple of things. One is great service. I was actually out with a customer yesterday where we're running raw fill rates north of 98% to 99%. Those industry-leading raw fill rates mean customers get what they order when they want it. That's a driver. I think another aspect has been new win implementations that are starting to take place, and then just better execution in the field. Those are three major factors driving the strong performance in the Medical Distribution division.

Operator, Operator

We'll go next to Eric Coldwell at Baird.

Eric Coldwell, Analyst, Baird

The distribution growth, either the 5% or the 10% ex-PPE, is pretty good, probably better than market trend in hospitals. I was hoping you could parse that out perhaps differently: what component of that growth is new wins versus penetration of existing accounts? Maybe what kind of offset you had from prior period losses, and then if you could sprinkle in some conversation around volumes and pricing outside of PPE, that would be helpful as well.

Edward Pesicka, President and Chief Executive Officer

I think at a high level, there's a reasonable blend between price and volume — roughly half price, half volume from a broad standpoint. Manufacturers a lot of times are setting the price with the hospital, and we're passing that out with the cost plus. Our same-store sales are driving a significant portion of this, which when used as a proxy for the health of our business and the industry, shows we're continuing to expand and gain share, both through additional services within the customer as well as a broader portfolio with additional products and penetration of the account. Partially offsetting this were some trailing losses that might have a point or so of impact. Then we've got one to two points of impact from new wins coming into place now. We expect that momentum to continue. We're really pleased with the way revenue growth in Medical Distribution is going. The 5% growth overall is a testament to what the commercial team has done as well as operational improvements.

Eric Coldwell, Analyst, Baird

When you cite additional services, could you give us a sense of what you're talking about there? Would that be things like kitting programs, stocking as a service? Is there any additional color you could provide on the additional services opportunities?

Edward Pesicka, President and Chief Executive Officer

I'll give you an example: outsourced logistics. You may have a device company or another manufacturer that's looking for outsourced logistics and for assistance getting product into the hospital — that's one example. We're seeing growth in our outsourced logistics business. We've spent a tremendous amount of time in our kitting business; our operations leadership has focused on how to eliminate cost and waste and improve service. We've increased our service levels to close to 100% for getting kits out on time, and that's done in the U.S., which helps get product to customers quicker. That's another example of what we're focused on.

Eric Coldwell, Analyst, Baird

What's the landscape for new business today in core acute care and alternate sites? Is the market seeing churn? Is pipeline activity ramping or stabilizing? What are you seeing in terms of RFPs or customers vetting other vendors, big picture on churn and pipeline expectations?

Edward Pesicka, President and Chief Executive Officer

We've seen some large RFPs out right now where there's opportunity and where we're also in a retention position. The good news is the bulk of our top 10 renewed for extended periods, which was critical. We are seeing a mix, including larger opportunities and also mid- and small-sized customers looking for higher levels of service and competitive pricing. Our pipeline is still strong — if you think about an average customer contract being three to five years, our pipeline should be $1 billion to $2 billion plus at any time as we look for opportunities to win business.

Operator, Operator

There are no further questions at this time. I would like to turn the call back over to Ed Pesicka for closing remarks.

Edward Pesicka, President and Chief Executive Officer

I just want to thank everyone for joining us on the call today. The participation of everybody on this call is extremely appreciated as well as we value the interest in the company. I think we've done a really good job sharing the progress that we've made as well as what we're going to continue to do in the coming quarters. I look forward to continuing to share that progress in the coming quarters and also at our Investor Day in December in Boston. Again, thank you for your time and attention today and I look forward to talking to you soon.

Operator, Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.