Merit Medical Systems Inc Q2 FY2020 Earnings Call

Ladies and gentlemen, thank you for joining us for the Merit Medical Systems Second Quarter 2020 Earnings Call. All participants are currently in listen-only mode. After the presentation, we will have a question-and-answer session. I would now like to turn the conference over to Mr. Fred Lampropoulos, Chairman and CEO. Please proceed.

Thank you very much. Ladies and gentlemen, thank you for joining us today. Usually, we open our comments by stating that our staff is assembled and present. However, like almost all of our activities today, only Raul Parra and Brian Lloyd are with me today. The rest of the staff is virtual like you. I would like to turn the time over now to Brian Lloyd to read our Safe Harbor provision. Brian?

Thank you, Fred. I'd like to remind everyone that this presentation contains forward-looking statements that receive Safe Harbor protection under federal securities laws. Although we believe these forward-looking statements are based upon reasonable assumptions, they are subject to known and unknown risks and uncertainties. The realization of any of those risks or uncertainties including the unpredictable effect of the COVID-19 coronavirus outbreak which is negatively affecting public health, financial markets, and global economic activities can cause actual results to differ materially from those currently anticipated. In addition, any forward-looking statements represent our views only as of today, July 29th, 2020 and should not be relied upon as representing our views as of any other date. We specifically disclaim any obligation to update such statements. Please refer to the section entitled disclosure regarding forward-looking statements in today's presentation for important information regarding such statements. Please also refer to our most recent filings with the SEC for a detailed discussion of the factors that could cause actual results to differ from these forward-looking statements. This presentation also contains certain non-GAAP measures. Reconciliation of non-GAAP measures to the most directly comparable U.S. GAAP measures are included in today's release and presentation furnished to the SEC under Form 8-K. Both today's preliminary earnings release and presentation are available on our website.

Thank you, Brian, and again, thank you ladies and gentlemen for taking the time to join us today. We have adapted our business locally as well as globally by conducting project and business meetings and sales training through Microsoft Teams, which has been of tremendous value to us. We have accomplished this without a hitch. The company has adapted to market conditions with health and safety as our primary concern. Because of the lower sales levels, we have employed various strategies to reduce costs. Some of these programs and reductions will be permanent while others will be modified in order to keep the company nimble and prepared for opportunity. In some ways, we have had an advantage in that we started many of these programs well in advance of the emergence of the COVID-19 pandemic. Every day, we hear of new solutions to the pandemic. We also hear about how things are improving. From our point of view, things have improved as represented during the quarter by month-over-month sales improvements. However, over the last few weeks, the momentum has slowed down. We have surveyed physicians who are very tired and worn out. Thus, we are cautious during the third quarter as we always are especially with new variables added to the seasonal conditions. We believe in many ways that the healthcare system and how we conduct business have changed forever. Many of our conversations and negotiations have been with different personnel and administrators, which is quite a change from the past. Going forward, we will provide more clinical training and support while we shift resources from products that simply don't require the resources we have directed previously. Let me clarify for a moment our direction in the development of new products. For many years, our core growth complemented with targeted acquisitions have helped Merit to have growth numbers in the top quartile of our competitors. We continue those efforts with fewer projects and more focus which will allow us to get to the market faster. On that note, I would like to discuss the market areas of interest to us going forward. The company has a number of electrophysiology products ready for release and several in development. We believe this double-digit market segment, which Merit already has a presence, has great promise. As you are aware, our WRAPSODY Endoprosthesis stent system is now cleared in Australia, New Zealand, and the European Union. In fact, this very day, we received our first orders from Europe. The company will proceed over the next several months to proceed with the WAVE pivotal IDE, which has been approved by the FDA. This study is the approval process for the WRAPSODY in the United States. This study will take three to four years to fully enroll and monitor, upon which time we'll submit a PMA request to the FDA for consideration. Equally important, however, is the ePTFE technology we have developed and the numerous opportunities for products and other parts of the anatomy are developed and deployed. We have also developed a number of new products for testing of patients suspected of COVID-19. This area has been somewhat dormant in my view for several years and is awaiting additional innovations. We expect a rapid increase in revenues in this segment and then topping and selling as we go forward. However, we do believe that this will be a very viable opportunity for Merit for a long time to come. Finally and importantly, we are looking forward to reporting our financial growth objectives during the third quarter. What you can expect is a plan which is sustainable, reliable, and competitive. In closing, I would like to announce that Anne-Marie Wright has left the company to pursue opportunities in lighting and to spend more time with family. She has been of immense value to me and the company for over 16 years. I, of course, will still see her every day, but I will miss the professional collaboration, the advice, and the many long hours she dedicated to several very important areas of the company. I'll now turn the time over to Raul Parra to discuss the financial data for the second quarter. Raul?

