Avanos Medical, Inc.

Good morning and welcome to the AVENOS third quarter 2021 earnings conference call. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing star then zero on your telephone keypad. 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 a question, please press star then two. Please note, this event is being recorded. I would now like to turn the conference over to Mrs. Scott Gallivan, Vice President, Corporate Strategy at Business Development. Please go ahead.

Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to the Avanos 2021 Third Quarter Earnings Conference Call. Presenting today will be Joe Woody, CEO, and Michael Greiner, Senior Vice President and CFO. Joe will begin with an update on our quarter and then discuss our business environment and progress against our 2021 priorities. Then, Michael will review our third quarter results and update our 2021 planning assumptions. We will finish the call with Q&A. A presentation for today's call is available on the Investors 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 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 risk factors described in our filings with the SEC. Additionally, we will be referring to adjusted results and outlook. The press release has information on these adjustments and reconciliations to comparable GAAP financial measures. Now, I'll turn the call over to Joe.

Thanks, Scott. Good morning, everyone, and thank you for your interest in Avanos. While we continue to see the impacts of the pandemic as it relates to elective surgeries, hospital staff shortages, and supply chain, We're very pleased with how our operational and commercial teams have responded to the challenging dynamics brought on by the pandemic. Across our enterprise, we remain focused on getting patients back to the things that matter as we meet the needs of our customers. I'll begin with a brief review of our results for the quarter before discussing the current environment and our progress against our 2021 priorities. We achieved sales of $184 million for the quarter and earned 25 cents of adjusted diluted earnings per share. Our sales results were primarily in line with our planning assumption. Other than the slowdown in sales we experienced with OnCue as a result of the Delta variant pushing out electives during the summer, we delivered solid sales results in each of our other product categories during the third quarter and through the first nine months of the year. As we noted last quarter, we anticipated a meaningful improvement in our gross margin profile throughout the third quarter. Gross margins for both August and September were 54%, with gross margins for the third quarter exceeding 52%, or 90 basis points better versus the second quarter. Our gross margins will continue to improve throughout the fourth quarter and stabilize into 2022. However, transportation and other supply chain inflationary pressures remain and we are therefore unable to determine how much further improvement we will see in the short term. As we mentioned last quarter, most of these headwinds impacting our gross margin are transitory, primarily pandemic-driven, being seen across industries, and do not indicate a permanent change to our operating structure. We remain confident in that assessment. Although gross margins have improved and will continue to improve as we exit this year, We are meaningfully behind our internal projections on gross profit and therefore have identified additional efficiencies throughout the business to reduce operating expenses. Teams are continuing to find ways to increase productivity and lower our cost structure, ensuring that we can deliver on our commitment of SG&A as a percentage of revenue being less than 40% on a go-forward basis. With that as a background, let's move to a discussion on the current market environment and provide an update on our progress against our 2021 priorities. As mentioned earlier, we delivered solid revenue outcomes across most of our product portfolio. Our digestive health business, led by Neomed, was up over 2% globally versus prior year and 6% in North America. Our respiratory business was down versus the prior year. primarily related to the pandemic-related push we received in the third quarter of last year, which contributed $8 million of additional sales. Sequentially, we were flat versus the second quarter as the standard of care with our closed suction catheter systems for patients needing hospitalization due to the coronavirus has primarily shifted to non-invasive ventilation procedures before moving to mechanical ventilation. On the pain management side, we saw almost 5% growth from our interventional pain portfolio, while acute pain was down a little over 1% due to the delta-related pause in elective surgical procedures impacting our on-queue franchise. As we have stated in the past quarters, based on conversations with our surgeons and hospital administrators, as