Convatec Group PLC (CTEC) Earnings Call Transcript & Summary

Good day, and welcome to the ConvaTec results conference call. At this time, I'd like to turn the conference over to Karim Bitar, Chief Executive Officer. Please go ahead, sir.

Good morning and welcome to everybody, and thank you very much for joining us. I hope you've all had a chance to view our presentation that was published this morning at 7:00 a.m. What we'd like to do now, Frank and I, is just to provide you with a brief overview of how we've been performing both financially and strategically and then maybe jump right into questions. Hopefully, you're able to see that we've had a strong financial performance in the first half of the year. In fact, we grew our organic revenue by 7.4% and our EBIT at Q1 has improved by 17%. So I think it's fair to say that top line grew well, bottom line grew well and we were highly cash generative and went ahead and invested in our business. On the strategic side, I think we're very much on track in terms of executing our FISBE strategy, and we're in the midst of pivoting to sustainable and profitable growth. I think it's fair to say that we have not pivoted past that. And we're in the midst of pivoting to sustainable profitable growth, and there's still a significant amount of work to be done. Having said all that, I remain optimistic on the growth prospects for ConvaTec. When you look at the whole year for 2021, we've gone ahead and updated our guidance. And we've gone ahead and increased the guidance in terms of revenue of about 3.5% to 5% on the top line. And we frankly tightened the EBIT margin to 18% to 19%. I think at this point, what I would say is fundamentally, when you look at the long-term prospects for ConvaTec, we continue to compete in very attractive markets. And at the same time, our competitive position is strengthening. And once again, what I would reiterate is the point that our long-term growth prospects are very robust. On that note, I'm going to open it up for Q&A. [Operator Instructions] At the end of the session, Kate Postans will go ahead and close this out with some closing remarks. On that note, I'm going to open it up for questions.

[Operator Instructions] We will now take the first question from Patrick Wood at Bank of America.

Perfect. And I love the new format, by the way. Two questions, please. The first one, thanks for flagging the SKU rationalization in Q4 for ostomy. I guess did you think that by the end of this year, you'll be -- I don't mean down in a negative way, but sorted in terms of SKU counts and geography, do you feel like the base exposure of the core business will be, at the start of '22, in the place that you want to? Or do you foresee a little bit more in terms of adjustments?

Yes. I think, Patrick, we're making good progress on the SKU rationalization. I would anticipate that we'll probably, also in 2022 frankly, to be able to frankly drive 80% plus of the SKU rationalization. So we're making good progress, but it will go into 2022. So I think realistically, we should be thinking once we hit 2023, we should have done the vast majority of the SKU rationalization.

Very helpful. And then second question, and I'll jump back in the queue. The guidance -- and I hate to look on the short term, but the guidance implies that the H2 OpEx in totality, including COGS, is up sort of $100 million relative to H1, which seems quite high with the cost inflation. And if it is cost inflation and FX, can you put pricing through to help offset that? Because isn't there a risk for the 2022 margins flat to down versus 2021? If you've exited the year with those incremental costs, they end up eating off the benefit that the transformation cost rolling off has next year? I guess that exit rate in H2, maybe help us understand what the implications are there because it seems quite a low margin number in that way.

Sure. Frank, do you want to take that second question with regards to margin?

Sure. Yes. So first of all, I don't think it is $100 million. It's, I think, a lot less, but let me explain. Indeed, we're expecting a very significant reduction in the EBIT margin from the first half to the second half. And there are several elements to this as we also explained. Clearly, a very significant increase in material inflation as well as freight cost, which we believe is going to be temporary. And there is no structural reason why this would stay. But for sure, that is a very significant headwind in our '21 outlook and specifically in the second half. Second, indeed, there is a step-up in operating expenses as well for several reasons. First, of course, is the phasing of our investments in sales and marketing, in the emerging markets, in R&D and innovation, in IT and digital, which is the majority. And then second, we are also starting to see some COVID normalization. As you perhaps remember, last year, we had a tailwind because there was a lot less spend related to COVID in, for instance, T&E as well as in ANSP. And we start to see a clear pickup. So we expect that in the second half, that will be sizably higher than in the first half. And then, of course, you have the usual merit and those type of things. So overall, we're expecting, you can do the math in these, coming in at 20% for the first half. Our guidance, 18% to 19% in constant currency for total year assumes that, but I don't get to $100 million. It's, in my view, a lot less. Now coming back to what can we do short term, it is very top short term to really drive prices up to counter this. As I said, I don't think these inflationary impacts are structural. We believe they will eventually get much close to pre-COVID levels. At the same time, of course, we're looking at pricing, not so much in a short-term response but more longer term. I believe -- I think we've done a good job in the last 18 months getting much better at pricing from a strategic positioning but also from a disciplined point of view. And then the final thing here is, of course, we will continue to drive productivity to try to offset these inflationary pressures. I hope that answers your question, Patrick.

