Earnings Call Transcript - AVNS Q3 2021

Operator, Operator

Good morning, and welcome to the Avanos' Third Quarter 2021 Earnings Conference Call. All participants will be in 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 Mr. Scott Galvin, Vice President Corporate Strategy and Business Development. Please, go ahead.

Scott Galvin, Vice President Corporate Strategy and Business Development

Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to the Avanos 2021 third quarter earnings conference call. Presenting today will be 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 against our 2021 priorities. Then, Michael will review our third 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, 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 your interest in Avanos. While we continue to see the impacts of the pandemic as it relates to elective surgeries, hospital staff shortages, and supply chain, we're very pleased with how our operational and commercial teams have responded 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'll begin with a brief review of our results for the quarter before discussing the current environment and our progress against our 2021 priorities. We achieved sales of $184 million for the quarter and earned $0.25 of adjusted diluted earnings per share. Our sales results were primarily in line with our planning assumptions. Other than the slowdown in sales we experienced with On-Q, as a result of the Delta variant pushing out electives during the summer, we delivered solid sales results in each of our other product categories during the third quarter and through the first nine months of the year. As we noted last quarter, we anticipated a meaningful improvement in our gross margin profile throughout the third quarter. Gross margins for both August and September were 54%, with gross margins for the third quarter exceeding 52%, or 90 basis points better versus the second quarter. Our gross margins will continue to improve throughout the fourth quarter and stabilize into 2022. However, transportation and other supply chain inflationary pressures remain, and we are therefore unable to determine how much further improvement we will see in the short term. As we mentioned last quarter, most of these headwinds impacting our gross margin are transitory, primarily pandemic-driven, being seen across industries and do not indicate a permanent change to our operating structure. We remain confident in that assessment. Although gross margins have improved and will continue to improve as we exit this year, we are meaningfully behind our internal projections on gross profit, and therefore have identified additional efficiencies throughout the business to reduce operating expenses. Teams are continuing to find ways to increase productivity and lower our cost structure, ensuring that we can 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, let's move to a discussion on the current market environment and provide an update on our progress against our 2021 priorities. As mentioned earlier, we delivered solid revenue outcomes across most of our product portfolio. Our digestive health business led by NeoMed was up over 2% globally versus prior year, and 6% in North America. Our respiratory business was down versus the prior year, primarily related to the pandemic-related push we received in the third quarter of last year, which contributed $8 million of additional sales. Sequentially, we were flat versus the second quarter, as the standard of care with our closed suction catheter systems for patients needing hospitalization due to the coronavirus has primarily shifted to non-invasive ventilation procedures before moving to mechanical ventilation. On the pain management side, we saw almost 5% growth from our interventional pain portfolio, while acute pain was down a little over 1% due to the Delta-related pause, and then elective surgical procedures impacting our On-Q franchise. As we have stated in the past quarters based on conversations with our surgeons and hospital administrators, as well as what our peers are also disclosing, we continue to believe inpatient procedural volume will remain below its full potential for the foreseeable future. That being said, we do anticipate sequential growth and recovery