Avanos Medical, Inc.

Good day and welcome to the Avanos fourth quarter 2018 earnings conference call. All participants will be in a listen only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. To withdraw your question, please press star, then two. Please note, this event is being recorded. I would now like to turn the conference over to Dave Crawford. Please go ahead.

Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to the Avanos Fourth Quarter Earnings Conference Call. With me this morning are Joe Woody, CEO, and Steve Oskell, Senior Vice President and CFO. Joe will begin with a brief review of our 2018 accomplishments, followed by an update on the outlook for our businesses and an overview of our 2019 priorities. Then Steve will review our results, offer details on our financial performance, and share our earnings outlook for 2019. We'll finish the call with Q&A. A presentation for today's call is available on the investor section of our website, Avanos.com. As a reminder, our comments today contain forward-looking statements related to the company, our expected performance, economic conditions, and our industry. No assurance can be given as to the future financial results. Actual results could differ materially from those in the forward-looking statements. For more information about forward-looking statements and the risk factors that could influence future results, please see today's press release and our prior filings with the SEC. Additionally, we'll be referring to adjusted results and outlook. The press release has information on these adjustments and reconciliations to comparable gap financial measures. Now, I'll turn the call over to Joe.

Thanks, Dave. Good morning, everyone, and thank you for your interest in Avanos. 2018 was a year of transformation and achievement as we completed the S&IP sale, increased investment to accelerate growth, and initiated our cost savings program. I'm pleased with our performance against the five priorities outlined last year. First, build on our top line momentum. Second, close the S&IP divestiture and deliver on our TSA commitment. Third, execute strategic investments to accelerate growth. Fourth, begin to right-size our cost structure to support our leaner, more agile business. And finally, strategically deploy capital through M&A. I will review these accomplishments and their expansion in 2019. First, we sustained our top-line momentum in 2018. For the year, sales grew by 7% to $652 million, slightly ahead of our revised expectations, and we earned $1.93 of adjusted diluted earnings per share, exceeding the high end of our outlook. We continue to see strong demand for our cool leaf, digestive health, and respiratory health products throughout the year. Buying these businesses grew 8%. Additionally, organic sales in the international markets increased from 1% in 2017 to 5% in 2018 in constant currency. As discussed during our third quarter conference call, the regulatory issues around the industry-wide drug shortage and pre-filler disruption continued to pose challenges for our acute pain customers. This, coupled with the inventory consolidation initiatives of two of our IV infusion distributors, impacted our overall performance for the year. The number of customers working with our exclusive pump filling partner continued to increase as we saw a 25% increase in sales in all lighters accounts for the quarter. In addition, drug supply for ropivacaine is beginning to return to the market, and we expect it to take several months to work through the supply chain based on our experience last year when supply was interrupted. We continue to see significant growth potential for acute pain, given the large addressable market of more than 20 million applicable U.S. surgical procedures annually and the growing demand from surgeons for effective opioid-sparing pain treatments. Our well-trained sales force is focused not only on expanding market penetration in orthopedic pain and healing, but in new growth areas where such as OBGYN specialties were on cue to make a meaningful difference in patients' lives by enabling opioid-free C-sections and hysterectomies. Our second priority was to complete the SNIP divestiture and deliver on our TSA commitment. We are pleased to be progressing as scheduled with our TSA commitment. Our third priority was to accelerate strategic investment to drive our near and long-term growth with the goal of achieving sustainable, high single-digit growth over time. Our investments were focused on three key areas, interventional pain, R&D, and international. Let me highlight some examples. First, in interventional pain, our fastest-growing business, we made significant investments in Cool Leaf, the only FDA-cleared RF treatment for OA knee pain. These investments are in advance of the expected 2020 CPT-1 code for genicular nerve ablation. To raise patient awareness of our unique and effective therapy, we launched our first direct-to-patient television commercials in a selected U.S. market. We are excited about the results, which generated a 35% sales lift in those markets over our normal growth expectation. Also, we saw a significant increase in patient awareness. Additionally, to further differentiate Cool Leaf and bolster our position in the payer community, we increased our investment in clinical research. As a result, company-driven Cool Leaf publications have grown from just one in 2016 to an expected seven in 2019. Three key studies, when published, intend to show Cool Leaf's benefits against the use of steroids for the treatment of knee pain, the health economic benefit for Cool Leaf, and new results for our study against hyaluronic acid for knee pain, which could enable us to target this billion-dollar market. We're optimistic about this study and expect to publish more details in the near future. In addition to raising awareness, we're advocating for the adoption of reduced and or non-opioid alternatives to help combat the opioid crisis in the U.S. To this end, we've strengthened our government relations efforts. Members of my leadership team and I have met personally with members of Congress to lobby for improved reimbursement of opioid sparing therapies. We're encouraged by the Opioid Crisis Response Act, which contemplates the removal of financial incentives for prescribing opioids rather than medical devices such as OnCue and procedures like Cooley. Furthermore, we have strengthened our reimbursement