Enovis CORP Q3 FY2020 Earnings Call

Ladies and gentlemen, thank you for standing by, and welcome to the Colfax Third Quarter 2020 Earnings Call. Please be advised that today's conference is being recorded. It is now my pleasure to turn the conference over to your speaker today, Mr. Mike Macek. Sir, please go ahead.

Thank you. Good morning, everyone, and thank you for joining us. I'm Mike Macek, Vice President of Finance. Joining me on the call today are Matt Trerotola, President and CEO; and Chris Hix, Executive Vice President and CFO. Our earnings release was issued this morning and is available in the Investors section on our website, colfaxcorp.com. We will be using a slide presentation to walk through today's call, which can also be found on our website. Both the audio and the slide presentation of this call will be archived on the website later today and will be available until the next quarterly earnings call. During this call, we'll be making some forward-looking statements about our beliefs and estimates regarding future events and results. These forward-looking statements are subject to risks and uncertainties, including those set forth in the safe harbor language in today's earnings release and in our filings with the SEC. Actual results might differ materially from any forward-looking statements that we make today. The forward-looking statements speak only as of today, and we do not assume any obligation or intend to update them, except as required by law. With respect to any non-GAAP financial measures made during the call today, accompanying reconciliation information relating to those measures can be found in our earnings press release and today's slide presentation. Now I'd like to turn it over to Matt, who will start on Slide 3.

Thanks, Mike. Good morning, and thanks to everyone for joining the call. I'd like to start by recognizing our associates for their continued dedication to protecting the health and safety of their colleagues while serving our customers and patients around the world. Thank you, team Colfax. Our results this quarter demonstrate that we have worked past the worst of the pandemic effects. We achieved very strong sequential improvements during Q3. Organic sales improved 30% from the second quarter, declining only 3% year-over-year. Both businesses are quickly recovering with lines of sight to regaining our pre-COVID momentum. We again outperformed our competitors, driven by strong commercial execution and growing innovation. I am pleased with our financial results this quarter. We delivered $0.41 per share of adjusted earnings and $49 million of free cash flow. These are strong sequential improvements over Q2, and we expect further strengthening in Q4. We also announced the signing of an acquisition that will strategically broaden our MedTech Reconstructive business. We are regaining our positive momentum with a clear strategy for compounding value creation. Slide 4 updates the pace of recovery in underlying customer demand. All markets strongly improved from Q2 lows this quarter and many returned to growth. Our MedTech business grew 1%, with a little help from nonrecurring PPE sales. Elective surgical procedures in the U.S. are nearly back to pre-COVID levels, and many organized sports activities and other injury drivers have resumed. Clinics in our served markets are operating much closer to pre-COVID levels, increasing demand for nonsurgical products and recreating the pipeline for our reconstructive products. With markets in the range of 90% to 95% recovered, we expect sales per day growth to stabilize at these flattish levels in Q4. The short-term range of outcomes will be influenced by continued positive activity and treatment trends versus reactions to COVID case escalation in some geographies. We believe that our markets should return to healthy growth in 2021 over 2019 demand levels. Our FabTech business rebounded sharply in the quarter, only down 6% versus 25% in the second quarter. Developing regions are mostly back to growth, again, demonstrating the strength of this business' global reach. Our improving trend continued in September and October, giving us a good start to Q4. We are forecasting growth to be on par or better than Q3, depending on the short-term risk from COVID reemergence in Europe and the U.S. elections. This overall positive trending gives us confidence in a return to 2019 demand levels at some point in 2021. MedTech business results are included on Slide 5. Q3 sales increased 2% to $314 million, including a 1% foreign exchange benefit and 2% from personal protective equipment sales that are not expected to repeat. This rapid and substantial rebound from Q2 shows the strength and resilience of our MedTech portfolio. Reconstructive product lines returned to fast growth, 9% above last year as we extended our multiyear record of taking share in surgical. Prevention and Rehabilitation product line sales also recovered strongly off of Q2 lows, declining only 2% year-over-year for the period. This part of the business is more global and impacted by a broader range of factors than just elective surgeries. We expect growth to return to P&R upon the full return to sports and general recreation that drive normal orthopedic clinic activity. The sales rebound in the quarter contributed to a strong improvement in profitability that narrowed the gap to prior year performance. We incurred about $5 million of higher supply chain costs in Q3 to overcome COVID-related challenges and maintain customer service during a period of quickly recovering demand in MedTech. We expect margins to improve a bit sequentially in Q4 and have a clear focus on driving further improvements. We continue to make good progress using CBS to strengthen the P&R supply chain and innovation engine to drive above-market growth and margin improvement in the future. We're also making key supply chain and technology investments to scale our fast-growing surgical business, enabling continued future share gain and productivity. Moving to Slide 6. We signed an agreement this month to acquire the STAR total ankle replacement business and certain finger implants from Stryker Corporation that should close in the fourth quarter. We're excited to complete our first strategic acquisition since acquiring DJO. The DJO team is ready to use our proven CBS toolkit to integrate these product lines. The acquisition complements our fast-growing reconstructive product line with an entry into the $1 billion-plus foot and ankle surgery market that consistently grows mid- to high single digits. The total ankle replacement segment is a strategic entry point, given its high growth, strong gross margins, and importance to the surgeons. The STAR Ankle is a great technology with compelling outcomes data and many loyal surgeons. We are confident that we can apply our proven DJO Surgical playbook to drive above-market organic growth over time. In addition, the fragmentation of the foot and ankle space presents multiple paths for further acquisition-based expansion into this very attractive adjacent market.

