Alcon Inc Q4 FY2022 Earnings Call

Greetings and welcome to Alcon's Fourth Quarter and Full Year 2022 Earnings Call. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Dan Cravens, Vice President and Global Head, Investor Relations for Alcon. Thank you. You may begin.

Welcome to Alcon's fourth quarter and full year 2022 earnings conference call. Yesterday, we issued a press release, interim financial report and annual report as well as posted a supplemental slide presentation on our website to enhance today's call. You can find all of these documents in the Investor Relations section of our website at investor.alcon.com. Joining me on today's call from Geneva are David Endicott, our Chief Executive Officer; and Tim Stonesifer, our Chief Financial Officer. Our press release, presentation and discussion will include forward-looking statements which expressly disclaim any obligation to update forward-looking statements as a result of new information or future developments, except as required by law. Our actual results may vary materially from those expressed or implied in our forward-looking statements. Accordingly, you should not place undue reliance on any forward-looking statements. Important factors that could cause our actual results to differ from those in our forward-looking statements are included in Alcon's Form 20-F and our earnings press release and interim financial report on file with the Securities and Exchange Commission and available on the SEC's website at sec.gov. Non-IFRS financial measures used by the company may be calculated differently from and therefore may not be comparable to similarly titled measures used and other companies. These non-IFRS measures should be considered along with but not as alternatives to, the operating performance measures as prescribed per IFRS. Please see a reconciliation between our non-IFRS measures with directly comparable measures presented in accordance with IFRS and our public filings. For discussion purposes only, our comments on growth are expressed in constant currency. In a moment, David will begin by recapping highlights for 2022 in recent months, including market dynamics, innovation, highlights, key product launches and acquisitions. After his remarks, Tim will discuss our performance and outlook for 2023. Then David will wrap up with closing remarks and we will open the call for Q&A. With that, I will now turn the call over to our CEO, David Endicott.

