Earnings Call Transcript - HBIO Q3 2022

Operator, Operator

Good day, and thank you for standing by. Welcome to the Harvard Bioscience Third Quarter 2022 Earnings Call. Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker, Dave Sirois. Please go ahead.

David Sirois, Speaker

Thank you, Shannon, and good afternoon, everyone. Thank you for joining the Harvard Bioscience Third Quarter 2022 Earnings Conference Call. Before we begin, I would like to suggest that you take a moment and download a copy of the presentation that will be referred to during this call. The file is entitled Q3 2022 HBIO Quarterly Earnings Presentation and is located in the Investor Overview, Events and Presentations section of our website. Leading the call today will be Jim Green, Chairman of the Board, President, and Chief Executive Officer; and Mike Rossi, Chief Financial Officer. Before I turn the call over to Jim, I will read our safe harbor statement. In our discussion today, we may make statements that constitute forward-looking statements. Our actual results and performance may differ materially from what we have projected due to risks and uncertainties, including those described in our annual report on Form 10-K for the period ended December 31, 2021; our subsequent quarterly reports on Form 10-Q; and our other public filings. Any forward-looking statements, including those related to the company's future results and activities, represent our estimates as of today and should not be relied upon as representing our estimates as of any subsequent date. Also, much of today's call will focus on our non-GAAP quarterly results, which we believe better represent the ongoing economics of the business, reflects how we set and measure our incentive compensation plans, and how we manage the business internally. The differences between our GAAP and non-GAAP results are outlined in the earnings release and today's presentation. These two documents, as well as a replay of this call, can be found on our website under Investor Overview, Events and Presentations. Additionally, any material, financial, or other statistical information presented on the call, which is not included in our press release and presentation, will be archived and available in the Investor Relations section of our website. I will now turn the call over to Jim. Jim, please go ahead.

James Green, CEO

Thanks, David. Good afternoon, everybody. Let me start by saying that in spite of a rough third quarter, we continue to work through actions to dramatically improve our portfolio and resize the cost of our organization by the end of Q4. Let's go to Slide 4 of the presentation and take a look at the highlights for the quarter. Revenue in the quarter was $26.9 million, down 9% from a strong Q3 prior year with 6% growth in cellular/molecular, more than offset by lower sales of preclinical, which was down 17%. Reported revenue includes a $1 million impact from unfavorable currency. And we experienced a very slow summer with lower sales to CROs and pharma across the regions. We continue to see a rotation out of obsolete low-margin CMT products sold mostly through distributors. Adjusted operating margin came in at 2.6% versus 13.3% last year, impacted by lower sales of preclinical products and higher cost of goods in the quarter. Gross margins came in at 51%, down from 56% last year, impacted by inflation and lower absorption and E&O charges. We had a poor mix in the quarter as we finished manufacturing of the low-margin products being obsoleted. Cost of goods was significantly impacted by lower preclinical revenue to absorb fixed overheads. Free cash from operations was $700,000 and net debt was roughly flat. Finally, as we previously announced last July, we're preparing for FY '23 with portfolio and restructuring actions on plan to complete in Q4, which are designed to underpin our goal of 58% to 60% gross margins and EBITDA margins in the high teens. Move on to Slide 5 to look at the revenue in the quarter by product family, which shows Q3 '22 revenue adjusted to reflect 2021 exchange rates. Starting with the first row of the table, on a constant currency basis, our cellular/molecular technology revenue was up 6% from last year, driven by the strong performance of our direct sales team. We had solid growth across geographies, driven by the strength of our cellular products in particular. CMT grew despite reductions in obsolete non-strategic lower-margin products sold through distributors. Looking to our preclinical products. Again, on a constant currency basis, revenue was down 17% from a strong prior year. European CROs and pharma sales of telemetry and inhalation systems was down significantly from a strong prior Q2. In Asia Pacific, China is recovering, but had a tough comparable to a large prior year telemetry sale and lower sales in other APAC countries impacted negatively on the very strong dollar. The U.S. was slower in Q3 on lower telemetry sales to CROs, though we see the pipeline improving here in Q4. The strong U.S. dollar compared to the euro and British pound drove a currency impact of $1 million, which will likely continue to hurt us through the year. Let's move to Slide 6. I can tell you a little bit about some of the exciting new product introductions. Starting with our cellular/molecular technologies. After the quarter ended, we received a large order from a top pharma company for our BTX Electroporation systems for use in bioproduction. This order will begin shipping in Q4. Over the longer term, this opportunity is expected to ramp to over $1 million annually, primarily driven by the consumption of our unique Flat Pack Reaction Chambers, augmented by expanded services. Furthering our initial inroads, we see an emerging value proposition for our BTX system in bioproduction, which is often used today in pharmaceutical research and development to create the initial strains of the therapeutics. BTX Electroporation has the potential to provide an ongoing stream of Flat Pack consumables, revenues that benefit from the production quantities in addition to those used in research and development. Secondly, after the quarter end, we introduced the new U7500, our premium spectrophotometer building on our well-known ultra-spec line. This system replaces three existing models and is designed to penetrate pharma CRO companies and top academic labs. Lastly, continuing to drive market leadership in preclinical wireless continuous monitoring, we also introduced our exclusive continuous monitoring glucose implant. This new implant allows for continuous monitoring of glucose levels and avoids the cost, inconvenience, and variability inherent in periodic manual sampling. Glucose monitoring is expected to be an incremental growth driver in academic labs, government labs, and pharma companies in the pursuit of solutions to the ever-growing problem of obesity and diabetes. This new line of implant is expected to add over $0.5 million annually to our business. Now let me turn the call over to Mike for a quick look at key financials. Mike?