Thank you, Matt. We reported $806 million of sales in the quarter, only 3% down organically from the prior year as we get closer to full recovery from the effects of the pandemic on our financial results. Our teams successfully flexed variable and fixed costs to control the gross margin impact from the lower sales to only 80 basis points. We continue to control OpEx and execute our restructuring programs while protecting growth and innovation spending. EBITA margins moved up significantly from Q2 levels and really narrowed the gap to the prior year. Excluding COVID friction costs, we achieved year-over-year decrementals in the low 30s, as expected. The tax rate drifted up in the quarter to recognize profit mix and other effects that are not expected to recur, and we expect the rate to land back in the low 20s in Q4. Overall, we achieved a very healthy $0.41 of adjusted EPS in the third quarter. I am very pleased with the progress we've made on cash flow this year throughout Colfax. Our teams have strengthened processes to reduce seasonality and improve prediction of future cash flows. We achieved $49 million of free cash flow and 86% conversion in the third quarter despite a $15 million net headwind for restoring working capital, as we signaled in our last call. We are clearly getting closer to the type of market and operating conditions that support $250 million or more of annual free cash flow at high conversion levels. Earlier, Matt reviewed current market conditions. And our financial outlook on Slide 10 reflects these improvements. We expect another sequential increase in sales in the fourth quarter of 1.5% to 2.5%. Excluding the 3% to 4% headwind from fewer selling days, we expect year-over-year core sales growth to be similar to or slightly better than third quarter performance. This reflects a year-over-year MedTech change of flat to down 2% and a FabTech change of down 4% to 6%. Interest costs should be in line with third quarter reported results. Adjusted EPS is forecasted to step up from $0.41 in Q3 to $0.45 to $0.50 in Q4 on sequentially higher sales, margin improvement, and a lower tax rate. We expect free cash flow to sequentially increase to at least $80 million. This range of earnings reflects the current risks to the global economy from COVID and U.S. elections. Our improving profitability and cash flow are also shown on Slide 11. Our second half 2020 profit performance should narrow the gap to last year's pre-COVID levels and demonstrate the cash flow potential of our transformed portfolio of businesses. Factoring in the expected cash flow in Q4 and annualizing second half performance shows that we would end the year on a run rate of 3.7x leverage. And this is before the expected additional cash flow and higher EBITDA in 2021 that will drive this metric down even further and create additional capacity to support our strategic growth program. We have a firm financial foundation that strengthens every day.

Wrapping up on Slide 12. The effects of the pandemic are largely behind us. Our teams demonstrated resilience, continuously outperforming competitors despite COVID pressures. We are close to returning to our pre-COVID momentum of growth in sales, profit, and cash flow, and the fourth quarter should show another positive step. We are again active in sourcing, closing, and integrating acquisitions that strengthen our businesses and increase their growth potential. To summarize, we are executing our strategy of continuous improvement and compounding value creation. With that, Brian, let's open up the call for questions.