Thanks, Dan. Welcome to Alcon's fourth quarter and full year 2022 earnings call. 2022 was a great year for Alcon. We ended the year with sales of $8.7 billion and double-digit sales growth of 11%. These results were driven by new product launches, solid demand from resilient markets and strong commercial execution. Core operating margin for the year was 18.2% and core diluted earnings per share were $2.24 which was up 23% year-over-year on a constant currency basis. Additionally, we achieved a core operating margin of 20% when adjusted for foreign exchange. Based on these results, it's clear that the Alcon team is delivering and our fundamentals are strong. As I reflect on 2022, I'm extremely proud of what we've accomplished, especially given the challenging geopolitical, macroeconomic and supply chain headwinds we faced. In surgical, we grew the business double digits, driven by industry-leading technology, solid execution and continuing international recovery. Our portfolio of PC-IOLs, PanOptix and Vivity had another quarter of strong share growth and we exited the year with a global PC-IOL share position in the mid-50s. During the year, we launched our portfolio of IOLs on the CLAREON platform in the United States. This highly differentiated material delivers among the lowest levels of glistening and surface edge and has a proprietary edge curvature designed to help reduce glare. Our new CLAREON material has been well received by doctors around the world and is helping us to gain share. We're also expanding our footprint with double-digit sales growth in the equipment category for the year. This growth was particularly strong in international markets where we continue to see solid uptake for our surgical machines, including our industry-leading Stancurion device, which is designed and priced for developing markets. We expect the demand for the equipment will return to more normalized growth rates this year. While we continue to grow our footprint in ophthalmic operating rooms worldwide, we've also significantly expanded our presence in the clinic with the ARGOS biometer. Doctors are responding favorably to ARGOS, thanks in part to higher capture rates, easier prediction of accurate lens power and data integration into the operating room, all of which helps drive clinic efficiencies and improve patient outcomes. Tying this all together is our digital offering, SMARTCataract, which we beta tested in 2022. SMARTCataract received terrific feedback from surgeons and we'll continue to develop this platform in '23. SMARTCataract is the first application in Alcon's comprehensive cloud-based platform that is uniquely designed for surgical ophthalmic practices. SMARTCataract links data systems and diagnostic devices in the clinic with equipment in the operating room. Data shows that SMARTCataract delivers significant time savings during the cataract evaluation, planning, operating room and postoperative workflows. Put simply, SMARTCataract is helping surgeons deliver better outcomes more efficiently. Also in 2022, we expanded our presence in surgical glaucoma with the acquisition of Ivantis, which brought Hydrus Microstent into our portfolio of implantables. Hydrus has long-standing clinical efficacy data. Its 5-year horizon data demonstrated meaningful and statistically significant clinical benefits over the full 5 years, including sustained reduction in medication use and decreased need for secondary glaucoma surgery. Now turning to Vision Care. Our team delivered high single-digit growth across both our contact lens and ocular health franchises. In contact lenses, our full year growth of 9% was driven by our portfolio of innovative lenses which continue to receive favorable market feedback as well as select price increases. We continue to fill out our portfolio and launch new contact lenses in our segments of the market or areas where we have opportunities to gain share. In 2022, we launched TOTAL30 into the reusable market. This is the first major innovation of the $4.2 billion reusable lens category in many years. TOTAL30 is the only water gradient lens available for reusable wearers and since launching TOTAL30, we are seeing share growth in this category. TOTAL30 is available in the U.S. and Europe, and we will continue to roll it out to more international markets in 2023. Just recently, we announced the launch of TOTAL30 for astigmatism, which competes in the $1.3 billion reusable toric category. This is the first reusable water gradient lens for astigmatic wearers. Since more patients with astigmatism wear reusable contact lenses, the availability of the toric T30 provides us an opportunity to gain share and bring exceptional comfort to these patients. This lens will be broadly available in the U.S. and Europe earlier this year, and we'll roll it out internationally throughout 2023. We also launched DAILIES TOTAL1 for astigmatism in early 2022 and customer response has been very favorable. DAILIES TOTAL1 toric joins the sphere and multifocal modalities for the premium DAILIES lens market. DAILIES TOTAL1 toric is also the first and only daily toric lens to feature our proprietary water gradient technology that delivers exceptional comfort. Now all of our toric lenses feature our proprietary balance design, which creates clear and stable vision. Our toric portfolio represents a significant opportunity as we estimate that toric is one of the fastest-growing segments of the contact lens market. Now turning to ocular health, where we also saw high single-digit growth in 2022 despite the supply chain challenges we faced. Starting with dry eye, our Sustained family, including Sustained Hydration, Ultra, and Complete continues to perform well with double-digit sales growth in 2022. There are over 30 million people in the U.S. alone that suffer from dry eye, and Sustained is the best-selling brand of artificial tears and is clinically proven to soothe irritated eyes quickly. Now with multi-dose preservative-free formulations, we have a full suite of convenient and affordable options for patients. Late in the year, we acquired Aerie Pharmaceuticals. With this acquisition, we expanded our glaucoma portfolio with two additional products, Rhopressa and Rocklatan, which are complementary to Simbrinza. Rocklatan and Simbrinza offer four different mechanisms of action allowing for maximum medical therapy in just two bottles. Additionally, the Aerie acquisition expands our R&D pipeline and builds upon our pharma development expertise. Our strong 2022 ocular health performance was offset by significant supply chain challenges, particularly in contact lens care. Our team continues to address these challenges which are likely to persist through at least the first half of 2023. Now let me provide an update on our end markets. In Surgical, global cataract procedures were up mid-single digits in the fourth quarter versus the prior year. This growth varies by region. In the United States, where surgical centers continue to experience staffing challenges, procedural volume was up low single digits. Outside the U.S., procedures were up mid- to high single digits as markets continue to improve. Encouragingly, we saw sequential improvements in ATI well penetration in the U.S. in the fourth quarter. We continue to focus on driving penetration by educating doctors, clinical staff, and patients about the benefits of advanced technology lenses. In contact lenses, the retail market growth in the quarter was mid-single digits, with low single-digit growth in the U.S. and high single-digit growth internationally. While mid-single-digit growth is in line with historical rates, it's important to note that this growth predominantly reflects price increases and trade-ups. Additionally, the market growth varies by modality, with the daily SiHy category continuing to grow significantly due to higher pricing and patient trade-ups. Torics also continued to grow nicely, primarily driven by the daily toric category. Finally, the reuse category was flat. Now with that, let me pass it to Tim who will take you through our financial results and comment on our outlook for 2023.

