Earnings Call Transcript - AVNS Q1 2023

Operator, Operator

Good morning and welcome to the Avanos Q1 Earnings Conference Call. All participants will be in listen-only mode. 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 Avanos 2023 first quarter earnings conference call. Presenting today will be Joe Woody, CEO; and Michael Greiner, Senior Vice President, CFO, and Chief Transformation Officer. Joe will review our first quarter and expectations for 2023 as well as provide an update on the current business environment. Then Michael will discuss additional details regarding our first quarter and 2023 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.

Joe Woody, CEO

Thanks, Scott. Good morning, everyone, and thank you for joining us to review our operational and financial results for the first quarter of 2023. Our first quarter results were generally in line with our expectations. As we noted in our year-end earnings call, our quarterly results for 2023 would likely be uneven given the timing uncertainties associated with our transformation plan, including the pace at which we rationalized our product portfolio, eliminated SKUs, or accelerated cost savings. The demand for our products remains strong and although supply chain disruptions have improved with our backlog coming down by $1 million during the quarter, we continue to have a sticky backlog that has limited our ability to fulfill our demand levels. Coming into the year, we anticipated that 2023 would continue to present supply chain headwinds and pockets of product availability challenges, but that as we got to the back half of the year, many of these headwinds would ease, and we believe that's still to be the case. 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 $192 million, which is a decrease of 2.9% compared to last year. Excluding both the negative impact of foreign exchange and the $5 million impact related to our previously announced decision to walk away from revenue that was not meeting our returns criteria, organic growth was unfavorable by 0.7% for the quarter. Separately, for the quarter, we generated $0.27 of adjusted diluted earnings per share and greater than $26 million of adjusted EBITDA. While our adjusted gross margin was 56.4% and our SG&A as a percentage of revenue was 41.6%. These results support the transformation priorities we laid out at the JPMorgan Conference in January and which we will expand upon at our Investor Day on June 20th. Now, I'll spend the next few minutes discussing our results at the product category level. On a constant currency basis, our adjusted health portfolio grew over 10%, bolstered by our NeoMed business, which posted another strong quarter with over 36% growth versus the prior year as we continue to take advantage of the strong demand for ENFit conversions in North America. Our legacy enteral feeding product line maintained its global mid-single-digit growth behind the continued expansion of our US CORTRAK standard-of-care offering. Our Respiratory business declined by a little over 6% with both our closed suction catheters and oral care solutions facing tough comparisons due to the Omicron spike in early 2022. We anticipate that the respiratory health business will grow by 2% for the full year 2023, with normal seasonal ordering patterns returning during the second half of the year. In total, our Chronic Care business grew greater than 5% in the first quarter. Excluding the negative impact of foreign exchange and low growth, low-margin product care categories, we are no longer selling. Turning to the Pain portfolio. Sales were down 10% for the quarter with soft results across our Surgical Pain, Game Ready, and five-shot HA product categories, each of which were down at least 10% versus the prior year. Our Interventional Pain Products categories grew by 1%. As noted on the year-end earnings call, we continue to experience supply headwinds within our surgical pain category. We expect these headwinds to remain a factor throughout the first part of 2023. Alleviating the supply chain challenges is critical as macro dynamic factors impacting the use of our surgical pain products during the past two years, like hospital staff shortages and an overall reduction of elective procedures, have subsided, and we are working diligently to take advantage of this improved landscape. Separately, our HA portfolio experienced a weaker-than-expected first quarter. However, this softness was primarily concentrated in our five-shot or GenVisc product. The five-shot market has specific pricing and competitive challenges that are not as prevalent within the three-shot market. TriVisc, our three-shot offering remains in line with our long-term orthopedic strategic goals and is performing as anticipated. Volatility will continue to be a factor throughout the year as we face strong comparables from last year and continue to experience the related swings from entering the ASP reporting environment in Q3 2022. Despite the volatility, we believe we have the right strategies in place to capitalize on the opportunities present in the HA market, including continuing to provide best-in-class service and support, expanding market access through both our direct-to-patient and specialty pharmacy business, and targeting long-term stability and reliability in pricing for our customers. Now, moving to an update on our 2023 priorities and transformation efforts. We have four key priorities for the next three years that will optimize our go-to-market opportunities and meaningfully enhance our financial profile. These priorities include strategically and commercially optimizing our organization, transforming our portfolio to focus on categories where we have attractive margin profiles and the right to win, taking additional cost management measures to enhance operating profitability, and continuing our path of efficient capital allocation to meaningfully improve our ROIC. In the first quarter, we executed well against these priorities as Kerr Holbrook announced his new sales and marketing organization, among other strategic initiatives. Our margin profile was enhanced versus the prior year's first quarter. We executed against our portfolio optimization strategy and remained on track to deliver at least $10 million in current year operating expense savings. Additionally, we continue to review our capital allocation priorities, including strategic M&A and opportunistic share repurchases. We look forward to presenting additional details regarding this transformation program and the related three-year financial targets at our Investor Day on June 20th to be held at the Convene 101 Park Avenue location in New York City.