Your first question comes from Andrew Obin from Bank of America.

So just a question in terms of the impact of COVID on your business model. Can you just talk about the shift from hospitals to ambulatory surgery centers? How much of that are you seeing? And what's the longer-term impact?

Yes. Thanks, Andrew. So obviously, there's been that ongoing trend from hospitals to ambulatory centers. A lot of shoulders have been done outside the hospital already historically, but knee is the product that's been going through that rapid shift. And certainly, in COVID, there's been some acceleration of that shift. That is a way that the hospitals have been protecting to be sure that they continue to do elective surgeries, even as we continue to have infections. And so we've seen that shift. I think for us, we see that ambulatory shift as a positive thing. It's a part of the market that grows faster. We've got products that set up well for that shift. Our knee product is one that does well with more active adults, and that fits well. The kind of patients that are the first ones to be shifted into the ambulatory environment, we provided our Oara risk scoring tool to doctors to enable them to help assess the risks around doing surgery and ambulatory. And we've got relatively simple equipment sets and continue to work on simplifying our instrument sets for that ambulatory environment. So we see that as an opportunity for us. And certainly, we've been able to continue to have knee, which is the product that has grown the least in COVID. The market has grown the least. But within that, we've continued to grow stronger than the market and have healthy growth in our knee product lines.

And just a follow-up question. Is there a difference in terms of sort of ability to postpone different kinds of orthopedic surgery? Is there a difference between shoulders, knees, hips? Do they behave differently? Or it's fairly similar?

Yes, they do. It's interesting. We refer to them as elective surgeries, but I mentioned in the previous call that most of these surgeries are more about deferral than being truly elective. Typically, patients are experiencing a significant amount of pain, prompting them to seek surgery, or their daily activities are being limited to a degree where they strongly desire to return to those activities. So, it essentially comes down to deferrals. We've observed that the hip segment of the market has rebounded the most vigorously, likely because those situations involve the greatest pain and the strongest need for surgery. That's the area that has recovered the most.

Your next question comes from Joe Giordano from Cowen.

So I'm guessing you do not want me to ask about 2021 necessarily, but you guys said that the DJO, the trends support 2021 being above 2019. So if that's the case, and that plays out, would you expect margins to be higher as well on a 12-month basis, different than what you guys reported and based on the stub period, but on a 12-year equivalency?

Yes. So Joe, we have talked about from a growth standpoint. If you look at Q3, where our underlying growth was just in the range of flat to minus 1%. The guide for Q4 being flat to down a couple in terms of daily growth, we feel like that reflects that even as there continue to be some challenges and risks that are very real, there is also progress on the fundamental demand drivers of the business and progress on people being more comfortable going and getting treatments and service. And so we feel like that points to a turnover to growth in 2021 and a kind of healthy year of growth in 2021 versus '19. On the margin front, I will say in our MedTech business, our primary focus on that business is to make sure that we can pick back up with the mid-single-digit core growth that we were starting to demonstrate in that business. Down to stretch the last quarter of last year, the first couple of months of this year, we started to show that mid-single-digit core growth capability of the business that is important to make the business very, very valuable. So that's our first focus on that business. We're also very focused on making sure that we drive margin improvement in that business, certainly back from where we are back to more normalized rates in that business. And where we land on the other side of COVID is a combination of the investments that we've been making in the business in the supply chain and in R&D and growth engines of the business up against the productivity that we've been driving. And we're certainly focused on making sure we could get the margins restored and that we have strong and healthy cash flow in that business. But we're also trying to make sure we do the right things to really solidify that mid-single-digit growth engine.

Fair enough. Yes, I think it was great to see the deal on the ankle portfolio. I think that people were hoping to see stuff like that coming out of the transaction with Stryker. Just curious if any color on the momentum of new talent acquisition in general or as a direct result of the transaction for some people kind of up for grabs, KOLs, salespeople, things like that?

