Fisher & Paykel Healthcare Corporation Limited

Hi, everyone. Welcome to Fisher and Paykel Health Care's results conference call. My name is Kellyanne. I'll be your operator for today's conference. At this time, everyone except the guest speakers will be in a listen-only mode. Later, we will conduct a question and answer session. We ask for your assistance in keeping the call to a maximum of one hour today. If assistance is required at any time, please press the star key followed by the digit zero on your phone and wait for a coordinator. If you require further assistance, you should redial into the conference. Please note that today's call is being recorded. At this time, I'd like to turn things over to Marcus Driller, Vice President, Corporate. Please go ahead.

Thank you, Kellyanne. Well, good morning, everyone, and welcome to the Fisher & Paykel Healthcare first half 2021 results conference call. On the call today are Lewis Graydon, our Managing Director and Chief Executive Officer, Lyndall York, Chief Financial Officer, Paul Scherer, Senior VP of Sales and Marketing, and Andrew Somerville, our VP of Products and Technology. Lewis and Lyndall will first provide an overview of the results, and then we'll open up the call to questions for the team. We'll be discussing our results for the six months ended 30 September 2020. And we have earlier today provided our interim report, including financial statements and commentary on our results to the NZX and ASX. These documents can be accessed on our website at fphcare.com forward slash investor. With that, I'd now like to turn the call over to Lewis.

Okay, thank you Marcus and welcome everyone. Today I'm going to be referring to the investor presentation pack that was released to the NZX and ASX this morning. We're going to start on page three, but before getting into details of our financial results, I really want to start by thanking some people who are very important to us. First, I'd like to express my thanks and our admiration for the thousands of healthcare providers around the world who have responded to the COVID-19 pandemic with such care and such courage. Second, I want to thank everyone across our entire business, but especially our families and partners, for the contribution you have made this year, supporting the single-minded focus of our people, either working from home or the long hours at the manufacturing and distribution sites, and all of this for extended periods of time. and all of this at a time when you may have had other major concerns as well. Our families and partners have made a big contribution to Fisher & Paykel Healthcare's results this year, and we really want to acknowledge that. And thirdly, I want to thank our suppliers all around the world. They've all gone above and beyond to provide the raw materials, the components and the services we need to answer the global call for our products. So thank you. So now turning to page three, I'd like to acknowledge some of the highlights for the half year. Our biggest achievement by far was ramping up production on a number of our hospital hardware and consumable products to meet that customer demand. We accelerated production in the new Daniel building and we commenced planning for our third manufacturing facility in Mexico, all in the half. We also developed a wealth of new online resources to support healthcare providers who are treating patients with COVID-19. So turn now to our results on page 5. For the first six months of the 2021 financial year Fisher & Paykel Healthcare delivered extremely strong financial performance. Overall operating revenue for the first half of 2021 was $910.2 million. This was a 59% increase compared to the first half of the 2020 financial year, and that's 61% in constant currency. Net profit after tax was $225.5 million. That's up 86% on the first half of last year, or 87% in constant currency terms. Growth continued to be driven by hospital hardware. and that increased 383% in constant currency. In short, the world needed our EVA, our OptiFlow, and our humidification systems, and we have delivered. Our consistent practice has been to pay a dividend to shareholders. Given the positive result, our board of directors has approved a fully imputed dividend of 16 cents per share, and that's an increase of 33% on the first half of the previous financial year. Now achieving these results has required an extraordinary effort from our entire team and to acknowledge the way our global team has gone above and beyond, the board has doubled the discretionary profit sharing bonus our people will receive for the first half of the financial year. This total bonus is equal to approximately 3.1% of annual base pay for each person and it's a total profit share of about $12 million. So now looking more closely at our product groups, starting with hospital, page six. So these are products and systems used for invasive and non-invasive ventilation and nasal hydrotherapy and during surgery. This includes the Evo devices and the therapies like OptiFlow that are being used to treat COVID patients. On page seven. Our reported revenue for hospital products was $681 million, up 93% or 94% in constant currency, and that's over the first half of the 2020 financial year of course. Sales in hardware and consumables continued to track surges in COVID-19 globally, and that's as the virus moved across Europe, North America, South America and South Asia. Revenue growth in new applications consumables was strong at 43% over the first half of the previous year in constant currency terms. So now if we move on to the home care product group, starting on page eight. So this includes products used in the treatment of obstructive sleep apnea, or OSA, and chronic obstructive pulmonary disease, or COPD, as well as other chronic respiratory conditions. We're heading to page nine. In our home care product group, operating revenue grew 5% to $226.2 million, with 6% growth in constant currency. The first half was challenging for our sales team in obstructive sleep apnea. Many sleep clinics around the world were closed or operating at reduced capacity, and that resulted in a reduction in new patient diagnoses. Having said that, customers have responded positively to our Evora and Viterra masks for OSA, our newer masks, and we're confident that these are great products and that they've yet to reach their full potential. So now I'll turn over to our CFO, Lyndall York, to give you some more details about the financials. Lyndall.

