Embecta Corp. Q3 FY2023 Earnings Call

Welcome, ladies and gentlemen, to the Fiscal Third Quarter 2023 Embecta Earnings Conference Call. Please note that this conference call is being recorded and that the recording will be available on the company's website for replay following the completion of this call. I would now like to hand the conference over to your host today, Mr. Pravesh Khandelwal, Vice President of Investor Relations. Please go ahead.

Thank you, operator. Good morning, everyone, and welcome to Embecta's fiscal third quarter 2023 earnings conference call. The press release and slides to accompany today's call and webcast replay details are available on the Investor Relations section of the company's website at www.embecta.com. With me today are Dev Kurdikar, Embecta's President and Chief Executive Officer, and Jake Elguicze, our Chief Financial Officer. Before we begin, I would like to remind you that some of the matters discussed in the conference call will contain forward-looking statements regarding future events as outlined in our slides. We wish to caution you that such statements are, in fact, forward-looking in nature and are subject to risks and uncertainties and actual events or results may differ materially. The factors that could cause actual results or events to differ materially include but are not limited to, factors referenced in our press release today, as well as our filings with the SEC which can be accessed on our website. In addition, we will discuss certain non-GAAP financial measures on this call which should be considered a supplement to and not a substitute for financial measures prepared in accordance with GAAP. A reconciliation of these non-GAAP measures to the comparable GAAP measures is included in our press release and conference call presentation. Our agenda for today's call is as follows: Dev will begin by providing an update on the progress we've made on our strategic priorities for 2023, as well as some remarks on the overall performance of our business during the third quarter and year-to-date period. Jake will then provide a more in-depth review of our Q3 financial results as well as our updated financial guidance for the year, and we will then open up the call for questions. With that said, I would now like to turn the call over to our CEO, Dev Kurdikar. Dev?

