Earnings Call Transcript - AVNS Q2 2021

Operator, Operator

Good day, and welcome to the Avanos' Second Quarter 2021 Earnings Conference Call. All participants will be in a listen-only mode. After today’s presentation, there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Dave Crawford, Vice President of Investor Relations. Please go ahead.

Dave Crawford, Vice President of Investor Relations

Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to the Avanos 2021 second quarter earnings conference call. With me this morning are Joe Woody, CEO; and Michael Greiner, Senior Vice President and CFO. Joe will begin with an update on our quarter and then discuss our business environment and progress towards our 2021 priorities. Then Michael will review our second quarter results and update our 2021 planning assumptions. We will finish the call with Q&A. A presentation for today's call is available on the Investors section of our website, avanos.com. As a reminder, our comments today contain forward-looking statements related to the company, our expected performance and economic conditions and our industry. No assurance can be given as to the future financial results. Actual results could differ materially from those in forward-looking statements. For more information about forward-looking statements and the risk factors that could influence future results, please see today's press release and the risk factors described in our filings with the SEC. Additionally, we'll be referring to adjusted results and outlook. The press release has information on these adjustments and reconciliations to comparable GAAP financial measures. Now I'll turn the call over to Joe.

Joe Woody, CEO

Thanks, Dave. Good morning, everyone, and thank you for your interest in Avanos. As we move into the second half of the year, I'm encouraged by our commercial teams' start to the year and the continued resiliency as they respond to the challenging dynamics brought on by the pandemic. Across our enterprise, we remain focused on getting patients back to the things that matter as we meet the needs of our customers. I will begin with a brief review of our results for the quarter before discussing the current environment and our progress against our 2021 priorities. Sales increased 14% for the quarter to $186 million, while we earned $0.21 of adjusted diluted earnings per share. Our sales results were at the high end of our planning assumption. We not only benefited from the return of elective procedures, but more importantly, execute well against our growth initiatives. Performance for the quarter fell short of our expectations within our manufacturing and distribution footprint, negatively impacting gross margin for the quarter. These higher costs are temporary impacts to our business, primarily pandemic-driven and being seen across industries and do not indicate a permanent change to our operating structure. My management team and I have made this our top priority, and I'm confident we will show meaningful progress in the second half of the year. Michael will expand further on the steps we're taking in his remarks. I'm pleased with our team's execution, finding additional efficiencies throughout the business to reduce operating expenses. Teams are finding ways to increase productivity and lower our cost structure, which not only assists in offsetting some of our in-year gross margin headwinds but also positions us to deliver on our commitment of SG&A as a percentage of revenue being less than 40% on a go-forward basis. With that as a background, I'll discuss our market environment and update you on progress against our 2021 priorities, starting with how we are strengthening our growth profile. As I mentioned in our last earnings call, we began the quarter with increasing top line momentum across our pain management franchise as elective procedures began to re-accelerate. Momentum continued throughout the quarter, and we saw the fastest acceleration in COOLIEF and Game Ready where outpatient procedures continue to recover faster than procedures performed within the hospital. Sales for both of these therapies eclipsed the pre-pandemic second quarter of 2019. While the recovery in ON-Q has trailed our other pain therapies, we delivered sequential sales improvement throughout the quarter. Based on the gradual increase in procedures and conversations with our surgeons and hospital administrators, we continue to believe inpatient procedural volume will likely remain below its full potential until the end of the year. As we move into the second half of the year, we continue to build on our solid foundation to accelerate growth across pain management. For COOLIEF, we're planning to launch the next generation of cooled radio frequency probe kits. The new probes will make it easier for physicians to perform COOLIEF procedures while maintaining our premium look and feel. The new probes will also be more efficient for us to manufacture and deliver scalability, thus