Thanks, David. We're pleased to report fourth quarter sales of $2.2 billion, up 7% versus the prior year. This growth was driven by continued recovery in most international markets and demand for our innovative products, including those acquisitions. Our overall fourth quarter sales growth reflects approximately 180 basis points of contribution from sales of acquired products. Our fourth quarter U.S. dollar sales growth included approximately 600 basis points of pressure from foreign currency. For the full year 2022, total company sales of $8.7 billion grew 11%. I’m extremely proud of how well the Alcon team has managed the challenges of 2022. We performed well while navigating a year of historic uncertainty, including a strong U.S. dollar, continued supply chain tightness and inflation. Moving to our fourth quarter sales results. Our Surgical franchise revenue was up 8% year-over-year to $1.3 billion. Surgical revenue for the full year was up 13%. Implantable sales were $434 million in the quarter, up 11% year-over-year, primarily due to market recovery in most international geographies, increased demand for our PC-IOL portfolio led by Vivity and sales of Hydrus. This was partially offset by declines in South Korea following a reimbursement change during the first quarter. Please recall that there was a significant spike in demand in Korea ahead of this reimbursement change and therefore, we expect difficult comps in implantables in the first quarter of 2023. Implantable sales for the year were up 20%. In Consumables, our fourth quarter sales were up 6% to $636 million, primarily driven by improving market conditions. For the full year, global sales were up 10%. Our strong consumables growth also reflects the expansion of our global equipment footprint. In equipment, sales were $204 million in the quarter, up 7% year-over-year, primarily due to continued strong demand for our cataract equipment and service, particularly in international markets as we upgrade older generations of equipment to Centurion and Legion. Growth in the quarter was partially offset by declines in the refractive equipment. For the year, equipment sales were up 10%. We continue to be very pleased with our strong equipment performance as well as the resilience of demand for these products. Turning now to Vision Care. Fourth quarter sales were up 7% year-over-year to $881 million. For the full year, Vision Care sales were $3.6 billion, up 8%. Contact lens sales were $530 million in the quarter, up 6% versus last year. Sales were led by our portfolio of SiHy lenses, partially offset by declines in legacy products. Additionally, we saw strong sales in the U.S. and slower international growth. Contact lens sales for the full year were up 9%. In ocular health, our fourth quarter sales were $351 million, up 8% year-over-year. This was led by our portfolio of eye drops, including our Sustained family of artificial tears and ophthalmic pharmaceutical products. Similar to last quarter, this growth was significantly offset by supply chain challenges primarily in contact lens care, which negatively impacted ocular health growth by approximately 400 basis points. As David mentioned, we expect these challenges to persist at least through the first half of 2023. Ocular health sales were up 7% for the full year. Now moving down the income statement. Fourth quarter core gross margin was 61.3%, which was flat on a constant currency basis. Core operating margin was 16.4% in the quarter, essentially flat versus last year on a U.S. dollar basis, but up 240 basis points on a constant currency basis. The improvement was mainly driven by underlying operating leverage from higher sales and favorability from incentive compensation, partially offset by increased inflationary pressures and increased investments in R&D, primarily associated with the acquisition of Aerie. Core operating margin for the full year was 18.2%. However, on a constant currency basis, we achieved a full year core operating margin of 20%. Fourth quarter interest expense was $40 million compared to $28 million last year, driven by higher debt following the funding of the Aerie acquisition and less favorable interest rates. The fourth quarter core effective tax rate was 30.6% compared to 10.4% last year. This increase was primarily due to the recognition of tax expense related to the advanced pricing agreement between the Swiss and U.S. tax authorities that we discussed on our last earnings call. There was also an impact from a decrease in inventory build in certain markets and the geographical mix of pretax income. Core diluted earnings per share in the fourth quarter of 2022 were $0.42 versus $0.56 last year. The decrease is mainly due to higher interest expense and taxes following the advanced pricing agreement I just mentioned. For the full year, core diluted earnings per share of $2.24 grew 23% on a constant currency basis. Before I discuss our outlook for 2023, I'll touch on a couple of cash flow and other related items. Free cash flow for the full year was $581 million compared to $645 million last year. This variance was primarily driven by lower cash from operations in 2022, driven by the negative impact of foreign currency on our operating results and the payout of the 2021 bonus, partially offset by lower capital expenditures. For 2023, we expect free cash flow to be significantly better than 2022 despite several one-time payments in the year, including transformation and a legal settlement. Similar to last year, we expect the first quarter to be the low point in the year, driven by the timing of the annual bonus payment and payments related to our expanded transformation program. Capital expenditures were $636 million for the full year, which were primarily related to investments in our contact lens manufacturing production lines. Transformation costs were $78 million in the quarter and $288 million of life to date. As we announced on our last call, we identified additional transformation opportunities which we launched during the fourth quarter and which accounted for most of the transformation expense in the quarter. We continue to expect the entire transformation program to wrap up by the end of 2023. Now moving to 2023 guidance. Our current outlook assumes that year-over-year market growth will be slightly below historical averages. Exchange rates as of the end of January prevail through year-end and inflation and supply chain headwinds moderate in the second half of the year. Accordingly, we expect 2023 net sales of $9.2 billion to $9.4 billion, which corresponds to 6% to 8% constant currency sales growth versus the prior year. Now turning to expenses. We're going to continue to invest behind innovation and expect core R&D expense to come in toward the high end of our prior range of 7% to 9% of sales. Moving to core operating margin. We expect efficiency initiatives and operating leverage to drive a core operating margin of between 19.5% and 20.5%. While we continue to see inflationary pressures, we've taken actions, including pricing and productivity initiatives to help mitigate the impact. Moving down the income statement. We expect interest and other financial expenses to be between $260 million and $280 million. This reflects the financing activities completed in May and December at higher interest rates, including the incremental debt used to fund the acquisition of Aerie. Additionally, we project our core effective tax rate to be in the range of 17% to 19%. Based on all these factors, we project core diluted earnings in the range of $2.55 to $2.65 per share, which corresponds to 16% to 20% constant currency growth over 2022. While we do not speculate on currency movements, based on exchange rates at the end of January, we expect a broadly neutral impact from FX to both sales and core net income growth for the full year. In terms of phasing, we expect FX to be a headwind in the first half of the year and a tailwind in the second half. Before turning back to David, I'm pleased to report that our Board of Directors is proposing a dividend of CHF 21 per share, which is in line with our payout policy of 10% of the previous year's core net income, pending shareholder approval. Shareholders will vote on this proposal at our upcoming Annual General Meeting in May. In summary, despite the challenges we faced in 2022, I'm extremely pleased with our performance and I want to thank the entire Alcon team for their hard work and determination. With that, I'll pass it back to David for closing remarks.

