Earnings Call Transcript - AVNS Q1 2022

Operator, Operator

Good morning. And welcome to Avanos First Quarter 2022 Earnings 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, Investor Relations

Good morning everyone, and thanks for joining us. It's my pleasure to welcome you to the Avanos 2022 first 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 current business environment as well as review our key objectives for 2022. Then Michael will discuss additional detail around our first quarter and affirm 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, 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 that are 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 first quarter of 2022. I was very pleased with how our operational and commercial teams continue to execute against a range of challenging macroeconomic dynamics. As always, 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 reviewing our 2022 priorities. We achieved sales of over $197 million for the quarter with 3% organic growth in constant currency and earned $0.26 of adjusted diluted earnings per share. Our chronic care portfolio remains flat despite an 11% contraction experienced in our respiratory business due to a tough comparison with last year's first quarter COVID outbreak. However, as compared to the first quarter of 2019, the last quarter without a pandemic impact on our respiratory business sales were up 3%. Our digestive franchise delivered another strong quarter with greater than 6% growth versus the prior year. Our pain portfolio overall grew by more than 6% with our interventional pain franchise growing over 9% and our acute pain product portfolio delivering more than 4% growth. This performance was driven by both elective procedure improvements and solid commercial execution. We were very pleased with the performance of OrthogenRx, which we owned for a little over two months of the first quarter. We remain confident that we will generate in excess of $70 million of net sales for fiscal year 2022 from our OrthogenRx offering. Including OrthogenRx sales for the first quarter, our growth rate for the company was a little over 9%. Another bright spot for us in the quarter was the delivery of gross margin of over 56%. Gross margin improved more than 400 basis points compared to the first quarter of 2021 and sequentially improved by 340 basis points compared to the fourth quarter of 2021. We experienced a favorable product mix in the quarter inclusive of OrthogenRx, as well as solid execution by our plants and the delivery of manufacturing efficiencies. Although we are very pleased with our gross margin results for the first quarter, we remain cautiously optimistic for the duration of the year, given continued headwinds related to raw material availability, inflation, and escalated shipping costs due to fuel increases and overseas capacity availability. Our backorder throughout the first quarter was between $7 million and $11 million and is currently under $6 million on a net sales basis, but continues to be volatile on a weekly basis. We still believe that most of these headwinds are ultimately transitory and will not impact our ability to ultimately drive our gross margins back into the high 50s. Finally, we remain confident that gross margins inclusive of our OrthogenRx acquisition will be between 55% and 57% for the full year 2022. 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. We would still execute on maintaining SG&A as a percentage of revenue to be less than 40% for the full year 2022. Although first quarter SG&A was slightly elevated versus our expectations, we remain focused on delivering full year SG&A as a percentage of revenue below 40%. Michael will provide additional detail regarding our expectations in a few minutes. With that as a background, let's review some detail on our product portfolio. As we stated on our year-end earnings call, we anticipated our pain portfolio would lead the way from a growth perspective as we start to see market tailwinds from elective procedures turn in our favor. Although the volume of elective procedures being performed remains depressed, our ON-Q franchise returned to growth, while Coolief experienced mid-single digit growth versus the prior year's first quarter. We anticipate low single digit growth for our pain portfolio for the second quarter due to a tough prior year comparison. But we then anticipate a return to double-digit growth across the portfolio for the second half of the year. In 2022, we are leveraging and seeing momentum on some of the product offerings and enhancements that were released to improve the efficacy and ease of use for our care partners. For ON-Q and ambIT, the continued adoption of PainBlock Pro, our data collection and patient engagement app, is driving momentum and adoption in the business. For Coolief, the launch and conversion to our advanced cooled radio frequency probe kits continues to be a positive driver, as we continue to strengthen our Cooled RF leadership position this year and beyond. Shifting to chronic care, the positive trend across our digestive health franchise continues. We maintain double-digit growth across our NeoMed portfolio and anticipate strong growth throughout 2022. Behind North American ENFit conversions, our legacy enteral feeding products continue to grow mid-single digits, and we anticipate that to continue throughout 2022 as well. Separately, although our respiratory health business was soft in the first quarter versus our own expectations, primarily due to product availability, we anticipate growth to revert to historical rates as we see more normalized comparisons in the second quarter and beyond. Our next priority for 2022 was to demonstrate our ability to generate consistent repeatable free cash flow. As you may recall, we generated $26 million of normalized free cash flow in 2021, excluding a number of one-time impacts, and anticipate generating approximately $90 million in 2022. Michael will discuss the first quarter and full year dynamics of our free cash flow profile in a few slides. Our final priority for 2022 is focused on efficient and value-added capital deployment. Our M&A pipeline remains healthy, and we're engaged in active dialogue with a number of potential tuck-in targets, which would leverage our existing footprint, generate synergies and enhance our top-line growth. We're very pleased with our addition of OrthogenRx, and its performance to date is in line with our initial expectations. We remain focused on the second half of the year as the reimbursement landscape changes for both our 5 and 3 shot hyaluronic acid offerings. Based on current understanding of the reimbursement outcome, we are anticipating rates in line with our expectations, which would be favorable and helping us maintain our position in the 5 shot category as we simultaneously work to expand our position within the 3 shot market. In summary, we're off to a solid start to the year building upon our 2021 execution and are well positioned to achieve our primary objectives for 2022 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. Additionally, we have in excess of $200 million of immediately available capital to execute on further bolt-on acquisitions, as well as consider additional share repurchases, should our shares remain meaningfully below our calculated intrinsic value for an extended period of time. Now I'll turn the call over to Michael.

