Earnings Call Transcript - AVNS Q3 2022

Operator, Operator

Good morning, and welcome to the Avanos Third Quarter 2022 Earnings Conference Call. Please note, this event is being recorded. I would now like to turn the conference over to Scott Galovan. Please go ahead.

Scott Galovan, Moderator

Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to the Avanos 2022 third quarter earnings conference call. Presenting today will be Joe Woody, CEO; and Michael Greiner, Senior Vice President and CFO. Joe will review our quarter and current business environment as well as provide an update on our key objectives for 2022. Then Michael will discuss additional detail regarding our third quarter and review our 2022 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, current economic conditions, and our industry. No assurance can be given as to future financial results. Actual results could differ materially from those in the 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 risk factors described in our filings with the SEC. Additionally, we will 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.

Joseph Woody, CEO

Thanks, Scott. Good morning, everyone, and thank you for joining us to review our operational and financial results for the third quarter of 2022. Our operational and commercial teams continue to execute well in this dynamic and uneven environment, which supports us in maintaining our full-year guidance ranges. The demand for our products remains strong, and we continue to manage supply chain disruptions to mitigate the impact of our persistent backorder challenges. Despite these challenges, we were still able to deliver strong operating and EBITDA margin results, along with consistent free cash flow generation that's now almost $80 million over the trailing four quarters. As always, our primary focus is on getting patients back to the things that matter as we meet the needs of our customers. For the quarter, we achieved sales of $202 million, representing over 12% total growth, with organic growth at 1.6%, both excluding the negative impact of foreign exchange. We generated $0.38 of adjusted diluted earnings per share and $23 million of free cash flow. On a constant currency basis, our Digestive Health portfolio grew by 14%, with NeoMed growing slightly greater than 39%, while our Respiratory business declined by nearly 21% due to industry-wide post-COVID slowdowns and inventory being sold through our distributor channel that had accumulated during later phases of the pandemic. Through October, we're seeing improved ordering patterns for our closed suction catheter systems and are closely monitoring the beginning of the flu season, specifically trends in pediatric viral cases like RSV. Excluding the impact of ortho generics foreign exchange, our pain portfolio was flat versus the prior year, with our interventional pain franchise growing 4% and our acute pain product portfolio lower by a little over 2% versus last year. The pain franchise continues to experience sluggish procedural volumes due to staffing shortages and patient preferences. Our hyaluronic acid offerings through OrthogenRx posted another strong quarter, with continued adoption of TriVisc, our three-injection HA regimen. Our favorable pricing position and service model is driving account transitions and new account acquisitions while meeting patient demands. As we noted last quarter, our service differentiators via our direct patient purchase program in Harmony, an online portal to enhance and streamline the customer experience, will help us retain these new customers as we enter 2023. Separately, our backorders were unchanged throughout the third quarter and are currently in the range of $11 million, which had a negative impact on the revenue we could have delivered across our portfolio in Q3. We currently anticipate and believe we have visibility to end the year with our backorder below $7 million. On gross margin, we delivered positive results with an adjusted gross margin of over 56% driven by a favorable product mix in the quarter, inclusive of OrthogenRx and our plants continuing to incrementally deliver on our manufacturing efficiency strategy set forth at the end of last year. Although we continue to experience headwinds