Merit Medical Systems Inc Q2 FY2022 Earnings Call

Please standby. Welcome to the Second Quarter of Fiscal Year 2022 Earnings Conference Call for Merit Medical Systems, Inc. Please note that this conference call is being recorded and that the recording will be available on the company's website for replay shortly. I would now like to turn the call over to Fred Lampropoulos, Merit Medical Systems' Founder, Chairman and Chief Executive Officer. Please go ahead, sir.

Thank you and welcome, everyone, to Merit Medical's second quarter of fiscal year 2022 earnings conference call. I'm joined today with Raul Parra, our Chief Financial Officer and Treasurer; and Brian Lloyd, our Chief Legal Officer and Corporate Secretary. Brian, would you mind taking us through the Safe Harbor statements, please?

Thank you, Fred. I would 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 unknown risks and uncertainties. The realization of any of these risks or uncertainties, as well as extraordinary events or transactions impacting our company, could cause actual results to differ materially from those currently anticipated. In addition, any forward-looking statements represent our views only as of today, July 27, 2022 and should not be relied upon as representing our views as of any other date. We specifically disclaim any obligation to update such statements, except as required by applicable law. Please refer to the section entitled Cautionary Statement 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 discussion of factors that could cause actual results to differ from these forward-looking statements. Our financial statements are prepared in accordance with accounting principles which are generally accepted in the United States. However, we believe certain non-GAAP financial measures provide investors with useful information regarding the underlying business trends and performance of our ongoing operations and can be useful for period-over-period comparisons of such operations. This presentation also contains certain non-GAAP financial measures. A reconciliation of non-GAAP financial measures to the most directly comparable U.S. GAAP measures is included in today's press release and presentation furnished to the SEC under Form 8-K. Please refer to the section of our presentation entitled Non-GAAP Financial Measures for important information regarding non-GAAP financial measures discussed on this call. Readers should consider non-GAAP financial measures in addition to, not as a substitute for, financial reporting measures prepared in accordance with GAAP. Please note that these calculations may not be comparable with similarly titled measures of other companies. Both today's press release and our presentation are available on the Investors page of our website. I will now turn the call back to Fred.