Michael Rossi, CFO

Thanks, Jim, and good afternoon, everyone. As a reminder, my discussion will focus on adjusted results for P&L performance, which aligns with measurements we use to internally manage the business. I'll skip over to Slide 8 with the data table and go right to Page 9 to go through the full financials. On gross margin, we reported 51% for the quarter on an adjusted basis as compared to 56% in the prior year. This decline was due to higher costs associated with inflation, including uniquely high levels of price increases in electronic components, which we see moderating on a go-forward basis. Fixed cost absorption was also a major driver given the revenue decline noted, compounded by the decline in sales coming from our preclinical products, which carry higher-than-average gross margins. Despite these short-term headwinds, we see go-forward traction and gross margin improvement with continued ability to increase our prices to our customers and the mix within cellular and molecular technology sales continues to improve, with niche cellular products delivering higher growth within CMT. CMT and overall gross margins will improve meaningfully with the portfolio and restructuring actions Jim has discussed. Gross margin for the quarter on a GAAP basis was 45% due to $1.4 million of charges associated with these portfolio and restructuring actions, which relate to products manufactured in our largest CMT facility, primarily inventory write-downs for low-margin products we will exit in the months. Adjusted operating expenses were up approximately 3%, with higher labor costs associated with inflation and R&D investment growth, primarily related to investments in our next-generation telemetry products, but also supporting the new product introductions Jim discussed. Adjusted operating expenses were down sequentially from Q2 2022 by approximately $800,000, reflecting initial benefits from the restructuring actions Jim noted, as well as lower overall discretionary spending than originally planned for 2022 given the softer revenue trends noted. While headcount grew in the second half of 2021 and early 2022 in reaction to the supply chain and labor dynamics that emerged over the last year, the restructuring plan we're finishing now will have headcount down approximately 10% from Q2 end with a workforce we believe can support growth in operating leverage in 2023. Adjusted operating income for Q3 is down meaningfully due to the factors noted above, most notably due to the drop in revenue discussed, which we believe represents a trough quarter for revenue due to the unique end-market slowness experienced this past summer. On cash flow and debt, net debt is up $4 million over the prior year due to primarily to the legal settlement we've discussed previously. Cash outflows related to this matter ended in Q2. With improvements in working capital in Q3, particularly DSO, we were able to generate $600,000 of cash flow from operations and keep net debt essentially flat at $45 million. For the rest of 2022, we expect net debt will be at a similar level in Q3. We expect to maintain strong collection efforts and to bring down gross inventory levels in Q4. However, net working capital typically increases overall in Q4 due to higher sales seasonally. Restructuring and transformation costs for Q3 were $1.7 million, with inventory write-down and severance costs associated with the portfolio actions and restructuring. These costs were partially offset by a reversal of accruals associated with the litigation. The line item detail of these costs are included in the GAAP to non-GAAP reconciliations included in this presentation. We anticipate up to $1 million of additional charges in Q4 to complete the restructuring plans noted. Importantly, with these actions, we believe the major restructuring initiatives needed to construct the growth platform we've been discussing are behind us exiting 2022, and we're planning for a significantly lower transformation costs in 2023. CapEx in Q3 was $400,000 or $1.3 million year-to-date, with manufacturing and technology infrastructure investments made. CapEx will be lower near term given the focus on cash flow improvement and deleveraging. Our leverage ratio or total debt to adjusted EBITDA at Q3 end is 3.9x, up from 2.7x at year-end due to the softening earnings, particularly in Q3. As you will see in more detail in the 10-Q to be filed shortly, we recently secured an amendment to our existing credit facility, which increases the maximum leverage ratio covenant and provides room for the company to complete its restructuring activities launched in the second half of this year. We believe this amendment, combined with the plans we are executing to set up 2023, which includes reducing inventory levels, which spiked up over the last year to address global supply chain dynamics, provides us the flexibility needed to continue to improve the business and deliver improved margins and cash flow, and ultimately return us to sustained leverage below 3x. Jim will give initial thoughts on the 2023 margin targets and its conclusion. And we are all laser-focused and accompanying this with strong positive cash flows and deleveraging in 2023. With that, I'll turn it back to Jim to discuss the full-year outlook.

