Avanos Medical, Inc.

Good day, and welcome to the AVENOS fourth quarter 2022 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 a touch-tone 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 Gallivan, Senior Vice President, Strategy, and M&A. Please go ahead.

Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to Avanos 2022 Fourth Quarter and Full Year Earnings Conference Call. Presenting today will be Joe Woody, CEO, and Michael Greiner, Senior Vice President, CFO, and Chief Transformation Officer. Joe will review our quarter and the current business environment and provide an assessment of our execution against our key objectives for 2022. Then, Michael will discuss additional detail regarding our fourth quarter and full year and share our 2023 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'll 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 fourth quarter and full year 2022. during the first nine months of 2022. Although the macro environment remained disruptive and dynamic, we focused on what we could control and manage. The demand for our products remained strong, and although supply chain disruptions persisted, we executed well, mitigating impacts to our financial results. We anticipate 2023 will continue to present supply chain headwinds, cost pressures, and pockets of product availability challenges. 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 $217 million, representing over 14% total growth and 4.7% organic growth, both excluding the negative impact of foreign exchange. We generated $0.60 of adjusted diluted earnings per share and $29 million of free cash flow. For the full year, we grew 12%, OrthoGenerex and delivered adjusted diluted earnings per share of $1.65. Additionally, our gross margin for the year was 56.8%, a 450 basis point improvement versus the prior year, and we ended the year with a leverage ratio of under one times. These results position us to confidently execute against the transformation priorities we laid out at the J.P. Morgan Conference in January. Michael and I will address Now I'll spend the next few minutes discussing our results at the product category level. On a constant currency basis, our digestive health portfolio again grew by double digits, topping 10%, with NEOMED growing nearly 40%. The positive trends across our digestive health franchise continued as second-half supply improvements allowed us to maximize North American NFIT conversions. alleviated in the latter part of the fourth quarter. Even though our respiratory business declined by 4% overall, our closed suction catheters grew over 8% versus the prior year. As we noted in our third quarter call, we experienced improved ordering patterns for our closed suction catheter systems throughout the fourth quarter, specifically due to trends with pediatric viral cases like RSD and the early flu season uptick. In total, our chronic care business grew just under 6% in the fourth quarter and 2.6% for the full year, excluding the negative impact of foreign exchange. Turning to the pain portfolio, for the quarter we experienced low single-digit growth in acute pain coupled with mid-single-digit growth in our interventional pain compared to the prior year. The demand for our products As anticipated, we continue to experience supply headwinds, particularly within our surgical pain category, and we expect these headwinds to remain a factor throughout the first part of 2023. Despite some of the ongoing pressures brought about by supply chain challenges, as well as hospital staff shortages that have kept elective procedure levels reduced, our team's resilience has ensured that our pain solutions are available to meet the needs of our customers. Separately, OrthoGenerects strategies. OrthoGenerax's unique patient access program, coupled with a relentless focus on service and support, allowed us to expand our portfolio to self-pay patients and differentiate our brands to providers. In parallel, our strategic pricing initiatives drove a favorable allowable of the three injection product