Thank you, Brian. And let me start with a brief agenda of what we will cover during our prepared remarks. I will start with an overview of better-than-expected revenue results for the second quarter. After my opening remarks, Raul will provide you with a more in-depth review of our quarterly financial results and the formal financial guidance for 2022 that we updated in today's press release, as well as a summary of our balance sheet and financial condition. We will then open the call for your questions. Now, beginning with a review of our second quarter revenue performance. We reported total GAAP revenues of $295 million in the second quarter, up 5.2% year-over-year. Our total GAAP revenue growth was driven by a 3.7% growth in U.S. sales and 7.2% growth in international sales. Our total revenue increased 7.4% year-over-year in the second quarter on an organic constant currency basis, excluding the headwind to our GAAP revenue growth related to changes in exchange rates compared to the prior year period. We delivered constant currency revenue results that exceeded the growth expectations that we discussed in our quarter one earnings call. Specifically, we shared our expectation for constant currency revenue growth in the range of flat to up 2% year-over-year in Q2. The strong constant currency revenue results were driven by solid execution from our team, stronger than anticipated demand in the U.S. and more favorable than anticipated international sales trends, particularly in the EMEA and rest of world regions. Now, let me provide you with a more detailed review of our revenue results in the second quarter, beginning with the sales performance in each of our primary reportable product categories. Note, unless otherwise stated, all growth rates are approximated and are on a year-over-year and constant currency basis. Second quarter total revenue was driven by 7.5% growth in sales of cardiovascular products and a 4.4% growth in sales of endoscopy products. Sales of our peripheral interventional products increased 7%, representing the largest driver of total Cardiovascular segment growth in quarter two. Within the PI product category, sales of our angiography products increased 18% and were the largest driver of our total PI growth year-over-year. Sales of our embolics, access, and drainage products increased nearly 8% year-over-year in quarter two and together contributed roughly half of our total PI growth year-over-year. Notably, sales of our SCOUT Radar Localization products increased 9% year-over-year, driven by continued positive demand for this highly differentiated wireless radar-guided localization system used to assist breast surgeons in identifying tumors for removal during breast conserving surgery. Within our cardiac intervention business, sales increased 7% in quarter two, representing the second largest contributor to total Cardiovascular segment growth year-over-year. We had standout contributions in total CI growth in quarter two from sales of our intervention products which increased 12% year-over-year, driven by sales of our Basix inflation device, continuing to deliver strong contributions to growth, increasing 14% in quarter two and a notable pickup in demand for our PhD hemostatic valve products. Sales of our OEM products were all stronger than expected in quarter two, increasing 15% year-over-year, driven by improving demand from larger customers in multiple categories, including cardiac intervention and access, fluid management, coatings, and kits. We were pleased to see that sales of our CPS products posted a 5% growth in quarter two, fueled by low double-digit growth in sales of trays. Finally, sales in our Endoscopy segment increased 4% in quarter two, ahead of expectations, as we saw strong demand for our Elation esophageal balloon products which offset the expected business disruption related to issues with a third-party contract manufacturer discussed in our last earnings call. Now, turning to a brief summary of sales performance on a geographic basis. Our second-quarter sales in the U.S. increased 2.6% year-over-year on a constant currency basis. Importantly, our second-quarter sales results reflect improving U.S. growth trends on both a two and three year basis. Our second-quarter international sales increased 13.6% year-over-year on a constant currency basis. And encouragingly, despite the challenging global macro environment in quarter two, our international sales results reflect improving growth trends on a two-year basis and largely consistent growth trends on a three-year basis. We saw contributions to our total international growth in each of our three primary regions around the world with EMEA sales growth representing the largest driver of total international growth in quarter two. EMEA growth was driven by demand from customers in Western Europe, the Nordic regions, and Africa and sales to customers in Russia which was not contemplated in our quarter two outlook, given the ongoing conflict in that region of the world. APAC posted mid-single digit growth in quarter two which was modestly softer than expected, with strong sales in Japan, Southeast Asia, and Korea more than offsetting the 1% sales decline in China. Our rest of the world region posted 57% growth year-over-year in quarter two which was well ahead of expectations as we saw particularly strong demand from customers in Latin America and Brazil. In summary, we're encouraged by the improving growth trends and proud of our team's strong execution, despite another quarter marked by a challenging operating environment. Before we turn the call over to Raul, I wanted to comment on a few other noteworthy items in the quarter. First, we delivered another quarter of impressive profitability improvement, margin expansion, and free cash flow generation in quarter two. Our non-GAAP gross profit, non-GAAP operating income, and non-GAAP net income increased 7%, 23%, and 20% year-over-year, respectively, in quarter two. Our non-GAAP gross margins increased 69 basis points year-over-year, despite continued inflationary headwinds. And our non-GAAP operating margin increased 280 basis points year-over-year to a record 19.1%. We also generated $31.5 million of free cash flow in