Earnings Call Transcript - AVNS Q2 2023

Operator, Operator

Good morning, everyone, and welcome to the Avanos Second Quarter 2023 Earnings Conference Call. All participants are in a listen-only mode. After today’s prepared remarks, there will be an opportunity to ask questions. Please note, today's call is being recorded. At this time, I'd like to hand the floor over to Avanos CEO, Joe Woody.

Joe Woody, CEO

Good morning, everyone. This is Joe Woody. We've asked the New York Stock Exchange, and they agreed to halt our trading as our results were inaccurately reported by one news outlet and possibly more. Our total results inclusive of respiratory health were $199.8 million in revenue and we delivered $0.37 of EPS. Throughout the day today, we're going to work with the various agencies and news outlets to correct the information. Now I'm going to turn the call over to Scott Galovan to begin our prepared remarks. Thank you.

Scott Galovan, Senior Vice President

Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to the 2023 second 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 second quarter and expectations for the remainder of 2023, as well as provide further insights around the strategy we laid out at our Investor Day in June. Mike will provide additional detail regarding these topics and provide an update of our 2023 planning assumptions, given our respiratory health business discontinued operations. We'll 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 second quarter of 2023. We are pleased with our second quarter. We noted in our year-end earnings call and reiterated at our Investor Day in June, our quarterly results for 2023 would be uneven given the timing uncertainties associated with our transformation plan, which included some of the transactions we announced just prior to our Investor Day. The demand for our products remains strong, and although supply chain disruptions have lessened, we continue to experience ongoing product supply challenges and the effects of inflation throughout our supply chain. Coming into the year, we anticipated that 2023 will continue to present supply chain headwinds and pockets of product availability challenges, but that many of these headwinds would ease as we reached the back half of the year. We still believe this to be the case with our anticipated year-end back order levels to be around $3 million, down from over $10 million at the beginning of the year. 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 $169 million from continuing operations or down approximately 1% compared to last year. Excluding both the negative impact of foreign exchange and the $5 million impact related to our previously announced decision to eliminate revenue that was not meeting our returns criteria, organic growth was favorable at 2.6% from quarter to quarter. We also generated $0.24 of adjusted diluted earnings per share and almost $23 million of adjusted EBITDA from continuing operations during the quarter. While our adjusted gross margin was almost 60%, our SG&A as a percentage of revenue was 45.1%. Actual sales for the quarter, inclusive of our respiratory health business, was $200 million, or 2.5% growth. Also excluding the adjusted revenue items I just referenced. SG&A as a percentage of revenue was 40%, supporting an adjusted EBITDA margin of almost 16% for the quarter. Now I'll spend the next few minutes discussing our results at the product category level. On a constant currency basis, our Digestive Health portfolio grew almost 17%, bolstered by our med product line, which posted another strong quarter versus the prior year as we continue to take advantage of the demand for NFI conversions in North America. Our legacy intra-feeding product line grew double digits globally, primarily driven by the continued expansion of our U.S. CORTRAK standard of care offering. As noted during Investor Day, we continue to deliver above-market growth and leadership in our core digestive health markets and are poised to sustain this momentum through innovations that we plan to launch over the next 12 months. Expansion into high potential global markets and actual M&A targets in large, attractive adjacencies. Turning to our pain management and recovery portfolio. Actual reported sales were down close to 11% for the quarter, with soft results across our interventional pain, game ready, and 5-shot HA product categories, each of which were down at least 5% versus the prior year. Separately, our surgical pain pump business was flat for the quarter, excluding the negative impact of foreign exchange and low growth, low-margin products we are no longer selling in this category. As I shared earlier, we continue to experience supply headwinds within these businesses, although we expect these headwinds to ease during the second half of this year. Alleviating these supply chain challenges is critical to supporting our pain management and recovery portfolio sales lift in the second half of the year. Finally, our HA portfolio experienced a weaker-than-expected first half. However, this softness was primarily concentrated in our 5-shot or GenVisc products. The 5-shot market has specific pricing and competitive dynamics that are not as prevalent within the 3-shot market. TriVisc, our 3-shot offering, continues to align with our overarching orthopedic call point strategy and is largely meeting our internal performance expectations. We expect volatility will continue to be a factor in both of these HA markets for the next several quarters as we face strong 2022 comparables and continue to experience the related swings from entering the ASP reporting environment in Q3 2022. Despite this volatility, we believe we have the right strategies in place to capitalize on our HA opportunities. Our pain management and recovery business results have not met our expectations over the last year. However, we are confident in our new strategy outlined during Investor Day. This strategy connects our pain brands across the patient life cycle and sets the stage for sustainable mid-single-digit growth as we enter 2024 with gross margins exceeding 60%. Our investments in the pain management and recovery business will be very selective over the short to midterm as we focus on securing consistent organic financial results. Now moving to an update on our 2023 priorities and transformation efforts, which includes some of the initiatives that I just described. As we originally outlined at the beginning of the year and further highlighted in June during Investor Day, we have 4 key priorities for the next 3 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. We continue to execute well against these priorities as evidenced by our recent divestiture and acquisition activity, implementation of our new go-to-market strategy for our pain management and recovery business, margin improvement, additional portfolio optimization decisions, and delivery on our transformation program expense savings. In addition, our Board has recently approved a $25 million share repurchase program. This will not impact our ability to continue to execute our tuck-in acquisition strategy, but rather provides us flexibility to allocate capital towards repurchasing shares that we believe are meaningfully undervalued versus our internally calculated intrinsic value. Finally, I'd like to thank everyone who participated in our Investor Day on June 20 and the subsequent feedback we received from many of you. Now I'll turn the call over to Michael, who continues to lead these efforts in his expanded role as Chief Transformation Officer and will further discuss our second quarter financial results.