and maintained five injection customers within the company's portfolio. In 2023, we will expand pay market. We also expect steady increases for the three-injection self-pay program. There will be continued reimbursement volatility in 2023, and pricing discipline and accurate average sales price, or ASP reporting, will be a focus for Orthogenerex to deliver stability for our customers. In total, our pay management business grew 2.6% in the fourth quarter and 2% for the full year, excluding the negative impacts of foreign exchange contributions from our OrthoGenerex acquisition. We continue to deliver on both our gross margin and SG&A commitments during the fourth quarter. Gross margin was 55.6% in the fourth quarter and 56.8% for the full year, driven by favorable product mix, inclusive of OrthoGenerex, and our plans continuing to incrementally deliver on the manufacturing efficiency strategy we set forth at the end of last year. Separately, we ended the year with back orders around $8 million. likely higher than we anticipated coming out of the third quarter. Additionally, current back orders have increased to just under $10 million, and we're cautiously optimistic that we can meaningfully reduce our back order throughout 2023. Turning to SG&A, our fourth quarter and full-year SG&A numbers as a percentage of revenue were 34.2% and 38.9% respectively, exceeding our commitment to keep SG&A We remain committed to this financial metric as we enter 2023, and Michael will provide additional insight when he discusses our 2023 planning assumptions. Our final two priorities for 2022 were to demonstrate our ability to deliver consistent, repeatable free cash flow and capital deployment via M&A. For the fourth quarter, we generated $29 million of free cash flow despite continued inventory and supply chain headwinds. Our ability to consistently deliver free cash flows is critical to support our other strategic growth and capital allocation initiatives and has been identified in our priorities for 2023 and beyond. While we are disappointed we have been unable to announce another acquisition since Orthogenerex in early 2022, we remain engaged in active dialogue with a number of potential tuck-in targets with the objective of leveraging our existing commercial infrastructure, generating synergies, and enhancing our top-line growth. We have been disciplined in our approach around strategic fit, valuation, and due diligence and believe that discipline is critical for long-term ROIC enhancement. On top of the early success of Orthogenerex, it is worth noting that our most recent acquisitions of Neomed, GameReady, and Summit Medical, our ambit device, averaged double-digit growth in 2022. Quickly summarizing 2022, our primary objectives were centered around consistent organic growth, delivering on our OrthoGenerX strategy, making meaningful improvements in our gross margin profile, and demonstrating our ability to deliver material-free cash flow. With organic growth in the middle of our range, excluding the unusual impacts of FX, OrthoGenerX exceeded our internal expectations. Gross margin improved by 450 basis points. We delivered free cash flow of $72 million. which, as noted earlier, effectively laid the groundwork for our longer-term transformation efforts. We outlined these transformation efforts in our JPMorgan presentation in January. In that presentation, I described four key priorities over the next three years that would optimize our go-to-market opportunities and substantially enhance our financial profile. These priorities include strategically and commercially optimizing our organization, transforming our portfolio, and the right to win, taking additional cost management measures to enhance operating profitability, and continuing our path of efficient capital allocation to meaningfully improve our ROIC. Now I'll turn the call over to Michael, who will help lead these efforts in his expanded role as Chief Transformation Officer, and will elaborate on both the near and longer-term goals of these efforts.