Michael Greiner, CFO

Thanks Joe. Before diving deeper into these transformation efforts, I'll provide additional color to our first quarter results. Total reported sales for the first quarter were $191.7 million, a decrease of 2.9% compared to last year. Adjusted EBITDA for the quarter was greater than $26 million compared to $23 million a year ago, with EBITDA margin improving 200 basis points versus last year. Adjusted net income for the quarter totaled almost $13 million compared to $12 million a year ago, translating to $0.27 of adjusted diluted earnings per share versus $0.25 a year ago. We ended the quarter with $96 million of cash on hand and a leverage ratio of 0.8. As Joe already noted, we delivered on both our gross margin and SG&A as a percentage of revenue targets. Our gross margin for the quarter was 56.4%, a 50 basis point improvement versus the prior year, primarily driven by the positive impact of our manufacturing efficiency programs. We anticipate second quarter gross margin to be slightly improved versus the first quarter. Separately, SG&A as a percentage of revenue improved by 140 basis points versus the prior year, primarily related to our cost savings efforts to streamline the organization and reduce our external spend profile. As with gross margin, we anticipate our SG&A levels will be largely similar during the second quarter compared to the first quarter, with material improvement expected in the second half of the year as our cost management transformation efforts begin to accelerate. As we previously shared, 2023 will be a transition year, given our product portfolio rationalization and cost management initiatives. The first quarter was an example of this unevenness with slightly lower revenue than anticipated across some of our product categories while profitability measures were either in line or exceeded our expectations. In summary, we are pleased with our first quarter execution in total and remain confident in our ability to meet our previously announced guidance for the year of earning between $1.60 and $1.80 of adjusted diluted earnings per share while delivering at least $60 million of free cash flow, excluding the one-time cash costs associated with the restructuring efforts expected to total approximately $25 million. Finally, including the current year impact of the approximately $35 million annualized impact of product portfolio rationalization, the company anticipates organic revenue growth to be low single-digits. Now, turning to our transformation priorities, which are designed to shift our product portfolio over time into a higher growth portfolio, leveraging our cornerstone product families in digestive health as well as our orthopedic pain and recovery-focused products. In addition, these priorities will right-size our cost structure and enhance our operating profitability, allowing us to generate significantly greater annual free cash flow over the next three years while meaningfully improving ROIC over this transformation horizon. As already shared, we expect to realize approximately $10 million of savings in 2023 while anticipating $45 million to $55 million of gross cost savings by 2025, most of which will be achieved in 2024. I will end with reiterating what I shared at the end of my prepared remarks at the year-end earnings call. We are excited to embark on our transformation journey and are confident we will improve on each of our financial metrics as 2023 progresses, with a slow start for the first quarter, followed by acceleration in the back half of the year, similar pacing to what we experienced in 2022.

Operator, Operator

We will now start the question-and-answer session. The first question is from David Turkaly from JMP Securities. Please go ahead.

Unidentified Analyst, Analyst

Yes, great. This is actually Danny on for Dave. So, just a quick one on gross margin. It was a nice increase during the quarter, and you noted some of that benefited from manufacturing efficiencies and improvements in the supply chain, but I guess our question really is more around looking ahead. How should we think about benefits to gross margin for the full year? More specifically, how much of the improvement should we expect from the exiting of lower-margin product lines and other portfolio rationalization efforts versus continued improvement in the supply chain that you've seen? Thanks.

Michael Greiner, CFO

Yes. Thanks Danny, for the question. We still anticipate, as we said previously, we will have a 100 basis point improvement in our operating margin for the full year. And given the uncertainties of the moving pieces, we weren't sure if that was going to come from gross margin or from our SG&A as a percentage of revenue, our total OpEx spend. But I do think as we move through the year, the 56.4% that we started with in the first quarter, which we were very pleased with the overall execution, should see higher figures for the full year.

Unidentified Analyst, Analyst

Thank you. I have a follow-up regarding free cash flow. There was an outflow of about $11 million this quarter, and you noted that it would be a focus for 2023. Could you provide some insight into what we should expect for the remainder of the year and any other considerations? Thank you for addressing these questions.

Michael Greiner, CFO

Yes. So, the first quarter for free cash flow is definitely going to be the lowest. It was going to depend upon how much execution we had on the transformation and cost savings plan. We spent, as you'll see in the one-time cost in a non-GAAP reconciliation, about $7.5 million in cash in the first quarter for those activities, and of course, revenue was a little bit softer than we anticipated. So, the combination of those two had free cash flow a little bit lower than we anticipated in the first quarter. That will be our lowest free cash flow quarter for the year, putting aside some tax payments that we may have. So, we should see an improvement in free cash flow through the rest of the year.

