Avanos Medical, Inc. (AVNS) Q2 2015 Earnings Report, Transcript and Summary

Good morning, and welcome to the Halyard Health 2015 Q2 Earnings Results Conference call. All participants will be in listen-only mode. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to David Crawford from Investor Relations. Please go ahead, sir.

Thank you, Frank, and good morning, everyone. It's my pleasure to welcome you to Halyard's second quarter 2015 earnings conference call. With me this morning are Robert Abernathy, Chairman and CEO and Steve Voskuil, Senior Vice President and CFO. Robert will begin with an assessment of our second quarter performance and the progress we are making on our key priorities for 2015. Then Steve will review the second quarter results in more detail and provide his perspective on our outlook for the balance of the year. We will finish with Q&A. A presentation for today’s call is available in the Investors section of our website www.halyardhealth.com. As a reminder, our comments today contain forward-looking statements related to the company, our expected performance, economic conditions and our industry. No assurance can be given as to the future financial results. Actual results could differ materially from those in the forward-looking statements. For more information about forward-looking statements and the risk factors that could influence future results, please see today’s press release and our prior filings with the SEC. Additionally, we will be referring to adjusted results and outlook; both exclude certain items described in this morning’s press release. The press release has further information on these adjustments and reconciliations to comparable GAAP financial measures. Now I will turn the call over to Robert.

Thanks, Dave, and good morning, everyone. I appreciate your interest in Halyard Health. Today marks our first midyear update as an independent public company. It’s an important milestone for Halyard and we are glad to have you here with us. I am going to use today’s call to talk about two main topics. First, the short term headwinds impacting our Surgical and Infection Prevention or S&IP business that resulted in our decision to revise our annual guidance. Second, to tell you that while we are very focused on generating better top line performance in S&IP, we remain well positioned to execute our long-term strategy of transitioning our portfolio to higher margin medical devices. Steve will take you through a more detailed breakdown of our results and expectations for the back half of the year in a moment, but let me start by sharing some headlines from our business segments and details on our revised guidance. As we shared in our press release this morning, our second quarter sales were down by 3% on a constant currency basis versus last year due to lower volume and sales price in S&IP. We reported $0.52 adjusted diluted earnings per share driven by growth in Medical Devices and a gross margin in line with our plan. We also controlled discretionary spending to mitigate increased distribution cost and the impact of lower S&IP sales. While we are focused on cost control and have delayed or reduced some discretionary spending, we have approached cost management in a very deliberate manner to realize savings without sacrificing long term growth. For example, we are increasing investment in our interventional pain business to ensure we have resources to meet growing demand and further expand the market. In research and development, our new leadership team has evaluated the status of our current portfolio and is aligned on areas for increased investment. We anticipate increased R&D spending in the back half of the year. Now let’s transition to the business segments, starting with the look at our S&IP business where the soft quarter impacted overall results. S&IP’s challenges can be categorized in three areas. First, unfavorable currency exchange rates, second distributor inventory reductions in North America and third competitive pressure that has impacted both market share and price. With respect to Medical Devices, I am pleased to report this segment had a good quarter with 7% growth on a constant currency basis compared to last year and 5% growth including currency. As you know, our long term strategy is to transition our product portfolio to higher margin medical devices. We are encouraged by our performance at the midpoint of the year in our Medical Device segment and expect to continue on a positive trajectory throughout the back half of 2015. On an operational level, the spinoff is progressing on track and we are pleased with our development as an independent company. We’ve recently exited a number of transition services agreements and anticipate exiting many of the large remaining agreements in the next 60 days. As one important milestone, we recently completed our IT migration where we moved from Kimberly-Clark servers to externally hosted servers. This was a critical step in our transition that moves us closer to our separation and frees up resources to begin transforming our IT cost structure and preparing for potential M&A. We are on plan with our re-packaging and rebranding efforts. During the quarter, we transitioned our third category, surgical drapes and gowns and once again the customers’ reception has been positive. Our balance sheet remains strong. We have $114 million of cash following a $50 million debt repayment this quarter. This demonstrates our focus on allocating capital in an appropriate manner while leaving ourselves the flexibility to support our long term growth strategy of reinvesting in the business and pursuing opportunistic M&A. Now let me detail our revised guidance. As a result of our first half performance in S&IP, we are lowering our overall net sales guidance for the year to between negative 1% and negative 3% on a constant currency basis. Lower S&IP sales along with higher distribution cost and lower than anticipated commodity deflation led us to revise our adjusted diluted EPS guidance to between $1.90 and $2.10. Consistent with our historical results, we expect the fourth quarter to be stronger than the third quarter. Steve will give you some more color when we talk about key planning assumptions. To be clear, my management team and I are disappointed in the midyear results and the need to revise our guidance. We acknowledge the short term challenges facing S&IP and are focused on generating better top line results from this business segment in the near term. Make no mistake, while our long-term strategy is to transform our product portfolio to focus on medical devices, S&IP generates a significant amount of cash and is key to executing our strategy. Generating improved results from this segment is important. That said, we remain confident in our strategy for three reasons. The first, because of the current performance of our medical devices and our plan to unlock future growth in this segment. Second, our expectation for sequential improvement in the S&IP business in the back half of the year and finally because of the strong foundation of our balance sheet. With that, I will turn it over to Steve for some more detail on the second quarter and to discuss our outlook for the balance of the year.