Thank you, Pravesh. Good day, everyone, and thank you for taking the time to join us this morning. This time last year, we announced the results of our very first quarter as an independent public company and I'm pleased to say that we have made tremendous progress standing up our organization since then. I'm especially energized by the continued execution of our global team across all elements of our business and strategic priorities because we are not just here to build a new company but to also continue our mission of developing and providing solutions that make life better for people living with diabetes. At Embecta, we keep their needs front and center because we want everyone to be able to enjoy life unlimited by diabetes. As we turn to the next slide, you will see the strategic priorities that will help us advance towards this vision. First, we remain focused on strengthening our base business while maintaining our global leadership position in the category of insulin injection devices. Second, we continue to make progress in standup and separation activities to ensure success as an independent company. And finally, we remain focused on accelerating our constant currency revenues as we continue investing in growth, most notably around our insulin patch pump program that is being developed for the type 2 market, as well as seeking merger and acquisition and additional partnership opportunities. We are moving with purpose and urgency in each of these three areas. During the third quarter, our team's disciplined execution was the key to delivering solid financial results that once again exceeded our expectations while also advancing these strategic priorities. In terms of strengthening our base business, we recently initiated a pilot launch of a finer gauge pen needle with our Nano Pro hub design in Japan. Today, with more than one out of three people injecting with a 34 gauge pen needle in Japan, we are proud to provide another option for them to choose from. We look forward to getting feedback from our customers regarding this new product over the next several months. We also made progress in our separation efforts, as demonstrated by the exit of several transition service agreements as we continue to build up our internal organization, systems, and processes. This includes the implementation of our own global HR information system, the rollout of a new customer relationship management system, and the setting up of our global IT network. Importantly, we also began the demerger process for our manufacturing facility in Suzhou, China. As we've noted before, this was a deferred entity at the time of our separation from BD. The transfer of the Suzhou plant to Embecta follows a specific process involving several steps, including obtaining licenses, registering products, and undergoing inspections. The first step is obtaining a business license and we have done so. Now, as required by local regulations and as we have long planned, we have temporarily suspended operations at our manufacturing facility as we go through the rest of the steps. During this temporary suspension period, we have begun implementing our new enterprise resource planning system at the facility. Also, as a reminder, we have built up enough inventory to ensure continuity of products supplied to our customers during the time that the shutdown is anticipated to last. Finally, from an invest-for-growth perspective, our patch pump program continues to make good progress, including on the development effort required for the integration of Tidepool's insulin dosing algorithm. We have also initiated a small observational study in partnership with Jaeb Center for Health Research to analyze adults with type 2 diabetes currently using Tidepool's algorithm. As you might recall, our Tidepool collaboration is specifically for the type 2 closed-loop platform. Based on the plan of the patch pump program we have previously laid out, our initial focus is on the filing of a 510(k) and obtaining FDA clearance in the U.S. for the open-loop version. This is expected to be followed by a clinical study for our closed-loop version with the intention to subsequently obtain FDA clearance for use of the closed-loop system in individuals with type 2 diabetes. Overall, even as our team has been working on critical projects to stand up Embecta, exit TSAs and drive future growth, our global team has continued to execute commercially. This has allowed our core injection business to remain stable and once again, raised our guidance for key financial metrics for fiscal year 2023. Now let's review our third quarter and year-to-date revenue performance in a bit more detail. During Q3, we generated revenue of $286.1 million, which represented a decrease of 1.7% on an as-reported basis and 0.3% on a constant currency basis. When normalizing for the impact of year-over-year changes of the non-diabetes products that we contract manufacture and sell to BD, our underlying core injection business grew approximately 0.5% on a constant currency basis. These results exceeded our previously communicated expectations which called for a sequential decline in our as-reported revenue dollars from Q2 to Q3. In relation to our previous expectations, from a product standpoint, Q3 revenue came in stronger, primarily due to the performance of our pen needles and safety products, as well as slightly more than anticipated contract manufacturing revenue during the quarter. While from a geographic perspective, Q3 revenue came in better than we previously thought in most countries, including the U.S. and China. Regarding the U.S., during the quarter, revenue totaled $153.9 million, which was a year-over-year constant currency decline of approximately $4.1 million or 2.6%. This was driven by two things that contributed almost equally. The first being lower year-over-year contract manufacturing revenue from the sale of certain non-diabetes products to BD, which impacted the U.S. by about $2.3 million, and the second being unfavorable changes in volume which had an impact of approximately $1.8 million. As a reminder, during the third quarter of 2022, our business in the U.S. benefited from the timing of distributed orders and as a result, had a difficult comparison. Had it not been for this timing item that positively impacted the year-ago quarter, our results in the U.S. for our core injection products would have been up modestly. Lastly, pricing in the U.S. was flat in the quarter as compared to the year-ago period as increases in the average selling prices of like-for-like products were offset by a rebate reserve adjustment that positively impacted the year-ago quarter and did not reoccur this quarter. Turning to our performance outside of the U.S. During Q3, international revenue totaled $132.2 million, which equated to year-over-year constant currency growth of approximately $3.2 million or 2.4%. Growth internationally was primarily due to favorable pricing dynamics as well as an increase in product volumes, which were aided by competitor product supply shortage in certain regions. Turning to our revenue performance for the first nine months of the year, we generated revenues of $838.9 million, which represented a decrease of 1.9% on an as-reported basis but an increase of 1.4% on a constant currency basis. When normalizing for the impact of year-over-year changes in the non-diabetes products we contract manufacture and sell to BD, our underlying core injection business grew approximately 0.8% on a constant currency basis. From a regional perspective, U.S. revenues totaled $449.6 million, which was relatively flat on a constant currency basis. While international revenues totaled $389.3 million, which equated to year-over-year constant currency growth of approximately 3.2%, driven primarily by emerging market performance. That completes my prepared remarks. And with that, let me turn the call over to Jake to discuss our Q3 financial results in a bit more detail as well as provide our updated fiscal 2023 financial guidance and underlying assumptions. Jake?