Thanks, Joe. As you noted, we are very excited to embark on our transformation journey. and believe our execution over the past 18 months has created a solid foundation to build upon. Before diving deeper into these transformation efforts, I'll provide additional color to our fourth quarter and full year results. Total reported sales for the fourth quarter and full year were $217 and $820 million, increases of 12.4% and 10.1% respectively. Adjusted diluted EPS for the quarter was $0.60, and $1.65 for the full year. Additionally, as Joe already noted, we delivered on both our gross margin and SD&A's percentage of revenue commitments, with full year gross margin at 56.8%, and SD&A's percentage of revenue for the full year at 38.9%. We also successfully executed on our orthogenerate strategy during the year and generated over $70 million of free cash flow, ending the year with $128 million of cash on hand and a leverage ratio of less than one. Excluding the negative impact of foreign exchange, chronic care sales grew by almost 6% for the quarter, with digestive health growing over 10%, and enclosed suction catheter systems growth exceeding 8%. Within our digestive health portfolio, Neomed grew nearly 40% globally, again fueled by strong execution of customer conversions to our NFIT technology. Although our closed suction catheter business showed a return to healthy growth, as we noted would happen during our third quarter conference call, our oral care sales were down almost 27% as we intentionally walked away from contracts with unattractive margin profiles. Within pain management, we grew 2.6% for the quarter, excluding the contribution of orthogenerex and the negative impact of foreign exchange. Our interventional pain business grew 6%, with our acute pain products growing a little under 1%. As Joe summarized earlier, we had another solid revenue quarter and overall positive financial contributions from OrthoGenerics. Game Ready and our Cool Leaf water-cooled RF system both grew double digits for the quarter, partially offset by a decline in our surgical pain products. Adjusted EBITDA totaled $45 million compared to $33 million last year, and adjusted net income totaled $28 million compared to $24 million a year ago, translating to $0.60 of adjusted diluted earnings per share versus $0.50 a year ago. In summary, 2022 was a strong year for the company, with adjusted gross margin improving 450 basis points compared to last year, while adjusted EBITDA margin exceeded 20% in the fourth quarter. Additionally, we delivered on our internal EBITDA operating profits and adjusted diluted EPS targets while further strengthening our balance sheet, even after allocating over $170 million towards M&A and share repurchases. As Joe noted earlier, our recent execution has positioned us to embark on the transformation efforts we outlined at the JPMorgan conference. Our transformation priorities are designed to shift our product portfolio over time into a higher growth portfolio leveraging our cornerstone product families in digestive health and interventional pain. Additionally, these priorities are aimed at right-sizing our cost structure and enhancing our operating profitability with EBITDA margins ultimately exceeding 22% while generating annual free cash flow of $100 million. Our three-year transformation assumes primarily organic efforts that we have visibility against and strategies that are in our control. While still early, we have made some impactful decisions already, including leadership changes. Kerr Holbrook was promoted to Chief Commercial Officer, leading our combined chronic care and pain franchises with a focus on realizing efficiencies and synergies within our commercial teams. Additionally, my role was expanded to include senior leadership oversight over this critical initiative through the Transformation Management Office. We also announced that internationally, we would cease selling certain products in our acute pain category and smaller product categories with insufficient profitability. As noted earlier, we have also walked away from customer contracts with low margin as we exit 2022. While these strategic decisions will result in an annualized revenue loss of approximately $35 million, we are not set up to win or grow profitably in these markets or categories over the long run. Our cost savings initiatives will primarily offset stranded costs associated with these product categories. In total, we expect to realize approximately $10 million of savings in 2023, anticipate $45 to $55 million of gross cost savings by 2025, of most of which will be achieved in 2024. We will present a refined view of our transformation program at our Investor Day on June 20th to be held at the convene 101 Park Avenue location in New York City. Although 2023 will be an uneven transition year, given the product portfolio rationalization and cost management initiatives, we anticipate improving our operating and EBITDA margins by at least 100 basis points. Separately, we expect to earn between $1.60 and $1.80 of adjusted diluted earnings per share for 2023, while delivering at least $60 million in free cash flow. excluding the one-time cash costs associated with the restructuring efforts expected to total between $20 and $25 million. Finally, including the in-year impact of the approximately $35 million annualized product portfolio rationalization decisions, the company anticipates comparable organic revenue growth to be low single digits. As I mentioned earlier, we are excited to embark on a transformation journey and I'm confident we will improve on each of these metrics as the year progresses, with the first quarter starting off slow and accelerating into the back half of the year, similar pacing to what we experienced in 2022. In summary, given our consistent execution over the back half of 2021 and throughout 2022, and considering that the current global macro and industry-specific environment remains uneven, we believe this is the appropriate time to proactively, and strategically optimize our commercial organization, portfolio, and cost structure.