the quarter. We believe our financial results in the second quarter and the first half of 2022 represent further evidence that we are making progress towards our goal of enhancing Merit's long-term growth and profitability profile. We remain committed to the financial targets that we outlined in the Foundations for Growth program for the three-year period ending December 31, 2023, which call for our constant currency organic revenue to increase at a CAGR of at least 5%, non-GAAP operating margins of at least 18%, and cumulative free cash flow generated of more than $300 million. Second, we are pleased with the progress in recent months towards our strategic initiative to expand the body of clinical evidence for our products. Specifically, our clinical study, the WAVE study of the WRAPSODY Endovascular Stent Graft, an investigational device being studied for the treatment of stenosis or occlusion within dialysis outflow circuits, continues to progress. We have 40 clinical sites actively enrolling patients. We also announced first patient enrollment in two new studies in recent months, the WRAP study and the STREAMLoc study. The WRAP study will evaluate the clinical benefits associated with the use of the WRAPSODY Cell-Impermeable Endoprosthesis in patients receiving hemodialysis that experience a narrowing, or stenosis, or blockage occlusion of blood vessels required for dialysis vascular access. This is a prospective, multicenter, observational study of up to 500 subjects with outflow circuit stenosis, or occlusion, who are receiving hemodialysis at medical facilities throughout Europe, South America, Australia, and New Zealand. Clinical outcomes of patients after the initial placement of the WRAPSODY Cell-Impermeable Endoprosthesis will be evaluated over a two-year period in accordance with instructions associated with its CE mark. The STREAMLoc study is a Canadian registry intended to demonstrate the utility of the SCOUT Surgical Guidance System to improve workflow and efficiency in Canadian centers diagnosing and treating breast cancer. The secondary objective of the study is to further evaluate the safety and performance of the SCOUT Surgical Guidance System when used according to the IFU in 500 consented patients with BI-RADS scores of 4c or 5c. By assessing the utility of the reflector insertion at the time of biopsy, this study is designed to measure the impact on patient visits to the breast center for invasive procedures between biopsy and surgery and quantify this value to the Canadian public health care system. Now with respect to our efforts to expand clinician awareness of the clinical efficacy of our products, we continue to work with KOLs to identify opportunities to feature our products in leading publications and look forward to Dr. Katerina Malagari's abstract on the European mCRC registry study which was completed in December 2021. The European mCRC study evaluated the use and value of transarterial chemoembolization of metastatic colorectal cancer to the liver with Merit's HepaSphere Microspheres loaded with irinotecan. Dr. Malagari's abstract was accepted for the CIRSE meeting that will be in Barcelona in September. Our marketing and medical affairs team were excited to host the inaugural Wassat Summit meeting here in South Jordan this week. And I will just say, it is a wonderful meeting to meet with these KOLs. This is a multiday meeting offered a valuable opportunity to engage with them from around the world on a variety of topics, including an overview of our endovascular intervention and embolic platforms, new technologies, our WAVE and WRAP studies, and GAE planning. Finally, I wanted to highlight another area where our team has been executing well towards one of our key strategic initiatives, specifically the development, clearance, and commercialization of new products. During the first half of 2022, we have highlighted our progress in these areas with four notable press releases. We received breakthrough device designation for Embosphere Microspheres in the use in genicular artery embolization for symptomatic knee osteoarthritis. We received clearance for the SCOUT Bx Delivery System, a notable addition to the Merit oncology, breast and soft tissue localization portfolio. This system addresses roughly 40% of breast biopsies performed under stereotactic or MRI guidance and the related need for an additional visit for reflector replacement prior to surgery. The SCOUT Bx is compatible with most commonly used stereotactic and MRI-guided breast biopsy devices on the market, allowing the patient to avoid an additional office visit and procedure. We also announced the launch of our new SCOUT Mini Reflector. The SCOUT Mini Reflector is designed for use in soft tissue such as breast and lymph nodes and measures 8 millimeters in length, 33% shorter than the standard SCOUT Reflector, offering more utility in difficult-to-localize areas. The SCOUT Mini Reflector provides improved directionality for accurate pinpointing of affected tissues within a margin of 1 millimeter, in line with Merit's standard SCOUT reflectors. The SCOUT indication for use extends to other soft tissue malignancies, expanding the applicability of SCOUT technology beyond traditional breast cancer treatment. Additionally, we introduced the ReSolve pneumothorax tray, the newest component of Merit's vascular peripheral drainage portfolio, which includes interventional catheters, stent systems, drainage systems, procedure trays, sets, and related procedures. The ReSolve pneumothorax tray has all the necessary products to perform a thoracostomy, a minimally invasive procedure that helps patients avoid the need for an open surgical intervention to drain fluids or air from the chest. Each tray component is placed in order of use, supporting procedural efficiency and ease of use. Now, I'm proud of the team's continued commitment to strong execution in the areas of development, clearance, and commercialization of new products. Now with that said, and this will be my last, finally, let me turn the call over to Raul who will take you through the detailed review of our second quarter financial results and our 2022 financial guidance which we updated in today's press release. Raul?

