Avanos Medical, Inc.

Good morning and welcome to Avanos' third quarter 2023 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 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 of Strategy and Corporate Developments. Please go ahead.

Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to Avanos 2023 Third Quarter 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 third quarter, expectations for the remainder of 2023, and provide an update on our transformation efforts. Michael will share additional detail regarding these topics. 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. After 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 releases 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 2023. We are pleased with our third quarter results, which align with the expectations outlined during our second quarter earnings call. We anticipated a continued reduction in supply chain disruptions and strong demand for our products. Last quarter, we indicated that our year-end backorder would be around $3 million, down from over $10 million at the beginning of the year, and we are making steady progress toward achieving this target by the end of December. Additionally, we continue to make steady progress against each of our transformation priorities, which I will further comment on in a few minutes. 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, our sales from continuing operations were $171 million, adjusted for the adverse effects of foreign exchange and the impact of our earlier decision to discontinue revenue that didn't meet our return criteria. In addition, we generated 30 cents of adjusted diluted earnings per share and almost $28 million of adjusted EBITDA from continuing operations during the quarter. Our adjusted gross margin exceeded 58%, and our SG&A as a percentage of revenue stood at approximately 42%. 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 showed robust growth exceeding 10.5%. This growth was bolstered by our NeoMed product line, which delivered another strong quarter compared to the previous year. as we continue to take advantage of the demand for NFIT conversions in North America. Our legacy digestive health product line grew just shy of double digits globally, primarily behind the performance of our legacy enteral feeding portfolio, coupled with the continued expansion of our U.S. core tract standard of care offering. Our ability to continue to deliver above-market growth and leadership in our core digestive health markets will be supported by innovations that we plan to launch over the next 12 months, expansion into high potential global markets, low growth product rationalization, and actionable M&A targets in large attractive adjacencies. Turning to our pain management and recovery portfolio, this quarter sales were down approximately 10%, excluding the benefit of dearest revenue. The negative impact of foreign exchange and our previously announced decision to discontinue certain low-growth, low-margin products. We continue to see softness across the game-ready and HA product categories, both of which were down greater than 10% versus the prior year. Our interventional pain portfolio experienced an 8% decline compared to the previous year due to supply challenges. Given our Q4 supply chain improvements, we anticipate our IBP portfolio to be at least flat versus prior year, excluding the positive impact of DEROS revenue. Separately, our surgical pain business is showing improvement. After several consecutive quarters of decline, we're making progress in executing our new go-to-market strategy and structure. In the current quarter, we delivered low single-digit growth, excluding the previously described market withdrawals of certain low-growth and low-margin products. We anticipate that our fourth quarter revenue for our surgical pain business will be largely consistent with our third quarter results. Our HA portfolio, though down versus prior year, met our internal expectations. As discussed during last quarter's call, we continue to experience volatility in our three- and five-shot offering, largely due to the competitive pricing and dynamics of the market environment. Nevertheless, we believe we have the right strategies in place to capitalize on our HA opportunities over the long term, but continue to anticipate near-term volatility and sequential quarterly declines. Finally, early performance of our newly acquired Trident product line has been solid, and we are excited about the U.S. market launch, which kicked off yesterday. Now I'm moving to an update on our 2023 transformational priorities and efforts. As a reminder, we have four key priorities for the next three years that will optimize our go-to-market opportunities and meaningfully enhance our financial profile. These priorities are strategically and commercially optimizing our organization, transforming our portfolio to focus on categories where we have attractive margin profiles 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. We are very pleased with our execution against these priorities as evidenced by divesting our respiratory health business, enhancing our portfolio growth and margin outlook, closing the DEROS acquisition, which broadens our interventional pain portfolio with accretive growth and margin products, continuing strong performance throughout our DH portfolio, progressing our pain go-to-market strategy, as I just noted, and accelerating our transformation cost savings, which we now expect to exceed $20 million in 2023. As we have consistently communicated since I first presented our transformation plan at the J.P. Morgan Conference in January, This year would be a bit uneven given to the transformation priorities, the realignment of our commercial organization, M&A execution, and our other portfolio optimization activities. We continue to execute solidly on each of these priorities, which serve as the building blocks for achieving the 2024 and the 2025 financial metrics we outlined in our June 2023 Investor Day. Now I'll turn the call over to Michael. who continues to lead these efforts as Chief Transformation Officer and will provide further insights into our third quarter financial results.