Operator, please open the line for 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 keys. If at any time your question has been addressed, and you would like to withdraw your question, please press star, then two.

At this time, we will pause momentarily to assemble our roster. The first question today comes from Rick Wise with Siebel.

Please go ahead.

Good morning, Joe. Hi, Michael. Let me, lots to tackle here. You know, I think that I'm going to start with the transformation commentary. And sorry, Michael, to make you say it again. Did I hear you correctly? It's $10 million cost reduction this year and the large portion next year. I'm sorry, it just went by quickly. And maybe you can just, whatever, you'll correct my words if they're wrong, but just help us understand better where the costs are going to come from what's involved, how quickly you can get at them, and to what extent, especially in the early part, is this going to be a net positive, offsetting other cost and inflation, et cetera, pressures? Sorry for the long start.

Yeah, no, no, that's okay. So, yes, approximately $10 million in 2023. A majority of the remainder amount of between 45 and 55 million in 2024. So just answer that first part of your question. Where a majority of these savings are coming from is a mix of things. We'll be outsourcing some opportunities. We will be rebidding on a lot of third-party contracts. We will be eliminating third-party resources. As we announced through the reorganization of naming Kerr Holbrook the Chief Commercial Officer, there was duplication of roles. Some of those roles have already been eliminated. We'll also just continue on the path that we've done the last couple of years with looking at trimming T&E and other areas as well. Some of those things, like outsourcing, will take, you know, into the back half of this year to figure out the right partner, to figure out the right way to do that without being disruptive. And so majority of those savings won't take place until 24. Gotcha.

Exciting stuff, you know, as it all unfolds. Your supply chain backorder situation, maybe you could give us a little more color on On the backorder, what drove the higher than expected backorder and fourth quarter and the increase earlier this year? I don't know. Is it particular product supply shortages? And, again, what's your optimism on resolution working through that now?

So, Rick, this is Joe, and Michael is welcome to comment as well. But we did a nice job at the end of the quarter producing our backlog and, obviously, second half, but the three areas right now, it's heavily weighted to digestive health at the moment, and particularly there's the Tyvek issue, and I think everybody knows that DuPont's, you know, building a new plant that'll be up and running in Europe, but not until the fourth quarter, so that's some of it. In our case, we also have a supplier of catheters on CUNAMBIT, where we actually could be producing more revenue, and the Now, that said, when we look out, we do see by the time we get to Q3 that most of that will be in the rearview mirror, and that's why Michael has talked about a progression somewhat similar to this year. The aim, though, and as I listen to Michael, the element of the transformation is to eliminate SKUs, to make some changes further in our portfolio. We believe that we can build ourselves into a consistently to be stronger than the first.

Gotcha. Just last for me, Joe, I heard your M&A comments that you were disappointed that something hadn't happened by now. And as I think back to chatting with you and Michael in mid-November at the Staple Healthcare Conference, you had said you'd hoped, you thought the potential was there to see two potential bolt-ons sometime in the first half. How are you thinking about those timelines today? Is that the track on your mind, or should I imagine, given the timing of the investor day, that, no, it's been pushed out longer? Just what's going on out there, and just where are you now? Thank you.

Yeah, yeah. So very robust pipeline. It's even built further since we last were together, I think, up in New York in November. We do think that we will have a transaction in place prior to the investor day, and We are orienting a lot of our focus in the digestive health area, but we still have a couple of pain items that we want to do. Again, being more focused in orthopedic pain recovery than we have been in the past. So we feel really good about this. We obviously have a lot on with the transformation, so we're carefully also looking a good track record. We have plenty of powder at one time to go out and conduct these, and they're going to enhance that growth profile as well, especially given that to the extent we do the two, then that's going to give us an even better outlook for 24 and parts of the end of the year.

Thank you very much.

The next question comes from Matthew Mishin with KeyBank.

Please go ahead.

Hey, morning, Joe. Morning, Michael. Morning. Yeah, could you guys help quantify the product ethics between chronic care and pain, where the $35 million is coming out of? And then does that also take the place of potential spins or divestitures, or is that something you're still looking at? Yeah.

So two points. Matt, we'll get more into details on Investor Day as to where these exits are coming from, partially because we have relationships that were still in place right now, which is why we're giving a range of what the full year impact would be. So some of these we may hand over to an existing distributor relationship. Some we may just get out of altogether due to product availability. Some we may get out of just due to other relationships. So we're not going to get into details into the split of that yet, but we will have more clarity and detail on Investor Day around that first question. To the second question, it's a mix. So some of the stuff we're deciding to get out of would be a little bit of the spins getting out of products that just aren't worth the effort of trying to sell because we just wouldn't get value for them. So it just makes sense to exit those. But it doesn't necessarily take place of other product categories where we do believe there's real value there and we would consider divesting of those product categories.

Okay. Excellent. And then for 2023, I think – Well, just taking a step back, it looks like Orthogen, including, you know, an extra week or two that pulls over from, you know, that inorganic for 2022 would be coming in at about $80 million for a full year on an annualized basis. Just what are the expectations for that in kind of 2023 as some of the pricing dynamics change?

