Earnings Call Transcript - EMBC Q1 2023

Operator, Operator

Welcome, ladies and gentlemen to the Fiscal First 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.

Pravesh Khandelwal, Vice President of Investor Relations

Thank you, operator. Good morning, everyone and welcome to Embecta’s fiscal first 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 Chief Executive Officer; and Jake Elguicze, our Chief Financial Officer. Before we begin, I’d 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. Starting on Slide 3, our agenda for today’s call is as follows. Dev will begin by providing an overview of Embecta, our strategic priorities for 2023, and some remarks on the overall performance of our business during the first quarter. Jake will then provide a more in-depth review of first quarter financial results as well as our updated financial guidance for the year. We will then open the call for questions. With that said, I would now like to turn over the call to our CEO, Dev Kurdikar. Dev?

Dev Kurdikar, CEO

Good morning, everyone and thank you for joining us today. A life with diabetes doesn’t have to come with limitations. And at Embecta, our mission is to develop and provide solutions that make life better for people living with diabetes. At every stage of the diabetes journey, we are there by a person’s side because we believe that no one should have to live with diabetes alone. We are driven by a sense of urgency to advance what’s next in diabetes, and for nearly 100 years, we have been accelerating the journey to better diabetes care. Whether you are newly diagnosed or transitioning to a new line of therapy, we are working to make a person’s everyday experience as comfortable and convenient as possible, while also advancing a new generation of solutions. During 2023, our strategic priorities are centered around three pillars. First, we will focus on continuing to strengthen our base business while maintaining our global leadership position in the category of insulin injection devices. Examples of this are our inclusion on the Express Scripts National Preferred Formulary as well as recent pen, needle and insulin syringe contract wins from the U.S. Department of Veterans Affairs. Second, as a recently spun-off new public company, 2023 is a critical year for Embecta to establish our own systems, processes, and procedures so that we can achieve a timely separation from BD. During the first quarter, we continued to make progress in this area, as evidenced by the exit of several transition service agreements. And finally, we also have our eye on the future and we intend to continue investing in R&D, most notably around a patch pump that has been developed for the type 2 market. In addition, we are continuing to evaluate suitable M&A and partnership opportunities to add market-appropriate products to our portfolio. We have been energized about our long-term prospects as we work towards creating the preeminent diabetes-focused company in the world. Turning to our performance during the first quarter of 2023, during Q1, we delivered strong commercial performance despite a challenging macro operating environment as we generated revenues of $275.7 million. This represented a decline of 4.7% on an as-reported basis but an increase of 0.7% on a constant currency basis. Our Q1 revenue was better than we initially expected as we exceeded our constant currency revenue expectations for both the U.S. and international markets. Foreign currency, while a headwind during the quarter, was modestly better than we had originally thought. And while Jake will go through this in more detail in a few minutes, like revenue, our adjusted gross, adjusted operating and adjusted EBITDA margins for the first quarter also exceeded our expectations as we generated adjusted gross margin of 68.5%, adjusted operating margin of 36.9% and adjusted EBITDA margin of 40%. This solid operating performance translated into adjusted diluted earnings per share during the first quarter of 2023 of $0.96. In addition to getting off on the right track from a financial perspective, during the first quarter, we also took steps to strengthen our base business, including holding over 50 scientific and educational events, which reached over 2,000 healthcare professionals. I am also pleased to say that effective January 1, Embecta’s pen needles and insulin syringes are the exclusive preferred products on the Express Scripts National Preferred Formulary. By working together to achieve widespread formulary access, Embecta and its partners continue to reduce barriers for patients and prescribers in the markets it serves. We also recently won national contracts for both pen needles and insulin syringes from the U.S. Department of Veterans Affairs for a 5-year term. These awards not only demonstrate our commitment to the singular focus of improving the lives of people who are living with diabetes but also ensure that our nation’s veterans have access to the highest quality products. Moving to separation and stand-up activities, we continue to make progress on that front as well as we exited several transition service agreements and continued to build up our own internal organization, systems and processes. From an invest for growth perspective, our commercial teams began to execute on the strategic partnerships we announced a few months ago and we continue to progress the development of our insulin patch pump. Finally, based on our strong first quarter results, we are raising our financial guidance ranges for as-reported and constant currency revenues, adjusted gross, adjusted operating and adjusted EBITDA margins as well as adjusted diluted earnings per share.

