Integer Holdings Corporation (ITGR) Earnings Call Transcript & Summary

Good afternoon. My name is Craig Bijou, one of the medical device analysts here at BofA. And it's a pleasure to have Integer with us today. And from the company, Joe Dziedzic, CEO. So welcome, Joe. Thank you.

Thank you, Craig. Thanks for having us.

So I want to start, you came out with some news with a CFO transition earlier this week. So I want to just kind of give you the floor just to talk about the transition and the news release.

Certainly. Thank you. I'll first start with what it was not about. It was not about the financial controls or accounting or reporting of the company. There was no fraudulent activity, no unethical behavior. We reiterated guidance. We tried to do that very visibly and very clearly. This change had nothing to do with the strategy of the company, the financial plans or strategy or execution in the business. It was really about reinforcing our commitment to our leadership culture, and that was really why we made the change. So everything that we've communicated about how we're running the company remains the same. I'm very confident in who we've named as the interim CFO. We're going to be conducting an external and an internal search and review of candidates, likely take 4 to 6 months as kind of the normal cycle. So it's really more about what it's not, but it's really just to reinforce our leadership culture.

Great. And so I wanted to start maybe with kind of supply chain dynamics. So a bit of a high level and then we'll kind of get into more specific with Integer. But you're uniquely positioned, at least as I see it, because you're kind of in the middle of the entire supply chain process. So you need to source materials and then you're a supplier for some of the larger med-tech companies. So just maybe a little bit on how the state of the world from a supply chain perspective and what you see? What are some of the challenges? How has it been trending? Is it getting better? Like are there still lingering issues? So maybe just a little bit of color on kind of what you see from your position?

Certainly, you're giving me a little more credit than I deserve on having visibility to the world of supply chain, but I can certainly speak to what Integer has experienced. When you think about supply chain, what you're looking for, are you getting material on time when you ordered it, are you getting it in full, and is it coming in spec. And obviously, there's been lots of supply chain challenges across the world, across the industry, med-tech. We've talked to our customers and our suppliers. And I think oftentimes, it points to a direct labor challenge, direct labor environment, whether it's direct labor turnover or whether it's acquiring the enough direct labor to be able to meet the needs. And then there's also been equipment challenges that have occurred in cycle times and getting equipment repaired, replaced or adding additional equipment to meet the growing demand. So I can speak to specifically Integer. We track the amount of supply chain challenges we have by supplier. We quantify the revenue risk impact. We identify what the root cause is and then work to mitigate it and remediate it. For us, the first quarter, we saw an improvement from the fourth quarter with respect to on-time delivery and getting material in full. Unfortunately, we saw a bit of a deterioration in the -- within spec. As we drilled into the root cause with our suppliers, oftentimes, it pointed to their direct labor workforce as they've hired new people, trained them. Unfortunately, sometimes they weren't following the processes that they had established, maybe it was they didn't set the equipment correctly, maybe they used the wrong material. But a myriad of issues that often times comes back to the direct labor environment and the challenge that many have had. So that was kind of a new development for us. For the most part, we caught a lot of the not in spec at incoming inspections. But there are suppliers who've had tremendous quality performance, and so there wasn't as much incoming inspection on those products. And this has been more of an acute issue, not a chronic issue. It's a lot or a manufacturing run. It's not like a week's worth of production. But what happens is when some of that does get into your production processes, you then put invest labor and other material into the production process and then end up having to scrap it. We have very strong controls and identified this before any product got out the door to our customers. But it has been a new development within the first quarter. So we put additional controls in place and working on root cause analysis with suppliers and helping them to remediate it. Our assumption, given that environment and that aggregate for the first quarter supply chain was about the same as fourth quarter, even though we saw kind of a different mix of the impact, we're assuming for the rest of the year that supply chain stays the same. And when it gets better, and we're confident it will at some point, I can't predict it, we wish we could, but when it gets better, it's going to show up in our results, and then we're going to tell investors after the fact that it got better because we aren't in a position to be able to predict it, but we're working very hard to manage the supply chain challenges that we've had. With your opening, I'll point to the challenges we had last year with a handful of suppliers. We've made tremendous progress with those. 2 of the 3 that we had a particularly challenged with, we feel like we have fully remediated that and with the third one, they're making tremendous progress on improving.

