Alcon Inc.

Greetings. Welcome to Alcon's second quarter 2023 earnings call. At this time, all participants are in the listen-only mode. A question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star zero on your telephone keypad. Please note this conference is being recorded. I will now turn the conference over to Dan Cravens, Vice President of Investor Relations. Thank you. You may begin.

Welcome to Alcon's second quarter 2023 earnings conference call. Yesterday, we issued a press release and interim financial report and posted a supplemental slide presentation on our website to enhance today's call. You can find all these documents in the investor relations section of our website at investor.alcon.com. Joining me on today's call are David Endicott, our Chief Executive Officer, and Tim Stonecipher, our Chief Financial Officer. Our press release presentation and discussion will include forward-looking statements. We expressly disclaim any obligation to update forward-looking statements as a result of new information or future developments, except as required by law. Our actual results may vary materially from those expressed or implied in our forward-looking statements. Accordingly, you should not place undue reliance on any forward-looking statements. Important factors that could cause our actual results to differ Materially from those in our forelooking statements are included in ALCON's Form 20F and our earnings press release and interim financial report on file with the Securities Exchange Commission and available on the SEC's website at sec.gov. Non-IFRS measures used by the company may be calculated differently from and therefore may not be comparable to similarly titled measures used in other companies. These non-IFRS measures should be considered along with but not as alternatives to the operating performance measures as prescribed per IFRS. Please see a reconciliation between our non-IFRS measures with directly comparable measures presented in accordance with IFRS and our public filings. For discussion purposes, our comments on growth are expressed in constant currency. In a moment, David will begin by recapping highlights from the second quarter. After his remarks, Tim will discuss our performance and outlook for the remainder of the year. then David will wrap up and we will open the call for Q&A. With that, I will now turn the call over to our CEO, David Endicott.