Michael Greiner, CFO and Chief Transformation Officer

Thanks, Joe. Before providing color on our discontinued operations reporting related to the sale of our Respiratory Health business, I'll first provide additional color and detail around our consolidated second quarter results. Total reported sales for the second quarter on an actual basis was $199.8 million, an increase of 2.5%, excluding the negative impact of foreign exchange, and the impact of low margin and low growth products we have ceased selling. From a continuing operations standpoint, net sales were $169.4 million. Adjusted gross margins were 59.9% and adjusted net income for the quarter totaled $11 million, translating to $0.24 of adjusted diluted earnings per share. Adjusted EBITDA for the quarter was $23 million, in line with prior year. Separately, we ended the quarter with $82 million of cash on hand and a leverage ratio of less than 1. Looking at our total results, including respiratory health, gross margin for the quarter was 56.7%, or 270 basis points lower than the prior year, primarily driven by the unfavorable impact of the Mexican peso as well as unfavorable product mix impact, mostly related to softness in our HA portfolio. Sequentially, gross margin improved by 30 basis points. Separately, SG&A as a percentage of revenue improved by 60 basis points versus the prior year and 160 basis points sequentially, primarily related to our cost savings efforts to streamline the organization and reduce our external spend profile. Adjusted diluted earnings per share were $0.37 and adjusted EBITDA totaled $31.8 million or 15.9%. Now focusing on our continuing operations results. Adjusted gross margin for the quarter was 59.9%, which reflects the benefits of our portfolio optimization decisions. SG&A as a percentage of revenue was 45.1%, an improvement of 100 basis points versus the prior year and a sequential improvement of 280 basis points. We anticipate SG&A as a percentage of revenue to be approximately 43% to 44% for the full year from a continuing operation standpoint with substantial improvement in 2024 ultimately leading to our 2025 goal between 38% to 39%. Adjusted diluted earnings per share were $0.24 versus $0.26 a year ago with adjusted EBITDA margin of 13.5% compared to 13.4% in 2022. For the first 6 months of 2023, the impact of discontinued operations totaled $19 million of EBITDA reduction. We anticipate the full year impact to be approximately $40 million, which also is directionally representative of the annual stranded cost impact for the RH divestiture. These stranded costs include allocations from shared service functions, shipping and freight synergies, and loss of scale in our international operations, among other fixed costs. Through 2024, we will offset a portion of these stranded costs via our transition services agreements with Air Life. Additionally, we are accelerating and expanding our existing cost reduction program to mitigate the majority of the remaining stranded costs, expecting approximately $30 million of incremental cost reduction by the end of 2025. We remain estimated $10 million to $15 million of go-forward dissynergies. Future M&A, of course, would enable additional stranded cost absorption. As a result of the Respiratory Health divestiture, which we anticipate will close early in the fourth quarter, we expect adjusted diluted EPS between $1.05 and $1.15 for the year, with gross margins around 60% and adjusted EBITDA margins of approximately 15%. Including the current year impact of the approximately $17 million annualized impact of product portfolio rationalization that we previously discussed. Company anticipates comparable organic revenue growth to be low single digits for the year. As previously communicated, the cost management aspects of our transformation program will total between $45 million and $55 million of gross savings by 2025. We now anticipate approximately $20 million of those savings in 2023, with the majority of the remainder to be executed in 2024. These savings do not contemplate the elimination of the stranded costs that I just described, which will be addressed separately. Our preliminary view for 2024 anticipates that we will deliver mid-single-digit revenue growth across our portfolio with adjusted gross margins of approximately 60%. Separately, we expect to reduce SG&A as a percentage of sales to 40% to 42% as a result of our cost takeout efforts and anticipate generating adjusted EBITDA of between $120 million and $140 million. These ranges will be negatively or positively impacted by our ability to accelerate our pain growth story and our cost management efforts. With regards to free cash flow, we now anticipate annual free cash flow of approximately $60 million as a result of higher interest and tax payments and weaker-than-anticipated performance in our pain management and recovery portfolio. This estimate also excludes one-time restructuring costs for this year. We remain confident in our ability to deliver approximately $100 million of free cash flow for 2025, assuming $25 million in tax payments, $20 million in capital expenditures, and $15 million in interest payments. In closing, we will continue to execute on each of our transformation priorities and have a laser focus on both the digestive health and pain management and recovery business strategies. We believe that the execution of these portfolio strategies, combined with our other transformation priorities, will support delivering mid-single-digit organic revenue growth, gross margins exceeding 60%, and adjusted EBITDA margins greater than 20%, along with free cash flow generation of approximately $100 million. Finally, we will remain prudent stewards of our balance sheet, pursuing margin-accretive tuck-in acquisitions and opportunistic share repurchases.