Thank you, Fred. Let me now turn to the financial highlights for the quarter. On the revenue front, revenue for the second quarter was approximately $218 million as reported, a 14.5% decrease over the comparable period of 2019 and 13.6% on an organic constant currency basis. Key puts and takes on these results included FX headwinds of approximately $2.7 million for the quarter. Peripheral Intervention products decreased by approximately $16.2 million or 18.2% primarily as a result of our biopsy, localization or Vertebral Compression Fracture endotherapy, angiography and intervention products. Cardiac Intervention products decreased by approximately $13.7 million or 17.1% primarily related to our intervention access and geography and CRM EP products. OEM products decreased by approximately $2.7 million or 9.4% primarily related to our angiography and CRM EP products, offset partially by increased kit, fluid management, and sensor sales. Custom Procedural Solutions decreased by approximately $1.9 million or 4% primarily related to our kits and trays, partially offset by increased sales of our critical care products, which saw increased demand due to COVID-19, including $4.4 million sales of our new sample collection and transport kit, used to collect and transport samples for COVID-19 testing. Endoscopy was the hardest hit sales channel and saw sales decrease of approximately $2.7 million or 30.1% as the elective procedure stopped. Our revenue contributions by sales division based on an organic constant currency were as follows. For the quarter, EMEA down 16%, U.S. direct down 20%, OEM down 9%, endoscopy down 30%, and worldwide dealers was flat. COVID-19 impact for the first half of the year resulted in a reduction of approximately $7 million from the revenue line, which includes $10 million in Q1 and $60 million in Q2. The most impacted regions year-to-date are our U.S. direct business, which is $33 million off-plan, worldwide dealers currently at $20 million under plan, and EMEA $12 million below plan. We saw sales improve from the low of April at a steady cadence through June, but have seen a slight slowdown in July in the U.S., EMEA, and the emerging markets as COVID-19 cases increased and elective procedures in certain areas are limited. Operating margin, our Q2 operating margin on a non-GAAP basis was 11.2% for the quarter, a decrease of 210 basis points over the comparable period. The decrease in operating margin is really a function of a lower revenue related to COVID-19. Our non-GAAP gross margin decrease of 400 basis points was mostly related to product mix, obsolescence, and increased freight costs, again, mostly related to COVID-19. The decline in revenue and the pullback on gross margin were offset by a decrease in operating expenses on a non-GAAP basis by 190 basis points or $17 million over the comparable period. Additionally, our operating expenses saw additional decreases for the third consecutive quarter dropping sequentially by approximately $14 million on a non-GAAP basis. Overall, we are pleased with our management of operating expenses in these unpredictable times. These cost savings came primarily from lower employee costs, R&D, and lower discretionary expenses including travel, trade shows, marketing, and promotions. In addition, we continue to evaluate our headcount and footprint to increase our operational efficiencies. As part of our operational efficiencies program in 2020, we have decided to close our PAC business in Australia along with the manufacturing site. We expect this to be done by the end of the year and to be accretive to operating margin in early 2021. We continue to be back on track for our previously disclosed improvements. In addition, we did take a one-time charge of approximately $18 million for the DOJ settlement. This amount is accrued as of June and is expected to be paid sometime in the third quarter. Tax rate on a non-GAAP basis was 18.1% for the quarter compared to 23.3% for the comparable period. The difference in the tax rate was primarily driven by a change in the forecast of the mix of earnings. On the earnings front, non-GAAP earnings were $0.31 for the quarter as compared to $0.42 for the comparable period. Again, we are happy with how we have managed so far through these times taking advantage of certain opportunities and remain committed to our operating expense improvement plan even with the impact of COVID-19 on our revenue. To wrap up, let me hit a few balance sheet and cash flow items and add some color on COVID-19 for everyone. Debt balance was $410 million and our cash balance was $50 million, putting us at a 2.65 net leverage ratio on an adjusted basis. Available borrowing capacity on a net basis was approximately $183 million. Our cost of debt is approximately 2.08%. We are happy to report that we had free cash flow from Q2 of approximately $32 million, which brings our total free cash flow year-to-date to $47 million. The increase in the quarter was primarily driven by receivables and capital expenditures. Working capital was $272 million, CapEx for the quarter came in at $12 million, G&A of approximately $24 million and stock comp expense of $3.4 million. A little more color on COVID-19. The decline in procedure volumes observed in the first quarter continued through April and we started to see some level of recovery in May and June, but have seen a slight slowdown in July. We continue to believe that COVID-19 will continue to be a headwind in 2020, but we are cautiously optimistic. We're also seeing some tailwinds. Our sample collection and transport kits saw sales of approximately $4.4 million. Visibility for procedures for the remainder of the year is limited and we are not able to predict when or how quickly procedure volumes will recover nor do we expect the tailwinds to outpace the headwinds. Accordingly, as we previously disclosed, we are not in a position to provide annual financial guidance for 2020. We continue to feel our broad product portfolio is particularly well suited to weather this storm, but we also cannot be precise on the pace of recovery. Models from some of our markets and more advanced states in the process give us some optimism as we try to estimate the timing and impact of the pandemic on our operations and financial results. However, we can't predict how long it will take to see the rebound, but we know this is a very fluid situation and with some other areas of our business down, we also have some areas with higher than normal sales. We have seen some states open elective procedures only to pull back and place limits on access or elective procedures. For example, our U.S. sales 10-day average has seen a 6% decline in the last 10 days. Having said that, it's our current belief based on the information we have reviewed that sales will see a gradual return to normal through the remainder of the year. However, with the fluctuation in models and underlying assumptions, we are not in a position to make any concrete forecast for the year. As many of you know, we historically see a decline in sales from Q2 to Q3 as our business has a level of seasonality to it. As we look forward and assess the impact of COVID-19, which is causing some anomalies and we try to forecast for Q3, we anticipate the following based on fluid information. We believe based on current trends that revenue for the third quarter could be down 5% or up 5% sequentially from Q2. We expect our gross margin to be roughly in line with Q2 and we expect our operating expenses to carefully increase in a gradual direction approaching levels close to Q1 as we ease some of the temporary furloughs and salary reductions in preparation for a gradual recovery. As we continue to manage through the impact of COVID-19 and as we start to see some markets stabilize, our models will continue to improve.

