Avanos Medical Q3 2023 Earnings Call Transcript

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November 1, 2023

There are 7 speakers on the call.

Operator

Good morning, and welcome to Avanos' Third Quarter 2023 Earnings Conference Call. All participants will be in listen only mode. After today's presentation, there will be an opportunity to ask questions. Please note this event is being recorded. I would now like to turn the conference over to Scott Galavan, Senior Vice President of Strategy and Corporate Development.

Operator

Please go ahead.

Speaker 1

Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to Avanos' 2023 Q3 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 Q3 expectations for the remainder of 2023 and provide an update on our transformation efforts. Michael will share additional detail regarding these topics.

Speaker 1

We will finish the call with Q and 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.

Speaker 1

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 Additionally, we will be referring to adjusted results and outlook. The press release has information on these adjustments and reconciliations to comparable GAAP and financial measures. Now I'll turn the call over to Joe.

Speaker 2

Thanks, Scott. Good morning, everyone, and thank you for joining us to review our operational and financial results for We are pleased with our Q3 results, which align with the expectations outlined during our Q2 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 back order would be around $3,000,000 down from over $10,000,000 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.

Speaker 2

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 $171,000,000 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 $0.30 of adjusted diluted earnings per share and almost $28,000,000 of adjusted EBITDA from continuing operations during the quarter. Our adjusted gross margin exceeded 58%, and our SG and 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.

Speaker 2

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 Thank you, Steve. Thank you, Steve. Thank you, Steve. Thank you, Steve.

Speaker 2

Thank you, Steve. Thank you, Steve. Thank you, Steve. Thank you, Steve. Thank you, Steve.

Speaker 2

Thank you, Steve. Thank you, Steve. Thank you, Steve. Thank you, Steve. Thank you, Steve.

Speaker 2

Thank you, Steve. Thank you, Steve. Thank you, Steve. Thank you, Steve. Thank you, Steve.

Speaker 2

Thank you, Steve. Thank you, Steve. Thank you, 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 and 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 DIROS revenue, We continue to see softness across the Game Ready and H8 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.

Speaker 2

Given our Q4 supply chain improvements, we anticipate our IBP portfolio to be at least flat versus prior year, excluding the positive impact of DIROS 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 4th quarter for our surgical pain business will be largely consistent with our Q3 results.

Speaker 2

Our portfolio though down versus Our earnings call for the prior year met our internal expectations. As discussed during last quarter's call, we continue to experience volatility in our 3 and 5 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 HE opportunities over the Our newly acquired Trident product line has been solid and we are excited about the U. S. Market launch which kicked off yesterday.

Speaker 2

Now moving to an update on our 2023 transformational priorities and efforts. As a reminder, we have 4 key priorities for the next 3 years that will 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 of growth and margin outlook. Closing the DIROS acquisition, which broadens our interventional pain portfolio Progressing our paying go to market strategy, as I just noted, and accelerating our transformation cost savings, which we now expect to exceed $20,000,000 in 2023. As we have consistently communicated since I first presented our transformation plan at the JPMorgan Conference in January, This year would be a bit uneven given to the transformation priorities, the realignment of our commercial organization, M and A execution and our other portfolio optimization activities.

Speaker 2

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, He continues to lead these efforts as Chief Transformation Officer and will provide further insights into our Q3 financial results.

Speaker 3

Thanks, Joe. From a continuing operations standpoint, net sales were $171,300,000 Adjusted gross margin was 58.2% And adjusted net income for the quarter totaled $14,000,000 translating to $0.30 of adjusted diluted earnings per share. Adjusted EBITDA for the quarter was almost $28,000,000 favorable more than $2,500,000 versus prior year. For the quarter, we generated over $25,000,000 of free cash flow despite continued headwinds in supply chain in 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.

Speaker 3

As a result, we currently have $105,000,000 of cash on hand and $169,000,000 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% in the 4th quarter. SG and A as a percentage of revenue was 41.6 percent, marking a 140 basis point improvement versus the prior year and a notable sequential gain of 3.50 basis points.

Speaker 3

Looking ahead, we anticipate SG and A as a percentage of revenue to range from approximately 40% to 41% for the Q4 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, 3rd party cost savings and business process optimizations among others. Adjusted diluted earnings per share were $0.30 versus $0.24 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 Q2 earnings call.

Speaker 3

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 $17,000,000 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 $45,000,000 $55,000,000 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%, adjusted EBITDA margins greater than 20%, and free cash flow generation of approximately $100,000,000 in 2025.

Speaker 3

Finally, As outlined at our Investor Day in June, we anticipate generating ROIC greater than 8% over this horizon, with ROIC exceeding 6% by the end of this year. Operator, please open the line for questions.

Operator

We will now begin the question and answer session. We will pause momentarily to assemble our roster. The first question comes from Rick Wise with Stifel. Please go ahead.

Speaker 4

Good morning, gentlemen. Nice to see the solid quarter. Let me start with gross margins. Just maybe Joe, Michael, you Expand on it. Yes, Q3 gross margins came in a bit softer than we were anticipating.

Speaker 4

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 did Were you cutting back on? And I think I heard you say That your goal is to did I hear you say in the 4th quarter To get to 60%, I know your full year guide is still in that 59.5% to 60% range.

Speaker 4

Just expand on all that if you would. Thank you.

Speaker 3

Yes. So Q4, 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 3rd quarter, We still had RH that we were working down. We were also working on 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 at Investor Day.

