CONMED Corp Q1 FY2022 Earnings Call

Good day, and thank you for joining us. Welcome to the First Quarter Fiscal Year '22 CONMED Earnings Conference Call. With us today are Curt Hartman, President and CEO, and Todd Garner, Executive Vice President and Chief Financial Officer. I will now hand the conference over to CONMED. Please note that this conference is being recorded.

Thank you, Debbie and Julie. Good afternoon, and thank you for joining us for CONMED's First Quarter 2022 Earnings Call. With me on the call is Todd Garner, Executive Vice President and Chief Financial Officer. Today, we'll share with you our first quarter results, a more detailed review of the In2Bones acquisition and the overall outlook for our business. We'll then open the call to your questions. I'll start by reviewing our first quarter results. Total sales for the quarter were $242.3 million, representing a year-over-year increase of 4.1% as reported and an increase of 4.3% in constant currency. From an earnings perspective, during the first quarter, our GAAP net income totaled $15 million. This compares to net income of $9.9 million in the first quarter of 2021. Excluding special items that affected comparability, our adjusted net income of $23.5 million increased 22.9% year-over-year, and our adjusted diluted net earnings per share of $0.70 increased 11.1% year-over-year. March was our best month in the quarter, as the impact of Omicron was strongest in January and dissipated throughout the quarter. In our international markets, I would note that Asia, Japan, and Canada all started slow, while Europe and Latin America delivered very solid performances. The U.S. market showed improvement late in the quarter. Overall, I'm pleased with the quarter and the commercial performance as we continue to navigate the impact of COVID. We introduced new products across the business and delivered solid results in both the top and bottom line. During the quarter, we saw additional smoke legislation passed in Arizona, Georgia, and Washington, which now places about 18% of the U.S. hospital network under some form of legislation. While this is favorable, it clearly indicates more room ahead on this important topic. We are encouraged by our revenue outlook after 1 quarter, both with and without the acquisition. Given the inflationary pressures and the impact expected from the acquisition, I'm comfortable that we have landed on a responsible earnings outlook, which Todd will cover in more detail. I'll now switch my comments to the acquisition of privately held In2Bones. Today, we announced that we signed a definitive agreement to acquire Memphis, Tennessee based In2Bones for a $145 million upfront payment, with the potential for an additional $110 million in revenue growth-based earn-outs over a 4-year period. We think In2Bones is an excellent platform for CONMED. The company brings to CONMED a very experienced leadership team, an innovative and comprehensive foot and ankle portfolio, a well-established and growing sales channel, and an existing international presence and an exciting platform for future innovation. We're excited to enter the lower extremity foot and ankle market, which is an estimated $4.5 billion market growing in the high single-digit range.