Rick Wise, Analyst

Thank you for the detailed information, which is a lot to take in. I appreciate the valuable data you provided. Michael, you clearly stated that achieving growth in 2024 relies on two key areas: growth acceleration or reacceleration and cost reduction. If I understood correctly, I’d like you to elaborate on these points, especially cost reduction, which seems to be more within your control. Could you provide more details on why you are confident in reaching your goals and outline some specific actions? Additionally, I noticed on Slide 7 that the pain portfolio is facing challenges. If you could take us through each segment and explain your action plan, it would help us better understand and believe in the potential for pain growth to reaccelerate in 2024. That would cover my first and second questions.

Michael Greiner, CFO and Chief Transformation Officer

I'll hand it over to Joe shortly to discuss our strategic approach to pain and relate that back to what we shared on Investor Day, explaining our confidence in achieving mid-single digit growth next year. I wanted to clarify that our initial estimate for EBITDA and pain growth in 2024 is between $120 million and $140 million. The lower figure would indicate that we didn't perform as well as expected in either pain growth or cost management, both of which are within our control, though progress may be slower than anticipated. Some factors during the transition agreements may have caused temporary distractions early in the year, affecting our cost management efforts, which we will focus on in the second half of 2024. We are optimistic about our targets for 2025 because we have strong programs in place, and we feel confident about the 2024 range as well. However, whether we reach $120 million or $140 million will depend on our ability to achieve mid-single digit growth in the pain category, which Joe will address shortly, and how quickly we can implement our cost management initiatives. These programs will proceed; the question is whether we can finalize them by March or if it will be later in July.

Joe Woody, CEO

And Rick, this is Joe Woody. To follow up on the pain growth for 2024, if you consider this quarter, the company is seeing about 2.5 percent organic growth when we exclude the disruptions. Unfortunately, we've encountered significant supply chain issues in IVP and acute pain. Without those issues, we could potentially achieve a growth rate of 4 to 5 percent for Avanos in its ongoing operations. We're optimistic about integrating Diros, which will allow us to engage in the ambulatory surgical center market and acquire a larger share in the standard RF market. Additionally, internationally, we're seeing positive reimbursement developments in Japan, and NICE in the U.K. is extending reimbursement for COOLIEF in Europe. Strategically, we are adopting a completely different approach focused on the ambulatory surgical center and the orthopedic market, involving changes in personnel and distributors. If it weren't for the supply chain challenges, we believe we would be close to our goals. Moreover, we expect to face easy comparables moving forward. Overall, we are confident we can achieve a stable mid-single-digit growth as we concentrate on areas where we can be successful.