Yes, we are very excited about incorporating the STAR product line. This presents a significant opportunity as it aligns well with our offerings. When we were planning the acquisition of DJO, we identified appealing adjacent markets to expand into, and foot and ankle stood out due to its strong growth potential and solid structure. It was a pleasant surprise to have the Stryker transaction provide us with this opportunity so early in our ownership of DJO at an appealing price. Changes like this bring about new opportunities, and we are dedicated to retaining our key customers while ensuring we have the right channels to effectively serve the foot and ankle market. We will utilize our existing surgical channel for some of this, while also acquiring additional resources. Our goal is to successfully launch this product line and drive robust growth over time.

If I can just sneak one last one in on FabTech real quick. I mean, you guys continue to outperform there, been a nice story. But how are you kind of managing the business now maybe preemptively around some of the Europe headlines around potential shutdowns again?

We are carefully monitoring global developments. Throughout this year in FabTech, we've been cautious about the expected revenue and recovery rates. We've significantly reduced structural costs and have ongoing projects aimed at further cost reductions while also investing to sustain growth. We want to be prepared for various recovery scenarios in FabTech. For a while, it seemed we might be moving towards a positive recovery and potentially see growth in Q4 or Q1. However, due to some slowing progress in the U.S. and ongoing issues in Europe, we are taking a more cautious approach, recognizing it may take several quarters before we see a turnaround. Globally, as new COVID waves emerge, countries are being careful to protect their industrial sectors. For instance, Germany and France have shut down substantial parts of their economies but have kept their industrial sectors operational. This suggests that the constriction we experienced in Q2 is unlikely to happen again, but behavior limitations may still hinder recovery rates, which we've taken into account in our statements.

Your next question comes from Jeff Hammond from KeyBanc.

A couple of questions on MedTech margins. One, just in the quarter, I guess, if you exclude the COVID cost, you're still down year-over-year. Is that mix or investments? And then just talk about the profitability profile of this acquisition?

Yes. So the first is, that business is going to have a little bit of quarterly variations in the margin levels for seasonality factors, whether certain investments are made in certain quarters, et cetera. And so the specific quarterly margin level that we're confident against was probably a little on the high side. You saw our full year number back in '19 was below that. So I think a little bit of tougher comp there. But then as we've talked about, we did have a pretty significant amount of inefficiency just from having to quickly turn that business down and then quickly turn it back up and really keeping our focus on serving customers as a first priority and being willing to take on some of the extra costs to expedite both shipments and do the things that it takes when you're kind of in that kind of a dynamic environment. It certainly took on some extra costs, and we'll still have a little bit of those as we move through the next couple of months here. But we certainly are focused on getting the margins recovered in that business and making good sequential improvements there. As far as the ankle business that we got, the gross margins in that business are very attractive. It's at the upper end of the surgical margins. And so it's an attractive add. And for sure, we'll be working on scaling the fixed cost base of that business. And so it will add some profit out of the gate. But as the business grows, the total profitability will scale up against those very high gross margins.

Okay. Regarding FabTech, it seems that developing markets experienced the strongest performance, while developed markets showed the most significant acceleration. Can you discuss where you are witnessing the best recovery geographically, and also share some insights on the end markets?

Most developing markets experienced growth during the quarter, which aligns with our earlier observations. This trend is evident in regions such as Asia, Russia, and parts of South America. However, India has been slower to recover and remains in a negative position due to strict lockdown measures in Q2, which have hindered its economic restart. Progress is being made in India, and there is a clear commitment from the government to avoid a full lockdown that previously harmed the economy. We expect India to return to growth soon, along with the majority of developing markets. Developed markets have shown significant improvement from Q2 to Q3, but they will take longer to fully recover, especially given current pressures. Nevertheless, we have seen positive developments in these markets and anticipate gradual improvements over time, which will support the overall recovery of the global welding industry. From a segment perspective, infrastructure and construction have rebounded quickly. The automotive market, particularly in the U.S. and Europe, is also beginning to recover, although our exposure is somewhat limited. The oil and gas sector is currently lagging and continues to affect markets in the U.S. and elsewhere, but we expect it to recover eventually, even if it is the slowest to do so.

Your next question comes from Nathan Jones from Stifel.

Just start with a follow-up on Jeff's question on the DJO margins. And specifically on that $5 million of supply chain costs. Can you give us a little more color around what those costs were? I assume those are temporary things that you should be able to get out of the business. What's the timing on being able to eliminate those for the business? Are they gone in the fourth quarter? Or should we expect a bit of a drag still from those supply chain costs?

