Ortho Clinical Diagnostics Holdings plc

Everyone, welcome to the Ortho Clinic Diagnostics Third Quarter 2021 Earnings Conference Call and Webcast. At this time, all participant lines are in listen-only mode. For those of you participating on the conference call, there will be an opportunity for your questions at the end of today's prepared comments. Please note that this conference is being recorded. An audio replay of the conference call will be available on the company's website within a few hours after this call. I would now like to turn the call over to Brian Brockmeyer, Vice President of Investor Relations. Brian, you may begin.

Thank you, Operator. Good afternoon, everyone, and welcome to the Ortho Clinical Diagnostics Third Quarter Earnings Conference Call. With me today to discuss our financial results are Chris Smith, Ortho's Chairman and CEO, and Joe Buskey, Ortho's Chief Financial Officer. Mike Iskra, our EVP of Commercial Excellence and Strategy, will join us on the Q&A portion of the call. This conference call is being simultaneously webcast on the investor section of our website, and a version of today's presentation can be downloaded there. Before we begin, I will cover our safe harbor statement. Some of the statements we will make during this call about the company's future expectations, plans, and prospects constitute forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, which provides a safe harbor for such statements. Our use of forward-looking statements is subject to a number of risks, uncertainties, and other factors that could cause actual results to differ materially from our current expectations. These risks and uncertainties include, but are not limited to, those factors identified on slide two of today's presentation. and our other filings with the SEC. Please refer to our SEC filings for a more detailed discussion of forward-looking statements and the risks and uncertainties of such statements. We cannot assure you that the forward-looking statements we make today will be realized. We undertake no obligation to update any forward-looking statement to reflect future events, developments, or change circumstances, or for any other reason except as required by law. Also during today's call, there will be a discussion of some items that do not conform to U.S. generally accepted accounting principles or GAAP. Please see slide three for a list of these non-GAAP measures, including but not limited to core revenue, constant currency, EBITDA, adjusted EBITDA, adjusted free cash flow, and adjusted diluted earnings per share. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures are included in the appendix to the investor presentation and the press release issued this afternoon. both of which are available in the investor section of the Ortho website. In addition, on today's call, we will refer to our core and our non-core business, our clinical laboratories, also known as clinical labs, and transfusion medicine businesses represent our core business. Our non-core business is comprised of our contract manufacturing and licensing revenue. Lastly, unless stated otherwise, all year-over-year revenue growth rates including revenue growth ranges given on today's call, are given on a comparable constant currency basis. Now I'd like to turn the call over to Chris Smith, Ortho's chairman and CEO. Chris?