Thank you, Curt. All sales growth numbers I reference today will be given in constant currency. The reconciliation to GAAP numbers is included in our press release. As usual, we have included an investor deck on our website that summarizes the results of the quarter and our updated guidance, including a few slides on the acquisition announced today. For the first quarter of 2022, our total sales increased 4.3%. The month of January was below the prior year January due to the impact of Omicron on hospital procedures and staffing, and each month of the quarter saw improving hospital volumes. For Q1, our sales in the U.S. increased 5.9% versus the prior year quarter. Our international sales grew 2.6% for the quarter compared to the prior year. Worldwide Orthopedics revenue grew 0.4% in the first quarter. In the U.S., Orthopedic sales grew 2.2% and internationally, Orthopedic sales decreased 0.5%. Total worldwide General Surgery revenue increased 7.7% in the quarter. U.S. General Surgery revenue grew 7.5%. Internationally, General Surgery revenue increased 8.2%. AirSeal and our direct Buffalo Filter product lines had a very strong quarter despite the slow start. The OEM side of the Buffalo Filter products continues to lag our direct products. Now let's move to the expense side of the income statement. We will discuss expenses and profitability in the first quarter, excluding special items, which include charges for restructuring, amortization of intangible assets, and amortization of deferred financing fees and debt discount net of tax. Adjusted gross margin for the first quarter was 56.1%, an increase of 90 basis points over the prior year quarter. Our improving mix continues to drive margins up. We are seeing increased costs that will affect future quarters, and we will talk about that more when we discuss guidance. Research and development expense for the first quarter was 4.4% of sales, 10 basis points higher than the prior year quarter. First quarter SG&A expenses on an adjusted basis were 39.7% of sales, an increase of 60 basis points from Q1 2021 due to the expansion of the sales force last summer. On an adjusted basis, interest expense was $4.1 million in the first quarter. The adjusted effective tax rate was 17.5% in Q1. Once again, we benefited from the excess tax benefit from stock plans. We do not expect that same level of benefit going forward. First quarter GAAP net income totaled $15.0 million, an increase of 51.9% over Q1 of 2021. The $0.47 of earnings per diluted share this quarter was up 51.6% over the prior year quarter. Excluding the impact of special items discussed earlier, we reported adjusted net income of $23.5 million, an increase of 22.9% compared to the first quarter of 2021. Our Q1 adjusted diluted net earnings per share was $0.70, an increase of 11.1% compared to the prior year quarter. Turning to the balance sheet. Our cash balance at the end of the quarter was $24.9 million compared to $20.8 million as of December 31. Accounts receivable days as of March 31 were 68 days compared to 60 days at the end of 2021. This is a function of the timing of revenue in the quarter, with March being much stronger than January; a higher mix of receivables came in the last month of the quarter than our normal cadence. Inventory days at quarter end were 215, and in our effort to serve our customers, we continue to build inventory to mitigate supply challenges. About half of the increase since December has been in raw materials and WIP. Long-term debt at the end of the quarter was $704 million versus $672 million as of December 31. About $23 million of the increase is due to the new accounting standard for convertible notes. The other side of the reclass is essentially a debit to equity. Our leverage ratio on March 31, 2022, was 3.5x, which is consistent with December 31. Cash flow provided from operations for the quarter was $0.3 million compared to $22.3 million in the first quarter of 2021. The difference is due to the increase in accounts receivable and inventory discussed earlier. Capital expenditures in the first quarter were $3.7 million compared to $3.1 million a year ago. Now let's turn to financial guidance. We are very pleased with what we're seeing on the revenue momentum. While the effects of COVID still linger, we are seeing good volumes in most of our geographies. Our confidence in our revenue projection has strengthened since January. Therefore, on an organic basis, we are raising our revenue guidance today to the range of $1.085 billion to $1.130 billion. That represents organic growth between 7% and 12% over 2021. Compared to our previous guidance, the new range is $10 million higher on the bottom and $5 million higher on the top. There is still a lot of year left, but we're seeing very good momentum on the commercial side of the business. As it relates to currency, foreign exchange has gotten worse since January, but our hedges are doing what they are intended to do so far. And at the end of the first quarter, we continue to expect a material impact to 2022 financial guidance from currency. On the cost side, we are definitely seeing elevated inflation compared to what we were seeing 3 months ago. Oil costs are significantly up, which affect freight and resins. We are currently projecting freight to be 14% higher for the full year 2022 than we were projecting in January. Material costs have also increased. So far, we estimate that materials in aggregate will cost us 5% more in 2022 than we thought 3 months ago. Because of how we recognize costs with inventory, those recent increases did not really impact our P&L in Q1, but they will begin to weigh on the margins we report going forward. Of course, we don't know how long we will live in this inflationary environment and where it goes from here. We are actively working to mitigate these pressures on the P&L. We have already implemented some price increases where it makes sense and are analyzing the opportunity to take price in other areas. We are also being extremely judicious with any new commercial spending. However, I do want to emphasize that we do not think it would be wise to make wholesale cuts to our commercial infrastructure in an effort to offset these macro and hopefully, temporary inflationary pressures. Our business momentum is strong, and we expect double-digit revenue growth in the back half of this year. We think it would be very unwise to jeopardize our revenue growth to solve what is hopefully a short-term macro issue. Due to those increased costs without the acquisition that we will talk about in a few minutes, we would have been directing investors to the low end of our prior full year adjusted EPS guidance. Specific to gross margins, 3 months ago, I told you I expected gross margins in 2022 to grow over each prior year quarter. Q1 was a good example of that forecast as it grew 90 basis points above the prior year. However, given the accelerated inflation, I now project each remaining quarter this year to be below the prior year gross margin for the comparable quarter, because we recognize manufacturing variances with inventory; we have a better forecast for Q2 than we do for the subsequent quarters. I can tell you that Q2 looks to be about 100 basis points lower in gross margin than Q2 of 2021. We will keep you updated as we move through the year. We also did an analysis of what our gross margins would be today if freight and material costs were simply static with pre-pandemic levels. Our estimate is that these 2 items alone have cost us approximately 300 basis points in gross margin since 2019. Our commercial engine is strong, our prior investments are paying off, and we are also navigating an unprecedented macro storm along with everyone else. We will continue to stay focused on the customer and serving them with an engaged workforce and innovative products, which has resulted in increased profits for our shareholders. That continues to be our approach. As we transition out of the pandemic, we believe customers will continue to reward our actions as valued partners with increased trust and market share. Now let's talk about the financial impacts of the acquisition we announced today. In2Bones had revenue of $36.8 million in 2021 at approximately 80% gross margin. We expect a late Q2 or early Q3 close, and we always want to be cautious in the first months of an acquisition due to potential disruption and channel issues. So we are estimating $20 million of revenue contribution in the back half of 2022 from the acquisition. As you see in the materials included in our deck, we expect the extremities market to grow in the high single-digits and In2Bones has been growing at least twice as fast as the market. We expect that similar growth rate to continue as we join together to address this important customer base. From an adjusted EBITDA perspective, we expect the acquisition to be slightly positive in 2022, contribute single-digit millions of EBITDA in 2023, and double-digit millions after that. From an adjusted EPS perspective, we expect the acquisition to be between $0.05 and $0.10 dilutive to both the remainder of '22 and the full year of '23 and to be accretive thereafter. That would make our full year 2022 revenue guidance, including the acquisition to be between $1.105 billion and $1.150 billion. Our full year 2022 adjusted cash EPS guidance range, including the dilution from the acquisition is $3.50 to $3.65.