Thank you, Dev, and good morning, everyone. Before I discuss the financial results, I would like to remind the investment community that Embecta was spun off from BD on April 1, 2022, and that the financial results during the pre-spin periods were based on carve-out accounting principles and do not reflect what Embecta's financial results would have been had Embecta operated as a stand-alone public company. Therefore, the financial results for the nine-month period ending June 30, 2023, and June 30, 2022, are not meaningfully comparable. Given the discussion that has already occurred regarding revenue, I will start my review of Embecta's financial performance for the third quarter at the gross profit line. GAAP gross profit and margin for the third quarter of fiscal 2023 totaled $189.5 million and 66.2%, respectively. This compared to $202.9 million and 69.7% in the prior year period. The year-over-year decline in GAAP gross profit and margin was expected and was due to a combination of factors which includes the impact of inflation on the cost of certain raw materials, direct labor and overhead, product and geographic mix, incremental standup and separation costs, and foreign exchange. This was somewhat offset by manufacturing productivity improvement programs and increases in the average selling prices of our products. While on an adjusted basis, gross profit and margin for the third quarter of 2023 was $189.6 million and 66.3%. As compared to our prior outlook, our adjusted gross margin during the third quarter of 2023 was better than we previously expected and this was due to higher-than-anticipated revenue, favorable geographic and product mix, and our ability to manage the costs incurred to stand up the organization. Turning to GAAP operating income and margin. During the third quarter, they were $51.3 million and 17.9%, respectively. This compared to operating income and margin of $97.1 million and 33.4%, respectively, in the prior year period. The decline in year-over-year GAAP operating income and margin is primarily due to the GAAP gross profit changes I just discussed. An increase in selling and administrative expenses associated with separating and standing up Embecta to operate as a publicly traded company. An increase in research and development expenses related to our insulin patch pump program as well as an increase in the amount of certain one-time separation-related expenses that we do not anticipate reoccurring in the future. While on an adjusted basis, during the third quarter of 2023, operating income and margin totaled $79.8 million and 27.9%. The adjusted operating income and margin performance during the third quarter of 2023 was better than we previously anticipated and this was due to the overachievement at the adjusted gross profit and margin line that I referenced earlier. Turning to the bottom line. GAAP net income and earnings per diluted share were $15.2 million and $0.26 during the third quarter of fiscal 2023. This compared to $62.4 million and $1.07 in the prior year period. The decline in year-over-year GAAP net income and diluted earnings per share is primarily due to the GAAP operating profit drivers I just discussed, as well as an increase in year-over-year interest expense associated with our variable interest rate debt. While on an adjusted basis, net income and earnings per share were $39.8 million and $0.69 during the third quarter of fiscal 2023. Lastly, from a P&L perspective, for the third quarter of 2023, our adjusted EBITDA and margin totaled approximately $92.2 million and 32.2%. Like our adjusted operating profit due to the revenue and gross profit overachievement in the quarter, our adjusted EBITDA during Q3 also exceeded our previous expectations. Finally, with respect to our balance sheet and financial condition at quarter end. As of June 30, 2023, we held approximately $317 million in cash and cash equivalents and approximately $1.64 billion in debt which, taken together with our last 12 months adjusted EBITDA, resulted in a net leverage ratio of approximately 3.4x. That completes my prepared remarks as it relates to Embecta's financial results for the third quarter of fiscal 2023. Next, I'd like to discuss Embecta's updated 2023 financial guidance and certain underlying assumptions. Beginning with revenue. Given our year-to-date performance, we are tightening our constant currency revenue guidance range as we are now calling for full-year 2023 constant currency revenue growth of between 0.5% and 1%. This is an increase of 50 basis points on the low end, with about half of the increase due to our core injection business and about half due to contract manufacturing revenue. As it relates to the contract manufacturing of non-diabetes products that are sold to BD, our updated full-year constant currency revenue range assumes no additional revenue associated with this during the fourth quarter. This compares to approximately $10 million of contract manufacturing revenue that was generated during the fourth quarter of 2022. And while we continue to make progress in this area, our updated full-year constant currency revenue guidance range continues to assume an immaterial amount of revenue associated with any recently announced partnership agreements. Turning to our foreign exchange assumptions, they remain unchanged from our previous expectations. And as such, our updated guidance continues to call for a foreign currency headwind of approximately 2.5% during 2023. On a combined basis, we are raising the bottom end of our full-year as reported revenue guidance from a range which called for a decline of between 1.5% and 2.5% to a new range which calls for a decline of between 1.5% and 2%. In dollar terms, this equates to a revenue range of between $1.107 billion and $1.113 billion. All totaled, our updated full-year revenue guidance range implies the following for the fourth quarter: an as-reported revenue decline of between 2.4% on the low end and a decline of 0.4% on the high end; a foreign exchange headwind of approximately 0.1% on both the low and high ends; and a constant currency revenue decline of between 2.3% on the low end and a decline of 0.3% on the high end. This implied constant currency range includes a headwind of approximately 3.6% related to the lack of contract manufacturing revenue in Q4. While we anticipate that our core injection business will grow between 1.3% and 3.3% on a constant currency basis. The expected acceleration in constant currency revenue growth within our core injection business during the fourth quarter is largely attributed to our anticipated performance in both the U.S. and China. Moving to margins. Based on the performance that was achieved year-to-date, we are raising our expectations for adjusted gross, adjusted operating, and adjusted EBITDA margins as we now anticipate that our adjusted gross margin will be approximately 66%, up from our prior guidance of approximately 64.5%. Our adjusted operating margin is expected to be approximately 29.5%, up from our prior guidance of approximately 28%. While our adjusted EBITDA margin is now projected to be approximately 33.5% for full-year 2023, up from our previous guidance of approximately 32.5%. Our updated guidance ranges imply a sequential step down in our margin profile from the third quarter to the fourth quarter and this is expected to occur due to a combination of factors, including lower anticipated revenue dollars in Q4 versus Q3, the associated negative manufacturing variances, the ongoing temporary suspension of our manufacturing operations of our facility in China, unfavorable product mix, and foreign exchange headwinds. Continuing down the P&L, we currently expect that net interest expense will be approximately $112 million or slightly favorable as compared to our previous expectation which called for interest expense of approximately $113 million during 2023. While our assumptions regarding our non-GAAP tax rate and weighted average shares remain unchanged at approximately 25% and 57.7 million shares, respectively. At the bottom line, this translates into our new full-year 2023 adjusted earnings per share range of between $2.75 and $2.80, which is an increase from our previous range of between $2.50 and $2.60 or a raise of approximately $0.23 at the midpoint. In summary, the better than previously anticipated performance in the third quarter is translating into our increased full-year financial guidance, as our thoughts regarding the fourth quarter are largely unchanged from when we last provided guidance in May. In closing, during the first nine months of the year, we made good progress in each of our three major strategic priorities, including strengthening the base business, separating and standing ourselves up as an independent entity, and investing in growth initiatives. And it has been the focus on execution by our global team and resiliency of our base business that has allowed us to generate solid financial results, thereby allowing us to raise our financial guidance for the year-to-date. That completes my prepared remarks. And at this time, I'd like to turn the call over to the operator for questions.