Yes, Nathan. There are a few different sources for those costs. First, when we quickly reduced our operations, there were certain regions where we couldn't reduce labor due to government restrictions. This led to some additional costs during mid-to-late Q2 that carried over into our Q3 sales, but that part will eventually clear. Second, as we ramped up operations again, we incurred extra costs from things like overtime. Lastly, we've also incurred a significant amount of costs from expediting both inbound and outbound freight and splitting orders to deliver as much as possible to our customers while we manage other delays. These operational costs contribute to the additional expenses this quarter. A significant portion of that should clear up, but some of the expediting-related costs may continue for a couple more months and add extra expenses in the fourth quarter. However, we expect that as we move into next year, these issues should be completely resolved.

When we experience recessions like this, industrial revenue typically shifts permanently to the right. I believe a significant portion of the Prevention and Rehab revenue has shifted permanently in that direction, while the Reconstructive revenue has not. People will eventually get those implants done. Do you think that the third quarter caught up on some of the deferred revenue from the second quarter, or is there still some pent-up demand that needs to be addressed going forward? What are your thoughts on the timing of that?

Yes. You are correct that our Reconstructive business is currently experiencing delays. A significant portion of our Prevention and Rehabilitation business relies on elective surgery, and if those surgeries aren't happening now, they are largely being postponed. While demand seems to have been impacted in some areas of Prevention and Rehabilitation, it's important to understand the overall portfolio dynamics. Most reports indicate that elective surgeries in the U.S. are recovering to about 90% to 95% of pre-COVID levels, and clinics are operating at approximately 80% to 90% of their previous capacity and making improvements. These factors are interconnected. Not long ago, the rate of elective surgeries was reducing the backlog, but clinics were underperforming. As these two factors align, the gap between current surgeries and future ones is narrowing, which we are monitoring closely. Our experience in the third quarter indicates that we left some surgeries deferred but still scheduled, which should help mitigate the impact of clinics not fully functioning and maintain elective surgery levels around 90% to 100% through the fourth quarter. The anticipated growth in our surgical business is linked to us gaining market share in this sector. Looking ahead to next year, we expect clinics to operate at full capacity eventually, allowing us to restore the pipeline. However, there may still be some backlog to address over time, and it is uncertain whether this will be resolved in the next year or extended into the following year.

Great. Just one more quick one on the margins. You did about 18% in 2019, with high incrementals in here. You're talking about some pretty decent growth in '21 over '19 levels. There's some operational improvement that's gone into the business. There's probably some higher investment as well. Is 20% EBITA margins in 2021 beyond the realms of possibility? Or is that a target you have in mind?

Yes. I didn't catch whether you were referring to the MedTech business or the ESAB. I didn't hear the question.

MedTech, MedTech.

Yes. We've discussed the need to return the MedTech business margins to 2019 levels as quickly as possible following the impact of COVID. The EBITA margins in 2019 were approximately 17%, while the EBITDA margins were closer to 20%. As I mentioned earlier, we are committed to sequential improvements in MedTech margins, taking into account the various seasonal factors that may affect different quarters. Our goal is to strike the right balance between making strategic investments in the business and enhancing productivity. This approach will enable us to quickly revive mid-single-digit growth and restore margins to pre-COVID levels, allowing us to continue driving growth and improving margins moving forward.

Your next question comes from Walter Liptak from Seaport.

I wanted to ask about the comment that you made about outperforming the FabTech peers. And I want to get an idea. Do you think it's the geographic mix that helps you guys get that little bit better lower declines in the last couple of quarters? Or do you think there's something with the changes you've made to products or channels that's helping you gain some market share?

Yes. Certainly, we take a look at both of those carefully. Most geographies, we can get a signal on specific share gain, and we also look at the mix. And I think what I'd say is that we've been over time shaping that business, both in terms of the geographies we serve, the segments we serve, the type of business model we have, the innovation that we drive to make sure we've got a very strong and healthy business that can have strong growth relative to industry growth and that also can have strong and consistent margins and cash flow. And I think if you look at not just the last couple of quarters but if you look at the last eight quarters, I think you'll see that the growth performance versus industry has been consistently very strong. And that is a combination of having a healthy footprint to our business in terms of the industries and geographies that we serve and how we're executing our growth model in innovation and channels.