Thanks, Dan. Welcome to Alcon's second quarter 2023 earnings call. I'm pleased to report that we had another strong quarter with double-digit sales growth of 12%, core operating margin of 19.9%, and core diluted earnings of 69 cents per share. These outstanding results were driven by our competitive product portfolio, favorable market conditions, strong commercial execution, and select price increases. We also saw strong performance in Asian markets, particularly in China. In surgical, our diverse portfolio and incremental innovation continue to deliver strong growth in a healthy market. In implantables, similar to last quarter, we saw the tail end of the Korea PCIOL reimbursement change, which increased out-of-pocket expenses for many Korean patients. If we exclude this impact, total implantable sales were up 5%. We have now fully lapped the reimbursement change and expect more normalized comparisons going forward. During the quarter, we introduced Vividi to select international markets, including Japan and Canada. Feedback from surgeons has been extremely positive, and we're excited to bring our patented non-diffractive technology into these important markets. As a reminder, Vividi is the first of its kind presbyopia-correcting IOL that provides patients with monofocal quality distance but excellent intermediate and functional near vision. all with low levels of visual disturbances. With Vividia Panoptix, we continue to lead the ATIOL category in the U.S. and international. Importantly, we remain encouraged by the resilience of global ATIOL penetration, which was up 80 basis points versus prior year and up 60 basis points sequentially. This growth was primarily driven by strength in international markets. As anticipated, we're starting to see more entrants in the U.S. IOL market, which will naturally have some impact on us given our significant share position. However, in China, where our IOL business is under-indexed, we're preparing to launch Vividi later this year, which we believe will help accelerate our share in this important market as it returns to significant growth. In the monofocal space, our Clarion material is helping us defend our market-leading position. Clarion is the latest material advancement in our 20-plus year history of continuous innovation in IOLs. As the name suggests, Clarion provides exceptional clarity, allowing surgeons to deliver long-lasting refractive outcomes and Clarion is glistening-free biomaterial that has amongst the lowest level of haze and subsurface nanoglistings compared to leading competitive IOLs. Additionally, the Clarion monofocal is available with the autonomy preloaded IOL delivery system. Autonomy is designed with advancements intended to benefit both surgeons and patients. Its automated delivery mechanism and ergonomic design allow precise and simplified single-handed control of IOL placement. Now turning to equipment, we are continuing to place Centurion and Legion devices in international markets as we work through the upgrade cycle of Legacy, Infinity, and other machines. Centurion with ActiveSentry is designed with advanced technology to help enhance surgeon confidence with lower intraocular pressure and enhanced chamber stability. Importantly, ActiveSentry helps maintain stability in the eye by adjusting for fluctuations in intraocular pressure. Our success in equipment also drives growth for consumables in three important ways. First, our growing share of the active equipment installed base naturally drives higher consumables demand. Second, as surge in productivity increase, so does consumption of consumables. And third, as we install higher value machines, there's a natural ASP uplift that drives consumables value. So all these factors, along with select price increases, have contributed nicely to our consumables growth. Now closely linked with equipment, is our world-class service offering, which we believe is one of the core strengths. Service is a critical component of our portfolio and is often a key factor for healthcare professionals when selecting technology for their practices. Our ability to offer market-leading technology supported by best-in-class services allows customers to fully realize the potential of Alcon's products, helping them deliver the best outcomes for their patients. Additionally, we're continuing to roll out Smart Cataract to new practices. Smart Cataract is the first of our digital health solutions that empowers surgical practices to work more efficiently while delivering optimal outcomes for patients. We specifically designed Smart Cataract with ophthalmology in mind. It seamlessly connects data systems, diagnostic devices, and surgical equipment from the clinic to the operating room. Later this year, we're rolling out a series of artificial intelligence-based features that enable Smart Cataract to automatically evaluate patient data and take into account surgeon preference, preferred formulas, and lens types to efficiently guide the surgical planning process. This enables surgeons to make optimized recommendations that we believe will help lead to better patient outcomes. Real-world data has indicated substantial time savings and efficiencies for cataract surgery planned with Smart Cataract, We're excited to bring this technology to more practices. Now I'll turn to VisionCare, where I continue to be pleased with our strong performance in contact lenses and ocular health. In contact lenses, our strategy of investing behind fast-growing market segments or where we have significant share opportunities working out well. As a result, we're outpacing market growth in every category where we have launched new products. I'll start with reusable lenses, where our latest products are total 30 and total 30 for astigmatism. Since launching Total30 TOREC earlier this year, we've seen an acceleration in the adoption of the Total30 family, which is now available in the U.S. and Europe. Later this year, we'll launch this innovative lens in Japan. Additionally, we'll further expand the Total30 family in the U.S. and Europe with the launch of our multifocal modality. The reusable water gradient design of Total30 is made possible by the introduction of our proprietary Celigent technology. Steligent mimics the ocular surface to help resist bacteria and lipid deposits. This is what enables Total 30 to provide a premium wearer experience similar to Daly's Total 1, but on a monthly platform. Now, turning to daily lenses, where we saw another quarter of double-digit growth, in particular, I continue to be impressed by the Florence R Toric lenses, including Precision 1 and Daly's Total 1 Toric. The Daly's Toric segment is the fastest-growing segment of the market, as it's estimated that approximately one-third of contact lens wearers have astigmatism, but only 10% wear toric lenses. And together, Precision 1 and Daly's Total 1 toric address the mainstream and premium market segments. A recent clinical study evaluated the performance of Daly's Total 1 sphere with wearers who have previously dropped out of contact lenses due to issues of comfort or dryness. This study found that approximately 90% of participants were likely to continue to wear Daly's Total 1 on a daily basis. This is important because preventing wearer dropout by improving the wearer experience represents an important patient feature as well as a sizable opportunity to contact lens value capture for our customers. Now, turning to ocular health, we continue to see strong retail, consumer, and physician interest in our portfolio of eye drops. I'll start with sustained, our family of artificial tears. A recent study examined the quality of life of high digital device users who are treated with sustained complete preservative-free. This study found a 40% reduction in dryness symptoms in treated patients. And now with these options available in the United States, we're bringing the benefits of preservative-free formulations to even more consumers at a more accessible price point. Moving to Pataday, our family of ocular allergy drops, encouragingly, we're seeing more consumers appropriately select ocular allergy drops to correctly treat their allergy symptoms as a result of our direct-to-consumer educational efforts in the U.S. And in our pharmaceutical eye drops, we're continuing to build momentum behind Roclatan and Repressa with ophthalmologists and optometrists. We're seeing positive uptake of these first-in-class therapies with low teens total prescription volume growth in the second quarter. Finally, I'm pleased to report that we're making solid progress towards resolving the supply chain challenges in contact lens care. Recall that these pressures started in the second quarter of last year, so we're wrapping around on an easier comparison. and we expect the situation to continue to recover throughout the back half of the year. Now let me provide an update on our end markets. In surgical, global cataract procedures were up mid-high single digits in the second quarter versus prior year. As I mentioned earlier, global ATI well penetration was up 80 basis points versus prior year and 60 basis points versus prior quarter. Notably, we're starting to see surgeon productivity improve, which when combined with the patient backlog should be an important driver of procedural growth. We continue to monitor penetration trends closely and are leveraging programs that digitally and conveniently educate patients about their lens options early in their cataract journey. Moving to contact lenses, retail market value was up mid to high single digits. Similar to last quarter, we saw steady wearer trade-up and meaningful contribution from price. Before I pass it to Tim, I want to briefly comment on our market outlook for the remainder of the year. On our May earnings call, we indicated that we were planning for a potential slowdown in market growth in the back half of the year. Throughout the first half of the year, global ATI oil penetration was solid, and contact lens trade-ups and price capture were both robust. Given these results, we've updated our outlook for the remainder of the year and currently assume that markets grow at or above historical trends. Now, with that, I'll turn it over to Tim, who will take you through our financial results and provide more color on our updated outlook.