That's great. And maybe just also following up on kind of the macro side and whether it's shipping costs or wages and -- any color on kind of what's structural versus what's temporary from what we're seeing today? And how does it persist in the future? And obviously, recognizing that you're not expecting any improvement in supply chain this year, but what can '24 bring?

Sure. So on the cost side, we think about it in the kind of the traditional buckets of the direct labor. Without a doubt, we did have inflation in direct labor last year. It happened throughout the year. And so that then becomes kind of an annualized full year impact in 2023. That's fully factored into our guidance. We made changes in a number of areas in our business. We did more to engage our associates and ensure that they understood the processes, they understood the impact of what they were having on the products that they were making for patients. We work with them to ensure that we were compensating them in a way that would reduce attrition in the business. We found that when there was ample date per shift jobs in the communities that they were in, we needed to hire a premium for second shift and weekend work. So that's what drove some of the wage inflation. I do believe there is a portion of that, that is structural that's there. I also believe that as we have been able to reduce the direct labor attrition that, that is giving us the opportunity to continue to improve the efficiency in the business. And we've seen for the second quarter in a row, we saw a meaningful improvement in reducing attrition. In our first quarter, we lowered the -- or we had 25% of our sites that were at or below pre-COVID levels of turnover. And so over the rest of the year as that continues to improve, we saw additional improvement in April, that will enable our associates to become more proficient and enable us to drive greater efficiencies throughout the year. And we think that's going to be a meaningful contributor to offsetting some of the structurally higher wages that we have in certain locations. On the direct material front, last year, we actually had a pretty good year at managing some of the inflationary pressures, but we did experience them. Many of them occurred throughout the year, and now they're annualizing again in 2023. And so we will see more inflation in '23 in the income statement than we experienced in 2022 as we work to push those increases out as far as we could. The way we've been working to mitigate that is to pass through some of that inflation to our customers. We have found our customers to be supportive of passing through some of the inflation. They've obviously experienced many of the same inflationary pressures. And they're doing the same thing with their customers where they have the ability to pass through some of that as well. And so the selling price increases that we'll have in 2023, which is slightly positive versus historical 1% to 2% price down is helping to mitigate some of those cost pressures.

That's great. Very helpful. So you guys had a very, very strong Q1, 16% growth, I think when you exclude some of the backlog work through that you've talked about. We've seen -- since then, since you guys reported, we've seen some other businesses or some other companies with OEM businesses, other contract manufacturing also have very strong growth. So taking a step back, I wonder if you can talk about what's going on like in the industry or in contract manufacturing. And obviously, the strong growth, we're kind of past the inventory building period. So what is driving this strong growth? Is it underlying markets? Is it a change in maybe larger OEM buying patterns? Just would love to kind of get your bigger picture perspective on contract manufacturing.

Certainly. So -- you're right, everybody seems to have reported higher sales for the quarter than what were expected and what it appeared that most companies were guiding to. I can speak specifically Integer. We guided to 7% to 9% organic growth in 2023, last October, because we have tremendous visibility to that level of growth in our customers. We have a lot of development programs and new products that are launching with our customers, and we have high confidence in those. And so we had visibility to this level of growth last fall, and that's when we provided the guidance. We have been striving to achieve 200 basis points of organic sales growth above our market, the market growth for the markets we serve. The markets we serve are growing 4% to 6%, our goal is 6% to 8% organic. And on our fourth quarter earnings call, we said we believe we can grow 6% to 8% organically going forward, which is an inflection point for us. We've had a strategy for the last 5 years driving to achieve that. And we've built enough of a pipeline of new products that we believe going forward, we can grow 6% to 8% organic. The reason that it's 7% to 9% in 2023 is because of the $15 million you referenced that slid out of '22 and into 2023. So when we look at our first quarter results, what was different for us than what we expected was we were able to fully recover that $15 million in the first quarter, we had thought that was going to happen more in the first half. In terms of how do I think about the industry volumes and the underlying procedure volumes. They remain strong, obviously. We continue to see incredibly strong demand from our customers. I wish I could tell you that we can identify or triangulate that because of the first quarter, we saw an increase in demand, but I'll frame it this way. We have $900 million of orders on hand for shipments over the next roughly 12 months. We have tremendous visibility to what our customers need from us over the next, particularly, 6 months. And that all feeds into our 7% to 9% organic growth rate that we guided to last year. If the underlying industry demand is stronger than what our customers were expecting, I would fully expect that to be incremental upside for us over the course of the year. And I'll just highlight recognizing where we as a medical device outsourcer, contract manufacturers sit in the supply chain. We ship a lot of product. A lot of the products we make go to our customers' manufacturing plants and get built into their finished devices. And so thinking about when we would see an impact from incremental demand in the marketplace, if the customers weren't predicting it, then they would then start to build more products and then place more orders on us so that we would see that in the presumably coming months or quarter. And so if, in fact, it is incremental demand to what the marketplace or our customers expected, I would expect that demand to flow through is incremental to what we had guided to.