Thanks, Brian, and good afternoon, everyone. It was another great quarter for Ortho, and excited to be able to share our results. I always love to start all our presentations with this slide, which it talks about the mission and the credo of the company, because every test is a life. And this is why we do what we do on a daily basis. We embrace this, and it's a critical role in the role that we play in the health care system every single day. To give you an example, today we'll help about 800,000 patients around the world, and I just want to thank our teammates around the world for everything they do every day to make a difference in those patients' and those clinicians' lives. With that, let's get into the third quarter results. We'll start with slide five. Core revenue grew 13% in constant currency to $509 million, with the strength in both our clinical labs and our transfusion medicine business. Our base business was up 16%, excluding three percentage points of headwind from COVID tests, reflecting underlying strength in our base business. Therefore, we have raised our full-year revenue growth guidance to 14% to 15% from the prior 10% to 12% for the full-year revenue. In addition to strong revenue growth, adjusted EBITDA grew 17% to $140 million, representing a margin expansion of 25 basis points to 26.7%. And adjusted earnings per share is up 50% year over year to 21 cents. We are very pleased with our continued resilience over the last couple of years, even now as COVID tests have shifted to growth headwind. This continued momentum in our business is a clear result of our dedication to customers and the patients that they serve. We talk about the importance of lifetime customer value and the long-term relationships that we build with our customers. And I'm even more confident now that this is resonating in the marketplace and is reflected in our results. I'll get into more of that later on in the call. Continuing with our third quarter performance, let's look closely at our geographies on slide six. The Americas, our largest geography, grew 15%. EMEA grew 13%, with Western Europe up 9%. Greater China grew 10%, and the other, which is really made up of Japan and Latin America, I mean, excuse me, Japan and Asia Pacific, grew 16%. In the U.S., commercial growth excluding COVID assays was up 13%, driven by strong instrument placements, especially of our integrated systems, our menu expansion, and our revenue reoccurring pull-through, as well as our CTS partnership in our transfusion medicine business. In EMEA, growth excluding COVID assays was up 14%, driven by strength across our ClinLabs business. This is the fourth consecutive quarter of growth in Western Europe following five years of declines. We remain encouraged by the continued strength in Western Europe, which continued to re-grain ground in the market as a result of leadership changes we implemented over the last few years in our commercial excellence program. Greater China grew double digits for the third quarter in a row, with particular strength in our ME assay business. While our ME assay business was up 20 percent, we have not seen full recovery in the routine clinical chemistry testing. Our install base grew 6 percent, and our integrated systems Growth was 13 percent, and these are very good indicators for future accelerated growth. In addition, our distributor inventory levels are at or below historic levels. We are incredibly pleased with the growth in both the developed and the emerging markets, which grew 12 and 19 percent, respectively. And growth was particularly strong in India and Latin America. In summary, our team around the world continues to successfully execute on our growth strategy that we launched in 2019. Next on slide seven, we remain steadfastly focused on executing against our three strategic priorities to drive profitable, sustainable growth and shareholder value. These priorities are product innovation, commercial excellence, and operational efficiencies. We continue to make progress against each during the third quarter, and let me cover just a couple of the highlights. Beginning with product innovation, as we discussed last quarter, we received emergency use authorization in the U.S. for our quantitative COVID spike antibody assay. We're the only company at this point that has that EUA. Multiple studies are underway to advance our understanding of COVID-19 immunity at individual levels, not just at populations and segments, and we believe these studies will support further recommendation from regulatory bodies around the world. Turning to our second priority, global commercial excellence, our commercial excellence program continues to improve our execution. In the third quarter, we delivered 16% growth in integrated install base. This is a driving strong growth in our MU assay business, which was up 14 percent, excluding COVID-related revenue. We continue to lead with service as a key differentiator. And as an example, in the recently published ServiceTrac awards, and ServiceTrac, as you may recall, is a third-party independent agency that surveys hospital customers, our net promoter score was 22 points higher than the next closest competitor, a true reflection of where we stand in the eyes of customers around the world. And finally, our third priority, operational efficiency. As part of our Follow the Sun approach, we're expanding our global footprint in India. Through this investment in the future, we continue our steadfast focus on innovation, customer excellence, and emerging market expansion, while also bringing efficiency, scale, and cost savings to our organization. Establishing shared service centers in different geographies and time zones around the world allows us to operate around the clock and thereby innovate faster. It will also position service and support teammates closer to our customers. This center in India will allow us to anticipate and quickly meet customer needs with innovative products and industry-leading services. It is designed to guide our organization to be a more agile and adapted company and also enable continuous reinvestment in our growth. Returning to the big picture on slide eight, I would like to highlight our strong growth trajectory and our integrated install-based growth. as well as our lifetime customer value, which underpins our strategy. As illustrated in the top chart, the growth trajectory of our core business reached an inflection point in 2019 when we pivoted from a value-based strategy to a new growth strategy as our integrated systems penetrated the market and pulled through reoccurring revenues, and our commercial excellence programs began their execution. The key driver is very clear noted in our integrated install-based growth shown in the bottom chart. Our integrated install base growth accelerated with the launch of our XT7600 and the concurrent sale of refurbished 5600s in emerging markets. This sustained double-digit growth in our integrated install base drove the overall growth of our clinical lab install base. We see a significant opportunity to carry this strength forward as we continue into the fourth quarter and into 2022. That integrated install base growth is important because our lifetime customer value, which is illustrated on slide nine, Lifetime customer value is all about building long-term relationships with our customers through the strong clinical performance of our assays, our instruments' ease of use, and our reliability of our instruments. It's also part of our best-in-class customer service and our low total cost of ownership. It is this focus on lifetime customer value that allows us to have an average customer relationship of greater than 13 years and leveraging these long-term relationships to replace our install base of standalone systems with integrated systems And that's a key source of growth for the company. The penetration of the market with our integrated analyzers is fundamental to our growth strategy. And that's because our integrated systems pull through 65% more revenue than our standalone systems. Our integrated install base continues to grow double digits. Given that our integrated install base is still just 26% of our total ClinLabs install base, we believe we still have a lot of room for growth in the coming years. Lastly, slide 10 illustrates how we are able to pull through so much reoccurring revenue on these integrated systems compared to a standalone. In 2020, our clinical labs revenue mix was weighted heavily towards clinical chemistry with a 62% to 38% split, while the broader market was the complete reverse with 68% of the revenues from MU-ASA. We believe this mismatch between our revenue mix and the proportion of the broader market represents a significant growth opportunity for us as we continue to expand our market share within IA and as we penetrate the market with our integrated instruments. This allows us to leverage our recently expanded test menu and execute on our commercial excellence program globally. In the third quarter, our MU-ASA revenue was up 14 percent, excluding COVID-related revenue. With that, I'd like to turn the call over to Joe to further discuss our Q3 financial results and our 2021 outlook. Joe?