well as what our peers are also disclosing, we continue to believe inpatient procedural volume will remain below its full potential for the foreseeable future. That being said, we do anticipate sequential growth and recovery for our Anki franchise for the fourth quarter, similar to second quarter levels of revenue. As we move into the last quarter of the year, we continue to enhance our product offerings to improve the efficacy and ease of use for our care partners. For Cool-Leaf, we successfully completed a limited launch of next generation cooled radio frequency Pro kits in Q3, with the full launch now in place for Q4. The new probes make it easier for our physicians to perform cool leaf procedures while maintaining our premium look and feel. There is also increased manufacturing efficiencies associated with the new probes, which supports gross margin improvement for cool leafs already high gross margins. Combined with the launch of our new generator last year, our new probe kits strengthen our cool RF leadership position. Within our on-queue and AMBIT business, we recently launched PainBlock Pro, a differentiated app and data collection vehicle to track, monitor, and improve patient outcomes through more direct feedback between the patient and physician. The app tracks a patient's recovery to understand both satisfaction and pain levels in real time. The app also helps us engage patients to improve their experience by giving education about the pump and providing an avenue for a physician to give active feedback on questions the patient might have. We also continue to see momentum building from our channel partnership agreements where we leverage orthopedic sales partners to gain access to orthopedic surgeons. Finally, we're delivering our electronic pump, AMBIT, into the ambulatory surgical setting, which is positioning us to capture additional procedure volumes. Shifting to chronic care, the positive trend across our digestive health franchise continues. We maintain double-digit growth across our NeoMed franchise, while our standard of care strategy for CorePak is accelerating sales of our CoreTrack hardware to record levels. As I stated earlier, our respiratory health sales were down given the prior year pandemic tailwind. We have modeled in nominal flu season for this year and consistent with that modeling, we have not currently experienced any higher levels of buying activity for our closed suction catheter products. Our second area of focus in 2021 relates to improving our gross and operating margins. We remain focused on recapturing gross margin loss since the start of the pandemic and made some meaningful progress in Q3 on these initiatives. We were very pleased with our gross margin improvements as we exited the quarter and anticipate seeing further gains throughout the fourth quarter. As noted earlier, we are confident these gross margin headwinds are transitory, but also recognize that significant work remains to get our gross margin profile back up to the high 50s and low 60s. Our third priority is to begin generating consistent, repeatable free cash flow. We generated $10 million of free cash flow in the second quarter and $18 million in the current quarter, and we anticipate generating positive free cash flow again for the fourth quarter. We received $47 million of CARES Act-related tax refunds during the quarter, which was partially offset by the $22 million that we paid to the DOJ to settle our outstanding litigation. Improved operating results coupled with some remaining working capital upside will support this priority of generating consistent and repeatable free cash flow. Our last priority for the year focuses on capital deployment. Our M&A pipeline remains healthy, and we are engaged in active dialogue with a number of potential tuck-in targets, which would leverage our existing footprint, generate synergies, enhance our top-line growth, and meaningfully improve our margin profile. We will remain disciplined in identifying targets that meet both our strategic initiatives as well as exceed our financial hurdles, ensuring we generate a strong return on capital. Lastly, over the last four quarters, we have resolved all material outstanding litigation, including the DOJ investigation, the indemnification dispute with Kimberly Clark, a positive outcome with regards to our IP infringement case with Medtronic, and other smaller product liability cases. Not only has this reduced a range of uncertainty for us, but it will also significantly reduce our legal expenses from a cash flow perspective. This positions us to be more aggressive with M&A, as well as freeze up capital to repurchase our shares, while ensuring we continue to meet each of our internal funding needs. We remain well positioned to advance our strategies across each of these four areas of value creation as we complete 2021 and begin to look toward 2022. Now, I'll turn the call over to Michael.

