Avanos Medical, Inc.

Good morning and welcome to the Avanos third quarter 2022 earnings conference call. All participants will be in 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 a touchtone phone. 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 Scott Galleran. Please go ahead.

Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to the Avanos 2022 Third Quarter Earnings Conference Call. Presenting today will be Joe Woody, CEO, and Michael Greiner, Senior Vice President and CFO. Joe will review our quarter and current business environment, as well as provide an update on our key objectives for 2022. Then, Michael will discuss additional detail regarding our third quarter and review our 2022 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, current 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 joining us to review our operational and financial results for the third quarter of 2022. Our operational and commercial teams continue to execute well in this dynamic and uneven environment, which supports us maintaining our full-year guidance ranges. The demand for our products remains strong, and we continue to demand supply chain disruptions to mitigate the impact of our persistent backorder challenges. along with consistent free cash flow generation that is now almost $80 million over the trailing four quarters. As always, our primary focus is on getting patients back to the things that matter as we meet the needs of our customers. For the quarter, we achieved sales of $202 million, representing over 12% total growth, with organic growth at 1.6%, both excluding the negative impact of foreign exchange. We generated $0.38 of adjusted diluted earnings per share and $23 million of free cash flow. On a constant currency basis, our digestive health portfolio grew by 14%, with NEOMED growing slightly greater than 39%, while our respiratory business declined by nearly 21% due to industry-wide post-COVID slowdowns and inventory being sold through our distributor channel that had accumulated during later phases of the pandemic. Through October, we're seeing improvements of the flu season, specifically trends we are seeing in pediatric viral cases like RSV. Excluding the impact of orthogenesis for an exchange, our pain portfolio was flat versus the prior year, with our interventional pain franchise growing 4% and our acute pain product portfolio lower by a little over 2% versus last year. The pain franchise continues to experience sluggish procedural volumes due to staffing shortages and patient preferences. Our hyaluronic acid offerings through OrthoGenerex posted another strong quarter with continued adoption of TriVisc, our three-injection HA regimen. Our favorable pricing position and service model is driving account transitions and new account acquisitions while meeting patient demands. As we noted last quarter, our service differentiators via our direct patient purchase program and Harmony, an online portal to enhance and streamline the customer experience, will help us retain these new customers as we enter throughout the third quarter and are currently in the range of $11 million, which had a negative impact on the revenue we could have delivered across our portfolio in Q3. We currently anticipate and believe we have visibility to end the year with our back order below $7 million. On gross margin, we delivered positive results with adjusted gross at the end of last year. Although we continue to experience headwinds related to raw material availability, inflation across all manufacturing inputs and shipping and distribution costs that remain elevated, we anticipate similar fourth quarter gross margin results as we experienced in Q3, while our full year gross margin guidance of 55 to 57% remains firm. Turning to SG&A, we continue to make progress toward our full year target of less than 40% as a percentage of revenue delivering 38.3% for the third quarter. Our third quarter SG&A as a percentage of revenue sequentially improved by 230 basis points, and we will continue to make progress during the fourth quarter. Michael will provide additional insight on the positive execution of our SG&A profile. But that is the background. Let's review some detail on our product portfolio. Positive trends across our digestive health franchise continued. bolstered by our Neomet portfolio enjoying a record quarter, growing over 39% versus prior year, as supply improvements allowed us to maximize North American infit conversions. Our legacy enteral feeding products maintained its mid-single-digit growth, despite supply constraints impeding further growth. We anticipate sustained demand for our closed-section catheter products as we enter the flu season and are monitoring its development on adult and pediatric patients. We anticipate growth to return to historical levels throughout 2023. Within our pain portfolio, we were flat in Q3 compared to prior year, with interventional pain growing low single digits offset by a low single-digit decline within acute pain, as noted earlier. We anticipate these issues to continue through the end of the year and, as a result, are expecting to finish at a low single-digit growth level for the full year. The demand for our products and solutions remains strong, and we're confident and motivated to continue working through these challenges to ensure our pain solutions are available to meet the needs of our customers. To that point, we want to highlight the impact our products have had in getting patients back to the things that matter. In Q3, over 100,000 patients benefited from our ominous portfolio of pain products, including our pumps, RF products, and HA offerings, as well as game-ready prescriptions. Our next priority for 2022 is to demonstrate our ability to generate consistent, repeatable free cash flow. As in the second quarter, we generated $23 million of free cash flow despite continued near-term inventory and supply chain headwinds. we anticipate sequential free cash flow improvement for the fourth quarter. Our ability to consistently deliver free cash flow is critical to support our other strategic growth and capital allocation initiatives and will therefore remain a priority into 2023 and beyond. Our final priority for 2022 is focused on capital deployment via M&A. Our M&A pipeline remains healthy, and as previously stated, we are engaged in infrastructure, generate synergies, and enhance our top-line growth. We are disappointed we have been unable to announce another transaction since OrthoGenerex and currently do not anticipate any M&A announcements until next year as we remain disciplined to our approach around strategic fit, valuation, and due diligence. Finally, we're very pleased with the expansion of our product offerings through the acquisition of OrthoGenerex and its performance to date has exceeded our expectations. In summary, even with various macroeconomic headwinds, including inflation, currency, and supply chain, we delivered a robust third quarter and are well positioned to exit the year with momentum around free cash flow generation, an active M&A pipeline, and continuing to demonstrate overall margin improvement. Now I'll turn the call over to Michael.