Thank you, Robert. First, I would like to remind everyone that our results for 2014 reflect the business as it existed when it was part of Kimberly-Clark. Included in 2014 results are pre-spin cost associated with executing the spin-off. Let me start with some key information from our press release. The second quarter sales were $389 million, a 3% decrease in constant currency compared to the prior year. Adjusted operating margin was 12.4% for the quarter compared to the prior year at 17.2%. Adjusted EBITDA was $58 million compared to $81 million in the prior year. Now taking a more detailed look at our results for the second quarter, overall sales of $389 million were down 6% compared to $414 million a year ago. Exchange rates negatively impacted net sales by 3% or approximately $13 million. Volume decline contributed 1% and price decline contributed 2%. Adjusted gross margin declined from 37.5% a year ago to 35.4% as we had increased standalone cost and synergies associated with the spin-off. Favorable material costs during the quarter were offset by higher distribution costs, unfavorable currency exchange rates and price erosion in the exam gloves category. As a reminder, in the first quarter, we incurred higher distributions costs associated with the West Coast port disruption and we anticipated that some of these additional distribution costs would continue into the second quarter. In addition to the West Coast disruption, which is now behind us, we incurred additional synergies associating with establishing standalone distribution capabilities in Australia. Going forward, we anticipate these costs will continue and impact us by approximately $2 million in the back half of the year. For the quarter, adjusted operating profit was $48 million, down from $71 million a year ago. The decrease was driven by lower S&IP sales, higher distribution costs as well as increased standalone costs due to our spinoff, which are tracking to plan. During the quarter, we incurred $20 million of post spin related charges and $7 million in intangible amortization expense that were excluded from adjusted operating profit. As a result, adjusted operating profit margin was 12.4% for the quarter. Looking at our performance on a segment basis, first, S&IP net sales declined 11% in the quarter to $255 million, down 7% on a constant currency basis. For the quarter, S&IP operating profit fell to $26 million compared to $41 million in the prior year as a result of lower sales volume and price, unfavorable currency exchange rates, higher distribution costs, and anticipated higher standalone expenses. As Robert mentioned earlier, we faced some headwinds in this segment on favorable currency exchange rates, distributor inventory reductions and competitive pressure that impacted market share and pricing. Let me provide some additional background on each of these. First, we continue to see the impact of unfavorable currency exchange rates. In S&IP, the top line currency impact for the quarter versus last year was unfavorable by approximately $11 million or 4%. Second, we experienced distributor inventory reductions in North America. This resulted in decreased volume demand of approximately $4 million. We do not anticipate further reductions in the back half of the year. Finally, moving to competitive pressure, let met talk about market share and price. While we continue to gain new accounts in surgical drapes and gowns, we were unable to offset the impact of accounts lost in 2014 in North America and Europe. The volume loss in Europe in particular was a result of our strategic decision to exit unprofitable business. Meanwhile, in sterilization, we’ve seen two new entrants in the last 18 months, using rest of discounting [ph]. Despite these challenges, we’ve lost little market share and are defending our position through customer education and product innovation. As we think about the balance of the year, we will continue to vigorously defend our leading market share position in this category. With respect to net selling prices, they were 3% driven -- lower at 3%, driven primarily by exam gloves in North America. As an independent company, we have heightened our focus on building our exam glove