James Green, CEO

Thanks, Mike. Now moving to our summary on Slide 11. First, looking at the upcoming fourth quarter, we expect fourth quarter revenue in the $30 million range. We see sequentially improving revenue and an improved product mix returning our adjusted gross margin to first half range and adjusted operating margin to the 14% to 15% range, plus improving inventory and working capital management will further improve cash flow. For the full year FY '22, we expect revenue of approximately $115 million, gross margin in the 55% to 56% range, and adjusted operating margin in the 9% to 10% range. Despite a challenging third quarter, we continue to drive the transformation of our business to the profitable growth-oriented platform we envisioned. We're on target to complete obsoleting low-margin nonstrategic product lines by the end of Q4. This, in combination with resizing and leaning manufacturing overheads and reducing operating expenses also by the end of Q4, supports next year's targeted gross margins in the 58% to 60% range and EBITDA margins in the high teens. New product introductions and improved portfolio with pricing power will underpin profitable organic growth for the future. Finally, our transformation costs are expected to be significantly lower with restructuring essentially complete at the end of Q4. Thank you. Now I'll turn the call back over to the operator and open the line for questions.

Operator, Operator

Our first question comes from Paul Knight with KeyBanc.

Paul Knight, Analyst

What's your goal now on organic growth potential?

James Green, CEO

I believe our organic plan for next year involves phasing out approximately $5 million to $6 million in nonstrategic low-margin products typically sold through distribution. I aim to achieve mid- to upper single-digit growth on a reported basis and slightly better when considering a pro forma perspective by excluding the revenue from the products we will no longer sell. So, we’re looking at around 10% to 11% on a pro forma basis, and likely around 6% on a reported basis after accounting for the revenue we are exiting.

Paul Knight, Analyst

You mentioned a sale of the BTX Electroporation configuration to a major pharmaceutical company. Is there additional potential in the pipeline for that?

James Green, CEO

Yes, there is. We've been working on this for a while. We are well-known in the initial discovery of various new drugs. Our BTX Electroporation system has been utilized for a significant number of new drugs, including COVID vaccines. Historically, our system was primarily used in the development of initial drugs at research labs, academic institutions, or in pharmaceutical companies, rather than in the actual production of those drugs. We are now focused on providing a bridge that allows users of our equipment to transition from generating the initial drug to early levels of production. We are observing initial production levels ranging from low to medium, which can vary depending on the drug and its application, as well as the specific electroporated content in the final drug. This is an area we have been developing for some time, and it represents a new growth opportunity for us. We have been collaborating with various companies. We highlighted one in particular due to a large order, which we anticipate will evolve into a multiyear opportunity and generate over $1 million in annual revenues from consumables related to this order alone. Additionally, we believe this could lead to further partnerships, making it an exciting growth area for us.