Thanks, Lewis, and good morning, everyone. On page 10, Gross margin decreased by 534 basis points to 61.7% for the half, down 420 basis points in constant currency. As Lewis discussed, there has been a sustained high level of demand for our respiratory products. Because of the challenges with global supply chains, we have been and continue to use air freight to bring in raw materials and deliver product to our customers quickly. The cost of air freight and expediting the supply of raw materials has been significant, with the cost per cubic metre of air freight averaging four to five times higher than normal. However, we have opted not to increase prices to our customers, and this has impacted our gross margin. Excluding the additional freight costs, gross margin was in line with the same period last year in constant currency. The amount and cost of air freight has reduced from the early months of the pandemic, but are still at elevated levels. We have assumed that the freight costs will continue at these current levels for the remainder of the year. Moving on to page 11, total operating expenses grew 17%. As this was significantly lower than the revenue growth, the operating margin increased 489 basis points to 34%. There was a negligible net impact on our operating expenses from COVID-19. Higher costs, such as personal protective equipment, wellbeing, cleaning and security, were largely offset by reduced travel and sales event costs. R&D expenses grew 20% to $64.6 million, reflecting continued growth and timing of R&D projects. R&D expenses were 7% of revenue for the half. We have a strong new product pipeline including new humidification systems, flow generators, masks, consumables and information solutions all under development. SG&A increased 15% to $118.1 million for the half or a 16% increase in constant currency. We anticipate that our constant currency operating expense growth for the second half will be slightly lower than the growth rate in the first half. Moving to page 12. Operating cash flow was $218.1 million. Our working capital increased, primarily reflecting the growth in the business and rebuilding our inventory, including the sea freight pipeline, which were lower than usual at the end of March. Capital expenditure, which includes purchases of intangible assets, was $94.5 million for the half, compared with $86.6 million last year. Our fourth New Zealand building, the Daniel Building, was completed this half and we have been accelerating our investment in manufacturing capacity to ensure we have an increasing supply of our products. We are still expecting to spend approximately $185 million in capex for the full year. Our free cash flow, which is operating cash flow less capital expenditure and lease payments, was $118 million for the half. From this free cash flow and our short-term deposits, we paid $89 million in dividends during the half. The balance sheet remained strong. Debtor days are within the normal range at 44 days and in line with the prior year. Inventory has increased with business growth and a rebuild from lower levels in March. Net property plant and equipment increased by $42 million from the 31st of March, mainly as a result of the acceleration of manufacturing capacity. Net cash at the 30th of September 2020 totaled $78.1 million, up from $42.2 million at the end of March, predominantly as a result of higher sales driven by the COVID-19 demand. We had cash balances and short-term investments mainly in New Zealand dollars, of $158.3 million at the end of September. Interest-bearing debt was $80.2 million, with 26% of it being non-current. The $30 million US dollar facility that matured on the 1st of November and was classified as current has now been replaced with two $30 million New Zealand dollar multi-currency facilities, maturing in September 2025. Most of the debt is held in US dollars as a balance sheet hedge. Turning to page 13, our gearing ratio at the 30th of September 2020 was minus 7.1%, which is below our target gearing range of minus five to plus 5%. Based on our guide assumptions that Lewis will go through shortly, we are projecting to be around the bottom of our target gearing range at the end of FY21. As Lewis mentioned previously, we will be paying an increased interim dividend of 16 cents per share, payable on the 16th of December. This represents a 33% increase on the interim dividend declared last year and enables us to make the accelerated investments in manufacturing capacity that we are currently doing and expect to continue over the next year. The dividend will be fully imputed and a supplementary dividend of 2.82 cents per share will be paid to non-resident shareholders. Looking now at foreign currency on page 14. Profit after tax for the half declined by $4.9 million compared to the prior period, primarily due to the New Zealand dollar being stronger than at the 31st of March 2020. This includes the results of our hedging program which contributed a loss of $1 million after tax for the first half of this year. Our policy remains unchanged and when there are opportunities to extend our hedging position we are able to do so up to five years forward and in some circumstances up to 10. At current rates and the assumptions used in our guide, for the second half this year we would have an after tax gain from hedging of approximately $10 million. These rates and assumptions would result in a decline of our H2 net profit after tax compared to the second half of last year by approximately $13 million due to net currency impacts. Now I'll pass back over to Lewis who will outline our full year guide assumptions. Lewis?