capabilities. When I started a year and a half ago, our reimbursement team was a single person. Today, we have built a team of nine primarily focused on expanding coverage for Coolief, but also working on several initiatives in our on-queue business. Second, we continued investing in R&D to strengthen our capabilities to commercialize new products and to build a robust pipeline of innovative medical devices. Our increased investment in breakthrough technologies is showing signs of returns. We were one of eight companies from more than 250 submissions selected by the FDA for its Opioid Innovation Challenge. In addition, we continue to make strong progress across our breakthrough initiatives and are excited to be starting our first inpatient trial around new methods to treat post-surgical pain. Turning to international, we increased our focus on this business, restructured the leadership team, and prioritized our investment around selected growth markets. Arjun Sarkar leads this business and has laid out his strategic plan and growth framework, which includes prioritizing geographies where we can win and build scale, acquiring top device industry talent, evaluating our distribution channels, and determining how to rationalize our channel partners. Overall, we expect International's growth rate to accelerate each year and become a double-digit grower by 2021. These are just three areas of strategic investment we made in 2018 to position us for future growth. Transforming our cost structure was another 2018 priority. As we've mentioned on previous conference calls, we're taking a phased approach to this transformation. As a reminder, the first phase was right-sizing our organization to align with our growth model. Second was our IT restructuring, where we've initiated deployment of our new ERP system. When the implementation is completed in late 2019, it will reduce our structural cost, enable more efficient inventory management, and improve the information available to speed up and enhance decision making. The third phase, which is slated to begin later this year, will optimize our product supply, global distribution, and network and procurement. To drive this process, two months ago I appointed Dave Ball as Senior Vice President of Global Supply Chain and Procurement. I'm excited to have Dave as a member of my senior leadership team. In my previous experience with him, he has demonstrated the ability to optimize cost structure, drive continuous improvement programs, and increase efficiencies in manufacturing sites. Combining the three cost transformation phases, we anticipate reducing costs by $30 to $40 million by the end of 2021. These savings will be initially reinvested to help accelerate our growth. Strategically deploying capital through M&A to drive shareholder value was our final 2018 priority. I am pleased with the game-ready acquisition, It's meeting our expectations and we expect its growth to be faster than our organic growth rate. Moreover, it strengthens our access to the orthopedic and healing call points, broadens our access to post-operative pain management market, and demonstrates our disciplined approach to capital deployment. We are committed to executing deals that meet our criteria and we will remain disciplined, ensuring our acquisition criteria are met. Our pipeline remains robust and we are evaluating potential deals ranging in size that will complement business now I want to highlight our four priorities in 2019 first accelerating top-line momentum remains our top priority to drive growth we will increase investment we continue to see our chronic care business as a mid single-digit grower and expect to launch multiple new products to maintain our leading share positions we're also investing behind our market leading core track tube tracking technology as our goal is to establish it as the standard of care for bedside placement of small bore and nasoenteric feeding tubes. Chronic Care also provides the foundation for us to accelerate our international growth in the near term. To build on our momentum in Coolief, we've already expanded our successful direct-to-patient advertising into 13 new and large US markets, accelerating investment for new clinical trials and expanding our sales team by 20%. We have seven clinical studies currently underway and in total 13 planned over the next three years. During the first half of this year, we expect six-month results from the hyaluronic acid study to be published, as well as the health economic study that shows nerve ablation is more cost-effective than the current standard of care. Turning to acute pain, we're focusing on regaining growth. As the drug supply gradually improves, we anticipate our sales performance will begin to meaningfully accelerate in the second half of the year. Second, on the international front, we'll continue investing in our growth frameworks. including strengthening our sales and marketing capabilities and hiring regional management and customer-facing roles. Again, we see this business as a double-digit grower over time. Similar to 2018, our investments will temporarily impact margin, but we expect these investments will lead to accelerated growth and significant margin expansion after 2019. Also, post-2019, we will curtail our level of investment once we've established an appropriate level of support for our future growth initiatives. Turning to cross-transformation, this year we will begin the third phase and execute multiple projects. These include simplifying our current distribution network to optimize transport costs, enhancing productivity in our plants through product insourcing, and the phased rollout of our new IT platform that will simplify, streamline, and standardize our global systems and process. We anticipate providing more details about the next stage of our cost takeout program during the second quarter. Overall, we expect savings of $7 to $10 million in 2019. With the establishment of our IT infrastructure, we expect additional savings of $14 to $18 million in 2020. And finally, deploying capital for M&A will enhance our plan. We are well positioned to succeed in 2019 as a pure play medical device company. Our diverse product portfolio and leading positions in large growing market, our scalable infrastructure, our focus on key strategic initiatives, and our talented team gives me confidence we'll accelerate growth. With that, I'll turn the call over to Steve.