This is Lilly on for Robbie. Maybe just to start with one on near-term trends. What are you seeing in terms of the recovery into 2Q? Has that momentum you called out continued into April? And are there any geographies or parts of the business that are still lagging?

I don't want to get too far into Q2, Lilly. But I think what we saw in the month of March, we feel good about that as an exit point and how that's continued as we started the second quarter. To the point of where there may still be challenges, I was reading some data relative to the China market. And I think everybody knows China is not a massive market for CONMED, but there was a reference that some 340 million people are under some form of lockdown. So obviously, China is still a little bit slow relative to other places around the globe. Other than that, I think things are moving forward around the globe in a positive fashion.

Okay. That's helpful. And then maybe just one on Buffalo Filter and AirSeal. How should we be thinking about how those 2 products did in the quarter? And is 25% of the business growing faster than 20% still the right way to think about those 2 products?

Yes. Thanks, Lilly. Yes, that's definitely still how we see it. Again, our direct business in Buffalo Filter is doing much better than the OEM business, which is to be expected. And so the OEM business is a little bit of a drag on that metric. But AirSeal and our direct side of the Buffalo Filter business continue to do very well.

Maybe, Curt, you could just expand on your thoughts in pursuing In2Bones. I mean, obviously, big TAM, rapid growth, better gross margins, those are pretty evident. But maybe talk about how you see the synergies between In2Bones and today's CONMED and how it's likely to evolve working together as we look ahead to the next few years.

Great question, Rick. You correctly identified the first three key points that are crucial as we explore this new area for us. While it falls under orthopedic care, we haven't had a significant presence in this market. We do have some offerings in our sports medicine division that relate to foot and ankle issues and the soft tissue components of the extremities market. This involvement has helped us become more familiar with the market, which shows great potential. In relation to In2Bones, they possess a highly experienced leadership team, an extensive product portfolio, and a well-established sales network. Importantly, from CONMED's standpoint, they have a strong international presence with a direct sales channel in several markets and coverage across 25 countries. All these factors align favorably for CONMED when considering this asset compared to others available in the market. As I mentioned earlier, we've been monitoring this market for some time and see it as an expansion opportunity in a high-growth sector. For these reasons and likely more, this aligns well with our strategic goals, both now and in the long term. We already compete with many of the players in this space, so we feel confident in our position. We have proven that we can navigate this competitive landscape, and this presents yet another opportunity for CONMED Corporation.

I have a follow-up question. I anticipate being asked how CONMED intends to compete with larger companies. We've discussed your existing business multiple times, and you've addressed it well. However, I wonder if your portfolio is substantial enough for competition, if the decision-making processes are different, and whether you'll need to invest more strategically to maintain the growth you've described for the sales force. Could you elaborate on some of these points?

Sure. We believe the existing portfolio that In2Bones has is a phenomenal starting point for CONMED. And they've worked very diligently to build that portfolio. And obviously, they continue on with their R&D efforts. And that was certainly one of the things that excited us as we delved in our diligence and looked at their portfolio and where they were taking the portfolio. So innovation is a consistent part of the story in extremities, just like it's a consistent part of what we've been trying to do at CONMED over the last several years. Sales force expansion, sales force excellence, consistent part of being in the implant market, which extremities certainly is in the implant market. It's a surgeon-driven preference item that's very similar to what CONMED already operates with our portfolio. And so all those things are very similar to what we already do today. And as I noted, the competitive base is very similar to the people we line up against. So those things are all very similar to us. I'm not going to say there aren't nuances to this market relative to our other markets. Every specialty has its own nuances. But I think our team feels very comfortable about entering that. And I say that because of the leadership team that In2Bones brings and has from a depth of experience in this marketplace. We are, in essence, buying a platform. We're not buying a product line. We're buying a platform, and it starts with people, and that's something I've said from day one. We want to find great people, and we'll do well in the markets if we have great people. And I think we're getting all of that and then some with this acquisition.

