Earnings Call Transcript - ITGR Q1 2023

Operator, Operator

Thank you for standing by. My name is Michelle, and I will be your conference operator today. At this time, I would like to welcome everyone to the Integer Holdings Corporation First Quarter 2023 Earnings Release Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session. Thank you. Mr. Andrew Senn, you may begin.

Andrew Senn, Conference Moderator

Good morning, everyone. Thank you for joining us, and welcome to Integer's first quarter 2023 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 financial measures. For a reconciliation of these non-GAAP financial measures, please refer to the appendix of today's presentation, today's earnings press release, and the trending schedules, which are available on our website at Integer.net. Please note that today's presentation includes forward-looking statements. Please refer to the company's SEC filings for a discussion of the risk factors that could cause our actual results to differ materially. On today's call, Joe will provide his opening comments, and Jason will then review our financial results for the first quarter 2023, and provide an update on our full-year 2023 guidance. Joe will come back to provide his closing remarks, and then we'll open up the call for questions. With that, I'll turn it over to Joe.

Joe Dziedzic, CEO

Thank you, Andrew, and thank you to everyone for joining the call today. In addition to KeyBanc and Benchmark, we are excited to welcome sell-side analysts from Piper Sandler and Bank of America, who have recently initiated coverage on Integer. We appreciate the coverage from all the sell-side analysts, and are excited by the opportunity to reach more potential investors. In the first quarter, we delivered strong year-over-year results. Sales grew 21% organically, with strong double-digit growth across all product lines. Our adjusted operating income grew 28%, generating nearly 70 basis points expansion of adjusted operating income as a percentage of sales compared to last year. First quarter sales were stronger than we expected, driven primarily by the recovery of the delayed shipments from the second half of last year. Although we largely caught up on those delayed sales, the supply chain environment remains challenging overall. On a positive note, we are continuing to reduce our direct labor turnover, and are largely at the headcount levels we need to deliver on our high single-digit organic sales growth this year. We are reiterating our full-year outlook. We expect our organic sales growth to be 7% to 9%, which is about 300 basis points above the growth rate in the markets we serve. We expect adjusted operating income to grow 10% to 16% year-over-year. We are also confirming our free cash flow guidance of $70 million to $90 million, a strong year-over-year increase. The strategy we developed in 2017 and began implementing in 2018 is now producing projected sustained above-market sales growth and margin expansion in what remains a challenging supply chain environment. It is an exciting time at Integer, because demand remains incredibly strong. We are making the investments needed to deliver sustained growth, and we have a strong pipeline of new products concentrated in faster-growing end markets. I am grateful for our associates around the world that are delivering for our customers and making a difference for patients. I’ll now turn the call over to Jason.