Thanks, David. We're pleased to report second quarter sales of $2.4 billion, up 12% versus prior year. This growth is primarily driven by continued strength and demand for our products, including two points of contribution from acquired products, as well as solid commercial execution. We also saw favorable pricing in the quarter, particularly in consumables, contact lenses, and ocular health. Overall, we estimate that price increases drove approximately three points of our total top-line growth. Our second quarter U.S. dollar sales growth included approximately 300 basis points of pressure from foreign currency. In our surgical franchise, revenue was up 10% year over year to $1.4 billion. And plannable sales were $437 million in the quarter, up 2% year over year. However, if you exclude the South Korean impact that David mentioned, and plannable sales were up 5%. In consumables, our second quarter sales were up 13%, to $714 million. This growth reflects favorable market conditions across geographies as well as pricing. We did see strong performance in China during the quarter as the country continued to recover. In equipment, sales of $231 million were up 15% year-over-year due to continued strong demand for Cataract equipment, particularly in international markets as we upgrade and expand our installed base. In the quarter, we also saw higher revenues from equipment service. I continue to be extremely impressed by how well our manufacturing and procurement teams have navigated the ongoing supply chain challenges. Thanks to their hard work and expertise, we've been able to manufacture, sell, and support surgical equipment worldwide. Given the remaining installed base of legacy FACO devices and our strong competitive performance, we expect solid equipment growth in the remainder of the year. Turning to vision care, second quarter sales of $1 billion were up 15%. Contact Lens sales were up 10% to $594 million in the quarter. Contact Lens growth was driven by our new innovations with meaningful contributions from our recent SIHI launches, including Precision One Sphere and Torque, Total 30 Sphere and Torque, and Daily's Total One Torque. We also saw a strong contribution from price. Inocular Health second quarter sales of $426 million were up 22% year over year. Approximately 10 points of this growth was driven by Roquepan and Ropressa, which we acquired in 2022. We also saw significant growth in Sustain and Pataday, including price. Finally, as David mentioned, we continue to recover in contact lens care, and we estimate that channel restocking was approximately three points of growth to Ocula Health in the quarter. Now moving down the income statement. Second quarter core gross margin was 63.8%, up 110 basis points. This growth is driven by higher sales and manufacturing efficiencies from higher volumes, partially offset by shifts in product mix and surgical, including the impact from South Korea and inflationary pressures. We continue to expect gross margin to be pressured in the remainder of 2023 as we sell inventory that was manufactured at a higher cost base due to inflation. However, on a full year basis, we continue to expect 2023 core gross margin to improve versus last year. Core operating margin was 19.9%, up 270 basis points. The constant currency growth was primarily driven by higher gross margin and improved underlying operating leverage from higher sales, partially offset by higher investment in R&D following the acquisition of Aerie. Second quarter interest expense was $48 million compared to $31 million last year, driven by higher debt following the funding of the Aerie acquisition and less favorable interest rates. The second quarter core effective tax rate was 19.2% compared to 11.1% last year. This increase was primarily due to the geographic mix of pre-tax income and a lower tax benefit from the build of inventory in certain markets. This was partially offset by favorable discrete tax items in the second quarter of 2023. Core diluted earnings per share were 69 cents in the quarter, up 19% from last year. Now, before I touch on our outlook for the remainder of the year, I'll discuss a few cash flow and other related items. Free cash flow for the first half of the year was $189 million compared to $233 million last year. This reflects a change in cash from operations as we paid a legal settlement in April, partially offset by lower capital expenditures. Similar to past years, we expect free cash flow to be stronger in the back half of the year. On a full year basis, we continue to expect an improvement in free cash flow versus last year, despite the higher outflows in the first half. Transformation costs were $26 million in the quarter and $340 million live to date. We continue to expect to wrap up the entire transformation program on budget and on schedule by the end of the year. Now moving to the 2023 guidance. Our current outlook assumes that markets grow at or above historical averages in the back half of the year, exchange rates as of the end of July hold through year-end, and inflation and supply chain challenges continue through 2023. Based on the strong momentum of the business, we are increasing our year-over-year constant currency sales growth guidance to 9% to 11%. This growth is partially offset by the continuing appreciation of the U.S. dollar against our basket of currencies, which we expect to pressure sales growth by approximately 120 basis points versus prior year. Despite this pressure, we're increasing our U.S. dollar net sales guidance for 2023 to $9.3 to $9.5 billion, and we're currently trending toward the high end of this range. Moving to core operating margin, we are maintaining the range of our full-year outlook of 19.5% to 20.5%, despite approximately 90 basis points of foreign exchange headwind versus prior year. We now expect interest and other financial expense to be between $230 and $240 million. For the full year, we expect lower financial expense, primarily due to higher interest income. We are maintaining our core effective tax rate guidance of 17% to 19%. Finally, we're raising our core diluted EPS constant currency growth outlook to 28 to 32 percent due to the strong performance in the first half of the year. This growth is offset by approximately 17 cents of foreign exchange headwind versus prior year. And despite this pressure, we're raising our core diluted EPS guidance to $2.70 to $2.80 per share. So, to summarize, I'm very pleased with our momentum in the second quarter. We continue to execute well in robust markets. And going forward, we'll remain focused on accelerating innovation, delivering above-market sales growth, and driving operating leverage. Finally, I'd like to thank the entire Alcon team for another great quarter. With that, I'll turn it back to David.

Thanks, Tim. To wrap up, we're extremely pleased with the robust results for the second quarter and the first half of the year. They reflect the determination of our associates to deliver market-leading innovation above-market sales growth, and increased operational efficiency. As we look to the future, Alcon is well-positioned to capitalize on our strengths. Our broad and balanced product portfolio, combined with our leading go-to-market capabilities, allow us to better serve the eye care community. By successfully executing our strategy across both franchises, we are further strengthening our ability to advance patient care and deliver long-term shareholder value. With that, operator, let's open the call for Q&A.

Thank you. If you would like to ask a question, please press star 1 on your telephone keypad. A confirmation tone will indicate your line is in the question queue. You may press star 2 if you would like to remove your question from the queue. And for participants using spicular equipment, it may be necessary to pick up your handset before pressing the star keys. We ask that you please ask one question and one follow-up question and then re-queue for additional questions. Our first question is from Veronica Dubijola with Citi. Please proceed.