business. As a result, exam glove volume increased in the second quarter. Customer reaction to our new Aquasoft glove has been positive, especially in Asia-Pacific, however, competition in this category remains intense. Lower nitrile costs and market pressures have caused price to deteriorate and we expect this to continue through the balance of the year. To put the decline in exam glove pricing in perspective, the change in net selling price for other S&IP categories was less than 1% for the quarter. Let’s now turn to our medical devices segment, where all categories had solid results for the quarter. Sales were up 5% to $127 million, compared to the prior year or up 7% on a constant currency basis. Results were driven by 7% higher volume, which was partially offset by 2% of unfavorable currency exchange rates. Interventional pain posted another robust quarter, up 33% overall with Coolief posting 68% growth in North America. As Robert mentioned, we are increasing our investment in this segment to build upon our momentum. Within the surgical pain category, we are seeing encouraging signs as the market dynamics appear to be improving. In the second quarter, on queue volume stabilized and improved sequentially. Medical devices operating profit for the quarter improved 34% to $33 million compared to $25 million a year ago. Our results were driven by higher sales and lower G&A expenses, related to reduced intangible amortization and lower litigations costs. Let’s turn to our balance sheet and cash generation. For the quarter, cash from operations was $16 million compared to $58 million a year ago. The decrease was the result of operating results and changes in working capital, including an inventory build as part of the brand transition and the asset reconfiguration in our non-woven facility. At quarter end, we had $114 million of cash on hand, down from the year end 2014 balance of $149 million, primarily due to the $50 million debt repayment. Our debt repayment demonstrates our commitment to allocate capital responsibly and to ensure we have the financial flexibility to pursue our growth agenda. Robert has already shared our revised full year net sales and adjusted diluted earnings guidance. Now, I’d like to review the key planning assumptions that we have revised and built in to that updated guidance. We’re at the midpoint of the year and S&IP sales are below our expectations. We anticipate continued lower pricing and volume for the balance of the year versus prior year. As a result, we now expect S&IP sales to decline 3% to 5% for the year on a constant currency basis. Based on our commodity outlook, we now anticipate less cost deflation in key inputs of $20 million to $25 million. Turning to capital allocation, we now expect capital spending to be at the low end of the range of $70 million to $75 million for the year. This is slightly above our long term target of 3% of net sales due to spin related projects. Now, I’ll briefly highlight our remaining 2015 key planning assumptions which we affirm. Device sales are performing in line with our expectations and we anticipate sales growth of 2% to 4% compared to 2014 on a constant currency basis. To support product innovation in our medical devices segment, we anticipate research and development investment of $30 million to $35 million. Exchanges rates remain volatile and we anticipate negative foreign currency translation to impact net sales at the high end of the 2.5% to 3.5% range. Additionally, we expect the negative currency impact on operating profit at the high end of our $10 million to $15 million range. For 2015, we anticipate spin related transitional cost to be in the range of $45 million to $55 million and we continue to forecast the total amount for 2014, ‘15 and ‘16 to be in the range of $60 million to $75 million. Our adjusted effective tax rate for 2015 is expected to be in the range of 37% to 39%. In summary, we have a heightened focus on improving S&IP results for the balance of the year, medical device performance as well as our separation are on track. And we remain in a solid position to execute our long term growth strategy. I will now turn the call back to Frank and we will take any questions.