Okay, excellent. So I'll move now to page 16. We've had a strong first half to the year and we've continued to expand our installed base of hardware in hospitals. Since the last trading update we gave in August we've maintained the same level of hardware and consumables revenue in our hospital group for the half year and in our home care product group OSA mask revenue also continued at similar levels to the first four months of the financial year. Now we cannot predict the course of COVID-19, the effectiveness of preventive measures, the adoption of preventive measures, the progress of a vaccine, outcomes of vaccines the impact of any of those on future hospital rates or investments that countries may choose to make in treatment measures. So consequently we really have no basis on which to provide traditional guidance for the full 2021 financial year. So what we're doing is providing a guide to the full year results based on the following assumptions which I'll list. We assume that hospital hardware sales return to normal levels from January 2021. Second, we assume that the use of our hospital hardware returns down to approximately normal rates for the second half of the financial year. Third, we assume that OSA diagnosis rates are reduced for the second half of the financial year and that's due to limited access to patients. And finally we assume that freight costs remain elevated resulting in a reduction in gross margin of approximately 200 basis points in constant currency terms for the full financial year. So now based on these assumptions and reflecting the sustained stronger hospital hardware sales to date, on that basis full year operating revenue would be approximately $1.72 billion and net profit after tax would be in the range of approximately $400 million to $415 million. This guide is based on exchange rates of 0.69 for the NZ dollar to the US dollar and 0.58 for the NZ dollar to the euro. Just to be clear, our assumptions used in providing this guide, they're not a prediction or a forecast of the course of COVID-19 around the world or its impact on us and they don't impact our production planning. We are continuing to grow the manufacturing capacity of those hospital respiratory products for the rest of the 2021 financial year and that's because we think the world's counting on us and we think it's the right thing to do. Now while the efforts to contain COVID-19 remain uncertain, we believe the exposure clinicians around the world have had to our hardware bodes well for treating respiratory patients in hospitals over the long term. Now with that I think we can now open to questions.

Thanks Lewis and operator Kellyanne if I could ask you to please open the lines up for questions. And before we move to the Q&A, could I ask everybody to limit your questions to two? This is just with a view to giving everybody an opportunity to ask their questions. And of course, if you do have further questions, you're welcome to join the queue again, or even one at a time.

Thank you. We'll now begin the question and answer session. If you wish to register a question, please press the star key followed by the digit 1 on your phone. Again, that will be star 1 for questions. We'll pause for just a moment.

Thanks, Kellyanne. I think we have our first question, and it's from Andrew Goodsell at MST Marquis. Please go ahead, Andrew.

Thanks very much for taking my question. Congratulations on a great response to the COVID and a great result. I was just going to quickly ask just if you could add any comment around third quarter trading to date, just with the Northern Hemisphere second wave and lockdowns.

Well, yes, I can, but before I do that, Andrew, I want to point out one really, really big thing, and maybe could relate to all the questions we're about to get, and that is when we look back on that first half, we have massive variability from month to month in both our hardware and our consumable revenue. If we look at a region over the six months, we have really big variability from month to month, It tends to track COVID hospitalisations. If we just take a snapshot of one month in time and we look at the world, again, we have really big variability. I think that if we took the last three months and we tried to forecast the next three months off that, we'd be changing our forecast on a monthly basis. I don't think there's a lot of value in Doing that or going there, Andrew, there's just such massive variability. Having said all that, with that caveat, it's looking pretty strong.

Anything else you want to add to that or just strong?