Thanks, Joe. As you noted, we have made meaningful progress against our value creation initiatives and are setting up well for a solid 2022 that will combine mid-single-digit top-line growth with M&A execution. Additionally, we will show improved growth in operating margins as well as consistent free cash flow generation. Now, let's begin with a review of our third quarter results. Total sales of $184 million was essentially flat compared to last year. Volume in currency was even with price being down around 1%. Given the pandemic-related tailwind for respiratory health in the third quarter of 2020, chronic care sales declined 2% to $117 million in the quarter. Adjusting for the 2020 tailwind, respiratory health sales would have been up $4 million for the quarter with improvements across the portfolio. Although the Delta variant spread quickly during the summer, and increased hospitalizations once again, we did not see meaningful growth in our closed suction catheters as hospitals carried out their first line of care before placing patients on ventilators. As we noted last quarter, our planning assumption in respiratory health for the second half of 2021 does not include any additional benefit from the pandemic, and we also stated we expected a negligible start to cold and flu season, which we are currently experiencing. Shifting to digestive health, we saw 6% growth in North America, offset by a decline in our international markets, providing total global third quarter growth of just over 2%. Neomed once again grew double digits from the continuation of conversions to our ENFit technology. Our backorder impact for Neomed currently sits at 1.5 million, which we plan to work down through the first quarter of next year. Moving to pain management, we delivered 67 million of sales, 1% higher compared to the prior year driven by strong performance across our RF ablation products, GameReady, and Ambit offset by OnQ. As Joe noted, growth in Q3 was hampered from impacts brought on by the Delta variant and a returned slowdown in elective procedures. While these impacts had an effect across the pain portfolio, OnQ was disproportionately impacted as inpatient therapy experienced rolling shutdowns across various regions in the U.S. during the summer. We partially offset these losses with the introduction of Pain Block Pro, channel partner growth, and expansion into the ASC setting. We are well positioned to drive sequential improvement in Q4 as these initiatives move forward with elective procedures slowly returning. Additionally, supply constraints and raw material shortages have impacted our ability to meet demand within the game-ready business, with back orders still exceeding $1 million. We anticipate these back orders will continue to grow into the end of the year. While these constraints will persist over the next couple of quarters, our supply chain team is actively working to find supply, and we expect to work down our backlog in the first half of 2022 to meet this market demand. Moving down the income statement, adjusted gross margin decreased to 52% compared to 55% last year. As indicated earlier, we are pleased with the progress on gross margins through the quarter, and anticipate further meaningful improvement into the fourth quarter. Compared to last year, gross margin was impacted by higher transportation costs and unfavorable mix. Ocean freight cost has increased due to global capacity constraints. Additionally, lower sales of closed suction catheters and on-queue products have unfavorably impacted our product mix. Those headwinds have been partially offset by lower inventory write-offs this year. Looking towards 2022, we continue to expect gross margins to steadily improve as a result of a range of programs we are implementing throughout operations. However, we also remain cognizant of the global supply chain environment that remains disrupted, and we are currently unable to predict the offsetting impacts of higher inflation and transportation costs, as well as availability of certain raw material components. Now turning to some bottom line financial metrics. Adjusted operating profit totaled $17 million compared to $18 million in the prior year. Slightly lower sales and unfavorable gross margins were partially offset by lower spend across SG&A and research and development expenses, as we noted earlier. Adjusted EBITDA totaled $22 million compared to $24 million last year. Adjusted net income totaled $12 million compared to $10 million a year ago, and we earned $0.25 of adjusted diluted earnings per share a 20% increase versus prior year. Turning to the balance sheet and cash flow statement, our balance sheet remains a strength for us and continues to provide us with strategic flexibility as we currently have $110 million of cash on hand and $130 million of debt outstanding on our revolving credit facility as we use some of the proceeds from the CARES Act refunds to pay down debt. We have over $200 million of available capacity to utilize towards our capital allocation priorities. Finally, while unpredictability of the coronavirus remains, we still foresee our net sales increasing 2% to 4% on a constant currency basis compared to the prior year. Additionally, as we have noted throughout these prepared remarks, we remain in an uncertain environment with regards to our supply chain, both from a cost perspective and availability of products. To partially offset that impact, we have managed our cost structure with regards to SG&A and R&D throughout the year, which has allowed us to maintain our guidance range of $1.10 to $1.20. We remain committed to and are also reiterating our guidance range given these factors, while also recognizing that the likelihood that we fall out of the low end of our guidance has now increased. We have made great progress in 2021 to set ourselves up for a successful 2022 and beyond, and we are excited that much of our cash flow uncertainty is now behind us. We remain confident in our ability to execute our strategy and to take the necessary steps to drive growth and operating margin improvement and deliver more consistent results as we look towards 2022. Operator, please open the line for questions.