In the meantime, we continue to take the following steps: continued execution on previously disclosed operational efficiencies as evidenced by the closure of our Australia PAC business, so please reference the slide deck for an update on previously disclosed plans; implementing salary reductions for our executive officers and most non-production employees; controlling discretionary spend across the organization including travel, trade shows, and events; deferring and or controlling capital and project spend; adjusting manufacturing capacity based on demand while ensuring sufficient inventory levels to support current demand. I'd like to end with thanking Anne-Marie for all her years of service. She had some great insights and made our jobs significantly easier. We are going to definitely miss her. In the meantime, as we look to fill her role, we have asked Judy Wagner to take on the Corporate Communications and Pat McCarty, VP of Finance to take on the IR role. We will be filling the position externally once someone is identified. Yeah, Raul, thank you very much. A lot of information there. I think the cash flow and the free cash flow is a significant issue. I think the focus that we are spending on the transfers of projects and the previously announced projects are on schedule. I think the CapEx budget is well-disciplined and well within the parameters, which we set. So despite all of these challenges, I think that we are focused on improving the business and preparing the business with new products and new opportunities as well, reducing costs, inventory and really spending a lot of time on the business in many ways. We did not comment and won't comment today as I mentioned in our previously prepared comments on the DOJ, but after that is finalized we will have an opportunity to explain the structure of the deal and why the deal was made and we'll do that in the future and we look forward to that opportunity to essentially tell our side of the story. All that being said, I hope you're pleased with the revenue line. I hope you're pleased with the things that we're doing. A lot more to come, a lot more work to do and we wish and thank you all again for being on the call, taking the time today in a very busy week for earnings calls. So with that said, we'll go ahead and turn the time back over to the administrator and we will take your calls and your questions and we will also be here for a good hour or two following the questions for clarifications of issues that you may not have understood or need clarity.

Our first question comes from Larry Biegelsen with Wells Fargo. Your line is open.

Good afternoon, thanks for taking the questions. Well, congrats on a better-than-expected result in a tough environment and the free cash flow result is nice to see.

Thank you.

Fred, I wanted to gain a clearer understanding of the trends through Q2 and the recovery. Thank you for the insights. Can you share what your growth rate was in June on a worldwide year-over-year basis? I assume it improved from the 14% decline. The information about July was helpful, though I'm a bit disappointed to see that the situation worsened in the U.S. with the negative 6% decline you mentioned. On a worldwide level, is the year-over-year growth in July worse than what you experienced in June? What was the June growth on a worldwide basis, and is July trending worse globally?

Yeah, we've seen a slowdown, Larry, a little bit in China, just a little bit there. We're still seeing some issues in Europe with dealers. Still a little bit slow. And again, remember, this is a 10-day average. We go back and look to watch the trends and in June, we saw something and then it came back strong on the end. So what we're just trying to say is we just don't quite know, but the one thing I do know is this, in talking to physicians as I mentioned in my comments, we thought this year, well, there's this pent-up demand, they'll still be busy and in talking and serving our customers and I talk to no less than five or 10 physicians in different countries. They're saying, look, we're tired, we're worn out, we're going to go ahead and take our holiday and when I hear that, it sounds to me like what I would normally see in a summer quarter. And then what is a little bit of an issue at least for 10 days and remember now, it's a full month, the first half of the month was reasonably strong and then slowed just a little bit. It just tells me that people are going to take a break and I just was concerned that although we've seen sequentially every month that you could see in the quarter, maybe July slows down just a bit and then that's a big problem. We just don't know. We see signs of this and then it turns around, reverses, and you'll see this or that. So the point is, it's difficult to predict. From a seasonal point of view every year, we always see that kind of slowdown and we always kind of talk about a 5% decline in the third quarter, but in this case, we said plus 5%, minus 5% because maybe we end up neutral, but remember, we've seen April, May, and June all improve sequentially. I'm not going to talk about this month. We did see there's a little bit of a slowdown, but we're just trying to say that we just don't know. I don't know how else to say it any better and we still have two months. I'm going to let Raul comment on it for a moment. Raul?