Rick Wise, Analyst

Yes. Got it. I lied, I'll ask a half. And the likely or the potential of Diros contribution? And then.

Joe Woody, CEO

Yes. So this year, it's going to be sort of, call it, $6 million in revenue.

Rick Wise, Analyst

And to $24 million? And how are you thinking about 2024, 2025?

Michael Greiner, CFO and Chief Transformation Officer

It will be double-digit growth, no doubt about. It will be an uplift, but obviously on a lower base. So the impact on the mid-single digit for pain will be somewhat de minimis.

Matthew Mishan, Analyst

I just wanted to start off with the new baseline for 2023. The $105 million to $115 million of EPS and the $100 million to $110 million of EBITDA. Those are clean numbers, excluding the divestiture. There's not necessarily revenue coming out and costs that are kind of stuck in the P&L. Those would be exclusive completely of the divestiture.

Michael Greiner, CFO and Chief Transformation Officer

There is $30 million of trapped costs that we will be addressing over the next 12 to 18 months. These costs are fixed and remain stranded, and they are not included in the figures discussed. However, the 2024 and 2025 projections account for our efforts to eliminate these costs.

Matthew Mishan, Analyst

No, no, it makes complete sense with how you're looking at it. And then if you think about the progression to 2024, it's about at the midpoint on the EBITDA of about $25 million of improvement year-over-year. Just can you help us kind of walk us to how you're getting there? It seems like a lot of that is going to be just from cost reductions that you have an opportunity and have a pretty good handle on.

Michael Greiner, CFO and Chief Transformation Officer

Yes, I believe there are two key factors. First, a significant part of it is cost reductions. Additionally, we are anticipating mid-single-digit growth along with an improved gross margin profile compared to this year. Our gross margin will increase considerably next year. While our SG&A as a percentage of revenue will rise slightly next year versus this year, we expect it to gradually decrease to our target of 38% to 39% by 2025. This improvement will stem from a combination of solid mid-single-digit growth, a better product mix contributing to profits, alongside our cost transformation efforts and further cost reductions following the complete divestiture of RH. We will be collaborating with Air Life for much of the year after the deal closes, as both companies will handle some manufacturing for one another. The two plants they will take over will allow us to streamline our operations, which we discussed on Investor Day. It’s a blend of these elements. I completely agree with your point, Matt—everything here is within our control. However, it’s difficult to predict exactly when we will see results—whether in the second or third quarter next year. This is why the 2024 figures are preliminary. As we progress into the latter half of this year and after closing the deal, which we expect to happen in the early part of the fourth quarter, we will have a clearer picture of how quickly we can address these costs and what the next year will look like. We are optimistic about the ranges we’ve provided because, as you highlighted, a significant portion of what lies ahead for 2024 and 2025 is largely within our control, provided we successfully execute our strategy.

Matthew Mishan, Analyst

All right. Excellent. And then last question, just on the HA market. As you think about the ASPs coming closer to parity between Orthogen and some of the competition. Kind of where is that in getting closer to parity? And kind of when do you expect that to converge completely?

Joe Woody, CEO

Matt, this is Joe Woody. I think we have several quarters, I maybe even said in the prepared remarks, but I can't remember exactly, but I think it's about several quarters. You move into '24, we're going to settle out a different base. And then we're very confident that we can get low single-digit growth out of that business on a go forward.

Kristen Stewart, Analyst

Congratulations on a good quarter when you look at the numbers in totality. I was just wondering if you could go through the Digestive Health business. You had a really strong quarter there. How should we just think about the sustainability of that franchise?