Thank you very much. We will now begin the question and answer session. To ask a question, you may press star and one on your telephone keypad. If you're using a speaker, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw a question, you may please press star and two. At this time, we will pause momentarily to assemble our roster. The first question is from the line of Matthew Mishant from Keep An Eye. Please go ahead.

Great. Good morning. Guys, I just want to start with revenue growth first because it seems like the sales growth has been fairly resilient throughout COVID-19 and last year with respiratory health and chronic care. And this year, you seem to be coming in at or above the midpoint of your guidance. What would it take for you guys not to come in at that 3% plus at this point, given 3Q versus 4Q, you know, typical seasonality?

Yeah, Matt, so first of all, and I'm sure we'll get this question as well as this, Joe, you know, we've seen a pretty good start to October with some improvement even in business. The thing that we're keeping an eye on really are the supply chain items that we talked about. And then just, it all comes down to how fast, essentially, the procedures come back. And I think a lot of the other companies have talked about the staffing issues, primarily at the hospital, and then how fast, and particularly in the south where there was Delta, will the procedures come back. And to the extent that they do come back faster, then that's better for us.

I would say too, Matt, when we look at October actuals right now, Yeah, we should hit those targets for Q4. And we saw November and December left, and we saw exactly what happened to us in the summer, where all of a sudden the Delta variant spiked in the southern part of the United States and, you know, meaningful impact on IQ. Right now, we have some pretty good trends, you know, working into the last 60 days of the quarter, but we also want to remain cautiously optimistic.

Okay. And when you say the likelihood that has increased that you could fall below the range of 110 to 120, but you still maintain your guidance, what's the thought process behind that? I'm just trying to understand kind of how you think.

Yeah, no, no, no. It's a great question. So there was a fair amount of debate internally around know do we move the guidance all together um do we do we make the guidance range larger and we just felt like with 60 days left to do any of those things just created you know clumsiness on the downside and the upside because they said we're coming out of october feeling pretty good about where we are um and so let's say we move the guidance range to a dollar five to a dollar fifteen And then we do $1.16. Well, that feels clumsy. If we increase the range by 15 or 20 cents, that doesn't feel exactly appropriate either. And so we just felt like, you know, this wording, which I think is unusual for most people, was more appropriate with where we are, which is if supply maintains... If the trends that we're seeing coming out of October maintain, if we don't see any other hiccups in distribution, we should be comfortably in the 110 to 120 range. If those things turn in a different way over the next 60 days, then we could fall slightly below and out of that range.

When you when you look at that range, just to get to the low end based upon sort of where the midpoint of the revenue guidance is, it would imply a pretty meaningful increase in the gross margin into the fourth quarter. How do you give people the sense of confidence that that that that is really what's what's going on there? You know, the trajectory that you're that you're that you're on?

By the way, and I think Michael's going to take it, but what I would say, just to reiterate, we did hit 54% gross margin in August and September, and a lot of these things are starting to improve for us. But go ahead, Michael, I know you want to take them through.

Yeah, no, I was going to say, we anticipate right now that our overall operating margins are going to improve by north of 400 basis points between Q3 and Q4. Significant majority of that is going to be the gross margin improvement And to Joe's point, the trends that we saw in August and September will continue into Q4. So you're spot on with your math, and we have high confidence levels. We should have been better in Q3, except that although freight was much improved, about 50 basis points, we thought freight would improve by even more than that. but then over-the-water shipping costs throughout the third quarter increased by fivefold. That's now coming back down, so that will help. We're no longer doing the overnight shipping as we had talked about previously, and we have other tailwinds going to the Q4 versus Q3. Another thing we saw in Q3 on gross margins was a little different mix. So how we got to our $184 million was a little different mix than we anticipated with some lower-margin products like oral care. having a particularly strong Q3, whereas on Q was a little bit slower than anticipated. We expect that trend to reverse in Q4. So we have a lot of favorable tailwinds going into Q4 gross margins. The biggest point we wanted to make on the Q3 call here on gross margins was there was concern about it being embedded, about it being more of a permanent change in our operations. Hopefully what we've demonstrated with our August and September results in particular on gross margins That is not the case, and we continue to be confident in where we're going to take gross margins in the Q4 and then ultimately in the 2022 as well. Excellent.

