Novanta Inc. (NOVT) Earnings Call Transcript & Summary

Good afternoon. My name is Raji Gunasekera. I'm an associate on the healthcare team at JPMorgan. I'm pleased to introduce the CEO of Novanta, Matthijs Glastra with me here today. Thank you.

Thank you. Good afternoon, everybody. It's great to be at the JPMorgan Healthcare Conference again. I will start with providing an overview in the presentation of Novanta and our strategy in high-growth markets. And then Robert Buckley, who's here with me, our CFO, will join me for a Q&A session. Before I get into the meat of the presentation, I just wanted to turn your attention into our safe harbor statement. I will be making some forward-looking statements as well as refer to non-GAAP financial measures, and you can see the details of the reconsolidation (sic) [ reconciliation ] of our GAAP to non-GAAP financial measures on our website. So moving on to Slide #3, the Novanta overview at a glance. We're about an $850 million revenue company, a technology provider of what we call mission-critical functionality to healthcare OEMs in advanced industrial OEMs. We're sole-sourced providers of that mission-critical functionality, working with the leaders in the industry in exciting areas such as robotic surgery, high-throughput DNA sequencing as well as minimally invasive surgery. Over 50% of our business is in healthcare markets that's up from about 5% 8 years ago. We're addressing a market of about $6 billion, growing nicely, mid- to high single digits, and you see we have a nice profit. So we're typically working with industry leaders in this space. You will see us working under the hood, working with those leaders on mission-critical technologies that really differentiate our OEM customers in their field. We work with about 3,500 customers worldwide. We're headquartered just outside of Boston with over 3,000 employees. So our operating model consists of 3 pillars: first, the differentiated OEM business model or businesses have -- and as part of core differentiated IP. So we have over 450 patents, 600 engineers. And we work very closely with the engineers of our customers to come up with unique solutions so that we just customize for our OEM customers. And then we come up with those solutions in platforms of our customers that are lasting often 10 years. So our customers are medical, healthcare equipment OEMs as well as industrial equipment OEMs. And for our size, we're fairly diversified. We address over 40 different applications. And no single customer is larger than 10% of our revenue. So as a result, in the last, let's say, 3 to 4 years, when you saw many macro shocks, our portfolio has been extremely resilient because of our diversification strategy, which is by design. So we sold these really high-value problems through differentiation, less than typically our a bill of -- our solutions are less than 10% of the bill of material to customers, so we have good pricing power. So the second pillar is focus on cash returns. We have an asset-light business model that produces nice cash flows, operating cash flow of about 100% of GAAP net income. We allocate our capital based on organic growth and return on invested capital, both on internal investments with the expense side of the business, R&D, marketing and sales as well as for acquisitions. We deployed over $750 million in acquisition capital over the last 8 to 9 years, where we have used the return on invested capital metric of 10% in year 2 for tuck-ins and 10% in year 4 for larger platform acquisitions. The last pillar is our high-performance collaboration culture, which we called the Novanta Way. And as core, our company consists of multiple autonomous business units, which we feel drives an owner mindset, entrepreneurial spirit, customer-focused agility, speed, which particularly, with changing market dynamics, are very useful. And then across these business units, we apply, of course, our common culture, the Novanta Way and an important aspect of that culture is the Novanta growth system that is our lean business system focused on driving both productivity as well as effectiveness of our growth engine. At Novanta, we spend a lot of time on -- so moving to Slide 5 now on where we play and how we win. So we have been very deliberate in choosing our end markets. Because as you imagine, our business model is one of long-term investment. So we often have to invest years ahead before our customers are introducing their platforms. And we, of course, want to do that in markets with customers that are growing and customers that are winning. And so we have aligned our portfolio with high-growth markets such as robotic surgery, minimally invasive surgery, high-throughput DNA sequencing, advanced diagnostics that aligned with long-term healthcare trends. And we all feel that these secular growth markets, particularly robotic surgery, DNA sequencing are in the early innings of what is going to be a very nice long-term growth trajectory. We went through innovation, so as I mentioned earlier, at the starting point. We're not a contract manufacturer. We're -- our starting point is our own proprietary IP. So industry leaders come to us for the unique solutions that we provide that they cannot find elsewhere. We have over 450 patents and spend 10% of revenue in R&D. In our medical business, actually, that percentage is higher. And more and more, we see increasing content with our OEM customers, where we move from components to intelligent subsystems with more and more embedded software content. So about 30% of our business is now in those intelligent subsystems, and we're investing to further increase that, which is both a growth engine as well as a margin enhancer. So the way we're structured is in 3 reporting segments that you can see here, fairly equally distributed from a revenue perspective. Like I mentioned, you see here the different business units with their own brand names, with their own general managers and with their own teams. But then across these groups, we might have either a common sales force or common manufacturing sites to drive synergies across the portfolio as well as, of course, we have shared services like HR, IT, finance across these organizations, corporate purchasing, which proved out to be a very good thing during the shortages as well as the Novanta growth system, which we drive across our businesses to improve the performance, the process excellence and customer satisfaction by driving process rigor. So let's dive into 3 particular examples that we -- that hopefully provides some color on what Novanta is doing. So Novanta is a leader in -- a leading supplier working with all the industry leaders in endoscopic surgery. So that's laparoscopy as well as arthroscopy. And when you look at an endoscope cart, you will find multiple Novanta technologies under the hood. I'm going to focus on one particular one where we are the category leader, that is smoke evacuation integrated with an insufflator. So when one per performs a laparoscopy procedure, one needs to insufflate the abdomen or the belly of the patients to create an imaging cavity for the surgeon to see. And Novanta is the category leader in that space. Now recently, there is more and more need to evacuate smoke that is generated by energy-based devices while operating. That smoke is not good for multiple reasons. One is that it's toxic and hospital staff inhaling a spoke, yes, of course, that's not healthy. So therefore, there is legislation being passed in multiple countries as well as states in the U.S. to make sure that hospitals allow or are mandated to use smoke evacuation technologies. The second reason why smoke is not productive is that it clouds the view of the surgeon and therefore, evacuating that smoke quicker and more effectively reduces time spent in