Speaker 3

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 2 plants that are currently RH plants, Moving to a smaller footprint and so the kind of 100 plus basis point impact we saw in the 3rd quarter It's 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 much better gross margins because we will have producing the right inventory at the right cadence, increasing returns from what's currently 1.3x, 1.4x per year to well north of 2.5x per year. And that is all That'd be obviously helpful on working capital, but also helpful ultimately on gross margin after you get through a couple of absorption negative absorption quarters.

Speaker 4

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 the setup? I feel like you've talked about Pain in the past returning to mid single digit top line growth as we entered 2024. Maybe just Take us through again a little more detail the interventional pain, which is supply chain, where are we there, the surgical pain.

Speaker 4

You were saying it's I wasn't quite sure what you said about the low single digit growth. Just take us through again. Thank you.

Speaker 2

Yes. 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 thing.

Speaker 2

And a couple of things are happening. 1, the backorders are Coming down and going to be down completely at the end of Q4, really they'll be gone. We have DYROS in the business now as a catalyst. And the example that you highlighted as well on surgical pain 2% growth in that category, it doesn't mean that we're automatically back to Same with Interventional Pain with the supply chain behind it, the addition of DYROZ. Even in the Q4, 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.

Speaker 2

And so even with 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 We've got the new team in place, the new structure in place and they're about in their 6th 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 was kind of high double digit dollars, 1,000,000 and 1,000,000 as part of that and we had some product that we discontinued sort of in the 15,000,000 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.

Speaker 3

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 Joan noted, Game Ready has had In the past, some supply chain issues then had a strategic kick up 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.

Speaker 3

And then to your very opening question, That should support the mid single digit growth that we've talked about before in the pain business overall in 'twenty four.

Speaker 2

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

Speaker 4

Got you. And I shouldn't do it, but I meant to ask the DYOROS technology contribution in the 3rd quarter. And then I'll stop. Thank you.

Speaker 3

I know the full year is we've talked about $6,000,000 Yes, it's about $2,500,000 in Q3.

Speaker 4

Perfect. Thanks so much.

Speaker 3

So, here, Doug. I remember that 2.5% was just international. We did not launch in the United States till today. So that's super exciting. But the growth that they have had Pine acquisition has been international only, Canada and Europe mostly.

Speaker 3

So we are launching in the U. S. Here very shortly here, Which is super exciting.

Speaker 4

I appreciate the color. Thanks again.

Speaker 2

Thank you.

Operator

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

Speaker 5

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 this growth rate is sustainable? And then I have a follow-up.

Speaker 2

Yes. The whole DH business globally continues to deliver. The market itself is sort of mid single digit growth, but excluding even the NeoMed performance, Digestive 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 4% to 5%, We're confident between the innovation, bolt on M and A that we do that we can deliver higher than the market growth, Although it will taper off from the double digit sort of mid single ish it can be to high single digit in any given quarter.

Speaker 2

So very stable Business with a good runway and a good M and A pipeline behind it and international opportunity around that as well.

Speaker 5

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

Speaker 3

Yes. Yes. Thank you for that question, Kristen. Yes, yes. Those are our targets for 'twenty four.

Speaker 3

And we will further update those and provide color to JPMorgan conference in January around 2024.

Speaker 5

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

Speaker 1

Thank you.

Operator

The next question comes from Daniel Stauffer with JMP Securities. Please go ahead.

Speaker 6

Yes, great. Thanks. So, just as a follow-up to that Digestive Health Sustainable growth question.

Speaker 2

A few good quarters of double digit growth here in

Speaker 6

a row And again, you noted driven by conversions of benefit. So, we just wanted to ask, how many more of these conversions are there and how sustainable is that and how much more space For growth you have here, but it sounds like the rest of the business is moving along great, but any commentary on just the white space for continued conversions? Thank you.

Speaker 2

Yes, Daniel. We've said in the past, and I really believe it to be true, we probably have about another half a year of the in fit conversion Benefit rather for the EMBED. But again, we have international opportunity there. Team is doing a great job and the base business growing high single digit. We've got a number of bolt ons and sort of semi large, I'll call them M and A deals for us that we think along with that Innovation as it goes into 2024 and 2025 that can really help us bolster that.

Speaker 2

So we feel that's a very consistent, sustainable Mid single digit, yes, it might be high single digit into the second half of the year back and forth in any given quarter. But it's a very, very Stable business for us.

Speaker 3

Yes. 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 1st 9 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 This is a 7%, 8% grower. We showed it on Investor Day.

Speaker 3

It will 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 $4,000,000 to $5,000,000 of revenue gained because we finally had back quarter solved and we had such a big 4th quarter. So just mathematically be aware of that.

Speaker 6

Great. Then just one follow-up on the operating expense side. You made some progress This quarter, especially in the SG and A line and thank you for the directional guidance for 4Q. But as we look a little further out, how should we think about We

Speaker 2

know you'll have some processing, but how

Speaker 6

should we think about operating expenses going to 2024? And more specifically, As you launch D. Rose in the U. S, how much more investment might that take as you start to ramp that up, especially in a different setting than your other ablation products? Thanks.

Speaker 3

Yes. I think that is a great question. I would 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 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 stand, whether that be a new launch product, R and D, other areas. So We still very much are on target and are focused on the 38% to 39% long term SG and A as a percentage of revenue targets, and there's nothing indicating that we should come off of those.

Speaker 6

Great. Thank you.

Operator

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

Speaker 2

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 at our Investor Day, we've definitely successfully executed product exits, Divested RH, acquired valuable technology Indiros and approved an additional share repurchase program and delivered most of our financial objectives. We really believe these results have established the foundation 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.

Operator

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

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