for our On-Q franchise for the fourth quarter, similar to second quarter levels of revenue. As we move into the last quarter of the year, we continue to enhance our product offerings to improve the efficacy and ease of use for our care partners. For COOLIEF, we successfully completed a limited launch of next-generation cooled radio frequency probe kits in Q3, but the full launch is now in place for Q4. The new probes make it easier for our physicians to perform COOLIEF procedures while maintaining our premium look and feel. There are also increased manufacturing efficiencies associated with the new probes, which supports gross margin improvement from COOLIEF's already high gross margins. Combined with the launch of our new generator last year, our new probe kits strengthened our cooled RF leadership position. Within our On-Q and ambIT business, we recently launched Pain Block Pro, a differentiated app and data collection vehicle to track, monitor, and improve patient outcomes through more direct feedback between the patient and physician. It abstracts patients' recovery to understand those satisfaction and pain levels in real-time. It also helps us engage patients to improve their experience by providing education about the pump and giving an avenue for a physician to get active feedback on questions the patient might have. We also continue to see momentum building from our channel partnership agreements, where we leverage orthopedic sales partners to gain access to orthopedic surgeons. Finally, we're delivering our electronic pump ambIT into the ambulatory surgical setting, which is positioning us to capture additional procedure volumes. 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. As I stated earlier, our respiratory health sales were down given the prior year pandemic tailwind. We have modeled a nominal flu season for this year and consistent with that modeling, we have not currently experienced any higher levels of buying activity for our closed suction catheter products. Our second area of focus in 2021 relates to improving our gross and operating margins. We remain focused on recapturing gross margin loss since the start of the pandemic and made some meaningful progress in Q3 on these initiatives. We were very pleased with our gross margin improvements as we exit the quarter, anticipating further gains throughout the fourth quarter. As noted earlier, we are confident these gross margin headwinds are transitory, but we also recognize a significant work remains to get our gross margin profile back up to the high 50s and low 60s. Our third priority is to begin generating consistent repeatable free cash flow. We generated $10 million of free cash flow in the second quarter and $18 million in the current quarter, and we anticipate generating positive free cash flow again for the fourth quarter. We received $47 million of CARES Act related tax refunds during the quarter, which was partially offset by the $22 million that we paid to the DOJ to settle our outstanding litigation. The improved operating results, coupled with some remaining working capital upside will support this priority of generating consistent and repeatable free cash flow. 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, enhance our top-line growth, and meaningfully improve our margin profile. We will remain disciplined in identifying targets that meet both our strategic initiatives and exceed our financial hurdles ensuring we generate a strong return on capital. Lastly, over the last four quarters, we have resolved all material outstanding litigation, including the DOJ investigation, the indemnification dispute with Kimberly-Clark, a positive outcome regarding our IP infringement case with Medtronic, and other smaller product liability cases. Not only has this reduced our range of uncertainty, but it will also significantly reduce our legal expenses from a cash flow perspective. This positions us to be more aggressive with M&A, as well as frees up capital for share repurchases, while ensuring we continue to meet each of our internal funding needs. We remain well positioned to advance our strategies across each of these four areas of value creation as we complete 2021 and begin to look toward 2022. Now, I'll turn the call over to Michael.