Yeah, Larry, maybe to give you some color on what the quarter kind of progressed like. We were roughly, and these are rough numbers, you know, 22% down in April. May looked a little worse than April, but only because of the number of selling days. So when I factor that in, you're talking about approximately 18%. And then in June, you saw roughly 1% to 2% decline in sales. So, hopefully that gives you a color of the cadence of how things are progressing. And as Fred mentioned, July, we saw a little bit of a step back, but I think we're optimistic about how things are trending.

I think it's interesting to note the feedback we're receiving from administrators. In the U.S., it's not that they haven't adjusted their operations to accommodate patient treatments and elective procedures; rather, it's about the public's willingness to return to hospitals. For example, a hospital on the East Coast mentioned their outpatient facility is busy, while the hospital itself is relatively quiet. It may take some time for patients to regain confidence in hospitals. Although the demand exists, it's not translating into treatments at this stage, and we're hearing similar sentiments from Great Britain. This pattern indicates that patients are postponing care, which may lead to issues becoming chronic over time. People are expressing concern about patients and their readiness to return to hospital care.

Thank you. That's very helpful. I have two quick questions. First, China represents a significant market for you, accounting for about 10% of sales. Raul, could you share what the growth was in China in Q2? And Fred, regarding the sample kit, I know you mentioned $4.4 million in sales for the first half and that it's hard to predict future performance, but one of you mentioned that there could be a good opportunity for rapid revenue growth. Could you provide any insights on how substantial that opportunity might be in the second half or moving forward? Fred, I appreciate you taking the questions.

Let me have Raul answer the first part of it on China and then I'll come back on the test kits.

Yeah, on an organic constant currency basis, it was about 12% Larry, growth.

That's compared to the 20% year-over-year growth we experienced last year. Regarding the test kits, we are waiting for the FDA to approve our Viral Test Media. We believe this approval is coming soon, which will help us scale the business. While having swabs is important, the complete kit and overall solution are crucial. Additionally, by September 1st, Merit will have its own vials ready for production. Once these vials are qualified and molded, we will have all the necessary components. Currently, our biggest challenge is sourcing vials from other vendors. The positive aspect is that we've invested capital while staying within our promised budget, and we have the capacity to serve both OEMs and our own kits. We will fulfill full kit demand for our customers and utilize any surplus for OEMs. The key factors at play are securing final approval, which I anticipate happening in the next week or two, and having our own molding capabilities. Right now, we are somewhat dependent on external suppliers for molded parts. Once we have those components in-house, I believe we can quickly ramp up to meet demand.

Thanks so much, guys.

Thank you. Our next question comes from the line of Steven Lichtman with Oppenheimer. Your line is open.

Thank you. Hi everyone. As we consider the operating expense savings as we move into the second quarter, what percentage of that would you identify as sustainable savings looking forward, compared to the temporary reductions implemented in response to COVID?

I think that's a great question. If you remember back to kind of our original guidance, we essentially were keeping operating expenses flat. Since then, we've identified a few other cost-saving measures. So I think essentially if you compare it to Q1, I think Q1 is a better number on kind of where we expect operating expenses to be from a kind of a more permanent standpoint. I think Q2 obviously has a lot of the furloughs and salary reductions and some of the temporary things we've done. So I think Q1 is a better baseline. I think if you're kind of trying to point to where we should be and that's before any new identified cost savings.

Okay, got it. And then just a clarification, Raul. So you mentioned that 10-day down in the U.S. So that was year-over-year that growth rate you were talking about, it was down year-over-year in that 10-day average?

Yeah, no, that's really just comparing it to our most recent trends, right? So as we compare it to the prior 10 days, we looked at, we noticed that we saw a little dip. Just a slight dip.

Got it and then lastly, Fred, you mentioned in your prepared remarks, obviously, lots of changes in the delivery of healthcare, a lot is fluid. Just wondering what that means to you and how things are changing at Merit to prepare for that?

Thank you for your question. One of the key points I mentioned in our release is that the administration level, particularly regarding test kits, is nearly complete, and this is being influenced by our collaborations with companies like Premier. The focus is on larger contracts rather than individual unit sales typical of cath labs or special labs. This shift is significant as things evolve. I also appreciate you bringing this up; I wanted to highlight that some segments of our business are very reliable, meaning there are frequently used products that customers have grown accustomed to. Despite being part of bidding processes or national accounts, these are products that people favor. We've been assessing how to allocate our resources towards these products and plan to reduce the support they receive, as some can operate independently or with much less assistance. Instead, we will concentrate on higher-margin products like WRAPSODY in Europe, our biopsy offerings, and Cianna products, which require more technical backing but bring better returns. We will prioritize areas that yield higher margins and proprietary advantages over some of our older products. Lastly, I want to note that we have been working in this manner for four months now. We recognize that there are approaches we've previously taken that are no longer necessary. I genuinely believe our business model is set for a significant transformation. We will likely see reduced costs and expanded use of platforms like Teams and Zoom for training, allowing us to allocate resources more efficiently. This change will fundamentally reshape our operations at Merit. Raul, would you like to add to this? We discuss this daily.