Thank you, Fred. Given Fred's detailed discussion of our revenue results, I will begin with a review of our financial performance across the rest of the P&L. For the avoidance of doubt, unless otherwise noted, my commentary will focus on the company's non-GAAP results during the second quarter of fiscal year 2022. We have included reconciliations from our GAAP reported results to the related non-GAAP items in our press release and presentation available on our website. Gross profit increased approximately 7% year-over-year in the second quarter. Our gross margin for the second quarter was 49.3% compared to 48.7% in the prior year period. The 69 basis point increase in gross margins year-over-year was primarily due to changes in product mix and lower obsolescence expense, offset partially by unfavorable manufacturing variances primarily related to purchase price variances and higher freight costs compared to the prior year period. As expected, our second quarter results reflect the inflationary headwinds we are seeing in logistics, labor and increasingly in raw materials. Specifically, while our prior guidance assumed higher raw material costs compared to the second quarter of 2021, our second quarter results included an incremental headwind to our non-GAAP gross margins of approximately 50 basis points from higher than expected raw material expenses. Second quarter operating expenses decreased 2% compared to the second quarter of 2021. The year-over-year decrease in operating expenses was driven by a 1% decrease in SG&A expense and a 5% decrease in R&D expense compared to the prior year period. Our operating expense performance in Q2 was better than expected and reflects continued prudent expense management as well as modest delays in hiring expenditures, given the ongoing challenges in the labor market. Total operating income in the second quarter increased $10.7 million, or 23% year-over-year, to $56.4 million. Our operating margin for Q2 was 19.1% compared to 16.3% in the prior year period. The year-over-year change in operating margin was primarily driven by the 69 basis point increase in our non-GAAP gross margin and a 210 basis point reduction in our non-GAAP operating expense margin compared to the prior year period. Second quarter other expense net was $1.1 million compared to $1.9 million last year. The change in other expense net that was primarily related to decreased interest expense as a result of lower average debt balance, despite a higher effective interest rate. Second quarter net income was $42.3 million, or $0.73 per share, compared to $35.3 million, or $0.62 per share in the prior year period. We are very pleased with our profitability performance in the second quarter where we reported year-over-year growth in non-GAAP net income and diluted earnings per share of 20% and 19%, respectively, despite the incremental pressure on our gross margin and a higher than expected tax rate in the period. Turning to a brief review of our financial results over the first half of 2022. Total revenue for the six months ended June 30 was $570.4 million, up $41.2 million year-over-year or 9% growth on a constant currency basis. Gross profit increased 7% year-over-year to approximately $277 million, representing 48.6% of sales in the first half of 2022 compared to 48.9% of sales in the prior year period, a 36 basis point decrease year-over-year. Operating profit increased 14% year-over-year to $96.6 million, representing 16.9% of sales in the first half of 2022 compared to 16% of sales in the prior year period, a 95 basis point increase year-over-year. Net income increased 12% year-over-year to $72.7 million, or $1.26 per share, compared to $65.2 million, or $1.14 per share, in the prior year period. Turning to a review of our balance sheet and financial condition. As of June 30, 2022, we had cash, cash equivalents and restricted cash of $65.2 million, long-term debt obligations of approximately $246 million and available borrowing capacity of approximately $481 million. This compares to cash on hand of $67.8 million, long-term debt obligations of approximately $243 million and available borrowing capacity of approximately $490 million as of December 31, 2021. Our net leverage ratio as of June 30 was 0.8x on an adjusted basis. With respect to our cash flow generation in the second quarter, our strong profitability performance in the second quarter of 2022 combined with strategic working capital investments, resulted in strong free cash flow generation of $31.5 million in the second quarter. As expected, our use of cash for working capital increased compared to the prior year period. In recent quarters, we have discussed our strategy to proactively invest in our inventory balances to build the requisite safety stock and ensure high customer service levels. This strategy represented roughly half of our total working capital use of cash in the second quarter. We generated $34 million of free cash flow during the six months ended June 30, 2022. We continue to expect strong free cash flow generation this year and remain on track to deliver our goal of generating at least $75 million of free cash flow in 2022. Of note, this free cash flow target assumes planned investments related to the Foundations for Growth program that are expected to drive our CapEx investments in the range of $55 million to $60 million in 2022. Turning to a review of our fiscal year 2022 financial guidance which we updated in today's press release. For the 12 months ended December 31, 2022, we now expect GAAP net revenue growth of approximately 5% to 6% year-over-year. This GAAP net revenue range now assumes a headwind from the changes in foreign currency exchange rates in the range of approximately $18.6 million, representing a headwind of approximately 170 basis points to our forecasted GAAP growth rate this year. This FX impact reflects an incremental headwind of $15 million to $15.6 million as compared to our prior 2022 guidance had assumed. Note, roughly one third of this incremental FX headwind was realized in Q2, with the balance of the increase expected to impact our GAAP revenue results in the second half of 2022. The GAAP net revenue guidance range now assumes net revenue from growth of approximately 5% to 6% in the Cardiovascular segment and net revenue in our Endoscopy segment in the range of a 5% decline to an 8% increase year-over-year. With respect to profitability guidance for 2022, we now expect GAAP net income in the range of approximately $62.4 million to $68.3 million, or $1.08 to $1.18 per diluted share. Non-GAAP net income in the range of approximately $139.6 million to $145.5 million, or $2.42 to $2.52 per diluted share. For modeling purposes, our fiscal year 2022 financial guidance now assumes non-GAAP gross margins in the range of approximately 49% to 49.15% compared to a range of 50.1% to 50.6% previously. The revised gross margin expectations reflect inflationary pressures in the areas of raw materials and in freight and logistics. While we are pleased with the continued progress we are seeing as a result of our FfG initiatives and in the area of pricing, we have seen a material increase in raw material costs in recent months and these cost increases were not contemplated in our prior guidance assumptions. With respect to freight and logistics costs, recall that our prior guidance did include the assumptions that we would see freight and logistics headwinds dissipate in the second half of 2022, given easier comparisons based on the uptick in these expenses over the second half of 2021. Our updated guidance now assumes that we do not realize the benefits of these easing comparisons as we now assume a higher mix of air freight versus shipping freight over the second half of 2022. Importantly, this is a direct result of our strategic decision to respond to the stronger than expected demand for our products around the world. Returning to a review of other key modeling assumptions supporting our updated financial guidance for 2022. We expect non-GAAP operating margins in the range of approximately 16.6% to 17.1% compared to a range of 16.6% to 17.3% previously. GAAP and non-GAAP other expenses of approximately $6.5 million and $4.8 million, respectively. Diluted shares outstanding of approximately 57.7 million compared to approximately 58 million previously. And a full year 2022 tax rate of approximately 24% versus a range of 22% to 23% previously. Lastly, given the continued uncertainty in the global macro environment, we would like to provide additional transparency related to our growth and profitability expectations for the third quarter of 2022. Specifically, we expect our total revenue to increase in the range of approximately 1% to 4% increase year-over-year on a GAAP basis and up approximately 4% to 6% year-over-year on a constant currency basis. Our growth expectations for the third quarter of 2022 reflect two items of note. First, the midpoint of our third quarter growth expectations assumes constant currency sales growth of approximately 3% year-over-year in the U.S. and approximately 7% year-over-year in OUS markets. Second, our third quarter guidance range assumes a notably wide range of sales of endoscopy devices, specifically a decline of 37% on the low end to an increase of approximately 12% on the high end as we continue to manage to business disruption related to issues with a third-party contract manufacturer. We view this disruption as transitory and expect to return to more normalized growth trends in the fourth quarter. With respect to our profitability expectations for the third quarter, we expect to see flattish non-GAAP gross margin trends compared to last year and modest declines on a quarter-over-quarter basis, driven by previously mentioned inflationary pressures we are seeing in raw materials and incremental freight and logistics costs compared to the prior year. We also expect to see non-GAAP operating margin trends remain flattish to modest improvements compared to last year. These margin expectations, combined with a notable increase in our non-GAAP tax rate compared to last year, are expected to drive a change in non-GAAP net income and EPS in the range of down 4% to 5% year-over-year on the low end to up 3% to 5% year-over-year on the high end. With that, I'll turn the call back to Fred.