Jake Elguicze, CFO

Thank you, Dev and good morning everyone. Before I discuss the financial results for the 3-month period ending December 31, 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 standalone public company. Therefore, the financial results for the 3-month period ending December 31, 2022 and December 31, 2021 are not meaningfully comparable. Turning to Embecta’s financial performance for the first quarter. Given the discussion that has already occurred regarding revenue, I will start with the gross profit line. GAAP gross profit and margin for the first quarter of fiscal 2023 totaled $188.8 million and 68.5% respectively. This compares to $203.9 million and 70.5% in the prior year period. The year-over-year decline in GAAP gross profit and margin was expected and primarily driven by the negative impact of inflation, the impact of low-margin contract manufacturing revenue that was not in the prior year period, and incremental standup and separation costs, including the markup on the purchase of Cannula from BD. While on an adjusted basis gross margin for the first quarter of 2023 was also 68.5%. The adjusted gross margin performance during the first quarter was better than we initially expected, primarily due to the mix of additional revenue that we generated during the quarter. Finally, concerning gross margin, during the first quarter of 2023, both our GAAP and adjusted gross margins benefited from the revaluation of our inventory to our new 2023 standard costs, which occurs once a year as well as from positive absorption as we manufactured additional product in advance of our planned temporary suspension of our facility in Suzhou, China later this year. While these items were taken into consideration when we provided our initial guidance, I point them out because as we move forward during the remainder of 2023, we do not anticipate the same level of positive impact to our gross margins. And as such, we currently expect our adjusted gross margins to trend downward in succeeding quarters. Turning to operating income and margin. During the first quarter, GAAP operating income and margin was $88.8 million and 32.2% respectively. This compared to operating income and margin of $116.6 million and 40.3% 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 and margin drivers that I just mentioned as well as an increase in operating expenses associated with separating Embecta and becoming a standalone publicly traded company. On an adjusted basis, during the first quarter of 2023, operating income and margin was $101.6 million and 36.9% respectively. This adjusted operating income and margin performance was significantly better than we initially expected in part due to the revenue timing benefit that positively impacted our adjusted gross margin as well as lower operating expenses in the quarter versus expectations, which we believe is also largely timing-related. This operating expense timing benefit was primarily due to lower separation and standup costs, the phasing of hiring and certain project spending. As we move forward during the remainder of fiscal 2023, we anticipate that this spending will occur, and as such, we currently expect our adjusted operating margins to trend downward in succeeding quarters. Turning to the bottom line. GAAP net income and diluted earnings per share was $35.2 million and $0.61 during the first quarter of fiscal 2023. This compared to $98.8 million or $1.73 in the prior year period. As I mentioned at the outset, because our financials for pre-spin periods were done on a carve-out accounting basis, the comparisons of pre-spin to post-spin periods are not meaningfully comparable. One example of this is interest expense, which burdened our P&L in the current year but was zero in the prior year period. While on an adjusted basis, net income and earnings per share was $55.4 million and $0.96 during the first quarter of fiscal 2023. Lastly, from a P&L perspective, for the first quarter of 2023, our adjusted EBITDA and margin totaled approximately $110.2 million and 40%. This compares to $138.3 million and 47.8% in the prior year period. Like our adjusted operating margin, due to the revenue and gross margin overachievement in the quarter, coupled with the timing benefit from lower operating expense spending, our adjusted EBITDA margin during the first quarter also significantly exceeded our original expectations. Finally, with respect to our balance sheet and financial condition at quarter end, as of December 31, 2022, we held approximately $385 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 2.9x. That completes my prepared remarks as it relates to Embecta’s financial results for the first quarter of fiscal 2023. Next, I’d like to discuss Embecta’s updated 2023 financial guidance and certain underlying assumptions.

