Enovis CORP Q4 FY2022 Earnings Call

Good morning, everyone, and thank you for joining us today for our fourth quarter and full year 2022 results conference call. I'm Derek Leckow, and joining me today on the call are Matt Trerotola, Chief Executive Officer; and Ben Berry, Chief Financial Officer. Our earnings release was issued earlier this morning and is available in the Investors section of our website, enovis.com. We'll be using a slide presentation on today's call, which can also be found on our website. Both the audio and the slide presentation of the call will be archived on the website later today. 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 may 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 referenced during the call today, the accompanying reconciliation information related to those measures can be found in our earnings press release and in the appendix of today's slide presentation. With that, let me turn the call over to Matt, who will begin on Slide 3.

Thanks, Derek. 2022 was a year of significant progress toward our longer-term strategic goals, and I'm excited about the future of our focused MedTech growth company. We successfully launched Enovis with a talented global team, our proven EGX business system driving continuous improvement, a healthy innovation engine, and a strong capital structure to support our growth. We completed the year with total revenue growth of 10%, which included 6% organic growth. Enovis is well on its way toward sustainable high single-digit organic growth. We made great progress in 2022 despite the choppiness related to macro challenges and the residual effects of COVID. We had double-digit organic growth in Recon and over 3% organic growth in P&R fueled by investments we've been making in our innovation engine. Our talented team continues to develop exciting new technologies and solutions that improve patient outcomes and satisfaction around the world. In P&R, we're reshaping the business for sustained mid-single-digit organic growth. In 2022, we once again outgrew our markets. We've improved innovation vitality in this business from close to 0 in 2018 to double digits as we exit 2022, and we have a strong pipeline for 2023 and beyond. In Recon, we made significant progress expanding this high-growth and high-margin platform. We delivered double-digit growth, continued to win in the ASC and expanded globally through Mathys. We made good progress on margins in 2022, improving our EBITDA margins by 70 basis points despite headwinds from FX and inflation. Our gross margin improvement shows the power of our mix-enriching strategy and EGX traction driving operational and pricing improvements. We delivered $25 million in fixed cost reductions, which is more than originally expected, making room to invest in our growth and absorb wage inflation. We accelerated our growth through our M&A strategy, enhancing our innovation capabilities and expanding geographically. Our acquisitions from the past few years grew double digits and have started to scale. In 2022, we added Arvis surgical navigation and also deepened our presence in the attractive Australian market with 360 Med Care. We exit the year with a healthy pipeline of acquisition opportunities and a strong balance sheet. Our fourth quarter organic growth was 5%, fueled by double-digit growth in Recon, once again, well above market levels. We had low single-digit growth in P&R, which was impacted by some temporary market softness. We're seeing a return toward more normal P&R growth rates so far in the first quarter. We expanded adjusted EBITDA margins almost 300 basis points in the quarter and are starting to see inflation and currency stabilize. You can see the power of our model with mix improvement and operating leverage clearly displayed in this higher volume period. We are continuing to build momentum with EGX, and we drove improvements in safety, service levels, and productivity. We made significant progress on our supply chain initiatives and invested in some extra inventory, which helped us to achieve a multi-year low past due level at P&R. We grew our Recon business 14% organically, and that growth was broad-based with U.S. hips and knees up 14% and extremities up 13%, led by our powerful shoulder franchise. Innovation momentum continues to build. There is very high interest in our Arvis enabling technology, and we're excited about the launch of the EMPOWR Revision Knee, which opens up a whole new market category for us. And in foot and ankle, we started a new phase of growth for the STAR Ankle with FDA clearance of our patient-specific instrumentation to improve surgical efficiency. We made great progress on our geographic expansion strategy with Mathys business up 16%, and I look forward to the opportunity ahead as we continue driving some of our strongest and high-gross-margin U.S. products into the Mathys channel. I'm excited about the progress we've made, reshaping our P&R business to set it up for sustainable mid-single-digit organic growth. Organic growth in the quarter was lower than the rest of the year as we experienced some temporary market softness that carried over from elective surgery slowdowns in the third quarter. But even with this finish, we had 3.5% full-year sales per day growth and share gain across most markets and products. Our bracing business grew over 4% in the year and is now reestablished as a strong global leader with great customer service and a healthy pipeline of additional new products coming. Before I turn it over to Ben to take you through our Q4 financial results and outlook for 2023, I want to say that I'm so proud of our talented team. I want to thank our teammates around the world for their hard work and many contributions this year as we continue to build a high-value MedTech growth company.