Thanks, Chris, and good afternoon, everyone. I'll begin with a bit more detail on our operating results for the quarter, starting with a breakdown of our revenues on slide 11. In the third quarter, we have total revenue of $523 million, an increase of 14.3% in constant currency. Currency translation increased sales growth by 150 basis points, resulting in 15.8% reported sales growth. Core revenue, which excludes Contract manufacturing and collaboration revenue increased 13% on a constant currency basis to $509 million. Note that the COVID-19 pandemic has impacted our quarterly seasonality, and therefore, third quarter core revenue was up 5% sequentially from the second quarter. The substantial revenue growth in the third quarter was primarily driven by the strong recurring revenue pull-through on the instruments we placed over the last couple years across our geographies in both ClinLabs and transfusion medicine. Our ClinLab business generated 12 million in COVID assay-related revenue, which was down from 21 million in Q3 of last year, representing approximately a 200 basis point headwind on total company core growth. And COVID assay revenue was actually down 5 million sequentially from Q2 of this year. Turning to our Q3 performance by line of business, ClinLab's revenue grew 10% in the quarter, largely driven by double-digit growth across all major regions, excluding COVID assay revenue. In transfusion medicine, we grew 21 percent, driven by strong growth in the Americas, China, and other Asia-Pacific countries. And as a reminder, the third quarter benefited from our new partnership with CTS, which went live in Q1 of this year. Non-core revenue in the third quarter grew to 13.6 million from 7.8 million, This non-core revenue in the quarter includes the benefit of an $8.5 million final arbitration award related to one of our collaboration agreements in the US. Now turning to our performance by geography on a constant currency basis, America's revenue grew 15%, including 14% growth in the US. EMEA grew 13%, including 9% growth in Western Europe. in Greater China grew 10%, and other, which again includes Japan and other Asia-Pac countries, grew 16%. Looking at our revenue by category, recurring revenue, which includes reagents, service, and other consumables, grew 14%, driven by strength in both clean chemistry and immunoassays, excluding COVID assay revenue, as well as donor screening. Instrument revenue grew 15%, in the quarter driven by placement of our integrated ClinLab instruments and our immunohematology instruments. Now turning to slide 13, I'd like to comment briefly on our third quarter financial performance versus the prior year. We delivered another solid quarter of performance below the top line with improvements in gross margin, OpEx, and free cash flow in the quarter. Gross profit margin for the quarter was 51.7 percent. This is a 360 basis point increase versus Q320. Eighty basis points of which is due to the impact from the previously mentioned arbitration award. And the remaining 280 basis points is made up of currency translation, volume, lower manufacturing costs, partially offset by negative impact from mix, primarily from the lower high margin COVID-related revenue. Additionally, within both cost of sales and operating expenses, we have seen higher spot error rates as we previously discussed. This trend continues, but we are actively managing and monitoring the situation, and we've included these higher costs in our guidance. Moving down the P&L, sales, marketing, and administrative expenses, percentage of revenue was flat year over year at 27% of revenue. Adjusted EBITDA grew 17% to $140 million. and adjusted EBITDA margin expanded 25 bps year-over-year to 26.7%, primarily driven by positive mix in our placement of integrated systems, efficiency improvements, and the successful execution of our value capture program. Now, if you exclude the arbitration award I mentioned a minute ago, which was recognized in non-core revenue, but we backed out of adjusted EBITDA, our adjusted EBITDA margin would have increased approximately 50 basis points in the quarter. Net interest expense for the period was $36 million, a decrease of $13 million as anticipated due to lower average outstanding debt balance and lower interest rates. Our provision for income taxes was $6 million compared to a benefit of $10 million in the year-ago period. We continue to expect cash taxes for the year to be approximately $20 million. Our adjusted earnings per fully diluted share for the third quarter increased 50% year-over-year at 21 cents. driven by our solid operating performance as well as lower interest expense. And on a gap basis, we reported EPS of $0.06 per share compared to a net loss per share of $0.20 in Q3 of last year. And positively, this was our first quarterly gap profit since 2019. Now turning to free cash flow, capital deployment, and balance sheet on slide 14. In the third quarter, we generated $56 million in adjusted free cash flow, after funding $8 million in capital expenditures. Our day sales at standing came in at 41 days, an improvement of 20 days compared to the third quarter of last year. Now, this includes a securitization of $75 million in the U.S. that we talked about last quarter. And without the benefit of this financing transaction, our DSO still would have improved by seven days compared to the third quarter of last year. And as I said on the second quarter call, we expect cash generation in the second half of the year to be greater than $100 million. Our strong cash generation enabled us to continue to deleverage our balance sheet and reduce our net debt to EBITDA ratio to 3.7 times, down from four times at the end of Q2. Given the strength of our business performance, we continue to expect to reduce this leverage ratio by at least a half term per year going forward as we move towards our more normalized leverage range of 2.5 to 3.5 times. while maintaining flexibility for strategic M&A opportunities. We ended the quarter with cash and cash equivalents of $256 million and total debt of $2.3 billion. Turning to slide 15, let me remind you that continued debt reduction is just one facet of our balanced capital deployment strategy. We are actively evaluating organic and inorganic growth opportunities that would complement our core business, further increase operating leverage, and give us new or additional exposure to high-growth markets. While we are guided by our focus on the continued deployment of industry-leading and innovative solutions for patients around the world, we believe that our expertise gained through our highly collaborative partnerships, coupled with our market-leading position in attractive IVD space and a healthy balance sheet found in our January IPO, provide us with an excellent platform to pursue mostly bolt-on acquisitions to accelerate profitable growth going forward. Now turning to our outlook for the remainder of the year on slide 16, first I want to provide some broader context on our fourth quarter and the full year 21 guidance. We saw very strong demand through the first three quarters of this year and given positive utilization trends as well as leading indicators including forecasted inpatient admissions, we expect continued strength in the fourth quarter of this year. We expect minimal COVID assay revenue in the fourth quarter of 21 compared to 26 million in the fourth quarter of last year, representing up to a 500 basis point headwind on our total company growth, core growth, in Q4. The fourth quarter 2020 included an extra week under our fiscal period, which we estimate positively impacted sales growth by approximately two percentage points. Now, consequently, we are raising our 21 guidance as follows. Core revenue is expected to grow 14% to 15%. on a constant currency basis to 2 billion to 2 billion 20 compared to our prior guidance of 10 to 12% constant currency growth to 1 billion 95 to 1 billion 98. At current rates, currency translation is expected to increase our full year sales growth by approximately two percentage points. Adjusted EBITDA. is expected to grow 19 to 20 percent on a reported basis to 542 to 547 million, an increase from a prior range of 526 million to 534. Diluted, adjusted diluted EPS is now expected to be 76 to 78 cents per share, an increase from a prior guidance of 67 to 72 cents based on a full year diluted weighted average share count of 235 million. Now, before turning back over to Chris, I'd like to discuss supply chain disruptions. Global supply chain challenges, combined with the strength of our business over the last several quarters, is putting increased demand on our supply chain. Our teammates have done a fantastic job implementing many initiatives in early 2021 to mitigate our exposure caused by the global pandemic, as well as our accelerated growth in our core business. We have factored in expected supply chain challenges into our guidance. With that, I'll turn the call back over to Chris to make a few summary comments.

