Earnings Call Transcript - AVNS Q2 2022

Operator, Operator

Good day, and welcome to Avanos Second Quarter 2022 Earnings Call. All participants will be in a listen-only mode. After today's presentation there will be an opportunity to ask questions. Please note, this event is being recorded. I would now like to turn the conference over to Scott Galovan. Please go ahead.

Scott Galovan, Investor Relations

Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to the Avanos 2022 Second 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 details regarding our second 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'll be referring to adjusted results and outlook. The press release has information on these adjustments and reconciliations to comparable GAAP financial measures. Now I'll turn the call over to Joe.

Joe Woody, CEO

Thanks, Scott. Good morning, everyone, and thank you for joining us to review our operational and financial results for the second quarter of 2022. Our operational and commercial teams continue to execute well against a range of macroeconomic challenges, and we remain focused on getting patients back to the things that matter as we meet the needs of our customers. Although we fell short of consensus revenue estimates for the second quarter and are also updating our full year guidance for revenue and adjusted EPS, which Michael will discuss further, we continue to experience consistent demand throughout our product portfolio and remain confident in our ability to execute against our longer-term financial objectives as the supply chain and other macroeconomic dynamics improve. For the quarter, we achieved sales of $203 million, representing 9% actual growth or greater than 10.5% growth, excluding the negative impact of foreign exchange. We generated $0.41 of adjusted diluted earnings per share and $23 million of free cash flow. Excluding the negative impact of foreign exchange, our Chronic Care portfolio grew by just under 1% despite a 10% contraction experienced in our respiratory business due to inventory being sold through our distributor channel that had accumulated during later phases of the pandemic. Our digestive franchise delivered another solid quarter with greater than 5% growth versus prior year excluding FX. Excluding the impact of OrthogenRx and foreign exchange, our pain portfolio was down 1% with our Interventional Pain franchise growing 5% and our acute pain product portfolio lower by a little over 4% versus last year. The pain franchise had a tough prior year comparison and continues to experience a slower return to elective procedures due to staffing shortages and patient preferences. Our hyaluronic acid offerings through orthogenerics posted strong Q2 sales with a rapid adoption of TriVisc, our three injection HA regimen beginning in June. Given our reimbursement position in the market compared to competitors, we will continue to see favorable tailwinds in TriVisc, capturing share from both the one and five injection segments with account transitions, new account acquisitions, and meeting patient demands. Additionally, we have service differentiators via our direct patient purchase program in Harmony, an online portal to enhance and streamline the customer experience. We believe these differentiators will help us retain the new business we are capturing moving forward. We remain confident in generating greater than $70 million of actual net sales for fiscal year 2022 from our OrthogenRx offerings. Separately, we delivered adjusted gross margin of just under 59%, driven by favorable product mix in the quarter, inclusive of OrthogenRx and our plan to continue incrementally deliver on our manufacturing efficiency strategy. We are very pleased with our gross margin results for the second quarter and first half, but are cautiously optimistic for the duration of the year, given continued headwinds related to raw material availability, inflation across all manufacturing inputs, and shipping and distribution costs that remain elevated. Additionally, our backorders worsened throughout the second quarter after making progress in the first quarter and are currently in excess of $11 million. Given this continued uncertainty surrounding our supply chain, including access to certain resins, silicone, and Tyvek and the costs associated with assessing some of these key raw materials for our product offerings, we are not increasing our full year 2022 expectation for gross margin but are confidently maintaining our annual gross margin expectation between 55% and 57%. Turning to SG&A, as we noted during our year-end earnings call, we identified a range of expenses that would impact our SG&A margin profile in the first half of 2022. Our second quarter SG&A as a percentage of revenue sequentially improved by 240 basis points versus our first quarter to 40.6%. Many of these expenses will not repeat in the second half of the year, as we had previously indicated, we still anticipate maintaining SG&A as a percentage of revenue to be less than 40% for the full year 2022. With that as a background, let's review some detail on our product portfolio. The positive trends across our Digestive Health franchise continue with our NeoMed portfolio growing over 27% and our legacy enteral feeding products growing mid-single digits, despite supply constraints impeding even further growth for both product categories. We anticipate continued strong growth for the duration of 2022, assuming no further supply chain disruptions for this product category. Separately, although our respiratory health business was soft in the second quarter versus our expectations, as distributors rebalance their inventory levels on the tail end of the pandemic, we anticipate growth to revert to historical rates and should benefit from a stronger second half as we approach the 2023 flu season. We believe we can return the pain portfolio to double-digit growth across the third and fourth quarters.