Thank you. [Operator Instructions] First question comes from David Turkaly from JMP Securities. Please go ahead.

Hi, guys. This is John on for Dave. So first thing I wanted to ask about is, you mentioned the IT migration, but you’re now on externally hosted servers, and I was just wondering if you could walk us through that aspect of what you’re doing in your separation planned and what else needs to happen before you’d be sort of positioned to be able to integrate an acquisition?

Yeah, this was by far the biggest element in terms of risk for the year of the all transition services agreements we had was this transition away from the Kimberly-Clark hosted servers to an externally hosted servers, it was a migration of several days down over the last weekend and it was very successful, very smooth and efficient, so we’re pleased by that. That then frees up the IT organization, obviously there is additional follow-up to be done but that frees up the IT organization to focus on two things, first to get our IT costs down as we start to look to simplify and reduce our IT costs as a percent of sales. Second, it frees up that group to be able to do an acquisition in the future, where we have those resources available to make sure that we got a new company embedded within Halyard and that we could put all the financials and other operating systems in place for an efficient integration of the company. We said all along that we had to get past this date before even considering an acquisition of any sort, so we’re very pleased that we have successfully had the migration of the IT system, and it does position us to be more capable now to do an acquisition from this point forward.

Okay, and then the next one kind of in a similar vein, I was wondering if you could talk to us a little bit about the resources that you have in place, the business development team, the kind of people you hired, how active they are currently, just any color you can give us around that would be helpful.

Yeah, we’ll do. We do have a strong business development team that we put in place, part of that team was part of Kimberly-Clark and then others on the team had joined us. The team is predominately folks who have extensive healthcare experience as well as members who have experience in investment banking, the team has a brought range of skills in finance and analytics, we have the ability to analysis opportunities to work closely with bankers to be able to look at whether we can delivery synergies quickly and get an acquisition accretive over an acceptable period of time and return higher than our cost of capital. So we feel good about that organization. The individual leading that group has been with the healthcare business here at Halyard, part of that Kimberly-Clark for most of his career, we was responsible for doing the acquisitions back in the late 90s, early 2000s when we did TECNOL, and Ballard, and Safeskin, so he has a lot of experience with healthcare acquisitions.

Alright that’s helpful, that’s it from us this morning thanks guys.

Thank you John.

The next question comes from David Lewis from Morgan Stanley. Please go ahead.

Hello, this is actually Jon Demchick in for David. So wanted to start off on updated guidance. I mean, I think heading into the quarter, we expected a reduction in the guidance but the magnitude was probably a bit larger than we would have expected. Obviously the two main adjustments coming from the S&IP and then also on the EPS side. So just starting off focusing on the S&IP segment, so volumes shelved quite a bit sequentially especially after you back out the larger headwind from pandemic spending that have impacted the first quarter and I think the pricing headwind is a pretty easier one to understand but I was wondering if you can give us a little more color behind the market share loss and more importantly, I was wondering if you could provide us with some reasons behind your confidence that there is going to sequential improvements at the back half of the year.

Yeah, let’s start with the market share loss first, we have seen some market share loss, we’d estimate that market share loss is at about $10 million in the second quarter but half of the shortfall to plan in S&IP would be market share loss, the share loss comes in sort of three categories; surgical, sterilization, and in the apparel category and what we’ve seen is some very aggressive pricing. But let me back up and talk about the share loss because some say, well did you loss contracts, the answer is no, we’ve maintained all our GPO contracts, new contracts that have been negotiated, we’d have been able to renew those contracts. Most of the contracts as you know are either single-sourced contracts, dual contracts or multi-contracts, meaning you have three or more on there. Where we’ve seen some share loss is in those duals and multi-contracts where you’re in then trying to negotiate with individual hospitals or hospital networks, and so we have seen share loss in those three categories; surgical, sterilization and apparel. We are seeing some price loss as well were competitors are prepared to go in with pretty low pricing due to the low commodity pricing that we’re experiencing now. So that’s the share loss portion. Why do we think sequentially that we’ll get better for the rest of the year, we have a number of new accounts that we see coming online for the rest of year, we’re focused on growing our glove business so that we can get glove contracts coming on for the rest of year or picked up glove business for the rest of year. So that part gives us confidence that we’re going to start to see some sequential improvements.