Thanks, Joe. Great update on the quarter. And look, we've shown this slide before, but it really is the investment thesis. We continue to believe that Ortho is a fantastic investment. You know, number one, because we are a pure play IBD and it is a highly attractive and growing market. Obviously, the second thing, we think we have very unique and clear differentiators. in the market, especially around our lifetime customer value, our service, and our reoccurring revenue stream, which is now approximately 90, you know, about 93%. And we have strong momentum with renewed focus on profitable growth, which we continue to show in the quarterly results. On that, let me take the call back to Brian, and we will turn it into Q&A. Okay.

Operator, we'll take the first question.

Thank you. Our first question comes from Tycho Peterson of J.P. Morgan. Your line is open.

Hey, Tycho. Hey, Chris, I want to start with China. You know, last quarter you talked about it being slower to return. I know you were still up 10% in greater China, but obviously there's a lot of focus on procurement, tenders, local competition, you know, kind of two things, China 2025, you know, and the local competitors and then kind of these volume-based tenders where they're trying to capture, you know, some of the high-value, low-volume tests. similar to what they did with pharma and 4 plus 7. So maybe can you touch on those dynamics? Are you viewed as a local competitor in China at this point? And then how do you think about the tender process?

You know, we're still not, Tycho, viewed as a local, and I think that's one of the reasons we've created our two partnership agreements or localization strategies, one around instrument and one around assay development. We're now about, I don't know, six, nine months into those partnership agreements, which we think will help us. You know, as far as the tender, you're exactly right. I mean, that is starting to occur. As you probably know, we did participate in really kind of the first tender that was out there. And you know the interesting thing, Tycho, everything's been tender always. I mean, hospitals in the United States are tender, Europe's tender, Middle East. But China, this was relatively new. Two, as you probably know, two major... multinationals chose not to participate. Now, for us, it actually worked out quite well. We didn't see a significant decrease in price, and we believe because we were awarded, we'll pick up share there. And so we do think that will continue, but we feel like we're learning a lot as we went through that process, and we believe in our ability that so much of our business is outside the United States and has been part of tenders across the world that we feel pretty well positioned there. But as you know, it grew double digits again We base a lot of where we think the business is going on install-based growth and integrated install-based growth. And both of those are really robust for the quarter. And I think the other thing that's nice is that, look, we had gone through a situation where distributors are really starting to destock. And we're now at kind of a place where we're at or below where distributor stocking was. So we still feel really comfortable with where our growth is. And that will continue to be in double digits going forward. I don't know if I answered all your questions. You had a couple, but I hope I got them all.

That's great. And then I want to follow up with Joe and the supply chain comments. You know, really it's about your ability to pass on higher freight costs and things to customers if they're under multi-year contracts. Can you maybe just touch on that and then any kind of input, you know, shortages or things you're going to have to deal with on the other end?

Yeah, Tycho, yeah, we are passing on price increases to our customers where possible. I mean, you're right, we can't do it in all cases, but we're certainly, where possible, we are doing it. And as far as, you know, what are the areas, you know, that we're seeing shortages, it's no different than what others have said on calls, microchips, resins, plastics. You know, and so we've got a lot of initiatives in play, you know, that I mentioned in the prepared remarks. You know, we're strengthening our relationships with, you know, our industry contract manufacturing partners. We're taking over portions of the distribution network. You know, we're bringing in additional key suppliers for key components. So there's a lot of activity going there, and, you know, we feel that there really wasn't a significant impact in our Q3 results.

Okay. I appreciate it. Thanks. Thanks, Tycho.

Thank you. Our next question comes from Vijay Kumar of Evercore ISI. Your line is open.

Hey, Vijay. Hey, guys. Hi, Chris. Hi, Joe. Congrats on a good print here. Just on the Q itself, right, 16% core growth. That's about eight points above sheet models. I'm curious, were there any one-offs in the quarter? I mean, this is really, really strong. It doesn't seem like COVID had a big, big impact. in a role here. Maybe talk about the underlying trends here on what grew up to 16%.

Yeah, Joe, do you want to take that and maybe talk about what happened in the quarter?

Yeah, Vijay, I think, as I noted in the comments, in the included non-core revenue, which obviously rolls up in the total revenue, we had an arbitration award, which was $8.5 million. Clearly, that's you know, something that wouldn't have been planned or forecasted. And then, yeah, the COVID assay-related revenue in the quarter was $12 million. So, you know, probably maybe a little bit stronger than maybe what some had expected.

Yeah. And you know, Vijay, we had originally put none in the second half. And so, obviously, we're getting, you know, some depending on where your model is built. But, you know, COVID coming around 12, Joe mentioned the one-off. But really, it's just, you know, I always talk about this in this being a portfolio business, but right now we're just really performing well everywhere, you know, across the world. And so I think what you're seeing is that strong execution being pulled through all regions at the same time.

But Vijay, just to be clear, I mean, but, you know, excluding that non-core collaboration revenue that I spoke about and the COVID, you know, the core revenue is up, it's up 16%. So it's just a strong quarter. And again, as Chris said, it was across all regions.