Michael Greiner, Senior Vice President and CFO

Thanks, Joe. As you noted, we have made meaningful progress against our value creation initiatives and are setting ourselves well for a solid 2022 that will combine mid-single-digit top line growth with M&A execution. Additionally, we will show improved gross and operating margins, as well as consistent free cash flow generation. Now, let's begin with a review of our third quarter results. Total sales of $184 million were essentially flat compared to last year. Volume and currency were even with price being down around 1%. Given the pandemic-related tailwind for respiratory health in the third quarter of 2020, chronic care sales declined 2% to $117 million in the quarter. Adjusting for the 2020 tailwind, respiratory health sales would have been up $4 million for the quarter with improvements across the portfolio. Although the Delta variant spread quickly during the summer and increased hospitalizations once again, we did not see meaningful growth in our closed suction catheters, as hospitals carried out their first line of care before placing patients on ventilators. As we noted last quarter, our planning assumption in respiratory health for the second half of 2021 does not include any additional benefit from the pandemic, and we also stated we expected a negligible start to cold and flu season, which we are currently experiencing. Shifting to digestive health, we saw 6% growth in North America offset by a decline in our international markets, providing total global third quarter growth of just over 2%. NeoMed once again grew double-digits from the continuation of conversions to our ENFit technology. Our backorder impact for NeoMed currently sits at $1.5 million, which we plan to work down to the first quarter of next year. Moving to pain management, we delivered $67 million of sales, 1% higher compared to the prior year, driven by strong performance across our RF-ablation products, Game Ready, and ambIT offset by On-Q. As Joe noted, growth in Q3 was hampered by impacts brought on by the Delta variant and a return to slowdown in elective procedures. While these impacts had an effect across the pain portfolio, On-Q was disproportionately impacted, as inpatient therapy experienced rolling shutdowns across various regions in the US during the summer. We partially offset these losses with the introduction of Pain Block Pro, channel partner growth, and expansion into the ASC setting. We are well positioned to drive sequential improvement in Q4 as these initiatives move forward with elective procedures slowly returning. Additionally, supply constraints and raw material shortages have impacted our ability to meet demand within the Game Ready business, but backorders still exceed $1 million. We anticipate these backorders will continue to grow into the end of the year. While these constraints will persist over the next couple of quarters, our supply chain team is actively working to find supply, and we expect to work down our backlog in the first half of 2022 to meet this market demand. Moving down the income statement, adjusted gross margin decreased to 52% compared to 55% last year. As indicated earlier, we are pleased with the progress on gross margins through the quarter and anticipate further meaningful improvement into the fourth quarter. Compared to last year, gross margin was impacted by higher transportation costs and unfavorable mix. Ocean freight costs have increased due to global capacity constraints. Additionally, lower sales of closed suction catheters and On-Q products have unfavorably impacted our product mix. Those headwinds have been partially offset by lower inventory write-offs this year. Looking towards 2022, we continue to expect gross margins to steadily improve as a result of a range of programs we are implementing throughout operations. However, we also remain cognizant of the global supply chain environment that remains disrupted, and we are currently unable to predict the offsetting impacts of higher inflation in transportation costs, as well as the availability of certain raw material components. Now, turning to some bottom line financial metrics. Adjusted operating profit totaled $17 million compared to $18 million in the prior year. Slightly lower sales and unfavorable gross margins were partially offset by lower spend across SG&A and research and development expenses, as we noted earlier. Adjusted EBITDA totaled $22 million compared to $24 million last year. Adjusted net income totaled $12 million compared to $10 million a year ago, and we are on $0.25 of adjusted diluted earnings per share, a 20% increase versus prior year. Turning to the balance sheet and cash flow statement, our balance sheet remains a strength for us and continues to provide us with strategic flexibility, as we currently have $110 million of cash on hand and $130 million of debt outstanding on our revolving credit facility, as we use some of the proceeds from the CARES Act refunds to pay down debt. We have over $200 million of available capacity to utilize towards our capital allocation priorities. Finally, while unpredictability of the coronavirus remains, we still foresee our net sales increasing 2% to 4% on a constant currency basis compared to the prior year. Additionally, as we have noted throughout these prepared remarks, we remain in an uncertain environment regarding our supply chain from both a cost perspective and availability of products. To partially offset that impact, we have managed our cost structure concerning SG&A and R&D throughout the year, which has allowed us to maintain our guidance range of $1.10 to $1.20. We remain committed to and are also reiterating our guidance range given these factors. While also recognizing that the likelihood that we fall out of the low end of our guidance has now increased. We've made great progress in 2021 to set ourselves up for a successful 2022 and beyond, and we are excited that much of our cash flow uncertainty is now behind us. We remain confident in our ability to execute our strategy and take the necessary steps to drive gross and operating margin improvement and deliver more consistent results as we look towards 2022. Operator, please open the line for questions.

Operator, Operator

The first question is from Matthew Mishan from KeyBanc. Please proceed.

Matthew Mishan, Analyst

Guys, I just want to start with revenue growth first because it seems like the sales growth has been fairly resilient throughout COVID-19 last year with Respiratory Health and Chronic Care. This year, you seem to be coming in sort of at or above the midpoint of your guidance. What would it take for you guys not to come in at that 3% plus at this point given 3Q versus 4Q typical seasonality?