I mean I think everybody is probably experiencing this. I think people like face to face and they're used to doing business face to face. I think what this allowed was really kind of a big testing environment to see how things would work out via webcast. I mean I think business is being conducted just fine. We haven't skipped a beat and I think a lot of people are finding that. So I think as we look at our office space, our meetings, our sales meetings and shows, I think all those things we've got to really think about and see what type of ROI we're getting.

Well and very casually, even investor conferences. Now, I think of all the time we spend week-after-week going back and forth, the cost and all those things. I think we're going to be the virtual guys. We can do a virtual investor day. There's a lot of things we think that we can do that will be more efficient for us, less costly, and allow us very candidly to get our message out I think better than we have in the past. So those would be my comments, Steve.

Hi, Fred and Raul. Thanks for taking our questions. Fred, I guess I just wanted to start with your commentary around prioritization of your pipeline and really your focus on EP and just see if you could provide a bit more color in terms of what your targets there are and what your focus areas are?

There were several areas I could highlight, but let's focus on the electrophysiology section. We have access to coronary sinus cannulation, various closure products, bailout balloons, and other tools necessary to support life during lead removals. There are countless opportunities in this space. Major competitors like Abbott, St. Jude, Medtronic, and Boston Scientific are focused on defibrillators and pacemakers, but most of them use our delivery systems. This area is experiencing double-digit growth and is one of the few thriving sectors in cardiovascular health. We have developed seven or eight products, with many more in the pipeline. Regardless of which major company other competitors purchase from, they almost universally utilize our delivery systems along with our high-margin ancillary products that uphold the quality Merit's known for. We excel in advanced products, such as transeptal needles and steerable catheters, which can retail for approximately $1,000. Our continued emphasis on development in this area reveals significant potential. Regarding the WRAPSODY technology, while I don't want to disclose our competitive edge, we currently procure a product for $750 that we can manufacture for $75. We plan to file for a 510(k) in about 60 days, aiming for a year-end launch using the technologies we've created with ePTFE for WRAPSODY. On a related note, I must clarify that my earlier comment regarding our approval in Australia was incorrect; that approval is still pending. However, we've conducted several procedures there under special access provisions filed by the physician with the government. In the test kit segment, we have identified numerous opportunities for improvement through advancements in molding, coatings, and science. While many are simply trying to meet a baseline demand, Merit creates products of high quality that are well-regarded in the market. There's still a significant influx of offshore products that lack reliability. We prioritize innovation and introducing new ideas alongside meeting existing demands. Additionally, I want to clarify that our research and development efforts are ongoing. We’ve streamlined from about 50 projects down to 25, expanded our team size, and made some headcount reductions. This focus allows us to better concentrate on projects with the highest potential impact, improving our revenue and ensuring we target products that yield higher margins for the company. Thank you, Cecilia. Do you have any other questions?

Yeah, just one follow-up and thank you for that, Fred. Fred, I was just wondering if you could talk a little bit about your outlook around Cianna going forward. Just your relative view versus other potential areas of strength and your evolving portfolio focus. And how you really view the ability to unlock the full potential of that?

It's a good question. This area has a capital aspect to it, and it’s essentially elective. It's interesting to note that we’re discussing a woman with breast cancer, which is considered elective. This highlights the balancing issue that needed to be addressed. We are beginning to initiate cases in Europe, where we’ve placed units. Although we've lost three or four months due to various factors, we are starting to see progress. Recently, a physician who previously used a competitive product reached out to me to say that after reviewing the options, she believes our product is the best and wants to implement it in other hospitals. This positive feedback is encouraging. We are continuing our research and development in this area, with some exciting advancements on the horizon that we will discuss as we announce our forecasts and year-end results. We have been actively engaged, practicing all necessary protocols, and there is a lot of activity with some innovative projects underway. We remain enthusiastic about Cianna. It’s important to emphasize that we consider it a remarkable technology and a market leader, and we are working on ways to enhance our technological edge in the future.

Hey, good evening guys. So I guess, second half of last year '19, you guys had stubbed your toe and you I think you and I were out and you sort of reassured investors, hey, we're going to start delivering free cash flow next year. Thanks for delivering on that. Can you just speak to maybe the two or three biggest contributors to sort of turning that metric around in a pretty significant way? Thanks.

Yeah, focus. I mean I think there isn't a day that goes by that we talk about free cash flow. Fred and I, we essentially with the help of our FP&A Group changed how we monitor CapEx. We're meeting every three weeks on it and making sure that we understand what's going out the door, what's coming down the pipeline. So I think that's a big driver, really the focus and also kind of the reduction in R&D projects as Fred mentioned. That also helps ease the pressure. We've developed essentially a process, it's very nimble for our liking and so we're able to make decisions and act quickly on opportunities that we see.