Michael Greiner, CFO

Thanks, Joe. As you noted, even with the uncertainty that persists in the economy globally and the industry-wide macro pressures, we met or exceeded most of our first half objectives. We delivered on our gross margin improvement and free cash flow generation as well as continued to successfully execute on our OrthogenRx strategy. Additionally, our SG&A spend as a percentage of revenue sequentially reduced significantly in the second quarter, and we remain committed to ensuring full year spend remains below 40% as a percentage of revenue. Even though we have built good momentum across these objectives, we believe it is prudent to update our revenue and adjusted EPS guidance based on the continuing macroeconomic pressures, currency headwinds, and increased interest expense. We now anticipate delivering net sales between $815 million and $835 million for fiscal year 2022 and adjusted EPS between $1.45 and $1.65, primarily due to further projected negative foreign exchange impact and higher interest expense totaling approximately $0.10 as well as slightly lower operating earnings due to lower gross margins in the back half of the year. Adjusted gross margin improved more than 740 basis points to 58.7% versus last year. As indicated earlier, we are pleased with the progress on gross margins with a combination of better product mix, including OrthogenRx, improved plant performance, and lower than forecasted shipping cost. If you recall, last year, to support the business, we incurred significantly higher shipping costs for our NeoMed products to capture the ENFit conversion opportunity. Although we are very encouraged with our second quarter results with regard to gross margin and across the first half, the global supply chain environment remains disrupted. Inflationary pressures are elevated, and the availability of certain raw material components presents a challenge as we work through our existing back order. As Joe already noted, even with these headwinds, we are confident in our ability to achieve our previously stated objective of full year gross margins between 55% and 57%. Adjusted operating profit totaled $28 million compared to $15 million in the prior year. Higher sales and improved gross margins were partially offset by additional spend across SG&A, resulting in adjusted operating margins of 14% for the quarter.

Rick Wise, Analyst

There are many aspects to consider here. Could you elaborate on some of the challenges anticipated in the second half? The supply chain issues are prevalent across the industry, including yours. Where do you currently stand in terms of securing new suppliers? How feasible is it to address these challenges? It would help us to understand this, as it seems related to your efforts in managing the backlog as well.

Joe Woody, CEO

That's correct, Rick. It's Joe Woody. I'll start and then, of course, Mike can add anything that he would like. For us, what we have been mainly seeing is a range of resins and silicone. That affects the ON-Q business, the Digestive Health business. In the first half, we saw some chip problems that affected COOLIEF generators, which looks to be dissipating in H2. And all of that, in turn, also affects the international business. Now, to the extent that, that clears up, as you can imagine, like other companies, we're working on numerous pathways to resolve it. There is also the potential for upside. But at any given time, just in the supply chain that we're in right now, other items emerge, whether it be around packaging or things as simple as ink and the list goes on from there. I think in H2, our major issue is going to be around Tyvek. We're working with Avamed and other companies to try to see how we can get more raw materials released for medical device products. So essentially, that's what you see in the range and in the guidance change. But equally, there's an opportunity. And if that does improve, obviously, we do much better. But I don't know, Michael, if you want to add to that?

Michael Greiner, CFO

Yes, I would just add to that, that the $815 million to $835 million on revenue, in addition to FX, which has a meaningful impact, was $5 million in the first half of the year, and we're estimating at least $5 million in the back half of the year. If those back orders clear up, then we have line of sight, getting us to the higher end of that range of $835 million is very realistic. If we're unable to secure the raw materials, as Joe just mentioned, then more towards the midpoint, lower end would be possible.