Thanks, Matt. I'll start my prepared remarks on Slide 7. We had a strong operating quarter in Q4, which was highlighted by our double-digit Recon growth and 290 basis points of margin expansion. Gross margins grew 190 basis points versus the prior year, reflecting our faster-growing and higher-margin Recon segment. As mentioned in our Q3 call, our supply chain stabilized in the back half of the year, and we were able to largely offset persistent inflation pressure. Our Q4 EBITDA margins of 18.3% are a result of our strong operating performance, productivity, and cost management. We also benefited from roughly 50 basis points of favorable expenses from lower-than-anticipated medical benefit charges. Normalizing from onetime tax benefits in 2021, our strong Q4 operating performance resulted in greater than 20% underlying EPS growth. For the full year, we expanded gross margins by 90 basis points, driven by strategically tilting our business mix to Recon, leveraging our EGX capabilities and making progress on the price cost equation in our P&R business. As Matt commented earlier, we increased our EBITDA margins by 70 basis points. We continue to invest for growth, and our $25 million of cost actions mostly offset headwinds from inflation, negative foreign currency, and acquisitions. We delivered double-digit EBITDA and EPS growth in a challenging market environment, and I'm extremely proud of the way our team battled and put us in a strong position entering 2023. Slide 8 details our quarterly progression in 2022. Our 6% sales per day growth was highlighted by 12% growth in our Recon segment with notably strong performance in the second half of the year. While overall Recon markets grew a little better than pre-COVID levels, cancellations, staffing pressure, and other market disruptions were obstacles throughout the course of the year. In Prevention & Recovery, overall market demand began to turn the corner versus pre-COVID levels. As Matt mentioned, we experienced a temporary slowdown in Q4 with lower-than-normal clinic volumes. Our strong business segments demonstrated resiliency during the course of 2022, and we continue to outpace our competition in both segments. Our EBITDA margins increased sequentially throughout 2022 as we improved mix and reduced the net inflation impacts as the year progressed. Our core margin improvement of 160 basis points was offset by impacts from recent acquisitions that carry initial less than company average margins. However, they are expected to continue to scale from rapid growth in the coming years. We also had about 20 basis points of negative currency pressure that impacted us primarily in the back half of the year. Overall, we are pleased with our results, and we continue to execute against our strategic goals. Turning to Slide 9. In 2023, we are projecting another year of strong operating performance, including 5% to 6% organic growth. We expect another double-digit growth year in Recon in a normalized market environment and moderate improvements in global P&R markets. We are expecting at least 50 basis points of margin improvement resulting in an estimated $255 million to $265 million of adjusted EBITDA. Quarterly phasing of margins is expected to be similar to the progression we saw in 2022, with Q1 organic growth rates consistent with full year guidance, offset by 1 to 2 points of negative currency impact. We anticipate that this currency impact, along with investments in critical industry meetings and events will result in modest margin improvement in Q1 versus the prior year. Depreciation is estimated to be roughly $85 million, driven by growth investments in our Recon segment. We expect interest to remain similar to our second-half 2022 run rate with slight increases from higher interest rates, resulting in approximately $23 million of interest expense in 2023. While 2022 included onetime tax benefits from the separation, we expect our effective tax rate in 2023 to settle into a more sustainable rate of around 20%. We are forecasting our adjusted earnings per share to be $2.15 to $2.30. Adjusting for the year-over-year impacts from tax and interest, this results in 6% to 10% of operational EPS growth. To summarize, on Slide 10, we have a strong first year as a MedTech growth company. We have created a company with a clear strategy and the building blocks for sustainable market outperformance in both growth and margins. Our business system continues to create value as demonstrated in 2022, and we have an exciting pipeline of M&A targets and ample capacity to execute.

Just two for me. So one, on your guidance, your EPS guidance was below Street expectations. Can you maybe talk about some of the headwinds that you're facing besides the tax rate and any puts and takes we should be considering for the coming year?