Mike, it's about data. It's about having the information and a budget, which allows us to take a pay-for approach. If we're going to proceed, we need to make some sacrifices, and the data will guide us. We collaborate with the ops team, the R&D group, and Raul from FP&A to assess our budget and determine where we stand. If necessary, we may have to scale back on certain projects. It's crucial to have input from the FP&A Group and continually monitor our progress. This approach is new for us, and we should have implemented it much earlier. Credit goes to everyone involved for their discipline, but the challenge arises when data is lacking. We're focusing on future opportunities rather than past performances, which is very beneficial. Go ahead, Raul.

One important point is that receivables collection improved due to the drop in sales, which benefited us in Q2. Looking ahead, while Q2 was strong for us, any rebound in sales may affect that, particularly in Q3. We have an upcoming payment of $18 million to the DOJ, and depending on demand, inventory increases might also impact that. We're still optimistic about our year-end numbers, but I wanted to set realistic expectations for Q3 as we proceed. We're very excited about it, and our focus remains on continuing to deliver results.

Excellent. So regarding sales and the commentary on Q3 expectations, I find it difficult to accept that the lower end of the range reflects anything other than extreme caution. This is because you're comparing the plus or minus 5% to a quarter where, in April and May, two-thirds of the quarter saw an aggregate decline of 20%. Therefore, unless the minus 5% anticipates a drastic worsening in the situation with the coronavirus and significant shutdowns, I struggle to understand how a 5% drop can be viewed as a realistic expectation. Could you clarify what is expected if we were to see a 5% decline?

Yeah, let's just maybe if we talk about it in the terms of the prior year. So last year we did around $243 million assuming you kind of have the same growth rate as you did in Q2 that kind of puts you at that 5% bottom. You'd essentially kind of be at 15% year-over-year growth for Q3. If you go kind of to the top, that 5% increase sequentially. That gets you to roughly a 6% decline in sales over Q3 of 2019. So I think what, if you kind of look at it that way, you do see some progression in kind of the decline in sales from Q2 to Q3, but look, again historically, we do see a decline in sales and so we've got to factor that in to along with what we're seeing on COVID-19. Does that help out a little bit?

Yes. And I guess last one for Fred. Fred you're part of that committee that's sort of trying to come up with a longer-term target and I think particularly maybe operating margin. Is there any chance the uncertainty around COVID causes you guys to sort of punt that down the road or are you guys coming out with sort of a long-term sort of normalized target and come hell or high water, you're going to speak to that in Q3.

We want to carefully analyze the business, which we're actively doing with the help of consultants for a long-term view. We've met multiple times under Lonny Carpenter's leadership to discuss recommendations for the Board. It's important for us to set achievable goals for the business under normal circumstances. Our operating income and growth rates show that we are committed to having a responsible plan. In the past, we've effectively achieved our goals when the whole team works together, whether it's regarding free cash flow or improving gross margins. Some of our ongoing initiatives reflect that success, including our plant consolidation efforts. While we have the knowledge internally, we've also engaged the Boston Consulting Group to ensure our analysis is credible and professional, presenting sustainable and realistic numbers. Our approach is evolving; we intend to demonstrate consistent growth over time, with employee compensation tied to these objectives. We've already started some of this work, which we will share at the end of the third quarter. Moving forward, it's crucial to develop and implement our plan so Merit can be viewed as a premium company capable of achieving significant milestones, similar to our competitors. We need to remove biases and present an honest overview of our future potential based on our technology and initiatives. Pat McCarty from our FP&A Group is taking on a champion role to facilitate this process, while Raul and I manage daily operations. We're addressing various aspects of the business, and we are committed to being straightforward and optimistic about the company's future. We're focused on delivering the necessary results that define a premium company, and I believe we're on the right path to achieve that.

Yeah, no, I mean I think we did carve out Pat, who was head of our FP&A Group. That's going to be his dedicated job. He's the day-to-day guy and he's going to lead the transformation. Fred and I and along with Ron Frost will sit on the committee and we're laser focused on it and as you can see by dedicating one person and carving that out as a specific job and a long-term job, we're serious about it.

The other members of the committee have integrated well into the business. They are experienced individuals who have successfully scaled a billion-dollar company to several billion, and they understand this process. We have a strong group of directors on the committee who are committed to working together towards a common goal, and this collaboration has positively impacted our business. There is a good atmosphere among us; no one feels offended or threatened. As we continue to move forward, you'll see the improvements we've made, some of which are already visible, and I believe even more will become apparent.

Hi guys. Excuse me, appreciate all the detail. I got on the call a little late. So I apologize if any of this has been covered. You mentioned the U.S. softness in July and I guess a bit in China. Are you seeing any relative softness in other geographies in July?

There are places like Brazil that have never really recovered, and it's been quite slow in some areas, although it's a small part of our sales. However, there are a few locations like that. I think Russia has shown some improvement, but there are still a couple of areas in Southeast Asia that have been a bit sluggish.

I think when we consider the emerging markets, there is a slight softness. It's important to note that this is just a general slowdown, not as strong as in June.