Okay. Great. Was there any difference in the growth rates or the decline rates for equipment versus consumables this quarter?

Yes, there was not a significant difference between equipment and consumables.

Okay. Great. And then the last one for me, just I guess with the CBS that you're doing, I guess, there's probably a lot of opportunities in the MedTech business. And I wonder what your experience is now with doing CBS there. Is it supply chain? Or is it factory work that you can do? How much margin do you think there is?

We have made significant progress with CBS activities in the DJO business. The team has fully embraced the toolkit and the cultural elements of CBS, and we have taken on a leadership role in this initiative. We have already conducted considerable work in the supply chain, primarily focusing on enhancing customer service and establishing a foundation for ongoing productivity improvements. This aligns with what I've observed in other businesses over time. Additionally, we have engaged in substantial CBS efforts within the innovation engine, specifically in the bracing and rehabilitation sector. This area will yield long-term benefits in terms of productivity innovations and growth contributions, which will assist with price adjustments. While this process requires time, we are making good progress and allocating resources to support it, leveraging individuals with experience in this space. Furthermore, there are opportunities for improvement in back-office processes, notably in the reimbursement process. Our initial efforts have aimed at removing barriers to growth within the reimbursement system, facilitating better flow at the front end to avoid hindering the growth of our businesses. We are also establishing a foundation that will enable future productivity gains.

Your next question comes from Joe Ritchie from Goldman Sachs.

Just wanted to kind of make sure we're all level set on 2021 and the recovery in MedTech. So if we assume 2019 had, call it, pro forma revenues of, call it, $1.2 billion, $1.3 billion and the 17% type EBITA margins that you talked about. Should we then assume the comments around 2021 being above 2019 levels that we're looking at, call it, $1.3 billion-plus type revenues and EBITA north of, call it, $210 million in the MedTech business?

Yes, Joe, really not ready to give specific guidance on next year. I think we've got pretty far on this call trying to kind of shape a little how we see the markets recovering and give a sense for how we're working on that. I think what I'll say is on the ESAB side, FabTech side, I think we've been clear that we've been working hard on making sure that we restore the margins and then some by the time we get back to get back to 2019 levels. And on the MedTech side, we're trying to make sure that we're getting back to those margins at the right time based on the investments in the business. And I think that's as far as we're going to go on this call, but certainly, not too far down the path here, we'll be giving much more specific guidance.

Okay. No, that's fair enough. I guess maybe just following on there, though, as we kind of think about the recovery into next year, just based on what you know today, the backlogs on the surgical side, the elective procedure side versus what you're seeing on the bracing side, do you expect at this point to see some type of mix benefit from a margin perspective as we head into next year?

Yes, it's a bit early to make a definitive statement on that. There are many factors at play beyond just the macro conditions. We will be glad to provide more specific comments when we offer our guidance.

Okay. All right. Maybe just kind of shifting gears, one last question on this acquisition that you did. Still a relatively small acquisition and what you guys have kind of defined as a potentially $1 billion-plus type market. And so maybe just discuss a little bit more about what this acquisition gets you into this specific market and what the potential opportunities are for bolt-ons within foot and ankle surgery.

The foot and ankle market is approximately $1 billion and presents various challenges for patients and procedures for doctors. It shows strong growth, favorable reimbursement margins, and significant fragmentation, which provides us with opportunities for acquisition. We are entering this market with a leading product that holds a strong market share and extensive historical data, supported by committed surgeons. This part of the foot and ankle market is strategically important for surgeons due to its financial significance per procedure and its relevance to patients. We view it as a key entry point, allowing us to establish a solid position and expand further into the broader foot and ankle market over time, particularly in areas with similar growth potential, like the TAR. Additionally, the shoulder market is somewhat larger, valued at around a couple billion dollars. Ten years ago, the shoulder market had a similar level of fragmentation and growth potential as the foot and ankle market does now. We have a highly valuable shoulder franchise at DJO that is experiencing strong growth and high margins, and we believe there will be plenty of opportunities to grow our new foot and ankle franchise from this starting point.