Thanks, Joe. From a continuing operations standpoint, net sales were $171.3 million. Adjusted gross margin was 58.2%, and adjusted net income for the quarter totaled $14 million, translating to $0.30 of adjusted diluted earnings per share. Adjusted EBITDA for the quarter was almost $28 million, favorable more than $2.5 million versus prior year. For the quarter, we generated over $25 million of free cash flow despite continued headwinds in supply chain and our pain management and recovery portfolio. Subsequent to quarter end, we successfully closed the sale of our RH business and used most of the proceeds to pay down a portion of our revolving credit facility. As a result, We currently have $105 million of cash on hand and $169 million of outstanding debt, giving us a leverage ratio of less than half a turn. As I just noted, adjusted gross margin for the quarter was 58.2%, which is down compared to the previous quarter. This decline, however, was mainly due to our efforts to reduce inventory, which negatively impacted fixed cost absorption. coupled with ongoing inflationary pressure on electronic components. We anticipate gross margin will exceed 60 percent in the fourth quarter. SG&A as a percentage of revenue is 41.6 percent, marking a 140 basis point improvement versus the prior year and a notable sequential gain of 350 basis points. Looking ahead, we anticipate SG&A as a percentage of revenue to range from approximately 40 to 41 percent for the fourth quarter from a continuing operations standpoint. This is part of our ongoing journey to further enhance our financial profile with continued improvements in 2024, ultimately leading to our 2025 goal of between 38% to 39%. These improvements are driven by reduced headcount, third-party cost savings, and business process optimizations, among others. Adjusted designated earnings per share were 30 cents versus 24 cents a year ago, with adjusted EBITDA margin of 16.2% compared to 14.6% in 2022. We are reaffirming our previously stated full-year continuing operations guidance, which was presented during our second quarter earnings call. This guidance includes an adjusted diluted EPS range of $1.05 to $1.15, gross margin greater than 59%, and adjusted EBITDA margin of approximately 15%. Taking into account the current year effects of the approximately 17 million annualized impact resulting from product portfolio rationalization, the company anticipates comparable organic revenue for the year to be flat to low single digits. As previously shared, the cost management component of our transformation program is on track to generate gross savings between 45 and 55 million dollars by 2025. As Joe noted earlier, we remain committed to the execution of our transformation priorities and are maintaining a sharp focus on our business strategies for both our digestive health and pain management and recovery businesses. The successful implementation of these portfolio strategies, in conjunction with our other transformation efforts, will enable us to achieve mid-single-digit organic revenue growth gross margins surpassing 60 percent, adjusted EBITDA margins greater than 20 percent, and free cash flow generation of approximately $100 million in 2025. Finally, as outlined at our Investor Day in June, we anticipate generating ROIC greater than 8 percent over this horizon, with ROIC exceeding 6 percent by the end of this year. 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 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. The first question comes from Rick Wise with Stifel. Please go ahead.

Good morning, gentlemen. Nice to see the solid quarter. Let me start with gross margins. Just maybe, Joe, Michael, you could expand on it. Yes, third quarter gross margins came in a bit softer than we were anticipating. Michael, you indicated that it was sort of specific deliberate efforts to reduce inventory. Maybe you can just talk that out a little bit. Are you through with that whole process? What inventory were you cutting back on? And And I think I heard you say that your goal is to, did I hear you say in the fourth quarter, to get to 60%? I know your full year guide is still in that 59.5% to 60% range. Just expand on all that if you would. Thank you.