I guess that segues to my next question, right? Because I'm going to speak to you clearly. Execution was above trend. At Q4 guidance, I understand some of the comp issues. Was there any timing element? Because I'm getting a sequential step down of almost 14%, right? I think implied is close to 470 million revenues in Q4. Was there any pull forward of revenues from Q4 and Q3? Why shouldn't we see sustenance of these strong trends? Because the comps don't seem that hard. They seem to be about five, six points harder in Q4 sequentially. Why shouldn't Q4 be a high single, double-digit core growth quarter for Q4?

Yeah, Vijay, you know, if you take the, we gave the four-year guidance and obviously just, you know, sort of imply the Q4 numbers out of that, you know, you're going to get, you know, in the range of 2% to 6% total. But excluding COVID, you know, it's going to be 6% to 9%. You know, that's the range. So, you know, the midpoint of that range, again, you're in 7% to 8%. growth on the top line, excluding COVID. So it is very much in the high single-digit range in Q4. So we do feel like that growth is continuing.

Yeah, I think, Vijay, we also remember we have pretty significant headwind in Q4. I mean, look, this COVID is always moving. We had a very strong COVID quarter of Q4 last year. There's not a lot in the Q4 forecast for us right now. It's minimal. So I think that would be obviously one factor to take in. But we've built in, for example, challenges in the supply chain and stuff into our numbers, if that makes sense. So think about it probably as, you know, four-ish plus total and ex-COVID, eight-ish. Yeah, high signal visit. Yeah.

That's helpful, guys. Thank you.

Thank you. Our next question comes from Derek DeBruin of Bank of America. Your line is open.

Hey, good afternoon. Hi. So, really impressive, you know, 14% to 15% constant currency revenue growth. Obviously, for this year, I mean, this obviously begs the question on, you know, thinking about trends as we go into 2022. And, you know, you're tracking well above, you know, where we had you in the deal model and, you know, certainly the outlook of It seems to be very good. I mean, can you give me initial thoughts on how to sort of thinking of the puts and takes on to 2022, you know, mid-single digits, sort of like core growth still in the cards when you sort of like do all the puts and takes? Just any high-level thoughts would be appreciated.

Yeah, obviously we won't do guidance for a bit, but, you know, kind of to give it to you, you know, high-level, Derek. I mean, look, I will tell you a couple things are happening. We continue to believe we should be growing at or above market. And I think because we believe we're moving share, and we're winning more than we've ever won before. And I think that's reflected in both the install-based growth as well as the integrated install-based growth. And remember, integrated installs could be first-time wins. But if we're changing a standalone and moving to an integrated, it's a net zero. So when you see 4% or 5% on the standalone growth or the install-based growth, that's really market share wins. And then where I think you see the rest of the business coming, I think people have really underestimated our ability since we expanded this menu on the IA side to pull through a lot more revenue when we convert a standalone to an integrated. That's why you hear in my statements and Joe's, everything's around integrated. We're really excited about where the integrated growth was because it lets us pull through so much more revenue. So I think when you take that combined with winning market share, that's why I think you're seeing the wins that you're seeing across the globe. And part of this has been this pivot in our strategy to not only go out and win accounts, but really expand our field organization globally with lab specialists or med techs that are in the hospital working for us to focus on pulling through that IA menu, which we really hadn't done as much until a couple years ago. And I think we're really starting to see that gain traction.

Got it. Yes, that was high-level. Thanks. Ouch, man. Ouch. I promise to do a call with you soon and give you guidance. So just out of curiosity, I mean, you know, when you sort of think about the China tenders and just the competing products there, I mean, obviously you have the dry slide technology, which is technologically differentiated from a lot of the other clinical chemistry and amino acid technologies out there. You know, is that seen as an apples-to-apples sort of like compare product, or is it differentiated because the technology really is not substitutable or – or for the other technologies? I'm just sort of curious, like, is that a competitive advantage in sort of going into some of these arguments, some of these standards?

You know, I think it is. I'm going to let Mike take this one in a second, you know, who runs our global commercial. But I definitely think it is an advantage because we get differentiation. Historically, we've gotten better reimbursement. I mean, obviously, you don't have the water issue. So I do think that having that differentiation helps us. I'll also say that our leadership team there – particularly the woman who runs China for us, is very astute, and I will say deep into the understanding of the market dynamics and helping as we go through tenders. But, Mike, do you want to – I know you've been pretty close to Iris as we've gone through this. Do you want to share just some views on that around the dry chemistry and then also how they're handling the tender situation there?

Yeah, it is a differentiator. I think Chris hit on the main reasons why. The other thing, when you think about the China market, we have – What's a little bit different for us in that market is we have a very large presence in the stat lab market in China. And a big part of that is the dry slide, the reliability of the slides. And actually on chemistries, it's pretty fast turnaround time compared to our competitors. And so all those things combined are what helps with the differentiation. Chris did mention there is reimbursement benefits that we do see in China. But, you know, again, globally, you know, customers, particularly customers that have used dry slide and see the benefits, you know, those attributes and the benefits they get can be written sometimes into tenders, which makes it very difficult for wet systems to compete.

Yeah. Okay. Yeah, and our view, by the way, Derek, is to participate in those tenders. I know some of our competitors are viewing it differently, but, look, we believe it's the real world. It's going to happen, and you've got to play ball. And so our view is we're going to participate. because we believe our share upside is significantly better than whatever pricing downside we would face. Great.

Thank you very much.

Thanks. Thank you. Our next question comes from Matt Sykes of Goldman Sachs. Your line is open. Hi, everybody.

