Integra LifeSciences Holdings Corporation (IART) Earnings Call Transcript & Summary

Thank you for joining another med tech session here at the 2021 Morgan Stanley Healthcare Conference. I'm Drew Ranieri, one of the medical device analysts here. It's my pleasure to have Carrie Anderson, CFO, from Integra with us today as well as Mike, Head of IR. Just before we jump into it, time for some disclosures. But for important disclosures, please see morganstanley.com/researchdisclosures. And if you have any questions, please feel free to reach out to your Morgan Stanley sales rep. So with that, Carrie, thank you so much for your time today. Really appreciate the opportunity to have a fireside chat with you. I don't think you're going to be surprised what our first topic will be.

So maybe just give us an update of the business, the procedure impact that you might be seeing from the delta variants or any impact on the capital business to start with.

Thanks, Drew. I'm really happy to be here, and I anticipated your question. That's on top of mind I'm sure for many investors. So look, we're still early in September. We're not at the midpoint of September yet. And the third month of any given quarter is always an important piece of the puzzle as it relates to where we might finish for the quarter, and that's no different here for the third quarter. So while I can't talk about Integra specifics, Drew, what I can talk about is some of those macro trends that we're seeing that many, many companies are talking about. There's no doubt that August clearly saw an increase in the number of COVID cases and hospitalization rates. They went up. But there are some differences between what we're seeing here today versus what we saw back in the winter months in January and February that also were a surge. And certainly, vaccination rates have improved since the winter months. There's no doubt. But we're dealing with a different variant, a highly contagious one, which has different implications as a result. And the other thing I think that is weighing equally important is that there's an abundance of staffing shortages out there that hospitals are dealing with, whether it's the inpatient or the outpatient settings. And it's no different than a lot of companies are seeing. That labor constraint is also impacting hospitals. And what I mean by that is very impacted in their ability to do as many procedures as they want to because of these labor shortages, and it certainly has implications as it relates to ICU bed staffing as well. What I would say is we're not seeing that same blanket impact across every single state the same way. There is a variability to the impact. And states like California, Texas, Florida, Ohio seeing bigger impacts, states with lower vaccination rates seeing larger impacts. But there are some states out in the Northeast, as an example, New York, that is not seeing the same level of impact. What I think it's difficult to know right now at this very moment is, did we reach the peak? Did we reach the peak in August? Or is there still another peak to reach in September? And ultimately, we'll have to see how September plays out. But September was important as it's post Labor Day now. So obviously, a big holiday here in the U.S. But also Labor Day in many school districts around the country signals the start of school. Many of those schools started in August, but a lot of them start until after Labor Day. So what we don't really know is the impact of any of that and whether or not we've reached the peak. Even outside the U.S., I would say that it's the same thing, different pockets having different levels of impact. Japan and Australia are countries that we hear a lot about. Japan, obviously, as a result of the Olympics, but also just low vaccination rates playing out there. Australia is a little bit of a different story and that just a little bit of COVID impact there in the country responded by putting strict shelter-in-place initiatives back in place. So a little bit different in terms of how it may -- you may see it on the rest of the world as well. I think that the best guidance I can give you right now is to go back to the commentary that we had on our July call, that's our second quarter earnings call and we talked about our third quarter guidance. We purposely gave a range of revenue outcomes from the third quarter, a low end to high. The low end factoring in some level of COVID variability and the high end, of course, with no COVID variability in that number. So ultimately, we'll have to see how September plays out. But my best view at this point is to refer investors back to that guidance commentary on the second quarter call. Drew?

Got it. And with the -- you touched a lot on kind of the procedure side of the house, but maybe kind of what are you seeing in terms of capital. Do you think that you're building a backlog? And you talked about -- sorry, this is going to be a multilayered question, but you talked about staffing shortages, but I would like to hear maybe how the Integra portfolio might be set up to kind of help those staffing shortages or if there's any efficiencies the portfolio kind of gets to clinicians and just the overall capital environment and potential backlog?