Hi, guys. Good morning, and thank you for taking my questions. I want to start with the US PCIOL comment, David, that you made about new entrants and some incremental share pressure. Maybe just give us an update on where you see your market share. at the moment, exiting the quarter? And what are the risks that you see that this declines meaningfully from here? If you could just give us some insights into that, and I'll have a follow up after that.

Yeah, sure. Veronica, thanks. You know, look, we in the US, as you know, we have about two thirds of the ATI oil business. And we continue to hold that share through the second quarter we had, I think, at PCI wells, we were up over 80. Again, you know, we obviously last couple of years, there have been a number of products that have come into the market. Last year, we saw two PCI wells come in. We dropped down a little bit in PC. We went back up after people had tried them. Look, they're going to be in the toric business now this year. There seem to be a couple of new entrants as well. And again, people are going to try those lenses. They'll experiment with them. And then I suspect what they'll find over time is that the performance of our lenses do quite well. So directionally, I think we feel very good about what we've assumed. There's really a performance that is better than expected from our perspective going on right now. And you know, you will see some trial out there. But I think after that, you know, we should see continued steady growth in our business going forward. I do think that when you start forward on this, you want to talk and think about the penetration rates more than share. And I think for us, you know, penetration, when you hold this much of the market, matters a lot. It's probably three to one more valuable than a share point. So we were very encouraged by the global penetration rate, which was up 80 basis points year over prior year. And

60 sequentially so a lot of that came out of uh international most of it did but i would just say that the the volume of procedures in the u.s looked pretty good in the second quarter so we feel pretty good about the prospects going forward excellent just to confirm them david the way we should be thinking about a bit of the softness in q2 is really you think there's some trialing going on but you don't see fundamental competitive pressure in us pciol is that fair

Yeah, that's fair. I think it's exactly as we would have expected it. You know, I think, you know, people are going to try new lenses when they come out. You know, there's always a place for price in the market. There's always something new that somebody's claiming. And surgeons want to try things, so they will. And then I think what happens is they figure them out and they kind of, generally speaking, I think have come back to where, you know, where we have, I think, very, very good offerings that compete well.

Claire, great. And then if I can just follow up. Obviously, we've now had two really impressive quarters and contact lenses. I think you're the fastest growing CL company in the market. I know it's not apples to apples, but it's the data that we have. Just curious how you're thinking about the sustainability of that momentum. And I'm not really asking about the second half, but as we transition into 2024 and 2025, how far along are you, you think, in that journey of winning market share and how much more is left? Thank you.

Well, you know, the thing about market share in contact lenses is it's kind of slow and steady wins the race. And I think, you know, as I see it, you know, you don't see anything really move quickly. You know, in some of our businesses, you know, everything's a discrete choice, but really every new patient, you know, that we get onto a lens gives us usually four or five years, you know, on average of value. So we are really pleased with the performance of contact lenses. I think we've made some good choices around where we've entered products and the sequencing of entering products and We feel very good about our manufacturing capability right now and our ability to deliver continuously lenses in these spaces. And so I would say, you know, we don't see anything that kind of, you know, open water in front of us. I think our view is that contact lenses, we've got two or three really unique ideas. You know, we've got more Torex now than we've ever had. Those Torex are doing very well pulling the family of products along. So think about that as, you know, total 30 Torex pulling the sphere of total 30 along. Think of it as you know, daily's total one growing, you know, the sphere growing in its 10th year, growing share, and really because the TOREC is pulling it along. And then P1 has been a terrific responder for us, continues to grow really well. So, you know, I think that plus thinking through, you know, we still have more new product flow coming in this area over the next couple of years. I think we talked about that at Capital Markets Day. So we feel pretty good about our sustainability in this over, you know, a long stretch.

Our next question is from Graham Doyle with UBS. Please proceed.

Hi, guys. Thanks for taking my questions. Just firstly on equipment, it obviously continues to grow really, really strongly. And at the Kaplan Marcus Day, you gave us a nice sort of showcase of what's coming up in terms of new products. So it'd be good to get a sense of what you see as white space and where you still have left to attack with that new equipment. And are we seeing any sort of pull forward of stuff? And then just a quick follow up back to that, please. Thank you.

Well, yeah, Graham, thanks for the question. You know, we obviously are excited about our equipment business right now. It's doing really well. I think internationally we have done a good bit better than we expected against competition. And, you know, I would say that, you know, we still have some upgrades to finish, but we're also excited about next generation equipment, which will give us a whole nother, you know, era of, product to revise from, which will give us some ASP uplift. It'll give, you know, some really interesting opportunities for efficiencies to the surgeons, and I think that will drive some real value for them and for us. The white space for us really is, I would say, microscopes, biometry, and I think, importantly, what we've loosely called kind of this digital movement or ecosystem where you're moving data and helping surgeons plan more efficiently and from the in-office environment where you take a lot of different diagnostic tests, you put them into a planner, you move that information into the OR, and then you come back and recalculate your surging constant, you know, to try and keep improving the outcomes for patients. I think the real magic in what we're going to do is integrate all of that and do it in a way that nobody else can, which is with our lenses and our equipment and uniquely with artificial intelligence driving a better outcome. And I think that will be the biggest white space. I think you see, you know, over the next four or five years. So very excited about what we're doing next in equipment, but also I would just say really great quarter for us in equipment. And we've had a, we've had a couple of years of good equipment. So, you know, really nice for consumables going forward.

