Avanos Medical, Inc. (AVNS) Earnings Call Transcript & Summary

Thank you, everyone, for joining us today for day 4 of the Morgan Stanley Health Care Conference. I'm Drew Ranieri, one of the medical device analysts here at Morgan Stanley. And from Avanos today, it's my pleasure to have CEO, Joe Woody; and CFO, Michael Greiner, with us this morning for a fireside chat. Before we jump into it, just a quick disclaimer. For important disclosures, please see morganstanley.com/researchdisclosures. And if you have any questions, please reach out to your Morgan Stanley sales rep. So with that, Joe and Michael, thank you so much for your time today and really looking forward to the discussion. And...

Thank you, Drew.

Thank you. And really just to start, I think you're not going to be surprised, but just through the pandemic, Avanos has had tailwinds in Chronic Care. There have been headwinds in pain management. Throughout the conference so far, there's been multiple elective procedure-oriented companies pointing to third quarter pressure given Delta even more so than what they anticipated when they were guiding earlier in August. So maybe what are you seeing across the portfolio for Chronic Care and for Pain Management? And then we can start there.

So we're definitely seeing the same thing. Some of the comments that have not surprised me, I would characterize it by sort of the third week in July in the southern part of the United States with hospital-based elective procedures, we could see a definite downturn, in particular, Florida, Texas but generally the South. And I have said before and it seems to be holding true here, it's really based on the care setting. On the other hand, so if we looked at COOLIEF, which is performed in a hospital outpatient department, we're not seeing some of the headwinds, and we're not seeing it so much in the Chronic Care business or in the International business. We have talked about the one change that could affect numbers or impact that would be any kind of a spike occurrence in a variant, which obviously, I think, we've had here in Delta. The key, I think, is to also watch it, where it goes from the south and does it have a similar kind of impact in the Northeast or the Midwest. Nobody knows, but I think everybody probably at your conference is watching that. But like they've all mentioned, it will definitely have an impact primarily in the ON-Q side of our business, which is primarily a hospital-based elective procedure with even a higher percentage in orthopedic. I don't know if you want to add anything.

No. I'm okay.

So that hopefully is what you're looking for, Drew, and happy to talk more about it or go on to the next subject.

Sure. Just a couple of follow-ups in there. And maybe you don't want to get too granular today, but maybe can you describe maybe the monthly trends in procedure volumes between July, August and September and maybe compare those to kind of what we saw or what you saw for the resurgence earlier in 2021? Is it a similar magnitude? Or is it any different?

I mean I would characterize it as similar to what folks experienced, including us, in that January, February winter spike. But that was more broad. This is more specifically related to, at least for our business, to the southern portion of the United States. So it will have an impact. That impact may not be as broad. But we're certainly not where we had reach sort of 90% procedures for 2019, which is a number that a lot of people were talking about, including us, in particular, on ON-Q. That won't be something that we experience in Q3.

And likely not in -- and likely not in Q4, Drew, given some of the trends we're currently seeing as of 2 weeks in September.

I think yes, to Michael's point, I think the learning, obviously, is we have bounced back in some of these things. And even early on in '20, I think we said, look, we don't think it comes back as quickly because there's a little bit of burnout at the facilities. They have to change some of their protocols and get themselves moving back to these surgeries. So a question mark is how much of it comes back in Q4 and then you have another geographical area pop up alongside of that. But just to kind of close it out, I mean, we -- that's really, in particular, focused on our ON-Q business. I think we're going to be able to talk to it when we do earnings release very explicitly by accounts and where that is in the rest of our business, International, Chronic Care and the COOLIEF business, we're not seeing that type of an issue.

And just maybe in Chronic Care, and this can be the last question here, but do you think the Delta variant will have a benefit towards kind of your respiratory business? Or is it not quite there yet?

We'll definitely see some benefit, I think, at the very end of this quarter and into Q4. That's certainly of the magnitude that we saw in 2020 because I think a lot of things have changed, the treatment of the patient on the ventilator or how and when they get to that need for a closed suction. But clearly, it looks like a lot of the U.S. hospitals, and in some cases international hospitals, have worked their way through the inventory, and we'll see some of that benefit. I don't think that that's going to be enough to offset some of the challenges on the elective side of the southern part of the U.S., but it will help.

