Envista Holdings Corporation (NVST) Earnings Call Transcript & Summary

We're going to get started. Good morning everybody. Welcome to the last day of Jefferies 2023 London Healthcare Conference. I'm Brandon Couillard. I cover the dental space, here at the firm. And this year, very happy to have Envista back with us at the conference, joining us for the conversation this morning, CEO of Amir Aghdaei; and Principal Financial Officer and Head of IR, Stephen Keller. So gentlemen, thank you both for being here.

Thank you, Brandon.

Amir, just to kick off, obviously, your third quarter came in a little bit light of expectations, principally due to imaging and implants in North America. We've now heard from several other companies in the space who are also echoing many similar trends. From a macro view, what are you seeing in the market right now? And how is that trending as we move into the end of the year?

Thank you, Brandon. Normally, the last 4 months in Europe specifically, we see a ramp after summer vacations, September. You see a number of implant, increased number of treatment. We really didn't see that at all. When people came back from vacation, especially the high-end procedures, full large adult ortho we didn't see that ramp take in place. That's one part of the equation. The second part is we have tremendous amount of insight into patient volume. DSOs in the United States, they have visibility on a daily track of how many patients they're going through, their practices are spending. Why the volume hasn't stayed consistent, spending has gone down. And again, to a large degree on the high-end activities. On top of that, some of the macroeconomics and geopolitical issues that you are well aware of in various places. It created a tremendous amount of uncertainty on top of a distribution in North America. So that caused us to take a pause and take a look at what's ahead of us in Q4, and we decided that it's prudent for us to readjust our guidance for the year. And -- without really moving away from the long-term perspective, building the business for long run, making some additional investment. And that's why we changed the guidance. Now if we want to talk about 2024, '25, '26, we can talk about that as well. But that's the primary reason for changing direction 8 weeks before and then right at the end of Q3.

I definitely want to get to kind of the LRP but just sticking with the fourth quarter, you just mentioned the guide tick down. How much did you handicap the fourth quarter guide for Schein and some of the disruption from the cyber attack there? Has your visibility improved at all relative to 2 weeks or so ago when you reported.

Yes. So the challenge that we have on the distribution about 40% of our business is distribution, 40% to 45% of it, and the top 4 distributors, top 4 or 5 distributors in the United States is almost 80% of our business. So when you lose visibility on sell out inventory, that really adds tremendous amount of concern. As you have heard, China is able to take order, deliver and -- but we don't have that visibility. We don't have that inside what is taking place. We have seen some ramp in other parts of our business with other distributors, but the loyalty is there, people are waiting a little bit. As an outcome, we don't think there is a major share loss taking place. It's just the timing, timing of where there -- are we going to see this additional order coming through, how do we manage the sell-in, sell-out. That's on the consumable where they have inventory. On equipment, there is no inventory. They take order from the customers, they give it to us, we deliver it, they install it and that link is yet to be worked out completely. So we know they have orders and they had. We haven't seen it yet, but we are confident that it's going to take place. How quickly that's going to take place is something to be worried about and concern. As an outcome of that, we consider all this element. That's why we say Q4 is going to be a little bit rocky given how much visibility. It has improved significantly in the past couple of weeks. We've got a great relationship with Schein. We talk to them all the time. We feel like we're there to help them. But it's realities of what they're dealing with. We are trying to kind of hedge that and make sure that we are not getting ahead of ourselves and try to manage that to get through the quarter.

One of the things you talked about on the call was some planned incremental investments in the North American implants business, which has struggled, it was, I think, down high single digits, North America in the third quarter. X-ray is doing the same thing. Why now? How long will these take to impact the top line in terms of results? And what exactly are you doing and investing in?