Michael Greiner, CFO

Thanks, Joe. As you noted, we were off to a solid start for the year and look forward to executing on our priorities for 2022. We delivered on both our organic growth plans and OrthogenRx strategy in the first quarter, as well as meaningfully improving our gross margins. Although SG&A spend was slightly higher than anticipated, we are committed to ensuring full year spend remained below 40% as a percentage of revenue, the additional spending in the first quarter related to selling and marketing investments planned for later in the year and inflationary costs on compensation and outside services. Now let's review our first quarter results. Total reported sales was $197 million, up 9.2% compared to last year, with adjusted EPS of $0.26. On a constant currency basis, organic growth was 3%. This excludes the contribution from OrthogenRx sales in the first quarter, as well as removing Maxter-generated revenue from the prior year's first quarter. Chronic Care sales were flat to last year at $119 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 first quarter growth of over 6%. Our digestive health portfolio NeoMed grew more than 30% from the continuation of conversions to our ENFit technology, despite supply constraints impeding even further growth. Separately, adjusting for the product supply challenges, respiratory health sales would have been down closer to 5%, consistent with our expectations, given the pandemic tailwind from the first quarter of last year. Moving to pain management, excluding the contribution of OrthogenRx, we delivered $63 million of sales, $3 million ahead of the prior year, driven by a return of elective procedures for ON-Q and a strong performance across our interventional pain portfolio growing more than 9%. With this start to the year, the pain portfolio is poised to capitalize on a return of procedural demands. The addition of OrthogenRx will help accelerate growth within the broader pain business as an extension in the continuum of care, giving us access to a wider base of patients and physicians. Additionally, the pain franchise will continue to benefit from the momentum and release of recent commercial products and initiatives like PainBlock Pro and the advanced Coolief probes. Now moving down the income statement, adjusted gross margin improved more than 400 basis points to 56.2% versus last year. As indicated earlier, we are pleased with the progress on gross margins with a combination of better product mix, including OrthogenRx, benefits from our pricing initiatives, and improved planning performance. Although we are very encouraged with our first quarter results regarding gross margin, 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 rolling backorder. That being said, 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%. Adjusted operating profit totaled $18 million compared to $16 million in the prior year. Higher sales and improved gross margins were partially offset by higher spend across SG&A. Adjusted EBITDA totaled $24 million compared to $22 million last year, and adjusted net income totaled $12 million compared to $11 million a year ago translating to $0.26 of adjusted diluted earnings per share. 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. We currently have over $100 million of cash on hand with $255 million of debt outstanding post the closing of the OrthogenRx acquisition and completion of our share repurchase program. Given our pro forma EBITDA post-acquisition, we are levered at approximately 1x. The cash outflow of just over $3 million for the first quarter was weaker than we anticipated and was primarily driven by poor collections in the quarter. We remain focused on delivering our free cash flow target, which will require a meaningful improvement in our cash collection activities combined with appropriate inventory management. We still anticipate approximately $25 million of capital expenditures for the full year. As I indicated, our primary objectives in 2022 centered on 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. To summarize, organic net sales is expected to grow 3% to 6% in constant currency, with OrthogenRx delivering sales of $70 million this year. The low end of this range assumes continued challenges with accessing raw materials and unevenness with the return of elective procedures. As we've already stated, we anticipate annual gross margins in the range of 55% to 57%. With the lower end of that range, we are capturing elevated inflation and distribution costs. We continue to target free cash flow of approximately $90 million in 2022 as we drive sales and margin expansion. And finally, adjusted diluted EPS is anticipated to range from $1.55 to $1.75. We were off to a strong start and made progress towards our key priorities already. We remain confident in our ability to execute our strategy and are taking the necessary steps to drive both gross and operating margin improvement as well as deliver more consistent results throughout 2022. Operator, please open the line for questions.