Got it. Okay. Maybe just a bigger picture question, Joe. And simply put, what's the Avanos story today? And how does the business -- how does the company kind of create value? I mean it seems like the top line has really a clear potential to be a steady grower. To be fair, I think the margin expansion story has been a little mixed near term. Gross margins have been working, but you were spending more on OpEx, and that has kind of shifted a little bit near term. But maybe what does 2022 look like? Will it become more apparent that the financials kind of really kind of support the Avanos story next year?

Yes. So a couple of things. I mean one, if you think about our business, only a year ago, we were trading at about $52 a share. And then obviously, we experienced some of the gross margin issues, which I think probably you're hearing more from companies at this conference and others of that being lasting into '22. But on the positive side, our underlying business, there haven't be any fundamental changes. We've definitely been knocked around and will be on Delta. And to the extent that those electives come back, that will come back. We're happy with the rest of our portfolio. We're probably in a better cash situation. We'll end the year in a better cash situation than we've been. We've got a very robust M&A pipeline of the kind of M&A that we've been conducting with good valuations, very accretive, things that are in and around our channel that we can integrate pretty quickly. If you look at our financials, you'll see that we've done a great job of managing OpEx, which I think can be lasting for us. We've been living in a world of SG&A below 40%, which we need to be doing as a medical device company anyway. So we're happy with our strategy. We're not happy with this moment in time where we're sort of caught into things like transportation, inflation, costs that we onboard, for example, in closed suction so that we didn't have a Defense Production agreement, and we're able to serve the U.S. and the international businesses during the height of the pandemic and sort of getting that cost out. But we're very confident, very comfortable that we'll get there. I guess the unknown part of that is anything more that the variants do or is there another variant or do we have any more dislocation in the electives, but we would definitely see a strong improvement in '22. And kind of going back to where we were building, I think, quarter-by-quarter, momentum, delivering, and we were enjoying value creation because of that. So the story is still there. But the 2 things hampering it again are the gross margin issues that are related to the pandemic on the transportation side and inflation and then obviously, the electives. That's how I see it.

Got it. I can appreciate that. And there's a lot to unpack in your answer. And maybe just to start on cash flow generation for a moment. After the S&IP divestiture, I think that you were targeting to really do maybe more active M&A. You did some deals. And maybe potentially, you spent more than you were originally expecting on the SAP program, which I think would probably be a longer-term benefit for the company anyway. But maybe just update us, if you can, on 2 other cash flow components here. One is kind of the CARES Act. You've been talking about that a little bit more frequently, but any update there? And I mean is it fair to say that you're now also kind of in an unencumbered cash flow situation now that the DOJ settlement is behind you as well?

Yes. I might just say 1 or 2 things about the past couple of years. I know Mike is eager to update. We're feeling good about our cash flow situation, where we're going to be at the end of the year. But I think if you clearly think about the SAP deployment, which was a part of the S&IP divestiture, and certainly, you've mentioned the right thing, which is the DOJ resolution now, of course, there's a lot of money involved in attorney's fees and legal payouts and things like that to those that were working with us in the resolution. That being behind us now, clearly, and some of the one-offs required to establish restructuring and do the things that we needed to do to separate are behind us, and that's a great piece of information. So we're feeling like we're getting in a good position. But I know you want to sort of update a little bit.

Yes. Drew, thanks for the question. We were very excited that we did get $40 million plus of our CARES Act refunds in over the last month. So that -- it's about $50 million in total that we received this year. There's still about $10 million remaining that will be pushed off into 2022. So we'll see how that portion plays out. So that was a nice win. That should leave us with the free cash flow that we expect to generate in the back half of the year with a net debt-to-EBITDA ratio of about 0.5 turn. So plenty of capacity. Back to your question around M&A, gives us plenty of capacity to do the types of M&A, things that we're currently looking at. And that just set us up well to 2022, should we get something over the finish line here at the end of '21, which is always dependent upon timing and diligence and all sorts of other things, as you're aware. The other thing you had mentioned earlier around 2022, does that start to give some sense around what the financial model could look like. And so 2 things we should be able to demonstrate in 2022. Because all these things, as Joe just mentioned, are now in the rearview mirror, SAP and legal cost and rebranding costs and a lot of that, we have a free -- a real look at free cash flow generation in 2022 that should be an indicator of the type of cash that this company can throw off. If you remember in the fourth quarter of '20, as a matter of fact, we generated $25 million in free cash flow. All of that was used to settle the Kimberly-Clark indemnification case. But that's a type of free cash flow in every quarter in 2022. That's a type of free cash flow we should be able to start generating on a more consistent basis. And that's one thing we should start seeing in 2022. And the other thing we should start seeing, as we mentioned, gross margins were in the 58%, 59% region back in '19, back in '18, even the beginning part of '20. And now we've been in the 51%, 52% region. So that's 600, 700 basis points of decrease across our operating margin profile. Now we've made up some of that with our EBITDA -- with our SG&A as a percent of revenue falling from, call it, 43%, 44% down to 38%. So all the gains that we made in SG&A this past 5, 6 quarters have been basically given away with the gross margins that have been compressed. We hope in 2022, when we see a pathway to do so where we maintain our SG&A in the high 30s while starting to show the meaningful progress back up to that 58%, 59%, 60% gross margin. Then you start putting those 2 together and you can start seeing the operating margin, the EBITDA margin expansion that we believe this model can throw off.