Yes, Vik. I'll take that one. As we looked at it, I think one of the things that we wanted to make sure that we were clear about were some of the building block components because as we looked at the Street estimates and the consensus, there were variations in terms of what was being modeled for depreciation, interest primarily, which is why we wanted to be more prescriptive about how those are playing into 2023. But overall, from an underlying EPS perspective, we are pretty much in line with where consensus was.

Got it. And then my follow-up, I think you mentioned a couple of times that you have a pretty active pipeline for M&A. So just curious whether we should expect a larger deal this year, or if the focus is still on tuck-in M&A. Maybe highlight some of the areas you're more likely to be acquisitive in than others? And just one more on guidance. Any color on free cash flow expectations for 2023?

Yes. Ben, do you want to hit the free cash flow first?

Yes. We plan to take a good step forward in free cash flow in 2023 after making significant investments around protecting the supply chain in 2022 with inventory. We expect free cash flow conversion to be 40% to 50% in 2023, and we have a strong pace that we see of improvement there over the coming years to get into the 80% plus that we've talked about in prior calls. So for the year 2023, it would be 40% to 50% free cash flow conversion.

Thank you for the question, Vik. Regarding mergers and acquisitions, we have a strong pipeline and sufficient balance sheet capacity to invest in the business. We've seen great success with small- to medium-sized strategic acquisitions in the past three years, which have significantly contributed to our growth, margin improvement, and overall momentum. Most of our current focus is on similar opportunities, allowing us to deepen our presence in attractive segments and explore geographic expansions. While we also have the ability to pursue larger acquisitions, our primary attention is on small to medium-sized strategic opportunities.

Just looking at 2023, could you provide a little more color on the progression of revenues throughout the year and kind of the puts and takes of revenue guidance? What really drives you to the low ends of the mid-single-digit range versus the higher ends? And also how do you think about the cadence of operating leverage in 2023 and beyond 2023 as well? And just any color on the mix of U.S., O U.S. and P&R and Recon revs would be great as well.

Yes. Thanks for the question. I think from a revenue growth standpoint, we're confident in our ability to keep growing our Recon business double digits as we've showed that sustainable capability to keep growing the Recon business double digits. And we're expecting kind of a pretty normal Recon industry environment and being able to continue the strong momentum that we've had there based on that. I think the range is more created by waiting to see how the P&R markets start the year here and trying to make sure that we've got a range that contemplates that things could be a little choppier at the start or could be strong in P&R. And we're seeing a good start in terms of working our way through the first quarter, how the P&R markets are going. But we've learned from the last couple of years that it's important to be cautious at the beginning of the year about what might come throughout the year. And so I'd say if we wind up at the lower end of that range, it would likely be based on a little softer P&R markets or based on a different Recon market than we and others are planning for right now.

Yes. In terms of the phasing, I would think about it similarly to what we observed in 2022. We experience some seasonal benefits regarding how revenue progresses throughout the year, along with the business mix. Additionally, there will be some currency pressure at the beginning of the year, which will create slight pressures in Q1 and Q2. However, overall, I would expect the progression of the margins to align with how we experienced things in 2022.

Great. And just a quick one on Europe. How is the cross-selling into the Mathys channel going? And any kind of new product clearances or launches in Europe since the Q3 call?

Yes. So first, obviously, as we talked about, Mathys had a great growth year. Markets were strong over there. And Mathys, as a core business to Mathys, has done very well. We've also got great momentum in terms of the cross-selling opportunities there, have had a lot of outreach in terms of connecting with surgeons, connecting them with our KOLs from the U.S. and getting instrument sets over, getting people started trying both the AltiVate and the EMPOWR. And so we're very excited about how much we prime the pump and got some initial revenue down the back half of last year, and we expect the synergies to be a nice contributor here this year to the growth of the Mathys business. So both EMPOWR and AltiVate are off to a good start in terms of that cross-selling.

Regarding the P&R business, it appears that last quarter did not meet expectations. You mentioned a recovery in Recon that could contribute to growth in the fourth quarter, along with some price increases. While you addressed temporary pressures in that market, are there any additional factors we should consider regarding those pressures? Also, how confident are you in achieving a return to 3% to 5% growth in the long term?