So we have been in an implant business since 2014, so a 8-year time period. We have tremendous money inside in a number of implants. If you take the top 4, what I call premium players. In the past 8 years, our company annual growth rate has been low single digit. The #1 player is Straumann obviously, has done a lot better and others haven't done as well. So that's 1 factor. The second, we have done what we are really good at with margin expansion, improvement of operational capabilities. If you look at our margin expansion in the past probably 7 or 8 years, far exceeds anybody else in that space. Or put that into perspective. Let me give you 2 more pieces of information and tell you what we are doing. Let's take 2016 to 2019 and say, that's norm, let's say 2020 and say forget about it, '21, '23 -- let's compare 2016 to 2019. Norm is that 2/3 of implants volume or value, 1/3 are premium. The premium segment is growing low single-digit plus mid-single digit, let's say, 3% to 5%. Value growth mid-single digit plus the high single-digit in that range, 6% to 8%. In 2016 to 2019, that is norm. 2021 to first half of 2022, we saw a ramp, a really ramp of both categories and then the continued decline. There's no shift between the premium and value, but the decline has come in place, and you can see that very quickly, very fast. Why do I make that assessment. There are 4.4 million implants are placed in North America specifically. There are 200,000 dentists in the U.S. 70% of these implants are placed by less than 10,000 people. So you're talking a very finite number of people. And then we started beginning to say who are these people? How do they get this? Two group of people. A specialist. A specialist in the North America, they place 40% of all implants. And the way that they get their patient is through the support network, referral network. 20, 30, 40, they train them, they educate them, watch and learn, study club, they send cases to them. They do the implant, they send it back to the GP, they do their assurity, they get the money. The referral network has radically changed. It changed during the COVID, post-COVID. DSOs playing an important role. Over 1/3 of those dentist said they were 65 and above. During COVID, they shut down their practices. So that referral network radically changed, and we got a little bit of a false positive in 2021 and early part of 2022 because of this ramp. What we saw in the second half of 2022 and beginning of 2023, the number of implants placed by this referral has declined. When we started talking to them, we recognize that there is a breakdown in the process. What we noticed was that we needed to do a better job on coverage, training and education, customer support. And what I mean by training and education is helping this oral surgeon to develop a new referral network so they can get the cases, put extra resources in place, given the curriculum and a lot of this referral network, the learning model is really different than the past, a lot more younger, diverse, female, they want to go online, they want to get 3 minutes YouTube. One other thing that's important in North America, very few states that you can go in there without license to place an implant. So you can take into Mexico, Brazil, other places, but we are building these training centers that you can go in place 5 implant under supervision and then that gives you an opportunity to really self feeling comfortable and refer those to specialists. So we noticed that, we started making some changes. We are putting a whole set of resources in place. One of those resources, field type of activities, marketing, training and education. As this market bounce back, we're going to be in a really good place to start seeing the benefit of it. That's a key part of that. Not really that committed, it's execution. We know how to do that. We have done it in Europe. We're replicating it in the U.S., and we're hoping that, that is going to begin to pay off in 2024 and 2025.

Is that the pathway for the implant business back to market growth, which you talked about trying to get back to for some period of time. And I thought N1 was the pathway back to market growth. But you haven't talked about N1 in a long time. Just update us on what exactly is going on with that new product.

So innovation plays a really important role in here. But innovation without infrastructure, training resources, it's just really not going to do any good. You need to have operational capabilities, training, customer support, N1 is an important part of that equation, but you need to have this infrastructure build in place, N1 is an add-on on top of it. N1 was originally developed for oral surgeon to teach the referral network to do simple cases and send complicated over. I just explain what has happened to the referral network. When we build this, when we start expanding that and N1 would be an important part of that equation, we don't have product category problem today. We don't have on-time delivery, operational skills. We are not behind proxies because of product challenge, it's because of commercial execution. About 50% of our implant in U.S., 50% outside the U.S. Outside the U.S., we are above market proxies, we are taking share. So I want to kind of clarify that. This is a North America phenomenon, and that's what we are doing. That's what we're working on to do this. Innovation plays a really important role, but it's not solve soft all of our issue. If you go back to Spark, product is really important, training and education, quality, network, key opinion. All of that plays a role to make that what is today. We're replicating that here in the business.

That's very helpful. Shifting gears over to Spark, definitely a bright spot in the quarter. You grew over 50% year-over-year, even amidst a tough macro, you're on track to hit your $200-plus million revenue target a year early. You've set ambitions to double that business again over the next 3 years. Where will the next leg of growth, the next $200 million of revenue for Spark come from.