Great. And just on the gross margin component for a moment. I think on the call -- and this is kind of a near term to 2022 kind of question. But on the call, I think you outlined maybe 500 to 600 basis points of gross margin expansion between the second quarter and the second half. Just -- I mean, as you're thinking about 2022, I mean, is the high 50s really kind of the floor that we should be thinking about? I mean what might have to go right to really kind of get Avanos into the 60% plus gross margin for 2022?

I'll just say a couple of things, and then Michael can pick up on whatever he'd like to point out. But generally, on the goals that we set for H2, I think we're going to show significant improvement. We may not get all the way, and it won't be because of our own initiatives internally. It will be about the continued transportation and inflation that I think everybody is articulating and all the supply chain challenges with supply and price increases and things like that. But I think we'll go a long way towards that. And I think our investors will be pleased with the progress that we make. And I think we have the opportunity in '22, although that's going to, I think, continue on, those headwinds and supply chain, to get to those type of numbers at some point in '22.

Yes, I think that's right. I don't know if the high 50s is the floor, but the high 50s is definitely an area that is absolutely reasonable for us to achieve during 2022. We will get out of the first quarter a little bit lower than that. Our first quarter is always a little bit lower due to revaluations and standard settings and things of that nature. But there's high confidence in the organization that we will be seeing high 50s through most of 2022 when you look at it from a quarter-to-quarter basis.

Got it. And Joe and Michael, you both mentioned that there's inflationary cost, and we've clearly been hearing that across the industry. But maybe go into a little bit more detail there, if you can, kind of size the impact or maybe set your expectations of what you're going to see over the next 12 months. And also, just to layer on to that, just what are you seeing in terms of semiconductor shortages, if any? I think that got brought up on the second quarter call. But kind of where do you stand there for any type of constraint as you commercialize products?

So we're experiencing the same things that most of our other peer companies are experiencing, definitely tracking down chips, making sure, for example, that we keep our Game Ready products flowing to customers. There could be, at some point, some disruption there. We're obviously, on a daily basis, really working with various partners on supply chain and gaps in the supply chain. I don't think that's any surprise. Near term, we feel pretty strong about the year, but there could be some things that go into 2022 there. I think when you think about this, too, with companies, in our case, we do have a very strategic part of our business right now being manufactured in China and NeoMed but are likewise converting record numbers of accounts as we're choosing to continue to transport in these high transportation cost areas because of the pull-through that, that will give us in 2022. And I remind folks that we did put in additional capacity and investment into the lines for closed suction catheters so that we would, most important, be able to serve the patients during the pandemic. But obviously, any sort of Defense Production Act on the company would have been meant even further cost. So we are cautioning that, that is going to go into next year. I think everybody sees that in the news, whatever they're looking at or in the media every day in various industries, medical devices, autos, computers affected. I'm real proud of the work the team has done so far to mitigate, but we'll definitely see some gaps, I think, into the future and into 2022. And we'll start to take those on in other areas and be as efficient as we can. I don't know if you want to characterize more.

No, that's great. I would just going to add that, to your point on NeoMed though, we did have a record month of NeoMed sales in August. So speaking of the actual execution on the conversions, it is working.