Rick Wise, Analyst

And turning to OrthogenRx. Obviously, a terrific quarter. You had said in the first quarter, you expected to generate sales in excess of $70 million, you're reiterating that. And I just wanted to make sure I was clear in my own mind now that we're halfway through the year, it sounds like you're feeling more confident. But how do we think about that outlook given the reimbursement change looming for HA and just how you're thinking about that and what you've dialed into that projection? And in a sense, what's next? It seems like you're doing better than others. Maybe help us understand why that could, should and will continue to be the case. I'd appreciate it.

Joe Woody, CEO

This is Joe. I'll get to do that. We are definitely more confident in the full year outlook. We knew with the new allowables, there would be a migration to TriVisc. That has happened a lot more quickly than we anticipated, faster from the five shots. In fact, a good portion of our five-shot customers want to transition into the three-shot market. We’re experiencing competitive moves over to ours. In the short term, there is a reimbursement favorability that customers can experience because of the way we strategically approached our pricing, focusing on the wholesale. We have to maintain a healthy ASP. We intend to add direct representatives and additional sales personnel. We think that we have a window of six to nine months of a pretty positive tailwind in this business where we're going to see some upside, and the strategy is working. We're definitely meeting the internal model, and that will be helpful. Overall, it's turned out to be an excellent acquisition for us and one that's strategic alongside other things that we're doing in orthopedic areas of our business like COOLIEF and ON-Q.

Matthew Mishan, Analyst

Just a follow-up on the TriVisc question. What specifically about TriVisc allows you to have a better reimbursement position than some of the peers in the space?

Joe Woody, CEO

Well, primarily, it's the way that we priced our product at the wholesale level, not a lot of specialty pharmacies rebating in our business, and that strategically was a way that we focused the business. So we've benefited from that with a wholesale price that's pretty robust. Yes, it should continue into about the middle of next year, and we think that will allow us to gain share from competitors fairly significantly during that period. We'll keep innovating and enhancing our service model too.

Matthew Mishan, Analyst

Okay. So you're expecting to change your favorable reimbursement position to sort of come together with the rest of the industry as you get through the second half of this year?

Joe Woody, CEO

Next year, particularly in the second half, we believe we will have a favorable position in the three injection area. It could extend a bit, or we may reach a more balanced state. We will need to utilize our other portfolio and service model, as well as some technology we are developing related to the syringe.

Michael Greiner, CFO

As Joe mentioned in the prepared remarks, we gain additional customers and service them well. Once pricing is less dynamic in this market, we can maintain the market share that we will have developed over the following quarters.

Matthew Mishan, Analyst

Okay. I understand that now. And then a question around NeoMed and Digestive. It seems like NeoMed is growing. Outside of NeoMed, is Digestive contracting? Or is that still growing as well?

Joe Woody, CEO

No. We see it as a mid-single-digit grower on a global level. It's impacted by Tyvek and silicone in the second half of the year. There is potential for improvement if we can secure the right amount of raw materials, particularly in the Digestive Health area, mainly with our MIC-KEY product. CORTRAK has seen some slowdown in North America due to staffing shortages and ICU patient numbers. However, we still believe it is a solid business that will experience mid-single-digit global growth, maintaining good margins and making a significant contribution to our cash EBITDA.

Michael Greiner, CFO

That's directionally correct, yes.

Chris Cooley, Analyst

Just maybe a clarifying question for me to start and then a little bit bigger picture follow-up. Michael, just in regards to the guidance, you mentioned the lower end of the top line did assume continued FX headwinds. I apologize if I missed this in your prepared remarks, but did you call out what you're assuming there in terms of the incremental headwind there from a basis point perspective or maybe alternatively, could you just give us where your markers were for the major currencies coming into the quarter? And then just kind of as another offshoot from a clarifying point. When we look at pricing for HA products, the way it gets published out there, I just want to make sure I'm understanding this correctly. When we look at your pricing versus, say, some of your competitors, you're assuming that discount continues. There's no additional rebates being added. So that's just going to be that price differential you think will continue until the midpoint of the next calendar year because there's quite a bit of disparity across three to four players here just in terms of published pricing on the HA offerings at this time.