Dev Kurdikar, CEO

Thank you, Jake. Our strong performance in the first quarter allows us to raise our guidance for full year 2023. We are increasing our guidance for as-reported and constant currency revenues, adjusted gross, adjusted operating, and adjusted EBITDA margins, as well as adjusted diluted earnings per share. We are pleased with the momentum we are seeing in both the U.S. and international markets and remain committed to executing our strategic priorities. This includes enhancing our base business, achieving a successful separation, and investing for growth. I will now turn the call back to the operator for the question and answer session.

Operator, Operator

And our first question comes from Cecilia Furlong with Morgan Stanley. Your line is open.

Cecilia Furlong, Analyst

Good morning, and thank you for taking the questions. I wanted to start on the gross margin performance in the quarter just well ahead of our expectations. But if you could walk through just the bridge 4Q to 1Q, you talked about some of the China plant manufacturing closure, that impact – if you could speak to that geographic sales mix, other drivers that really supported the sequential step up? And then how we should be thinking about gross margin beyond fiscal ’23 kind of towards your 62% or so longer-range plan?

Jake Elguicze, CFO

Yes. So thanks, Cecilia. Thanks for the question. Let me begin by saying that as we provided our initial financial guidance for fiscal 2023, we always anticipated that our adjusted gross or adjusted operating and our adjusted EBITDA margin profile would be strongest during the first quarter of the year. The 400 basis point sequential improvement in adjusted gross margin from the fourth quarter - from our fiscal fourth quarter of 2022 to the first quarter, it’s primarily due to two things: First, during fiscal year 2022, we saw really an unprecedented increase in the cost of raw materials, labor and overhead. And as we move into fiscal year 2023, we need to revalue the inventory that existed on our balance sheet to our new standard cost for 2023, which include the impact of those higher raw material labor and overhead costs. This is something that occurs once a year, at the beginning of every new fiscal year, and it essentially resulted in Embecta needing to increase the value of the inventory that was on our balance sheet, with the offset being a credit to the income statement. So as such, the revaluation of that inventory drove a sequential gross margin benefit of approximately 300 basis points from the fourth quarter of fiscal ’22 to the first quarter of fiscal ’23. Now since that inventory is now on our balance sheet at a higher cost, as we move forward into future quarters and then sell that inventory into the channel, we should then actually see a decline in our adjusted gross margins moving forward because now that inventory is valued at a higher cost. So the inventory revaluation is something that called the benefit from the fourth quarter of ’22 to the first quarter of ’21 but will then cause adjusted gross margin to go down from the first quarter of ’23 through the remainder of the year. In addition to the impact that we saw from, I would say, revaluing the inventory, we also saw a sequential benefit stemming from favorable absorption. And that’s because we continue to manufacture inventory to service our business in China ahead of the temporary shutdown at that facility, which we would anticipate occurring later this fiscal year. So we built additional inventory as safety stock during the first quarter, and that led to about a 100-basis-point sequential improvement in gross margin from the fourth quarter to the first quarter. And again, like the positive impact that we saw in Q1 related to the inventory revaluation, as we move forward during the remainder of fiscal ’23, we’re not going to be manufacturing or do not anticipate to be manufacturing the same levels or amounts of inventory. And eventually, we may incur negative variances in the second half of 2023 as we temporarily shut down production in our facility in China. So we would expect adjusted gross margin to go down from the first quarter through the remainder of the year because of this as well. So all that said, our adjusted gross margin performance in Q1 did exceed our expectations. And because of that as well as the raw material – as well as just an expectation that raw material costs for quarters two through four are actually trending better than we initially anticipated, we’re increasing our full year guidance range from the original guidance, which called for approximately 62% adjusted gross margin to a new range of 63.5%.