improving COOLIEF's already high gross margin. Combined with the launch of our new generator last year, our new probe kits strengthen our cooled RF leadership position. With respect to ON-Q, we continue to see positive results from our channel partnership agreements where we are leveraging orthopedic sales partners to gain access to orthopedic surgeons. In an effort to differentiate ourselves from other manufacturers, in the coming months, we'll be launching Pain Block Pro, a data collection and patient engagement app that will allow physicians to track their patients' recovery and understand their satisfaction levels and opioid consumption in real-time without needing to speak with patients. Pain Block Pro will also help us engage patients and improve their experience by providing education about the pump and the ability for us to answer their questions. We will be the only pump company to offer both data collection and patient engagement to this extent. Finally, we continue to leverage our exclusive relationship with Leiters to further solidify our customer base. Shifting to Chronic Care, the positive trend across our digestive health franchise continues. We maintained double-digit growth across our NeoMed franchise, while our standard of care strategy for CORPAK is accelerating sales of our CORTRAK hardware to record levels. In Respiratory Health, sales were down as expected, given the prior year pandemic tailwind. Finally, we continue to execute on our international expansion opportunities. Our market development initiatives focused on the clinical benefits of our therapies continue to pay dividends, and we are bolstering the growth of recently acquired products through our global footprint. While growth for the quarter was muted given the pandemic benefit last year, we delivered results at the high end of our expectations. Our second area focuses on gross and operating margin expansion. As I noted earlier, it is imperative that we begin to recapture gross margin loss since the start of the pandemic. Last year, we took the necessary steps to protect our employees from the pandemic and expand manufacturing of products to treat COVID patients. We responded well when presented with these challenges, but now need to address the inefficiencies and costs that arose out of our manufacturing sites. In addition, this year, we have made a short-term trade-off to capture market share for our NeoMed product family at the expense of higher freight costs to ensure that we take full advantage of its growth potential. These short-term cost increases will allow us to maximize the long-term investment of our NeoMed acquisition, but have obviously created some in-year headwinds on gross margin that we did not anticipate coming into the year. Our continued cost discipline and emphasis on driving efficiencies and spending continues to produce results. I'm seeing a cultural shift in how our teams examine investments and make the necessary trade-offs to achieve the best value for our spending. Improved efficiency also carried over into improved management of working capital, which helps drive a return to positive free cash flow in the quarter. We are on target for our third priority to begin generating consistent repeatable free cash flow and continue to expect significant free cash flow acceleration in the second half as we await receipt of tax refunds we highlighted on prior calls, coupled with our improved operating results and working capital discipline. Our last priority for the year focuses on capital deployment. Our M&A pipeline remains healthy, and we are engaged in active dialogue with a number of potential tuck-in targets, which would leverage our existing footprint, generate synergies and enhance our top line growth profile. M&A is a priority for us, but we will remain disciplined on identifying targets that meet both our strategic initiatives as well as exceed our financial hurdles, ensuring we generate a strong return on capital. Lastly, as a follow-up to the DOJ investigation, we updated you on last quarter, in early July, we entered into a deferred prosecution agreement with the United States Department of Justice that resolves the DOJ's criminal investigation related to the company's macro accrual surgical gallons, which are part of the S&IP business we divested more than 3 years ago. As part of the agreement, we paid $22.2 million, in line with the expectations we previously communicated. I want to assure our customers and our team members that we will continue to maintain robust compliance and quality programs, and we'll continue to enhance them through new and revised policies, procedures and training requirements. In conclusion, we remain well positioned to advance our strategies across each of these 4 areas of value creation as our focus on execution remains strong. This, along with our market leading portfolio, gives me confidence we can successfully deliver on our 2021 priorities. Now, I'll turn the call over to Michael.