Joe Woody, CEO

You have the HA pricing right. We haven't structured a rebate type of business or discounts to payers. The specialty pharmacy is not a big area for us. We've managed to maintain a robust wholesale price, and this should continue into the middle of next year, allowing us to capture share from competitors significantly during this period. We're also focused on innovation and expanding our service model.

Michael Greiner, CFO

So we had about a $5 million headwind across the first half related to FX versus our planning model. We anticipate that we'll probably see $5-7 million in the second half as well. The reason for the increase is just that we're going to do $25-30 million more in revenue in the second half. That obviously has a bigger FX impact. In addition, the majority of our back orders were international related. So we have greater ramp in the back half of the year related to international orders, hence, the additional FX impact.

Chris Cooley, Analyst

I appreciate the additional color. And then just a bigger picture follow-up there. You alluded to stronger capital demand on the pain management side as we think about the COOLIEF franchise. Any way you can quantify that for us a little bit here in terms of maybe side of service where you're seeing the incremental demands relative to prior periods? Just trying to get a little bit better granularity there around just how much incremental demand you're seeing versus kind of relative levels there.

Joe Woody, CEO

Sure, Chris. Yes, one of the benefits is that as the chip shortage took hold in the first half, there was an opportunity for the channel to connect with existing customers and regain penetration or bring active accounts back. The other driver is the continued studies that are coming out, certainly, as they are published. As we all know, we're in the OA space, which is a strong grower for us for those sites treating OA. The quantification is really that it may seem tough as we all came out of the first aspect of COVID and bounced back in this quarter last year, but I believe as we get into the second half, there are better comparatives for us. We certainly see that quantifying double-digit growth in the teens again for Q3 and Q4, as we have significant demand for the capital. Our backlog for these units is increasing, and our team is doing a great job selling the capital. So that's where the demand is coming from.

Drew Ranieri, Analyst

Maybe just keep it on the HA topic for my first one. Joe, I'd be kind of curious to hear more about some of the innovation that you're putting behind the product. I know that there was eventually like a single injection product coming. But can you go into a little bit more detail about what you precisely mean by innovation and the service model? And also as the cash pay kind of struck me. Just kind of curious how that would work in the HA market? And then I had a follow-up.

Joe Woody, CEO

So we've talked a bit in the script about the Harmony portal just making it easier for customers to do business with us to order and get reimbursement assistance. The next step on the differential side, and innovation after the reimbursement changes, is technology that will allow for the injection to be guided more precisely into areas that need it. It's known that if you're not in the right space when making this injection, you get less of an impact. Patients might experience less pain relief than others. I think this will be a differentiator. We can also expand access sites and provide services to those who want pain relief and are willing to pay cash for it.

Drew Ranieri, Analyst

Okay. And just maybe on the injection for accuracy. Is this going to be just around using kind of ultrasound and improving the needle or anything else there?

Joe Woody, CEO

It's more related to guidance of the needle.

Michael Greiner, CFO

Yes, fair questions. On the EPS side, the biggest reason for the call down was the higher interest expense, the FX impacts, and then a little bit on the lower operating earnings. We will offset the lower revenue organically that you just referenced with OpEx savings. Revenue down on the organic side will be offset by more favorable OpEx. The other piece that relates to the ultimate EPS guidance change is higher interest expense, FX, and a bit of the lower gross margin.

Joe Woody, CEO

Thanks. I just want to thank everybody for their continued interest in Avanos. While we're very pleased with our overall execution this quarter, given the uncertainty in this environment, we are committed to creating meaningful shareholder value. I am confident that the priorities we've detailed combined with our market-leading portfolio position us for consistent sales growth, margin expansion, and significant free cash flow generation as we enter the back half of 2022. We'll probably see a lot of you at the fall investor meeting. So thank you very much. Bye-bye.

Operator, Operator

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