Michael Greiner, Senior Vice President and CFO

Yes. Matt, this is - so first of all, and I'm sure, we'll get this question, as well as Joe. We've seen a pretty good start to October with some improvement even in the Pain business. The thing that we're keeping an eye on really are the supply chain items that we talked about, and then just, it all comes down to how fast essentially the procedures come back. I think a lot of other companies have talked about the staffing issues, primarily with the hospital and then how fast, in particular, in the South, where there was Delta, while the procedures come back. And to the extent that they do come back faster, that's better for us.

Joe Woody, CEO

I would say too, Matt, when we look at October actuals right now, yes, we should hit those targets for Q4, and we saw that in the November and December months, then we saw exactly what happened to us in the summer, where all of a sudden the Delta variant spiked in the Southern part of the United States and had a meaningful impact on On-Q. Right now, we have some pretty good trends working through the last 60 days of the quarter, but we also want to remain cautiously optimistic.

Matthew Mishan, Analyst

When you mention that the likelihood has increased of falling below the range of 110 to 120 while still maintaining your guidance, what is the thought process behind that? I'm trying to understand how you are thinking about this.

Michael Greiner, Senior Vice President and CFO

Yes. No, no, no. It's a great question. So there was a fair amount of debate internally around do we move the guidance altogether, do we make the guidance range larger. And we just felt like with 60 days left to do any of those things just created clumsiness on the downside and the upside because, as I said, we're coming out of October feeling pretty good about where we are. And so let's say we moved the guidance range to $1.05 to $1.15, and then we do $1.16, well that feels clumsy. If we increase the range by $0.15 or $0.20 that doesn't feel exactly appropriate either. And so we just felt like this wording, which I think is unusual for all people was more appropriate for where we are, which is, if supply maintained, if the trends that we're seeing coming out of October maintained, if we don't see any other hiccups in distribution, we should be comfortably in the 110 to 120 range. If those things turn in a different way over the next 60 days, then we could fall slightly below and out of that range.

Matthew Mishan, Analyst

When you look at that range, just to get to the low end based on the midpoint of the revenue guidance, it would imply a pretty meaningful increase in the gross margin into the fourth quarter. How do you give people a sense of confidence that is really what's going on there, the trajectory that you're on?

Joe Woody, CEO

And by the way, and I think Michael is going to take it. But what I would say, just to reiterate, we did hit 54% gross margin in August and September and a lot of these things are starting to improve for us. But go ahead, Michael, I know you want to take them through.

Michael Greiner, Senior Vice President and CFO

Yes. No, I would just, we anticipate right now that our overall operating margins are going to improve by north of 400 basis points between Q3 and Q4, with the significant majority of that being the gross margin improvement. And to Joe's point, the trends that we saw in August and September will continue into Q4. So you're spot on, Matt, with your math. We have high confidence levels. We should have been better in Q3 except that, although freight was much improved about 50 basis points, we thought freight would improve by even more than that. But then over the water shipping costs throughout the third quarter increased by fivefold, and that's now coming back down. So that will help. We're no longer doing the overnight shipping, as we had talked about previously, and we have other tailwinds going into Q4 versus Q3. Another thing, we saw in Q3 on gross margins was a little different mix, so how we got to our $184 million was a little different mix than we anticipated with some lower margin products like oral care having a particularly strong Q3, whereas On-Q was a little bit slower than anticipated. We expect that trend to reverse in Q4. So we have a lot of favorable tailwinds going into Q4 on gross margins. The biggest point we want to make on the Q3 call here on gross margins was there was concern about it being embedded, about it being more of a permanent change in our operations. Hopefully, what we demonstrated with our August and September results, in particular on gross margins, that is not the case, and we continue to be confident in where we're going to take gross margins into Q4, and then ultimately into 2022 as well.

Operator, Operator

The next question is from the line of Ravi Misra from Berenberg. Please go ahead.

Ravi Misra, Analyst

I just want to kind of ask a big picture question. As we get into '22, the story here has long been about the heavy lifting and small lifting to be done with this company. It sounds like you've resolved one of them with the legal settlement this quarter. As we go into 2022, can you just help us think about how you and the Board are thinking about the key drivers here? What do you prioritize between M&A, organic growth, and restructuring? Maybe help us think about where you're going to be spending your resources in 2022, and then how investors should prioritize those as they think about Avanos?