I'll jump back in the queue. Thank you, guys.

Thanks, man.

Thank you. The next question is from the line of Ravi Mishra from Berenberg. Please go ahead. Hi. Good morning. Can you hear me okay?

We can hear you.

Morning.

Great. Thanks. Thanks, Joe. Hi, Mike. So just I want to kind of ask a big picture question as we get into 22. You know, the story here has long been about there's a lot of kind of heavy lifting and small lifting to be done with this company. It sounds like you've resolved one of them with the legal kind of settlements this quarter and kind of resolutions there. As we go into 2022, can you just help me think about, Joe, how you and the board are thinking about kind of the key drivers here, what you prioritize between, you know, it's always been kind of this M&A organic growth and restructuring kind of trifecta here. Maybe help us think about, you know, where you're going to be spending your resources in 2022 and maybe how investors should kind of prioritize those as they think about Abenos.

Yeah, I mean, I really like where we're positioned for 2022 because We have taken a lot of cost out of the business in the pandemic. And as an example, we've said, look, we feel comfortable that we have a business with less than 40% SG&A. These gross margin challenges this year are really tied to the pandemic and transitory. We were early kind of talking about that. I think it took another quarter for that to kind of prove out more in medical devices like it was. in other industries. And I think you can see the progress. And if you just think about the quarter that we just went through, something like 160 basis points of mix on on-queue electives being down, that won't be there. So we, again, see kind of a mid-single-digit organic growing business very solid when you don't have these pandemic impacts. The other thing I would say is that we've spent a lot of time with our M&A targets, and we've been talking about near-term two acquisitions that we think we'll be able to talk about shortly that'll be added to the business. That's always been a part of the equation where we can improve our gross margin as an example. But some of these acquisitions pick up some EBITDA, obviously get some growth, get the synergies where at least these things are, you know, bolt-ons, if you will, right into our channel. So we really actually feel good about going into 22. I think it really all comes down to, again, just how fast the hospitals with their staffing issues and the electives and how fast. I know they want to come back too because obviously they're being infected. But I believe that we're very well positioned moving into 2022 for sure.

Great. And I guess you just touched on my next question around M&A. Can you just help us think about what kind of integration you're willing to stomach here? I mean, would you look at deals that might be gross margin dilutive or kind of EBITDA dilutive in the near term or kind of are you going after things that are just going to kind of add to the bottom line very quickly? Can you just give some detail on that? Thanks.

I mean, generally I'd say that we're on the accretive side of the house at the moment. And, you know, we've done some deals in chronic care, but we've got some things that we want to do in pain. Again, I think they're going to be accretive from a revenue gross margin perspective, pick up some EBITDA. And then we also have done deals and we've looked at some deals that didn't do that, weren't accretive initially immediately, but are very strategic. So we sort of have both sides of the house covered, but I think they're going to be definitely additive to 22.

Thank you. Ravi, is the question answered? Yes, thanks. Okay, thank you.

Thanks, Ravi. The next question is from the line of Rick Weiss from Stifel. Please go ahead.

Good morning to you both. I just wanted to start off and maybe give us a little more color. You're saying obviously very positive things about how the quarter began, how the month of October went. I just wanted to make sure I understood a little more carefully the drivers there. I mean, one seems to be on the gross margin side, Michael, if I understood you, lower transport costs and fewer manufacturing inefficiencies on the gross margin side. But on the sales side, I wasn't as clear about what's happening. Is it just Is it the rollout of the next-gen Cooley? Just help us understand the moving pieces there.

So overall, October revenue results across the board were strong versus what we expected on the chronic care side and the pain side. When our full results are executing in step with each other, our mix improves. So it's just when we have outsized improvements like we did with oral care towards the end of the third quarter, and obviously on cue being down throughout the third quarter, that that tends to have an outsized impact. But when our entire portfolio is moving forward and growing, that is net-net going to have a positive influence on our mix profile.