the OR. Now there are different ways on how to evacuate smoke. There are stand-alone options or stand-alone solutions. Basically consider it a separate very sophisticated vacuum cleaner, basically cleaning out the smoke. The issue with that, though, is that you have another device, the insufflator pumping CO2 gas into the belly. So you've got competing forces in the abdomen of the patient, which creates an unstable situation, which surgeons don't like. The second, let's say, issue is that you have to engage with a separate piece of capital as well as chipsets. So integrating, basically, smoke evacuation in existing real estate, like an insufflator is there anyway, is more cost effective and also has better clinical benefits, which is the reason why a lot of OEMs have come to us with the request to introduce with them the next generation smoke evacuation integrated with insufflation. There's currently on leading OEM in the market, but in the next few years, multiple other OEMs will launch this technology as well. So that -- we're very excited about that. We also see a second growth driver in this business of, basically, convergence of robotic surgery with endoscopy. So we see robotic surgery in soft tissue needing this smoke evacuation technology as well. And the third growth driver in this business is that we can use the competence of gas pressure and gas management into liquid management, which is basically sophisticated pumps for arthroscopy, which is a business that we have fairly low market share in and that we've won some business in recently as well. So the combination of which will create about a $50 million opportunity by -- revenue opportunity by 2025 through these 3 drivers, which is kind of an intermediate calibration point because after that, the consumable business, that's also part of this business will start to kick in. So a very exciting growth opportunity for the company in an attractive space where we, over time, will see more mandates on smoke evacuation. And even there, we think that's early stages from a mandate perspective. And so a good example of where Novanta has proprietary technology, long-term relationships with multiple industry leaders in the business, which will drive long-term organic growth. The second example is, besides smoke evacuation and insufflation that is going to be used in robotic surgery, we have multiple other technologies that are being used in robotic surgery. A lot of it related to sensing and precision motion. And so you see here a sketch of the multiple locations in which our technology plays, both on the surgical console as well as on the robot itself. Our claim to fame is basically that we have the most accurate, precise position sensing. So when you want to move, which, of course, is mission-critical in robotic surgery, you need to know where you are and then -- through sensing. Then you need to know where you're going through very precise low-latent motion drives. And then, of course, you need to set the motion, including haptic feedback. So Novanta has all these capabilities in-house and can work with both heart tissue and soft tissue OEMs, by the way, which we are all supplying. So we work with all the well-known names here, depending on their needs to supply them with different combinations of competencies. Now robotic surgery, as you know, is still fairly early innings, less than 10% penetrated. We feel that by increasing both our content as well as presence in multiple platforms, we're really set up well for long-term growth in this area with multiple technologies. Last example is our intelligence solutions for advanced diagnostics. That's a broad field where we provide multiple technologies, again, working with multiple industry leaders. I will highlight a few examples and a few trends. So first and foremost, we're the leading provider, the sole provider of a sophisticated light laser engine subsystem for high-throughput DNA sequencing, where obviously, we're very excited to be part of a recent new product cycle where we see a tremendous demand, not only from the research but on the clinical side. And also their high-throughput DNA sequencing is fairly early innings in terms of penetration, less than 1% or 2% of the world's DNA has been sequenced. And we're, again, part of the core engine under the hood of that equipment. Another key trend is laboratory automation where, of course, more and more samples will have to be produced with fewer and fewer people. Here, we're -- this is an area well known. Other industries have gone through similar automation trends on the industrial side. And so we see this now moving into the advanced diagnostics side. So you see benefits of being playing in multiple end markets here. And so we're bringing multiple motion and sensing technologies to bear on the laboratory automation. And the last is the detection and analysis part of the business where we have both machine vision, barcode and RFID technologies to help to detect, let's say, the types of samples that need to go through the advanced diagnostic machine. So you can imagine that when we have conversations with OEMs, we can have multiple technology conversations depending on their needs. So hopefully, those are 3 good examples to give you an idea of the type of things that Novanta is doing. When you wrap it up, it -- ultimately our strategy results into a double-digit growth over a decade, both on the bottom and the top line. And so we're very excited about this performance, of course. We are very confident and are committed to continue this performance going forward, where the financial algorithm is basically mid- to high single-digit organic growth, augmented by acquisitions resulting into double-digit reported growth, expanding our gross margins by 100 basis points per year for the next few years to about 50% and continue to drive strong free cash flow, which we then can reinvest into the business as well as acquisitions. Last but not least, I would like to draw your attention on our ESG environmental, sustainability and governance framework. I mean you can read the targets and the goals here by yourself. But maybe it's good to point out is that our business is a very low carbon footprint business, basically the majority of our Scope 1 and 2, let's say, exposure is primarily the energy and the heating of our buildings. We're an asset-light and a low-CapEx business, so that's one thing. And so we, of course, committed to ultimately drive our exposure further down. The second piece that is important is on the S side is this, that for an engineering company, we are -- we have a truly embedded diversity, equity and inclusion effort that has been going on for multiple years that we feel sets us apart and differentiates us from other engineering companies and really is a part of the fabric, which we call the Novanta Way. It will help us actually create a better culture, but also it helps us find talent in all parts of the world in all places. And of course, you -- we will produce our next ESG report in, I think, March or April of this year to the 2022 report, according to standards that you can expect from us, so SASB and TCFD. So in summary, Novanta, a mission-critical technology provider towards healthcare OEMs, advanced industrial OEMs in exciting end markets such as robotic surgery, high-throughput DNA sequencing, minimally invasive surgery where we have unique technology leadership, working with the leaders in the business, in the industry that you would know, providing unique solutions that are sticky and sole-sourced towards these industry leaders, driving sustained long-term organic and reported growth profile that we're very excited about. So with that, I would like to turn it over to questions. I'd like to invite Robert here as well. [ Come up high or lower ] it down, so.