Cecilia Furlong, Analyst

It is. And just also how you’re thinking about the long-term outlook kind of tied in with your LRP that you previously provided?

Jake Elguicze, CFO

Yes. So maybe I’ll start again by saying I think that we had very strong margins throughout the P&L during the first quarter, again, exceeding our initial expectations. Part of that Q1 overperformance is something that we anticipate remaining for all of 2023, hence the raise of about 150 basis points compared to our initial expectations. However, part of that margin performance in Q1 is something that we do attribute to timing. And because of that, we expect that timing benefit to reverse itself during the remainder of 2023. So let me just try and address that throughout the different line items of the P&L. So from a gross margin standpoint, I would tell you that we would expect our adjusted gross margins to first trend into the mid-60s during the second quarter of this fiscal year really for two reasons. First, we don’t anticipate that same level of distributor purchasing that positively impacted our U.S. revenues during the first quarter, and, as a result, we may see some decline sequentially from Q1 to Q2 gross margin. And then second, during Q2, we anticipate that we will begin to see that negative impact roll through our gross margin from the revaluation of our inventory at those higher costs. Now as we move throughout the second half of 2023, we would expect to see that our adjusted gross margins could actually trend into the low 60s as we currently expect to see the negative impact of the higher cost inventory continue to impact us. And we also then would anticipate seeing a potential negative impact from no longer manufacturing at the same levels in our facility in China and not generating those same positive impacts from absorption. So that’s sort of the thoughts on kind of gross margins trending to the mid-60s for Q2 and then trending into the low 60s for the second half of the year. Now, turning to operating margin, I would say we expect them to trend to the mid-20s beginning in the second quarter and then sort of remaining at that level for the remainder of the year. And part of that sequential decline in adjusted operating margin is because of the gross margin drivers that I just mentioned. But we also do, right now, anticipate seeing a sequential increase in both R&D and SG&A as we move forward through the year.

Marie Thibault, Analyst

Good morning Dev. Good morning Jake. Congrats on a great quarter here. I wanted to start here with a question here on the constant currency revenue growth guidance. If I look at what you did this quarter, this fiscal first quarter, constant currency revenue growth was actually about 0.7%. And when I look at what you are guiding for this year, it looks like the top end of your new range is 0.5%, just a little below what you already accomplished in Q1. So, curious how you arrived at that guidance? I know you have given us some details on the various markets, but just curious why not go a little bit higher?

Jake Elguicze, CFO

Yes. Thanks for the question, Marie. So, I am really pleased to say that we got off to a really strong start in the first quarter. Quite frankly, we exceeded our internal estimates, I would say, by approximately $14 million on an as-reported basis. Now, about $2 million of that was due to the positive impact from FX as compared to what we had originally expected it to be. But on a constant currency basis, we exceeded, I would say, our internal estimates by almost $12 million. Now, about $6 million of that additional constant currency revenue beat was driven by the strength within our international business that Dev just mentioned. This was very broad-based, covered several countries, and it’s something that we expect will remain for the entirety of fiscal year 2023, hence we increased both the low and high ends of our constant currency revenue range by about 50 basis points. Now, the other $6 million of, I would say, overachievement in comparison to our initial expectations that occurred in the quarter was really largely due to the timing of distributor orders and it positively impacted our U.S. business. And that occurred, I would say, very late in the month of December. And it’s something that could happen from time-to-time. However, during the course of an entire year, it does tend to even itself out. And as we look forward, really beginning as early as the second quarter of the year, we would anticipate that positive benefit that we saw in the first quarter from those distributor orders to reverse itself. And we have taken that into consideration when we updated our guidance range.

Dev Kurdikar, CEO

Yes, sure, Cecilia. So, several parts of this question here, right. So overall, international performance was strong, right. I mean it was, we saw a favorable price and volume in several markets. In China, in particular, our performance by our team in China has been quite resilient because you remember, through the calendar year of 2022, fourth quarter calendar year 2022, there was a rise in spikes. So, we certainly had a rise in infections as well, but our team has managed through it. What we see in China certainly is that the situation is certainly improving as we went from zero COVID to now open. And like I said, our team has fought through those infections that occurred. Our outlook on China obviously, remains uncertain. It all depends upon the path that COVID takes and the resulting government policies that are put into place.