We'll now take the next from Paul Cuddon at Numis Securities.

Just 2 questions, please. So the OpEx investment percentage of sales has gone from 37.2% to 38.2% versus H1 '21. Just wondering if you could quantify how much of that is just sort of an FX impact versus actually putting more feet on the ground in line with the increased sales and marketing investment that you aspire to. And then just secondly, the kind of guidance that you've given for the year, could you -- is it possible to quantify how much caution and hesitancy you've put in there with regard to potential future restrictions in winter 2021?

Yes. Sure. So the impact of foreign exchange in dollar terms is, of course, pretty sizable. I would say 50% or so of the increase is related to foreign exchange increases because we've seen a significant uptick in euro, in British pound, which is, of course, those are pretty heavy OpEx centers for us. However, in terms of percentage of sales, the impact is smaller because, of course, there is also an impact on the top line, right? We have seen also a lift, something like 400 basis points or so, in top line because of foreign exchange. So therefore, the -- in terms of percentage of sales, the impact is relatively small. In terms of absolute dollars, it's probably around 50%. Then on guidance portion, listen, if we look at the full year, and we've been very clear about that. Clearly, the second half comparatives are a lot tougher if you compare it to the first half and specifically wound. We've seen last year a double-digit increase between the first half and the second half. Second, the Infusion Care business is also, of course, facing quite some tough comparatives. Last year in Q3, we had 27% growth in the market. That is probably higher single digits, somewhere between 6% and 8%. So you can expect a very different profile for our business and don't expect any stellar performance in Q3 because of those specific items. And then indeed, there is a level of caution here given that the emerging markets, we've done very well in commercial execution, leadership changes, focus on in-market demand, professional education. But on top of that, we've also had some tailwinds in terms of, for instance, government-funded programs. And we're seeing lately, again, a resurge of COVID lockdowns. Japan is completely locked down. ANZ, I think, is at this moment 60% locked down. We see a pretty challenging environment still in Latin America. And therefore, we are a little cautious. I don't want to put a number on it, but we are a little cautious for our second half given these uncertain circumstances in one of our key growth engines of the business. But I really don't want to put a specific number on it.

We'll now take the next question from Hassan Al-Wakeel at Barclays.

I have a couple. So firstly, on the top line, as you think about the full year organic growth guidance, what would your expectation be from any one-off benefits you may have received this year from COVID? And how should we think -- how should we be thinking about more sustainable growth next year? Or is this year's growth sustainable going forward in your view? And then secondly, just following on, on margins. What was the rate of inflation you witnessed in raw materials and freight? And what mitigating activities are you implementing? And just, again, trying to understand whether you'll be able to offset this as we look into 2022.

Okay. Let me try to give a little bit of qualitative color to both, then I'm going to ask Frank to probably be a little bit more quantitative. I think in terms of sustainability of the top line, I think we've been very, very clear that fundamentally, the markets that we compete in are growing at 4% approximately. And then in the Infusion Care area, we're anticipating that, that end market is growing high single digits, right? And so really, our goal in terms of sustainability is to be able to grow the top line in constant currency at 4-plus percent. So we're really saying the minimum being, "Hey, we got to [indiscernible] carry the market if not more than that." And I think it's fair to say that if we've been executing our FISBE strategy, that we're positioning the business to be able to do that. I think some of the businesses are further ahead in that journey. And so I think if you look at the area of Advanced Wound Care, Continence Care and Infusion Care, I think they're well on their way to that journey. I think Ostomy Care was starting from a more further back, let's just say, from a competitive position. I think they're improving their position, but there's still a ways to go. So I think that from a long-term sustainability position, I think that my confidence in being able to achieve that is increasing in time. And I think you see that reflected in our performance and in our outlook statement on the top line. In regards to the inflationary pressures that we're getting, right, we proactively do manage prices, an earlier question about price. And so we look at price strategically and tactically. We have a pricing center of excellence. And frankly, that center of excellence is delivering. Also qualitatively, in terms of productivity, we have an entire productivity effort both in quality and operations, which we're driving impressively and providing outputs, and that's really driven by the transformation execution office and a whole series of interventions. And along that, frankly, looking at the whole area of G&A and through global business services, whether that be in HR or finance or IT or legal, we're looking to get and drive efficiencies there. So that's how I'll describe the 2 qualitatively. But maybe I'll let Frank jump on in and provide a little bit more color.

