Good morning, and welcome to the Avanos Third Quarter 2018 Earnings Conference Call. [Operator Instructions] Please note this event is being recorded. I would now like to turn the conference over to Dave Crawford, Vice President of Investor Relations. Please go ahead.

Good morning, everyone, and thanks for joining us. It’s my pleasure to welcome you to the Avanos third quarter earnings conference call. With me this morning are Joe Woody, CEO; and Steve Voskuil, Senior Vice President and CFO. Joe will begin with a brief review of our financial performance, our progress on our 2018 priorities and an outlook for our business. Then Steve will review our results and offer additional detail on our financial performance and earnings outlook for 2018. We’ll finish the call with Q&A. A presentation for today’s call is available on the Investors Section of our website, avanos.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 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’ll be referring to adjusted results and outlook. The press release has information on these adjustments and reconciliations to comparable GAAP financial measures. Now I’ll turn the call over to Joe.

Thanks, Dave. Good morning, everyone, and thank you, for joining us on our third quarter earnings call. During the quarter, we continued to make significant progress on the transformation of our business with a focus on strategic investments and growth initiatives while streamlining our business and measuring our cost base. Overall, we delivered a solid performance this quarter with 10% topline growth and adjusted EPS of $0.37, ahead of our expectation. As a result, we are maintaining our full year 2018 adjusted diluted earnings per share guidance of $1.75 to $1.90. We are seeing continued momentum, particularly in Interventional Pain and Digestive Health, and Game Ready is already contributing to our performance. Looking ahead, several factors are expected to drive continued momentum over the long term. The continued strong demand for minimally invasive and nonsurgical outpatient procedures for joint, back and knee pain, the unmet need for non-opioid Pain Management solutions, highlighted by the recently passed bipartisan legislation, known as the SUPPORT for Patients and Communities Act and the continued strong market share in our Chronic Care portfolio with an opportunity to enhance growth internationally. Now I’d like to cover our franchises in more detail. In Interventional Pain, we delivered another quarter of significant double-digit growth in North America. We continue to invest in patient awareness to drive demand for COOLIEF. Our recent direct-to-patient television ad campaigns have been successful, and we will expand these over the coming quarter. Chronic Care grew in line with our mid-single-digit expectation. Digestive Health saw strong results and the market dynamics underlying the business are healthy. However, we expect to see softening in the Chronic Care business overall in the fourth quarter. This is due primarily to the timing of distributor purchases as they reduce inventory and some share loss in oral care. While…

Thanks, Joe, and good morning, everyone. I’m pleased we continued to deliver solid earnings and remain on schedule to deliver on our IT implementation and cost transformation goals. Overall, Avanos delivered sales of 165 million, an increase of 10%. Our Game Ready acquisition contributed 6% of the growth. Excluding Game Ready, volumes increased 4%, driven by continued robust demand in Interventional Pain and solid growth in Digestive Health. Growth was partially offset by unfavorable product mix and lower selling prices of 1%. Investment in direct-to-patient advertising accelerated our growth in COOLIEF as our overall Interventional Pain franchise delivered another quarter of double-digit sales growth in North America. In Digestive Health, we continue to make inroads in the alternative site market. We also saw volume growth in the 14 French Mic-Key GJ Tube, which we recently added to the portfolio to help round out our offering. Despite the strength in Digestive Health, we expect to see a temporary slowdown in growth in our Chronic Care franchise in the fourth quarter due to a couple of factors. First, we are seeing pressure from the timing of distributor orders. Second, we lost some oral care business due to internal capacity constraints. Our supply has been increased and we are now positioned to offset this loss and drive new business in 2019. These factors do not change our view of the growth potential of the Chronic Care business. Medical Device operating profit came in at 29 million for the quarter compared to 38 million a year ago, and operating margin was 18% compared to 25% last year. As we discussed over the last several quarters, we continue to increase investment for short- and long-term growth. During the quarter, we accelerated funding for clinical evidence to support the 2020 Cap 1 CPT code, elevated spending…

We’ll now begin the question-and-answer session. [Operator Instructions] And our first question comes from Larry Keusch of Raymond James.

So Joe, I’m wondering if you can talk a little bit again about the headwinds in the Acute Care pain segment. And what I’m really trying to understand I guess is, how much of this is being driven by shortages of drug supply versus your ability to transition people over to Leiters. And I guess the distribution situation, I guess, a little bit new to me. But just really trying to understand kind of how you would parse that out? And then looking forward, how do you see the kind of resolution of these things progressing?

Larry, I’ll just say a couple of things to you just about Q3, and then I’ll talk to about Acute Pain, in particular. We were above 3% with 4% volume for the quarter overall, which is roughly 1% to 2% mystic consensus. But very, very good performance in Chronic Care and had mid-single-digit, and IVP had double-digit. In terms of Acute Pain, the impact is primarily drug, it’s regulatory. And we’ve been told different stories from Pfizer and from PharMEDium on when they would come back into the market. We also had another filler go down that was a 1 point -- or 0.5 impact in the quarter. So overall, 2 percentage point impact in Acute Pain. We do have indications that Pfizer and PharMEDium are coming back, but they’ll come back gradually. If you take the drug, for example, there will be other uses for ropivacaine as an example, which is 70% of the drug that we use. So we do see it with us in the 2019. But we do see sort of the second half of ‘19 or into the second quarter of ‘19 being a bit better for us.