Great. Thanks. Hopefully it's the quick follow up on them on dry iron comet too. It looks like that primary completion is sort of mid July. And typically these types of trials, it could be a couple of months of data cleaning before you would have that in-house. Do you guys have to show that to us once you get it? Typically with other companies in similar phase three trials, that has been the case. But I know you've kind of insinuated it would be more like a Q124 data sharing with the markets. Can you just give us an update on that, please?

Yeah, we have actually three studies going on right now, and they're all kind of sequentially finishing over the next, I would say, six months or five months, let's just say. Most of that data, I think, finishes late this year, maybe early next year. And once we have it in hand and can look at it, we'll obviously report out what we've got.

Super clear. Thanks, Lucas.

Our next question is from Ryan Zimmerman with BTIG. Please proceed.

Good morning, and thanks for taking the question, David and Tim, and the results. Just want to ask a couple, following up on the ATIOL space, you know, you guys have laid out and showed investors, you know, what you're working on in adjustables and accommodative lenses in the market, or excuse me, what you're working on. Given what we're seeing in the market in the U.S., David, I'm wondering if you're willing to put some timelines out there in terms of your adjustable and accommodative efforts when we could expect that in the market to maybe fend off some of the competition?

Yeah, we're not in a position right now where we want to lay out exactly when we're coming with adjustable and accommodative. It's, you know, as we said at Capital Markets Day, it's late in the plan. It's just slightly outside the plan. And so it's going to be a while for us to get what we think is a market-ready product. And I would say, You know, the view we have, of course, is that we've got some terrific lenses with Panoptix and with Vividi. They're kind of unsurpassed in their ability to create a reading for patients. I understand there are other lenses out there that are kind of working through some of these similar kind of adjustability ideas, but as you know, we haven't really figured out whether those are really kind of just niche ideas or whether they're really durable. My sense of it is that we'll find that out over the next coming years, but directionally, nobody's really working on the combination of accommodative and adjustable like we are. And I think we've probably got the right idea, but it's going to take some time. I think over the next, I would say, three or four years, the real magic is going to be in getting the diagnostics and getting the procedure, you know, tuned in a way that really performs. And I think that's very likely to happen with our equipment and our lenses. I think we've got a very good combination of things that will move the market along in the PCI well area.

Okay, fair enough. And then on guidance for Tim, you know, first half revenue and guidance implies essentially no growth in second half 23, despite seasonality. And then at the midpoint, it'd be a little bit of a decline, I believe, on revenue. And so, Tim, just wondering kind of what your thoughts are there, given what your underlying assumptions are for the market dynamics in the back half of the year.

Yeah, great question. You know, as we said on the prepared remarks, we expect we're trending right now towards the higher end of that range. You know, if you look at sort of the first half, Asia ran a little bit hot, particularly China. So we'll see how that plays out over the course of the year. But, you know, we're tracking pretty close to those historical trends. So I would plan on that. And as we gave the guidance, you know, I think we're trending towards the higher end.

Good stuff. Thank you.

Our next question is from Daniel Butcher with ZKB. Please proceed.

Yes, thank you very much, gentlemen. Maybe the first question on margin phasing. I mean, Tim, typically you like to give a bit of an update. What do you expect if we say for the second half now? I mean, if I understood you correctly, FX at the top line level then for the rest of the year should be relatively neutral. Finally, after one and a half painful years, is this fair to assume also then for margins that FX is not a headwind anymore? And how is it with other cost items like R&D, like marketing spend and other topics like that? And then maybe the second question on the outlook for price increases. I mean, 3% now in the second quarter also? meaningful contribution still. Have there been any new price hike announcements or can we expect this to fade off for the rest of the year and then 2024 only a minimal spillover effect on the pricing side? Thank you very much.

Yeah, I'll handle the margin one and then pass over the pricing to David. As far as margins go in the second half, they will be a little bit depressed and that's primarily driven by gross margins. So as we said in the prepared remarks, our second half gross margin will be a little bit lower than first half. And that's primarily driven by the fact that we are going to be having higher cost inventory flow through the P&L. So when you think about the cycle from when we buy the inventory versus when it runs through the P&L, it takes about six months. So we had inflationary pressures, obviously, towards the end of last year, beginning of this year. That inventory will start flowing through in the second half. We're going to continue to get SG&A leverage. We're going to continue to invest in R&D. You're going to see that heavier spend related to the area acquisition that you saw in the first half. But overall, we would expect gross margins to be higher year over year, and we feel very comfortable with the 19.5% to 20.5% margin rate that we guided at the beginning of the year.

And, Daniel, just on price increases, yeah, we had announced a price increase, I think, in May, June, and that's where we are right now. I think going forward, we'll evaluate what price looks like and what inflation looks like and see what the consumers are doing to try and figure out what we can and can't do. We'll have to make that call as we get later in the year and into next year.

Understood. Thanks, gentlemen.

Our next question is from Anthony Patron with Mizuho Group. Please proceed.