Yeah, so fourth quarter, we anticipate gross margins north of 60%. and still affirming that kind of 59.5% plus range for the full year. So that's an accurate read, Rick. And then in the third quarter, you know, we still had RH that we were working down. We were also working down other parts of our portfolio, which is part of the longer-term goal around 61%, 60% to 61% annualized gross margin profile that we've talked about in Investor Day. So... There will still be some efforts to reduce inventory for sure. If you look at our balance sheet, that is not the inventory levels that we're happy with. However, we will be doing that as we get out of the two plants that are currently RH plants, move into a smaller footprint. And so, the kind of 100 plus basis point impact we saw in the third quarter is not going to necessarily be showing up in future quarters, but we are not done with our inventory reduction efforts. that longer term is going to support much better gross margins because we will have producing the right inventory at the right cadence, increasing returns from what's currently 1.3, 1.4 times per year to well north of two and a half times per year. And that is all going to be obviously helpful on working capital, but also helpful ultimately on gross margin after you get through a couple of absorption, you know, negative absorption quarters.

Yes. And just for a second question, Joe, you were talking very quickly through a couple of key aspects of the pain story. And I just wanted to make sure I'm understanding really clearly how that business gets back on track. and, you know, the setup. I feel like you've talked about pain in the past, returning to mid-single-digit top-line growth as we enter 24. Maybe just take us through, again, a little more detail, the interventional pain, which is the supply chain. Where are we there? The surgical pain. You were saying it's... I wasn't quite clear what you said about the low single-digit growth. Just take us through again. Thank you.

Yep. You got it, Rick. We don't really see pain continuing to worsen at this point. We're seeing improvement. We expect sequential improvement in Q4, and we're still standing by and feel very bullish about 2024 growth, as you outlined, in the mid-single-digit area, which is also what we outlined in the New York Investment Day. And a couple things are happening. One, the backwaters are coming down and going to be down completely in At the end of Q4, really they'll be gone. We have DEROS in the business now as a catalyst. And the example that you highlighted as well, surgical pain, 2% growth in that category. It doesn't mean that we're automatically back to growth because in Q4 we have sort of tough comparators from year over year. But we are feeling strong about that business getting into growth. Same with interventional pain with the DEROS. Supply chain behind it, the addition of DEROS. Even in the fourth quarter, if you go all the way around the infield here, we're going to see growth we feel like in game ready, maybe in the low to mid-single digit arena for Q4. And so even with HA, which is still experiencing the CMS reimbursement changes and the pricing declines, we do believe we'll achieve mid-single digit growth in 2024. So the other thing to think about in that is that, you know, we've got the new team in place, the new structure in place, and they're about in their sixth month, really. So things are starting to click in, and we're feeling much, much better about it. Not feeling great about this year. Obviously, remember, too, that, you know, AHA was kind of high double-digit dollars and millions of part of that, and we had some product that we discontinued sort of in the $15 million-ish range as well that didn't help us in that effort. But we feel like we'll be definitely back to growth and the growth that's needed, frankly, in 2024.

To Joe's point, surgical pain has a little bit of a tough comp in Q4. However, quarter over quarter, Q3 to Q4, on an absolute dollar basis, we expect surgical pain to grow. As Joe noted, Game Ready has had in the past some supply chain issues. then had a strategic hiccup here. We do anticipate Q3 to Q4 for game ready to also have a nice growth as well. So there are pockets that have been holding us back that we feel like we're starting to see some green shoots, some of which we saw in Q3. We'll continue to see more in Q4. And then to your very opening question, that should support the mid-single-digit growth that we've talked about before in the paint business overall in 24.

And to your first question on gross margin, also with the addition of DEROS, and as pain comes back, that should be an improvement in some mixed areas for us too.

Gotcha. And I shouldn't do it, but I meant to ask the DEROS technology contribution in the third quarter. And then I'll stop. Thank you.

I know the full year is about $6 million. Yeah, it's about $2.5 million in Q3. Perfect.

Thanks so much.

I remember that two and a half was just international. We did not launch in the United States until today. So that's super exciting. But the growth that they have had upon acquisition has been international only, Canada and Europe mostly. So we are launching in the U.S. here, you know, very shortly here, which is super exciting.

I appreciate the call. Thanks again. Thank you.

The next question comes from Kristen Stewart with CL King. Please go ahead.

Hi, thanks for taking my question. I was wondering if you could just expand a little bit more on the digestive health business and to what extent you think the growth rate is sustainable, and then I have a follow-up.

