Integer Holdings Corp Q1 FY2021 Earnings Call

Good day, and thank you for standing by. Welcome to the Integer Holdings Corporation First Quarter 2021 Earnings Call. Please be advised that today’s conference is being recorded. I would now like to hand the conference over to your speaker today, Anthony Borowicz, Senior Vice President of Investor Relations. Thank you. Please go ahead.

Good morning, everyone. Thank you for joining us, and welcome to Integer’s First Quarter 2021 Earnings Conference Call. With me today are Joe Dziedzic, President and Chief Executive Officer; and Jason Garland, Executive Vice President and Chief Financial Officer. As a reminder, the results and data we discuss today reflect the consolidated results of Integer for the periods indicated. During our call, we will discuss some non-GAAP measures. For a reconciliation of these non-GAAP measures, please see the appendix of today’s presentation and the notes to the financial statements in today’s earnings release, which are available on our website at integer.net.

Thank you, Tony, and thanks to everyone for joining the call today. We are off to a strong start in 2021 because of our dedicated associates who have continued to deliver for our customers throughout the pandemic. During our last earnings call, I shared with you how Integer has managed through the pandemic by taking care of our associates while remaining focused on executing our strategy. We have continued to invest in our strategy by adding capabilities, capacity and talented associates to lead our product line and operational strategies. We have continued to strengthen our high-performance culture, and it is because of the strength of our associates that I have confidence in our ability to deliver for all Integer stakeholders. We delivered strong sequential improvement in our first quarter sales and profit and at the high end of our guidance. As expected, our reported sales and profit were down from the first quarter of 2020 because COVID did not impact us until the second quarter of 2020. We continued to generate strong cash flow and reduced net debt by another $25 million. The strength of our first quarter supports the increase in our full year guidance. We are often asked by investors, when will you get back to pre-COVID levels. We developed this chart in an attempt to quantifiably answer that question with the acknowledgment that this is not a perfect metric, but we believe it is a representative and useful analytic. We selected Boston Scientific and Abbott as the most representative proxy for the total industry to compare to Integer. Integer serves very similar end markets as both OEMs, with the exception of Abbott, where we removed their publicly reported diabetes care sales from their reported Medical Devices segment sales. We believe the best comparison for pre-COVID is the fourth quarter of 2019 because we believe there was very little or no COVID impact in that quarter. Just to be clear, we are using sales that were publicly reported to investors and the SEC. We graphed the reported sales from the first quarter of 2020 to the first quarter of 2021 as a percentage of the fourth quarter 2019 to see how the sales in each quarter compared to the pre-COVID quarter. We believe this is a representative measure of the decline and recovery from the impact of COVID on medical device sales in the industry.

Thank you, Joe. Good morning, everyone, and thank you again for joining our call. I’ll provide more details on our first quarter 2021 adjusted financial results, including cash flow, summarize our product line sales trends and conclude with our increased expectations for 2021. I’ll start with our first quarter results, which continued to be impacted by the COVID pandemic. First quarter sales were at the high end of our guidance and up $22 million sequentially over the fourth quarter of 2020. At $290 million, this was down 12% versus the prior year, with our first quarter 2020 results not being impacted by COVID. At $46 million, our adjusted operating income was also at the high end of our guidance and was up $8 million sequentially over the fourth quarter. This was 21% lower than prior year, with adjusted net income at $32 million, we delivered $0.97 of adjusted diluted earnings per share. As projected, the trend in sequential profitability improvement continues as our first quarter’s adjusted operating income as a percent of sales improved more than 180 basis points over the fourth quarter of 2020 on the increased sales, combined with the continued focus on manufacturing excellence and cost management. As we mentioned previously, we have maintained strategic investments throughout the pandemic and are confident that Integer, our customers and the patients we ultimately serve will benefit. Our adjusted net income declined $9 million in the first quarter of 2021 as compared to the prior year, primarily due to the impact COVID had on our volume and deleveraging. We saw some offset through the reduction of interest expense by $2 million year-over-year, benefited by our cash flow strength, our continued focus on debt reduction and lower LIBOR. The impact from foreign exchange and our effective tax rate were both limited. In the first quarter, we continued a strong conversion of income to cash, generating $36 million in cash flow from operating activity, up 12% over the first quarter of 2020. This improvement was driven by continued working capital management and decreased year-over-year incentive compensation payments as the pandemic driven decline lowered our 2020 incentive compensation. We generated $29 million in free cash flow, inclusive of $8 million of capital expenditures. We still expect the full year capital expenditures to be in the $50 million to $60 million range. Consistent with our strategy, we continue to steadily reduce our net total debt and in the first quarter, reduced it by $25 million.