Yes. I think related to sustainable growth, I think, Karim, you said it all clearly, the COVID benefits. Well, COVID clearly has distorted a lot of the growth rates. And that is more a function of what happened last year than this year with one exception, and that might be in Critical Care. But we've seen the big double-digit growth rate in the wound business written in the first half. If we strip out COVID and some other phasing or destocking, stocking activity last year, this year, we believe that business grew around 4% to 5%. So that gives you the idea of how distorting the COVID dynamic is. And the other business where we have seen quite some movements related to COVID is, of course, the Critical Care business, which typically grows below mid-single digits, so low to mid-single digits, has been growing 17% last year. So we expect that, that business still had some benefits in the first quarter, coming back to your questions, because it grew 7% or so. But we've now started to see that business dip into the negative territory. And that is, again, a function of that huge demand in ICU products that was extraordinary last year. So again, COVID has sort of introduced a certain, I would say, variability in the quarter-over-quarter, year-over-year type performances but largely related to last year. Now related to pricing, Karim has said, and I mentioned that before as well, I think, in answering Patrick's question, we're managing price through pricing COE, more disciplined, more transparency, training and those types of things. We have opportunities to respond short term, but they are relatively limited. And where we can, we, of course, are raising prices as a result of the fact that, for instance, material, specifically resin prices, have increased. So where possible, we are responding very tactically. But it is, to a certain extent, limited what we can do in the short term. And as I said, in the long term, first of all, I think these prices will start to normalize or at least come back closer to pre-COVID levels. When? Exactly tough to estimate. We don't expect that to happen in '21. And then the final comment here, of course, long term, we have more opportunities to do something about the pricing. But we are also driving productivity to offset these type of temporary pressures.

That's very helpful, and if I could just follow up on that. Based on what you see today, I mean is it still fair to assume that 2022 should see margin expansion over 2021?

Well, again, I don't want to get into 2022 guidance here, but the way you have to think about it is as follows, coming back to what Karim said. We're investing here to pivot to sustainable and profitable growth to get us growing in line with the market or better than the market, and that is our first and foremost focus and priority. And then we expect to see a gradual improvement in the margin rate over an extended period of time. And that's how you have to think about it. Again, I don't want to get into '22 specific here, but expect that 4 -- 4-plus percent growth rate and then a gradual improvement in EBIT margin over time.

I would just add to Frank's comments and say if you're trying to understand sort of the overarching financial picture we're driving for is top line growth of 4-plus consistently, okay? I think in terms of the bottom line of the EBIT margin, right, I think it's realistic in the short-term time frame period, you'll be having sort of in that low 20s, okay? And I think from a long-term structural perspective, as you said, the only thing limiting us when being able to get into the mid-20s, I think the short answer is no structurally, okay? So hopefully, that gives you some sort of broad parameters to be thinking about. I think on the balance sheet, we're looking at the balance sheet conservatively with net debt-to-EBITDA ratio of 2.0 or less. And then frankly, we're generating significant free cash flow of north of $350 million per annum. And so we're looking to leverage that free cash flow, obviously making significant investments in the business. But then if there are inorganic opportunities to pursue bolt-on acquisitions like the Cure Medical acquisition, which strengthens our competitive position in the 4 categories in 12 -- in the 12 geographies, we'll do that proactively and aggressively. I think you'll continue to see us do that.

We'll take the next question Charles Weston, RBC.