Thanks, Joe, and good morning, everyone. Let me also say how pleased I am of our accomplishment and the effort of our teams throughout the year. As Joe said, completing the SNIP divestiture was a major accomplishment, which transformed us into a pure-play medical device company and enabled us to focus on accelerating growth and increasing investments in our strategic growth initiative. These investments are paying off and position us for success in 2019 and beyond. Now, let's begin with a review of our fourth quarter results. Overall, we delivered sales of $170 million, an increase of 2%. Sales from our Game Ready acquisition contributed 5% of the growth. Excluding Game Ready, we saw another quarter of double-digit growth in interventional pain driven by our continued investment in direct-to-patient advertising and the increased adoption of Cool Leaf. In digestive health, demand remained strong for our CorePak and Legacy enteral feeding products. In respiratory health, growth was below its normal mid-single-digit rate due to the expected reduction in our lower-margin oral care business. Growth was offset by the expected lower volumes in acute pain, due to the continuing regulatory issues impacting the industry-wide drug shortage and drug pre-fillers, along with the impact of inventory consolidation between several of our IV infusion distributors. During the quarter, our on-queue franchise performed ahead of expectations, but was offset by our lower margin IV infusion category. Overall, these factors resulted in lower sales volumes of 2%. Unfavorable product mix and lower selling prices impacted results by 1%. For the quarter, adjusted gross margin of 60% was in line with our expectations and compared favorably to 55% last year, which included costs previously allocated to the S&IP business. Sequentially, adjusted gross margin contracted due to last quarter's above-average manufacturing performance and the planned downtime in our manufacturing site. Adjusted operating profit came in at $20 million for the quarter, compared to $7 million a year ago, and operating margin was 12% compared to 4% last year, as last year's results were impacted by $30 million of costs allocated from discontinued operations. As we discussed, we continue to increase investment for near- and long-term growth. The higher level of investing, coupled with the expected synergies from the SNIP divestiture, impacted operating profit. Adjusted EBITDA for the quarter was $22 million compared to $64 million a year ago, as results from last year included discontinued operation. Adjusted net income totaled $14 million compared to $35 million a year ago. For the quarter, we earned 30 cents of adjusted diluted earnings per share, which was above our expectation. Two factors contributed to our strong performance. First, net sales came in above expectation, largely driven by chronic care, as we continue to see distributors hold an elevated level of inventory in our digestive health product. We expect during the first quarter, inventory will revert to its normal level. Second, we saw a favorable adjusted tax rate due to a change from our initial assumption when the final purchase price allocation for our SNIP divestiture was completed. Now for a brief recap of our full year 2018 results. Net sales totaled $652 million, an increase of 7% compared to the prior year, including game ready, which contributed 3% of the growth. As a reminder, Due to the divestiture, we were required to allocate shared costs previously allocated to the SNIP business entirely to continuing operations in the process and for the first four months of 2018. Prior to closing the transaction on April 30, 2018, four months of these previously allocated costs to SNIP totaled $37 million and were allocated to continuing operations. For the full year 2017, these allocations totaled $116 million. As a result, our year-over-year comparisons are skewed. With that, for the year, we delivered adjusted diluted earnings per share of $1.93 compared to $2.35 in the prior year. Shifting to our balance sheet, we ended the year in a strong financial position with $385 million of cash on hand. Our balance sheet remains strong, and we are well positioned to invest in future growth initiatives. Now, let me turn to our 2019 outlook and the key planning assumptions. Based on current trends in our business, including our expectation for improved acute pain performance beginning in the second half of 2019, we expect net sales on a constant currency basis to increase 6% to 8%, including game-ready, compared to the prior year. As I've mentioned, in 2019, we're making investments in our growth initiatives, most of which will happen during the first half of the year. During the first quarter, we're expanding our Cool Leaf direct-to-patient television advertising into new markets and are continuing to build our international team. Overall, we expect our investments for the first half of 2019 to exceed our second half investments. Also, in the back half of the year, we expect cost savings to build as we transition our focus from IT implementation to cost savings programs. Given the acceleration of investments for the year, we expect to earn between $1.15 and $1.35 of adjusted diluted earnings per share. In summary, I'm confident our increased investment will accelerate our growth. We have a strong financial profile in a disciplined approach to deploying capital to drive organic growth and execute M&A. With that, operator, we are ready to take questions.

We will now begin the question and answer session. To ask a question, you may press star, then 1 on your touchtone phone. If you are using a speakerphone, please pick up your handset before pressing the key. To withdraw your question, please press star, then 2. Our first question comes from Larry Cush with Raymond James. Please go ahead. Thanks. Good morning, everyone.

Joe, I was hoping that maybe you could talk a little bit about the drivers or the components of the 6% to 8% growth. And I guess as part of that, what I'm really trying to understand is how are you mapping out on cue for the year?

Larry, thanks for the question. We've said before that OnQ is progressing quarter to quarter. We actually beat our internal goals in Q4. Drug is coming back, especially on the ropivacaine side, but really the second half is where we see the growth there. Remember that our business outside of the drug supply was about 7% to 8% organic growth for the year. And the drivers are real similar, mid-single digit for chronic care. We're also really happy with 4-PAC and had its highest sales in the fourth quarter for us. And we think have an opportunity to make that standard of care for hospitals and visualization for the placement of feeding tubes. Cool Leaf continues to double-digit growth in the overall business and then higher double-digit growth in Cool Leaf. The investment that Steve outlined in the script, we're taking advantage of going to 13 more markets and direct to patient. These clinical studies are going to help us with commercial payers, I think differentiate us alongside as well of another platform coming out in the summer, a new platform in that category. So all of the same elements, if you sort of thought back to H1 2018 and saw that growth are sort of in place. and the drivers remain. The one sort of unknown is the exact plane of when the drug comes back and the filler comes back fully for acute pain. And remember also for us, game ready is about 3% organic growth for the year for 2019.