Well, again, it's impossible to draw a trend off what looks like a pretty random graph It doesn't look to us like anything's going away.

Okay. And then the second question, just curious around your outlook comments on OSA and the comment on diagnostics in the second half. I was just going to see if you could expand on that because I guess I'm reading it as you're seeing a slowing of new patients in the second Northern Hemisphere lockdown because of lack of access to diagnostics.

Yeah, I think that's a fair comment. And we're trying to take account of the impact of COVID on sleep labs being open, whether they can pivot to home diagnosis, whether patients want to be engaged in treating sleep apnea, whether patients have the money to contribute to that. So we're trying to take account of a whole lot of things. We've kind of landed on it's almost impossible to try and predict those impacts. So we've taken an arbitrary number to put in our guide and that arbitrary number we just assumed that we would have 80% of last year's new patient starts, our second half would be 80% of that this year. I just want to emphasise we've used that, it's a relatively arbitrary number. Fair comment to say I think from what we're seeing, we know it's reduced but to what extent and to how long in the future, we just pick the number.

That's fantastic, thank you very much.

Okay, thanks Andrew. So next question comes from Marcus Curley at UBS, go ahead Marcus.

Good morning, I just wondered if you could talk to what you think the benefit from COVID has been across invasive ventilation versus new apps or high flow. I suppose it looks like the growth in consumables in invasive ventilation was stronger. Obviously, the average consumable price there is lower. So it would suggest quite a large skew in terms of COVID patients towards your traditional business versus your new app business.

That's a complex question, Marcus. Remember that we've given you new apps growth rate and in new apps you've also got non-invasive ventilation that's running a bit under the average rate and you've also got surgical which has pretty much disappeared during the last six months. So you've got some drags on the new apps rate, that would be the first comment. to your question would be that we're fairly confident that all these intensive care ventilators that have gone out, a large proportion of these ventilators that have gone out, we've managed to supply them with humidifiers and humidification products. Then I guess the third caveat is typically in a normal year we talk about utilisation, we're talking about our revenue. And in a normal year that kind of makes sense. But we don't actually have visibility to utilisation. So what we have visibility to is our sales. So there's another variable there that we can't put a number to and that is how much of this is being utilised and how much of this is customers, hospitals, supply chains rebuilding their inventory.

Could you talk a little bit to what you think your installed base has increased by across invasive ventilation and high flow?

No, that's not a place that we're comfortable going. You can see certainly the numbers for the half, so you can draw a conclusion that it's increased substantially.

OK. And secondly, just on the flu season, is that an influence on why you are suggesting for the second half, or assuming, I should say, that utilization in the hospital space falls back?

So we're not really thinking about the flu season this year. We think it's just been completely and utterly swamped by the other flu, the COVID-19 one. So that really hasn't played into any of the assumptions. Again it's kind of an arbitrary number that we've chosen to say well we'll assume normal utilisation for the second half. I spoke about all the variability in the first half and on a month-to-month basis it's all over the place but if you take the average over the first half it doesn't look too unusual. So that's kind of the only thought that's gone into that assumption for the second half of averaging about normal utilisation.

Thanks very much Marcus. I appreciate that. Next question comes from Leanne Harrison at Bank of America.

Good morning all. Thank you for taking my question. I know you've mentioned you can't speak exactly to the October and November trends, but can you give us some indication, and if we look at hospital revenue, if we look at hardware, are you still seeing demand on hardware come through from all the geographic regions such as US, Europe, APAC and other, or are there specific regions that you can call out that are still demanding hardware?

I think the answer to your question, Leanne, is yes, and it's all regions. With the caveat that we're talking about two months, what's been a very variable, well, you're up to eight months now, very, very variable eight months. Those last two, I'd say across all regions and hardware demand continues.

Okay. And would that hardware demand... be stronger or less strong than what you've experienced through the first wave, particularly through the United States?

Again, I'd caveat that with the very, very verbal, taking two months out of something. Just try and put a color on it. We can have a month that utilization looks like maybe double normal to months where it looks like half. So you're talking big variation, which is why I think it's very, very dangerous to focus in on two and a bit months, one and a half months. One and a half months, really dangerous. And again, with that caveat, the last couple of months, you could pick a couple of months that looked like that out of the first half for any region, actually.