related to raw material availability, inflation across all manufacturing inputs, and shipping and distribution costs that remain elevated, we anticipate similar fourth quarter gross margin results as we experienced in Q3, while our full-year gross margin guidance of 55% to 57% remains firm. Turning to SG&A. We continue to make progress toward our full-year target of less than 40% as a percentage of revenue, delivering 38.3% for the third quarter. Our third quarter SG&A as a percentage of revenue sequentially improved by 230 basis points, and we will continue to make progress during the fourth quarter. Michael will provide additional insight on the positive execution of our SG&A profile. With that as the background, let's read some details on our product portfolio. Positive trends across our Digestive Health franchise continued, bolstered by our NeoMed portfolio enjoying a record quarter, growing over 39% versus the prior year, as supply improvements allowed us to maximize North American ENFit conversions. Our legacy enteral feeding products maintained mid-single-digit growth, despite supply constraints impeding further growth. We anticipate sustained growth for the remainder of 2022, assuming no further supply chain disruptions with this product category. Separately, our respiratory health business continues to experience industry-wide post-COVID interruptions. Despite softness in revenue in the third quarter, we're seeing higher demand for our closed suction catheter products as we enter the flu season and are monitoring its development on adult and pediatric patients. We anticipate growth to return to historical levels throughout 2023. Within our pain portfolio, we were flat in Q3 compared to the prior year, with interventional pain growing low single digits, offset by a low single-digit decline within acute pain as noted earlier. Supply chain challenges have persisted throughout the year, with our surgical pain and RF categories disproportionately impacted in Q3. We anticipate these issues to continue through the end of the year, and as a result, are expecting to finish at low single-digit growth for the full year. The demand for our products and solutions remains strong, and we're confident and motivated to continue working through these challenges to ensure our pain solutions are available to meet the needs of our customers. To that point, we want to highlight the impact that our products have had in getting patients back to the things that matter. In Q3, over 100,000 patients benefited from our Avanos portfolio of pain products, including our pumps, RF products, and HA offerings as well as Game Ready prescriptions. Our next priority for 2022 is to demonstrate our ability to generate consistent, repeatable free cash flow. As in the second quarter, we generated $23 million of free cash flow, despite continued near-term inventory and supply chain headwinds. We anticipate sequential free cash flow improvement for the fourth quarter. Our ability to consistently deliver free cash flow is critical to support our other strategic growth and capital allocation initiatives and will therefore remain a priority into 2023 and beyond. Our final priority for 2022 is focused on capital deployment via M&A. Our M&A pipeline remains healthy. And as previously stated, we are engaged in active dialogue with a number of potential tuck-in targets, which would leverage our existing commercial infrastructure, generate synergies, and enhance our top-line growth. We are disappointed we have been unable to announce another transaction since OrthogenRx, and currently do not anticipate any M&A announcements until next year, as we remain disciplined in our approach around strategic fit, valuation, and due diligence. Finally, we're very pleased with the expansion of our product offerings through the acquisition of OrthogenRx, and its performance to date has exceeded our expectations. In summary, even with various macroeconomic headwinds, including inflation, currency, and supply chain, we delivered a robust third quarter and are well-positioned to exit the year with momentum around free cash flow generation, an active M&A pipeline, and continuing to demonstrate overall margin improvement. Now I'll turn the call over to Michael.