Paul Knight, Analyst

Is the BTX intended for cell and gene therapy applications?

James Green, CEO

It can do that as well. It was actually one of the first electroporation systems involved in early cloning, progressing to the development of items like monoclonal antibodies. It's utilized not only in drug development, but also for various types of drugs, whether they are large molecules or small ones, as long as they undergo electroporation for creating initial cell lines. We have been deeply engaged in this for many years. For us, the ability to provide a transition or a bridge from the initial drug to a stage where they can start producing at some volume level is crucial. Especially if they have used our technology to develop it, we believe we will be able to demonstrate that scaling up production is much safer, allowing for initial low-level production and eventually increasing that output.

Paul Knight, Analyst

And then lastly, the spectrophotometry product, can you kind of give us a gauge of how big the overall spectrophotometer business is? Is it Harvard Bio? Is it more than 10, less than 20? Is there any metric you can give us? I know it's been large, but if that would be helpful.

James Green, CEO

The spectro business represents about 5% to 6% of our revenue. While it is not a major part of our total revenue, it is significant. We have typically focused on selling through distributors and targeting academic research. This new version is designed to facilitate easier transitions and sales to pharmaceutical companies, where we have direct sales and strong connections. This represents an expansion of our business in that area.

Operator, Operator

Our next question comes from the line of Bruce Jackson with Benchmark Company.

Bruce Jackson, Analyst

I wanted to take a little time to talk about the inhalation business. Obviously, it experienced a significant boost during COVID-19. You have the leading products in that space. How much of the current downturn would you say is due to general economic conditions, and how much could potentially be a shift in the market towards a more normalized level?

James Green, CEO

Yes, that's a good question. In hindsight, there's no doubt that when we launched the product around the onset of COVID, we saw an immediate increase in demand. We focused on enhancing the product's capabilities to better cater to long-term use and to compete regarding the precise measurement of what was delivered through the system and inhaled by the model. I would expect that we experienced a surge in sales of the inhalation units due to the circumstances surrounding COVID. Many of those sales went to pharmaceutical companies globally, and they adopted it quite rapidly. We could indeed be moving towards a more normalized level of revenue and sales, and we will grow from this point based on the new features we have added, including the capability to specifically measure the amounts inhaled.

Bruce Jackson, Analyst

Okay. Okay. And then you mentioned there’s going to be about $5 million to $6 million of revenue impact from discontinued products in 2023. Were there any discontinued products in this quarter that had any impact on the top line number?

James Green, CEO

Yes, in Q3, we began informing customers that we were phasing out certain products. We observed a continued transition away from some of these products, particularly those sold through global distribution mainly to academic research sites, which led to a expected decline in sales. This transition is viewed positively. With the launch of the 7500, a new premium unit that is set to replace several lower-margin, lower-capability units, we anticipate this will help maintain our revenue levels despite the shift away from the lower-margin products.

Bruce Jackson, Analyst

Okay. Then last question for me. You discussed the fourth quarter CRO pipeline, was starting to look a little bit better. I was wondering if you could maybe give us a little bit of color on the types of the studies or the types of products that are catching some of this upturn in the fourth quarter?

James Green, CEO

We've had strong performance with our implantable telemetry continuous monitoring systems. However, during this past summer, particularly in July and August, we experienced a noticeable slowdown in Europe and globally. This decline occurred quite rapidly during the mid to late summer, but we're beginning to see a recovery in that area, which is encouraging for our implantable telemetry segment. Additionally, the launch of our new glucose product is expected to provide incremental business opportunities. This product aligns with what academic research, government labs, and pharmaceutical companies have been seeking, and should further enhance the growth of our high-margin telemetry monitoring business. The delays we faced with our highest margin products during the summer affected our revenue, impacting the absorption of overheads and highlighting the need for ongoing structural changes to reduce costs. These efforts aim to create the financial cushion necessary for our company, particularly when encountering unforeseen slow quarters due to factors like COVID or supply chain disruptions. This situation has been exacerbated by the strong dollar, which complicates transactions for countries like Japan and those operating in euros and pounds, crucial markets for us that lead to currency translation challenges. By effectively reducing our cost structure, we position ourselves well for profitable quarters ahead. While temporary downturns may arise, our strategy is designed to mitigate significant impacts on our financial performance.