Okay. And just a quick follow-up on that one. So is it Is it fair to assume that, you know, your assumptions built into that 68% growth for on-queue are, you know, sort of similar trends in the one-queue from the four-queue, or do we actually see some improvement there? And then are we actually normalized from your vantage point right now in the second half of the year? And then I guess lastly, a question on M&A. You mentioned the pipeline was robust. Again, any thoughts on your expectations to be able to get a deal done in 2019? Thank you.

We expect improvement from Q4. Obviously, the big lever, Larry, is acute pain. To the extent that we get into growth, let's say, in the end of the first half and start to see a better position for H2, that would be a big impact for the current plans. You know, on M&A, our criteria remains the same. You know, sort of we're focused in and around the channel in pain, obviously, and also enhancing the portfolio and the chronic care business. We did get the one acquisition done in Game Ready, which we're very pleased with the performance. I think that's going to enhance orthopedic pain and healing. We actually had another one that we were very close to, and through diligence we decided to back off. So the good news is we have a good discipline around that being the right deals for shareholders. We have two sets of deals for 2019. We have a number of sort of what's called core Packer game ready, more creative deals, deals with EBITDA. We also have a good batch of growth deals that are important as well for our business. I'm very confident that we would basically can transact at least one deal in 2019, if not more.

Great.

Thanks very much, guys.

Thank you. Thanks, Lee.

Our next question comes from Matthew Michon with KeyBank. Please go ahead.

Hey, morning, Joe. Steve, I guess the first question is, how confident are you that you guys return to growth in the first quarter of 2019 and that these, like, 4Q issues are going to be relatively transitory? And can you talk a little bit about the headwind you're going to be lapping in the flow?

So I'll start, and Steve can sort of add anything he wants. One thing we talked about all the way back to Q3 is that Q1 has the potential to be softer for us because you've got the cold and flu season coming through, particularly in respiratory, and then we obviously start to work our way out of that in Q2. We also talk about the on-queue recovery. Still, you know, with us, even though the drug for ropivacaine is back, it's working its way through the distributor's We did see a little bit of inventory build in digestive health in Q4 that could have a Q1 impact. And then our investment peaks in Q1 because we're taking advantage of getting back into these direct-to-patient areas. Obviously, we have some spend around those clinical studies that we outlined, and we're actually driving next week a big global sales meeting that is very important in getting the training out across the country. the whole world really for our initiatives for the year. But maybe Steve wants to comment a little bit further.

Yeah, just a little more color on the top line on the first quarter, Matt. Certainly we'll have growth in total in the first quarter with game ready on top. I think from an organic standpoint, we'd like to be flat as we go forward. I think that may be a bit of a challenge. Part of it is the still the ramp up on the acute pain side. And one of the things I talked about on the call is we had a We have some distributor inventory building in chronic care towards the back end of the year. I think we're going to see that start to bleed out in the first quarters. We're going to have a little bit softer, in addition to the flu impact, the year-over-year flu impact, we're going to have a little bit softer on the chronic care side in the first quarter. And I think a combination of the flu comp, the destocking by distributors, and the acute pain side are going to put some pressure on organic growth sequentially. But then clearly, as Joe said, if you look forward over the quarters, As acute pain ramps back up and we have mid-single-digit expectations for chronic care on a full-year basis, and then obviously a big Q4, as you have acute pain fully back on the gas and have the seasonality and so forth, that's what kind of brings you back from a full-year guidance standpoint.

Okay. And then on slide 9, I noticed that you have the cadence of savings from your cost initiatives But it says annual savings reinvested for growth. Are all of the savings not dropping down and going to be reinvested, or is there a portion that's going to drop down the margin?

Yeah, so first of all, we're getting the savings. So the savings are real. That 7 to 10, you know, a portion of which is in the gross margin side, a portion of which is in the SG&A side, all actioned and all, you know, pretty real savings, which we'll build upon as you see on slide 9 going forward. But we are investing this year all of that back into the business in one way or another. And if you think about just step back on, take SG&A as an example, you really have three things on SG&A. in 2019. One is you've got some reset of targets from, you know, softer sales performance that we've talked about in the past on 2018, significant investment behind Cool Leaf and International, as Joe talked about on the remarks. And then depending on what your comp is, some additional SG&A related to game ready for that half year that we pick up if you look year over year standpoint. So the savings are real. The savings are coming through. But we're choosing, just given the opportunity we have on Cool Leaf with that CPT code coming in 2020, to be on the gas from building that business this year.

Yeah, I think the only thing I would add, Matthew, Steve outlined it very nicely. It was a strategic decision on our part because, you know, we've talked about getting back to mid-single digit. But our real goal is high single digit and then double digit. And we just have such an opportunity right now. the CPT code, with the direct-to-patient advertising, and even some things that we're doing across the other business in particular, also international, which, by the way, grew, you know, high or mid-single-digit for the fourth quarter and going to improve from there for the full year. And so obviously putting the people in place there, these are things that are going to really get us to that high single-digit in the longer term. So, again, it was a very strategic decision.

Okay, got it. And lastly, on free cash flow, It was another outflow for the fourth quarter. You know, what is still driving that? What are your expectations for 2019 and some of the major moving pieces for that free cash flow? And with the 2018 outflows, did it change any of your dry powder expectations for M&A?