Operator, Operator

Our first question comes from Chris Cooley with Stephens.

Chris Cooley, Analyst

Good morning, Joe and Michael. Thank you for taking my questions, and congratulations on a strong start to the new year. I have two quick questions. I apologize if you've already addressed this, but I want to clarify my understanding of OrthogenRx for the year. You're expecting a $15 million contribution in the first quarter, with growth accelerating to reach $70 million by the end of the year. I want to ensure I grasp the underlying assumptions driving this acceleration, particularly in the second half of the year, especially since several of your competitors have mentioned changes in disclosures during this time and the continued shift towards one and three injection modalities. I'm interested in your expectations regarding reimbursement utilization and broader market conditions. I have a quick follow-up after that. Thank you.

Joe Woody, CEO

Okay, Chris, I can start with that. I mean, we're confident in the $70 million that we've talked about. We have said that the entire business will be mostly accretive to overall Avanos and in our diligence, we were very much aware of the reimbursement changes, which is sort of reporting ASPs, if you will, currently in Q2, and then a Q3 reimbursements shift to more of an ASP plus 4% to 6%, depending on where Medicare lands, and that's really going to affect all suppliers at any type of level of shots whether five, three, or one. So again, I think we captured that in diligence, in part to thinking about the confidence we have in the $70 million. The way that we're kind of going after that strategically managing our pricing, we have differentiable approaches with the customer and different customer access points. And then, obviously, a non-AVN product offering as well. But more importantly, as we're going to be incorporating more 1099s in our own channel, with this product, over the second half of the year, it's actually already started in some places. And just to kind of go back up for a second when we made the acquisition, we talked about the accretive growth this year and the $70 million, then we said the reimbursement changes could mean a level this year in ‘23. But then going forward, we really see it for us as a solid, mid-single digit grower. And that's really what we need to achieve from the strategic aspect of tying this into the other areas of OA treatment. Coolief, if we want to head toward. So hopefully that helps.

Chris Cooley, Analyst

No, that was great. I really appreciate all the additional a couple of other, makes make sense. And then just lastly, for you look to the P&L here in the quarter really good, nice to see the gross margin moving up. And but I did want to look at just the overall OpEx spend in the quarter. I know you alluded to some comments, and I apologize. I think this is the right one when I hopped in, but kind of an elevated one-time level there on the SG&A side, but could you just walk us through how that comes back down such that you stay below 40% and actually can realize some leverage as that gross margin comes up? It's not burned or weighted in all the P&L. Thanks so much.

Joe Woody, CEO

Correct, I think Michael will handle that. Yes, sorry, Michael, do you want to go?

Michael Greiner, CFO

No, that’s okay. We are in different places, so sorry about that, guys. So the two things on SG&A, one we had indicated that the first half of the year we wouldn’t be about 40%. Now once you did come into your point, Chris, did come in a little bit harder than we thought. And so specific to your question. The reason for that is we had a couple of selling and marketing initiatives that we expected to spend in Q2 or Q3; we decided to bring those forward. So we would just want to have those spends in Q2, Q3. So those were normalized throughout the year. That being said, there was also about $2 million of additional headwinds, with inflationary factors on compensation and outside services. Those we're going to have to make up for as the year goes on. So about $2 million that we're going to make up for before the year goes on. The other part of that headwind that we're experiencing in Q1 are things that will normalize as the year goes on just because we've already spent it.

Chris Cooley, Analyst

Okay, and maybe could you help us maybe just quantify that part, last part, Michael, and I'll get back in queue. Is that 50 basis points, is that 100 basis points? I'm just trying to think about what's how much did you pull forward into the quarter?

Michael Greiner, CFO

Yes, going forward into the quarter was about 100 basis points in OpEx.