Thank you, very, very helpful. On the EPS side, I guess the reduction there was a little large than we would have expected, kind of the running the math, it sounds likes half of the reduction is probably associated with lower S&IP sales, then maybe there is another $0.10 associated with the distribution costs as well as the lower commodity benefits. I was just wondering if there is anything else kind of going into the reduction here those are really the main points. And then, kind of also running the math it seems like margins are expected to kind of stay at the current level and do you see them improving into the back half of the year or you think the kind of where we’re exiting 2Q is where we should really be expecting it to the balance. Thank you.

Let me start with the last question first, the margins we expect assuming commodities don’t move dramatically, we expect margins to be similar to where they are now. We’re on plan, we’d always talked about once we fill out all the capabilities to be an independent publically traded company that we’d see gross margins come down about 200 basis points and operating margins come down about 500 basis points and that’s exactly what’s happened so far. So we think the margins are in the range, I mean they would be up or down 50 basis points at given anytime but they are in the right ballpark. Moving to the guidance movement, you have each part almost exactly right Jon, the way we profiled it, of the $0.40 decline in our guidance, we said about half of that is the volume and price loss, again S&IP, we would then say distribution is a full $0.10 by itself. We then got currency and commodities as kind of one big bucket, add another $0.10 and then there is a hit to cost of sales at about $0.10 which is offset by some Opex savings that we’ve seen. So that nets you out at about that $0.40 drop that we have but by far the biggest impact, half of it is the volume decline and price loss in S&IP.

Thank you, that was very clear. And then just one follow-up on M&A plans kind of following up on John’s question from earlier. Do you have a specific focus on size and I think earlier you guys talked about maybe the max size that you’d go up to is about $500 million than last quarter, I think it maybe inched up a little bit. Do you guys have a preference to go more of a larger deal versus more of a tuck-in variety and does recent performance in the S&IP segment maybe changed the urgency in getting a deal done or is it still a status quo?

Well, let me start by saying a key part of our strategy is to dramatically shift the portfolio toward more of the high margin medical devices and we’re going to do that through growing organically our current medical devices and through acquisition of medical device products or companies. We’ve always had an urgency to get the acquisitions started early in 2016 and we haven’t changed that opinion. We feel very good about our balance sheet, giving us the flexibility to do that. We feel very good about the fact that we’re efficiently getting the transition services agreements exited and that’s setting us up to be able to move to a phase where we can start thinking specifically about companies and product lines to acquire. We’ve also been taking our Board of Directors through very rigorous process, strategy development process to get them aligned on the sort of companies and the product lines that we would be interested in buying. So, that’s how far we progressed so far. Size of the acquisitions, we haven’t limited ourselves saying they have to small tuck-ins. We haven’t said, they need to be above a certain size. We’re really looking more at whether they’d strategically fit our business, do they offer higher growth in our current medical devices, do they offer better margins than our current medical devices, do they fit in terms of our product portfolios such that we can get synergies in year one, both sales synergies and manufacturing synergies. So, that’s really how we thought about it.

Understood. Thank you very much.

[Operator Instructions] Next question comes from Larry Keusch from Raymond James. Please go ahead, sir.

Hi, good morning. I was wondering, Robert, if you could start off a little bit just thinking about the M&A strategy in a slightly different way, which is given the size of the S&IP business and the margin profile of it, just trying to think about over the next couple of years, how we should be thinking about the move towards higher margin products, because obviously it’s the smaller acquisitions going to take a lot longer to influence the overall profile of the business. So, maybe just help us calibrate a little bit as to how we should be thinking about this over the next several years.