Unidentified Analyst, Analyst

Great. Thank you very much.

Rick Wise, Analyst

Good morning, Joe. To begin, during this earnings season, we've heard a lot from larger companies discussing the challenging macro environment, but they're experiencing less supply chain headwinds as things have stabilized. It would be interesting to hear your insight on how this is playing out for Avanos. How did things trend in the last quarter? What are you seeing so far in the second quarter? How does all of this tie into your outlook for the year? Thank you.

Joe Woody, CEO

Yes, Rick, I mean, a couple of things, and I noted the other earnings calls as well and a lot of the larger companies have a broader portfolio to your point. But they did indicate some issues. For us, specifically, ON-Q and some catheter availability is hurting us there generally. We really had it across the board, though, even in our COOLIEF product line and our ambIT product line, somewhat into Digestive Health, although we did move a lot of that through in the quarter. It's definitely going to improve, but still be with us we do agree that the second half is likely going to be much, much better, given that these things are going to disappear. However, for us, we probably had $4 million to $5 million more that we could have pushed through if we were all the way clear on our backlog.

Michael Greiner, CFO

I think the other thing too, Rick to add to that is our confidence in reiterating our previously announced guidance is high because we do think the storm clouds are clearing. Some of the things that we missed this quarter were very specific to us, our raw materials and our input costs, but we think we have visibility to those things clearing and giving us confidence to be able to still achieve our full year guidance outcomes.

Joe Woody, CEO

And if you have been following us for a while, you know that our portfolio unfortunately starts slow, with the first quarter being the weakest. If you consider last year, we made progress each quarter and then had a very strong performance in the third and fourth quarters.

Rick Wise, Analyst

Yes. No, that makes sense. Thanks to both. And Michael, maybe this is a question for you. On the Interventional Pain side, if I'm doing the back of the envelope math correctly, I may not be, please don't hesitate to correct me. It looks like what I would call the base ex-OrthogenRx pain management business. It was down sequentially 25% versus the fourth quarter. I know that seasonal sequential figures down, whatever, down 5% to 10%, is that the backlog? Is that component? Is there something else going on? Just maybe I missed your language, is Pain more uniquely affected here? Or you're seeing less of a recovery? Any extra color would be great.

Michael Greiner, CFO

Yes. No, that's helpful. So, it's a couple of things. It's one, as you just hit on, which is there is some component and access to material issues there, but in particular, Game Ready had a very strong fourth quarter and a less than optimal first quarter. So, a big part of the math that you're doing is attributed to Game Ready. In addition, standard RF was also down. That was more attributable to the availability of product. COOLIEF was by and large a push from Q4 to Q1. So, primarily, our RF and our Game Ready are the pain points, no pun intended, for the weak transition from Q4 to Q1 in Interventional Pain.

Rick Wise, Analyst

Got you. And just one more thing from me. Joe, I hate to keep asking, but what can I do about the M&A question? I know you had hoped to announce at least one transaction before the upcoming June Investor Day, if I remember correctly. We're about a month away from it. Any additional updates would be appreciated to bring us up to date.

Joe Woody, CEO

Yes, we do feel like we're going to be able to talk about an additional bolt-on for the Orthopedic Pain business, something that would help us in the ambulatory surgical center strategic area. It's also possible that we'll be able to say some things more explicitly about the portfolio that would be a significant change for us. So, we feel pretty good about that. And you know a lot of times we hit it, and it's hard to predict these things, but we're working very hard to make that happen because I think that will be very key for the Investor Day.

Operator, Operator

We are exploring an additional acquisition for the Orthopedic Pain business that could enhance our presence in the ambulatory surgical center sector. We may also provide more detailed information regarding our portfolio, which would mark a significant shift for us. We are optimistic about this development. While it's often challenging to forecast these outcomes, we are dedicated to making it a reality, as we believe it will be crucial for our Investor Day.

Michael Greiner, CFO

I don't think there's anybody else queued up, operator.

Operator, Operator

Yes, sure. There are no more.

Michael Greiner, CFO

Sorry hold on, Matt just got in. Let's let Matt ask his question.

Matthew Mishan, Analyst

Sorry, I think I had an issue getting into the queue at first. Just wanted to ask on guidance thinking about the cadence sequentially. I think you guys kind of have hinted that a little bit of a softer first quarter relative to the low single-digit organic guide. Just wanted to think about the rest of the year, how it plays out? I know you said that the second half would likely be stronger but also just maybe breaking out Pain Management versus Chronic Care and what you'd expect to see as a base case for the rest of the year?