Yes. So there is a growth equation on Spark. The growth equation starts by targeting. We have said all along, we're going to go after orthodontist, 8,000 of them in the U.S., another 8,000 in Europe, all in all, about 25,000, 30,000 worldwide. We haven't even scratched the surface. We've got a long way to go. Less than 50% of Spark today comes from Ormco customers, bracket and wire, Damon customer. These are other 55% to 60% to go. And we consider active customer is somebody who signs up that's the first 3 cases in the first 90 days and then reaches 5 or 6 case in an ongoing basis, 12 to 18 months. So the growth is going to come by getting new customers, which is plenty of room to do, and existing customer ramping up. So we have been adding new customers continuously. Growth equation starts with training and education and geography, bring people in, for lack of better explanation, think about 101, 201, 301 and 401 training. First training, second training and go on and on and on. We are doing this training, then we follow up with them. We go to their office. We help them ramp up. We bring them up to speed. We bring the next cohort. Go back to 2018, 2019. If you recall, we talked about 5 customers at the time. That number has drastically has changed of how many people that use Spark today. But in no way or shape you saturate it. We've got plenty of runway to go with orthodontics and then with the existing that they can ramp up to come up to speed. When you look at the ortho as a whole, we're the #2 player if you put bracket and wire, digital bonding, lab, as well as a clear aligner. And this combination has given us a competitive advantage. It allows us to give people choices that they can select one versus the other, and it gives us an opportunity to kind of teach, help and coach, and innovation play a really important role in there. We have been keep building capacity. We just opened a factory in Czech Republic. In October, they start shipping, reduce the time, reduce transaction costs for European which is the fastest-growing part of our Spark business.

As Spark becomes a bigger part of revenue in the future years, it's actually a drag on margins. Where are Spark's gross margins today relative to Envista's fleet average? And I guess, where do you think they'll be in 3 years when this business is $400 million, $500 million of revenue.

Okay. So we said in 2026, we want to be high single digit, 22.5%. Spark plays such an important role both on the top line as well as on a margin. It's below fleet average. And has been in the investment mode, we built capacity ahead of everybody else. We hired 2,000 people in 2020. We built a factory, we built or -- we have design capabilities in every geography now. We have gotten ahead of what the capacity -- what the need is in order to be able to deliver on it. Every quarter, the gross margin is improving. It's going to get to fleet average. And when that happens, you're going to see a huge shift in our EBITDA, and that combination secure that long-term view of 2026. We're not there yet, but we're improving continuously. Growth is there. One of the other reason you rightfully touched on it, the bigger it becomes the more drag it is. So it has become a lot bigger, faster than what we anticipated, but we're not slowing down. We're trying to get to that gross margin as quickly as possible to make sure that we don't back off what we're trying to balance the growth and margin at the same time.

Just to clarify, you're saying that the gross margins are actually not that far off. And were you saying that the operating margins or EBITDA, whatever, will approach corporate average by '26, just to clarify.

Gross margin is below fleet average, but it is improving every quarter. Now because the fleet average is below it. But if I look at Q4 of 2022 versus Q3 of 2023, it is significant improvement. And where is it coming from? Efficiency, automation, price improvement and cost of service is coming down significantly. That initial sign up when you give it to them, then after that when they become really comfortable, it becomes a lot easier. Refinement, continue that support that is required. Initially, investment has been really high, and we have been managing it going forward.

Stephen, I want to get you in here. I'd like to just unpack what's going on with pricing. I mean in the third quarter, ASPs, I think, were down 300 bps. In the E&C segment, you're talking 400 basis points of margin pressure is that entirely coming from imaging, which I think is 40% or so of that segment?

It's mostly from imaging, both traditional imaging as well as the IOS business. We have seen a faster erosion in price than we originally anticipated. Volume has been very strong on the IOS side, but pricing has been a little bit weaker. It's begin to stabilize, and it's getting to be where we expect it to be long term. We just got there a little bit sooner. And pricing on the specialty side, which also eroded, I just want to point out that more than 100% of that pricing erosion was actually due to VBP. Outside of VBP China, we actually gained price on both Spark as well as part of our -- other parts of our orthodontic portfolio as well as our implant portfolio.

Were you saying that you expect imaging pricing to begin to stabilize? Because I think...

IOSs. So IOS pricing it should beginning to stabilize now. Imaging, the price erosion has probably been more around -- it's a very difficult market from an interest rate environment. And so the demand has been a little bit weak there. And so we have been working with our customers to support them during a more challenged macro environment. So I think that pricing -- I think IOS pricing is what really we're watching more and that we think is stabilizing, and it was something that -- again, it's probably where we expect it to end up. It just got there faster than what we originally expect.