Yeah, the whole DH business globally continues to deliver You know, the market itself is sort of mid-single-digit growth, but excluding even the Neomed performance, the Gist of Health delivered high single-digit growth in Q3. I think it was roughly around 8-ish percent in that category, driven by a lot of growth in the core Mickey business. So even though the market growth is 45 percent, we're confident between the innovation, both on M&A that we do, that we can deliver higher than the market growth, although it will taper off from the double-digit, you know, sort of mid-single-ish it can be to high single-digit in any given quarter. So very stable business with a good runaway and a good M&A pipeline behind it, and an international opportunity around that as well.

Perfect. And then my follow-up from Michael, you'd given last quarter some preliminary numbers around 2024. I was just wondering if you still feel confident in the ability to achieve those.

Yes, yes, thank you for that question, Kristen. Yep, yep, those are our targets for 24. And we will further, you know, update those and provide color to JPMorgan Conference in January around 24.

Okay, perfect. Thanks. That's it for me.

Thank you.

Again, if you have a question, please press star, then 1. The next question comes from Daniel Stauder, with JMP Securities. Please go ahead.

Yeah, great, thanks. So, just as a follow-up to that digestive health sustainable growth question, you know, a few good quarters of double-digit growth here in a row, and again, you know, driven by convergence of benefit. So, we just want to ask, you know, how many more of these conversions are there, and, you know, how sustainable is that, and how much more space for growth do you have here? But it sounds like, you know, the rest of the business is moving along great. But any commentary on just, you know, the white space for continuing conversions? Thank you.

Yes, Daniel, what we've said in the past, and I really believe it to be true, we probably have about another half a year of the NFIT conversion benefit rather for NeonMed. But, again, we have neat international opportunity there. The team's doing a great job. And the base business is growing high single digit. We've got a number of bolt-ons and sort of – semi-large, I'll call them, M&A deals for us that we think along with that in innovation as it goes into 24 and 25 that can really help us bolster that. So we feel that's a very consistent, sustainable, mid-single digit. Yes, it might be high single digit, you know, the second half of the year, back and forth in any given quarter, but it's a very, very stable business for us.

Yeah, and just being very specific with the numbers here to Kristen and Dan, your questions. If you remember Q4 of last year, we had, for the first nine months of the year last year, we had digestive backlog building from a supply chain standpoint. We had a really big Q4 last year in digestive. So digestive for Q4 this year is not going to be anywhere near double-digit growth. But that is not a product of any worsening macro environment for Digestive or anything like that. This is a 7%, 8% grower. We showed it on Investor Day. It'll continue to be that. But just heads up that in Q4, it's going to be a low single-digit, mid-single-digit grower in Q4 because of the year, because of the Q4 we had last year. where we had $4 to $5 million of revenue gained because we finally had back-orders solved and we had such a big fourth quarter. So just mathematically be aware of that.

Great. Then just one follow-up on the operating expense side. You made some progress this quarter, especially in the SG&A line, and thank you for the direction and guidance for 4Q. But as we look a little further out, how should we think about We know you'll have some costs, but how should we think about operating expenses, you know, going to 2024 and more specifically as you launch DROs in the U.S., you know, how much more investment might that take if you start to ramp that up, especially in a different setting than your other ablation products? Thanks.

Yeah, I think that is a great question. You know, I point to what I just shared in the script on our expectations for Q4. And to Kristen's question on our confidence in 2024, which we talked about in the last earnings call, I would point to those numbers as well. We're very much on target, OpEx-wise, with those numbers, both through the cost savings transformation efforts, but also just through good discipline on where we spend, whether that be a new launch product, R&D, other areas. So we still very much are on target and are focused on the 38% to 39% long-term SD&A is a percentage of revenue targets, and there's nothing indicating that we should come off of those.

Great. 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.

So thanks, everybody, for your interest in Avanos. And I think everybody understands our primary focus is on precise execution as we deliver the strategic plan that we outlined in our investor day. We've definitely successfully executed product exits, divested RH, acquired valuable technology in DEROS, and approved an additional share repurchase program and delivered most of our financial objectives. We really believe these results have established the foundation for to deliver on our midterm financial commitments, and we're confident that our transformation priorities, coupled with our market-leading portfolio and the attractive markets, will position us well for sales growth, margin expansion, and meaningful free cash flow generation. So we appreciate, again, everyone's interest in Avidus. Thank you very much.

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