Yes, Dane, thanks for the question. One of the things that we've seen clearly in the P&R business over the past few years is that any market impact from elective surgery gets felt with a lag in our P&R businesses because the majority of the P&R activity comes post-surgery, not pre-surgery. And so we talked a little on the Q3 call about starting to see a little bit of pressure in that business as we came out of the summer, and what played out in Q4 was some of that elective pressure that we saw back in the summertime on the Recon side in the industry flowed into the bracing business, in particular, but also some of the other businesses there in Q4 and led to some softness. As we said earlier, we've seen the recovery we'd expect as we've been working through the first quarter here, which is consistent with the fact that elective surgery got strong there down the stretch of the year and remained strong. So we feel comfortable that it was a temporary pressure point on the industry on the business. As far as 3% to 5%, yes, I mean we're very comfortable that the P&R business can grow in that 3% to 5% range. We're shaping it to be able to consistently grow in the 4% to 5% range, but I think it's appropriate to think of it right now as more being in the 3% to 5% range. You can see the first three quarters of last year, we were sort of comfortably in that range, and we'd expect that as we work through this year, we'll be able to demonstrate that kind of performance as well.

Got you. Okay. And then the second question, just more of a modeling question. Did you end up exchanging your ESAB equity stake for debt? It looks like on the balance sheet, your debt has decreased by around $200 million. With interest expense increasing a bit this year with your current debt, it seems to suggest an upper single-digit interest rate. Is there anything else in that line item that we should consider?

No. You got it, Dane. We did sell the retained stake. We're carrying about $250 million of debt right now, but we expect some interest rate increases throughout the course of the year and overall relatively modest levels of new debt kind of added to that as well.

This is Brett Fishbin on today for Matt. Just wanted to start off on some of the near-term revenue dynamics. I think the P&R side has definitely been covered well. But just curious, based on some of the trends we saw this quarter from your peers on the reconstructive side, the 13.5% organic growth looked like a decent number, but maybe more in line with expectations. So just curious maybe why you didn't see more upside that could have potentially offset some of the headwinds in P&R this quarter?

Yes, thank you for the question. When discussing Q4, we mentioned that we were expecting a strong seasonal finish, and that is what we experienced. It’s helpful to compare our fourth quarter growth not only to last year but also to 2019, as doing so reveals that our growth relative to 2019 is significantly better than others. This analysis shows a better picture. We had a slightly stronger comparison in 2021, which contributes to the narrative. However, we observed a solid finish in Recon and are optimistic about the beginning we have seen this year as well.

All right. Perfect. And then just on margins, taking a bit of a step back and thinking about your long-term ramp to call it, like 20% adjusted EBITDA margins you guys have previously spoken about. Just curious how you're now thinking about the progression towards that level based on the starting point for 2023 guidance?

Yes. Thanks, Brett. I mean we're still very committed and expect to see continuous margin improvements as we go across the next several years. The building blocks still remain in place. I mean if you think about our mixing the business towards higher gross margin, Recon business, as you think about scaling some of the recent acquisitions that we've done and then generating leverage on our fixed costs. All of that allows for us to have continuous margin improvement as we go forward into the coming years. So we're very much committed to continuing that pace. As we've said, we expect at least 50 basis points or more of gross margin improvement a year, and we expect that to continue.

All right. Awesome. And then just the last one for me. I thought it was interesting in the slide deck and some of the prepared remarks that they were calling out 30% growth in clinics using MotionMD. I was just curious how you think that's translating to revenue growth? And also if you expect a continued robust level of new center additions or new clinic additions at a similar level into this year as well?

Yes, there are a couple of different ways that supports our bracing revenue growth. The first is sometimes we get entire clinic conversions and we generate a meaningful amount of revenue converted over to our brands. We had actually a couple of really nice large clinic conversions in the fourth quarter of last year that are going to be helping us this year. The second is in the clinics that are using our solutions, we tend to have deeper penetration into their overall wallets of products that they use over time, and that is a contributor to our growth as well. And then third, the clinics where we sell the software as a service, we do get a software fee there; that fee is a small amount of revenue for us, but it's been growing nicely. As we continue to add clinics, that SaaS software revenue will grow as well.