I have another question about In2Bones. The press release mentions both upper and lower extremities, but it seems the comments in the prepared remarks focused more on the lower extremity part. Could you discuss the mix within the portfolio? Specifically, in the foot and ankle area, are there any significant gaps or missing products?

It's a great question. And if you go to the In2Bones website, you'll see that they do mention upper and lower extremities as their company descriptor. And it's a fair descriptor. And if you look at our investor deck, we've got a slide in there with the product portfolio that does show some upper extremity items. If you dissect that $36.8 million of revenue, the majority of that revenue is driven by the lower extremities, and that's really what we valued the company on. Now in saying that, we do believe that there is some value in that upper extremities portfolio. And we do believe that over time, we can look at that and see if we want to invest more and continue to develop that. We certainly have a channel that calls on that space. If you think about the shoulder and what we do in sports medicine in the shoulder, we've got some products that go into the hand and wrist. So there may be some opportunity there, but that's to be determined, Mike. We're more focused on the value that they've created in the lower extremities and where that's going to take us right out of the gate.

Yes, Mike. We're managing that like everyone else is. It's part of the increase in material costs because suppliers are facing scarcity. If you want the product, you essentially have to pay the price. This is definitely a factor in what's happening. To give you some historical context, we're currently at about two days' worth of sales in back order. Before the pandemic, we usually operated below half a day of sales. So while two days of sales may not seem significant on a material basis, it's a shift from where we used to be. I would prefer to have an extra two days of sales in Q1. Our team has done an admirable job of navigating these pressures, but we are not immune and are experiencing the same challenges as others around the world.

Okay. And then just a follow-up on that, Todd. I think I heard you say you expect double-digit revenue growth in the second half. Is that because you're including the inorganic component from the acquisition? Or were you referring to organic growth? Or did I just completely mishear that?

No, you heard it right. That's on an organic basis. Now part of that is the back half of 2021 was a lot worse than it was supposed to be, right, because of Delta and then Omicron. So there's some easy comps in there. But yes, we do project without the acquisition, we expect double-digit revenue growth in the back half of 2022.

Congratulations on the acquisition. I wanted to address the dilution in 2022 and 2023 resulting from it. How are you approaching the financing costs associated with this acquisition? Does that also take into account the investments necessary to support growth?

Yes, that's a great question, Matt. The financing aspect is essentially what leads to dilution. From an EBITDA standpoint, it remains positive even in the first half of 2022, and it contributes single-digit millions to EBITDA in 2023. The financing transforms that positive EBITDA into diluted earnings per share. We can manage the $145 million upfront cost, which comes with milestones over four years, and we have the capacity within our current credit facility, but interest rates are increasing. It’s important to note that there are two quarters in 2022 and four in 2023 that impact this. While it becomes more accretive as we progress, we will still incur four quarters of interest costs in 2023, which is why it remains dilutive during that year. We anticipate becoming accretive after we get through 2023.

Sure. I'll do my best here from what I know of the history. I started out as a French-based company, developed a U.S. commercial presence. At some point, there was a merger of the U.S. commercial presence with the French entity. And both entities had some form of R&D established. And that's in part why they have a bigger presence internationally than a lot of companies at this scale. So today, they retain a presence split about 50-50 in terms of people in the U.S. and internationally. The U.S. sales channel is a sales channel we're very familiar with. It's a distributor-based sales channel, which is not atypical in this particular specialty. And we obviously have a hybrid sales channel here in our U.S. Orthopedics business. So we're familiar with those. And majority of their product portfolio to the best of my knowledge has come through organic innovation and development. So I think it's been built very financially responsibly and has a very good, solid and growing presence in the leadership team. The experience and depth of knowledge of the market is very evident when you look at the background. So a lot to like here, and that's what made it very appealing to CONMED.

This concludes our question-and-answer session. I would like to turn the conference back over to Curt Hartman for any closing remarks.

Thank you, Debbie. I want to thank everybody on today's call for your time, and we look forward to speaking with you again on our next earnings call. Thank you. Have a good evening.

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