Michael Greiner, Senior Vice President and CFO

Thanks, Joe. And as you noted, we remain in a challenging environment, especially with regards to supply chain and operations, and yet the team continues to find ways to overcome these challenges. Now let's begin with a review of our second quarter results. Total sales of $186 million increased 14% compared to last year. We saw a 13% increase in volume and a 1% benefit from favorable exchange rates. Unfavorable price offset sales by 1% as we saw price movement return within our normal range after slightly higher-than-normal price impact last quarter. Given the $10 million pandemic-related tailwind for Respiratory Health in 2020, Chronic Care sales declined 4% to $116 million in the quarter. Adjusting for the 2020 tailwind, Respiratory Health sales would have been down slightly for the quarter as we saw hospitals draw down their inventory of closed suction catheters and other related products as pandemic-related hospitalizations significantly declined. Although a new wave of pandemic-related hospitalizations appears to be upon us, through July, we have not yet experienced material acceleration of orders from distributors or hospitals. Our planning assumption for Respiratory Health in the second half of 2021 does not include additional benefit from the pandemic, and we also expect a normal start to cold and flu season. Shifting to Digestive Health, we saw above-normal growth as we experienced some pandemic-related disruption last year for our legacy, MIC-KEY franchise, providing a favorable comparison for this year. NeoMed once again grew double digits from the continuation of conversions to our ENFit technology. Moving to Pain Management. We delivered $70 million of sales, 62% higher compared to the prior year, driven by the favorable prior year comparison resulting from the cancellation of elective procedures due to the pandemic. As Joe highlighted, growth has returned faster for our COOLIEF and Game Ready therapies. Both of these therapies saw sales growth ahead of their pre-pandemic level for the second quarter of 2019. With respect to ON-Q, though the recovery for the therapy has trailed COOLIEF and Game Ready, we continue to see the average day rate of sales increase on a monthly basis for the quarter. Sales through Leiters and new customers using them as a pre-filler again increased by double digits as our partnership with Leiters continues to benefit customers as a pre-fill option. Finally, despite a difficult prior year comparison, international organic sales grew at a low single-digit rate for the quarter. Sales did, however, benefit roughly $1 million due to the timing of shipments to distributors taking place at the end of June that were originally scheduled for early July. Moving down the income statement. Adjusted gross margin decreased to 51% compared to 56% last year. As we indicated on our previous earnings call and as Joe noted earlier, gross margin was expected to be impacted due to higher transportation costs to bring NeoMed products from China to the U.S. to meet customer demand. In addition, we continue to have inefficiencies at our manufacturing plants, in part for the safety precautions to protect our employees from the pandemic as well as additional employees we hired during the pandemic at our plants. These factors have resulted in less productivity, higher overhead cost and increased waste in recent quarters. While we saw improved mix given the increase in Pain Management sales, these headwinds had us behind our gross margin expectation for the quarter. Looking at the second half of the year, we continue to expect adjusted gross margin to significantly improve based on some of the following factors. First, we expect to continue to benefit from our sales mix as sequential growth continues with Pain Management while we anticipate that demand for our Respiratory Health products will remain at normalized pre-COVID levels. This favorability will be magnified in the fourth quarter as we anticipate the normal seasonal uplift in our Pain Management franchise. Second, we will see a meaningful decrease in air freight costs versus the first half of the year. Although the anticipated benefit will be less than originally planned in the second half, given that higher transportation costs for ocean freight are still relevant for our NeoMed product family. Additionally, to ensure we achieve higher gross margin in the second half, in July, we have initiated several steps to return our facilities to pre-pandemic efficiency levels. We have recently reduced the number of employees at our manufacturing plants by approximately 10% to return employment at our facilities to pre-pandemic levels. We are also taking steps to reduce waste and scrap levels and are working with our commercial teams to sell slow-moving inventory to reduce the increase in write-offs incurred recently. Finally, in order to offset some of the inflationary pressures across our supply chain, we are informing some customers of price increases beginning later this year. Due to the slow start for the year, our adjusted gross margins are now expected to be slightly below our 2020 margin levels. To offset this reduced gross margin level, we are reducing operating expenses in order to maintain our commitment for operating margin improvement for the year. Now turning your attention to some bottom line financial metrics. Adjusted operating profit totaled $15 million compared to $13 million in the prior year. Performance was primarily driven by higher sales volume, which was partially offset by the lower adjusted gross margin I just reviewed. Adjusted EBITDA totaled $20 million compared to $19 million last year, and adjusted net income totaled $10 million compared to $6 million a year ago as we earned $0.21 of adjusted diluted earnings per share. Turning to the balance sheet and cash flow statement. As Joe highlighted, we achieved positive free cash flow absent the receipt of any of our CARES Act refunds. Keeping a healthy balance sheet and generating meaningful free cash flow remains a key go-forward priority. Our balance sheet is solid and continues to provide us with strategic flexibility as we ended the quarter with $100 million of cash on hand and $165 million of debt outstanding on our revolving credit facility, an improvement of $10 million versus the end of the previous quarter due to a small repayment. Free cash flow represented an inflow of $10 million, enhanced by improved working capital. Finally, while some unpredictability of the coronavirus remains, we are reaffirming net sales on a constant currency basis to increase 2% to 4% compared to the prior year. However, due to increased manufacturing and transportation costs, partially offset by operating expense savings, we are reducing the top end of our earnings guidance. We now expect to earn between $1.10 and $1.20 of adjusted diluted earnings per share. In closing, we are off to a solid start at the halfway point in the year. I'm confident in our ability to execute our strategy and to take the necessary steps to drive gross and operating margin improvement and deliver significant free cash flow in the second half of the year.