Just on this Q4 organic front in the guidance here. You guys had a thesis of a high single-digit growth for the company, and we had 5% organic guidance or 5% to 6%. When I look at your ortho peers, all of them are citing an improved hospital staffing situation and procedures coming in above. I'm curious, has anything changed here from your longer-term aspirations of that high single-digit outlook? And what is driving this below LRP performance?

Thanks, Vijay. I think we've consistently said that we would have a high single-digit growth business by 2024, and that we had some work to do in expanding the Recon part of our portfolio that grows a lot faster and shaping the P&R portfolio to be a consistent mid-single-digit grower. I think we've made tremendous progress on that path, and we're sort of pretty close in terms of the performance last year and the guide that we've given for this year. But we're trying to be kind of cautious about the market environment this year. I think the last few years have taught us that it's important to be cautious as we step into the year about what might play out in the year. And so we've tried to have a plan that is based on a cautious view of the market environment. I think still delivering this plan would give us a very clear view of how to go from there to that high single-digit organic in 2024, and is a more favorable market environment than maybe we can get there faster. As far as the commentary in the market environment, I think that if you look at the data that's out there, it's clear that last year, the Recon markets were a little higher growth than a normal year, just on a year-over-year basis. And I think we're expecting the growth this year to be more normal. I know there are views that potentially there's a pent-up backlog that could push the Recon growth to be higher market levels, et cetera. If that opportunity presents itself, we'll be participating in it for sure, but we're planning for a more normal market environment for Recon.

Understood, Matt. Then on a quick follow-up on the guidance assumptions here. The 50 basis points of margin expansion, is that coming from gross margins? Or is that operating margin expansion? And what are you assuming for stock comp expense and share count for fiscal '23?

Yes. So we're expecting to see the leverage from the mix of the business and really kind of ride that benefit from gross margins as we think about driving most of the leverage of the margin improvement; there will be some fixed-cost leverage as well that will be offset by some investments that we put into the business, but I'd say primarily driven by continued shaping of the mix of the business and some productivity as well on the gross margin side. In terms of share count and stock comp expense, we can follow up with you later on that, Vijay, in terms of getting more specific.

Maybe a few product-specific questions. I was wondering if you can share some color on your expectations for Arvis sales and brand in '23. In some of our survey work in channel checks, we hear pretty positive feedback on AR technology and the opportunity in general. Can Arvis do mid-single or double-digit million in revenue in 2023?

Thanks for the question, Xuyang. Yes. So we're super excited about Arvis. The reception from the market has been very positive about the technology and as we put it into the market there, last year in some of our existing surgeons. It was just what they were looking for and was a great strengthening of our relationships with them. We also were able to use it to already drive some surgeon conversions last year. So great new technology, and I think a really positive market reception to that. As we work through this year, we expect to broaden it into the marketplace, use it to drive conversions, and also start to see the per-procedure fee grow for a low level initially, but it will start to become larger over time. Definitely, the first per-procedure fee would be more in the low single digits of millions this year, starting out at a low level, but it will be a contributor to our overall implants growth in terms of the conversions that we can drive as we work through this year.

All right. Great. Very helpful. I guess it seems like foot and ankle growth is rolled into extremities. Seems like it's below 13%. I was just wondering if you can share the growth rate in Q4? And what's your level of confidence in that business growing 2 to 3 times the market rate in '23 as well as your expectations for the growth ramp for STAR in 2023?

Yes. So we talked openly about foot and ankle being double digits for the second half of last year, and in each of the quarters of the second half of last year, we had that double-digit growth in our Foot and Ankle business down the back half of last year in both quarters. We have a clear plan for the business to grow double digits this year as well, with the channel being more stabilized now than where it was in the first half of last year and some good innovation coming through the pipeline there. STAR is going to start to contribute this year, but as we've talked about, we need to get the cutting guide out, and we did. Now it's made its way into the marketplace. We're working through the poly changes as we're in the first half of this year, still working through the approvals on those. This year will be a year where we get to start to go on offense in STAR, an area that was a detractor from growth last year. But I think it will be the back half of the year and moving into next year that we really get strong momentum in that product line.

Thank you, everyone, for joining us today on the call. We appreciate your interest in Enovis. And if you have any further questions, please contact me in Investor Relations. Thanks a lot.