So just to clarify that, if I looked at... you know, the first, you know, say one and a half months of third quarter compared to, you know, April and May, or April and the first half of May, would that demand be, the hardware demand be stronger or less strong than that period? I guess what I'm trying to understand is... Oh, hang on. Back to that caveat there.

What I'm telling you is I could find two months in the third quarter... I could find two months in the first half that looked like these two months. So I think we are just on such dangerous ground trying to draw any extrapolation out of two months. I really want to caution you on that.

It's dangerous. Okay. No problems. Why don't I move on and let's talk about consumables revenue. Would you say that there is possibly... likely to be increased consumables growth, given that you've got a higher installed base now, and then also a second wave of coronavirus, particularly for the United States.

Well, yeah, we do think that's likely. And if you look at the guide we gave to the second half, that is kind of built in there. We're assuming that the hardware base is utilized So that gives you consumables growth and then the only additional comment to make to that was once we get to our second half we're lapping February and March. February and March we had already begun to see the pandemic response in our consumables revenue.

Okay, thank you very much.

Thanks Leanne. Thanks Leanne. Now the next question comes from David Lowe at JP Morgan.

Thanks very much. Lewis, could we start with just talking a little bit about how much pull forward sales you think you've received as a result of the recent period? So where did the air flow, air flow, nasal high flow sales end up versus where you perhaps would have predicted they would have been a year ago? I'm just trying to get a sense as to how much additional equipment's been sold into the market from the hardware side.

Well the best sense we can give you is that 383% hardware growth of what's happened. In terms of trying to estimate what's been pulled forward, I wish we could but at the moment we have, I'd just say we couldn't, we can't interpret what's been pulled forward at all. We don't think this is pulled forward. So far looking at our data we see It looks like what we've placed is being utilised.

Okay. Yeah, I guess what I was trying to get a sense is just how far ahead of plan are you in terms of rolling out the nasal high flow? And then, of course, the real question, I think, for the business is where to after the pandemic? Have we just stepped forward a number of years and growth continues from there, or have we seen a whole lot of hardware sales into the market, which will now take a little bit of time for the underlying normalised demand to catch up. Any thoughts on that?

Yeah, you're right. That is the question. In terms of Optiflow and Airvos, we had such low global penetration prior to the pandemic, we don't think we're anywhere near saturating that market whatsoever. We think The challenge and what our job is, what our opportunity is, is to ensure it continues to be used post-pandemic as a default therapy for respiratory support. That's what we'll be working on and that's what we'll be aiming for. So if we achieve that, well then, you're right, we will have just managed to roll progress forward several years, depending on how long these rates go on for.

So we saw a lull in the COVID cases, particularly in the US. I'm wondering if there's any anecdotes that came through from that period. As we passed the peak, there was a lot of this hardware, Fisher & Paykel's hardware, in some of these hospitals. And I'm thinking in some regions, obviously, more had earlier peaks than others. And what happened to utilization in those periods that followed? Perhaps that's possible to say, but just any thoughts or anecdotes on that front?

I think during the lulls it was mostly about trying to replenish inventory so it's a bit hard to say from any data what was actually going on there. People were trying to build inventory and that might have impacted their treatment decisions also and also bearing in mind that our sales people haven't had great access to hospitals. It's been really essential access only during this whole period. I'm wondering if Paul wants to add some colour.

Well, it's been lumpy for a whole variety of reasons, David. And of course, COVID has kind of started in New York and spread in other states and things, so that has an impact too. It's too much variability there to be able to draw any real conclusions.

And no real anecdotals that I've heard talking to the guys.

I think there's only one other thing I would say. What has been very helpful is that we've got a whole lot of new customers that are now gaining exposure and interest in airborne OptiFlow, and I think that bodes really well for the future.

Yeah, now look, I gather it's an impossible question, but it's also the crucial question. If I could squeeze in one more, just the home care business, there's a comment there about MyEvo sales being strong. Can we just talk to how much demand you saw for treatment of patients at home, presumably COVID patients at home with MyEvo?

So we don't know what the MyEvo product is being used for in the home. We can't give you any data around that. I think three or four months ago, Moeva's been growing strongly for a while. It was sitting on a similar trajectory three or four months ago, and I'd say it's probably picked up. It's been accelerating over the last three or four months. It's been useful, harder to say.