Thanks for taking the question and good morning. Let me start off with Dave just on the surgical backlog you mentioned and the prepared remarks. Just wondering how deep or how extensive that is as we sit here today and can it be a driver well into 2024, and a quick follow-up there would be just on not necessarily competition, but the patient choice between monofocal and premium. Are there any kind of, you know, changing characteristics just from a spend level from those patients? And I'll have one quick margin follow-up for Tim.

Yeah, I think directionally, you know, it is interesting to watch the surgical backlog. You know, we've talked about it for a number of years now just because of the COVID, you know, miss, and there was, you know, you know, millions of procedures ex-U.S. There's probably a million plus in the U.S. that were either delayed or avoided. I think it's been our view and it continues to be, you know, our view that, you know, we'll see that come back, you know, kind of in a slightly warmer than historical growth rates. And I think that's what we saw to a certain degree in the second quarter and partly why we have changed our outlook a little bit going forward, which is we do think that the surgical patients are out there. There's plenty of them. and they are looking to get into surgery. What was important was we saw on a, you know, we measure procedures on an active unit basis, and we saw a significant uplift in number of procedures per active unit that we have. That's a productivity increase, which we're kind of pleased about. And I think it probably reflects, you know, a view that, you know, you can, you know, whatever the historical growth rate was, let's call it, you know, three-ish percent, two to three percent in the U.S., you're going to see something a little bit warmer than that. you know, for an extended period of time, because there isn't really capacity to bring a whole bunch of people through in one bolus or something. It's really going to be, you know, getting patients back in the office, getting the surgery centers up and running, outfitting additional ORs, getting staff trained, and moving that way. That's really, I think, a durable idea, you know, probably for several years. I think between mono and premium, you know, we continue to believe that if given the right understanding, the headroom in this is quite large. You know, we think there's you know, kind of in that 30% to 40% of patients, you know, should be, you know, interested in or are interested in at a price an advanced technology lens because it gives them, you know, freedom from spectacles. It gives them reading, gives them really good intermediate. And our lenses obviously are the preferred choice and continue to be in the U.S. So we're very comfortable that that is going to continue on. I do think that what's nice to see is some of the staffing in the offices is improving. And so in the back half of the year, You know, we're hopeful that we'll see, you know, long term penetration continue to move forward. And I would just say 50 basis points in the U.S. would be a good number. That's certainly what we think about outside the U.S. I think you do a little better than that because it starts from a lower level at, you know, kind of 12 percent. But again, you know, we benefit a great deal from from the penetration moving up. And we again, we're encouraged by what we see.

And just quick for Tim, an update on the DSM flex lines. Just when will those be complete and any thoughts on a margin uplift over time from that effort? Thanks again.

Yeah, nothing really different from what we talked about at Capital Markets Day. We've got some more lines going in next year. I'd say next year is sort of our last kind of big installation phase, if you will. And then as you get to kind of the 25-26 timeframe, It's more of just kind of keeping pace with what we think the expected demand would be. But no significant changes from what we talked about at capital markets, Seth.

Thank you.

Our next question is from Larry Bagelson with Wells Fargo. Please proceed.

Good morning. Thanks for taking the question. Quick one for Tim, and then I had a follow-up. The operating margins, Tim, were higher in Q3. versus Q4 in both 2021 and 2022. Should we expect a similar dynamic this year? And I had one follow-up.

Yeah, like I said, we're going to have a little different dynamic than what we've had historically because of that inflation. So it takes six months to work that inventory through. So, you know, I would just take your first half actuals and peg whatever you think you were going to be in that 19.5 to 20.5 range, and I'd sort of model it that way.

Got it. And then, David, on Aerie, it looks like, you know, it's not 100% clear, but it looks like revenues were down quarter over quarter. I heard you talk about the teams, I think, total prescription growth. Could you give us an update on how Aerie is doing, kind of the revenues on a year-over-year basis, and just an update on your kind of appetite for M&A and if you're still focused on, you know, pharma? Thank you.

Yeah, Larry, actually – No, Aerie's up year over year, and TRX's is up year over year, and Cher's doing pretty much exactly what we thought, so we feel very good about what's going on there. I think if you look to the TRX's in particular, that's probably your best indicator of how we're doing, and that's audited data you can find. I think directionally, we continue to be interested in it, but we're not anxious about it. You know, we'll be very disciplined going forward about RX, but I do think iDrops is a business that we know well, we're good at, and we'll continue to kind of over time, add things into that portfolio, either internally or externally, through our own efforts with the Area R&D Group, which we're excited about. For example, AR512, we'll see how that does. But I think directionally beyond that, we can come up with some other good ideas that I think add some real value, both, I guess, organically and externally.

Thank you.

Our next question is from Matthew Meacham with KeyBank Capital Markets. Please proceed.

Hey, guys. This is Brett Fishman on today for Matt. Thanks very much for taking the questions. I know it's a little late in the call, but just wanted to ask at a high level, you know, if you could walk through a couple of the factors that led to a change in, you know, your view of what the market looks like going into the second half. like what really changed incrementally in a three-month period that gives you more confidence that recent trends can be sustained for the rest of the year?