Your next question comes from Steve Tusa from JPMorgan.

Can you discuss the current state of valuations in light of the recent M&A activity? How are you modeling the DCFs for the opportunities you’re considering? What multiples are you observing right now? The multiples seem high, but there is a lot of uncertainty, making this a unique time. How are you approaching this issue at a high level?

Yes. Steve, so sure. There was a period of time where it was tough to do acquisitions because there was so much uncertainty. But as things have started to clear, certainly on the MedTech front, as elective surgery has largely recovered and there's kind of more clarity of where we'll probably pick up on the other side of this thing. I think you've seen certainly more deals being done. I think as we look at acquisition opportunities, certainly on the MedTech side, we see a range of opportunities from things that are more straight up bolt-ons of product lines or channels that we can see opportunity to do them at attractive multiples with kind of faster return pass. And then we see adjacency kind of opportunities like the STAR Ankle. The STAR we got for a very attractive price, given the backdrop of Stryker needing to sell it. But then we see other ones that are adjacencies where we might have to pay a higher multiple, but they're really going to contribute to organic growth in a significant way and strategically strengthen the business and for the longer path to returns. And so there's a range of opportunities. We've got a very full pipeline. We continue to keep focused on our 10% return threshold. But we appropriately flex that. Sometimes we're expecting it a lot sooner. And sometimes, we're willing to take the full five years to get to that threshold based on the strategic importance of what we're adding. I got to say I'm really encouraged by the amount of opportunities that we've got in the pipeline. I'm excited about the STAR Ankle. I think it creates a great growth vector for us that we'll be able to build out over time.

Your next question comes from Julian Mitchell from Barclays.

This is Trish on for Julian. So just maybe one more question on MedTech margins. I know you mentioned that there's some seasonality there and maybe some supply chain costs are still there, but you expect sequential improvement. These margins were down around 1,000 basis points in Q2 and 250 basis points in Q3. Is it possible to get back to flattish in Q4? Or should we still expect them to be down year-over-year? And then just one on the acquisition. I think you mentioned high gross margins when we consider kind of selling costs and everything else. Are the operating margins similar to MedTech?

Yes. So first, Q4 has got less days than last year, which is going to be kind of a meaningful effect on the margins. And it's also got some of these costs that we talked about will continue on. And so we're definitely more focused on sequential improvement in Q4 and then being able to roll over and drive to a good healthy 2019 or 2021 overall margin. And I think certainly, Q4 margins likely will be lower than last year for the reason we've talked about here on the call in MedTech. And then as far as the acquisition, we see this acquisition and the broader foot and ankle opportunity over time as having the opportunity to have the same or stronger margins over time as the rest of our MedTech business. And certainly, on an incremental basis, as we can scale a position in that space, it can be accretive to overall MedTech margins. So the gross margins are attractive. And whether it's accretive or not, it's just how much you invest for growth versus when do you take more margin decision.

Got it. That's very helpful. And then just maybe one more from me on free cash flow. You guys mentioned you're on track for $250 million kind of if we annualize the second half. I think the first half tends to be seasonally weaker in terms of free cash flow for you guys. So has anything changed in terms of what you're expecting for seasonality of free cash flow? And should we not be expecting a big working capital headwind next year as sales recover? And then just one final point. Last year, you talked to kind of the $185 million adjusted base free cash flow. That implies kind of flattish with your guide for this year. But in the slides, it looks like we're comparing to GAAP for that second half number. Kind of what's the right base we should be comparing this year's free cash flow with?

That's a lot of questions. Let me try to address that. The main point we want to highlight is the significant efforts we've made this year across all teams to enhance predictability and slightly reduce the seasonality of our cash flow. This means that while we expect cash flow in the second half of next year to be higher than in the first half, we don't anticipate as sharp of an increase. This improvement is an important aspect to note. Our second half performance this year strongly suggests the potential for next year, and I believe it provides a clear indication that we can return to the high conversion rate we previously expected in terms of cash flow generation. We have presented our current year cash flow clearly, allowing people to understand it, including the impact of COVID. Until mid-March, we were confident we could reach $250 million or more in 2020, but we had to manage the pandemic's effects. The good news from the second half, despite having a Q3 marked by working capital building, is that we've clearly shown we are back on track to generate significant cash flow for the upcoming year.