Operator, Operator

And the first question comes from Matthew Mishan with KeyBanc.

Matthew Mishan, Analyst

I just first wanted to start with NeoMed. I mean, this is an acquisition you made a couple of years ago. It seems to be doing very well from an annualized sales run rate but the gross margin still has been a problem. Can you kind of walk us through kind of where you started with NeoMed? Kind of where you're at now and kind of how you think about the gross margin progression for that business?

Joe Woody, CEO

Yes, Matt, I'll mention a few points, and as always, Michael may have additional thoughts. This acquisition has been highly successful for us, with growth in the double digits again this quarter. Additionally, we are experiencing what's known as the infant conversion, a global standard that needs to be completed by our customers moving into next year. As a result, we've made the decision to ship products by air from our manufacturing in China during the pandemic, which has caused increased transportation rates, especially for air shipments. Our customers are facing timelines, and completing these conversions will certainly benefit us with repeat sales in the future. However, this situation has created a challenge for our gross margin. Generally, I believe that once we navigate through the pandemic and these temporary gross margin issues, we will be in a strong position regarding all our established metrics, similar to how we felt about CORTRAK. Michael, would you like to add anything?

Michael Greiner, Senior Vice President and CFO

Yes, I believe we are making strategic decisions to secure these conversions. Despite the challenges affecting our gross margin, our model indicates that the discounted cash flow remains very appealing for this business in the upcoming years. From the outset, we did not anticipate NeoMed to achieve gross margins surpassing our overall consolidated gross margin. Therefore, when NeoMed returns to a more standard operating condition, it will still be slightly below the company's average gross margins. Currently, it is significantly lower due to the impact of freight costs. However, it is important to note that even in a normalized state, NeoMed was never expected to exceed our company-level gross margin, which I hope clarifies the situation.

Matthew Mishan, Analyst

Yes. But just going back to the question, when you purchased it, I believe it had an annualized run rate of about $40 million. Once you complete the in-state conversion, how significant a portion of the business will NeoMed represent for you?

Joe Woody, CEO

I mean, so I see it like a lever similar to international business, but more like COOLIEF where it's a similar size and growing double digits and have some consistency for that in the next couple of years. So we like it quite a bit.

Matthew Mishan, Analyst

Okay. Shifting over to COOLIEF, how do the new probes that you will be rolling out next year, which have a higher gross margin, enable doctors to use them more effectively in the ASC or physician office?

Joe Woody, CEO

We will discuss that later. This is not what we addressed in the prepared remarks, and we anticipate both upgrade opportunities in new business, which we believe will be driven by this introduction.

Matthew Mishan, Analyst

Okay. And then lastly on the gross margin side, I understand there's a lot happening, and many are discussing the challenges related to freight and manufacturing inefficiencies. When you mention significant improvement in the second half, could you provide some insight into what that entails? I realize gross margins will be lower than last year, but what kind of range should we expect regarding that improvement?

Joe Woody, CEO

Yes. I’m going to mention a couple of things, and then Michael will explain how we view the second half of the year. We discussed this in our earlier calls, mentioning that we still expect challenges in gross margin for Q2, and we encountered a bit more than we anticipated. When considering NeoMed, about half of the advantages came from there, which is why we view this as a temporary issue rather than a fundamental change in our business. We’re dealing with several factors, including challenges related to China and airfreight, as well as our investments in Mexico and our interactions with the Mexican government and employees. We also expanded the closed suction line to avoid any delays caused by government defense procurement actions. All these aspects create two unique situations. However, we have a distinctly clearer outlook for the second half, and Michael will guide everyone through that.