And our first question comes from Kallum Titchmarsh of Morgan Stanley.

Just across the core injection business. I know you touched on it briefly in your remarks but I'd appreciate some extra clarity if possible on pricing, specifically where you've been able to take price, capturing both products and geographies. And then how you expect this to trend as we head towards your fiscal year 2024.

Kallum, this is Dev. So with regard to pricing, ever since we spun off, now five quarters ago, we've been able to consistently take price across a variety of geographies. Most recently, in the most recent quarter, we were able to get some price in the U.S. as well as in geographies outside the U.S. Pricing is something, Kallum, that happens to us on a rolling basis because we certainly have contracts that roll in and out across various geographies. Pricing overall globally can also get affected by customer mix, and whether it's a tender business and whether we've won a tender or not, versus normal, what I'll call sort of retail channel business. But I think consistently, we've been able to take price. I really don't want to project price going forward. But certainly, our efforts to optimize price in various markets around the world will continue. The pricing actually has also helped us in this recent inflationary environment by allowing us to offset the inflationary pressures that we've certainly experienced since the spin. Jake, is there anything you would like to add?

Yes, sure. Maybe just a little bit more color regarding the impact. So I would say on a consolidated level, we saw pricing drive a little less than about 1% of positive year-over-year constant currency revenue growth for total Embecta. That was largely due to pricing tailwinds that we saw outside of the U.S. Pricing in the U.S. was flat. But I would say that in the U.S., we actually did see like-for-like pricing increases that would have driven about 1% of revenue growth in the U.S. year-over-year. But that was offset by about a 1% headwind coming from certain rebate reserve adjustments that were made in the third quarter of 2022 that did not reoccur and were a headwind then in terms of 2023. So we continue to be pretty pleased with our ability to drive price both in the U.S. on a like-for-like basis as well as through most countries internationally.