Yeah, no, thank you. Go ahead.

I thought you asked about gross margin as well.

I did. And I'll just go ahead and expand on the gross margin. I mean, obviously, you're seeing such a significant improvement in October already. I mean, that's, you know, very encouraging. But when you talk about getting back to the high 50s, low 60s, how much of that is today's portfolio you know, today's mix and sort of returning to more normal times as COVID hopefully fades? And how much of that's going to be driven by M&A and hopefully margin accretive M&A? Yeah.

So two things. None of that high 50s, low 60s has any M&A in it. So this is all an organic conversation around our margin and gross margin improvements. That being said... With the current environment we're in, the work we're doing, really focusing on our manufacturing inefficiencies, how we think about freight, our product planning, all of those different things, we can get up to the 57, 58 range by just focusing on those things that are controllables. However, to get up beyond that and back into the low 60s and consistently be in the high 50s, we will need a more normalized environment across the portfolio because the lumpiness we have with our price and mix and the range of gross margin that we have in our product portfolio is significant. So you don't need a lot of movement within a given quarter across that portfolio, depending on what's positive and what's negative, to have that impact. So again, if everything is firing, it is a net positive gross margin environment that we have with our product portfolio. But when we have something like oral care up in a given quarter versus on cue down, that's going to have significant headwinds for us. So what we can control, we absolutely have meaningful progress to be made from here, but to consistently be in the high 50s, low 60s, we're going to have to feel a slightly more normalized environment from a total product offering, if that makes sense.

And Rick, also on sales, our intent is not to be alarmists here, but we're a $740-ish million, if you will, business And so things like Australia and their lockdown, Japan access or European access has an impact. And we were saying earlier in the call, how fast we come back is a bit of a gauge. But again, to be clear, we've had strong results in October. We're just being cautious given that this is a pandemic and it changes week to week.

Yeah, no, I mean, obviously, as you said, you're not alone. And Joe, I'm glad you mentioned COVID. international, because that was my last question. I was hoping you could give us a little more of color on the international business. You called out a couple of pockets of weakness. You mentioned Australia. What's happening more broadly? What initiatives are underway there? And how are you thinking about how should we think about international as we head into the fourth quarter and start thinking about next year? Thank you so much.

Yeah, a couple of things. First of all, generally, we've been over the past couple of years really happy with the performance of the international business. This year in EMEA, we're impacted somewhat with access to customers. And then, of course, there's the headwind from closed suction from the beginnings of the pandemic. And now, obviously, we've talked about patients being managed differently and non-invasive approaches and then eventually mechanical. LATAM's been a good grower for us, double-digit. We've been happy with the work that we've done down there. And really, AsiaPak has been strong. We just have a little bit of access and conversion issue with the pandemic in Japan, and Australia's really been in a lockdown for about 200 days. So it's affecting some of the growth, but we still feel it's a solid, mid-single-digit organic grower going forward. And then obviously what we're trying to do is the same success that we've met with Neomed and core track in the U.S., get that rolled into international. And I do think as we come into 22 and more so, if you will, out of the pandemic, that should improve as well. Thanks again.

Yep. Thank you. The next question is from the line of Drew Ranieri from Morgan Stanley. Please go ahead.

Hi, Joe and Michael. Thanks for taking the question. Just maybe for Michael first, you touched on free cash flow generation at our conference and through this call, but I'm just hoping to get kind of a better understanding of kind of the company's capabilities. I think at our conference you mentioned that third quarter could be a proxy for go-forward free cash flow. I mean, are you still expecting that? But just maybe a broader update on your understanding working capital, anything free cash flow. Thank you.

Yeah, so we do anticipate, as Joe mentioned in prepared remarks, having another positive free cash flow quarter in the fourth quarter. And, you know, we had some one-time items on cash this year. That will clear out. And we anticipate a very nice conversion rate on free cash flow going forward. Primarily due to improved operations, Drew, We've done a lot of work on accounts receivable, on inventory. There's still some working capital upside, for sure, 10 to 15 million. But a majority of what we're going to see generating going forward is, A, these one-time costs on legal, on SAP implementation, on other items that we had internally. Those are now in the rearview mirror. So we'll have a much cleaner set of cash flow generation off of operations. and then some improved opportunities set in working capital throughout 2022. But the bigger part of it is just going to be consistent execution on our operating results.