Michael Greiner, CFO

Thanks, Joe. As you noted, even with the uncertainty that persists in the global economy and the industry-wide macro pressures, we met or exceeded most of our third quarter objectives. Total reported sales were $202 million, up 9.8% compared to last year, with adjusted EPS of $0.38. On a constant currency basis, organic growth was 1.6%. Organic growth results exclude the contribution from OrthogenRx sales in the third quarter as well as removing approximately $500,000 of maximum generated revenue for the prior year's third quarter. We delivered on our gross margin commitment, and sequentially SG&A spend as a percentage of revenue significantly reduced again this quarter. We continue to successfully execute on our OrthogenRx strategy, and we generated $23 million of free cash flow, as Joe noted earlier. Chronic Care actual sales were down by $1 million versus last year at $116 million in the quarter, excluding the prior year impact of sales coming from our exited Maxter facility. We continue to see strong growth in our Digestive Health business, with third quarter growth of 11%, despite supply constraints impeding even further growth. Within this portfolio, NeoMed grew over 39% globally, fueled by strong execution of customer conversions to our ENFit technology. Separately, our Respiratory Health business experienced a 24% contraction in the third quarter, facing continued industry-wide post-COVID headwinds from distributors selling through their inventory as we added the pandemic to lower ICU census combined with some supply disruptions. Moving to pain management. Excluding the contribution of OrthogenRx, we delivered $66 million of actual sales or $1 million lower versus the prior year, primarily driven by supply chain difficulties related to raw material shortages. The interventional pain side of the business saw 3% as reported growth in the quarter, whereas acute pain declined by over 4%. We are continuing to see positive contributions from OrthogenRx with a high level of adoption of TriVisc, our three-shot HA regimen, as we capitalize on the upside opportunity that will be present through the remainder of this year and into 2023. Moving down the income statement. Adjusted gross margin improved more than 420 basis points to 56.3% versus last year. As indicated earlier, we are pleased with the progress on gross margins with a combination of better product mix, excluding OrthogenRx, improved plant performance, and lower shipping costs. The sequential decrease in gross margin from the second quarter was primarily related to our LIFO restatement and an increase in the cost of raw materials. Our year-to-date results with regards to gross margin are as anticipated. However, the global supply chain environment remains disruptive, inflationary pressures are elevated, and the availability of certain raw material components presents a continuing challenge as we work through our existing backorder. As Joe already noted, we are confident in our ability to achieve our previously stated objective of full year gross margins between 55% and 57%. Separately, adjusted operating profit totaled $27 million compared to $17 million in the prior year. Higher sales and improved gross margins were partially offset by higher absolute spends across SG&A, resulting in adjusted operating margins of 13% for the quarter. With regards to SG&A as a percentage of revenue, we indicated that we would have had sequential improvement in each quarter this year due to front-loaded spending in the first four months of the year. We have executed against this trend and anticipate fourth quarter SG&A spend to be approximately 37%. Adjusted EBITDA totaled $33 million compared to $22 million last year, and adjusted net income totaled $18 million compared to $12 million a year ago, translating to $0.38 of adjusted diluted earnings per share. Now turning to our financial position and liquidity. Our balance sheet remains a strength and continues to provide us with strategic flexibility as we currently have over $120 million of cash on hand, with $254 million of debt outstanding post the closing of the OrthogenRx acquisition and completion of our share repurchase programs. We have consistently maintained leverage levels of approximately one times providing us flexibility against our capital allocation options. Our current available capital exceeds $350 million, which provides ample liquidity for our near-term priorities. Additionally, we believe there is a disconnect between our intrinsic value and our market capitalization, as we look at our strategy and ability to drive higher cash flows and ROIC, and have therefore allocated $55 million to repurchasing our own shares over the prior three quarters. To reiterate, our primary objectives in 2022 center around consistent organic growth, delivering on our OrthogenRx strategy, making meaningful improvements in our gross margin profile, and demonstrating our ability to deliver material free cash flow. As Joe noted, we are reaffirming our full year guidance with total net sales between $815 million and $835 million, annual gross margins in the range of 55% to 57%, and ensuring full year spend remains below 40% as a percentage of revenue. It is important to note that challenges remain with accessing raw materials, unfavorable impacts of currency, and unevenness in the return of elective procedures. As noted on our last earnings call, if these challenges persisted, we would be closer to the low end of our net sales range versus the upper. Finally, we continue to expect to earn $1.45 to $1.65 of adjusted diluted earnings per share for 2022. Although the current global macro and industry-specific environment remains difficult, we remain confident in our ability to execute against our strategy and priorities, and are taking the necessary steps to drive both gross and operating margin improvement and delivery of significant free cash flow, ensuring that we maintain a solid financial position.

Operator, Operator

Please open the line for questions.

Rick Wise, Analyst

Good morning to you both. It's encouraging to see the positive progress here. I have a couple of questions to start with, particularly regarding the back order challenges. I want to ensure I fully understand the exact drivers. Joe, what is your outlook on the potential to address this by the end of the quarter? And for Michael, does your guidance for the year already account for the backlog, whether it's 3 million or 4 million, or would that be in addition to your current estimates?

Joseph Woody, CEO

Morning Rick, it's Joe Woody. I'll say a couple of things. I think Michael will want to make a few comments. But the way to look at our backlog is about 50% of it is Digestive Health, which is primarily tied to Tyvek, which is an industry-wide backlog problem. I mean, Avanos Med is involved; all the companies are involved in working to get as much of that product as possibly can. The other sort of 20% is around the acute pain area and various components, and one major one being the catheter used that impacts the revenue opportunity there. The other 30% of it is changing day-to-day. It could be ink, it could be silicone, it could be geographic to things that affect the international business. And we have assumed today that we'll get down to that 7%. But what I think we would say, and most of the folks on these calls have been saying, is that in a very difficult environment, to manage it because of spot buys or you get a commitment for a particular sort of materials, and they don't come through. And so that's the general high level. I don't know, Mike, if you want to add anything to it.

Michael Greiner, CFO

Yes. So Rick, the 7% is included in our current guidance; if we were to go below 7%, that would exceed expectations.

Rick Wise, Analyst

Got you. And Joe, you mentioned M&A and it's interesting to learn that you're still actively engaged in dialogue. You've expressed some disappointment, and I would like to know where the challenges lie in progressing with these deals. Are the prices still too high, or is competition a factor? What are the reasons behind the delay in the deals you were hoping to secure?