Our next question comes from Marie Thibault of BTIG.

I wanted to start by discussing the revenue guidance. It seems that contract manufacturing revenue was strong this quarter, but we do not anticipate any for this quarter or the next. I understand that situation, but could you elaborate on your expectations for base business growth? What are your thoughts on volume growth, specifically in the U.S., international, and emerging markets for the remainder of the year?

Yes. So Marie, maybe I'll start and then Dev can certainly weigh in here. One of the reasons why we sort of break out the contributions from contract manufacturing revenue as compared to sort of the core injection business is because all along, we've known that it's going to be somewhat transient in nature as BD begins to just sort of in-source their ability to manufacture that product itself, right? So I think it's important for the investment community to understand that there's going to be some ebbs and flows in any given quarter as it relates to kind of the contract manufacturing revenue. And while we did generate about $3 million worth of contract manufacturing revenue in the third quarter of 2023, it was still a headwind year-over-year of about $2.3 million. And that equated to about just under 1% of a constant currency headwind in the quarter itself. Now as we sort of move forward here for the fourth quarter, contract manufacturing is going to be a much larger headwind for us as compared to the fourth quarter of 2022. So right now, given what we know, we're not factoring in any additional contract manufacturing revenue for the fourth quarter of 2023. And that compares to about $10 million worth of contract manufacturing revenue that we generated in the fourth quarter of 2022. So that alone equates to about a 3.6% constant currency headwind in Q4 versus the year-ago period. So if you were to sort of normalize for that, our guidance for the core injection business actually implies a step-up in Q4. And right now, we're anticipating that the core injection business on a constant currency basis grows somewhere between 1.3% and 3.3%. And that sort of acceleration in year-over-year constant currency revenue growth is largely coming from both our expectations for the U.S. as well as for China.

And maybe just a couple of points, Marie. You probably remember that contract manufacturing is a very low-margin business for us. As it decreases, it allows us to consider how we can utilize that capacity in our plants. This isn't unexpected and it doesn't significantly impact our bottom line. Regarding revenue, you asked about volume. With the growth rates we're discussing for Q4, we have easier comparisons due to a timing benefit in Q3 of the previous year, which moderated itself in Q4 of that year, helping our growth comparison. Additionally, China was still facing COVID challenges, providing an easier comparison for Q4 as well. That said, the anticipated growth will primarily come from volume. From a guidance perspective, we've taken our Q3 performance and added that to our expectations for the full year. Our expectations for Q4 haven't changed significantly from what we've previously stated. We're pleased that our business is operating at the higher end of our range, and we've adjusted the low end of our guidance upward, maintaining our expectations and showing increased confidence for Q4.

Okay. That's very helpful detail. Maybe I can ask my follow-up on China. Good to hear that you've initiated the demerger process for the China facility. As we get closer now, what are your best expectations for when that facility will be shut down, how long that might take, and when we should start modeling an improvement in gross margins again.

Sure, Marie. So China, you remember, was a deferred entity long planned. In fact, we've been planning for it more than 1.5 years now. Several steps are involved. The first step of which is getting a business license and we've actually done so already. And so with the receipt of that business license, as required by local regulations and again, as long planned, we've suspended manufacturing operations. We wanted to take advantage of the fact that since the operations are suspended, we wanted to do our first deployment of an ERP solution and that's going on right now. Obviously, when you implement ERP at a plant, you want to be able to test that and run through different manufacturing work orders and whatnot to make sure it's all operating. So all of that process is going on right now. Marie, with respect with timing, we've refrained from actually talking about timing. Clearly, we don't want to get ahead of the regulatory authorities. We want them to follow their process. And secondly, obviously, it would be competitively sensitive information. China and emerging markets tend to be fairly competitive markets. Having said all of that, we certainly built up enough inventory to cover and maintain continuity of product supply to our customers during the anticipated time. Everything so far is going per plan. And certainly, our thoughts are all incorporated in the guidance that we gave for this year.