Yeah, great question. Maybe I'll just walk right through those pieces. So you're right, from a Q4 standpoint, negative free cash flow, really three Bigger pieces inside there, obviously, CapEx is one. We spent $18 million on CapEx. A big piece of that is IT, and that will be a carryover theme as we talk about 2019 as we get that kind of disproportionate amount of CapEx investment for IT behind us. Q4, we also had a large tax payment, so that was a factor. And then finally, as you see from the press release, still pretty high separation and restructuring costs, roughly $14 million in the fourth quarter. So those combined were the drivers for the negative Q4. As you look to 2019, you say, you know, how's that going to look? Obviously, we're going to be positive in total. I expect we'll be negative probably in Q1 and Q2 and then turning positive in Q3 and Q4. And the drivers in the first half are very similar to what we just talked about in Q4. You're going to see the rest of the CapEx spending falling mostly in those two quarters on the IT side. Not, you know, normal capital spending beyond that, but the increment for IT is Still the higher separation and restructuring costs through the first half as we get the full disconnect from the OMI side, then offsetting that benefits from the business itself generating cash.

Just to pick up on your question about capacity, we believe our capacity is about $650 million at the moment. Things can change that, right, like EBITDA generating acquisitions, et cetera. So over time, we don't see a change in our strategy for deploying capital for M&A.

Our next question comes from Jonathan Demchik with Morgan Stanley.

Please go ahead. Hello. Thanks for taking the questions. I had a quick question just on the earnings guidance and mainly, I guess, on how wide the range is. I was just hoping to get a little bit of a better understanding on what can kind of drive us to really both ends of the ranges. I think it implies a couple points of potential margin variation. So just really just looking for what you guys are expecting on the margin side.

So, Jonathan, just a couple things. I mean, obviously, that wide dispersion, keeping our eye on acute pain, obviously, we're also making those investments that we talked about, and they're fun and loaded. That's kind of the main perspective, but Steve looks like he wants to make a comment.

Yeah, I would say, you know, as we always probably say this time of year, you know, we'd be disappointed to be on the low end of that range, but at the other time, you know, we're early in the year. We've got a lot of assumption on the top line based on that recovery and acute pain, which we have confidence in, but, you know, we want to see that prove itself out here as we go a couple quarters into the year. I think from an OpEx standpoint, you know, we talked about some of the key drivers on the investment side, and depending on the top line, we've got some discretion on how we deploy, although I'll say we're going to deploy some of that investment early in the year, as we talked about on the conference call, to get a fast start on the interventional pain side.

Some of our benefits have been tax-related, and we think we'll go to a more normalized tax rate as well, so really all of the above.

understood. And just a couple quick ones on Cool Leaf. Just really trying to understand a couple different parts of it. How much of this business is, I guess, focused on the knee versus spine? And how are each one of those, I guess, growing? And then also, we talked about the CPT code into next year. Just wondering what level of reimbursement you think is necessary there to really be, I guess, as market expansive as you're hoping for?

Right, so today still the greater majority, Jonathan, of the business is spine. We obviously also have shoulder and hip in that business. The big opportunity is knee. In fact, in the near term, I would say inside the next couple of weeks here, we're going to be reporting some data on the VSCO supplementation trial and what our pain relief looks like at six months, and we're very encouraged and optimistic about that. But at the moment, we're also providing invoices. We've had RUT committee meetings. We have additional meetings with Medicare, and there'll be the proposed rule for OA coverage for the knee in July of 2019. And we've got a big strategy with physicians, patient societies, et cetera. And the final rule is going to be published in 19. And essentially, it really needs to be moving the code up from sort of the low hundreds for the Amateur Surgical Center to more up towards, you know, $1,000 or so would be an excellent outcome. And there's sort of mid- outcome would be more like in the 700 range than obviously having the physician fees go up as well. That's another reason we're investing. I think everyone needs to clearly understand that because these studies are going to be very impactful, very important. They're going to make major statements, and I think that's what the commercial payers want and what the Medicare wants in order to make decisions like this.

Thank you very much.

Our next question comes from Kristen Stewart with Barclays. Please go ahead.

Hey, guys. Hey, good morning. Good morning. Just wanted to go back to kind of the revenue assumption for this year. If I kind of think about that mid-single-digit growth for the chronic care business, about a three-percentage point, I guess, contribution overall to Game Ready for the full year, it's probably like $17 million incremental within the pain business. it sort of gets me to this, call it 3% growth for organic pain. And I would assume that interventional cool leaf probably is double digits. So that seems to imply on cue down maybe something in the mid-single digits. Is that kind of fair in terms of back of the envelope for on cue expectations for 2019?

No, that's not the way we're viewing it at all. I mean, I actually see the possibility that we get back to some small positive growth in on-Q and maybe as early as Q2. But we actually see the greater majority in H2. A couple of reasons. One, we'll be back to the full supply. Remember, also, there's still going to be 30% of the market in bupivacaine not available to the end of the year. Frankly, we do have some pretty soft comparators as well. in H2. So we see growth, you know, in OnCue for the full year.