Jason Garland, CFO

Thank you, Joe. Good morning, everyone, and thank you again for joining today's discussion. I'll provide more details on our first quarter 2023 financial results, and provide an update on our 2023 outlook. We started 2023 with a strong first quarter. Sales of $379 million delivered growth of 22% year-over-year on a reported basis, and 21% organically, which excludes the impact of the Aran acquisition and currency differences. Our sales growth is indicative of continued demand strength across all product lines, and includes the impact of delivering products that have been constrained by supplier delays in the second half of 2022. Although we did recover these delays, the supply chain environment remains challenging. We delivered $66 million of adjusted EBITDA, up $12 million compared to last year, or an increase of 22%. Adjusted operating income was up 28% or $11 million versus last year, and we have made progress on our year-over-year margin expansion. With adjusted net income at $29 million, we were able to offset the impact from higher interest rates, and deliver $0.87 of adjusted diluted earnings per share, up $0.03 or 11% from the first quarter of 2022. In the first quarter of 2023, sales for all four product lines grew double-digit year-over-year due to strong customer demand, and continued recovery from the previous supplier delivery challenges. The cardio and vascular product line delivered 20% sales growth in the first quarter compared to a year ago. We executed on strong demand in all markets and key products such as guidewires. We also delivered new product ramps in electrophysiology, and benefited from strong performance from the recent Oscor and Aran acquisitions. Cardiac rhythm management and neuromodulation first quarter sales increased 18% over the first quarter of 2022, with double-digit growth in both CRM and neuromodulation, also driven by strong overall demand, and particularly strong double-digit growth from emerging customers with PMA products. Advanced surgical, orthopedics, and portable medical saw 42% growth in the first quarter versus a year ago, driven by increased price and demand as a result of the execution of the multi-year portable medical exit announced in 2022. This was partially offset by a single-digit decline in advanced surgical and orthopedics. And finally, Electrochem, our non-medical segment, delivered first quarter sales growth of 63% versus first quarter 2022, driven by strong demand across all market segments. Further product line detail is included in the appendix of the presentation. To provide more color on our first quarter 2023 adjusted net income performance, we increased a total of $3 million compared to first quarter 2022, primarily due to operational improvements, and supported by strong sales volume, partially offset by higher interest rates. In this higher interest rate environment, we incurred interest expense of approximately $7 million, or $6 million tax-affected, more than last year. However, on a sequential basis, compared to the fourth quarter of 2022, we reduced our interest expense by $1 million tax-affected, driven by the previously announced convertible notes. Moving to cash, we generated $6 million in cash flow from operating activities in the first quarter of 2023. The lower nominal level of first quarter cash flow from operations is consistent with our typical annual profile, driven primarily by payment of associate short-term incentives and rebate payments. That said, on a year-over-year basis, we did deliver $12 million less cash flow from operations than the first quarter of 2022. Despite higher adjusted EBITDA, we had headwinds from higher interest expense, income taxes, and the final payment of employer Social Security taxes deferred from 2020 as part of the US Government CARES Act. In addition, we were impacted by the timing of customer collections, which pushed into the first week of the second quarter. These are not collectability concerns, but we are working with our customers on improved payment timing. Our CapEx spend of $25 million in the first quarter was at a rate in line with our expected annual CapEx. As a result, free cash flow was a usage of $19 million. As an update to the factoring program shared during our fourth quarter 2022 earnings call, we received our first tranche of funding last week totaling $20 million. For clarity, this is not in the first quarter results, but we reported in the second quarter, and will help fund our one-time facility investments needed to support growth. Net total debt increased $71 million to $978 million, driven primarily by fees associated with the $500 million convertible notes, and the $35 million related cap call. As a result, our net total debt leverage at the end of the first quarter was 3.6x our trailing four-quarter adjusted EBITDA, just slightly above our strategic target range, which remains at 2.5x to 3.5x. We'll now transition to providing more detail on our guidance for 2023, sales, income, and cash. As Joe mentioned in his opening comments, we are reiterating our 2023 outlook, with a sales range of $1.47 billion to $1.5 billion, an increase of 7% to 9% versus last year, which is above our underlying market growth rate. We expect margin rates to continue to expand through improved manufacturing efficiencies from greater stability in our direct labor workforce and increase product development sales through the remainder of the year. We generally incur product development costs evenly across the year, while product development sales can be lumpy and are usually weighted towards the end of the year based on milestone achievement. Our adjusted operating income should grow through the year from higher product development sales, mostly visible as a reduction in our D&E expenses. Given these dynamics, we anticipate adjusted EBITDA growth of 11% to 16%, adjusted operating income growth of 10% to 16%, and adjusted net income growth of 4% to 11%, with adjusted earnings per share growth of $0.12 to $0.42. To provide more insight into our outlook, first quarter sales of $379 million benefited from the closure of the second half of 2022 supplier delivery constraints of approximately $15 million, above an underlying run rate of approximately $365 million. As we begin the second quarter of 2023, we expect sales similar to the first quarter run rate of $365 million, as we continue to execute in a challenging supply chain environment. We expect adjusted operating income as a percent of sales to improve throughout the remainder of 2023, as we improve manufacturing efficiencies and achieve higher product development sales. Before we close our financial discussion, I want to also affirm our cash flow guidance. As mentioned, last week we received initial funding from the previously announced factoring program for approximately $20 million, which is being used to fund the strategic growth in capital investments. We plan to continue to grow that program through the year to an estimated total of $35 million. We expect to generate cash flow from operations between $180 million to $200 million. As previously shared, capital expenditures are expected to temporarily increase in 2023, as we invest in capacity expansions, resulting in a total estimated CapEx investment between $100 million to $120 million, resulting in free cash flow between $70 million and $90 million. The free cash flow generated will be used to reduce our net total debt, and we expect to end the year with our leverage ratio within our target range of 2.5x to 3.5x adjusted EBITDA. With that, I'll turn the call back to Joe. Thank you.

Joe Dziedzic, CEO

Thanks, Jason. Integer had a strong start to 2023, with 22% year-over-year sales growth, and adjusted operating income up 28% versus last year. We are reiterating our 2023 outlook as we continue to successfully execute our strategy to deliver above-market growth with expanding margins. We have a strong pipeline of new products, and are investing in the capacity to sustain this growth. We remain focused on delivering for our customers and the patients they serve to generate a premium valuation for our shareholders. Thank you for joining our call this morning. I will now turn the call back to our moderator for the Q&A portion of our call.