Well, Matt, I think it's really just the underlying fundamentals on, for example, productivity per machine that we're seeing in surgical. You know, we keep a pretty good eye on what the throughput in ORs is, and we can see that pretty visibly because we have a very large share of the cataract equipment. And so, you know, we saw more, you know, we certainly have been growing our footprint. So we're growing equipment share on the ground, but we're also, we monitor how many, you know, procedures per machine is going on and we're seeing an uplift in that metric. And so directionally, I think what you're seeing is what we had hoped for, which was staffing improving. And I think directionally ORs getting back to work. And that has been, you know, what we've been kind of counting on. So I think we see a little bit of that on the surgical side and on the, Consumer side, you know, we've seen a steady movement of a mixed return. I think our underlying demand by patient volumes is solid. And, you know, we were worried in the first half, you know, if you go back a ways, we didn't see, you know, kind of through the first quarter any reason to change our outlook because there was nine months in front of us that lots of things could happen on. I think as we sit here today, you know, we're almost eight months into the year. And I think we believe that, you know, probably anything that happens, even if it was a macro change, is manageable inside of the guidance we just gave you. So, you know, we're trending towards a high end of it. And, you know, assuming that things kind of continue on, you know, we should be in a really nice spot. So I think I don't really see anything right now on the horizon that we should be particularly concerned about affecting demand at the market level.

All right, great. And then just as one quick follow-up on contact lenses, just curious if you could provide a brief update on how you're currently thinking about the launch of precision seven and maybe just touch on some of the feedback you've gotten from optometrists ahead of that product launch. Thanks very much.

Yeah, thanks. You know, we'll get more into precision seven probably next year. We're certainly not going to launch it this year. We're trying to give room for the success that we're having with the existing products. So of course we've got a sales, Salesforce is all over the world right now promoting a lot of products. And so there is a, a bit of a capacity and timing question around this one. By capacity, I only mean Salesforce capacity. We can make plenty of this. But I do think the basic proposition is really interesting, which is a lot of optometrists tell us that a one-week regimen is a more intuitive regimen than a one-month regimen because people forget, they overwear, they do a number of things. But getting a clean lens once a week on a Monday is you know, just makes a whole lot of difference, I think, in the way people wear this lens and also the comfort of a reusable lens. So there's a combination of price point, which is a little bit better than your daily's product and a little bit, you know, more expensive than a monthly, but way more intuitive and way better for you and a more comfortable feel. So I think the proposition of Precision 7 will be nicely positioned, I think, between daily's lenses and monthly lenses and And we know that really still 50% or more, almost 60% of the patients are still in reusable wear. So they're in a monthly or two-week lens. And so we're trying to access that volume by bringing Precision 7 to market. So we're very excited about the product. We're continuing to collect data on it to make sure that we have a data package that will be compelling. But I think Think about this as a kind of next year idea, maybe late next year. We haven't really settled in yet on what our timing looks like.

Our next question is from Jeff Johnson with Baird. Please proceed.

Thank you. Good morning, guys. David, I wanted to go back to maybe the first question of Q&A just on the IOL comments you made on the U.S. market. You know, I think Veronica asked on PCIOLs, you kind of answered on TORC IOLs. We didn't address monofocal IOLs. So maybe across those three categories, can I just make sure I'm understanding what you're saying on kind of the new market entrance and kind of where you're seeing stability or not in your share across PCIOLs, TORC IOLs? and the monofocal side of the business. Thanks.

Yeah, so I think in the U.S., monofocal share was up for us. I think ATIOL share was off a little bit, but PCIOL share was pretty stable. So most of the action was in TORIC. And, you know, again, there's a couple of new entrants, three actually, I think, if you think about it year on year. in that space. And, you know, people are going to try those lenses. You know, one of them has got a very low price point. You know, one of them is making claims, you know, that I think are, will bear out to be, you know, a little more complicated than, than said. And then, and another one is a, is kind of a, I think a niche product for complicated patients. And so I think that will bear out over time, but, you know, you gotta, you gotta live with these things as we try and go into markets all the time. You know, we, we knew there'd be some pressure here, but directionally we're holding up really well.

Yeah, no, that's very clear and very helpful. Thank you. And then just on China, it seems like there's maybe a little clarity starting to emerge on VBP for next year. I know you get that question a ton, and you're probably tired of that question. But just, you know, kind of how should we be thinking about the early year versus maybe the volume recovery and back half of next year? Just any kind of early phasing or thoughts we should be thinking about China VBP next year on your implantable business? Thanks.

Yeah, look, I mean, we sat out VBP, you know, really the last time through. So we did not, you know, VBP for China is going to be IOLs and OVD. And so the opportunity for us is to participate. I don't know whether we will or not. We'll find out as we kind of get closer to this as to how we see it. But it really isn't a big deal to us because we didn't participate last time. So there is really no downside to us. There is, we see kind of China really as an equipment opportunity, you know, durably, you know, if we can get our consumables business growing there. Remember, consumables is our biggest business by a lot. And so, you know, we see consumables as the way through China. Equipment in particular is a real strength of ours there. Those are not going to be in VBP. So I think the way to think about China is, A, it's, you know, 4% of our business, so relatively small versus some other people's. B, Our IOLs are not in the VBP win column right now, so we don't have much to lose in terms of pricing or volume there. And C, you know, we're kind of thinking a lot about equipment and how we move forward in things like refractive surgery or things like cataract surgery equipment, which will drive a long-term durability of consumables once we get those in. So that's kind of directionally what I'd say about China.

Yeah, very helpful. Thank you.

Our next question is from Sergei Azener with HSBC. Please proceed.