Okay. And then how are you guys just thinking about the longer-term forecast? You guys outlined last year at the Investor Day. Sounds like you're investing maybe a little bit more nearer term to help kind of drive the performance over the longer term, and maybe that's why 2019 EPS came in a little bit below where the street was expecting. But how confident do you still feel about some of those numbers you gave in terms of the margin performance of the business? Is this near-term kind of reinvestment? Should we think about that as really, truly a sustained permanent level of reinvestment that is really needed to get you to that mid- to high-single-digit growth profile?

Thanks. A couple things on the top line, and then I see you want to make a few comments, but Remember, outside of acute pain, you know, we had a 7% to 8% organic growth performance on the rest of our business. International is coming out. There's no doubt that we're investing a bit in the business because we want to take advantage of some real opportunities, and obviously our goal is getting quickly to high single digits as quickly as we can anyway. And obviously I think everybody understands that M&A enhances. The one thing I would say, because I think Steve wants to make a comment, or he certainly looks like he wants to make a comment, But we are going to get, despite the investment, $7 to $10 million out this year and then $14 to $18. We've also done well in $17 as well. So that all starts to kick in. We back off the investment. We're going to have to keep this level of investment in these areas going forward past 2020, and we sort of get to a point where we get the drop through. Obviously, M&A would enhance some of the shortfall that we've experienced from the acute pain top line. But Steve?

Yeah, no, Jill captured it. This is not something we see increasing in $19 and then sticking. If you think about it, things like direct to patient with the CPT code coming has great ROI in the year we do it, but also has a lot of stickiness in terms of raising awareness. We're doing it as much to raise the awareness and build the brand and have that visibility so when the CPT code comes and reimbursement improves, we can be out on the front foot. That's not something that you just continue to scale up. Likewise, other areas like clinical, I think as Joe came in and said, hey, in 2016 we did one clinical study. and we were targeting new seven to publish this year that we sponsored. That's more what we need to take advantage of kind of the unique opportunity that we have right now. And it's kind of the same thing we saw in R&D. You know, if we think back in the story to when R&D was 1% of sales and we kind of got it up to a sustainable level and it cleaned out and, in fact, you know, it's kind of trimmed out nicely. SG&AC, the same thing. We've got to get to just, especially given the growth opportunities in international and cool ease, get that investment in now, and then I expect it will be, you know, curtail and clean out as we go forward.

So the LRP targets, are those still firmly in place and achievable?

Yeah, those are still the targets that we're using internally as our goals, and so no change on that side. You know, we'll update if we think there's a material change at some point, but right now those are still the targets we're shooting for.

Okay, thank you.

As a reminder, if you would like to ask a question, please press star, then 1. Our next question comes from Rick Wise with Stiefel.

Please go ahead. Hi, guys. It's Drew Ranieri on for Rick. Thanks for taking the question. I guess I just had several questions on OnQ that I'll just toss in together. But, Joe, you've talked before about in 2018 you converted several hundred orthopedic surgeons to OnQ, and that was a year that was hindered by the drug shortage. So can you talk about your expectations for 2019 doc conversions with supply resolution in sight? And just with supply recovering, you touched on this a little bit, but can you give us a little bit more detail on progression for on-queue growth through the year, especially since you said meaningful sales acceleration in the second half, but what does meaningful mean to the Avanos team?

So for us, I mean, obviously meaningful, first step would be getting back to mid-single-digit growth and, you know, full year. There's a potential, you know, for some of that's comparator, but also the drug is coming back. The same level of physician conversion on incisional seems to be happening around the total knee in orthopedic space, but we're also very focused in C-section, and then also working a little bit around the rib fracture, and we're getting good traction there. So as the supply comes back, that's why we feel strong about H2, because we are getting those conversions. And as you know, there's still a good series of patients that are, sorry, physicians that are looking for the five-day for their patients and the titratable nature of the OnQ. The other thing I think that the market is learning, and I think investors are learning, is that oftentimes with these long-lasting locals, there's still questions on duration and drug leaching and falls and things like that. But they're using both products, really, in a lot of cases. So we do feel like when drug supply, the net is when drug supply is back, we already have a relationship, obviously, with lighters for the filling. that we'll be in a good spot to get to back where we were sort of in H1, actually H217 and part of H118.

Got it. And then just on the opioid addiction innovation challenge, can you talk maybe about potential timing on the potential product or milestones that we should look to in 2019 and then just maybe some timing around some of the breakthrough products that you're also working on?

Yeah, so the award was around utilizing AI technologies for better visualization for an anesthesiologist or really any physician using ultrasound to place the catheter, which would be a speed and ease of use component to the actual procedure itself. Our breakthroughs are moving along in our internal milestones. We have a couple that are inhuman now, which is great progress for us, but like we've said, It's really sort of a 2022 kind of impact on the business, but still important because we're working towards sustainability in our growth.

Great. Thank you. Our next question comes from Ravi Misra with Berenberg Capital Markets. Please go ahead.

Hi. Good morning, Joe, Steve. I was hoping you could help us kind of parse out some of the cadence around the revenue growth. I mean, it sounds like from an organic perspective you're saying – Flat seems to be kind of an as-hoped-for scenario in the first quarter, but any kind of commentary on the remainder of the year would be helpful. And then maybe just a second one on some of these cool leaf studies that you're putting together and the timelines on that. Would we kind of expect something potentially as soon as AAOS, or how should we think about the publication around those?