Thanks, David. Next question comes from John Deacon-Bell at Citi. Go ahead, John.

Thanks very much. I was just trying to get a little more, just to ask that question a little differently around the geographic demand. So we've got your general geographic growth, North America 44%, Europe 70%, so quite a big difference, but we don't have any colour between the businesses and also between the hardware and the and the consumables in the hospital site. Can you just try and give us a bit more colour on where the demand geographically has come from?

Yeah, I will. First of all, those numbers you're looking at are confounded by a couple of things. They're confounded by currency, foreign exchange rates, and also you've got kind of different proportions of OSA in those different markets also. So I wouldn't go to that as my guide. And also they're more strictly defined as the geographical region where the sale was made, which may not be where the product ends up. So I don't know if I'd rely on those numbers. What I can tell you is that over this last half, about... Somewhere around half of the hardware placements during the half were outside North America and Europe and we saw stronger consumable growth of a smaller base in consumables outside North America and outside Europe. I would say in that region outside North America and Europe it's pretty well distributed across kind of all the different sub-regions. They all look pretty similar. growth rates and magnitudes.

And in those numbers I was quoting, there's a very big other line which is outside of North America, Europe and APEC. I just wasn't sure where that was. Me neither.

Yeah, John, it's Lyndall here. So that is basically everything that's not Europe, North America or Asia Pacific. So it's You're Africa, Middle East, Latin America primarily there.

Right, OK, because that grew 300% or something. So effectively, you've sold stuff everywhere in the world is what you're saying. Correct. OK, thanks very much.

If you take any kind of sub-region, if you take Latin America, if you take Middle East, if you take Eastern Europe, they all look pretty similar over a six-month period. Thanks, Lewis.

Thanks, John. Next question comes from Chris Cooper at Goldman Sachs.

Hi. Thank you for taking my question. My two were really on utilization, but I think you've been as clear as you can be, I guess, that you expect to see some relative stability there. Look, perhaps I can just ask an even longer-term question. I mean, the longer-term ambition to sort of displace conventional oxygen therapy, you've got it on slide 27. How much has that changed? Let's take a five-year view instead of like a one or two-year view here. I mean, what percentage of conventional oxygen therapy has been displaced already today, sort of pre-COVID or during COVID, and where do you think that number is in five years' time, and I guess the question is, has that steepened that penetration trajectory through COVID, or do you think it's more or less the same as it was? I'd just be interested to hear your thoughts on the slightly longer-term view here, but perhaps I can also ask a slightly more granular one just on gross margins. Air freight is obviously still having a material impact. I wonder whether you're seeing any sort of selling advantages, actually, in terms of efficiency or speed to market I know you're now sort of, you know, having spent a few years above your gross margin target, you're now a bit below it. Should we think there's any sort of stickiness to some of these costs that you've incurred through this, through the pandemic? And, you know, it's actually helping to deliver some of this top line strength that we're seeing or, you know, rather, you know, as we get back to more normal conditions, do we see gross margin come back up to where it was?

Okay, we'll park the gross margin one for now. And we'll go to the first question. So longer term. So over the last six months, I don't know if we can put any data or number, even anecdotals, on have we displaced conventional oxygen therapy. You can see it in some of the clinical data, certainly for COVID patients where the protocol is to start patients on nasal high flow, OptiFlow. So you can see it in some of the clinical data where that's a protocol. I don't know if we can help you with what percentage. I think the fundamental here is that we've placed a lot of hardware. So in terms of our normal selling process, we need to talk about clinical advantages and clinical benefits of OptiFlow. We need to talk about the economic advantages And then we need to have our customer purchase some hardware and then we need to go in and install it and then we need to go in and train every single user in the institution on how to use it. So by placing all this hardware, we're certainly over, I'm going to call it half the hurdles. The job's half done. Maybe it's all done, depending on the experiences and thinking about COVID versus respiratory patients. Maybe it's not, but that's what we'll be working on. To date, the way we are thinking of it is that, and it depends how long things go on at this rate, of course, where we finish, but we are thinking that we've at least moved things forward maybe two or three years. And if we've got some work to do to displace conventional oxygen therapy, we're doing that work with a lower hurdle. So I think that's the best answer I can give you. That's your first question. Of course I've forgotten the second question, so Linda will reckon she can remember it.