Thanks, Joe. As you noted, even with the uncertainty that persists in the global economy and the industry-wide macro pressures, we met or exceeded the most of our third quarter objectives. Total reported sales were 202 million, up 9.8% compared to last year, with adjusted EPS of 38 cents. On a constant currency basis, organic growth was 1.6%. Organic growth results exclude the contribution from orthogeneric sales in the third quarter, as well as removing approximately 500,000 of maximum generated revenue for the prior year's third quarter. We delivered on our gross margin commitment, And sequentially, SG&A's spend as a percentage of revenue significantly reduced again this quarter. We continued to successfully execute on our orthogeneric strategy, and we generated $23 million of free cash flow, as Joe noted earlier. Chronicare actual sales were down by $1 million versus last year at $116 million in the quarter, excluding the prior impact of sales coming from our exited Maxter facility. We continue to see strong growth in our digestive health business, with third-quarter growth of 11% even further growth. Within this portfolio, Neomed grew over 39% globally, fueled by strong execution of customer conversions to our NFID technology. Separately, our respiratory health business experienced a 24% contraction in the third quarter facing continued industry-wide post-COVID headwinds from distributors selling through their inventory as we added the pandemic to lower ICU census combined with some supply disruptions. Moving to pain management, Excluding the contribution of orthogenerics, we delivered 66 million of actual sales, or 1 million lower versus the prior year, primarily driven by supply chain difficulties related to raw material shortages. The interventional pain side of the business saw 3% as reported growth in the quarter, whereas acute pain declined by over 4%. We are continuing to see positive contributions from orthogenerics with a high level of adoption of Tribisc, our three-shot HA regimen. as we capitalize on the upside opportunity that will be present through the remainder of this year and into 2023. Moving down the income statement, adjusted gross margin improved more than 420 basis points to 56.3% versus last year. As indicated earlier, we are pleased with the progress on gross margins with a combination of better product mix, including orthogenerics, improved plant performance, and lower shipping costs. The sequential decrease in gross margin from the second quarter primarily related to our LIFO restatement and an increase in the cost of raw materials. Our year-to-date results with regards to gross margin is as anticipated. However, the global supply chain environment remains disruptive, inflationary pressures are elevated, and the availability of certain raw material components presents a continuing challenge as we work through our existing backorder. As Joe already noted, we are confident in our ability to achieve our previously stated objective of full-year gross margins between 55% and 57%. Separately, adjusted operating profit totaled $27 million compared to $17 million in the prior year. Higher sales and improved gross margins were partially offset by higher absolute spend across SG&A, resulting in adjusted operating margins of 13% for the quarter. With regards to SG&A's percentage of revenue, we indicated that we would have had sequential improvement in each quarter this year due to front-loaded spending in the first four months of the year. We have executed against this trend and anticipate fourth quarter SG&A spend to be approximately 37%. Adjusted EBITDA totaled $33 million compared to $22 million last year, and adjusted net income totaled $18 million compared to $12 million a year ago, translating to $0.38 of adjusted diluted earnings per share. Now, turning to our financial position and liquidity, our balance sheet remains a strength and continues to provide us with strategic flexibility as we currently have over $120 million of cash on hand, with $254 million of debt outstanding post the closing of the orthogenerates acquisition and completion of our share repurchase programs. We have consistently maintained leverage levels of approximately one times, providing us flexibility against our capital allocation options. Our current available capital exceeds $350 million, which provides ample liquidity for our near-term priorities. Additionally, we believe there is a disconnect between our intrinsic value and our market capitalization. as we look at our strategy and ability to drive higher cash flows and ROIC, and have therefore allocated $55 million to repurchasing our own shares over the prior three quarters. To reiterate, our primary objectives in 2022 center around consistent organic growth, delivering on our orthogenerate strategy, making meaningful improvements in our gross margin profile, and demonstrating our ability to deliver material free cash flow. As Joe noted, we are reaffirming our full-year guidance with total net sales between $815 million and $835 million, annual gross margins in the range of 55% to 57%, and ensuring full-year spend remains below 40% as a percentage of revenue. It is important to note that challenges remain with accessing raw materials, unfavorable impacts of currency, and unevenness in the return of elective procedures. And as noted on our last earnings call, if these challenges persisted, we would be closer to the low end of our net sales range versus the upper. Finally, we continue to expect to earn $1.45 to $1.65 of adjusted diluted earnings per share for 2022. Although the current global macro and industry-specific environment remains difficult, we remain confident in our ability to execute against our strategy and priorities and are taking the necessary steps to drive both gross and operating margin improvement and delivery of significant free cash flow. ensuring that we maintain a solid financial position. Operator, please open the line for questions.