Got it. Thank you. And then just on SG&A, you've talked about it before, being sub-40% of sales kind of going forward. But, I mean, where are you pulling back on spending? And, I mean, are you sacrificing any future growth opportunity in 2022 and beyond, but would like a little bit more color there? Thank you.

Let me do some qualitative and then jump in wherever you want to. But we have obviously learned that some of the marketing initiatives didn't need to come back and some did. And then we have things like short-term incentive and there'll be some headcount that we need to add into the business. But generally, we also have still some you know, smaller, if you will, structural things that we can do inside of our channels that can be helpful there. So, you know, we're committed to the below 40%. Michael, you may want to add.

Yeah, the only thing I would add to that, Drew, is, you know, last year with COVID, everybody had to kind of look at their SG&A and R&D and say what makes sense, what doesn't, but also ensure, to your point, that we weren't cutting ourselves short for future investments. And then as we, so we got some discipline, In 2020, that was somewhat new, which I think was healthy across the board. We came in at 21. We definitely expected overall SG&A dollars to increase versus 20. And we ended up with these gross margin headwinds. And so we wanted to manage around that. So those disciplines that we started in 20 around how we think about SG&A just continued into 21. And so we were very thoughtful about where can we cut, what heads from a backfill standpoint could we reduce and think differently about some of the talent we have internally, which roles will we ultimately have to replace, what we could delay for a little bit, which project, to Joe's point around marketing initiatives, So it doesn't feel that we have done anything that would impact our 2022 or go forward. Perhaps there's an R&D thing here and there that gets delayed by a quarter based on some of the programs we pulled back on here during 2021, but nothing meaningfully significant to our ultimate revenue profile or where we're headed with our margin profile.

Got it. And then just on 2022 gross margins, so I hear you loud and clear about the fourth quarter step of about 400 basis points. We should be thinking that for 2022 there should be an improvement above the fourth quarter rate on a full year basis.

Yeah, I don't know how meaningful that will be, Drew, but it should be north of where we are in the fourth quarter for sure for the full year, yes.

All right. Thank you for taking the questions.

Thank you. Thank you. Participants, if you have a question, please press star and 1. The next question is from the line of Chris Cooley from Stephens. Please go ahead.

Good morning, and thanks for taking the questions. If you could just tell me... Good morning. I'm a little confused on some of the commentary as it pertains to the top line, and I was hoping you'd kind of help us walk through these countervailing forces. So we've I've seen the reiteration, obviously, of the corporate guide for the top line, and you commented to two different areas of backlog that is accelerating and expected to continue to accelerate here in the back half of the calendar year and not be worked through until we get into early calendar 22. So I guess what I'm trying to make sure I fully understand the messaging here about is you're saying that the base business X those two primary product lines, really you're seeing that type of an acceleration to offset the backlog that you see growing? I just want to make sure I'm getting that messaging right. And then maybe as an adjunct to that, could you help us better understand what's really there that's limiting your ability to get that resolved prior to the first half of, or I should say the first quarter of next year.

Yes, Chris, you are right, and we are thinking that we'll get a good portion of it resolved through the first quarter of next year. And again, from my perspective, and Michael can give you his, it's the things that are not predictable, like in Australia or like in Japan or what we were talking about in the EMEA or how fast the electives all come back in the hospital setting, where we're focused with OnCue, gives us a little bit of uncertainty. But again, we've started off strong in October. We could just as easily do better than we're lining out here. But what we've seen with the pandemic is that a lot of different things can potentially happen. But you're thinking about it the right way. The backlog is improving. We can improve our position from the backlog. So I don't want to be too confusing, or as I said, a little bit early to alarm us, but it's worth calling out while we're in the pandemic. And Michael, you're going to add.