And Marie, maybe I'll just jump in here. As it relates to the potential margin pressure, obviously, as Dev said, we're anticipating a sequential step down in part due to the fact that we're going to see some negative manufacturing variances as a result of this temporary suspension. Again, I think it's still too early at this point in time and we certainly don't want to jump in front of any regulators regarding timing. But we will see some continued year-over-year margin pressure as a result of that in the near term. And then I think it's probably still a little bit too early to talk specifically about calendarization for 2024. But obviously, this is something that we've known about for quite a long period of time dating back to the pre-spin periods. And we still feel very comfortable and think that an adjusted EBITDA margin of approximately 30% for 2024 is still very reasonable.

And our next question comes from Travis Steed of Bank of America Securities.

I guess the first one, I'll ask on the patch pump. Just curious, have you already started a trial with the patch pump? I know you've said timing, not in 2024. But is there a chance that we could see something in 2025 there? Just any additional color you can provide on that pipeline program.

Yes, Travis. When you ask about the trial, I assume you are referring to the trial for the closed-loop pump. The data from that trial will be submitted to the FDA along with our 510(k) for the closed loop. We have not initiated that trial yet. Currently, our focus is on the open-loop system. As we've mentioned, we want to submit the open-loop 510(k) to the FDA first. We have started a small observational study with Tidepool and initiated development work to integrate the Tidepool algorithm with our system. We are working on our closed-loop system in parallel, but our primary focus remains on obtaining the FDA 510(k) for the open-loop system. Regarding timing, although we have stated no revenue in 2024, we recognize that as 2024 progresses, we will want to provide a multiyear outlook. As part of that, we will discuss our patch pump development throughout 2024. To answer your question directly, the trial we have is an observational study that will provide data to aid in developing the closed-loop system, but it will not be the data submitted to the FDA for the closed-loop 510(k) clearance.

Great. Regarding the follow-up, there has been much discussion about competitive threats from the pharmaceutical side, particularly with once weekly insulin and GLP-1s. So to frame my question, first, are you currently investing in R&D and manufacturing to develop products that could benefit from GLP-1s? Secondly, concerning once weekly insulin, does your overall business mix align with the market, where about half of the patients are using basal-only insulin? How would you assess the impact if patients transition from seven basal injections per week to just one?

Yes, Travis. Regarding GLP-1s, we closely monitor that market. It's too early to predict its long-term impact. We gather all the market data and track prescription trends. Currently, the information is somewhat confusing because there are many prescriptions for obesity as reported in the media. Additionally, the journey from diet and exercise for type 2 diabetes to oral medications, then injectable drugs, and finally insulin is a lengthy process, so it will take time for us to fully comprehend. This primarily pertains to developed markets, mainly in the U.S., while our growth is largely coming from emerging markets. GLP-1s have been available for several years, and our U.S. business has remained relatively stable during that time. We prefer not to speculate on future impacts on our business, but we are monitoring the situation closely. Concerning your question about our efforts to leverage opportunities in the new drug space, I do not want to discuss specific R&D initiatives, but we are paying attention. The way these drugs are administered aligns well with our manufacturing capabilities, such as producing injection molding plastic parts and needles for these delivery devices. Therefore, it's an area of interest for us, but I will refrain from detailing specific expenditures on programs. Regarding once weekly insulin, I view it similarly to other new drugs. There is always the risk of overdosage with weekly insulin. We need to observe its future developments. As for the proportion of our product used for basal insulin compared to multiple daily injections, the market data is unclear. We do not get information at the point of dispensation that indicates whether patients are using our products for daily or weekly injections. Instead of providing vague estimates, I’ll emphasize again that these trends will primarily affect the U.S. Our growth is in emerging markets, and we do not anticipate significant integration of these new drugs, whether they are once weekly insulin or new GLP medications, into emerging markets for some time.

I would now like to turn the conference back to Dev Kurdikar for closing remarks.

Thank you. Before we conclude the call, I would like to express my gratitude to all my colleagues around the world for just the incredibly immense amount of work that they've been doing over the past one and a half years to stand up Embecta as an independent company. That they have been doing so without impacting our customers through what has been a fairly challenging operating environment and in the midst of a spin is a testament to their commitment to fulfilling our mission of developing and providing solutions that make life better for people with diabetes. Thank you all for attending the call. We look forward to speaking with you again in a few months, and thank you for your interest in our business.

This concludes today's conference call. Thank you for participating and you may now disconnect.