Marie Thibault, Analyst

Okay. Thank you for taking the questions.

Dev Kurdikar, CEO

Thanks, Cecilia.

Operator, Operator

And our next question comes from Marie Thibault with BTIG. Your line is open.

Marie Thibault, Analyst

I guess last question here. I did want to – it sounded to me like you were confirming that your pre-spend fiscal '24 outlook hasn’t changed. I believe that was low-60s gross margin, about 30% adjusted EBITDA margin. But I did want to just confirm that there is no change to that outlook. And then if there is any way that you can start to help us think about fiscal ’25, kind of after this transition is completed, how we should be thinking about Embecta as a standalone company at that point? Thank you for taking the question.

Dev Kurdikar, CEO

Marie, with respect to ’24, nothing that we have seen so far would say we should change our outlook on 2024. But obviously, we will give more formal guidance when ’23 is done. And just given the number of activities we still have to complete as we exit the TSAs and the implementations we have talked about, I want to refrain from talking about 2025. We are focused on getting and executing all these separation-related activities and getting FY ’23 done before we start talking about FY ’25.

Operator, Operator

And our next question comes from Travis Steed with Bank of America. Your line is open.

Travis Steed, Analyst

Hey guys. Thanks for taking the question. I did want to follow-up a little bit. I think we talked a lot about margins and EBITDA margins and stuff already, but the guidance does imply a pretty big step down sequentially from Q1. And I am not sure you did some explanations for that, but anything else to call out on the EBITDA margin, operating margin side, what’s built in from a macro standpoint, currency inflation? And just looking at the earnings side, like you raised the guidance by $0.40 at the midpoint, but given FX has gotten a little bit better, I am just curious why there wasn’t a little bit more of a tailwind on the EPS side with FX rates?

Jake Elguicze, CFO

Yes. Travis, so I will try and take that and Dev feel free to jump in. So, I think largely, our thoughts on margin, obviously, we got off to a really good start. Quite frankly, we expected the first quarter of the year margins to be strongest. That said, we did do a little bit better in terms of our adjusted gross margins, largely because of the additional revenue and the mix of that revenue. And then from an adjusted operating margin and then flow through to EBITDA margins, even more significant over-performance largely because of the timing benefit as it relates to certain OpEx spending related to separation and standup costs. Now, as we move forward during the remaining quarters of the year, we would expect those gross margins to kind of trend from sort of the upper-60s, first going into kind of the mid-60s in Q2, primarily because of the fact that we would expect to see some of that distributor order benefit that positively impacted our revenue in the first quarter to reverse itself in the second quarter. That tends to be, in the U.S., at a higher gross margin area. And then, second, we are not going to get that same positive impact, if you will, from the revaluation of our inventory.

Dev Kurdikar, CEO

Yes. Tavis, good morning, this is Dev. I will take that. Obviously, we follow all the public announcements in the pump space. And I really don’t want to comment on competitor moves on acquisition of patent products. Let me just say that our patent product program is progressing as we would expect in line with our internal expectations, nothing new to share. I would say that certainly, from our own perspective of what that product can do for us in the market, I mean nothing has changed vis-à-vis our outlook on our product in light of all the announcements that have taken place in the marketplace. Nothing new to share with respect to milestones. As I have said in the past, when we have a meaningful milestone, Travis, we will share it for now. We are just focused on keeping our heads down and getting the work done.

Pravesh Khandelwal, Vice President of Investor Relations

Thank you, operator, and thank you everyone that joined us on the call today. This concludes Embecta’s first quarter 2023 earnings conference call. Have a nice day.

Operator, Operator

This does conclude the program. You may now disconnect. Everyone, have a great day.