Operator, Operator

Our next question comes from Matthew Mishan with KeyBanc.

Matthew Mishan, Analyst

Good morning, Joe and Michael, and congratulations on a strong start to the year. I want to discuss the gross margin. The sequential improvement is quite impressive. What do you consider to be sustainable compared to the last three or four quarters when you were in the low 50s? What has changed that could make this current performance more sustainable? Did you surpass expectations for gross margin in the first quarter, and are we starting to encounter tougher inflationary conditions and more raw material issues?

Joe Woody, CEO

I'll just say one thing, and then I think Michael wants to take you through further on gross margin. But generally, on the commercial side, the mix was a positive. We're seeing more pain sales, and I would expect that to increase each quarter throughout the year. So definitely some mix and eventually some pricing. But Michael can take you through where we think sort of the new normal is and some of the other things that are happening Michael?

Michael Greiner, CFO

Yes, great. So Matt, if you recall, at year end what we said was and affirm again today, our range for the year is 55% to 57%, off of last year's 52%. We said up to 55%. So that 400 basis points or 300 basis points 52% to 55%. Half of that would be just the favorable impact of OrthogenRx. The other half of that, another 160 basis points would be manufacturing efficiencies, cost savings initiatives, just better planning performance. Our 56% that we executed on in the first quarter was about that half and half of the performance, so OrthogenRx gross margin was slightly better than we had anticipated, which was good. And our overall planned performance was slightly better than we anticipated. We don't expect that to change as the year goes on; we expect to see much of that continue and improve. Now the one thing that would keep us in the 55% level versus 57% would be, as Joe mentioned, some additional headwinds, some additional inflationary issues that we are not currently dealing with. So we think we've priced in the current environment, we think we've priced in the shipping issues that we've experienced, and we'll continue to see somehow. And that leaves us at 55%. If we continue to perform better than that, which we did in the first quarter, then we could reach ourselves up to 57%, which would be a great year. Ultimately, though, as we said in the written comments, there's no reason why we can't get back up to the high 50s again, in a more sustainable basis and a more normalized environment.

Matthew Mishan, Analyst

Okay, excellent. And then just going back to OrthogenRx. How should we be thinking about modeling in the cadence of that $70 million? Is it steady like from here? Or do you have embedded in a little bit of cushion for the reimbursement change in the second half of the year? Thank you.

Joe Woody, CEO

Yes, that's fine. Typically with the HA, the Q1 is a little bit softer as things get going in the year. And then it grows from there not unlike the pain business. So that's one thing, yes, we did consider the reimbursement change and any effects that might have in the Q3 time period. But at the same time, we're bringing on a number of new 1099s in selling channels into the market to sort of convert try this accounts more in the orthopedic space, and early indications of that are going well. So it all comes together as how we landed that $70 million.

Matthew Mishan, Analyst

Got it. Thank you. Maybe Michael, for you. Just to go back to gross margins for a moment. You did 56 bit over 56 this quarter. You maintained your guidance. And just to be clear, are you suggesting that should be kind of just improving sequentially throughout the year or is there any risks that you see a downturn in gross margins in the second quarter just and some of the inflationary pricing, inflationary concerns, kind of push through your inventory? Thanks.

Michael Greiner, CFO

We could see a slight downtick in Q2 through possibly, that's not necessarily anticipated. But could see a slight downside in the second quarter just due to mix and expectations of some of the programs we're putting in place. We're confident Q2 will be obviously above our 56%. And we think, again, we should be able to be above that midpoint between 55% and 57% for the year given how we got off the start to the year and the programs that are in place, but we're just very cognizant of the overall macro environment and we just don't want to get too far ahead of something until we put a few more months and quarters on the board.

Joe Woody, CEO

Jordan, I think that might be it on the questions, is that right? That's correct. This concludes the question and answer session. I would now like to turn the conference back over to Joe Woody for any closing remarks. I'd like to, as always, thank everybody for their continued interest in Avanos. And while we're very pleased with the overall execution this quarter, given the uncertain environment, we are committed to creating meaningful shareholder value and anticipate that 2022 results are going to deliver on that commitment. I'm confident the priority of detailed combined with our market-leading portfolio and attractive markets. They're all going to position us for growth, margin expansion, and positive free cash flow as we go through 2022. Thanks, and we look forward to further discussions this week. Thank you all.

Operator, Operator

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