Thank you, Raul. In closing, despite the challenging operating environment in the second quarter, I'm very proud that we delivered revenue and profitability results that exceeded expectations. We are confident in our 2022 guidance, which now indicates total revenue growth on a constant currency basis of 5% to 6% year-over-year. We continue to anticipate progressive improvement in our operating environment, particularly regarding access to patients and elective procedures as we progress through 2022. We also expect to report improving non-GAAP gross and operating margins along with strong free cash flow in 2022, supported by the successful execution of our multi-year strategic initiatives under the Foundations of Growth program. Our team is executing well and remains focused on our strategic initiatives while being prepared to adapt quickly to market changes. We want to thank all our team members, as this performance in the first half of 2022 would not have been possible without the global contributions of the entire team. Now, I will hand it back to our operator to open the line for questions.

And our first question comes from the line of Jayson Bedford of Raymond James.

So I guess first, 2Q was quite strong. I guess on the revenue side, were there any one-timers or notable orders that elevated the revenue level in 2Q?

No.

No.

No, I think we're business as usual but it was strong but nothing unusual.

Yes. Strong execution from the team. I think we saw stronger than anticipated demand in the U.S. and then just more favorable trends in EMEA and rest of the world.

As I examine the implied guidance for the third quarter, it seems that sales could decline by 7% to 8% sequentially, which appears steeper than usual. So, I'm curious about what differences you anticipate in the third quarter compared to the second quarter.