Operator, Operator

Your first question comes from Matthew Mishan from KeyBanc. Please go ahead.

Matthew Mishan, Analyst

Hey, good morning and thank you for taking the questions. Just a first one on what you're seeing around your production schedules. You've kept your revenue guidance the same. 1Q was definitely much better than expected. What are you seeing from your customers, and are you seeing demand increase through the course of the year versus what you initially expected? And are you able to meet that incremental demand?

Joe Dziedzic, CEO

Thanks for the question, Matt. You're seeing it across the industry that the underlying market seems to have been stronger than everyone expected and projected, and you're seeing that show up in sales. The thing that we're asking ourselves is, was that reflected in our customers’ expectations when they placed orders on us, let's say in the second half of last year? If that underlying strength in the marketplace was in that demand, then we wouldn't expect to see much different than the 7% to 9% organic growth that we guided for the year, because that's what we've been planning for. Given our backlog and the amount of visibility we have to demand over the next six to nine months, unless customers were to adjust the timing of that demand, we won't see it. But if the demand that's happening in the underlying markets is unexpected, then we would expect to see customers ask us to pull some of that demand that's on order now. They would ask us to move it to be earlier in the year. That has the potential to lift our full-year outlook, because obviously we're operating with really good visibility to demand with over $900 million on order, most of it for this year. It really comes down to whether our customers were expecting this incremental growth that's being observed in the underlying markets. I wish I had a clear answer for you, but we're obviously working with our customers to understand their needs near-term and long-term. We see this as all upside for us because we've got really good visibility to the year. We had a strong start to the year, and we're excited about the prospects of the industry becoming even stronger than everyone expected.

Matthew Mishan, Analyst

And then just Joe, and Jason, I guess just to flow through, if you were to see some incremental upside on the revenue, how should we think about the flow-through of that? Is this a situation where you need to hire more people, you need to expedite freight, or is it something that could actually flow through at a higher rate given the volume in your plans?

Joe Dziedzic, CEO

Yes, it's another great question. We have the direct labor. We've been able to hire the direct labor that we need to deliver for this year. We think we can achieve the 7% to 9% organic growth without adding much labor from where we were at the end of last year. Remember last year, we had 15% more direct labor on 6% sales growth organically. As our workforce becomes more proficient, that creates more capacity with the existing footprint and existing workforce. We feel like we'd be able to get some volume out without having to add more direct labor and without needing to invest more. We've also seen a significant improvement in our direct labor turnover. I think that's been a challenge for everybody. We see it in our suppliers as well. We improved significantly in the fourth quarter versus third quarter last year. We are actualizing about a quarter of our manufacturing sites back to pre-COVID levels of direct labor turnover. Our plant leadership teams have done a great job of engaging our workforce. We've gotten better at identifying through the interview process, associates who are ideally suited for the manufacturing environment.

Matthew Mishan, Analyst

Okay. Excellent. Thank you for taking the questions, and I'll let some of the new guys ask some more.

Operator, Operator

Your next question comes from the line of Craig Bijou with Bank of America. Please go ahead.

Craig Bijou, Analyst

Hey guys, thanks for taking the questions, and obviously congrats on a very strong start to the year. Wanted to follow up on the demand question, and I appreciate your thoughts that you can manage any demand above what you're expecting with your current infrastructure. But when does it get to a point where you do have to add people and capacity? Is M&A a part of it? Or on the other side, if the supply chain worsens or some of these quality issues become more pervasive, I guess it's just a follow-up on asking how you plan to deal with that and how nimble you guys could be if you do need to add capacity.

Joe Dziedzic, CEO

Great question, Craig. Thank you for picking up coverage and welcome. Last year we added 15% more direct labor workers, and we only grew sales about 6%. If you only grew sales 6% and added 15% more people, that's 9% capacity with your workforce. This year, we're projected to grow 7% to 9%. So, you can see how we don't really need to add a lot more direct labor workforce to get to that growth. The other thing we’re focused on this year is reducing overtime. We've worked a lot of overtime due to the supply chain challenges and training of associates. I think we've the capability to flex, maintain or add overtime in order to meet a surge in demand if it occurs. I also think we’re becoming more proficient due to the lower turnover and increased stability. That training and proficiency is impactful. It's very, very positive to capacity and efficiency. We're also pragmatically managing the supply chain, assuming it’s what it is for the foreseeable future. We’re seeing fewer issues and some suppliers improve, but there remains a group of persistently delayed suppliers. If demand is higher and stronger than what we're forecasting, we feel we have both the workforce and the capacity to deliver.