Yes. I mean capital, even if you go back to the start of COVID, and that certainly felt so long ago, but even at the very onset of COVID, we had provided a bit of an X-ray into our portfolio that looked at areas of the portfolio that would rebound more quickly and which ones would be laggards. And we had identified early on that capital would be one of those laggards in the portfolio. And I would say that it's played out largely that way. And even when I go back to the first quarter of this year, it was a bit of a mixed bag of our capital performance. There were areas of the international capital that actually rebounded quite well and our international capital actually saw growth compared to 2019, and that was primarily driven by spots in Japan and Canada, very specific reasons on those. Japan's fiscal year ends in the fourth quarter or ends at our -- their fourth quarter ends in our first quarter. And then in China, they saw some nice growth in capital as well in the first quarter, and I attribute that to the distribution model there. We go indirect, and it was probably more in anticipation of recovery of capital in and around the pipeline. But U.S. capital was still down in the first quarter. And as we moved into the second quarter, it played out as we expected. We saw sequential improvement from Q1 into Q2, but still down relative to 2019 levels. So it's still an area that continues to lag the recovery. And when will we will get back to 2019 levels, we'll have to see how it plays out. Remember, capital is only about 6% of our revenue. So it's not a big, large piece of our portfolio. But as we think about getting all of the parts of our portfolio back, it's an important one to measure it in terms of a barometer. I still think fourth quarter can be a good capital quarter for us. It coincides with many hospitals fiscal year ending. Fourth quarter always tends to be the peak of capital purchases. And I do think that the fourth quarter can see some resiliency and some capital come back in nicely. We'll have to again see how that plays out. In terms of your second part of your question, when we think about like our CUSA capital, which is our most expensive piece in capital, it's a couple of hundred thousand dollars. Definitely, there is a value proposition when it comes to efficiency in the OR. And that is something we do talk about as one of the selling propositions of that, that it can help turn over that OR much more quickly in terms of setup time, ease of use, the power core of that instruments bringing in efficiencies as it relates to the tissue ablation procedure itself. So there's a number of time efficiency savings that we think creates a propelling -- a great business case for the CUSA as we try to move that forward even in a more dynamic environment as we are today.

Got it. Thank you. And maybe let's move over to kind of some non-COVID topics for a moment. But when we kind of look at your long-range plan and underlying business, I think you're calling out 5% to 7% organic growth over the longer term. So maybe just what underpins that 5% to 7% organic growth? And maybe why is Integra better positioned now to deliver on that growth rate than 1, 2, 3, 4 years ago?