Thank you. We will now begin the question and answer session. To ask a question, you may press star then 1 on your telephone keypad. If you're using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star then 2. At this time, we will pause momentarily to assemble our roster. Today's first question comes from Rick Wise with Stifel. Please go ahead.

Good morning to you both. It's good to see the positive directional progress here. A couple questions for me. Maybe just starting off, if you would, with the backorder challenges. I just wanted to make sure I'm fully understanding the exact drivers and, Joe, your optimism about the potential for working it down by the time you get to the quarter. And maybe just the last part of that little part, maybe more for Michael. Does your guidance for the year already assume that, you know, that whatever it is, the math is three or four million backlog work done? Or no, that would be over and above?

Morning, Rick. It's Joe Woody. I'll say a couple things, and I think Michael will want to make a few comments. But the way to look at our backlog is about 50% of it is digestive health, which is primarily tied to Tyvek, which is an industry-wide backlog problem. I mean, Abbam is involved. All the companies are involved in working to get as much of that product as we possibly can. The other sort of 20% is around the acute pain area and various components, and one major one being it. that impacts the revenue opportunity there, and the other 30% of it, call it changing day-to-day, right? It could be ink, it could be silicone, it could be geographic to things that affect the international business, and we have assumed today that we'll get down to that seven, but what I think we would say, and most of the folks on these calls have been saying, is that it's a very difficult environment to manage in because of spot buys, or you get a commitment for a particular set of materials and they don't come through. And so, that's the general high level. And I don't know, Mike, if you want to add anything to it.

Yeah. So, Rick, the seven is put into our current guidance. So, if we were to get below seven, that would be above and beyond. Yeah.