Craig Bijou, Analyst

Got it. Very helpful. And then if I can ask about the pricing environment for you guys. I don't know if you disclose how much price contributed to the sales growth in the quarter, but if you don't provide a specific number, maybe just talk about your ability to take some price, how durable you see that through ’23, and then even in ‘24, ‘25 as we start looking at the out years.

Joe Dziedzic, CEO

Sure. We have positive pricing this year. It’s low, but it is positive. Historically, we’ve been 1% to 2% price down. Last year we were about 1% price down. We began to pass some material and wage inflation through in 2022. We've been successful at passing more of that through in 2023. We think the pricing is mainly covering cost increases, not to expand margins. Our customers have been willing to work with us on this. We believe we're now in an environment where we can be price neutral-ish going forward, and we’re excited about this ability to pass through inflationary pressures in ‘23 and maintain a neutral pricing environment.

Craig Bijou, Analyst

Great. very helpful. Thanks for taking the questions and look forward to the ongoing discussion.

Joe Dziedzic, CEO

Great. Thank you, Craig. Thanks again for picking up coverage.

Operator, Operator

Your next question comes from the line of Phillip Dantoin with Piper Sandler. Please go ahead.

Phillip Dantoin, Analyst

Hey, this is Phil on for Matt. He sends his apologies as he's currently in Europe and was worried about his connection here. But just a few from us, and I appreciate the commentary on the delayed sales recoup here, the $15 million in the quarter. That's totally behind you at this point, is that correct? And that $15 million, is that derived from any segment in particular or is it spread broadly across all segments?

Joe Dziedzic, CEO

Yes, Phillip, thank you. The $15 million mostly captures everything that was pushed out late last year, with a few million left in a few spots to complete that. It was spread across both the cardiovascular and mostly neuromod segments. I think it was about evenly balanced, leaning slightly more heavily on the cardiovascular side. We’re glad to put that behind us. There are still pockets with certain customers where we know they need to replenish inventory, and we are working to resolve some specific supplier constraints. That has been factored into our guidance, with the expectation to replenish those inventories this year.

Phillip Dantoin, Analyst

No, that’s helpful. And I'm just trying to parse out, I mean, you said that your underlying markets are strong. Is there any particular market, even with the bolus of this backlog in cardio and neuromod, they both grew nicely, but is there any particular market that you'd call out as being stronger compared to the others? Or is it just broadly speaking, every market is doing well?

Joe Dziedzic, CEO

Every market, all of our product lines were up double-digit, and we've seen strength in many underlying submarkets. Specifically, we saw strong demand in electrophysiology, which was evident in the industry and certainly with our customers. We also saw robust growth in neuromodulation beyond just spinal cord stimulation, diversifying into other therapies and markets. The pipeline of emerging customers we've been able to grow is favorable, and we’re making significant investments in facilities to boost capacity for high-demand products.

Phillip Dantoin, Analyst

Great. And just shifting gears here really quickly, I mean, you've been targeting operating income about 2x revenue growth. Given you've maintained guidance for the year here, you're close, but not fully all the way there yet. What's kind of holding you back? And how did quarter one go in terms of your own internal expectations regarding getting to this 2x op income versus revenue growth down the road?

Joe Dziedzic, CEO

You’re getting at one of our three financial objectives, which is to grow profit twice as fast as sales. The main impediment this year is both supply chain and continuing to get direct labor turnover back to pre-COVID levels. A quarter of our manufacturing facilities have direct labor turnover at or below pre-COVID levels, and we need to improve that across the board to achieve greater proficiency and efficiencies. When the supply chain improves, we are confident we can deliver operating profit growth twice as fast as sales. That’s the bigger picture, and we hope to reach that ideal scenario by 2024-2025.

Phillip Dantoin, Analyst

Well, that was my next question, but thank you so much for taking all of our questions and I'll hop back in queue. Thank you so much.

Joe Dziedzic, CEO

Great. Phillip, thank you very much for the coverage. Look forward to working with you.

Operator, Operator

I’m indicating that there are no further questions at this time. I'll turn the call over to Mr. Senn.

Andrew Senn, Conference Moderator

Great. Thank you, everyone, for joining today's call. As always, you can access the replay of this call on our website, as well as the presentation that we just covered. Thank you for your interest in Integer, and that concludes today's call.

Operator, Operator

And this does conclude today's conference call. You may now disconnect.