Joe Woody, CEO

Yes. So Kristen, thanks for your comments on the quarter. I think that we had a very strong NEOMED performance at very high double-digit growth in our core tract, really good in our legacy business. We think NEOMED has the type of growth that we've been experiencing double-digit anyway, at least in the next 12 months. And we've got some great global opportunity in the legacy side of our business. But that said, obviously, we'll have tough comparables next year. Nonetheless, we still see it as a fairly rock-solid mid-single-digit grower across the board. And then, of course, as we said at the Investor Day, we're going to be additive with M&A bolt-ons there, too.

Kristen Stewart, Analyst

And just on the M&A environment, is there anything that you can share with us in terms of anything proceeding?

Joe Woody, CEO

No. As you can imagine, our heads down on execution right now on integration. And all the things that you saw in the release, but we do think that as we move into '24, we'll start to open our aperture again there.

Michael Greiner, CFO and Chief Transformation Officer

Yes. The only thing I would add, Kristen, to that, obviously, we just have a lot to absorb right now and we really want to execute on what we just laid out today over '24, '25 and it ties back to what we shared on Investor Day. We are very focused going forward though. We're not adding a third leg. We'll be very focused primarily in the DH space. We've done a couple of nice things, we believe, in the pain space. We've got to go execute organically there. So should we do anything actionable over the next 12 months, you most likely would see that come from the DH space.

Daniel Stauder, Analyst

So just first one would be on gross margin. I mean, you talked about both today and during your Analyst Day, and you're almost there right now with earnings, but you talked about 59% for the full year. But really just looking out, I just wanted to ask about how do some of these new products play into that? I think you had talked about them being accretive to margins upon full ramp. But I just wanted to ask, post-launch of some of these new products in the next 12 months, how long will it take to really add to that gross margin and add some even more power there.

Michael Greiner, CFO and Chief Transformation Officer

Yes. So I think you're referring to a couple of launches we have in DH, plus, obviously, adding the Diros technology. They will be, over time, Daniel. They will be additive to gross margins, which could provide some upside to our 60% to 61% that we have previously disclosed, but we also have those inflationary headwinds that we described, which some may argue were conservative that we shared on Investor Day, it was over 400 basis points of inflationary headwinds. So we still feel very comfortable with the 60% to 61%, but as you see the numbers already roll up at 50 to 59 and what we're looking at, you can make other assessments that perhaps 60 to 61 is too conservative. But we're comfortable with that range right now until we see how the inflationary environment in Mexico plays out over the next 12 to 18 months and ensuring that these launches occur successfully.

Daniel Stauder, Analyst

And then just one more for me on pain management. You mentioned that the softness was due to some supply chain issues. But I really just wanted to ask about the underlying procedure demand here. How does that trend throughout the year? And then as far as the supply challenges, what was the main issue there? It seems interesting to us that the headwinds were so broad-based. So any specific thing you can would be helpful.

Joe Woody, CEO

Underlying is trending up, and we're in a situation with backorder where we're sort of having to allocate to our top 200 accounts, and we can't take advantage to your point of the upswing in procedures. We think that's going to close out as we move into the fourth quarter, really more towards the mid-part of the fourth quarter and as we go into 2024, so we can take advantage of those, which is why we're feeling a little bit more positive around that. The actual areas are around chips and components in some of our CRGs and some of the supplies that are part of the COOLIEF or the RF procedure. And then we have a catheter issue that we're dealing with on a supplier to really affect the ON-Q growth in particular. So it's really holding us back. We're monitoring it. We’ve worked our way through it. We again, have said, we think we'll be through it by the end of the year, and that's when we'll start to jump in and take advantage of some of this natural procedural growth, which is there.

Operator, Operator

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

Joe Woody, CEO

Thank you. I think everybody can get the feeling that we're focused on execution and delivering this plan and all the things that we outlined at Investor Day. So this year, already, we've executed on product exits, divested our RH business, acquired what we think is a valuable technology in Diros, and approved an additional share repurchase program, and we're delivering on most of our financial objectives. Our feeling is these results have established a necessary foundation for us to deliver our midterm financial commitments. We're confident that the transformation priorities and our market-leading portfolio in attractive markets position us for sales growth, margin expansion that we're talking about, and, of course, meaningful free cash flow generation. So I know we'll be talking to a number of you going forward. Thanks for attending the call and your continued interest in Avanos.

Operator, Operator

The conference has now concluded. Thank you for your participation. You may now disconnect.