My first question relates to gross margin. In your prerecorded presentation, you indicated that margin was up 160 basis points, excluding FX, and you talked about price/mix and productivity it's contributing. So could you just talk a bit more in terms of the mix of those 2? How much is price/mix? How much is productivity? And in fact, can you even split out like-for-like price and the mix impact? And my second question, please, is around employee churn. Could you update us on what that -- where that stands at in the sort of planned and/or unplanned basis?

Okay. Sure. I will take the first one, Karim. So indeed, we have an increase in our gross margin, excluding foreign exchange. And in price/mix, we saw a positive impact year-over-year, specifically in mix. And of course, mix is a combination of different growth rates between the different business units but then also the growth rates of brands within the business units, any geography type of mix. And that was a very material driver of that first half gross margin improvement given the trends that we saw in the different brands and the different businesses. I really can't go too far in this because I don't want to provide too much competitive information, but mix was a material positive impact. And then second, we have continued to deliver growth productivity programs as part of our transformation, which really started in 2019, and that continued to deliver a steady stream of positive productivity. Of course, we have the usual headwinds like labor inflation, usual material inflation. As I said, the majority of that additional hike in material inflation will come in the second half and additional depreciation. But it was a combination of positive mix, very, I would say, modest pricing and productivity. And I would say that the mix was probably the biggest contributor of that total package.

Thanks, Frank. Yes. Look, on the employee turnover, what I would say is that from an overarching perspective, the level of engagement across the organization has improved significantly during the course of the last couple of years. We do measure that through an index, which we call the Organizational Health Index. We measured it back in the spring of 2019. We measured it back again in the fourth quarter of 2020. There were some very, very significant improvements in terms of level of engagement and motivation and practices that we were trying to incur such as, say, being more customer focused, being more execution oriented. To your specific question, though, which was what about turnover. We look at turnover in terms of voluntary turnover and involuntary turnover. And obviously, we focus particularly on voluntary turnover. That number has been coming down. But during the course of the last 12 months, it has stabilized and right now trending at about 8%.

Can I just follow up please on the price point? Was like-for-like price negative year-on-year for the first half? And is that mix effect that you talked about structural, i.e., is that all the various different mix components you talked about something that's likely to be continuing for the remainder of this year or next?

Yes. So price basically was very modest, as I said, very modestly positive in some areas and modestly negative. We expect a little bit more price erosion in the second half specifically in the Wound business because, for instance, as an example, we are going to see the full impact of the French reimbursement cut in form. The form is the biggest segment within France. So that is going to be putting some additional pricing pressure on the business in the second half. So price was really -- net-net, really not of any significance. Mix, if you say mix, is that sustainable? Mix is very tough to forecast, of course, because as I said, it's a combination of differences between business units and brands within business units, sub-brands and then also regional mix. So that's very tough for me to answer. Clearly, we try to manage it as good as we can. But in the end, market demand determines the majority of that.

We'll now take the next question from Michael Jungling at Morgan Stanley.

I have 2 questions, please. Firstly, on new product launches. Can you comment on what we can expect -- sorry, I'll go through this again, what we can expect with respect to new product launches in ostomy and in wound over the next 12 months? And then secondly on the sales force expansion. Can you comment on China, on what progress you've made in hiring salespeople? And if you don't want to give the numbers or the increase, perhaps some sort of index increase and how that compares to 2019.

Yes. So look, in regards to new products in wound and Ostomy Care, we're anticipating launching ConvaFoam in 2022 and Avelle 2.0 in 2023. In Ostomy Care, we're anticipating we're launching Esteem 2.0, which is a one-piece comp. That's offering in 2023, so that's what I would say new products. I would say, overall, across all 4 of the categories we're competing in, there is movement on the pipeline. In Continence Care, we're anticipating launching GC Air Male in 2022 and GC Air Female in 2023. This uses our proprietary FeelClean technology, but we're looking to basically offer it in a compact format. And then also Infusion Care, there's more developments to be coming about, particularly with extended-wear infusion sets being launched also in the United States next year. And then also with the whole development effort that we had with Tandem Diabetes in terms of their innovative t:sport new offering, which is a very compact innovative offering for the smart glycemic control segment. And we've got a very differentiated infusion set that we've developed for this particular application. So that's a little bit on new products. Now sales force expansion in China, look, what I will tell you is that we're investing heavily in China. It's a very significant increase in the number of folks on the ground. But what's important to highlight is that our approach to China has been not purely feet on the street. It's very targeted in terms of what are the key hospitals and medical centers in China we want to focus on. So we have those very clearly identified. And then b, frankly, we're really focused on how do we interface with customers in the digital manner. And so we've made heavy investments there in terms of digital interface with clinicians. So if you look at, for example, the ConvaTec Academy of Professional Education, where we trained over 130,000 health care professionals, many of them in China. If you look at our e-commerce platform, Wound Care and Ostomy Care, approximately 1/3 of our revenue now are being generated in our e-commerce platform. So I think the bottom line is that it's a significant investments that we're making, and we'll continue to grow and invest in global emerging markets. And I think China will continue to be important for us.