Thanks, Tim. To wrap it up, I'm extremely proud of what the Alcon team achieved in 2022. Despite challenging macroeconomic headwinds, we produced strong operating results, improved efficiencies and we delivered innovation and outpaced market growth in several categories. These results reflect our strong business fundamentals, robust long-term strategy and the talent and expertise of our more than 25,000 associates. As impressive as those results are, what I'm most proud of is Alcon's purpose of helping people see brilliantly. And I recently learned about a patient who suffered severe traumatic issues which were later complicated by the development of a cataract. This man experienced significant difficulties when it came to light, sun, snow, and glare. He underwent a cataract procedure, and when the surgeon removed the patch from his eyes, his vision was so improved that he was moved to tears. This is the kind of procedure that genuinely changes lives. It’s moments like these when our purpose of helping people see brilliantly really does come to life and it's what drives the hard work and dedication of all of our associates. I want to thank the entire Alcon team for their commitment to our purpose, and I'm excited for what's to come in 2023. With that, let's open it up for Q&A.

Our first question comes from Graham Doyle with UBS.

Just two for me. So just firstly, on the premium IOL penetration, where you've obviously seen a sort of sequential improvement back towards sort of the trends the last 2 years. And I know you were talking about staffing issues being a little bit of a headwind. Is there anything you've been doing from a marketing standpoint, for example, that's really been driving that improvement that we can kind of book into 2023? And then just a question on pricing. Would you be able to give us a sort of shape in terms of pricing as to what's happening in '23, say, versus '22?

Yes, Graham, let me start with the penetration. We noticed a positive sequential movement from the third quarter to the fourth quarter. We expected this rebound as the results had been relatively flat throughout the year. It’s important to note that we were slightly down in the third quarter, which was concerning. We seem to be experiencing some effects from programming changes, and this year will really show if our investments in programming are effective. Our hope is that by educating the staff on how to discuss patient options and better position those choices, patients will come in prepared to make decisions, which will streamline the process for everyone involved. While we are optimistic about the program, it is still too early to draw firm conclusions. The overall penetration is encouraging, but keep in mind that we're also comparing against last year's very high penetration rate in Korea, which was in the high 40s for a period. Once we move past this comparison by the end of the second quarter, we should have a clearer understanding of our position. There is some noise in the data, but the fourth quarter shows some promising trends. Regarding pricing, most of our price adjustments relate to contact lenses, with a small portion in ocular health. In our Surgical business, pricing is primarily determined through long-term contracts, and we have seen some upward adjustments last year that will take effect this year. We are closely monitoring the impact of these changes to ensure that we are not deterring consumers or compromising our competitive margins. Overall, we are optimistic about pricing and believe it will continue to move in the right direction, but we will keep a close watch on the situation. For 2023, we don’t have much to report yet since we still need to fully evaluate the effects from 2022 and will provide updates on the actual numbers later.