Hey, thanks for taking my questions. I just want to focus on the commentary in the slide you have on the integrated installed base growth. It obviously continues to be impressive and it's great to see in that teens. It's also gone from 14 to 15 to 16 over the last three quarters. Is that a trend that we should expect? Are you seeing accelerating growth in an integrated installed base? I mean, I think being mid-teens is great, but I'm just wondering if there's any additional trends that you could highlight that maybe is resulting in an accelerated growth of the integrated installed base.

Yeah, Matt, I think that's been an interesting phenomenon. If you look back at 17 and 18, I think a lot of that would have been a conversion from a standalone to an integrated. I think the difference you're starting to see now and why we're seeing some of that growth is we're winning with integrated. So I was at a large hospital system in Florida, I don't know, three weeks ago, four weeks ago, a big system. You're talking a system that's doing 2.5 million plus a year, and we won that from a competitor system. but we only did integrated. So they've never had a standalone of our analyzer. And so when you look at that, that would be not only increasing our install base, but it also increased our integrated install base. And so I think some of that is that tip of the spear while you're seeing it. I would say that our demand is higher for our integrated. As we manage the supply chain, that's one of the things that we're staying close to with our instrument manufacturer is trying to make sure that we stay out in front of it because the business has been good. So I think it's a little bit of both. Mike, again, do you want to comment any more that maybe you see?

No, Chris, I think you're on it, right? One of the things, when you listen to the narrative you hear, we keep saying some of the same things over and over, but it's really the playbook. And I think when you see this, we're now executing that globally. So What was happening in the U.S. and a few other markets, now you see globally, and it is both using integrated to move standalone instruments up, but to win new business. And so it's not just one market either. I think that's what's helping some of the pacing that you see. It's a broad application.

Great. Thanks for that. That's a helpful caller. And then just, you know, you continue to take down the net debt, and, you know, you put yourself in a position for M&A. You've talked about exploring the market in the past. Just anything involved in your thinking? You know, how does the landscape pipeline look? How are you thinking about valuations here? Just any thoughts on M&A at this point?

Yeah, you know, Matt, I don't think a lot has changed since we talked about this last quarter. I mean, we're still looking primarily in the areas of specialty, IA, molecular, and point of care, and we're still primarily looking into the areas of bolt-on and niche acquisitions. You know, nothing transformational here. You know, we are getting pretty darn close to our desired leverage range of 2.5 to 3.5. You know, we're at 3.7 now. We're going to probably tick down a little more as we move to the end of this year. So, we're getting pretty close. So, it's just a matter of continuing to look and find the right deal at the right valuation. So I don't think there's been a whole lot of change in philosophy here.

Great. Thanks very much. Appreciate it.

Yeah, sure.

Thank you. And next, we have Patrick Donnelly of Citi. Your line is open. Hey, Patrick.

Hey, guys. Thanks for taking the questions. Joe, maybe one for you on the margin side. You continue to put up pretty good performance there, guidance suggesting it's going to continue. You know, obviously we keep hearing about inflationary pressure, supply chain logistics issues, et cetera. Can you just talk about the moving pieces there, dynamics as we go through 4Q and into 22? I mean, it feels like expansion should continue, but I just want to talk through the different pieces there.

Yeah, it's actually a very good question. We did have a good quarter in Q3 from a gross profit margin expansion perspective, and, you know, it laid out by market. you know, the factors I talked about in the prepared remarks, you know, I just want to remind you that, you know, 80 bps of that was driven by that arbitration award of $8.5 million that we put in non-core revenue. But, you know, the rest of it was a combination of some FX tailwinds and mostly operational. As we move, though, into Q4, and this is something I've been talking about on every quarter call, Q4 tends to be a quarter where we do more heavily heavy mix of instrument revenue, which is typically lower margin than the recurring reagent revenue. So built into the guidance is an expected decline in gross profit margin for the fourth quarter. And that's, again, we've seen that every quarter for several years now and wouldn't expect anything different this year. But when you think about full year, for sure we're still very much in line with the guidance that we put out of the, you know, the increase in gross profit margin of, you know, at least 30 to 60 basis points annually.

Okay, that's helpful, Keller. And then, Chris, maybe just on Europe, EMEA, I mean, Western Europe has been a really good story for you guys. Can you just talk about what you're seeing there, expectations going forward, just general trends there would be helpful.

Yeah, look, I think when we got into this business, you know, we kind of went through our leadership change a couple years ago. I think our view was, you know, Europe had been going backwards consistently for five years. So our first view was we'll get it to flat to 1%, you know, 1% growth. But I will say that that team has really done a nice job of changing out not only the leadership, but the team that we have there. And I And I would say in our countries where we did have strong leadership, like in Italy where we didn't make changes, they continued to perform a little bit above the market. And I think, again, I come back to I think we're just winning more. And part of this goes back to this philosophy that we've kind of had, this will to win. And I think under J&J, it just wasn't a desire. And so we continue to feel really good there. I will say that one of the nice things we've also, for example, we saw in the Middle East, Russia, Eastern Europe, all up double digits in the third quarter. You know, that would have been, you know, that's a change in a new leader in the last 12 months. And if you look at places, you know, like where we have to win in places like the UK, you know, Spain, where we had not won before, again, great, you know, close to double-digit growth type of thing. So I think we're seeing it not just coming from one place. It's really coming from that whole region under John Martin's leadership.