Yes, the main issue we're facing is linked to our endoscopy devices. As mentioned earlier, we're experiencing a decline on the low end of 37% and an increase on the high end of 12%. This situation is largely due to disruptions caused by a third-party contract manufacturer. We are on track to meet our expectations, but given the dynamic nature of the environment, we're taking precautions to ensure we have some flexibility in case we don't achieve our goals. However, we remain confident in our revised guidance for 2022, which suggests total revenue growth of 3% to 6% in the latter half of the year, consistent with our previous guidance assumptions.

I understand that I'm asking multiple related questions, but I'm curious about the margin in the third quarter. While I see there's been a decrease in revenue sequentially, there’s also a significant drop in operating margin. Was there a timing issue with spending that differed from the second quarter and will be reflected in the third quarter? I'm interested in the higher level of operating expenses indicated in the guidance.

Yes. Most of it is related to the modest decline in non-GAAP gross margin. The inflationary pressures we are experiencing in raw materials, along with the increased freight and logistics costs compared to the previous year, are affecting the operating margin. We do anticipate that operating expenses will gradually increase from their current levels due to the nature of spending. But that is what is driving the situation, Jayson.

Okay. I'll get back in queue.

Our next question comes from the line of Larry Biegelsen of Wells Fargo.

Congratulations on a strong quarter, Fred and Raul. Fred, there were two challenges that didn't seem to affect you much in the second quarter: the contrast shortage, mainly in the U.S., and the lockdowns in China. How much better do you think your performance would have been without these two issues?

Right. Larry, I don't know. I think you're fair to say that we didn't see a lot of impact from the contrast. I thought we might but we just didn't. It wasn't there. But it's hard to tell. China was always very hard to read. So it's a really difficult question and I'd have to spend a lot of research on it to get to it. So I'm just going to leave it with a general comment, I don't know.

Fair enough. Considering the inflationary headwinds, what gives you the confidence in the Foundations for Growth targets for 2023? Raul, the midpoint of your guidance for operating margin is around 16.8%. What gives you the confidence that you could improve margins by more than 100 basis points next year?

Yes. I think I'll start off by saying, look, we just delivered a 19.1% operating margin. So the confidence is there. And I guess I'll just reaffirm what we called out for Foundations for Growth on our November 20 call. The constant currency organic revenue CAGR of 5% at least, feeling confident there. The non-GAAP operating margin by at least 18%, again, we just delivered 19.1%. And then cumulative free cash flow generated of at least $300 million. Free cash flow, we continue to be very strong in. Delivered $31 million of free cash flow in the quarter, $34 million for the year and we remain on pace to deliver the $75 million. So we see the initiatives working, the Foundations for Growth initiatives and are really excited about continuing to deliver on those.

And Larry, I think we all recognize the significant momentum we have. It's the main focus for our team, and we have discussed it extensively. It's been effective, and we are all dedicated to it, including our Board. This remains the central point of our goals, despite the challenges we face. The team is focused, and that momentum creates a positive energy among them. I'm very pleased with the team's effort, which truly reflects a collective achievement. While everyone talks about teamwork, not every team succeeds. I believe our management approach, along with the commitment from the Board and, importantly, the staff who execute the plans, has been commendable. I'm thrilled with our people and their contributions. The recent rewards benefit them, the shareholders, and everyone involved as this effort evolves. I'm happy we embarked on this journey, and as you know from our history, it's encouraging to see the Merit Foundation making progress. I'm just glad we pursued it.

Our next question comes from the line of Steve Lichtman of Oppenheimer & Company.

Fred, just given some of the underlying momentum you just talked about, it seems like you guys are you leaning in on some of the growth initiatives. You talked a lot about some of the R&D programs tonight. Where does the M&A fit in on that in your current thinking? You've given with the momentum and also the free cash flow you also talked about, is that potentially going to see some increased activity here for you guys over the next 12 to 18 months?

Yes, in that area, we have been very disciplined when necessary. While things were enticing, we chose to remain cautious. Our balance sheet reflects our strong position. We are actively exploring opportunities, but they must align with the criteria we've established to avoid hindering our progress. We want to maintain our momentum. As values become more favorable and we encounter more realistic pricing, more opportunities will arise for Merit. We are engaged and actively participating, not just watching from the sidelines.

Yes. I think I will add, Steve, that considering the strength of our balance sheet, our leverage ratio is 0.8x on an adjusted basis. We made two small investments that you'll see when the 10-Q is released. One was for $1.4 million in Fluidx Medical, a company we had previously invested in, and we purchased additional stock in it. We also made a second investment with an initial cash outlay of $3 million to acquire Restore Endosystems. So we've made a couple of small moves, but we are definitely exploring other possibilities.