Michael Greiner, CFO

Yes. So, great question. So, Q2 is going to look largely similar, give or take, to Q1. There'll be some pushes and takes there, but largely similar to Q1. As we said, I think gross margin will improve given that we've got some programs that are picking up momentum. The back half of the year will be very strong both on the gross margin and OpEx side. What we'll do at Investor Day in 45 days is provide a little more specific layout. We'll kind of pre-talk about Q2 given that it will be June 20, and then we'll lay out the back half of the year with more detail, including some of these transactions we think we'll be able to get over the finish line to talk about on June 20th.

Matthew Mishan, Analyst

All right. Great. And then just a quick follow-up. I'm not sure if you said in the prepared remarks, if there was any change around the Orthogen expectations for the rest of the year? Does guidance still contemplate relatively flat full-year sales versus last year? Or has there been any type of change? Thanks very much.

Joe Woody, CEO

No, there's been some change there. We talked about really a combination, if you will, of a 10% decline in Orthogen in the HA, primarily in the five-shot area as well as the Game Ready and even the acute pain sector ON-Q being tied to supply chain. So, there is that potential that's kind of pulled into our, but we're still lining up to our full-year guidance. One thing we've talked about a lot in this HA environment that we're in is that there are ebbs and flows quarter-to-quarter or customers go away for a bit. They're chasing the best reimbursement and they come back, but it's really going to all kind of even itself out by the end of the year.

Matthew Mishan, Analyst

So, just to clarify quickly, are you still contemplating like flat Orthogen sales relative to last year?

Joe Woody, CEO

No, we're not contemplating flat. No.

Matthew Mishan, Analyst

All right.

Michael Greiner, CFO

TriVisc is expected to be flat or better compared to last year, while five-shot is anticipated to decline relative to last year. We are not yet certain about the exact mix, but overall, it will be down compared to last year.

Matthew Mishan, Analyst

Okay. I guess like lastly for me, would you point to any product areas as a potential offset to guidance like given low single-digit organic was unchanged and it seems like Orthogen might be a little bit lower?

Michael Greiner, CFO

Yes. Digestive in particular, we also believe there is upside in acute pain as we get visibility to the supply chain issues. And then internationally as well, we think we have some pockets of strength internationally that have not been fully accounted for.

Matthew Mishan, Analyst

All right. Thanks very much for taking the questions. Appreciate it.

Michael Greiner, CFO

Thank you.

Drew Ranieri, Analyst

Hi Joe, Michael. Thanks for taking the questions. Just another on Orthogen for a moment, but I hear you on the five-injection and three-injection market, but just curious maybe on the five-injection. Is the decline at all more of just a mix shift into the three-injection? Can you give a little bit more color there? And then I had a follow-up. Thanks.

Joe Woody, CEO

Yes, yes. I think there's really two things. One is some customers clearly with the reduced reimbursement in that segment, which is a lot of it is the non-orthopedic segment. It's more of a Pain Center segment are leaving the business. The other component of that is that we had a competitor that has a special code in the first quarter. I believe that's going away in Q2 as they start reporting too. So you have a number of customers that moved over for a bit to take advantage. We benefited from that, obviously, in Q4, but we didn't in Q1 that all settles out and our intention is to maintain the base that we have of five but we're growing and stabilizing in the three and we've actually have another focus that includes additional new structure, a new VP of Sales coming in to focus on the orthopedic space, not only in HA, but in the ambulatory surgical center with some of our other products and then the bolt-on that we alluded to in the earlier comments.

Drew Ranieri, Analyst

Got it. Thank you. And then just another follow-up to one of Rick's questions on M&A. But kind of in response to this question, you mentioned there could be more of a portfolio move. It sounds like more of a divestiture than anything. So, are we kind of hearing you right into Investor Day that, that could be something that's still on the table? And should we think about that as a multiple of what you're doing already in kind of the product rationalization for 2023? Thanks for taking the questions.

Michael Greiner, CFO

If we were to do a divestiture, it would be a multiple of the product rationalization. So, that's a fair assessment.

Operator, Operator

Gentlemen, there are no more questions at this time.

Joe Woody, CEO

Again, I want to thank everybody for their continued interest in Avanos. We feel the demand and fundamentals of our products remain strong. We are committed to obviously creating meaningful shareholder value through thoughtful strategic capital allocation. We believe the 2022 results have built the necessary foundation to deliver on the commitments that we have and are confident in the priorities that we've detailed in the transformation program combined with our market-leading portfolio in attractive markets. This all positions us for growth, margin expansion, and cash flow, as we've outlined and as Michael has talked about in the transformation process. We do look forward to seeing everybody at the June 20th Investor Day to be held at the Convene 101 Park Avenue location in New York City. Have a great rest of your week. Thank you for your interest. Bye.

Operator, Operator

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