Yeah, and just to clarify, the average we discussed for July is based on a 10-day rolling average. It's important to keep that in mind. While I wouldn't say it worried us too much, it did prompt us to be cautious. We must not overlook past events, as that could lead to repeating mistakes, which we want to avoid. We're aiming to be both conservative and realistic. It's possible that things could improve in the coming days and that the next 10 days may change the outlook, but it would be unwise not to take this situation seriously, and we have been and will continue to do so.

Okay, if I back out the $60 million in, let's call it lost COVID related revenue, I think it implies about 8%, 9% underlying growth, and I realize that the $60 million is not an exact science here, but I guess the question is, do you think you can sustain high-single digit revenue growth even with a slimmed down cost structure?

I believe what we've learned from this situation is that we've assigned different levels of cost to various aspects of our business. Without a salesperson present and considering other factors, we've identified certain areas of our business that are stable. Customers really like our products, which are priced competitively, and the diversity of our portfolio encourages them to purchase multiple items. We plan to reallocate resources towards the areas that show greater potential for growth. Essentially, some legacy areas need less support and funding, while we want to concentrate on those with better margins and growth prospects. We do believe we can maintain growth, but our perspective has shifted compared to six months or a year ago.

Okay, that's helpful. Gross margin, is there a revenue level where the overhead absorption becomes a little less of a drag. And maybe if you can just kind of identify the key drivers here that could help gross margin expand from these levels?

Yeah, I mean I think a lot of it is really kind of sales driven, right, unfortunately. So we had some negative variances obviously that we created during April and May. June actually turned out to be a fairly good month and we've got obsolescence, which some of it is related to COVID-19 we're looking at. That is one of the initiatives that we're working on because we think there's leverage there to be had and freight. To be honest with you, we had less revenue, less shipping to customers, but the freight costs are up. So as a percentage of revenue, they're kind of almost fixed and kind of squeezing the margin. So I think as we progress and revenue grows, I think we should see the gross margin rebound specifically as some of these higher margin products start to come back.

Our esophageal business is recovering, and the GI business is also starting to improve. This is partially due to the product mix. In the last quarter, we experienced significant demand in our critical care segment to fulfill the needs of the National Health Service, primarily for lower-margin items like CBCs and pressure infuser bags. We anticipate that this demand will eventually return to a more normalized state. As we introduce additional products, including WRAPSODY, and associated costs decrease, we expect to see better absorption. The impact of COVID-19 and changes in customer purchasing behavior, particularly regarding tubing products, has led to a slowdown that we are now addressing. We aim to reintroduce our other products, which should help improve gross margins back to previous levels over time.

Okay, just one last question from me. I believe you mentioned that you are closing the PAC business in Australia. Is there a revenue impact from that decision, or are you manufacturing those products in other locations?

No, so we manufacture and sell those products in Australia. The revenue impact would be about $10 million, but it will be immediately accretive once that's fully shut down. So sometime in Q1 of 2021.

It will be immediately beneficial to margins once that's fully shut down.

Accretive to EPS, gross margins, and operating margins.

So just a couple of quick ones. You've got WRAPSODY approved in Europe, but can you launch it or are you kind of being put in a holding pattern now until your reps are able to get in to see physicians?

No, it is not in holding. We have in fact launched it and received orders. I expect to have another three or four cases completed by the end of the week. That being said, access and availability are not what they used to be, but there is a lot of enthusiasm. Most of our initial procedures were conducted in Europe, and many physicians and hospitals recognize that this product offers superior performance and outcomes, which is especially important for dialysis patients. You want to keep them out of the hospital, and having a product that can reduce restenosis and thrombus is crucial. So, yes, it has been launched and is starting to ramp up. It may be slower than I want, but it's not slower than I anticipated. Additionally, we've completed some cases in Australia under special access and received approval in New Zealand. We'll also be discussing the WAVE study regarding the WRAPSODY arteriovenous efficacy product, which is significant. About 30 U.S. hospitals will participate in that. Overall, the future looks very promising for this company.

Are you able to start enrolling patients now even with COVID, or are you waiting for COVID to calm down before you begin the enrollment process?

We don’t have direct control over the situation; it’s the hospitals that are managing it. However, we are currently involved in the enrollment process. Several hospitals are already contracted, and negotiations are ongoing with more institutions. As hospitals figure out how to balance the treatment of COVID patients with elective procedures, those procedures will begin to resume. For instance, I received a call from a Key Opinion Leader at an East Coast hospital yesterday who was advocating for their inclusion in a study, emphasizing its importance. It's encouraging to see that kind of interest.

All right and then the last one for me on the legal. I know you have the settlement that you're going to announce details on next quarter, but it's been kind of a drip, drip, drip, the last couple of years with legal expenses and the lawyers. Now that this is resolved, does that go away and about how much were you spending on that?