Great. And then just secondly on the macro, I guess two quick things. One, are you seeing success with pricing? I was wondering if you could provide some more details on potentially getting some price increases to offset inflationary pressures. And then secondly, are you experiencing any backlog buildup? Are you losing opportunities due to supply chain issues? We understand the impact on expenses, but are you seeing any effects related to supply constraints and your ability to sell?

Listen, one of the great blessings that Merit has and fortunate things is that we're vertically integrated. We've talked about it a lot. And so although as we've said many times in the past, we're not immune to these pressures in the marketplace, we're in a good position because of our extrusions, our molding, braiding and so on and so forth, sensors, of the things that we make ourselves. So that's part of I think the thing that helps us in terms of the supply chain. Raul, you wanted to comment?

Yes. One inflationary factor that I can elaborate on is freight and logistics. We had planned to increase our reliance on ocean shipments instead of airfreight. However, we've been unable to make this transition due to the strong demand for our products. It's crucial for us to meet our customers' needs. As a result, we haven't been able to shift to ocean shipping as quickly as we had expected. From a broader perspective, this is something we can manage. I believe we will eventually reach our goals, but in a quarter-to-quarter environment, that isn't always feasible.

The ship doesn't turn that fast.

Yes, we're working to meet customer demands and haven't been able to shift to ocean shipping as much as we had hoped. We're really excited about our FfG initiatives and the progress we've made. Fred mentioned earlier the contributions from the team, including pricing strategies. We're optimistic about our efforts, but we recognize there's still a lot of work to do. It won't all be accomplished in one quarter; it will take time to reach our goals.

Our next question comes from the line of Jim Sidoti of Sidoti & Company.

So the 20,000-foot story here, it sounds like you're able to raise your top line guidance despite the stronger dollar. So obviously, you must be seeing stronger demand or stronger growth in procedures. Is that primarily in the U.S., or is that worldwide?

Well, I think I can speak to EMEA and I can speak to the U.S. I think we're seeing more demand for the procedures. I think those are progressing. And as I've listened to other players, I think that's a fact. What's going on? Raul, you wanted to comment. You have your hand up there.

No, I was just going to say that's true, specifically on a constant currency where we're up $60 million at the midpoint. So that was a good pickup, Jim, and I think we're excited about the momentum in the business. The U.S. constant currency growth increased from 3% to 5% compared to the previous guidance of 1% to 4%. So again, I think we're seeing the momentum in the business, and we tried to reflect that in the updated guidance.

And that was the biggest portion of our revenues.

Yes.

Gives us a big advantage there.

Yes.

And Raul, I think you mentioned in your part of the script that R&D expenses were down year-over-year. Is that just the timing of some of these trials?

Well, it's a little bit of the trials. It's also some of the hiring. The current market, it just takes longer to hire people, quite frankly, finding the right candidates. So that's been part of the slower spend that was anticipated, on top of people kind of managing their expenses better just given the environment.

Our next question comes from the line of Mike Matson of Needham & Company.

I noticed we haven't discussed the impact of currency on your margins or bottom line. Is it effectively neutral because of the hedges you have in place, whether national or otherwise?

Yes. We're not going to quantify the impact to our operating expenses or our gross margin. So we do talk about revenue and I think we'll leave it at that. It just gets pretty complicated, as you can imagine.

Okay. But I mean, you're not really lowering your guidance or anything like that because it's a big enough headwind to your earnings, right, so…

That's correct. The only impact to our guidance was the gross margin, which we adjusted down by 110 to 150 basis points. The main factors affecting this were raw materials and freight and logistics. Raw materials contributed an additional 50 basis points beyond our expectations, which is largely beyond our control. On the freight side, it accounted for 60 to 80 basis points, but we are more confident in managing that. Considering the strong demand for our product, we view it as beneficial to continue delivering in this environment rather than altering our shipping methods from air to ocean.

Okay, got it. And then I wanted to ask a product question or a pipeline question, I guess, about this genicular artery embolization for knee arthritis. Can you maybe talk about the market opportunity there and the timing of when you could launch that indication, I guess, for your Embosphere product?