Our next question comes from the line of Anthony Petrone with Mizuho Group.

Congratulations on the year. I have a question about Aerie and another for Tim regarding margins. To clarify on Aerie Pharmaceuticals, can you provide insight on the current share of the inhibitor market in the United States? I believe Gary mentioned it was around 3% of the IOP market. Where do you anticipate that share could grow over time compared to other brands? I’m trying to set the stage for a multi-year perspective. Additionally, Tim, regarding margins, you mentioned the constant currency margin outlook for 2023. When we compare it to 2022, it appears we are still expecting 150 basis points at the midpoint. I want to ensure that this calculation is accurate, even after excluding constant FX effects.

Yes. Let me shift away from the discussion on row kinase. We are excited about the progress made since the acquisition. We have observed steady growth in both Rocklatan and Rhopressa, and we are pleased with this direction. I prefer not to speculate on how far we can go at this moment. We are focusing on how to reposition both products and are also working significantly on managed market access. These developments are crucial for us, and with some additional promotional efforts, we aim to improve our current trend. However, success in both repositioning and access is essential. Currently, these products account for about 2% combined of the market, slightly more than that. It's a small segment of the overall glaucoma market, which is predominantly made up of generics. We have realistic expectations about achievable markets and hope to see an upward trend from our current position.

Yes. And then on the margin, you're in the ballpark, the right ballpark, Anthony. I mean if you think about moving from the 18% up to the 19.5% to 20.5%, we would expect gross margins to improve. We've got a lot of productivity initiatives in place. We also have inflation subsiding a little bit in the second half. So that should be helpful. There'll probably be some pressure on the R&D line. Our R&D expense in 2022 was roughly 8% of revenue. That's going to be a little bit higher as we integrate Aerie because we're doing some work there. So I'd expect a little bit of pressure there. On the last call, we talked about the additional transformation, so that $100 million of savings. That's obviously going to drop through to the margin rate. That alone is probably 100, 110 basis points. And then we continue to get leverage. We're not on the SG&A front. So it probably won't be as high as last year given the revenue growth. And when you take out the transformation, we continue to expect that. So those would be the levers to get you to that 19.5% to 20.5%.

Our next question comes from the line of Larry Biegelsen with Wells Fargo.

Two for me. I wanted to start on the U.S. and the market growth embedded in the guidance here. And then I wanted to ask a second one on just kind of revenue cadence for the year. Just starting on the market growth, Dave or Tim, can you talk about what you're seeing in the U.S.? Your organic growth in the U.S. has been in the low single digits the past 3 quarters. And is that why you expect market growth to be below historical averages in 2023? And what are you modeling for market growth in '23? Obviously, it looks like it's probably sub-5%. And I had one follow-up.

Yes, Larry, you're correct. The North American market has been relatively quiet this past year, but we've adapted to the impact of COVID. It's important to consider the natural growth rate and compare it to 2019 figures. Typically, analyzing a two-year span to skip over 2021 has proven to be effective. This year, the Surgical business experienced market growth of about 4%, while the Vision Care segment, particularly in contact lenses, also saw growth in the range of 3% to 4%. These numbers are consistent with historical trends. However, Vision Care was a bit softer than we anticipated for the full year, especially in the fourth quarter, which still showed a 4% growth in the U.S. We noticed some unit growth softness during the fourth quarter, primarily in Vision Care, driven by pricing and product mix. While we are cautious, we believe we're operating in resilient markets. Cataracts and eye disorders continue to persist, and we expect to see historical growth rates of about 4% to 5% in these areas. The Vision Care market may face challenges, reminiscent of what we saw in 2009, where growth dropped from around 8% in 2008 to roughly 3% as units slowed down. We have not yet observed similar trends internationally but are preparing for softer numbers due to COVID. Given the market's uncertainty, we've decided to plan for at least some softness. If we are incorrect in our assessment, we will adjust our approach accordingly. Overall, we're heavily invested in high-growth areas and feel well-prepared for success.