All of this is included in our quarterly report, and all the relevant information is there. I would describe it as more than just minor expenditures; it was a significant investment to defend ourselves over the past 4.5 years. That said, Jim, I’ve mentioned this before and will reiterate it to you: we expect the final documents to be completed in the next four to eight weeks. However, this depends on the government’s timeline. Once they are completed, they will release their statement, and then we will have the opportunity to present our case. I believe it will become very clear what the situation is, and I’m looking forward to sharing our perspective on the matter.

We spent about $6.5 million in legal costs last year.

Yeah, that's more like a bite, bite, bite instead of drip, drip, drip.

Okay, but all that should go down to free cash?

That's correct.

Hi, thanks for fitting me in since the call has gone over an hour, I'll just limit to one question here, but can you just talk about the WAVE trial design for WRAPSODY and your expectations around the timing of enrollment and follow-up and when you could potentially have that product launched in the U.S., the WRAPSODY product launch in the U.S. Thanks.

We'll begin enrolling patients in January, so we have a few months to finalize everything and ensure we have all the necessary inventories in place. Many of these sites may have 30 to 50 stents and around 30 accounts, so we need to place the stents accordingly to match the patients. My regulatory team estimates that it will take about 3 to 3.5 years to complete the process and conduct the required follow-ups. I currently have information on 350 patients, and I want to emphasize that we hold breakthrough status on three of the cohorts from the FDA. Additionally, obtaining approval for an IDE is a lengthy and complicated process, but we have collaborated well with the FDA, which recognizes the importance of this product. We have reached an agreement on the necessary metrics and next steps. We will start in January, and the data is crucial; we aim to publish the first-in-man data soon, which I believe will clarify the significance of this product for many. That's the best way I can respond to that, and I will have more updates from my regulatory team if you have follow-up questions.

Good afternoon. Thank you for taking my questions. I have two to ask together. Raul, regarding free cash flow, I know there’s a DOJ payout coming and you've benefited from collections related to COVID and inventory adjustments. If we were to net out those COVID-related benefits, what does the free cash flow for the year look like? Can we estimate that performance? Is it $20 million year-to-date excluding COVID benefits, or is it $25 million? Would it potentially have been $40 million or $50 million for the full year, excluding the one-time DOJ payout? How should we view that metric specifically and what are your plans for that cash? I understand you might be conserving cash this year, but are you planning to aggressively pay down debt next year? And for Fred, regarding the operating committee, who makes the final decisions about commitments? What metrics should we consider beyond typical operating margin commentary? Will you provide more information on gross margins, the sources of benefits, products you may decide to stop selling in the future, and lower margin items? What else can we expect in the next quarter? Thank you.

Sure, so real quick. I think originally at the beginning of the year, we had thrown out free cash flow of $40 million to $50 million. I think given everything that's happened, we'd love to be somewhere in the $35 million or closer to $40 million range.

So Raul that's the adjusted number?

That's excluding the DOJ, yes, that's the adjusted number.

So, then why would you be at the lower end of the range if you're making these improvements on the CapEx side of the business elsewhere? Why would you be $35 million to $40 million versus $40 million to $50 million.

Because accounts receivable will start to translate into sales again, along with the inventory. I previously mentioned that we expect to see negative free cash flow in Q3 due to the working capital aspects as we recover. This will affect the $47 million we have year-to-date, and we will have to see how much we can retain into Q4. Our goal is to reach the low end of our target range, but I believe there is potential for more. I'm optimistic that we can achieve this, and we'll assess how it unfolds.

So again it's the three new directors and myself. The ultimate decision is made by the full Board. Let me just say that we have met with a number of advisors and analysts including Starboard and looked at various types of models of what others have done, how they've done it and we're analyzing the capabilities and what we think that we can do and analyze, we don't want to do something that's irresponsible. We don't want to get out in front of ourselves and I don't want to get in front of the committee. So we are meeting I think every two weeks and then we have committee assignments in between that and then we will bring that thing forward. As I mentioned, I don't know if you were on the call, we brought in the Boston Consulting Group that's going to walk through our business and as those things are all formulated and the staff buys into the recommendations, and we will have a negotiation with that consultant who works for Merit and then we will bring in the committee, we'll go ahead and establish what they think is realistic, what they think is sustainable. And then we will make that recommendation to the full Board, the full Board will decide and then we will make that presentation to the shareholders at the end of next quarter. So that's kind of the scenario.

Okay, thank you.

You bet.

Thank you. I'm showing no further questions in the queue. I'll turn the call back over to management for closing. Well again, ladies and gentlemen, I know it's been a busy day. We had Boston and we had CONMED and a whole bunch of people out there reporting today and so we appreciate the time you've taken to be on the call. I'm pleased with this quarter. I think the entire staff is committed and we'll look forward to the next call and we're engaged and we like the challenge. So I want to thank you again. Raul and I will be here for the next couple of hours if you need clarification on some things. And again, we thank you for your interest in the company and wish you a good day. We'll sign off now from Salt Lake City. God bless you all and thank you. Good night. Ladies and gentlemen, this concludes today’s conference. Thank you for participating. You may now disconnect. Everyone have a wonderful day.