Yes, I appreciate the question, Drew. And let me start with that piece of the question in terms of why we think we're in a much better position. There's been a couple of inflection points with Integra. And one of those occurred a couple of years ago with -- when we were essentially kind of pencils down with the majority of the integration of the Codman acquisition. We did the Codman acquisition back in 2017, and it was a pretty transformative acquisition, our largest in the company's history. And it was a complex transition as it was a carve-out from J&J. And so it took us a few years to really great integration work, and it's really exceeded all expectations. And for the most part, that integrating is 100% complete. The commercial integration was done in 2019. We have one last hurdle on that one, which is the exit of a transition manufacturing agreement, which will happen at the end of this year. So that was a near-term inflection point. The other one, more recent, was the portfolio change we did here in January where we completed the divestiture of our Orthopedics business and we acquired the ACell business. Another inflection point, meaning that we took a business that was dilutive to earnings and to margins and bringing in a business that will be accretive to both top line and bottom line. We've had a slower start with ACell as we tried to integrate that and underestimated the impact of COVID. But no doubt, we have a lot of enthusiasm for that asset in our portfolio. And we can talk a little bit about ACell in maybe some of your coming questions here in a moment. So let me get back then to the overall 5% to 7% organic growth rate. So those are 2 inflection points that I'd point to that give us a bit more confidence in that 5% to 7%. There are 2 pieces of the portfolio that you really need to understand that make up and drive that 5% to 7%. 2/3 of our business is in the CSS, the Codman Surgical Specialty area. That's our neuro side of the business along with our instrument portfolio. Our expectation here is to grow 3% to 5% on a long-term basis. And we've actually demonstrated that if you go to pre-COVID year like 2019, when, again, we had that commercial integration complete for the Codman integration, we were above -- we were slightly above 5% for 2019. So overall, a really nice year for Codman Specialty Surgical. The drivers of what keeps us in that 3% to 5% is -- it's going to be about new product introductions, international expansion, including China and Japan, and really leveraging that leadership position we have on the neurosurgical fees. And then when I turn to the tissue technology business, which makes up the other 1/3 of our business, our expectations there, it will grow 7% to 9%. And why we think 7% to 9% is the right metric there is that the markets that underpin Tissue Technologies are expected to grow about 7% to 9%. So there's a number of sub end markets that sit under the tissue technology business, including burn, including complex wound reconstruction, surgical and plastics reconstruction, nerve repair as examples. And all of those grow anywhere from 5% to 12%. The weighted average of those markets are about 7% to 9%, and that's essentially what we're saying is we think that we can grow in line with those market growth rates. And so I think, Drew, if I could take a little bit of time and maybe talk about some of those catalysts over the next 12 to 18 months. And some of those are a little bit longer than that, that help get that confidence level of why 5% to 7% makes sense. And these are going to be certainly whether they're first base, second base or even home runs in our portfolio that give us more consistency and confidence around that. So the first one, of course, near term is just the normalcy of COVID. Yes, COVID dominates the conversation right now and that's unfortunate. But at some point, we will get through this. Like every other company, we will get through this, and I can point to areas of our portfolio between Q1 and Q2 to see some of that nice rebound. Our revenue rebounded by $30 million from the first quarter to the second quarter and some of that is related to many of our products and procedures. They just can't be deferred for that long of a period of time without doing serious injury to a patient or making a patient's situation worse. So again, there are parts of the portfolio that are lagging, and those will come back. And so you'll see a bit of accelerant as it relates to COVID recovery. The second area is around international expansion, particularly China and Japan, but even other areas of international expansion as we think about other areas in Asia Pacific, as an example. Korea and Taiwan are examples of that. But certainly, our expectation for China and Japan will be high single-digit growth for the near-term horizon, and that will add some nice acceleration over the next 12 to 18 months. CereLink is certainly a catalyst within the CSS business. We can talk about CereLink a little bit more in detail later, Drew, but this is a product that we are launching here. It's a commercial launch, a limited launch here in the third quarter. And our full market release is planned for the fourth quarter. And this is, as a reminder, a razor blade type of product. So you have the initial equipment sale, which is probably in that 30,000 type of level. And then it has a nice recurring revenue stream from a microsensor product. And so as you seed the market with the installed base, the capital sale, then subsequently you'll get the disposal of recurring revenue over time. We'll be launching that here in the U.S. and Europe first and then taking that to China in 2025. So it has -- this is a product that has multi-years of opportunities that contribute nicely to our revenue growth. And then the last piece I would talk about on the CSS side, and then I'll switch to the TT side is for CSS, we talk about our Aurora Surgiscope. This is a product we acquired back in the fall of 2019 with an acquisition called Rebound. And it's a great opportunity. It was pre-revenue at the time that we purchased it, put some additional investment in this. And we are doing a limited clinical launch here in the second half of 2020. So it's not a significant revenue driver in 2021 or 2022, but more of a revenue driver for us in 2023. Two shots on goal here to really transform neurosurgery. The first is related to minimally evasive surgery. As it relates to neurosurgery, think of that as a burr hole type of approach rather than an open flap to get after tissue tumors as an example. And then the second shot on goal is deep bleeds in the brain associated with the stroke market, where there really hasn't been any opportunity for medical intervention here other than medical management here. So that's another opportunity for us. And then switching to the TT side, there is really a number of great things happening here, the ACell acquisition, maybe a slower start certainly in 2021. But remember, this will move to organic growth in 2022 when we anniversary our first -- the date that we closed the transaction on January 20. And so -- that's where we'll start. Again, if you can -- have confidence in the Integra team that we can turn that slower start around, which we believe we can, then everything is fixable here, and it's just we've underestimated the COVID impact as we integrated this business. That will all move to organic growth and will be some nice upside for us as we move into 2022. Just a few other opportunities then on the tissue technology, if I could just have a few minutes on. The next one is the diabetic foot ulcer study that was published here in the summer related to our product called PriMatrix. And why this is important for our portfolio is the product has been around, but we've had limited reimbursement coverage that really was limited to only Medicare and Medicaid. And we haven't had a ton of private commercial payer reimbursement. The opportunity here is to take this study, which, again, was very favorable to the outcomes of PriMatrix and go to the various hospitals to get that increased reimbursement coverage. So the covered lives here almost doubled by having this opportunity to get that additional insurance coverage. And then 2 more opportunities here I just want to touch on. NeuraGen 3D. We launched that here in early 2022. That gives us a solution that goes after the mid-gap repair for nerve. Our current product on the market is for long or short -- I'm sorry, for short gap repair only. This gets us to mid-gap, which approximately is about half of the market opportunity. Now we still need long gap, and we're working on that. But incrementally, this is helpful to get that mid-gap product solution out in the market in 2022. And the last one, which, again, as I think about potential home runs in our portfolio, this one is one that definitely can be characterized that way is the SurgiMend opportunity to get a breast indication for breast reconstruction surgery. There's no other -- there's no product on the market today that has an indication for breast reconstruction. We, like others, have a general surgical reconstruction indication, but not a specific breast reconstruction one. 90% of this market is human ADM, and they don't have a breast indication either. And so we've been working very closely with the FDA to get our PMA filed, which we've done here in the summer. And the great news is that on October 20, we have our panel discussion with the FDA, which is the first step in a multi-step process to get that breast indication. There's 3 things that, that panel will discuss and that's around safety, efficacy as well as the risk, benefit, reward trade-off here. But we're really excited about that. And that puts us potentially on a pathway by 2023 to have that breast indication. So I know it's a long answer, Drew, but I wanted to give you some of the things that we get really excited about that really give us more confidence in that 5% to 7% organic growth number. Drew?