Michael Greiner, Senior Vice President and CFO

Yes. Matt, as Joe mentioned, we were about 200 basis points short in Q2 compared to our expectations. Looking ahead to the latter half of the year, there are a few factors to consider. We won't experience the revaluation impacts that occurred in the first half, which accounts for around 200 basis points. We expect price and mix to improve by about 150 basis points, partly due to price increases passed on to customers and a steady improvement in our ON-Q business, particularly the day rates mentioned. Another 200 basis points is attributed to plant performance, influenced by a 10% workforce reduction and a decrease in write-offs from the first half. Additionally, we anticipate a 50 basis points improvement on freight, primarily related to NeoMed, where we initially expected a higher figure, but we are seeing increased freight costs from water transport, which are significantly lower than the air freight expenses incurred in the first half. Altogether, these factors suggest over 600 basis points of specific improvements, alongside other items we are addressing. To answer your question about significance, we believe it is very significant. However, due to the 200 basis points shortfall in Q2, we expect to end up at or slightly below our 2020 results, which was not the trajectory we aimed for at the start of the year.

Operator, Operator

The next question comes from Chris Cooley with Stephens.

Ross Osborn, Analyst

This is Ross Osborn for Chris. Can you walk us through the factors that you consider in the lower and upper bounds of your revenue guidance?

Joe Woody, CEO

Yes. I'll start by sharing a few points about the quarter, after which Michael may want to provide additional insights on our outlook and guidance. We observed ongoing sequential improvement in our pain business, particularly in Game Ready and COOLIEF, which we attribute to the performance of hospital outpatient departments. We also noted some progress with ON-Q, although it remained slightly below 2019 levels. Some hospital procedures haven't returned to pre-pandemic levels as seen in the ambulatory surgical setting. For our Chronic Care division, we anticipate a mid-single-digit growth trajectory for the full year, consistent with our internal plans. Additionally, we are facing challenges related to comparatives in respiratory and closed suction sales due to COVID-related results from the previous year. For example, we expect that $12 million in respiratory sales from 2020 will not be included in our 2021 results, which factors into our guidance considerations for the latter half of the year. Michael?

Michael Greiner, Senior Vice President and CFO

Yes. I think the upside to Joe's point would include ON-Q continuing to improve and accelerate as electives come back, while on the respiratory side, we have a normal respiratory season. To the downside, you would see ON-Q kind of level off here, not continue to have electives come back because of the variants, while treatment protocols no longer necessary to look for closed suction catheterization. So we would continue to get a normalized respiratory, but we wouldn't get that extra benefit. So we'd have normal respiratory ON-Q coming back down because electives are coming back down, that would put us more on the low side. On the upside, both of those are actually moving forward where we get hospitalization and closed suction catheter being part of that treatment protocol, while the electives don't pull back like they did in the previous period last year.

Ross Osborn, Analyst

Got it. That's really helpful. And then kind of just a bigger picture question. So guidance for the full year is 2% to 4% x 100 bps from currency. I guess what's holding back top line from approaching kind of mid-single digits growth on an organic basis?

Joe Woody, CEO

Yes, I think Michael covered some of this. We should discuss it briefly again. We have a $12 million comparator in respiratory that we won't have anymore. That's one point. There's also some uncertainty remaining, even though we haven't noticed regional discussions about elective procedures being impacted by the Delta variant and how that might affect our international business, which is mainly in Chronic Care. This could certainly be influenced by having less impact. However, the Respiratory and Chronic Care segments are still a consideration. Is there anything else you would like to add?

Michael Greiner, Senior Vice President and CFO

And Ross, I mean, it's a fair question. And if you do look at 2019 Q2 versus 2021 Q2, we do have organic growth of over 7%. So that does get you in that mid-single digits. I think we're just being appropriately cautious in the back half of the year, just not knowing exactly how the new variant is going to play out and exactly, how hospitals and other treatment protocols will react to that.

Ross Osborn, Analyst

Okay. Fair enough. And then just kind of a clarifying question. Just to make sure you have the cadence right for the rest of the year. So lower gross margin and then that will hopefully be offset by greater OpEx reductions?