Yes. And then as far as the cadence, Larry, revenue, I think it's going to be broadly in line with historical trends. So I go back to '21 and '22; you can probably go back to '19, I wouldn't look at '20. And as we've seen historically, Q2 and Q4 are typically higher than Q1 and Q3 from a revenue perspective. If you think about allergy season, that's predominantly in Q2, which drives revenues up. And then when you get to Q4, hospitals are managing their capital budgets, consumers are managing their co-pays by the end of the year. So we typically see a little bit of a renewal lift in Q4 as well. And then while we're on cadence, just from a P&L perspective, if you look at R&D, that will be a gradual progression throughout the year as we've seen in the past. SG&A, I'd just remind folks that Q2 is a heavy spend for us as we get advertising and promotions, back-to-school programs, and things like that. So I take a look at those historical trends because there's a big jump from Q1 to Q2. And then interest expense, I would just level-load the interest expense.

The inorganic contribution, Tim, about 2% in '23?

Yes, that's about right.

Our next question comes from the line of Daniel Buchta with ZKB.

My first question maybe on product launches. I mean, obviously, you were pretty active in the last 3 years, I would say, especially on the contact lenses side where you launched a lot of things. But looking back at what you announced on the last day in terms of products to come, I would say, at the moment, there is not so much left anymore. Can you give indications at least what would come in '23 and also '24 here? And then on the M&A side, obviously, we're pretty active on the ophthalmic Rx side. Is there something left you could be interested in acquiring? Because in my view, there are just the large indications like what AMD left where the outcome is not yet present. Would you help me hear that?

We have significant growth opportunities ahead of us, both in terms of geography and in the launch phases of new products. Over the past 24 months, many of our new products are still in their early stages. Specifically, with our toric lenses, we've introduced DAILIES TOTAL1 toric, followed closely by the P1 toric, and later we launched T30 Toric, which only recently entered the European market this year. There is plenty of potential for growth in our toric line, especially since we started with almost no market share in this category. Looking at international markets, there are many regions where we still need to introduce our products. We plan to share more details about our product pipeline during our upcoming Capital Markets Day, but currently, I view our position in Vision Care as promising. In Surgical, we launched CLAREON last year, and it has not yet been introduced outside of Europe. We are beginning to roll out Vivity in Japan this year, which is another indicator of our growth momentum from new products. It's crucial for us to leverage our existing offerings as we continue to develop new ones for later this year and early next year, which we'll also discuss at Capital Markets Day. Our focus remains on major categories like glaucoma, dry eye, and retina. It seems that aside from the multibillion-dollar retina products or specific orphan products, larger pharmaceutical companies are less interested in our sector. However, there is substantial potential in smaller products, which have historically driven Alcon's success. We're good at producing valuable products that benefit patients and the healthcare professionals who use them. Additionally, we are exploring opportunities in the M&A space carefully and conservatively, especially regarding capital deployment.

Our next question comes from the line of Matthew Mishan with Keybanc Capital Markets.

I first wanted to start on ocular health. I mean I guess with some of the headwinds you're seeing in solutions, I was just hoping you can call out trends in, let's call it, OTC and kind of dry eye. Are we kind of underestimating or some of the success you're having in that area, especially with driving growth from the new sales force?

Thank you for your question, Matt. For our IOL business, we are reporting a 7% growth for the full year. If we break it down, the underlying performance from Sustained, Pataday, and the rest of our eye drops business grew around 8%. However, we faced about a 6% offset from the CLC business, which brings our organic growth down to approximately 2%. Additionally, some pharmaceutical contributions help us reach the 7% figure. We're observing market growth in the mid-single digits, and we are outperforming in both contact lenses and the surgical sector. Interestingly, the surgical business doesn’t get as much attention, yet it is quite significant for us. The main concern for this quarter is that we are losing some ground in contact lens care due to a supply chain issue we've been facing for nearly a year with one of our peroxide solution products. We are doing everything we can to resolve this issue, producing everything we can, but our output is not at previous levels. We hope to address this by the middle of the year, but until then, the situation will remain challenging. Overall, our underlying growth trends are very positive.

I have a follow-up regarding your comments on contact lenses. You mentioned that the fourth quarter looks a bit softer. Do you have any insights into the reasons for this softness? Is it related to staffing issues, supply constraints, or are you noticing a change in consumer spending behavior?