Got it. Okay. And maybe just going to new products for a moment. I mean looking at the portfolio today, I think we talked about this before that it's getting set up to be this mid-single-digit portfolio. You've been spending 4% to 5% on R&D a year. But maybe just talk about any upcoming products that you're excited for, Joe, that might be accelerating growth. It seems like you've done a fantastic job taking acquired products, developing them, moving to like a 2.0 version. But kind of what gets the Avanos internal R&D engine really kind of humming along over the next couple of years here?

Yes. So a couple of things that I would say there. I mean we're all internally excited about our [ Project Genus ], which is electronic block that's further out. But we think that that's going to be a real game changer for blocks for the total need. We've been meeting a ton of success with the new console in COOLIEF, the new probe technology. And the work the team had done there has really kept us very far differentiated from Medtronic, who's been in the market now for almost close to 3 years, I guess, and not making a lot of inroads. They've also done a nice job with refreshing that Chronic Care piece so that we can maintain the GPO contracts and the IDN contracts in that base heavy cash generation business that we have in the U.S. And you made the other point, which is we've advanced CORTRAK to new generations and that becoming more of a standard of care. Same thing that we're doing with NeoMed and the ENFit conversions. And obviously, then bringing those products into international, that's been a big success for us, too, in terms of the growth that we've seen from where our International business was 4 years ago to where it is today. But our fundamental velocity, you've seen us pull back a little bit on R&D because a lot of the innovation comes from the smaller companies. We're investing in some of those companies and have positions so that we're out there on an open innovation platform, looking at various things. And I think that our type of M&A sets us up for a smaller company, the NeoMed, the CORTRAK type of company, even the endOclear was an example of that, where we can then sort of iterate and innovate without having to draw it from the scratch. So I think that's our strongest suit, is doing the integrations, doing the smaller bolt-ons, looking for the accretive deals and then really innovation versus being this giant, large innovation factory like an Apple or some of the larger med tech companies. That's just not our suit.

Got it. And just sticking on the topic of M&A for a moment. I guess with the free cash flow that Michael was mentioning earlier that were from the CARES Act that you're going to be at a sub-1x net debt-to-EBITDA ratio. But just how active is the pipeline today? I mean should we see more of a steady cadence now that some of the cash flow issues that have encumbered the balance sheet are behind you? It's like should we get more prepared to see some press releases that Avanos is buying these incremental products? And would you think that you'd be targeting more of the Chronic Care side of the house or things to layer on to Interventional Pain, for instance?

We're very active. We have a robust pipeline really on both sides, both chronic care and pain. I would say that at the moment, in this given point in time, we're a little bit more active on the pain side. And it's the very similar type of acquisitions that investors have seen before from us with good valuations where we're kind of hanging out around private companies, and we can put it in our channel, and it can be very accretive. So you can never forecast these things, but we're very active in a couple of deals that we really hope to try to get done by the end of the year or the early part of next, which I think would be exciting as we sort of roll into '22 and we get through some of these temporary, if you will, issues associated with the pandemic in terms of transportation and inflation and things like that alongside of that. And -- plus maybe even a deal that generates EBITDA, we'll see for the company, which could help us on our earnings. But look, these are just forecasts for now because you can never call whether or not you're going to get an acquisition, but we're very active, for sure.

The thing we're seeing, Drew, is that the pipeline around our strategic initiatives has gone a little broader in the last 6 months, both on the chronic side and the pain side, and we continue to see new things come to market that we really like strategically. And so we're excited about that. We have no shortage of opportunities that we're taking books on and doing the diligence matters on.

Got it. Okay. So Joe, this is going to be a very unfair question to you. But taking the other side of the coin here, we've talked about M&A clearly. I mean as you kind of look across med tech for really the past year, we've seen some spin-offs announced, asset sales. As you look at the portfolio, I mean, are there some assets that you feel would be better served in other companies' hands? Just trying to think if there's other ways that you can really kind of accelerate top line growth or your margin expansion opportunity.

Absolutely. I mean we can't obviously go too far in that conversation. But one thing I would say is that what we've done is create a lot of optionality in our business, and we've been talking very openly to our investors about that, which gives us the ability to move on some things that we may think could be better in other's hands but, yes, put us in a stronger position for faster value creation, if you will, for our investors. So it's nice to be in that position. We're constantly reviewing our portfolio. It shouldn't be surprising if something like that we do inside the next year. So it's something that we definitely are vocalizing, to your point, to investors. And it would really enhance, I think, more than anything else the speed at which we get back to the value creation that we really, I think, are capable of.