I want to stick with the imaging business because it's been a moving target. I mean you've got negative comps by the last 6 quarters, anywhere from 5% to down 20%. You just talked about pricing you did expect it to begin to stabilize in the second half of this year. Where is the bottom? And can you help us just compartmentalize, because you have done a lot of things yourself to get out of some markets that you don't want to be in. How much is self-inflicted and how much is the market? And I guess, why should we expect this business to, I guess, find its footing as we go into '24?

So think about it in 3 different dimensions. New build, replacement, maintenance. 1/3 of the business is maintenance and has a statement system that's support, repair, contract, software, that has been a pretty good place. New build has radically slowed down. Replacement has radically slowed down. But if I look at the last 9 months, 10 months, the majority of this product are software distribution. The sellout is what we are watching. We're at or above sellout proxies. Quarter-to-quarter, I get it, but in a 9, 10 months' time period, if we look at the number of units that have been sold, we are at or above proxies. So which means that we haven't lost here. What has happened is the 2D category has been declining, low-margin, commoditized, and we have decided we don't want to be in it. We have been exiting continuously, and that has added more complexity to this setup. 3D category is stable, prices are good. We have introduced a whole set of new product categories. We think it will be in a good place, we're executing moving forward. We just introduced a whole set of new product category, OP 3D LX, which is the best in the market. The IOS, we talked about the IOS price erosion. The volume has improved, the prices come down. And then last but not least is software. We're the only one at this point that has AI capability has put in there. We have the largest installed base, 6 anomaly detection, DEXIS, we put it out there and we are -- saw transitioning customers to the next level. All of that, put all of that into perspective. This business should be low single digit, mid-market close to about fleet average, that's what we want to do, that's where we want to get to. And I think we're going to be there in 2024 moving forward. With all the changes we have done, with the shift that we have done in the portfolio, with the product introduction, I think we are building in this business for that transformation.

So assuming a stable macro, that's a reasonable base case for '24 in that segment.

Low single-digit growth, mid fleet average. By the way, I'm not ignoring the pricing. But if you look at the equipment and consumer, the average margin has gone up by almost 400 basis points in the past several years, and it's been deliberate moving away from product categories, focusing on the specific geographies. And then using some of that money and financial in order to build the faster-growing part of the business.

I want to come back to your LRP targets that you laid out back in February, talk about 6% to 8% or high single-digit growth by '26 and 22.5% EBITDA margin compared to a little bit better than 18%, what you'll do this year. It feels like everything kind of has to go right, at least on the top line for those numbers to be realistic. What is the realistic outcome over the next 2 years, both on top line and margins, just in general.

Two things got to go right. Not every thing, 2 things. And in past 3, 4 years, macro hasn't been that helpful, but we took 450 basis points of margin improvement. We took a business that had 55%, 60% distribution equipment. We shifted the portfolio radically by investing about $1 billion, exiting about $150 million [ selling, $400 million ] we have done all of that despite of the macro. But 2 things got to go, well, Spark got to be 2x of what it is, margin got to be at fleet average. That's the first thing that really make a huge difference on the mix because it's going to become a lot bigger, as impact on growth, impact margin. Implants going to get back on proxies. The entire implant got to be at market proxy because margin is there already. The growth is what is going to make a difference. Outside of that, a lot of that has to do with us through EPS and work improvement, consolidation, supply chain. And we have done that. We have proven record that we can do that. We're going to continue to do that regardless of the macro.

In the last couple of seconds here, Amir, I mean, since you became public, we've been through a lot, right? The pandemic, right after you became public. And you've done a lot with the portfolio, with multiples pretty depressed right now. What do you think investors are missing or underappreciating about the story?

So I don't think everybody has that really good understanding of what's going on in the Spark and the growth and the margin piece. I think we got to do a better job explaining what that is. The equipment and consumable piece we've got to stabilize it and show that this is low single digit, really good margin, and then we need to describe our transformation on the implant, put all of that together, some of the pieces is far better than individual by itself. Right now, we're being measured under piece-by-piece situation rather than the value of the entire portfolio. We need to do a better job. We need to show that outcome. I think the next several quarters will be a good indication that we can do what we say.

Great. Look forward to that. We're out of time, so I'll have to leave it there. Amir, Stephen, thanks so much for being here.

Thank you so much.

Have a great day.

Thank you.