Hey. Hey, Patrick. Hey, it's Joe again. Can I go back to your margin question for a second? I addressed the sequential impacts to the gross margin, Q3 to Q4, but I probably should have mentioned also the year-over-year impacts to Q4. I mentioned this in the prepared remarks, but again, we did $26 million of COVID assay revenue in Q4 of last year, and as Chris said a minute ago, we have minimal COVID revenue in our guidance for the remainder of the year. So you are going to see a headwind on gross margin year over year due to mix, you know, dropping that COVID assay revenue, which is fairly high margin revenue. So that, you know, year over year, you know, we will see a headwind.

Right. Yep. That makes sense. Thank you, guys.

Okay. Thanks.

Thank you. And next we have Tejas Savant of Morgan Stanley. Your line is open.

Hey, guys. Good evening. Joe, maybe to stick with the margin theme here, as Patrick was just mentioning, there's a bunch of moving pieces here with inflation and freight costs and the mix of cash versus reagent rentals and the instrument front and the supply chain issues, etc., And then there's the COVID comp as well. I mean, you have some COVID revenue this year, less than last year, but presumably as you guide for next year, you'll assume sort of zero COVID contributions like you have here in the fourth quarter. So as we look at sort of margins in 2022, is 30 to 40 basis points of margin expansion still a fair way to think about it, or should we be considering some incremental downside from some of these dynamics?

Yeah, you know, Tejas, I think you'll definitely see the tailwinds continuing that we've talked about all year, and that is the value capture program that targets $25 million of savings annually, most of which end up in gross margin. You'll still see the tailwinds of gross margin coming through, you know, from the strategy of shifting customers to integrated, which drives more immunoassay, higher margin revenue. But, you know, the drop in the COVID assay revenue is gonna be likely significant in our view. To your point, you just said, if you assume it's zero, we're gonna go from roughly, call it mid 60s of COVID assay revenue this year to zero, that's three points of top line growth and a lot of headwind on the gross margin. So I think the best way to think about the gross margin expansion in that 30 to 60 basis points annually for next year is ex-COVID. If you exclude COVID, for sure, given the value capture program and the tailwinds we get on the integrated strategy, we can get there.

And if COVID ends up playing through, look, I think we talked about it on the quant assay, and there's not a lot of movement going on with quant assay, yet we're the only ones that have something that will measure your immunity level. I will say researchers are really interested, and there's a lot of clinical trials that are going on. And I think if that ends up getting some traction with regulatory bodies and the ability to identify immunity levels before you get your booster or, to give you an example, I got my booster on Monday and I didn't know what, I didn't, you know, I should have tested with our own device to know where my immunity level is and I didn't. But I think we may see some opportunity with that test with COVID next year that we just don't have built in yet.

Got it. And then a quick one on emerging markets for you, Chris. Can you share some incremental color and the strength you've seen in India and Brazil? In the past, I think you've noted, at least for India, that a lot of it is in the base business and not so much from COVID testing upside. Just curious as to how you see those two GOs evolving for you heading into 22?

Yeah, look, I think when we look at, like, I would say kind of our big three on the emerging would be, not including something like China, but that would be Mexico, Brazil, and India. And again, those are all up high double digit growth in Q3 continuing like they were. And it's not COVID, especially in those markets. And I think there's a couple things happening. I would say if you look at Mexico and Brazil, which report to the same He has done a fantastic job of leading with integrated, probably before we did anywhere else in the world except for maybe the U.S. So you're seeing great reagent revenue pull through there. They're doing a fantastic job of selling the full menu as opposed to just chemistry. And that's why we've seen consistent, I think, growth like that coming out of there. If you look over in India, I think the thing that's really started to play incredibly well is that we've always been the number one service provider, but I don't think that was as important to hospitals until we started to go through the challenges with COVID and some of the challenges large multinationals had servicing their customers. And our field engineers are direct. Our field organization is direct. You know, we have seven distribution centers in India. It's a high presence market for us. And I just think that's, again, a situation where We're selling the menu, but I think it's more about we're winning more than we won before, and the team has just done a really nice job there. So I see all three of those markets continue with very nice growth as we go into next year, and it's about how do you take some of those lessons learned and put it into other of those emerging market countries.

Got it. Very helpful, and congrats on the print, guys.

Thanks.

Thank you. And next up, John Sauerbeer of UBS. Your line is open.

Hey, John. Hi. Thanks for taking my questions. I guess just maybe digging a little deeper on supply chain. You know, I think previously, you know, some of the highlight was maybe 100 to 150 biff of pricing pressure there. You know, given the supply constraints and inflation, is that still the right way to think about the diagnostic market and then I think that Ortho also might use more contract manufacturing than some of your competitors. Anything to highlight there?

Yeah, I'll let Joe take the first one kind of around pricing, and then I'll take the second one kind of around contract manufacturing.

Yeah, John, I would say that the typical annual price erosion we're seeing has not changed. It's still in that 150 basis point range. No change there. Yeah.