Can I briefly follow up on the China sales force expansion? Are you getting the productivity that you thought out of these investments? Are they delivering the speed of sales growth with the speed of sales...

Yes. I think the short answer is yes.

We'll now take the next question from Ed Ridley-Day at Redburn.

A couple of follow-up questions, please. First on ostomy. Could you just detail which European markets were particularly soft, and any particular reason for that? Or is it just more COVID disruption ongoing? But clearly, it would appear that your underlying ostomy growth is moving very much in the right direction. And secondly, also, I had a question on the extended-use set. Obviously, great to have FDA approval there. Can you help us -- first of all, was there much benefit in the European approval in the first half? And how should we think about the impact on your infusion business in the second half from those approvals?

Yes. So look, what I would say is on the ostomy growth, we're making progress particularly in global emerging markets, where we saw significant growth. We're strengthening our commercial execution in the United States. And I think that when it comes to Europe, I think the reality is that it's a very competitive marketplace. And so really when you see our very performance in Europe, it's really more a reflection of our historical competitive position. So in some markets such as Italy and Poland, where we've performed well, we'll continue to bolster that. And in other markets, let's say, such as Germany and U.K., we continue to be challenged. And so we're intervening from a commercial perspective. In terms of improving our commercial execution, but I think that that's still going to take some time, frankly, to bear fruit is what I would say on Ostomy Care. So more -- the European performance fundamentally is more a reflection of our ability to execute in our historical competitive position is what I would say. On the second question, which was extended-wear infusion set, how much is the benefit in Europe up to this point? Very modestly, frankly. We've launched in a few geographies such as Belgium. So we're just starting with that. And then in terms of the extended-wear infusion sets that also will be launched in the United States, I think all of these sort of take time to materially impact us. So I think it's fair to say that we're in the midst of launching in Europe. We will be launching next year, but we've not seen as of yet any material impact to our financial performance. I think we will see that during the course of the next couple of years.

We'll now take the next question from Chris Gretler at Crédit Suisse.

I actually have two questions, first on Wound Care. I think in your prepared remarks, you mentioned that, that was performing ahead of your own expectations. Could you maybe elaborate where that has been -- the place in particular? And my second question is relating to your emerging market business. I think you called out strength in Latin America and Asia. And obviously, as skeptical analysts, we're always a bit in curious in these markets. There is a lot of opportunity with respect to distributor stocking effect, et cetera. Could you maybe provide a bit more comfort about the sustainability of these growth rates? That would be great.

Frank, do you want to take the Advanced Wound Care one, and then I'll take the question on sustainability as top line in GEM?