Operator, Operator

Our next question comes from the line of Christopher Sakai with Singular Research.

Unidentified Analyst, Analyst

This is for Chris. I was wondering if you can provide us a bit more details on the preclinical revenue stream in terms of what happened this quarter? And how do you kind of see it going forward?

James Green, CEO

Yes, we saw a slowdown in preclinical revenue this quarter, primarily due to delays. Many of our preclinical products are provided to pharmaceutical companies and contract research organizations, which are closely monitoring their financial performance. Consequently, we noticed some cost-cutting measures being implemented during the quarter, along with people returning to work after COVID. Given that summer typically presents challenges, we found that many Europeans were unavailable for communication until they returned to work around September. This was a contributing factor. It's evident that belt tightening is occurring within the CRO sector. Additionally, as Bruce mentioned, there may have been extra sales last year that impacted our comparisons. Last year was particularly strong, including a significant $1 million purchase from one of the largest CROs in China, which complicates our current comparisons. However, we anticipate an improvement in our revenue mix as we approach Q4, and with the adjustments we're making in costs, our revenue stream will benefit from robust margins and strong growth.

Unidentified Analyst, Analyst

We are aware of the slowdown we are experiencing in the U.S., particularly in biotech, as we have moved past the peak of IPO activity over the last couple of years. You pointed out that the majority of this is outside the U.S. Do you think the situation is similar in both regions in terms of slowdown, or could we see a slight slowdown in the U.S. that we haven't yet observed?

James Green, CEO

Yes, we noticed a slowdown in the U.S. preclinical revenue stream. You raise a valid point regarding biotech, which we continue to see as a significant growth opportunity, especially with our new products like BTX. We can now cater to smaller biotech and pharmaceutical companies involved with orphan drugs, providing them with additional options for bridging to production. However, biotech has not contributed significantly to our revenue. Most of our North American revenue comes from CROs and pharmaceutical companies. With some slowdown in that segment this quarter, we expect our pipeline to improve, aligning with our natural growth from Q3 to Q4. Introducing new products, particularly the new glucose monitoring system, will help enhance our positive mix in implantable monitoring. We're also monitoring headwinds in Europe. We believe that the situation in China is improving, and we anticipate a strong rebound despite the periodic shutdowns they have experienced. Europe remains a concern due to market conditions and currency issues.

Unidentified Analyst, Analyst

And finally, apart from the three new products that you talked about in terms of early stages in R&D, if you can talk a little bit about, give us some update about you guys are thinking, what's cooking over there that will be very helpful.

James Green, CEO

We appreciate the question. We're directing our investments towards areas with significant barriers to entry, strong pricing power, and robust sales potential for our products. We're focusing on the cellular and molecular areas, particularly on cellular approaches. We anticipate greater adoption of cellular testing technologies within the product development process, from preclinical to clinical stages. This will continue to be a focus for our investment, as seen with BTX, and we have more multi-electrode array products in the pipeline. Implantable telemetry remains a key area where we aim to maintain our leadership position, and we will keep investing in that. Additionally, expect new software products to emerge. We have mentioned this before, but we are now better positioned to manage data and offer valuable capabilities to CROs, pharmaceuticals, and academic research, which will lead to increased investment in our software business as well.

Operator, Operator

This concludes the question-and-answer session. I would now like to hand the conference back over to Jim Green for closing remarks.

James Green, CEO

Well, thank you for joining us. This ends our presentation today. We hope you'll join us again for our Q4 results in February time frame. So thank you very much, and we'll see you soon. Thanks.

Operator, Operator

This concludes today's conference call. Thank you for your participation. You may now disconnect.