Gotcha. Thank you for that. And, Joe, you talked about M&A and it's interesting to hear that you're still engaged in active dialogue, et cetera. You said the word you're a little bit disappointed. I'd be curious, where are the hurdles in moving ahead with some of these? Is it that prices are still too high or you're facing competition? Why aren't some of these deals happening that you've been hoping for?

Less about, you know, actionability. It's just the time for diligence. We also are dealing a lot in private circumstances with private companies. Sometimes they take, sometimes they can't work very quickly. Sometimes they take a little bit more time, but we're active in working towards and paying to to just Appel. And so we're also happy with the valuation that we think we'll achieve, very similar to what we've done in the past. You might see as we move through the year next year that we do some slightly larger, but not larger for us, a couple hundred million dollar deal. It's not betting the farm, as we've always said. And so we actually feel pretty good. I think we've shown a decent confidence Q1 next year.

Gotcha. And it always, just my last question, it just always seems to fall to the first questioner on third quarter calls to ask about 23. I know you're anxious to comment in detail, but maybe you could, maybe are you comfortable with current consensus, X, FX? Do you feel like the business, you know, mid to upper single digits, XFX growth? What are you aspiring to? Can we see the kind of gross margin, very solid gross margin improvement continue next year? Any color or direction would be obviously incredibly welcome. Thank you so much.

Yeah, just a couple things, and then Michael will add whatever he wants. But look, I'm very happy with the financial metrics. We can look at gross margin, EBITDA, cash flow generation. So basically, we've set the really get leverage and that's been that's been a lot of work and actually really good execution there's more you know more that we can do and more that we're working to do it's just real difficult right now to judge the top line it's so independent we do believe one thing which is ability to do that.

Yeah, you'll know that is very comfortable with the margin profile continuing to expand attractively, continuing to demonstrate free cash flow generation, solid balance sheet. Top line is just a little bit of a hit and miss right now. So really nothing to comment on there. But the rest of the income statement, we really feel good about going into 23.

Thank you very much.

The next question comes from Matt Mission with KeyBank. Please go ahead.

Hey, guys.

Hey, Matt.

Hey, this is actually Brett on today for Matt. Thanks a lot for taking the question. One thing that stood out as positive was the continued stability around gross margins, and was just hoping you guys could provide some more color around what drove the year-over-year improvement, and then maybe touch on specifically how much of it was driven by the contribution of OrthoGenRx?

Yeah, so just as the second quarter read and what we indicated earlier in the year, whatever improvements we have in gross margin year over year, about 50% of that was going to come from OrthoGenRx contribution and 50% would come from the improved manufacturing efficiencies and other programs we're doing within the plant. And that remains to be the case through the third quarter. And as we line up the fourth quarter, where we think fourth quarter will fall out, that will be the same thing. So remember, we said 55 to 57. We started the year 52 or exited last year at 52. We said wherever we are within that range, about 50% of that will come from orthogenics, definitely in the low end of the range as we start to approach the higher end of the range. A little bit more will come from the manufacturing efficiencies and plant work that we're doing, which is, again, why going into 23, we feel very good about continued improvement in our gross margin profile.

All right, excellent. And then just wanted to follow up on that. Given gross margin had been such a strength of the company, just thinking longer term, maybe 2024 and beyond, do you see an opportunity to maybe get back to that 60% level that you were at several quarters ago? And if not, what's the right level that you guys are targeting? And, you know, how do you think about the remaining levers to get there?

Yeah, so there definitely has been, you know, since the last time we printed a 60, we have acquired some companies post-side orthogenerics. We've acquired some other companies that are below that 60. So our new baseline as a company is called 58% to 59%. that we can naturally get to. So into 23, 24, 58, 59 is a very comfortable place for us to talk about. To get back up to 62, things will need to happen. We could acquire some other companies, obviously, that have a gross margin profile that'll just naturally help and provide a tailwind and some additional savings or footprint opportunities we may have in the plant. So Can we get 60 again, and do we feel confident we will? We do, and we think there's a pathway there. But in a natural sense, 58-59 is about what we can do with our current mix without other things having to get pulled in, if that makes sense.

