ICU Medical, Inc.

Good afternoon, and welcome to the ICU Medical third quarter 2022 earnings conference call. All participants will be in a listen-only mode. Should you need any assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, please press star, then one on your telephone keypad. To withdraw your question, please press star, then two. Please note that this event is being recorded today. I would now like to turn the conference over to John Mills with ICR. Please go ahead, sir.

Good afternoon, everyone. Thank you for joining us to discuss ICU Medical's financial results for the third quarter of 2022. On the call today representing ICU Medical is Vivek Jain, Chief Executive Officer and Chairman, and Brian Bunnell, Chief Financial Officer. We have a presentation accompanying today's prepared remarks. To view the presentation, please go to the investor page and click on the events calendar, and it will be under the third quarter 2022 events. Before we start our prepared remarks, I want to touch upon any forward-looking statements made during the call, including beliefs and expectations about the company's future results. Please be aware they're based on the best available information to management and assumptions that are reasonable. Such statements are not intended to be a representation of future results. and are subject to risk and uncertainties. Future results may differ materially from management's current expectations. We refer you to the company's SEC filings for more detailed information on the risk and uncertainties that have a direct bearing on operating results and financial position. Please note that during today's call, we will also discuss non-GAAP financial measures, including results on an adjusted basis. We believe these financial measures can facilitate a more complete analysis and greater transparency into ICU Medical's ongoing results of operations, particularly when comparing underlying results from period to period. We've also included a reconciliation of these non-GAAP measures in today's release and provided as much detail as possible on any addendums that are added back. And with that, it is my pleasure to turn the call over to Vivek.

Thanks, John. Good afternoon, everybody, and we hope you are well. Once again, it's been a quick 90 days or so since the last call. and our legacy ICU business unit revenues were, again, very predictable in Q3, and we did have operational performance improvements for the businesses that came with Smith's Medical. The external economic volatility in the supply chain around freight and fuel that we've been describing since mid-2021 surpassed even the Q2 2022 levels, which was hard to believe. As we said previously, Q2 was the highest peak for any time our team's been in the industry. However, the issues around raw material availability are narrowing. From a customer perspective, we felt U.S. hospital census was stable and international underlying demand was good in all geographies in Q3. Like everyone in our industry, we wanted to start first by thanking all of our customers and their frontline workers for trusting us to serve you during these times. While Q3 revenues were generally in line with our previous comments for legacy ICU medical, Our revenues for Smith Medical were ahead of our expectations that we laid out on the last call. And since everyone is now talking about items they would have never imagined describing on an earnings call, we'll join that group and wanted to use the time today on the call to comment on the year-over-year drivers of the three main legacy ICU businesses, explain the Smith Medical revenues we achieved in Q3 and how that bridges with our comments on the last call, provide a status update on the Smith Medical two buckets of challenges we've been highlighting all year, Go a bit deeper on the specific items that have really hurt gross margins this year because the scale is so astounding and it answers the question of where has the profit gone this year. Foreshadow, and it's subject to change, how we might report next year as we realign our reporting business units. Highlight the continued challenges with the strong U.S. dollar and why we're taking our medicine today and its most up-to-date impact in the near term. And lastly, note a few important strategic items we've now finished as they will impact the base of 2022 going forward as these were the first must-do strategic items as they were negative situations. And we'll skip the standard long-term value creation comments as that is after we get the self-help items secured in the near term. Q3 2022 is our third quarter of joint reporting, and finally the story is getting a bit shorter. I'll quickly summarize the whole company results and then discuss each segment of the business. We finished the quarter with $582 million in adjusted revenue. Adjusted EBITDA came in at $93 million, and adjusted EPS was $1.75. We had a softer quarter of investment into the business, and it was largely about inventory builds that Brian will describe. Again, it was a less clean quarter in the cost of goods as we spent at a very high rate to improve the service levels of Smith's Medical, and we had restructuring and integration costs that we remain focused on reducing next year as they impact cash flow. The strong dollar and current and FX impact are worse in Q2, worse than Q2 at the moment. So let me start with Legacy ICU Medical, which is a relatively straightforward story. In Q2, Legacy ICU had $320 million in revenue, which is flat on a constant currency basis and minus two reported. We had small growth on a year-over-year basis in our most differentiated businesses with negligible COVID impact, and as previously discussed, Q3 2021 had a strong COVID surge. Nothing was dramatically different on underlying demand in Q3, but there was some inter-quarter slowdown during the quarter and bounce back in September. The public hospital companies validated our view on their recent calls that surgeries were up and long-stay high-acuity admissions were down. Our U.S. sales were flat to down year over year due to the strong COVID comp in Q3 of 21, and all the growth came from the international markets. So let's go through the businesses quickly and then come back to discuss the current environment. Starting as usual with Infusion Consumables, which is our largest business, Infusion Consumables had revenues of $141 million, which was a 1% increase on a year-over-year constant currency basis, and minus 3% on a reported basis. We had growth in the OUS markets, and the U.S. market was slightly down in core IV and helped by the specialty categories, which foots with a strong COVID comp in the summer of 21. In oncology, we've been a bit constrained due to some raw material challenges that should abate by the end of this year. We're happy the international markets are holding up, and the U.S. is a little harder to