And Chris, I think the point you made on what we're signaling there is the natural demand is there. And even with these back orders, we still feel confident in a solid fourth quarter. But also an indication that the supply chain environment remains disrupted. and Game Ready, for instance, where literally the reason that we have a backlog there is because of one component that goes into the entire product of many, many, many, many components. And so that's what we were trying to signal and make the connection is, hey, demand is strong, that's good, and the supply chain availability concerns remain. And if we can get those fixed sooner rather than later, to Joe's point, we have further upside. We're scouring the world, as everybody else is, to try to find some of these raw material inputs. Sometimes we get lucky in a given week, and sometimes we just don't have the same level of success.

I appreciate the color there, and if I could just do one other quick follow-on here, maybe similar in nature. You talk about obviously a very strong sequential step-up in gross margin, the vast majority of that step-up being in your direct locus of control, but we still have higher inflation costs, really not seeing freight go down that much from what we can see in the channel. I'm just curious when you think about these transitions from COVID-related costs and these related inputs, are these now becoming more structural in your mind? And so you're actually getting better operating leverage? Or are you implicitly stating that these headwinds abate as we go through the fourth quarter and we get back to a more normalized environment in the first quarter where you can contract in the spot market at lower rates on freight. And similarly, we see declines in inflationary pressures on raw material and labor. Thanks.

Yeah, I think it ties back to the other question around our exit rate in Q4 and where we think we can take the gross margins into 2022. The reason why we're being a little cautious on calling any sort of meaningful upward trends in the 2022 is for these factors that you're identifying. So inflationary pressures remain. Some of these freight cost pressures remain. And until we see better visibility with those lifting, our improvements on gross margins will be limited. On top of that, as we stated earlier, if we get back to a more normalized revenue environment, That will also help our gross margins just by virtue of the positive mix component with some of our larger selling products. So those are two factors that we just don't quite have visibility to yet. So, you know, that's why we're not saying, hey, 59%, 58 and a half percent in 2022, because those factors would have to lift in order for that to be the reality. But we also know that as far as the embedded conversation, we're not a 52%, 53% gross margin player, right? And so that's where we're kind of fighting right now. We're getting to that more normalized state in Q4 and into the early part of next year. And then as these other factors lift, we'll get back up to the high 50s again. X M&A.

Thank you for the clarification. Thank you, Chris.

Thank you. We have a follow-up question from the line of Matthew Mission from Cuban Act. Please go ahead.

Hey, Michael. Hey, Michael. Just a quick one following up on free cash flow. I think previously you had indicated that you would do $70 or $80 million of free cash flow in the year. It seems like most of the moving pieces as far as the DOJ and tax refunds seem to have already kind of come through for you. How should we think about 4Q in relation to that step up into free cash flow?

Yeah, great. And Q4 to that point, Matt, tying back to an earlier question, should give a good feel. Assuming we execute as we're feeling coming out of October 31st here, should give a good feel for, okay, what does a normalized free cash flow look like? And we should generate somewhere around $15 million of free cash flow in Q4, primarily due to operations. but also with some slightly better working capital management as well. So, you know, should have a decent Q4. I'm not saying that that is the best we can do. I think there's upside potential to that, but that should give you a decent feel for our recast flow conversion. Okay.

Thank you. Thank you.

Ladies and gentlemen, this concludes our question and answer session. I would like to turn the conference back over to Joe Woody for closing remarks. Thank you, and over to you, sir.

I want to thank everybody for their interest in Avidus. We feel we're continuing to execute well in a very uncertain environment. We are committed to creating shareholder value, and I'm confident the priorities that we've detailed, combined with our market-leading portfolio and the attractive markets that we're in, do position as well. for growth and margin expansion and positive free cash flow as we exit 21 and go into 22. That said, Michael will be presenting at the Barenberg Conference upcoming, and we'll both be attending the Stifel Conference, and I look forward to talking to everybody more there. Thanks, and have a great day.

Thank you very much. Ladies and gentlemen, the conference has now concluded. Thank you for attending today's presentation. You may now disconnect.