Joe Woody, CEO

Yes. I mean, I really like where we're positioned for 2022 because we have taken a lot of costs out of the business in the pandemic. As an example, we've said, look, we feel comfortable that we have a business with less than 40% SG&A. These gross margin challenges this year are really tied to the pandemic and are transitory, and we were early talking about that. I think it took another quarter for that to sort of prove out more in medical devices like it was in other industries, and I think you can see the progress. So if you just think about the quarter that we just went through something like 160 basis points of mix on On-Q, that is being down, that won't be there. So we again see kind of a mid-single-digit organic growing business very solid when you don't have these pandemic impacts. The other thing I would say is that we've spent a lot of time with our M&A targets, and we've been talking about near-term two acquisitions that we think we'll be able to talk about shortly, that will be added to the business. That's always been a part of the equation, where we can improve our gross margin, as an example. But some of these acquisitions pick up some EBITDA, obviously get some growth and get the synergies, where at least these things are bolt-ons, if you will, right into our channel. So we really feel good about going into '22. I think it really all comes down to again, just how fast the hospitals with their staffing issues and the electives and how fast, I know they want to come back to you because obviously they're being affected. But I believe that we're very well positioned moving into 2022 for sure.

Ravi Misra, Analyst

You just touched on my next question around M&A. Can you just help us think about what kind of integration you're willing to stomach here? I mean, would you look at deals that might be gross margin dilutive or kind of EBITDA dilutive in the near term? Or are you going after things that are just going to kind of add to the bottom line very quickly? Can you just give some detail on that? Thanks.

Joe Woody, CEO

Generally, I say that we're on the accretive side of the house at the moment. And we've done some deals in Chronic Care, but we've got some things that we want to do in Pain. Again, I think they're going to be accretive from a revenue, gross margin perspective, pick up some EBITDA. And then, we also have done deals, and we've looked at some deals that weren't accretive initially immediately but are very strategic. So we sort of have both sides of the house covered. But I think they're going to be definitely additive to '22.

Operator, Operator

The next question is from the line of Rick Wise from Stifel. Please go ahead.

Rick Wise, Analyst

I just want to start off, and maybe you could give us a little more color. You're saying obviously very positive things about how the quarter began, how October, the month of October, went. I just want to make sure I understood a little more carefully the drivers there. Is - I mean one seems to be on the gross margin side, Michael if I understood you, lower transport costs and fewer manufacturing efficiencies on gross margin side. But on the sales side, I wasn't as clear about what's happening; is it just mix, is it the rollout of the next-gen COOLIEF type? Just help us understand the moving pieces there?

Michael Greiner, Senior Vice President and CFO

Yes. So overall, October revenue results across the board were strong versus what we expected on the Chronic Care side and the Pain side. When our full results are executing in step with each other, our mix improves. So it's just when we have outsized improvements like we did with oral care towards the end of the second - third quarter that, that - and obviously ON-Q being down throughout the third quarter that, that tend to have an outsized impact. But when our entire portfolio is moving forward and growing that is net-net going to have a positive influence on our mix profile.

Rick Wise, Analyst

Thank you. And, go ahead.

Michael Greiner, Senior Vice President and CFO

I thought you asked about gross margin as well, so I thought.

Rick Wise, Analyst

Again, I would like to elaborate on the gross margin. I mean, obviously.