judge right now. Moving to infusion systems, which is primarily our LVP pumps and associated dedicated sets, this segmented $88 million in adjusted revenues, which was an increase of 1% on a constant currency basis or minus 3% on a reported basis. We did have a decent level of installs in Q3, and here we had some dedicated set declines on a year-over-year basis in the U.S. due to COVID in 2021, but the segment grew due to better international performance. On the last call, we said we felt that customer attention was back, with bandwidth to have real discussions as some of the fatigue from COVID is passing, and the acceptance of inflation and the cost of nursing, et cetera, are being internalized. Yes, the stresses of the current environment do make it a bit bumpier for decision-making, but we don't believe over the medium term, relative to our size, there's any change to our competitive opportunity, and we are focused on commercial execution here and have no change to our previous commentary on the segment. Finishing the segment discussion with Infusion Solutions, we had $81 million in adjusted revenue, or about the same as last year on a year-over-year basis. No additional comments on the revenue side here. The bigger issue for us is this is a segment that has disproportionately absorbed the majority of inflation at LegacyICU, which has impacted LegacyICU profits. The vast majority of unexpected inflation and earnings pressure relative to our view on 2022 LegacyICU profits is primarily about fuel and shipping costs and currency, and to a lesser degree, electronic component surge pricing. Through Q3, labor has been much more consistent this year, and we budgeted those items properly. Yes, there's been some raw material surge pricing, but as we highlighted in the last few calls, These items are not so much more inherently valuable over the long term. We've talked about believing in the markets, and when capacity increases, pricing should rationalize. So for us, it's about trying to run a stable and predictable operation in a normal environment to get price improvement where we can, and to try to illustrate to customers the need to have some of these costs indexed with a belief that supply and demand will balance over time. But there is a longer-term tactical element to this in some of the businesses. We listen to the comments on price actions from the larger players in the industry, and we obviously support that. But we're also focused in the next round of contracting how to separate the costing on some of these items. For example, where transportation and logistics costs should be separate items, no different than airline seat and baggage fees or next-day delivery. Given the historical margin structure of the healthcare industry and historical negligible inflation, suppliers never had to think this way. Okay, so let me move to the Smith businesses, first talking about aggregate revenues relative to our last comments, and then to update the two buckets of issues we've been talking about all year. The Smith medical revenues came in at $262 million, with infusion systems at $97 million, vascular access at $95 million, and vital care at $70 million. This was more than we expected, and the short story on why this happened is a combination of a few more billing days, and that part we knew, but with more stable operational processes in terms of IT systems and labor. all of which led to improved performance on clearing some of our backorders, albeit, again, spending freely to do so. The underlying performance for the domestic business has substantially improved, with international performance still under repair. On the last call, we talked about more confidence and predictability in the Smith Infusion Systems line. We did better than we thought in Q3 as we supported existing MedFusion customers And more importantly, all U.S. backorders on CAD disposables were cleared, which makes the competitive focus on new wins more actionable. We had not anticipated recovery until Q4, but regardless, the entire unit is running better now with reliable production and fulfillment on the Smith's dedicated pump sets and some of the other items. On the last call, we also said vascular access would have some improvement, but still a work in progress, even with a strong Q3. We did benefit $5 million from the last COVID syringe order, and here, too, we're very healthy from a production and U.S. distribution standpoint on all the major sub-product lines, but our commercial execution remains a work in progress, as Smith, like Hospira, did go backwards here. Lastly, vital care remains an area where some of the supply challenges remaining backorders continue to be worked as it was neglected the most. We've spent a lot of time, airtime on the last two calls, explaining the two buckets of issues. Let me take them in reverse order today from the previous scripts. On the quality-related interruptions, we continue to make execution progress that supports the previous communication to both customers and regulators in our view of a path forward and have made some significant decisions. Those decisions, such as stopping sales for certain older generation products and committing to a deliberate and timely remediation plan, have allowed us to begin supporting existing MedFusion syringe pump customers in early Q3. We've also made progress in addressing the root causes of the warning letter that we received in late 2021. This part feels very similar to Hospira and our previous experience, and we have the right people who have been through the exact same experience, and our team is fully embedded into the operation. We'd say the main difference since the last call is in Q3, we began to execute the various field actions in line with our commitments that we had made in the earlier communication period. As we said on the last calls, the existence of a warning letter, while undesirable, is the regulatory agency trying to move the ball forward, and we talked about how these regulations give us the right to participate. We're making progress in solidifying the foundation and hope to be in a position where we can demonstrate further progress as soon as possible. Again, regardless of where it appears on the P&L, we're spending heavily, so making progress here is extremely important. On the operational issues, with regards to production, it can generally be said that the entire Smith's production network is producing at acceptable levels with a few minor interruptions. The silicone availability we described in the last call has resolved, and now we're fully producing those items. We continue to work on securing the base of supply and insourcing the key high-margin disposable components with proper factory staffing levels. From an expense perspective, we've been spending carte blanche to improve customer service levels with an ICU mindset, and with factories only getting to