As we shared in our press release, we have been holding a KOL meeting this week to discuss this opportunity. It's still early, Mike, and I'm being honest about that. There are studies and experiences that need to be conducted, but it involves an existing product, which is crucial. We are collaborating with our KOLs and other groups regarding the structures and plans they want to implement in their facilities, whether in Canada or elsewhere. It's too soon to provide specifics about the opportunity and the filing. We already have the product, but we need the evidence and support to be established. It may take some time, and I believe it would be premature to provide further details. Some others are discussing this as well, but we're not going to speculate on numbers at this stage. What I can say is that we are actively engaging with physicians, rheumatologists, and others to understand the potential here. We will eventually assess the market and the prevalence of osteoarthritis, but that’s not the focus for today. It's early days, but we are making progress because, similar to UFP or PAE, this represents the next horizon for our Embosphere, microcatheters, and access products. That's the best way I can address it for now.

I understand. Got it.

Our next question comes from the line of William Plovanic of Canaccord Genuity.

I just have one question. With interest rates increasing, you're probably looking at an additional $0.5 million to $1 million each quarter. Does that influence your decision regarding mergers and acquisitions, or do you intend to accelerate the payment of your debt? How are you approaching that and managing the increased costs?

Yes, interest costs and other related expenses have to be considered in the formula when analyzing these factors. Those are the realities we face, and predicting where those rates will go is part of the process. Regarding your numbers, Raul, would you like to add anything?

No, I was just going to say the same thing. Look, if you find the right asset and the cost of capital is going to be obviously factored into that, so it should be kind of taken care of from that perspective. But we did factor in some rate increases in our debt calculation. We're obviously paying things down. And so we'll continue to do so to the extent we generate free cash flow. So I think things are on pace for what we anticipated; no changes there.

Our next question comes from the line of Joseph Downing of Piper Sandler.

Congrats on the solid quarter. I'm on air for Jason Bednar tonight. Just digging a little deeper into the China point. As you mentioned, it's a tough market to get a read on but can you just describe in a little more detail what you're seeing on the ground in that market? How are procedure volumes recovering if lockdowns are lifted? And what are you seeing thus far on the tendering side, whether it be good or bad?

Yes, it's interesting that you asked. Just this morning, I read that they are locking down Wuhan again, affecting another 11 million people. We'll see what happens tonight and tomorrow since things change every day. Overall, I can say that everything related to China is considered in our guidance to the best of our ability. So I'll answer the question this way: there are many factors, and it changes daily. However, based on what we're observing on the ground, it's all included in our guidance.

Okay. And then anything else...

Well, do you mean regarding China or are you still on that topic?

I think he dropped.

Okay. I think we lost him. He might come back here.

We'll take Mike.

Our next question comes from Michael Petuski.

I may have missed this, Raul. I'm trying to understand this endoscopy guidance. And I understand you guys were sort of looking for some impact in Q2. It didn't come. And now it appears like you're thinking that maybe it can come in Q3 but maybe it won't. And I guess my question is, is it absolutely sort of a downdraft inevitable, it's just timing? Or is it possible you avoid this issue altogether?

So it did happen, Mike. I think what masked it was that we experienced increased demand for the Elation balloons in endoscopy. We're fully engaged in addressing it. As I mentioned, we're on track to outperform the lower end of expectations. However, this is a very delicate situation. We have to go through necessary qualifications, and the current macro environment is challenging. We're actively working to mitigate the effects of the macro environment, to be honest.

But Mike, it's not a mystery. It's not a, we don't have an idea. It's actively being worked and followed and it'll come into play in the end of this quarter. The question is, what happens in this next quarter, the third? Does that roll into the early fourth or whatever? But in the meantime, as Raul pointed out, the Elation balloons were sold at record levels.

Did you take the full hit that you expected to take in terms of that issue in the quarter, in Q2?

It's not exactly what we expected. However, I believe we achieved about 70% to 75% of our target. I would need to check the numbers, Mike.

I will say the vendor, which is a U.S. company and someone we've worked with in the past, is one of the best vendors. These guys are solid.

Optimistic. Hopefully, you're an optimist. However, I believe we've made efforts to ensure there are no surprises, even though everything is on track.

And as there are no further questions in queue, are there any remarks from management?

Thank you to everyone for joining us today. It’s been a busy hour, and we appreciate your commitment. We are pleased with the quarter and hope you are too. If you have any comments, we look forward to hearing them. We will provide some clarifications in our one-on-ones now. Thank you once again for attending, and we look forward to reporting to you again soon. Best wishes from Salt Lake City and good night.

That does conclude our conference call for today. Thank you for your participation.