Hi. Thanks for taking my questions and congrats on the results on the outlook upgrade. One question on the U.S. market, actually a follow-up, please. In terms of the changes in the pricing you see, What are the dynamics with the new entrants? Does that change anything on the bundling structure or the conditions of your pricing? And also, is it somehow related to the lack of expansion in the ATIOL penetration in the U.S. market? Is that the reason driving some people switching to some of the monofocals?

No, look, I think the pricing is fairly stable. And I think, you know, you're always going to have some new entrants come in with, you know, lower price offerings or some combination of value that's different than the market leaders. But again, I wouldn't put that in the category of interest to us. I think, you know, we've done a lot of work on pricing in ATIOLs over the years. We do, we relook at it every year. We looked at it just late last year. And again, I think we believe that there is kind of 30 to 40%, depending on what year you're in, but last year was kind of mid-30s, of percentage of patients who will pay the current prices for PCIOLs because they get real value out of it. They can see without glasses. They don't have to buy readers. It's a lifestyle change that they can afford. It's a one-time purchase that they don't have to redo. And I think that value proposition, if explained correctly, you know, is very compelling. And so I don't think we believe there's a price dynamic here that really matters to the patient. You know, obviously, when you kind of look at the ATIO business broadly, penetration is growing globally. We think that's a big deal because, you know, I think 80 basis points up this year, mostly internationally, is a good sign around the economy. And I think directionally, the U.S. is, you got to remember the U.S., you know, grew from, I think, 14 to 19 over about three or four years. So it really has accelerated quickly. We did a lot of that work with Panoptix and Vividy. So those are really what's driving. Those two brands are what's driving the ATIL market right now. And, you know, so if it takes a little breather during this, you know, kind of COVID hangover, we're not super surprised about that. We've been talking about it for a while. I suspect it will come back into what's a much more normal frame historically, 50 basis points a year, that kind of thing in the U.S., and look for international to really be the driver of ATIL penetration because ATIL It's starting right now, you know, around 12. It probably has got a lot more room to grow. And there are some really interesting markets. We talked about China in the prepared remarks because it's a fairly low penetration rate. And we're just getting in there now with the right products. So, you know, we'll see how that takes shape, you know, this next year.

Thanks very much.

Our final question is from Chris Gettler with Credit Suisse. Please proceed.

Thank you, operator. Hi, I'm David. I'm Tim. I have two questions. The first is on guidance. Actually, to what degree, you know, is your guidance upgrade on top line, you know, driven by the improved market assessment, and to what degree is it to, you know, outcome-specific factors? And then related to that, you know, you know, why was there no increase in margin guidance given, you know, the stronger top line one obviously would have expected, you know, some leverage, you know, with these higher sales? Could you maybe discuss that quickly? Thank you. And I have a follow-up question on China.

Yeah, Chris, let me take the first half, and I'll give Tim the second half of that. You know, this was really driven – it is a combination of really great performance in equipment, consumables, and contact lenses. As you look – well, and frankly are – our eyedrops business. Those have all been overperforming relative to expectations for us. You know, I think Implantable is right on pretty much what we expected. So I think directionally, we're doing better in, you know, all cases, you know, for our business than expected. But the market has also improved. So, you know, I think we had concerns in the beginning of the year, as everyone did really, about what was going to happen with the consumer. The consumer has been relatively robust. in most markets. And I think as we look out through the remainder of this year, I think we can confidently say there's probably not much that's going to happen timing-wise for us to have for the rest of this year that's going to affect us much more. So markets look solid, a little bit better than expected, performance a little bit better than expected.

Yeah, and as far as the margin rate, it's really driven by FX. I mean, if you look at the rates as of the end of July and compare them to when we last spoke, the dollar has continued to appreciate So that's really what's driving the pressure on the margin rate, which is why we didn't increase it. But again, we're still comfortable with that 19.5 to 20.5 range.

Okay. And then on the follow-up, you know, on China, you broke out about a four percentage point contribution in consumables from China, you know. Is that, you know, kind of just, you know, a COVID recovery effect or would you expect, you know, kind of a more of a structural kind of element to that as the year progresses? Thank you for taking the question.

Well, the four percentage points, just to be clear, is the revenue percentage of our total revenue, just to kind of size China for you. So many companies have much larger exposure to China than we do. So it's reason to give you that number. Um, I think directionally China is an opportunity for us. We see it that way. Um, but largely as a matter of, of equipment and consumables going forward, uh, we certainly sell implantables there and we see an opportunity there. Um, but directionally, um, we're very interested, um, in what's happening in the market. Um, the market itself, you know, is wrapping around a pretty big COVID number. So I think to your point, um, you know, we had a big growth in China this particular quarter because, um, there was a pretty soft year last year. So I think, um, combination of what picked up in China started in kind of late February, really March, April, May has been very solid for us. We hope that continues.

Okay. I was more referring to the 4% contribution to consumable sales growth from China as you mentioned on your earnings release. I guess you covered it for some reason. Thanks.

We have reached the end of our question and answer session. I would like to turn the conference back over to Dan Cravens for closing remarks.

Great. Thanks, everybody, for joining us this morning. If you have any follow-up questions, certainly reach out to either Alan or myself in investor relations and enjoy the rest of your day. Thanks.

Thank you. This will conclude today's conference. You may disconnect your lines at this time, and thank you for your participation.