Thanks, Jason. To summarize our first quarter, we delivered sales and profit at the high end of our guidance and delivered strong sequential improvement compared to the fourth quarter of 2020. We continued to generate strong cash flow and reduced net debt. The strength in the first quarter enables us to increase our sales and profit outlook for the year and positions us well to continue investing and executing our strategy. I’ll conclude our remarks today with the same message as last quarter, which is by offering our view on why now is a good time to be an Integer shareholder. We believe we have a clear vision, a compelling strategy and strong values, combined with the most talented associates amongst all medical device outsourcers. The industry dynamics of mid-single-digit growth and high barriers to entry, combined with Integer’s breadth of product portfolio creates a very resilient business model. Integer’s world-class research and development capabilities, our global manufacturing footprint, combined with our deep customer relationships, creates a compelling growth strategy. Our commitment to our associates and investment in their growth, coupled with our focus on building leadership capability to deliver performance excellence, creates a performance culture that is creating a competitive advantage. Finally, our track record of delivering on our financial commitments and generating strong cash flow, reinforces our financial strength. I am confident in our strategy, in associates and our ability to execute our strategy to earn a valuation premium for our shareholders. Thank you for joining our call this morning. I’ll now turn the call back to our moderator for the Q&A portion of our call.

Your first question comes from Matthew Mishan from KeyBanc.

It’s good to see everything moving in the right direction, here. Joe, I really appreciate the analysis you’re doing versus your customers. But one of the things it does is it assumes that you’re static with the industry. So when do you think you can start showing a level of outperformance versus what the industry is doing? And it goes also back to the question in the first quarter, numbers came in at the higher end of what you were thinking. Is the outperformance in the first quarter attributable to Integer, the market or an inventory build?

Thank you for your question, Matt. I appreciate your emphasis on our goal to accelerate growth beyond the industry and the markets we operate in, as that is indeed our strategy. We remain committed to this objective and are making significant investments to achieve it. We have discussed our growth team structure and the reorganization of our sales team, bringing in new leadership. Our pipeline of opportunities is strong, and we are increasing our engineering team, which is crucial for winning more development programs. This expansion will be key to driving accelerated growth. We share your focus on this goal, and while we don’t have a specific timeline, we are confident in our path forward. Once we start converting development programs into sales and they are ready to impact our financials, we will inform our investors in a timely manner because we are committed to meeting our financial obligations. Regarding the first quarter, we operated at the higher end of our expectations, considering we factored in a potential industry pullback due to increased hospitalizations, especially in the U.S., during late 2022. Our earnings call in mid-February gave us a clearer picture, and we anticipated some customer pullback, which did not occur. Instead, our results were consistent with our initial guidance, which we consider a positive sign. While our customers may have accumulated more inventory than expected, this gives us confidence looking ahead as we examine the orders and backlog for the second quarter and beyond. We adjusted our guidance upwards based on the strong first-quarter performance. The lower end of our guidance assumes no significant industry improvement, which aligns with our customers’ feedback for the year. We frame our outlook as cautiously optimistic. The variance at the higher end of our guidance can be attributed to normal quarterly fluctuations rather than a significant outperformance on our part. We believe we are keeping pace with the industry and anticipate tracking similarly in future quarters. We will communicate any visibility we have regarding outpacing industry growth on the top line when it arises.

All right. Excellent. And you previously communicated a potential for accelerated revenue from some early commercialization customers. Can you give us an update on how some of those have progressed? Were they held up a little bit in their commercialization efforts due to the extension of COVID or are they generally on track here?

Yes. Matt, you might be referring to the emerging customers we mentioned during the third quarter earnings call. At that time, we had 5 customers in the product introduction phase, and we expected around $20 million in revenue for 2020, which we achieved. We projected about $40 million for the same customers in 2022, and we are on track to meet or possibly exceed that target. A few of these customers faced minor delays in rolling out their new products, but this does not significantly alter our 2022 outlook. The products and innovations they are providing are in high demand, and we are confident they will successfully complete the product introduction. While the pandemic did affect their operations due to restricted access to hospitals, it doesn't change our expectation of reaching at least $40 million in sales from these customers. At that time, we also mentioned 15 additional emerging customers in development, with 3 in clinical and 3 in regulatory stages. We continue to make strong progress with these customers and have added to our development pipeline. We are very enthusiastic about the potential of our emerging customers to help accelerate our revenue growth.

And then Jason was talking about the sequential not acceleration, the sequential increases in R&D investments you guys are making maybe to support some of this growth. And I think you mentioned a bunch about the hiring of engineers with the development programs. I’m just trying to understand what’s the right base to start with on R&D because it’s not just R&D, it’s an R&D minus a level of reimbursement you expect to get from your customers. And it does swing. I’m not sure whether that $13.5 million is the right starting point for sequential ramps in investment?