Michael Greiner, Senior Vice President and CFO

If you're seeing such a significant improvement in October already, I mean that's very encouraging. But when you talk about getting back to the high 50s, low 60s, how much of that is today's portfolio, today's mix and sort of returning to more normal times as COVID hopefully fades? And how much that's going to be driven by M&A and hopefully margin accretive M&A? Yes. So two things. None of that high 50s, low 60s has any M&A in it. So this is all organic conversation around our margin and gross margin improvements. That being said, with the current environmental and the work we're doing really focusing on our manufacturing inefficiencies, how we think about freight, our product planning, all of those different things, we can get up to the, excuse me, 57, 58 range by just focusing on those things that are controllable. However, to get up beyond that and into the low 60s, and consistently be in the high 50s, we will need a more normalized environment across the portfolio because the lumpiness we have with our price and mix and the range of gross margin that we have in our product portfolio is significant. So you don't need a lot of movement with any given quarter across that portfolio depending on what's positive and what's negative to have that impact. So again, if everything is firing, it is a net positive gross margin environment that we have with our product portfolio. But when we have something like oral care up in a given quarter versus ON-Q down, that's going to have significant headwinds for us. So what we can control, we absolutely have meaningful progress to be made from here. But to consistently be in the high 50s, low 60s, we're going to have to feel slightly more normalized environment from a total product offering timing sense.

Joe Woody, CEO

And Rick also on sales, our intent is not to be alarmist here. But we are a $740 million business, and so things like Australia's lockdown, Japan access, or European access have an impact. We mentioned earlier in the call that how quickly we recover is a bit of a gauge. Nonetheless, to be clear, we've had strong results in October. We're just being cautious given that this is a pandemic, and it changes week to week.

Rick Wise, Analyst

Yes. No, I mean, obviously, as you said, you're not alone. And Joe, like you mentioned international because that was my last question. I was hoping you could give us a little more color on the international business. You called out a couple of pockets of weakness. You're mentioning Australia. What's happening more broadly? What initiatives are underway there? And how should we think about international as we head into the fourth quarter and start thinking about next year? Thank you so much.

Joe Woody, CEO

Yes. A couple of things. First of all, generally, we've been over the past couple of years really happy with the performance of the international business. This year in EMEA, we are impacted somewhat by access to customers, and then, of course, there is the headwind from closed suction from the beginnings of the pandemic, and now, obviously, we've talked about patients being managed differently in non-invasive approaches and then eventually mechanical. Latin America has been a good grower for us double-digit. We've been happy with the work that we've done down there. And really Asia Pacific has been strong; we just have a little bit of access and conversion issues with the pandemic in Japan, and Australia has been really in a lockdown for about 200 days. So it's affecting some of the growth. But we still feel it's a solid mid-single-digit organic grower going forward. And then, obviously, what we're trying to do is the same success that we've met with NeoMed and CorTrak in the US, and get that rolled into international. I do think, as we come into '22 and more so, if you will, on the pandemic, that should improve as well.

Operator, Operator

The next question is from the line of Drew Ranieri from Morgan Stanley. Please go ahead.

Drew Ranieri, Analyst

Hi, Joe and Michael, thanks for taking the question. Just maybe for Michael, first. You touched on free cash flow generation at the conference and through this call, but I'm just hoping to get a better understanding of the company's capabilities. I think at our conference you mentioned that the third quarter could be a proxy for go forward free cash flow, I mean, are you still expecting that? But just maybe a broader update on your working capital and free cash flow? Thank you.

Michael Greiner, Senior Vice President and CFO

Yes. So we do anticipate, as Joe mentioned in the prepared remarks, to have another positive free cash flow quarter in the fourth quarter, and we had some one-time items on cash this year that will clear out, and we anticipate a very nice conversion rate on free cash flow going forward, primarily due to improved operations, Drew. We've done a lot of work on accounts receivable and inventory. There is still some working capital upside for sure, $10 million to $15 million. But the majority of what you're going to see generating going forward is A) these one-time costs on legal, on SAP implementation, on other items that we had internally; those are now in the rearview mirror. So we'll have a much cleaner set of cash flow generation from operations, and then some improved opportunity set on working capital throughout 2022. But the bigger part of it is it's just going to be consistent execution on our operating results.