No, that -- It's a lot to unpack, and I have some follow-up questions in there. But maybe on ACell for a moment, you mentioned that there were some -- not integration challenges, but COVID has kind of been a barrier headwind to the acquisition. But I mean, do you think that ACell revenues can return to kind of a pre-acquisition run rate? I mean I think it might have been $100 million. Is that kind of the right way to think about it for 2022, assuming we get through COVID and any variants?

Yes. I'm not in a position to talk about 2022, but what I can talk about is the things that we're doing with ACell. Certainly, I'll take you back to when we did the acquisition of ACell. It was a business that was not even breakeven. So it was not a profitable business. And we needed to identify cost synergies as we think about our own financial criteria for that acquisition. And it's not surprising that the bulk of those cost synergies were identified in the selling channel. It's a very complementary product, sits on many of our existing call points from a sales channel perspective. And so we went aggressively after realizing those cost synergies. And so day 1 of the acquisition, we took over some of the ACell representatives, but most of those we did not take over. And so what you had is essentially taking the existing ACell portfolio and dropping in largely to the existing Integra legacy sales team. I think what we underestimated is the difficulty of that integration when you're -- when you've got essentially a brand-new sales team that doesn't have the relationships on that product and has restricted access because of COVID. And so certainly, Q2 did not play out relative to our expectations. The sales came in slightly lower than our expectations, and we did lower guidance for the full year. I think the restricted access will continue to be a headwind for us as we look into Q3. And we'll see where Q3 lands for ACell. But again, I point to that these disruptions are temporary in nature. I go back to the initial reasons why we did the deal, and there's nothing that has changed for us and our excitement for this portfolio and this asset. The products here are very complementary. A couple of products that are key for us. A little bit less than 50% of ACell's revenue is in powderized MicroMatrix product. We don't have anything like that in our existing portfolio. Really excited about being able to sell that in by itself, but also in concert with many of the skin products. In addition, on the complex hernia side of the business, they have a product called Gentrix, and they have a laparoscopic indication, which we do not have on our SurgiMend product. So incrementally, again, it is additive to the portfolio here. So certainly, our expectation is that we can get this business back to an accelerated level, and it would grow in line with the rest of the TT business, which is again in that 7% to 9%. Drew, I can't hear your...

Sorry about that. First time I didn't unmute myself. So with the SurgiMend's panel coming up on October 20, just -- I know that there's still some time, there's still some milestones that you have to go through to get approval for it. But how should we kind of think about the ultimate opportunity for you? And kind of what's the lift to proceed commercially? Is it just getting the word out to surgeons? Or kind of what are the education and training initiatives that have to go behind the launch of a -- for a product like this?