Thank you, Matthijs. We'll now open the room for any questions, please. Any questions? Okay. I can get us started with some easy ones, hopefully. Can you explain the competitive environment for your smoke evacuation technology and why you feel so confident about it?

Well, I covered it a little bit, but I can maybe go into a little bit more depth. We feel we have a unique advantage. I mean, I explained that there is a need for smoke evacuation, both for clinical as well as a safety perspective, that there is more and more legal mandates towards hospitals and states and countries that mandate hospitals to use smoke evacuation technologies. There are different options and they're not necessarily bad. We feel that our solution of using a proprietary smoke evacuation functionality included in what is already there, so the insufflator is a, more cost-effective. We've been using existing equipment and real estate that is already there. Secondly, there's a clinical benefit of creating a basically more stable abdomen during surgery, which is what surgeons need and would prefer. And that is based on the voice of customer input from key opinion leaders is what and our OEMs are telling us as well, which is why they're pulling for this technology. And the third is that there is a more optimized workflow by having everything integrated. You don't need to kind of worry about pushing multiple buttons of multiple nonintegrated pieces of equipment. So that's why we're excited about it. We're unique. It's based on proprietary IP that others don't have.

And can you explain what sort of visibility do you have into customer demand plans and also new product development plans?

So generally, we're tied into our OEM's engineering organization. So it's an engineer-to-engineer relationship and think of us as part of the supply chain of the OEMs themselves. So we -- the way the relationship works with our customers, that they're placing orders on us with their lead times, but they're giving us a rolling 12-month forecast. And so we have very good visibility over the next 12 months. But then from a new product introduction perspective, we're generally seeing what they're working on over the next 3 to 4 years. So we know the next platforms that are being developed and the types of technologies that they're expected to incorporate in those. And so we can make investment decisions around our own technologies as well as our facilities in order to ramp for the expected outcomes of those plans. So it's not uncommon for us, and we're doing this right now in the smoke evacuation. We've been investing for the last 4 years. We've now won the vast majority of platforms out there that we felt that we can address. We're looking at product launches starting in 2024, ramping in 2025 with $50 million of incremental revenue in 2025. We have very good visibility into that based on customer forecasts.

Okay. And in the same vein, can you sort of go over your long-term financial goals and also your long-term business plan goals?

So from a financial goal perspective, I think Matthijs talked a little bit about this. Think about it as mid-single-digit organic growth, achieving double-digit growth via acquisitions. We're driving the gross margin expansion of about 100 basis points a year upwards of 50% gross margins to really drive the contribution from those incremental sales. That should flow down to the EBITDA margin, and so seeing a similar type of expansion on an annualized basis on EBITDA, which then drives our free cash flows, the free cash flows that we use the excess free cash flow is to pay for acquisitions. We consider our acquisitions in really 2 categories, technology bolt-ons and then platform adjacencies. So very consistently, every year we deploy the excess free cash flows towards those type of acquisition targets, which then compound the earnings growth of the overall company, which has been driving the expansion that you see in the valuation.

And given what you know now, how do you see the 2023 macroeconomic environment impacting your company?