Joseph Woody, CEO

It's more about diligence at this time. We're involved with a lot of private companies, and the pace can vary; some deals move quickly while others take longer. We're actively working on expanding our offerings in the Ambulatory Surgical Center and are excited about prospects in Digestive Health. Overall, we're pleased with the performance of Digestive Health and plan to invest more in that area. We're confident about achieving a valuation similar to previous ones, potentially involving slightly larger deals next year, though still manageable for us. We feel optimistic about our progress and had hoped to finalize something in the fourth quarter, but you might see one or two deals come together by mid-Q1 next year.

Rick Wise, Analyst

Got you. Just my last question. It always seems to be the first question on third quarter calls to ask about 2023. I know you're eager to provide details, but could you share if you are comfortable with the current consensus excluding foreign exchange? Do you feel the business can achieve mid to upper single digits growth excluding foreign exchange? What are your aspirations? Can we expect to see continued strong gross margin improvement next year? Any insights or direction would be greatly appreciated.

Joseph Woody, CEO

Yes. Just a couple of things, and then Michael will add whatever he wants. But look, I'm very happy with the financial measures. If you look at gross margin, EBITDA, cash flow generation, we’ve set the stage for when the top line turns to really get leverage, and that's been a lot of work and actually really good execution. There's more that we can do and more that we're working to do. It's just really difficult right now to judge the top line. It is so independent. I mean, we do believe one thing, which is at least through the middle of 2023, we're still going to be dealing with some of these supply chain challenges. And I think that's been echoed in some of the other calls. We've not changed our view of the business or the range that we can achieve. And actually, what we've said is that in any given quarter, this year, we had $3 million to $4 million more we could have essentially produced in revenue had we not been dealing with these headwinds. We have the opportunity to enhance through M&A and actually have a great balance sheet and the ability to do that.

Michael Greiner, CFO

Yes, Joe, I would add that we're very comfortable with the margin profile, continuing to expand attractively, continuing to demonstrate free cash flow generation, solid balance sheet. The top line is just a little bit of a miss right now. So really nothing to comment on there. But the rest of the income statement, we really feel good about going into '23.

Brett Fishbin, Analyst

Hey guys.

Joseph Woody, CEO

Hey Matt.

Brett Fishbin, Analyst

Hey this is actually Brett on today for Matt. So thanks a lot for taking the questions. One thing that stood out as positive was the continued stability around gross margins. I was just hoping you guys could provide some more color around what drove the year-over-year improvement and then maybe touch on specifically how much of that was driven by the contribution of OrthogenRx.

Michael Greiner, CFO

Yes. As we mentioned earlier in the year regarding the second quarter, we expect that approximately 50% of the improvements in our gross margin year-over-year will come from the contribution of OrthogenRx, with the other 50% stemming from enhanced manufacturing efficiencies and other initiatives within our operations. This expectation holds for the third quarter as well. Looking ahead to the fourth quarter, we anticipate the same trend. Remember, we projected a gross margin range of 55% to 57%, having exited last year at 52%. Regardless of where we land within that range, about 50% of our improvement is anticipated to derive from OrthogenRx, particularly at the lower end of the range. As we approach the higher end, a greater proportion will come from the efficiencies we are implementing in our manufacturing processes, which reinforces our confidence in continued improvements in our gross margin profile as we enter 2023.

Brett Fishbin, Analyst

All right. Excellent. And then just wanted to follow up on that. Just given gross margin had been such a strength of the company, just thinking longer term, maybe 2024 and beyond, do you see an opportunity to maybe get back to that 60% level that you were at several quarters ago? And if not, what's the right level that you guys are targeting? And how do you think about the remaining levers to get there?

Michael Greiner, CFO

Yes. Since we last reported the 60% margin, we have acquired some companies after our acquisition of OrthogenRx, along with other companies that fall below that 60%. Our new baseline as a company is around 58% to 59%, which we feel we can achieve naturally. Looking ahead to 2023 and 2024, 58% to 59% is a comfortable range for us. To return to 60%, we would need to make additional acquisitions that have a favorable gross margin profile, which would help us and provide some additional savings or opportunities within our plant operations. Do we believe we can reach 60% again? Yes, we are confident there is a way to get there. However, under our current mix, without any additional factors, 58% to 59% is a more realistic target.