Yes. So let's stand back and talk about the market opportunity first in the area of breast reconstruction. The market today is about $500 million. We expect that market to grow at about 12%. And by 2025, to be a market size of $900 million. So the market itself is a fast-growing market for us, and we think we're well-positioned to capitalize that with SurgiMend. Now again, remember, there's no product out there that has a specific indication for breast reconstruction. So as I think about that market opportunity going from $500 million to $900 million, that's an opportunity for us, again, to have that specific indication and hopefully be a leader in this space to really drive that growth. I think the important thing to understand is that more and more of the breast reconstruction procedures are going above the pectoral muscle. So you hear this subpec and pre-pec. A lot of the procedures up into this point have been subpec. And that's the initial indication that we're going after is the subpec indication. But there's also an opportunity to surgically do a pre-pectoral. So it's essentially that the SurgiMend product is overlaid over top of the breast over the pectoral muscle. There's a lot of reasons why the surgical procedures are moving that way, better outcomes, better -- less pain. And so we do believe that over time, as we move this market, more and more is going to go to this pre-pec type of procedure. SurgiMend lends itself really well compared to a human ADM. And the reason why that it lends itself to this pre-pectoral process is the uniformity and the large sizes that you can get with an engineered product like SurgiMend, a bovine product, as opposed to a human ADM product where you're much more limited in terms of uniformity and size. So we're really excited about this. But as I mentioned, this -- getting the indication is a multi-step process. No doubt the October 20 panel discussion is a critical first step in this multi-process, but you've also got to get product manufacturing approval and you've got some post-market surveillance studies that you have to do as well. So it is a long process, but one that we've been working very closely on with the FDA. And we think -- remember, this is a product that's been out there for 15 years. We've been selling it. We just don't have a specific indication. So when you get that specific indication, all of your literature can then change. We cannot promote for the surgical -- for breast reconstruction. So once we get that indication, we can actively start promoting for breast reconstruction.

Got it. I know we're getting close to the top of the session here, but just in terms of margins for a moment. Just from being an observer of the company, it sounds like -- it seems like margins have been a pretty solid bright spot for the company over the past several years. So maybe kind of -- is that right, kind of what are you expecting in terms of some margin levers coming up? And are you seeing any near-term supply disruptions, inflationary costs or anything that you call out?

Yes. On my second quarter call, I did talk about some inflation or some headwinds as it relates to gross margins. It's interesting how that plays out with COVID because what's -- some pressure on gross margin is actually some tailwinds on the OpEx line. So the biggest impacts we're seeing right now on the gross margin line that impacted my first half margins was around labor constraints and material inflation, mainly in the specifics around freight increases. Labor, it's interesting because it creates an issue in our factories because you can't get folks in your factories to build your product, and so you end up having some idle capacity costs and fixed costs that can't be absorbed. And for us, we take those as period costs through the P&L at the time you're experiencing that idle capacity as well as some incremental freight costs as well that hit you associated with getting product where you need it to be. The opposite is happening in my SG&A line, right? I can't get those positions filled. And therefore, my operating expenditures are coming in lighter than I intended them to be. So ultimately, you can still get EBITDA margin expansion in 2021. And so I think that's largely how things will play out for 2021 is that we'll still see some margin expansion on the EBITDA line because of the fact that operating expenses are just not ramping as fast as we expected them. But in my mind, that's temporary. At some point, your margins will -- your operating expenses will normalize here as your revenue recovers. And then I go back to, once we get through some of these COVID aftershocks, and I do expect and hope that some of this material inflation and these labor issues we're seeing will be temporary. How long they play out, I don't know. And we're certainly working on our own contingency plans for those and looking at actions to recover price and other initiatives in-house to work to offset that margin pressure. But the rest of the margin levers that we talked about, Drew, in the past are still there. On mix line, there's a few levers there. There is the work that we've done around getting out of discontinued products, products that are not strategic fits that are dilutive to growth, dilutive to margins. The bulk of that work being completed between 2019 and 2021. A little bit of tail here left in 2022. The overall new product introductions add incrementally to margins and the whole mix shift. If TT is growing at 7% to 9% compared to CSS growing at 3% to 5%, that is a favorable mix equation as tissue technology has a higher margin profile than CSS. And then there's a few other manufacturing levers that we still have in the toolkit here. We have -- getting off of that TMA agreement, we talked about related to Codman here at the end of the year. And then at the end of 2022, closing another high-cost facility in France, that will add to that lever here for gross margin expansion. So hopefully, that gives you a sense that there's a lot of still opportunities to improve margins. We got to get through some of these temporary aftershocks related to COVID though.

Very good. Unfortunately, we've hit the top of our session time, Carrie, but I really appreciate you being here and Mike as well. Thanks so much for the update and a great discussion.

Thanks, Drew. Really appreciate it.

Thanks, Drew.