No, that definitely does. And then last question from me, just thinking about understanding it's a very challenging environment but just wanted to hone in a little bit more on what you're seeing um in in pain management just given the expectations that you communicated last quarter around a potential improvement to double digit growth in 2h so just wondering if you could touch on beyond beyond the supply constraints what might have contributed to to that delta and then what maybe gets better into 4q yep i mean there's a little bit of where we've um

are focused in pain is in the hospital, and I think everybody knows things are moving to the Hamilton Surgical Center, but we're getting active there, and some of the staffing components that people have outlined. But really the biggest part of it, if you think about acute pain, you know, the catheter issue and other supply chain backlog issues, you have to think of that business also to include AMBIT, when it all moves that way. That's, you know, today, less than 10% of our business, but nonetheless, we're still focused there. And IVP, I see that as a, and that's a cool leaf in our RF, a high single digit, you know, to double digit in any given quarter with a good runway. It's really been hit hard by the CRG backlogs of really our consoles, and you have to sell the capital to then generate and expand the business. It is strengthening in Q4, and we'll see more strength in Q4, and then we have some internal and external plans in place to move more of our Coolief RF, if you will, or IVP products into the ambulatory surgical center. And then, you know, we've been happy. We said we've got some opportunity in the short term, you know, with OrthoGenerex and GameReady as a steady mid-single-digit grower. So, at the same time, we're trying to enhance it, you know, with M&A. So, underlying demand seems to still be there for the business, and like everybody, and I'm sure you're probably tired of hearing all these calls, we've got to work our way through supply chain to really see the true opportunity.

All right.

Thanks again for taking the questions, guys.

Thank you. Thanks, Brett.

The next question comes from Drew Ranieri of Morgan Stanley. Please go ahead.

Hi, Joe and Michael. This is Jacob on for Drew. Hi, Jacob. Thanks for taking the questions. I'll ask my two questions up front. First one, following up on some of the previous 2023 questions and looking at margins for next year, if the macro environment stays as is, to what extent could we still see a gross margin improvement next year? And then my second question on OrthogenRx, how has your thinking shifted, if at all, since last quarter? in terms of the expected reimbursement tailwind into 2023. Any changes there in how you're thinking of the size or duration of the tailwinds? Thank you.

So maybe just two quick comments, and then Michael will say a few things. But with respect to gross margin, I think that we also have some price and mix opportunities, but he's laid that out a little bit, and he'll maybe say a few more things there. In terms of that, I think we're going to start to see that tailing off a bit because we said it was going to be a short-term sort of blast on impact. And then by the end of the first quarter, if you will, everybody will be on a very level playing field. And yes, we are adding both. little bit, but Michael, anything you would add?

Yeah, I don't think the macro environment on gross margins for us, or operating margins for that matter, are going to impact us too much next year. That was my point in the earlier question from Rick, is that put aside the top line, which is still a little bit fuzzy, the core of our income statement, we've done a lot of work the last 18 months, for those of you that have followed us closely, and we're seeing that those benefits come through Q2, Q3, Q4, So CM&Q4, those trends should continue to either improve or stabilize at very attractive levels in 23, irrespective of the macro environment. It's really the top line that the macro environment has had a much more meaningful impact on both FX and the backorder situations that we've been dealing with for the last, geez, now six quarters.

This concludes our question and answer session. I would like to turn the conference back over to Joe Woody for any closing remarks.

Look, I just want to thank everybody for the interest in Avanos. We're pleased with the overall execution given the environment we're in. We are committed to creating a shareholder value. I believe our 2022 results are getting to that foundation to deliver on that commitment. I'm very confident the priorities we've detailed and combined with our

and have a great remainder of your week thank you the conference is now concluded thank you for attending today's presentation you may now disconnect