So the publication is forthcoming. We're having the data worked on now, and we'll be likely putting a press release out of some sort in the next couple of weeks. And again, we're very optimistic on that, so coming soon. And on the revenue growth, yeah, Steve outlined sort of getting from a negative perspective organic to more of a level-ish Q1. And then the desire obviously from there is there's a significant move up that we feel confident about actually, but probably low to mid signal in Q2 and then moving up from there. Again, all of the drivers are in place on the businesses outside of acute pain and obviously you're seeing, you know, we talked about strong performance international in Q4 and that's an important part of our plan. So, obviously, the lever being the faster that drug is fully back in the market or the faster progression with the movement through the distributor channels, through the McKessons and Cardinals of the world, you know, the better that that plan can be.

Yeah, I think that's exactly right. You know, it's sort of the reverse of 2018, you know, 2018, the fourth quarter hurt because that's typically a larger seasonal impact on on-queue, and we have to throttle back the sales team. based on drug availability. And so if I kind of reverse that into 2019, we've got high expectations for the back half of the year. And I'd say, as Joe said, you know, signs look positive that that's coming that way.

Great, thanks. And then maybe just one, maybe two follow-ups, just on the gross margin kind of profile. You know, kind of appreciate you saying that there was some kind of timing issues in the fourth quarter around plants. How do we then kind of consider the ramp in 2019? I mean, is kind of the 60s, the low 60s still the right place to think about this? Or are you trying to say that, you know, with sales increasing as the year goes on, that gross margin should improve?

Yeah, on balance, low 60s is the right place. You know, kind of picking up your point, if we got softer volume in the first quarter, you know, you may have some more absorption in the first quarter, so you might expect a you know, on a relative scale, a little bit lighter gross margin there and stronger towards the back half where you're producing more. You know, I'd say we're also conscious that we built some inventory in 2018. You know, that's one area we want to bring back down. We've got some rebranding activity that has to flow through the supply chain as well as the warehouse optimization. So we're going to be a little bit cautious there. But from a gross margin standpoint, I would think that the lighter volume early part of the year is going to be a little softer than the back half where we'll have higher volumes.

Our next question comes from Chris Cooley with Stevens. Please go ahead.

Hey, good morning, and thank you for taking the questions. I just want to revisit the OPEX kind of guide that's implicit here and kind of trying to reconcile that with the adjusted earnings. Am I thinking about this correctly then in terms of the savings that you are to realize in 2019? you're essentially assuming that you're going to be reinvesting about $7 to $8 million of that. Sounds like more so towards Cooley for about $0.10 to $0.11 that would have dropped through. And then similarly, I'm trying to think about the tax guide here. I noticed the upper bound was 25%, which I was a little bit perplexed by with the growth abroad. But that would seem to imply about $0.02 to $0.05 in incremental earnings here. headwind relative to what we had been modeling previously from an effective tax rate standpoint. Am I kind of reconciling the math there correctly? And then I've got one quick follow-up.

Sure. On the OPEC side, yeah, you're in the right zip code. You know, we're reinvesting that savings largely towards Cool East and international. And, you know, that's the right order of magnitude to think about. On the tax side, you know, 2018, we haven't talked about this prior to a couple of calls, but we had a pretty big benefit from mid-year from the options exercise of some past executives that in the new tax world allowed us about a 200 basis point benefit to ETR in 2018. And then as you saw or we talked about here in the call a little while ago, some additional benefit in the fourth quarter related to purchase price allocation from the sale. And so if I sort of reset or level set against that, that's what brings me back into that 23% to 25% guidance range. Now our goal is still to go lower than that over time. And so we still have, as we've talked in the past, some planning opportunities that we're putting in place. I would say we're targeting those more for 2020 once we get past the IT implementation because there is some IT, you know, you think about invoicing changes and so on, there's some IT implication there that we gotta be a little bit careful about doing in 2019 given the IT transformation. But hopefully that helps, Chris, in terms of, you know, we're not taking our foot off the pedal from a tax standpoint, but we did get some fortunate benefits this year that aren't repeatable.

No, appreciate the additional color. And then I just wanted to go back to Cooley. I think it's great that you're moving forward now, both with the DTC effort, but also expanding the sales force. And you mentioned, I think, in your prepared remarks, you're increasing that head count by approximately 20%. Could you just remind us where you are now, both domestically and how you maybe see that sales force ultimately scaling as you more aggressively go after the ortho indications. I'm assuming there's going to be a heightened focus on in-office procedures as we enter 2020. Thank you.

Yeah, we really haven't disclosed the exact number of sales force, but obviously giving you a percentage. And when you do that, it's a combination of clinical people and selling bodies. But you're right, it's sort of gearing up because we have, frankly, a lot of opportunities still with our spine business and our shoulder business and our hip business, but wanting to be ready for the CPT code when it comes out to be able to drive that, especially with the right reimbursement. And then obviously we've talked about this study that we're going to be, you know, having a press release and making that more public in the near term. We think that's going to be an impact as well. So mainly getting ready for that, but also frankly some of this investment is just helping us enhance the existing core business as well.