Drew Ranieri, Analyst

And then just on SG&A, you've talked about it before being sub 40% of sales kind of going forward. But I mean, where are you pulling back on spending? Are you sacrificing any future growth opportunity in 2022 and beyond? Would like a little bit more color there? Thank you.

Joe Woody, CEO

Let me give some qualitative and then jump in if you want to. But we have obviously learned that some of the marketing initiatives did need to come back and some did. And then, we have things like short term incentive, and there will be some headcount that we need to end the business. But generally, we also have still some smaller, if you will, structural things that we can do inside of our channels that can be helpful there. So we're committed to the below 40%.

Michael Greiner, Senior Vice President and CFO

Yes. The only thing I would add to that, Drew is last year with COVID, everybody had to kind of look at their SG&A and R&D and say what makes sense, what doesn't. But also in short to your point that we weren't cutting ourselves short for future investments. And then, as we got some discipline in 2020, that was somewhat here, which was healthy across the board. We came in '21, and we definitely expected overall SG&A dollars to increase versus '20. And we ended up with these gross margin headwinds, and so we wanted to manage around that. And so those disciplines that we started in '20 around how we think about SG&A just continued into '21. We are very thoughtful about where can we cut, what heads from a backfill standpoint could we reduce and think differently about some of the talent we have internally, which roles will we ultimately have to replace or we could delay for a little bit, which project to Joe's point around marketing initiatives. So it doesn't feel that we have done anything that would impact our 2022 or go forward. Perhaps there is an R&D thing here and there that gets delayed by a quarter based on some of the programs we pulled back on here during 2021. But nothing meaningfully significant to our ultimate revenue profile or where we're headed with our margin profile.

Drew Ranieri, Analyst

And then just on 2022 gross margins. So I hear you loud and clear about the fourth quarter step-up of about 400 basis points. Should we think that for 2022, there should be an improvement above the fourth quarter rate on a full year basis?

Michael Greiner, Senior Vice President and CFO

Yes. I don't know how meaningful that will be, Drew. But it should be north of where we are in the fourth quarter for sure for the full year.

Operator, Operator

The next question is from Chris Cooley from Stephens. Please go ahead.

Chris Cooley, Analyst

Good morning, and thank you for your questions. Could you please assist me?

Michael Greiner, Senior Vice President and CFO

Hi, Chris. Yes.

Chris Cooley, Analyst

Yes. Good morning. I'm a little confused on some of the commentary as it pertains to the top line, and I was hoping you'd help us walk through these countervailing forces. So we've seen the reiteration obviously of the corporate guide for the top line and you commented on two different areas of backlog that is accelerating and expected to continue to accelerate here in the back half of the calendar year and not be worked through until we get into early calendar '22. So I guess, what I'm trying to make sure I fully understand the messaging here about is you're saying that the base business ex those two primary product lines, really you're seeing that type of an acceleration to offset the backlog that you see growing. I just want to make sure I'm getting that messaging right. And maybe as an adjunct to that, could you help us better understand what's really there that's limiting your ability to get that resolved prior to the first half of, or I should say the first quarter of next year?

Joe Woody, CEO

Yes. Chris, you are right, and we are thinking that we'll get a good portion of it resolved through the first quarter of next year. Again, from my perspective, Michael can give you his, is the things that are not predictable like an Australia or like a Japan or European access have an impact. We were saying earlier in the call, how fast we come back is a bit of a gauge. But again, we started off strong in October. We could just as easily do better than we're aligning out here. But what we see with the pandemic is that a lot of different things can potentially happen. But you've got to be thinking about it the right way; the backlog is improving, and we can improve our position from the backlog. I don't want to be too confusing, or as I said, a little bit early too alarmist. But it's worth calling out while we're in the pandemic. And Michael, you're going to add.