Michael Greiner, Senior Vice President and CFO

That's right. To clarify on that question, Ross, we adjusted the top end of the guidance, but that doesn’t mean that achieving $1.17 or $1.18 is out of reach. The range is $1.10 to $1.25. Typically, people would take the midpoint, which gives $1.17. Our adjustment from $1.25 to $1.20 simply indicates that $1.25 is not feasible, but it does not exclude the possibility of reaching $1.17 or $1.18.

Operator, Operator

The next question comes from Ravi Misra with Berenberg.

Ravi Misra, Analyst

Can you provide an update on ON-Q and the elective rebound? Are you still operating within the current parameters? Is this a business that can finally return to growth for the full year? It seems like you are a bit cautious about the elective outlook. Could you help me understand how to model this going forward based on the expected procedural growth?

Joe Woody, CEO

Yes, that would be the big driver, the electives being the biggest lever as to growth. We're seeing our initiatives work. A couple that we're really focused on as channel partnerships with large orthopedic 1099 groups. We're happy with what we're seeing on the ambIT acquisition and how we're now having an electric pump offering, and that's working well from us from a portfolio perspective. The Pain Block Pro from some of the initial rollout of that, we're seeing success, and customers are very interested in that being able to track the outcomes of not only our product, but against other approaches to pain management. And we're happy with what Bill Haydon has done under his leadership to kind of point that business in the right direction. And then obviously, we've just come out of a strategic Board meeting where we've talked about some future products, in particular, the electronic nerve block that we think can be a big game changer in that space. So we're happy with where we are. We think, again, the biggest lever on whether or not you get the growth and how fast it comes is the elective procedure. So to the extent Delta doesn't quell a lot of things, then we can do better.

Michael Greiner, Senior Vice President and CFO

And Ravi, electives has become a big word in med device over the last 16 months. When you look at Game Ready and COOLIEF, as Joe talked about in the prepared remarks, those are back and above where we were. So that definition of electives has worked well, and we've captured all that's appropriate there. But obviously remember, it's generally for very specific types of procedures, multi-day stay often are definitely multi-day recovery. And so those types of electives have not come back as quickly.

Ravi Misra, Analyst

Okay, great. Regarding the gross margin, I don’t want to dwell on it, but I’m interested in the significant shift this quarter towards the Pain Management business. You mentioned the higher freight costs from NeoMed. Could you clarify or quantify those freight costs? If those costs weren’t a factor, would you have achieved the 53% margin that you were targeting internally? Or was there something else at play? I would think that the shift towards Pain Management would have more than compensated for some of those costs.

Michael Greiner, Senior Vice President and CFO

The freight costs played a role in our performance, essentially balancing out the mix shift. Additionally, we experienced a planned shortfall in efficiency, contributing to an underperformance of around 100 basis points. You're correct that freight was a factor, but we also had the anticipated underperformance in the second quarter, which we have begun addressing since mid-July.

Ravi Misra, Analyst

Great. And then maybe one last one, Joe. Just on kind of opioid safety in that project there. What should we be kind of thinking about here for the rest of the year? Or is this now a 2022 event?

Joe Woody, CEO

I'm sorry, I didn't hear the first part of your question, Ravi.

Ravi Misra, Analyst

The novel technology, the opioid product.

Joe Woody, CEO

We are currently rolling out the Pain Block Pro product and will continue to do so throughout the second half of the year. As we approach the end of the year and head into 2022, we will be expanding its availability.

Operator, Operator

As we have no further questions, this concludes our question-and-answer session. I will now turn the conference back over to Joe Woody for any closing remarks.

Joe Woody, CEO

Thank you. As many of you may know, and have been talking to Dave Crawford after 9 years from the spin of Halyard to Avanos, Dave is going to be moving on. He's been our Treasurer and obviously, our Head of Investor Relations. We definitely want to thank him for his service to the company, but I would say that his business guidance and consultation, partnership have really been outstanding. And so we wish Dave the best, and we'll definitely stay in touch with him. And I thank all of you for your continued interest in Avanos. We continue to execute well in an uncertain environment. We remain really committed to creating shareholder value. I'm confident we've got the right queries detail, combined with our portfolio, and we think we're in attractive markets. We're positioned well for sales growth, margin expansion and the free cash flow that we want to generate. So look forward to chatting as we go forward. Thank you all.

Operator, Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.