Yeah, Joe will talk in a second about the strategic aspect of what we're doing there. The $80 million, I think it's a little south of the $80 million, but you're directionally right.

And just on a strategic level, Um, Hey, Jay.

Okay. And then on SG&A, last year you started at a high point in the first quarter and then it sequentially decelerated through the course of the year. How should we be thinking about SG&A through the course of 2023? Is the fourth quarter a good starting point or does it ramp again and then come down through the course of the year?

Yeah, the pacing will feel very similar. That being said, the $10 million of in-year costs, there may be some movement between Q2 to Q4 as to when some of these costs come out, but the pacing will feel very similar in that, to your point, Matt, we'll have a high point in Q1, and it will come down on actual dollars as the year goes on. Whereas, you know, revenue will be a low point in Q1 and will be even-ish in Q2, Q3, but higher than Q1. And then we'll have a solid Q4. And therefore, you have that, obviously, you know, you have your high 30s, low 40s starting in 2023, Q1, fresh teenage percentage net sales going down into the, you know, mid-ish 20s. percentage in Q4. Some of it's just math. Some of it is the pacing of the savings that we just talked about, the $10 million.

Okay. And the last one, maybe I just missed it. What are your expectations for growth margin in 2023? I know you kind of put out the 100 basis points of operating margin, even a margin improvement in 2023.

Yeah, so that was purposeful. We aren't sure exactly what where we're going to get the 100 basis points from. What we do know is gross margins should be sticky in these 57 percent level, if not higher. And SG&A at 38.9 should be a little bit lower, if not in the range. So, again, depending on how these savings come in and when we exit some of these low-margin, lower-gross-margin product categories, we'll shift where that 100 basis points comes from. So we're not trying to be cute on the 100 basis points at OP EBITDA. We're trying to be thoughtful and know that we'll have more information to share at Investor Day in June.

All right. Thanks, Michael. Thanks, Jim.

All right. You got it.

As a reminder, if you would like to ask a question, please press star, then 1 to enter the question queue. The next question comes from Drew Ranieri with Morgan Stanley. Please go ahead.

Hi, Joe. Hi, Michael. Thanks for taking the questions. Just maybe on the cost transformation side for a moment, and I understand that there's a lot going on that we will eventually get details with. But just kind of looking back at the company, it's been kind of a few years of talking of right-sizing the business and getting the expense structure in place. But I was just kind of curious how you can, or if you can really kind of give more details about the growth side of the equation and really what you're thinking on that side, because it just feels like Avanos has kind of been a low single-digit grower, so I'd like to hear more about how you're thinking about growth improving and accelerating over the next 12, 18, 24 months.

Maybe I could start with a little bit of growth, and I think Mike will pick up on some more of the costs. But obviously, we want to set that foundation so that we get the drop-through and leverage. And if you go around and look at what's going on in chronic care, you do see a lot of spots of double-digit growth. I mean, Neomet almost hitting 40% consistent, mid-single-digit growth, really, in the rest of the digestive health portfolio on a global basis. another $2 million or so a quarter going to be this year that would be backlogged each quarter that we could sell through. Then also, we know we have a line of sight to some strong acquisitions and good valuations like we've been doing before in the areas where we compete, so orthopedic pain and recovery, back in a normalized situation, we feel like we do have and generally being, in many cases anyway, complementary to EBITDA and accretive growth. So with that, I'll let Michael maybe hit some of the costs.

Yeah, no, I would say, Drew, this is not a cost takeout effort. This is a, to Joe's point, a portfolio rationalization optimization effort. And, oh, by the way, if we're going to do that, there's some cost opportunities. And obviously, for a reporting requirement, we've got to get restructuring and other things out of the table. But when you look at all our internal messaging, this has nothing to do with cost takeout. That's just a byproduct, and a good byproduct for sure, what we're doing with our portfolio.

Our intention to make further portfolio moves, and maybe by the time we get to New York in June, there's some other things that help enhance the profile of our growth that are related there. So we're pretty excited about it.