Something about gross margin. So I'll talk you through gross margin Chris. We have seen significant impact from freight in the first half. If you stripped out the excess freight cost which is the percentage that we've sent air freight which got up to 60% earlier in the half and averaged around 25% for the half, it's currently down slightly below 20% that we're sending air freight at the moment and that's what we have assumed in our guide for the second half, so in terms of stickiness there. Then it's also the cost per cube of that air freight. It got up to about eight times what it would normally cost us, which is in a normal world four to five times more expensive than sea. So air freight is more expensive than sea freight and we were seeing it exorbitantly expensive in the early months of the pandemic. Now that has come down slightly and we're currently tracking around two times the normal cost of air freight. That's what we've used in our assumptions for the guide for the second half. So on those assumptions and if that freight level of air and cost per cube of air hold steady, we're expecting or we would project then our second half gross margin in constant currency to be about the same as it was in the second half of last year. So we will still have some elevated freight costs compared to last year. But don't forget last year we did start to see some of that elevated freight costs in March. But we are then going to see some of that volume benefit and that efficiency benefit come through to offset it so that for the total half, second half, we would be assuming to be similar to last year's second half which is around about that target 65% constant currency.

And then long-term, when we are carrying some additional operating costs related to COVID, we don't see anything there that thinks long-term sticky.

No.

You know, PPE and sterilizing and cleaning. Correct. Yeah.

Yeah.

Got it. Thanks. And just a quick follow-up, just on price. I mean, I noticed, I mean, last two times you've given us updates, you've commented that you haven't increased prices. Prior to the pandemic, I believe there were modest price increases going through. You've obviously paused them. Should we be thinking that price increases begin to come back at some point as we get to more normal conditions, or are you happy with the current level?

I'll pass that question over to Paul.

Yeah, I think we can just assume, Chris, that when things go back to normal, that our business will go back to normal, and the way we've conducted our business in the past will be pretty consistent with how we'd like to conduct our business in the future.

Understood. Thank you.

Thanks, Chris. Next question comes from Tom Deacon at Macquarie. Go ahead, Tom.

Good morning, guys, and congrats on the good result here. Good morning. Just one on CapEx from me. How are you guys feeling about manufacturing capacity at the moment with the continued COVID demand? And you kind of mentioned that we should expect $185 million or so in this financial year. Any indication of what we could expect in FY22 at the moment, given what you're seeing out there?

Thank you. So I'll give you the thinking, and then I'll hand over to Lyndall to get the numbers straight. Our thinking is that we keep building manufacturing capacity for these products until things have clearly stabilised. That's the sum total of the thought. The manufacturing expansion plans currently go out to mid-next year, and obviously it's something we are continually reassessing. Lyndal, do you want to talk to the CAPEX FY22?

Yeah, look, we haven't had a good look through into FY22 at this stage. However, there will be some carryover capex from what we have started this year, particularly our third building in Mexico. We'll finish and continue spending and complete there. Likewise, as Lewis said, we'll be continuing to accelerate that manufacturing capacity into sort of the middle of next year, so there'll be some carry-on of that. So that will probably have it a bit more elevated than it would normally be. it really will depend on how we're seeing COVID as well as our sales play out and making sure that we always are aiming to keep plenty of manufacturing capacity ahead of the demand and the need.

And then I suppose the other comment, we're not thinking of this as abnormal or extraordinary or one-off CapEx in any way. We're just thinking of it as being pulled forward We would have built this equipment and built these buildings sooner or later anyhow. Correct.

That's very helpful guys. Thank you very much and that's it from me. Cheers.

Thank you. Our next question comes from Chelsea Leadbetter at Forsyth Bar.

Thanks Marcus and morning team. Maybe if I come back to the questions that have been around hardware in the hospital and just trying to see if I can get some context in terms of, I mean clearly it's been a big year in terms of the uplift, but in terms of the mix between Evo versus your sort of 950, 850?

Sure. Well, Evos offer smaller base and rate, so it's the higher end of the growth rate. Humidifiers, larger base. larger underlying rate, so it's at the lower growth rate end, lower side. That help you?

Okay, so no visibility on sort of, I guess, mixed 50-50 split, 60-40, you know, that type of kind of split between the actual demand?

Chelsea, you're right again.

Okay, all right.