scale recently, there continues to be a drag to gross margins. In the vein of we can't believe we're talking about this, we did want to give a little more detail on the largest gross margin variances from expectations, because at this moment, those are the largest buckets of addressable opportunities, and the scale is so astounding, and it goes a long way to answering where has the profit gone. Brian will go through those in more detail. We've already seen our ability to manage our costs across operating expenses, and our focus obviously needs to be on growing revenues, but it's equally important to improve our gross margin performance. One area I'd highlight is our freight and logistics costs, which will approach $250 million this fiscal year. That is orders of magnitude more than any historical level. Part of that is diesel costs, part is ocean freight rates, part is expedited shipping costs, not only to our customers, but also to ensure we have the right raw material supply to our network. This is not something we intend to talk about regularly, but it's hard to understand the profit shortfall without some huge drivers, as it's not like ASP is going down anywhere in the business. This area, along with other large items like improving the quality system and reducing remediation costs, are all large areas for self-help in cash flow generation. In terms of next year, we did want to foreshadow, and it's subject to change, how we might report as we realign our reporting business units. It's likely that we'll aggregate revenues into three segments. The largest would be a consumable segment that would contain the legacy ICU IV consumables, most of the legacy Smith's medical vascular access, and a few other consumable slides. We think production and operations for most of that pillar should be improved in 2023. with work needed on the vascular access commercial execution as previously mentioned. The second segment would be a system segment, which was all the legacy ICU IV pumps combined with most of the legacy Smith Medical IV system segment and the associated dedicated disposables. Again, we think service levels and quality for most of that pillar should be improved in 2023. This segment would have almost all the capital sales of the company. And as a reminder, we published in previous investor presentations Capital sales are less than 15% of the total company, and that includes a large amount of software, service, spare parts, accessories, et cetera. The remaining segment would be a vital care segment, combining legacy ICU IV solutions, critical care, and most of what is in the legacy Smith's medical vital care segment. We'll provide some schedules when ready. And just to note, there are a few strategic efforts that would adjust the base year of 2022. Some examples are items we just finished recently, such as an agreement to exit India as a direct selling organization via distributor and exiting other negative margin situations if pricing or cost cannot be rational. So these may be a small hit to base year revenues, but are being done to improve a negative profit situation to a neutral or positive. In terms of the balance of this year, from an earnings perspective, the only real difference from our previous call is currency. Even though the euro has been in a more stable range the last few months, our largest direct countries are Canada, Japan, Australia, which have all had additional currency weakness. For what it's worth, we only carried the legacy currency hedges inherited from Smith this year. ICU always ran unhedged, so to speak. As a result, we've really taken our medicine today, and it's had a large impact on the year. From a revenue standpoint, we felt Q3 showed what we can do when fulfillment operations are more stable, even if more expensive. We did catch up on some of the back orders faster than we thought, so that may impact Q4, depending on where this underlying market settles. Regarding longer-term performance, I'm not going to repeat the comments from the previous calls, as we feel we've been transparent here on the size and scale of the self-help opportunities. What we want to get back to after the challenges of this year is the aggregate positioning of the combined portfolio and its relevance for customers and their reactions. Yes, the situation is harder than we expected, but the customer logic continues to make sense. Like with the hot spirit transaction, we need to change the conversation from the historical perception to demonstrating our value through innovation and service. These portfolios make sense together, and we're working on how to integrate them either literally or economically when necessary. And we do believe more doors are being opened as a result of having a broader set of items that are mandatory for care. We get this needs to show up on the P&L to prove that value. For legacy ICU, our most differentiated businesses will end 2022 larger than ever with appropriate profitability levels. The core premise of the Smith transaction is to enhance the product offering for these exact categories that drive our returns as well as add logical adjacencies predicated on the same characteristics of sticky categories, low capital intensity, single use disposables, opportunities to innovate and participate in a logical industry structure. Even though we've been consumed with basic operations, we still believe this is all the strategic case and the big opportunity over the long term is using this combined portfolio to improve our position in existing markets and also move to the right areas as the value shifts into new spaces. The construction of the Smith portfolio was logical and frankly, why it's survived over the years. The other part of value is maximizing the opportunity with each piece of the portfolio. We believe as we clean up, stabilize, and improve the operations, we could be presented with more opportunities here. While the pandemic introduced substantial volatility, strategically, we do think the weakness it exposed in the healthcare supply chain add to the argument for all participants to be healthy and stable, which has been our commentary since we became a full-line supplier. Smith's Medical also produces essential items that require significant clinical training, hold manufacturing barriers, and in general, are items that customers do not want to switch unless they have to. The market needs Smith's Medical to be a reliable supplier, and the combination positions us better. Our company has emerged stronger from all the events over the last few years. We've gotten knocked down a bit, but we see the hill to run up again together with our new colleagues to drive value out of the combination. Thank you to all the customers, suppliers, and frontline healthcare workers as we improve each day. Our company appreciates the role each of us has had to play. And with that, I'll turn it over to Brian.