John, I think as Joe mentioned earlier, there are places in contracts where we are able to push through some, pass along some price increases, you know, looking at things like, you know, COVID surcharges and things, but I think that's a good model. Look, you are right that we use contract manufacturers, but on our instrument. We don't do it on any of our assays, and we believe that that's one of our key differentiators is our assays. It's core competency and the development and manufacturing of that. On the instrument, a decision was made at the carve-out to to outsource that, but I feel really good about the partner. We chose the largest in the world and, you know, deep relationships, giving example, because of the supply chain challenges, you know, they're, they're doing stuff for Tesla and airlines. And, and I'm, but I have a call every single week with the CEO of that company and talking about where we are in the process, because we've raised our demand significantly with them because our business has grown. But, um, look, I think it's something like any business, you know, you're probably, I probably spent a lot more time on it now than I probably, you would have two or three years ago, but I think you go to where the opportunities are or where the issues may lie and you try to manage those. And I think our team has done a fantastic job putting things in place to manage through it, but we're spending time doing it. And I think there's a lot of things that we continue to do, like taking over our distribution center in Memphis from K&N. We had outsourced that to K&N, Kuninago, but we believe that's part of the customer experience, the shipping of our product, so we wanted to own that. And we took that over and we'll do it for less then we were paying them to do it. And so back to Joe's point, next year that will improve margins, but it also improves service levels. So I think the things that we think are core competencies, we want to own those and do them ourselves, but other things that we think aren't, we have outsourced some of that.

Thanks. And maybe just one follow-up. On the essay menu expansion, You know, is the target there still, you know, 8 to 10 assays per year? Is that the right way to think about it? And any areas to discuss on where you may be focused on menu expansion?

Yeah. Mike, so I think we've talked about 20 to 30 new or improved assays in the next three years. But, Mike, do you want to give a little more color around that?

Yeah, I think that's right, the right number to think about, 30 assays over the next three to four years. You know, it's a combination of menu expansion, new items, some enhancements and improvements. I think we're, you know, as you see, we have some assays that we've released in parts of the world, but we have yet to release in other places. So as an example, HIV combo, we're just getting through the regulatory approval in China. Procalcitonin, which we've launched worldwide with the exception of China, we're targeting for next year. So there are things like that that have been big drivers of growth for us in many parts of the world that we still have markets to open. We have a few assays we're working on, for instance, hemoglobin A1C on a microslide we think will be a difference maker we're pretty excited about for a launch early next year, things like that.

Got it. Thanks for taking my questions.

Operator, we have time for one more question.

Thank you. Our last question comes from Jen of H.E. Wainwright. Your line is open.

Thank you for taking my question. Could you comment on whether the supply chain issue is limited to a certain geographic area or present in your worldwide markets, and whether the issue is primarily related to manufacturing or shipping logistics?

Yeah, listen, I think that's a good question. I would say I think there's challenges in both. I would say that the logistic issues are readily manageable with price. So as you probably know, spot rates have gone up significantly, and I think you have the ability to get the products where you need the products to go based on what you're paying. And I would say one of the things I think we've done a good job of is that we do have a pretty broad distribution network across the world. We use two primary distribution points, one in Memphis and one in Strasburg, but then we go as close to the customer as possible. And so I think that's helped us a lot. I don't know if you picked this up, but we're carrying more inventory than we have carried. And I think that's one of the other reasons we're being able to do that is to make sure that we do not have logistic issues. So I'd say that's one, but we've managed that pretty well. If you look at the manufacturing one, look, I think it's the same thing. I think what you're seeing, at least with us, and I don't know about all the companies you follow, but our view has been to get as far in front of it as possible. So Joe mentioned this. For example, we have relationships with suppliers that we – have felt very good with for years. And we may have a primary and a secondary, but we historically maybe wouldn't have carried a third. We are now engaging that. And, look, I think, you know, our view has been that we think we, again, have to be out in front of it. And so I would say there's a lot more contracting going on, a lot more vendor fairs where we go out and see, you know, our vendors. So I think it's actually impacted both parts, candidly, of our business, but I think they're all manageable as long as we think we're out in front of them.

Thank you. And just a quick follow-up. Do you believe the COVID-related revenue could continue to decline in the coming quarters?

You know, I'm trying to think where we did Q2. What did we do in Q2? Yeah, so we did 17 and we did 12. Look, I think we see it's minimal, so we're planning for less in Q4. I think a lot depends on what happens with the quant and how quickly we can get some of those innovative clinical trials published and getting some government bodies to look at that. It's interesting. A lot of people like it. They just don't know what to do with it yet. And so what we need is, you know, we're working pretty close candidly with the CDC and NIH on some things around the quantitative test. But I would say that as we look at next year, I would say that our COVID projections are to be significantly less than they were this year currently.

Okay. Got it. Thank you.

Hey, listen, guys, it kind of brings us to the end of the time and on the call, but I did want to let you know one other quick point is that we know that you probably, look, we have never had an investor day kind of as a public company, so we're going to do an investor day. We know people want to do it in Rochester in January, but we have chosen to do it in New York City on March 21st, so we'll send out more information. But we're really excited about that because what we want you to do is, one, is, Pauline Chucklingham is here with me. He's our Chief Innovation Officer. Pauline's going to really give you some insight into where our new technology is going. We got some exciting stuff that will release at the end of next year from an instrument perspective as well as some things that we're working out on four to five years. And then we're going to have a couple regions. In particular, we're looking to have China, if hopefully China's open, and Iris Lin who runs that market for us and Warren Stone who runs the Americas be able to spend some time with you to give more color And then Mike and his team will really kind of focus around the business units and giving you really nice insight in how we're running the business in the transfusion medicine and the ClinLabs. And then finally, we'll let Joe bring it home and give you more insight on the financial. So we think it's going to be an exciting day. We probably will provide lunch, so you're going to want to definitely get there. But look, we'll send out more information as it gets closer. And again, we appreciate you taking the time today on the call, and we'll look forward to seeing you guys out in the market. Take care.

Thank you. This concludes today's conference call. Thank you all for participating. You may now disconnect, and have a pleasant day.