Your next question comes from Chris Snyder from UBS.

So just following up on a previous conversation around 2020 MedTech guidance. The Q4 outlook seems to suggest that the deferred backlog built up in Q2 is being worked through this year. And then so when we look out to 2021, mobility on the margin should be depressed versus 2019, at least, early in the year. So what are you guys seeing that gives you confidence around healthy growth next year over 2019 levels?

Yes, Chris, I believe there is a range of potential outcomes by business segment. When we delve into the specifics, I would highlight that in the surgical area, there are still opportunities for recovery next year, which may lead to stronger performance in the Reconstructive segment compared to the part of the P&R business that isn’t surgery-related. There are some activity limitations expected that could impact whether we achieve a full year of growth. However, the P&R segment consists of both surgically driven factors and other activity-related drivers. Overall, the outlook suggests that 2021 has strong potential to reflect a healthy year of growth compared to 2019.

I appreciate the clarification. I understand the balance between Reconstructive and P&R. Should we consider that part of the business as having a split of around 30:70 between mobility-driven injuries and general wear and tear, which is less affected by mobility? Is that an appropriate assessment for the entire...

Yes, the 30% of Reconstructive cases is mainly driven by surgical needs, primarily due to disease. It's important to note that while we can address the backlog of scheduled surgeries, there are still patients who cancel their procedures but still require them, which will affect us next year and beyond regarding elective surgeries. The Reconstructive segment is entirely surgically driven. In the P&R section, a significant part is also surgically driven, whether it involves implant surgeries or sports medicine surgeries. Some of these sports injuries were present before COVID, while others have arisen during the pandemic. Additionally, a part of P&R is related to workplace injuries. As industrial and construction workplaces resume, we will see a recovery in that area. Moreover, sports participation, including organized sports, has faced restrictions, but recreational activity has increased, especially among those who have been more active. Thus, while the surgical backlog will be addressed, it's essential to remember that there are deferred procedures that will add back to the backlog, alongside activity-based factors driven by mobility and the return to work.

Your next question comes from Nicole DeBlase from Deutsche Bank.

So I just want to ask a little bit about FabTech decremental margins. Obviously, have been really, really strong for the past two quarters in the low 20s. I mean when we think about what's embedded in fourth quarter outlook, is the expectation that you guys can kind of stay in that low 20s range in that segment? Just trying to think about the impacts of temporary costs come back, all of the moving pieces into next quarter.

Sure. Yes, Nicole, the team has done a great job of managing the cost in the downturn. As you note, the decrementals. And it really comes from two factors: Number one is some of the temporary cost actions that were taken that we continue to manage and work. And then as the business improves, some of those will come back into the business and have already started to come back into the business. The second is the restructuring activities that are well underway in the business that were planned for the year, and some of those actions may have been accelerated a little bit as COVID came to bear earlier in the year. So we have both of those at play, and both of those should come together to produce some pretty respectable decrementals again. But I think we should set expectations that, as COVID continues to abate, we continue to have growth in certain regions. We have easing declines in other regions that those decrementals should, in fact, start to climb a little bit. That's natural and healthy business, and we would expect to see that.

Okay. Got it. Understood. That makes sense. And then secondly, I'm not sure if you're willing to comment on this, but you did talk about encouraging signs of improvement in September and October. I'm focusing on the welding business. I mean can you give us a sense of the exit rate in FabTech in September and October, just to give us a sense of how 4Q is shaping up initially?

Yes. Not going to get specific on that, but more than what we said, which is that we did see those two months better than the previous and we've certainly factored that into how we've thought about and are talking about the fourth quarter. But at the same time, we've seen some of these risks that people have asked about on the call, like some of the European resurgences and things that. And so we've tried to combine what we've seen in the first couple of months with the best understanding and thinking we have about how the next few would play out and give guidance based on that.

There's no further question at this time. I'd like to turn the call over back to Mike.

Great. Thank you, everyone, for joining our call today. And look forward to talking to you going forward. With that, we'll end our call.

Thanks, everybody.

Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.