Okay. Helpful. I'm going to push you a little bit on your strong growth, taking out the backlog. Like I said, 16%. That's obviously well above 7% to 9%. And so the implied rest of the year is below that 7% to 9%. So I guess the question really is, and I don't know if you're going to characterize it as conservative. But when I look at it, it looks like a conservative implied guidance, especially given such a strong Q1. So I'll ask it, is there anything that is concerning or potential headwind that we're not thinking about when we consider your full year guidance and the strong Q1?

I do not have concerns about the 7% to 9% organic growth. We feel very, very positive about that given our backlog, given the demand and given -- the results of the first quarter were strong. But again, it was in line with what we expected with the exception really of being able to resolve the supply chain issues and get that product shipped out. I'll highlight one thing. In the first quarter last year, in January, February, there was a COVID surge and it caused some absenteeism that caused our first quarter sales to be the lowest of the year, roughly $310 million versus $340 million, $350 million for the rest of the year. That volume was made up over the rest of 2022. So when you think about the quarter splits, there's a little bit of that dynamic in there. But I'll also say that if supply chain improves, and we think it will at some point. We're not predicting that it will this year. But if it does, that will deliver -- should deliver additional upside opportunity if the industry volumes were, in fact, stronger in the first quarter than what our customers were planning for, that volume will flow through into our business. And so as the year progresses, we will absolutely keep you updated on how that's progressing.

Great. That's helpful. Wanted to talk, one of the interesting things since picking up coverage is really your strategy on emerging PMA customers and driving growth through that unique kind of product channel. So maybe just can you expand a little bit on your strategy there? And why that is such an attractive product base or products to go after?

Well, I'll start with, it's an exciting part of the marketplace because these are early-stage companies. It's oftentimes a group of engineers who had an idea or licensed an idea from a research institution to help patients with conditions that currently aren't being fully treated or are undertreated. And so the role we're playing in that process is, we're supporting them to develop and prove out efficacy and safety of these ideas and building prototype units and then supporting them through clinicals and regulatory and then into market introduction and full production and launch and hopefully, at high volumes. And so we're excited because it makes an incredible difference and it's meeting an unmet patient need. So that's from a -- it's motivating and exciting to be part of that process. The other advantage is there's no one else really in the market that has the comprehensive skill set capabilities to do design, development prototype support from a clinical and regulatory perspective, which we have a lot of regulatory expertise within the company in depth. And then market introduction and full production ramp. We've added a second manufacturing location for manufacturing implantable pulse generators. A couple of years ago, we invested in our Tijuana facility to become the first FDA-approved manufacturing facility for active implantable medical devices for Class III devices. And so we now have multisite capability to support those ramps. These are customers in, as you said, the neuromodulation space. And we've shifted the mix. You look 4 or 5 years ago, we were primarily a spinal cord stim business in neuromod. And now we've progressed to expand that into sleep apnea, sacral nerve, vagus nerve, Cochlear. And now the spinal cord stim/pain management piece is less than half of our neuromod business. We had shared some information in the last couple of years at year-end on the group of customers that are currently in market introduction or launch that in 2020, we had about $20 million of sales with that group of customers. We had predicted that would grow to about $40 million in 2022, so double. It actually grew to about $50 million. And now we're projecting in 2024, that, that group of customers will grow to $80 million to $100 million in sales. And so it's really exciting to see these products start to be introduced into the market to help patients, and we're excited to be able to support these customers with the market introduction and launches. It also brings significant growth for us, and it's part of our accelerated growth, coming back to achieving our strategic objective of growing 200 basis points above the market. This is an important component in being able to do that. And so it's exciting to see it coming to fruition after a number of years working on this. You know the PMA products often take 5- to 9-plus years to bring them to market. We have customers that we've been working with for 15 to 20 years. And so we'll support them as long as it takes to bring these therapies to market.