Matt, you recognize that as we increase our engineering team, customers are compensating us for the work we're doing. Typically, R&D programs start to gain significant momentum in the latter half of the year, and the revenue from customers often increases as the year advances, with the fourth quarter frequently being the strongest. For instance, last year, we saw a high of $13 million in the first quarter and a low of $11 million in the fourth quarter, illustrating this pattern. We moved from $11 million in the fourth quarter to $13.5 million in the first quarter. You're noticing the shift in timing regarding when we receive sales revenue from our customers. We believe that $13.5 million is a solid run rate for the remainder of this year. We will continue to hire more engineers throughout the year as we progress on additional development programs, which we have a significant pipeline of. Thus, while this will increase our costs, we anticipate generating more revenue from customers as we reach key milestones. When considering the entire year, $13.5 million seems like an appropriate figure for our run rate for 2021, reflecting our ongoing investment in R&D and these development initiatives that precede the anticipated revenue growth.

Yes. And then last question, it’s a cyclical question. I think your Non-Medical is a cyclical business. I think we are entering into a period of time where I think we’re not just early cycle, people are talking about, maybe we’re getting early to mid-cycle on that, and you guys are just bottoming at $7.5 million. How should we be thinking about that business here?

So you’re referring to our Electrochem, Non-Medical.

Yes. The Non-Medical, yes.

We believe this is certainly the lowest point. We've noticed an uptick in orders and customer demand. However, we don't anticipate this will significantly alter our outlook for the rest of the year. In 2020, our sales were around $35 million, and we expect this year to be similar, perhaps slightly higher, by a few million. Looking at the first quarter's $7.5 million, that translates to a $30 million run rate, so we need to see some improvement to reach the $35 million to $38 million projection we have for the year. Our expectation is that the oil and gas market won't fully recover until 2022, which aligns with what we've heard from customers both publicly and privately. While we might be being conservative by projecting a similar outcome to 2020 at $35 million, that serves as our baseline assumption. If conditions improve, you'll notice that reflected in our guidance for the remainder of the year. However, we expect minimal year-over-year growth, with 2022 being the year when we see a significant recovery.

Your next question comes from Jim Sidoti from Sidoti & Company.

Hopefully, things are a little more normal this call than they were in the last call in Texas.

Absolutely, Jim. Thank you.

Just following up on the R&D topic. Can you give us a sense how long it takes for that expense to translate into top line revenue? I know some of these are longer-term projects. So is this something you should be looking for in maybe 24, 36 months, or could it be sooner?

The fastest turnaround typically takes about a year when developing a tailored component product for our customers and navigating the regulatory qualification process. The duration can vary based on the complexity of the project. For existing products that do not require clinical trials, it may take 1 to 2 years. If clinical trials are necessary, the timeline extends to 3 to 5 years or even longer for complete devices. We understand the importance of securing enough business to drive sales across short, medium, and long-term horizons. Our product management teams are actively building a pipeline of targets and opportunities to help accelerate revenue growth and facilitate sustainable growth beyond our current markets. The timeline for results can vary, but we acknowledge the need for a robust pipeline of successes that can deliver results in the near, medium, and long term. Our focus is on achieving an accelerated sales level and maintaining that momentum.

All right. And then the follow-up for me is with regard to capacity. Let’s say you’re wrong about the industry recovery and it happens much faster than you think. I mean with the vaccines rolling out, we’ve seen some indications that things have really started to pick up. If your customers do see a fast recovery and increased demand. Are you in a position where you can meet that demand?

Jim, we believe we are ready. As you mentioned, we did reduce our workforce last year due to a significant drop in sales, losing about 700 employees year-over-year. Now we are beginning to reinstate some positions, specifically in direct labor, to prepare for accelerated revenue growth. Looking at the data, we observed our quarterly sales gradually increasing from approximately $240 million to $270 million in the fourth quarter and $290 million in the first quarter. This growth has necessitated bringing people back ahead of actual sales to account for training cycles. The recovery process incurs additional costs as we bring workers back to the plant, whether it's retraining or training new hires to fulfill that demand. We are collaborating closely with our customers to gauge the possible rate of recovery and ensure we are adequately prepared. We are confident in our capabilities and believe that our customers are providing us with the insights we need regarding potential demand. Another important factor is the inventory levels our customers maintain, which can serve as a buffer. Their inventory turnover is between 2.0 and 3.0 times, indicating they hold a substantial amount, but what truly matters is the inventory needed according to demand. We are focused on understanding this dynamic and are well-prepared to support our customers, which is a key part of our strategy. We believe we are managing this effectively and are ready to recover at the pace that our customers require.

There are no further questions at this time. I will turn the call back over to Anthony Borowicz for closing remarks.

Great. Thank you for joining us on today’s call and your continued interest in Integer. The call can be replayed on our website at integer.net. Thank you for your interest today, and that concludes our call.

This concludes today’s conference call. Thank you for participating. You may now disconnect.