Got it. Maybe just going to ON-Q for a moment. How do you think about that business on a go-forward basis? I mean there's obviously been some headwinds in that, that have been out of your control. But what's the vision for the product? And how would you frame ON-Q for investors in the broader context of Avanos' business or full portfolio?

Right. So really the strategy is to take the base business of elastomeric pumps, sort of transition over time, which is why we made the Summit acquisition to electronic pumps, which is allowing the customer to drive more data and programming in the bolus and things that they want to do with the patient. We've obviously introduced a product for better interaction with the patient and provider and generating data about pain relief. And then we think that the longer term element of that is then this [ Project Genus ] a couple of years out, which could just dynamically change the market. And we still have a strong story against opioids and really against the longer-lasting locals, and a lot of that has been working through the system. So there's a home for us. What's happened with that business, so just so that investors are clear, is that first there was the drug shortage and then the 503B shutdown, which then prohibited a lot of accounts from filling pumps and utilizing that technology. And then you got hit with the pandemic in elective. So it's been hard for investors to see some of the progress we've made, new talent in the business, some new products in the business, some new positioning, medical education and clinicals that we've been putting forward. So I think as we come out, that business will really be more visible as electives come back and we push more towards where 2019 number is in terms of growth there. But we have said it's a smaller portion of our business now. Our goal is to kind of get it growing low single digit than mid, but we can get to those achievements in terms of value creation with that as opposed to needing that business to be a double-digit grower anytime we fill. And so there's a lot of things around that in terms of what we've done with the channel and also a lot of things that we've done in terms of cost as well, set the stage for that.

And how critical -- we were talking about gross margins earlier for 2022, but how critical is getting ON-Q back on track for achieving the gross margin expansion next year?

I mean it's a portion of it, but I think that the elective bounce back gives it to you versus some kind of enormous unachievable growth. The bigger issue for us is really this point in time, air transportation from China, other ports being backed up, making sure that we're getting all the efficiencies and the cost out that we've put in during the pandemic, things like the closed suction investments that we've made but also kind of things that we've done to take care of our factories and keep them running. That's the bigger -- way bigger issue than just the return of the ON-Q product.

I agree.

Got it. And just to shift gears for a moment, we had Masimo, for instance, talking about flu season -- the upcoming flu season. I think they're expecting it to be a little bit more muted. It would be more pronounced than 2020 but at this point unlikely to reach kind of the above-average 2017 to 2019 levels. I mean what's your take on the flu season so far? I think on the 2Q call, you mentioned that you expected normal cold and flu season overall. But do you have any other additional color at this point?

I think it's more aligned to the Masimo statement on that where there'll be some. The bigger focus is going to be on COVID. And I think our general benefit is more going to come from the Delta variant and the other variant that moves up as folks work their way through the inventory versus the flu element of this. As we know, it was fairly light last year. It might be a little bit more this year than -- because people are more active now a bit more across the world than they were in 2020. But no, I wouldn't say that it's going to reach a normal flu season.

Got it. I mean we only have a couple of minutes left, Joe. But I'd love to open the floor to you if you have any closing remarks.

Look, I think the closing remarks from my perspective would be the underlying business is strong. The strategy is strong. We're in a point where we're dealing with gross margin challenges associated really with coming out of the pandemic. And I think we're not the only ones that are talking about that. I like what I see in terms of the execution of the initiatives that we have to show the progress, for example, this quarter and next on the gross margin. We finally have come to a point where the cost and the margin expansion that was prohibited by rolling out an SAP system -- we're kind of performing the service level agreements. The S&IP spin are behind us. The DOJ is behind us. And I feel like we sort of -- we're on a good track here until the gross margin challenges hit us and others. And I think that we've got an opportunity. It's not to say that '22 is going to be easy for anybody because we're still in this pandemic and trying to get out of it. But we should be positioned well that by mid-'22 and into the end of '22, we're going to start to see some, I think, real value creation as we walk through the point in time when gross margin and the electives come back. Those are really the only 2 hindrances that we have right now that I think has really hurt the stock. So to the extent that this turn around, there should be a bounce back.

Good. I think we hit the top of our time slot today, Joe and Michael, so I have to call it there. But I appreciate both of your time, and thanks so much for being able to make the virtual conference this year.

Thank you so much. Thanks. Good conference.