Yeah, and thinking ahead to, you know, we get that CPT code in the future, and we do have a stronger orthopedic call point at that point where you might see, you know, OnCue and GameReady and CoolLeap all hitting into that orthopedic space. We want to make sure we're playing that game ahead and getting a team in place now, getting scaled up, so as that comes to fruition, we're not playing catch-up on what is a great opportunity for us. Thank you, guys.

Thank you.

Our next question comes from Dave Tercali with the JMP Securities. Please go ahead.

Thanks. Good morning. I think you mentioned, you know, beefing up your reimbursement expertise folks tonight, and I think you said they're primarily focused on Coolies. I'm just wondering, you know, from a broad stroke, if there's any way to kind of categorize, you know, for Coolies and OnCube, what does the reimbursement landscape look like today? Maybe even if it's a percent that you could throw out, but something to give us an idea of what kind of percent of those procedures, both for Coolief and OnQ, are getting covered today.

So just, Dave, this is Joe Woody. OnQ is covered as part of the DRG, and there's no real problem, although we have some government affairs work going on to see if we can't expand better reimbursement into the ambulatory surgical center. And in terms of Coolief, it's pretty much covered by most commercial payers, but it's in the hospital setting with the interventional pain specialist. And so what we're driving to is trying to get this available to the ambulatory surgical center and the orthopedic surgeon, especially for the OA treatment for the knee. Where we invest in reimbursement is sort of twofold. At the government affairs level and working with consultants and obviously working with folks on the Hill, reimbursement specialist, but then also sort of day-to-day embedded in the interventional pain business would be specialists that work with the commercial payers to sort of show our studies, show the comparison of our technology, the length of pain relief, the outcomes, and the health economic studies that we invest in as well there. But just broadly, what we have said is that a big catalyst for the business would be reimbursement in the ambulatory surgical center for OA. And this study that we'll be talking about in the near term on viscous supplementation, which is the injections of synovial fluid into the knee that you would normally get at an orthopedic surgeon, that's a billion-dollar market for us. And if we have better results, then that's where you sort of have a catalyst for the business.

Got it. Thank you.

Yep.

Our next question is a follow-up from Kristen Stewart with Barclays. Please go ahead.

Hey, guys. Hey, Kristen. Hey, guys. I was just wondering if you could help out, maybe just talk about the cadence for earnings for the year, because it does seem like you are reinvesting a fair amount back into the business. Should we think about those reinvestments being more front half loaded, which I suspect they are? So how should we just think about the cadence from a revenue perspective?

Yeah, if I kind of flip, we have an unusual year this year from a profile. We talked about the revenue a bit already. Later in the first quarter, as we get drug supply back and we have a little bit of chronic care destocking at distributors, ramping up as we go through the quarters with a larger back half and a larger finish, taking advantage of the seasonality and drug availability. On the OpEx side, We talked a little bit about it on the prepared remarks, but R&D will be heavier in the first half than the second half. It's just more the timing of projects than anything else. So we'll have more of that in the first half. And OpEx profiles similarly. So, you know, we're on the market right now in 13 markets. In fact, we're in Atlanta on TV right now with Cooley. And so we wanted to get an early start on both the Salesforce hiring and the DTP. and that's going to pull more OpEx as well into the first half, including the first quarter. So, you know, if I'm profiling the earnings, our earnings are definitely going to be softer in Q1, and then build as you go forward as the OpEx kind of ramps, you know, starts to taper off, and the revenue begins to pick up.

Okay, that's helpful. And then could you maybe just comment just broadly on how you think about some of the potential risks with new drugs coming on the market for OnQ? later this year, and to what extent you have built that into your forecast, or whether it's the case of you believe there's just so much overwhelming demand for non-opioid use that you feel like there's still a long runway of growth for the OnCue franchise.

I think the market is big enough, $4 billion plus, and there are differentiation between the products. So again, for us, it's the five days. the titratable nature. And the other thing is, and I think the market is learning and the physicians are learning that in a lot of cases they use both or they use these technologies at the same time. We're very different. I mean, they all have homes. I mean, the long-lasting locals, and obviously there are formulas that the surgeons use themselves, and then obviously we have a competitor in the market now and one coming. What will be different about those products is that they're still going to have an issue on duration. there are some issues around drug leashing and falls and just the number of procedures or the type of procedures that are available. So I don't think it, for our goals anyway for this market, which is to get to mid-single-digit growth, then to high and drive it through a very focused area around the total knee C-section, and then we'll be moving into rib fracture as well. I think there's room for everybody.

Okay, perfect. Thanks very much, guys.

Thanks.

As a reminder, If you would like to ask a question, you may press star, then one. At this time, there are no further questions, and this will conclude our question and answer session. I would now like to turn the conference back over to Mr. Joe Woody for any closing remarks.

I'd like to thank everybody for your interest in Avanos, and I think you can tell from our discussion today that we're confident in the business outlook and essentially our ability to achieve these goals. Fundamentals are solid, and we're well-positioned to deliver, we think, value for our shareholders. As a reminder, Steve will be presenting next Wednesday at the Raymond James Institutional Investors Conference in Orlando, and there is information on how to access that presentation on the investor relations section of our website, Avanos.com. Thank you very much.

The conference has now concluded. Thank you for attending today's presentation, and you may now disconnect.