Thank you. And maybe just a little bit more clarity on how we should think about the product exit for 23, if there's any way to think about the weighting of what you're going to be doing. I know you don't want to get into specifics of chronic care or pain, but can you at least help us with understanding the cadence for 23 and just with 23, with your guidance, The low single-digit growth rate, we should be thinking around like 790 to 810 for reported revenue for 23. Is that the right range? Thank you.

Yeah, I think we're probably a little higher than the 790 just based on the timing of some of the exits. But, yeah, 795 to 810-ish feels like the right range. You did that math correctly, Drew. And so, again, the timing is incumbent upon some of those relationships. You know, we believe we have responsibility to some of these customers from a medical device product standpoint, and so some of these we can do sooner, some of these we are choosing to do later. There's some opportunities to work with distributors in some of these categories to hand off, you know, one, two years of inventory and have them continue to run that, maybe even buy, you know, some of our assets for a few dollars. So there's a range of things we're still very much working through on the exit timing. But your math broadly, your range is appropriately stated.

Did I answer that, Drew? The next question. All set, thank you, Michael. All right, thanks, Drew. Thanks, Drew.

The next question comes from Dave Turkley with JMP Securities. Please go ahead.

Great, thanks. You mentioned the new CCO position, and you mentioned some synergies and kind of putting chronic pain under one organization. Again, it doesn't sound completely intuitive that that would be the case, that there would be opportunities like that, but maybe you could highlight some of the areas where you see those opportunities and why that makes the most sense.

Yeah, there are a lot of areas where we're seeing headcount opportunity and strategic marketing, areas like customer service. Really, Kirsten can also look at the way he spends and the returns in various areas of the business. to help expand our business and also address sometimes some of the cost of the sales. So all those areas are areas that are built into Michael's plans.

Got it. And then the comments you made on the EBITDA north of 22% free cash flow of 100, is that what you expect to do at the end of the three years? So like say exiting 25, is that the timeline for that? Great, thanks.

David, again, to that question, we will have some more specifics around the pacing on that. You know, one of the signals, obviously, we're providing today is that we exited the fourth quarter at 20.8% EBITDA margin. Last year, we exited the fourth quarter at 16%, and we did full year this year at 16.8%. You know, we're not going to do 21% in 2023. But these are how the pacings will work for us, right? Our Q4, ultimately, as we manage our portfolio optimization, some of this offsetting cost opportunity, these are the types of numbers we produce on an annual basis, not just the Q4 basis.

Got it. Thank you.

The next question comes from Matthew Mission with KeyBank.

Please go ahead.

Thank you. Just one follow-up. I just want to just I just wanted to give you guys the opportunity to talk a little bit about Neomed and Fit. It's up 40% again. I mean, this product has grown significantly for you over the last year to two years. Where are you at in this conversion cycle? How much more is there? And then are some of the initiatives that you're doing going to help improve the profitability of this product as well?

Yeah, I mean, yes to all the above, and I at and why we're focusing more on digestive health and neonatal type of targets where we think we can build, you know, get strong synergies at good gross margins in our organization where we have a right to win and where we can get deals and really pay, you know, fair, reasonable prices for those deals. So it's been a home run. Obviously, you know, CoreTrack was strong run for us. And again, it does have, there's opportunities everywhere, including Neomed around with our manufacturing efficiencies and transportation and just all the ways that we're going to market. I don't know if you wanted to add anything. No, Michael's good with that.

But thanks for pointing that out, Matt. And what ending do you think you're in in that conversion?

Like how much is kind of left?

I like transitioning from the seventh to the eighth inning. But then just remember, you know, we still think we'll be north of our mid-single digit for quite some time beyond that. It's just that you can't grow up 30%, 40% forever. All right.

Thank you.

Thank you.

This concludes our question and answer session.

I would like to turn the conference back over to Joe Woody for any closing remarks.

I'd like to just basically thank everybody for the continued interest in Avanos, and as you're hearing from us, the demand for our products cash flow generation in 2023. We look forward to sharing a lot more detail about the transformation program on our June 20 Investor Day in New York City.

Thanks for your time today.

This conference is now concluded. Thank you for attending today's presentation. You may now