Brett Fishbin, Analyst

No, that definitely does. And then last question for me. Just thinking about understanding it's a very challenging environment, but just wanted to hone in a little bit more on what you're seeing in pain management, just given the expectations that you communicated last quarter around a potential improvement to double-digit growth in 2H. Just wondering if you could touch on, beyond the supply constraints, what might have contributed to that delta and then what maybe gets better into 4Q.

Joseph Woody, CEO

Yes, our main focus in pain management is in hospitals, although we recognize the shift to Ambulatory Surgical Centers. We're actively engaging in that area, along with addressing staffing challenges. A significant concern is acute pain management, particularly with catheter issues and supply chain delays. We should also consider the ambIT business, which, while smaller, has been experiencing substantial growth rates of 30% to 50%. The trend is moving towards electronic pumps, and we are well-positioned for that transition, which currently represents less than 10% of our operations. In terms of IDP, I expect it will show high single-digit to double-digit growth each quarter with good potential ahead. It has been impacted by the backlog in CRG units, as capital sales are needed to grow the business. However, we anticipate increased strength in Q4. We are planning to integrate more of our COOLIEF RF and IBP products into Ambulatory Surgical Centers. We're optimistic about short-term opportunities with OrthogenRx and Game Ready, aiming for steady mid-single-digit growth. Additionally, we're exploring M&A to further enhance our position. Overall, there still seems to be strong underlying demand, but like everyone else, we need to work through supply chain issues to fully realize our opportunities.

Brett Fishbin, Analyst

All right thanks again for taking the questions, guys.

Joseph Woody, CEO

Thank you. Thanks, Brett.

Operator, Operator

The next question comes from Drew Ranieri of Morgan Stanley. Please go ahead.

Unidentified Analyst, Analyst

Joe and Michael, this is Jacob on for Drew. Thanks for taking the questions. I'll ask my two questions upfront. First one, following up on some of the previous 2023 questions and looking at margins for next year. If the macro environment stays as is, to what extent could we still see gross margin improvement next year? And then my second question on OrthogenRx. How has your thinking shifted, if at all, since last quarter regarding the expected reimbursement tailwind into 2023? Any changes there? And how you're thinking of the size or duration of the tailwinds? Thank you.

Joseph Woody, CEO

So maybe just two quick comments and then Michael will say a few things. But with respect to gross margin, I think that we also have some price and mix opportunities, but he's led that out a little bit and maybe say a few more things there. In terms of OrthogenRx, I think we're going to start to see that tailing off a bit because we said it was going to be a short-term sort of last impact by the end of the first quarter, if you will. Everybody will be on a very level playing field. Yes, we are adding both direct sales representatives and 1099s, and we want to take this into some of our other areas. But we've also highlighted from the very beginning, probably from the initial acquisition that we would see a flattishness for one year in that business as we transitioned reimbursement. But we'll get some benefit in Q4. I think that will start to wane into next year and can come back a little bit. But Michael, anything you would add?

Michael Greiner, CFO

Yes. I don't think the macro environment on gross margins for us or operating margins for that matter, are going to impact us too much next year. That's my point in the earlier question for Rick is that put aside the top line, which is still a little bit fuzzy, but the core of our income statement, we've done a lot of work the last 18 months, for those of you that have followed us closely, and we're seeing those benefits come through Q2, Q3. We'll see them in Q4, those trends should continue to either improve or stabilize at very attractive levels in 2023, irrespective of the macro environment. It's really the top line that the macro environment has had a much more meaningful impact on both FX and the backlog situations that we've been dealing with for the last now six quarters.

Operator, Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Joe Woody for any closing remarks.

Joseph Woody, CEO

Look, I just want to thank everybody for the interest in Avanos. We're pleased with the overall execution given the environment we're in. We are committed to creating shareholder value, and believe our 2022 results are getting to that foundation to deliver on that commitment. I'm very confident in the priorities we detailed. Combined with our market positions and attractive markets, I think we're going to see eventually consistent sales growth and margin expansion, and continue the free cash flow generation. Just next week, Michael will be at Credit Suisse, and the week after, both Michael and I will be at the Stifel Conference in New York. So appreciate everybody's interest, and have a great remainder of your week. Thank you.

Operator, Operator

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