Yeah, I think the way I think about it, Larry, is number one, S&IP, we got to protect that business, we got to make sure that it continues to generate the cash flow that has historically generated. So, the focus on S&IP is going to be to shore that business up, stabilize it, get it back into a stronger position in terms of volume growth and minimized price loss. Historically, in that business, we have seen volume up 1%, price down 1% and obviously in the first six months of this year, it has not performed to that profile. So, we need to focus on that. But the entire M&A activity is going to be on medical devices. So, we’re not thinking about any M&A within the S&IP categories. In the end, it’s all about how fast can you go, how much financial flexibility do we have, how close do we want to buff up against our banking covenant ceilings, how much do we want to go outside the range of our current credit ratings and we set all along, we’re prepared to stretch that but we like to be able to get back to our current credit ratings over time and work with the rating agencies to allow that to happen. We profiled that and say that over about a five year time period, we believe we can get to where we are 50% medical devices and 50% S&IP by effectively using cash available to us while maintaining our current credit rating. It doesn’t rule out a transformative acquisition where we’d say we’re prepared to go outside of those planning assumptions but that’s the planning assumptions we’ve talked most frequently with investors as well as our Board of Directors.

Okay. That’s really helpful. And then, you partially answered this, but I just wanted to dive back in if I could, so, obviously S&IP business remains very important from a cash flow perspective and so, you’re sort of talking about again needing to execute in that business but again over the -- given what we’ve seen in the first six months, maybe just specifically can or to the extent that you can, just help us understand what the strategy really is to kind of shore that business up and make sure that it’s generating cash flows that are necessary. I guess part of the question, do you think the S&IP business, given where we are today, is capable of generating the historic cash flows that it has?

The answer is yes. I think it is capable of generating the historic cash flows that it has. It’s a strong business, a stable business. These are product categories that are critically important in hospitals for preventing infection and as hospital utilization grows, we expect these categories to grow. I am expecting higher price loss, that’s the one thing that with low oil prices leading to low monomer prices, we are expecting potentially higher price loss than we’ve experienced in the past, particularly in some categories where folks now look and say, boy, it’s possible that oil prices could stay down for a number of quarters or even a number of years. So, as a result of that, competitors are far more likely to come in with slightly lower prices realizing there is less risk that the commodity goes up dramatically and you get saddled with a very low cost unprofitable contract. So, I think that dynamic has shifted but over time, our strategy is to continue to aggressively our cost, our manufacturing cost, our distribution cost and to dramatically change our product designs with design for value products. You’ll see more and more products where just like our AERO BLUE gown where we got a more protective front panel on a surgical gown, but then a less expensive lighter weight and more breathable back material to allow us to have higher margins with lower cost materials. So, it’s a matter of continually transitioning the products to lower costs, so that we can maintain margins in the business, while we also work on improving the volume.

Okay, great. And then just lastly, the R&D, which you’ve indicated, I believe it will be in that $30 million, $35 million for the year. I think if I did the math right, you’re kind of in the 12-ish million range for the first half. I know you indicated that that would pick up in the second half of the year, but are those kind of firm numbers where the projects are there and will be kicking off or is it possible that that number does come in lower?

No, those are firm numbers, and we’re confident we’re on track to double our research spending over a four-year time period. We’re ramping up this year. We got a new leadership team in our research and development area. We have specific projects that are now being funded. We had a fun exercise across all of the technology teams and marketing teams within how -- where we did, what we call [indiscernible]. We then selected a number of key projects to begin investments and these are new to Halyard, new to these category opportunities. We started funding those now. A lot of that funding comes in the second half of the year. And we’re confident that we’re going to be in that $30 million to $35 million research spend range by year end.

Okay. Terrific. Thanks for all the color. I appreciate it.

Thank you, Larry.

[Operator Instructions] This concludes our question-and-answer session. I’ll now like to turn the conference back over to Mr. Robert Abernathy for any closing remarks.

Well, thank you for your interest today in Halyard Health. Information about how to access today’s presentation can be found on the Investor Relations section of our website, halyardhealth.com. Thank you everyone.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect the line.