Michael Greiner, Senior Vice President and CFO

Yes. And Chris, I think the point you made on what we're signaling there is the natural demand is there, even with these back orders, we still feel confident in a solid fourth quarter. But also an indication that the supply chain environment remains disrupted. Game Ready, for instance, whether literally the reason that we have a backlog there is because of one component that goes into the entire product of many, many components. And so those are the - those - that's what we were trying to signal and make the connection, is hey, demand is strong, that's good, and the supply chain availability concerns remain. And if we can get those fixed sooner rather than later to Joe's point, we have further upside. We just - we're scouting the world as every else does to try to find some of these raw material inputs. Sometimes we get lucky and get a week, and sometimes we just don't have the same level of success.

Chris Cooley, Analyst

Understood. Appreciate the color there. And if I could just add one other quick follow-on here maybe similar in nature. You talk about fundamentally a very strong sequential step up in gross margin. The vast majority of that step-up is in your direct locus of control, but we still have higher inflation costs, and we're really not seeing freight go down that much from what we can see in the channel. I'm just curious, when you think about these transitions from COVID-related costs and these related inputs, are these now becoming more structural in your mind? Or are you actually getting better operating leverage? Are you implicitly stating that these headwinds abate as we go through the fourth quarter and we get back to a more normalized environment in the first quarter, where you can contract in the spot market at lower rates on freight and similarly, we see declines in inflationary pressures on raw material and labor? Thanks.

Michael Greiner, Senior Vice President and CFO

Yes. I think - I would say it ties back to the other question around our exit rate in Q4 and where we think we can take the gross margins into 2022. The reason why we're being a little cautious on calling any sort of meaningful upward trends in 2022 is for these factors that you're identifying. So inflationary pressures remain, some of these freight cost pressures remain. Until we see better visibility with those lifting, our improvements on gross margins will be limited. On top of that, as we stated earlier, if we get back to a more normalized revenue environment, that will also help our gross margins just by virtue of the positive mix component with some of our larger selling products. So those are two factors that we just don't quite have visibility to yet. So that's why we're not saying, hey 59% or 58.5% in 2022, because those factors will have to lift in order for that to be the reality. But we also know that as far as the embedded conversation, we're not a 52% or 53% gross margin player, right? And so that's where we're kind of fighting right now. We're getting to that more normalized state in Q4 and into the early part of next year. And then as these other factors lift, we'll get back up to the high 50s again, ex-M&A.

Operator, Operator

We have a follow-up question from the line of Matthew Mishan from KeyBanc. Please go ahead.

Matthew Mishan, Analyst

Just a quick one, following up on free cash flow. I think previously you had indicated that you would do like seven year $80 million of free cash flow in the year. It seems like most of the moving pieces, as far as the DOJ and tax refunds seem to have already come through for you. Should we think about 4Q and related to that step-up into the free cash flow?

Michael Greiner, Senior Vice President and CFO

Yes, great. So in Q4 to that point, Matt, tying back to an earlier question should give a good feel assuming we execute as we're feeling coming out of October 31st here, should give a good feel for okay, what does the normalized free cash flow look like? And we should generate somewhere around $15 million of free cash flow in Q4, primarily due to operations, but also with some slightly better working capital management as well. So should have a decent Q4. I'm not saying that is the best we can do. I think there is upside potential to that. But that should give you a decent feel for our free cash flow conversion.

Operator, Operator

Thank you. Ladies and gentlemen, this concludes our question-and-answer session. I would like to turn the conference back over to Joe Woody for closing remarks. Thank you, and over to you, sir.

Joe Woody, CEO

I want to thank everybody for their interest in Avanos. We feel we're continuing to execute well in a very uncertain environment. We are committed to creating shareholder value, and I'm confident the priorities that we've detailed combined with our market-leading portfolio in the attractive markets that we're in, will position us well for growth and margin expansion and positive free cash flow, as we exit '21 and go into '22. That said, Michael will be presenting at the Berenberg Conference upcoming, and we'll both be attending the Stifel Conference and look forward to talking to everybody more there. Thanks, and have a great day.

Operator, Operator

Thank you very much. Ladies and gentlemen, the conference has now concluded. Thank you for attending today's presentation. You may now disconnect.