We have analyzed the situation quite a bit. The fourth quarter in the U.S. differed significantly from international results, where we performed very well. However, I would describe the overall performance as relatively soft. We're closely monitoring the contact lens segment because the good news is that people don't stop wearing contact lenses; they may opt for private labels, seek better deals across different channels, and extend the life of their lenses. We recognized this trend previously, particularly in the 2009 frame, and in the fourth quarter, the primary drivers of U.S. growth appeared to be pricing and product mix. The actual unit sales were essentially flat or slightly down. We're being cautious as we try to interpret what this means. We believe that this downward trend is likely to be temporary and that growth will return to more normal levels eventually, but we'll need to see how it unfolds.

Our next question comes from the line of Veronika Dubajova with Citi.

I'll keep it to two. One, Tim, just maybe thoughts on the levers that you have on gross margin and help us think through the bridge for 2023 between the inflationary headwinds, the tailwinds from productivity, including contact lenses, and anything else that we should be bearing in mind. If you could just walk through those pluses and minuses, that would be great. And then if I can follow up on your comment on the significant inflection in the free cash flow. Similar question maybe quantify and tell us what is the biggest delta there that gets you to a meaningfully higher free cash flow number in 2023?

Yes, that’s a good question, Veronika. I expect gross margin to improve year-over-year due to various productivity initiatives. We believe some inflation has eased, especially in the latter half of the year. Additionally, the pricing changes we've made this year will carry over into next year. We anticipate a slight improvement in gross margin and ongoing operating leverage, aligning with the transformation we announced last year. This represents a gain of 110 basis points from our last call, along with continued leverage. Regarding free cash flow, we ended the year at 581. As we move into 2023, we expect to see growth in operating income, which should positively impact free cash flow. We may also experience some improvement in net working capital, especially with inventory, as we had built up stock in 2022 to address supply challenges; we may see reduced capital expenditures. These will serve as our key tailwinds. However, we will face headwinds such as increased interest expenses from financing Aerie, the costs associated with the transformation, and the legal settlement with J&J, where $120 million of the $199 million settlement will affect free cash flow. Overall, we expect to see higher free cash flow despite these additional one-time costs in 2023.

And Tim, you've talked about this $1.8 billion to $2 billion of free cash flow by 2025. Is this a linear improvement from the 580, or is it front or back-end loaded?

Yes. If we assume that we improve in 2023 by utilizing the strategies I mentioned earlier and then exclude the one-time items, we can reach a normalized level that is considerably above 581. The growth will primarily come from increased volume, enhancements in rates, and likely some additional improvements in net working capital. There is definitely a clear way to achieve this.

Our next question comes from the line of Cecilia Furlong with Morgan Stanley.

I wanted to start with equipment, just off of the strength you've seen in international markets. Can you talk through, as you think about '23, both durability, sustainability as well as OUS versus U.S. outlook for growth, especially given the comps from 2022?

We had a great year in equipment, with overall growth of 10%, and mid-teens growth internationally, which aligned closely with our expectations. However, the U.S. experienced minimal growth. The international market really drove our performance. Despite the feeling that we might be reaching a plateau in the equipment sector, there continues to be strong capital investment, particularly in our Centurion and Legion products, both of which performed well. Part of our equipment success can be attributed to new product introductions. We had a full year of ARGOS internationally, which saw significant year-on-year growth, along with strong performance from Revalia. We also have notable individual products like Active Century Hemp for our older Centurion that enhance unit performance. Overall, we have many positive developments. However, the growth in refractive equipment declined, and if it had remained flat, we would have exceeded our expectations. Looking ahead, we believe the market will return to normal levels eventually and expect next year to align more closely with procedural growth rates. Typically, equipment growth slightly precedes procedure growth since more equipment is needed for an increase in procedures. This year, we underestimated the competition due to supply chain issues faced by some competitors. Overall, we were pleased with our performance and anticipate a solid year ahead, though we don’t expect double-digit growth next year.

Great. And if I could follow up also, just TOTAL30, some of your comments, both around toric, the recent launch planned OUS expansion in '23. If you could just level set what you've seen from both a growth as well as share standpoint through '22 and then your outlook for '23 as well?