Yes, I will. Chris, so the wound was -- performance was indeed somewhat ahead of our expectation. And I think, clearly, one of the reasons for that was the growth engine in emerging markets. That has been performing very well in the first quarter as well in the second quarter and helped as well by a pretty speedy recovery, specifically in the U.S. in the second quarter. So those 2 elements have been helping. And therefore, we are a little ahead of expectation. Related to GEM, listen, the -- if you think about the success of the emerging markets that we have, first of all, Latin America has been already, for some time, a very stable growth driver for us with a terrific leadership team there. And a couple of years ago, we also brought in a new leader for GEM, Supratim Bose, who has hired a new team for the Asia Pacific region, has really focused the team away from dealing with distributors and creating in-market demand. Tim has very much focused on also creating brand equity by creating a professional adaptation muscle in the first half. And I think we mentioned that in the presentation, we basically trained over 130,000 professional employees in the health care market in the emerging markets. And then the last thing here is what we've done specifically in China is developing the e-commerce platform. So there are a lot of pillars, I would say, that are a foundation of that growth in the emerging markets. Now coming back to your question related to distribution, distributor stocking, I think that comes back to what I just said. We're very focused on in-market demand. We know what the inventories are of our distributors. And we are, of course, closely following that and working with them. So I think there is a good level of confidence that it is managed, that there is the right level of transparency and, again, the right level of focus on in-market demand creation with our team. Now about sustainability. Our expectation is that the emerging markets will continue in the medium and long term to be an important growth engine for ConvaTec. Of course, not every quarter will be the same type of growth. There will be some volatility. I already mentioned some of the COVID-related dynamics that we're seeing in the second half, for instance. So we expect that the growth in the second half will be different than the first half. But you got to look at this more at a -- sort of through a lens of a longer horizon than just 1 quarter or 2 quarters. And with the investments and the changes I just described, we believe we have the right setup here to continue to drive very strong growth in the emerging markets.

We'll now take the next question from Christian Glennie at Stifel.

A couple of questions related to R&D and the impact there. I think in your prepared remarks earlier, you talked about a doubling of -- you're in the way to doubling R&D investment. Just wanted to clarify in terms of what's the time frame? Is it related to sort of last year versus -- in terms of doubling and what's the time frame there? And there were some related comments around sort of moving 5% sales and/or above. Just a bit more context and clarity on that side of things. And then secondly, in terms of the -- you laid out quite a few new product launches across some of your divisions coming over the next few years. In terms of just thinking about the impact of that, is it more about supporting that 4%-plus top line number? Or could it be accretive to that? So you're expecting a bit more of acceleration of that growth based on those sort of pipeline products coming through?

Yes. I think on the first one, on the doubling, really, if you look at our reference point back in 2018, 2019 time frame period, right, relative to approximately the, let's call it, '22, '23 time frame period, I mean, roughly that's going to give you a sense of the doubling, right? So it is a very significant step-up, and Frank can comment more precisely. But really, what we're focused on is less, "Hey, here's a percentage of sales. Here's an absolute number." Fundamentally, what we look at is, is there an unmet need in the marketplace. We believe we can develop and successfully launch a differentiated solution and see do we believe that we can deliver and develop an intellectual property position. If those 3 elements are met, then what we do is proactively manage our portfolio. And we very systemically review the portfolio across, frankly, the core categories we're in, across adjacencies. And then we look at the innovation pipeline, both from an organic vantage point, but also from an inorganic management, right? So it's a very sort of systematic approach towards thinking about the innovation engine. In terms of the potential impact, I would say that the launches that I highlighted to all of you, I think at a minimum, they should underpin the 4-plus because, frankly, innovation and R&D is the lifeblood of being a med tech company and particularly for ConvaTec. And so we need to ensure that. Could we do and -- go above and beyond that? I think time will tell, frankly, Christian. And so I think there's a range there. And so the minimum is to bolster and ensure credibility behind the 4-plus. And then the question is, is it a 4 or is it a plus. I think, frankly, time will tell. Frank, did you want to add anything?

No. I think in pure numerical, I want to just give you a little bit of a historical perspective. A couple of years ago, R&D as a percentage of sales was 2.5% and we are now in the 4% range. So we are clearly investing. We're investing in capabilities and also in programs and drive that sort of what we call velocity of innovation up in the company. That will then yield in a family of product introductions in the future, and that's basically what Karim talked about. So it gives you a little bit of numerical examples where we came from and where we are today and where we're going.

[Operator Instructions] Because there are no further questions at this time, Kate Postans, I'd like to turn the conference over to you.

Thank you. I really just want to finish by reiterating our thanks to everyone for diving in and showing an interest in ConvaTec. If you do have any follow-up questions, please don't hesitate to reach out to me. And I hope everyone has a good day and once again, thank you.

Thank you.

Thanks, Kate, and I just want to thank everybody on Frank and my behalf. Really appreciate the interest in ConvaTec, and we'll be in touch.

That concludes today's call. Thank you for your participation. You may now disconnect.