That's correct. Yeah.

and then in terms of the actual um guide assumption set so when you say return back to normal levels and i appreciate this is just a um you know a statement that you're basing your assumptions on but what do you mean by normal are you referring to sort of pre-covered levels of revenue for hardware or are you assuming is that the way i should be thinking about it yeah absolutely right we're thinking pre-covered you know so take

first part of FY20 or FY19 or something like that and pro-rata it. That's what we're thinking.

No, that's clear. And just for the second question, I appreciate we've all tried to ask the same types of questions today around understanding what's going on geographically, et cetera. But can we come to, I guess, one market, be it China, that maybe is in a slightly different position? And could you kind of give us some context in terms of what's actually happening there with respect to demand turn rates for your consumables, all of those type of things that may help add some colour to the discussion?

Yeah, that is interesting. So of course we saw the big jump up in demand in China, just like everywhere else, and we saw it in hardware and we saw it in consumables. Then we saw, when they kind of got on top of it, we saw a lull. I would say over the last six months or so, China for us has now returned to normal, bearing in mind that China for us, normal is actually pretty high growth anyway. So it looks like China's returned to normal high growth rather than COVID high growth. And for our Chinese market, we are seeing a higher proportion of consumables which looks like higher utilisation. So we're seeing a higher proportion of consumables than we would have seen 12 months ago.

Okay, I appreciate it. Thank you.

Thanks, Chelsea. Next question comes from Stephen Ridgewell at Craig's Investment Partners.

Good morning. I just wanted to try and clarify some earlier comments in response to the questions about trading the last one and a half months. Lewis, noting your comments about not extrapolating, which are good caveats, I guess to be clear, are growth rates tracking similar or stronger or weaker relative to the 383% growth that we saw in hospital devices in the first half, and similarly for hospital consumers. Can you give us directionally how that's tracking for the last two months?

I'm going to repeat the caveat, Stephen. This is a very dangerous business, extrapolating monthly stuff where months can go all over the place. Very dangerous business. So having said that, let's do it, shall we, is kind of where we're going. I think it's fair to say if you look at the period right up until now, the overall trend is probably increasing hardware. Although we'll have a month where it goes the other way, for sure. But we don't see any let up, I would say. That's the best interpretation I can give you. If we average the whole what is it, eight and a half months, seven and a half months, we'd say probably more up than down would be a trend.

And for consumables in the hospital space?

Similar, similar comment, exact same comment.

Yeah, okay, because I guess reading from your early comments it sounded like The peaks you saw in April and July, you're probably seeing that again at the moment.

Yeah, something like that.

Okay, and then also just to flesh out the comments on production capacity, I think back in June, Lewis, you guided to 100% growth in production capacity for high flow and breathing circuits by about this time of the year. I guess, could you just clarify, have you kind of hit that target for 100% production growth? And then can you give us any insight as to how much more runway you've got to increase production over the second half or plans to further increase production by the end of the period?

Yeah, that is a real tough one. As I said, the plan is keep increasing production capacity until things stabilize. We've hit all our targets. We've hit or exceeded all our targets actually that we were aiming for. Maybe I'll give you a bit of colour on what we're trying to do. We're trying to rebuild inventory. Inventory is a nightmare at the moment in that we normally talk about it in weeks of revenue. The problem right now is weeks of what revenue? So our inventory target is three months of peak demand for hardware. Three months of whatever we've seen as the peak, we'd like to be carrying that as stock. For consumables, we'd like to head to a similar rate, three months, 14 odd weeks of stock related to peak demand for the hardware. What I can tell you is we're nowhere near that kind of inventory holding at present. So we think we're going to keep building up the capacity till mid next year to... There's the thinking.

Okay, no, that's helpful. Yeah, that's helpful. Thanks very much.

Thanks, Stephen. We've got no more questions in the queue. So I think in the interest of keeping this call to an hour, we'll pass back to you, Lewis, to wrap up.

Thanks, Marcus. I just want to say our heartfelt thanks does go out to our customers and to those healthcare providers for all of their efforts this year and to our suppliers, shareholders and clinical partners who are doing an outstanding job of supporting us during this extraordinary year. At a time in history that really does defy expectations, we're still doing what we do best and that's improving care and outcomes for patients. So thank you all. Thanks for the high quality questions. Much appreciated. Thank you.

That will conclude today's conference. Again, thank you all for joining us.