We are really pleased with the product. It is a very unique product with a special material that enables a water gradient on a different type of surface and has properties that reduce bacteria over time. This material is durable yet retains water at the surface, which has not been achieved before. After 30 days of use, it feels just like the first day you put it on. We are excited about the potential of the lens, and the feedback from doctors has been excellent, with new prescriptions showing strong market share. However, I want to emphasize that for the monthly lens, the adoption takes longer to ramp up. It’s clear that for daily patients, when they are given a trial, they quickly transition to purchasing a month or three-month supply. In contrast, patients using TOTAL30 typically wait about two months before they decide to return for a purchase, creating a natural delay in both the buying and return cycles for reusable lenses. Reusable users often are those who have used their lenses for a longer duration or are just starting out, so we are particularly focused on attracting new patients. We see this as a leading indicator and are pleased with the lens performance. The speed at which it gains traction will be clearer as we move into next year. However, we are optimistic about the trajectory. Introducing the TOTAL30 toric lens is significant, especially as many reusable lens users have astigmatism, and we have a strong option for them. Together, these two lenses represent a premium offering in the reusable lens market, and we anticipate a positive response. So far, the reactions have met or slightly exceeded our expectations.

Our next question comes from the line of Ryan Zimmerman with BTIG.

Congrats on your progress this year. So I want to talk a little bit about Hydrus. You guys have had it for a few quarters now. I wonder if you could talk to us a little bit about kind of the attachment rate you're seeing with your IOLs and whether you're getting a lift in IOL sales as a result of entering the surgical glaucoma market because you really are the only player in the glaucoma space now that has the benefit of having both in IOL and then a surgical option in the combo cataract market.

Yes, that's an insightful question. We haven't specifically examined the attachment rates, but I suspect they are quite high since we are primarily working with surgeons in operating rooms. We are focusing on cataract surgery, particularly in a market that involves combination procedures. Regarding Hydrus, we are satisfied with our progress this year and are closely aligned with our targets. We're especially excited about the product's effectiveness, as it appears that patients are reducing their medication usage and postponing the need for additional surgeries that are often required with other methods. As surgeons grow more accustomed to this procedure and observe its effectiveness, I believe this will become a strong advantage over time. It's important to note that the reimbursement environment affecting visco injections around the canal has significantly influenced our market penetration. The market has actually expanded more than we anticipated, and we have seen a positive response to canaloplasty as a procedure, which has exceeded our expectations. The performance of this procedure has been surprisingly robust, and it may be related to the favorable reimbursement compared to the more complex stent products, which could be influencing this trend. Eventually, I think people will return to the core reason for these procedures, which is to manage eye pressure effectively. I believe that Hydrus will emerge as the preferred solution in the long run. We remain optimistic for the future, having met our plans from last year. If there's a way to find additional leverage, I’m eager to explore it, though I'm not certain if it exists. I tend to think this product is selected independently.

Yes. A couple of thoughts. First on Hydrus, I guess the way to think about it is the market itself, the MIGS market, we think, is growing mid-teens. That's kind of where we thought it would be, and that is where it is. I would say the mix inside of that is a little bit more heavy to the canaloplasty and visco dilating agents. So that grouping is growing a good bit faster than market. And so obviously, the stents are growing a little bit slower than that. That's directionally where we are. We haven't really commented on the size and we try not to go after individual products. But I think we're pleased with where we were. And if you go back to when we acquired the product, what we projected on it, I think we're right on that path.

Our next question comes from the line of Chris Gretler with Credit Suisse.

I have two questions. First, I wanted to come back to the contact lens business and elasticity. Could you actually speak about the price action you've taken internationally versus the U.S. and the relative price differentials in these markets. But do you see different response and also what is the spillover effect of the price effect into '23 and whether you intend to take further price action? And the second question was just on capital expenditures this year, should be trending in the midterm guide of mid-single digit or not?

Yes. We really haven't articulated the detail around the flow-through on price. It's directionally low single digits. So I think what we believe is that both internationally and in the U.S. when we've taken price, we've done them in different moments in time. So I think the U.S. took some price originally at the very beginning of last year. International took, I think, something like closer to midyear. And then again, the U.S. announced an additional price increase for this year, late last year. So all of that said, it's a little bit tricky to compare it side to side. What I would say is that directionally, we thought that we would get kind of low single-digit flow-through from those activities. They are different market to market. We're very specific in how we think about products, markets, and competitors and consumers, trying to make sure we get that mix right. And so a little tricky to answer that question any more specifically than that. CapEx.

Yes. Then on the CapEx, we'd expect this year, we'll probably be at that 5% or 6% of revenue for CapEx on 2023.

Thank you. Ladies and gentlemen, this concludes our Q&A session and this concludes our call today. We thank you for your interest and participation. You may now disconnect your lines.