Maybe, Larry, just to pick up on the distributor side on the IV side that one we haven’t talked a lot about on the calls. But in the past typically year-end, sometimes in quarter 2, we talk about large distributor buys on that lower margin IV business and with a couple of the large distributors consolidating late in the summer, they’re working to consolidate inventories. And that in the past, where they would do a large quarter 4 buy to attain a rebate, I think the new ownership is not as intrigued by the rebate. And so we expect to see that order pattern actually normalize, kind of a onetime impact in Q4. And then normalize, little bit less bumpy profile in 2019.

And the IV impact is a onetime in Q4. But generally, overall, it’s frustrating on the Acute Pain supply side. But we feel confident in the business, feel like our thesis maintains that organic growth going forward at mid-single-digit is very achievable. We still have the capital to deploy. We’re still really $750 million or so for M&A and a very strong cost takeout program. So it’s a frustrating element with the drug supply, which I think everyone is aware of.

Okay. And then just as a follow-up question. Since you’ve mentioned M&A, I think Joe, you had certainly said in the past that it was your desire to try to get 2 deals announced in 2018. So here we are at the beginning of November and just again trying to take your temperature on kind of how you think that process is going, I certainly heard the comments that the pipeline sounds like it’s full and you guys are working on stuff. But again, just kind of want to take your temperature?

It is possible. We’re very active in dialogue in a number of areas. We would love to be able to conduct it whether or not that happens by the end of the year or just shortly as we turn the corner. After the New Year, it’s really hard for us to predict. But I am very, very encouraged by our pipeline and our efforts and the fact that in the near to midterm, we should see another acquisition for sure.

Our next question comes from Matt Mishan of KeyBanc. Please go ahead.

Just based on the supply shortage and -- any way you can tell us how many accounts are impacted by this order of magnitude? And then has it helped in any way increase penetration up this year. Are you going to lose sales from this long-term as a result of not being able to supply?

I’ll say a couple of things, Matt. Steve may want to add to it. But generally, we’ve talked about roughly $30 million in revenue being impacted. If you think about this and step back, really it’s actually about a 4 point headwind of which our team has really done a nice job mitigating 2% of it out by finding different fillers, working with our accounts and our pharmacies. Secondary to that, we’re extremely encouraged by our progress in incisional and conversions of orthopedic surgeons, which was our real strategy at the beginning of the year. In terms of customers coming back, I think if we look at Leiters as a new source, it’s really about their contracting, new contracting, looking at the quality and auditing process of those particular sites. And on then in the drug availability, as I said a moment ago, ropivacaine is used about 70% of the time in our pumps. And as ropivacaine comes back up to speed, there’ll be other sources that will be allocated from the various vendors. And that would be a slower process that’s impactful. But at the moment, we have not seen customers leaving the product when they’re using it, because they’re using it for different reasons, it’s 3 days of pain relief to getting patients up, for example, in a total knee walking around and a better health economic story.

Yes, all I would add, as you’d expect over time, we have seen more accounts impacted as those drug shortage and pre-fill issues have continued to linger. We do track at a fairly granular level, flosses and trading share with Pacira and other alternatives. I mean as Joe said, that really hasn’t been a big part of the story so far. Obviously, we’re anxious to get supply restored so that we can get back on the gas pedal.

And then a quick one on free cash flow. What was the tax payment that you had to make on the gain? Were there any other like moving pieces in there? And then did you get the $60 million cash inflow from, I think from divesture accounting that you are expecting as well?

Yes, the tax payment was about $65 million. And that was in line with what we had estimated at the time of the transaction. So it really was no surprise on that side. The other drawn cash for the quarter, as we still build some inventory in the third quarter as part of our rebranding effort, clearly, as we kind of get past that, we probably got another quarter of working through some of that rebranding. But we want to get that inventory brought back down a bit. Those are really the two biggest drivers for quarter three. Of course, untangling some of the free cash flow noise from the sale that we talked about in the second quarter earnings call kind of clouds up the picture. But those are really the two big drivers for Q3.

And Matt, this is Dave. One thing I’d say, with respect to additional cash, we got some of that in. The other piece is going to happen when we sell inventory back to Owens & Minor. And that’s scheduled to happen in the first half of 2019.

Okay. And then last question. You look at this -- you look at the quarter and what really stands out is gross margin and the strength there. But it seems like you guys were talking that down as unsustainable. Can you walk through the drivers of that again?

Yes, sure be happy to, Matt. We saw this a little bit the last couple of quarters. We’ll have a quarter where cost savings contribute a little bit more and we’ll get a little stronger result. We still expect where we’re at right now, I mean our transition at low-60s is the right ongoing landing spot. Obviously, it’s going to build up over time as some of those restructuring and broader cost savings kick in. But we did have a strong quarter plant performances, is very strong in the third quarter. But again, thinking about Q4, and probably looking ahead a little bit to ‘19, low-60s is still probably the right space to plan us for.

Our next question comes from Ravi Misra of Berenberg Capital Markets. Please go ahead.

So couple of thoughts there. Can you talk about what you think the outlook for the overall pump market is kind of annualizing at right now? And then where does that stabilize once these supply issues are resolved? And how do you guys kind of peg your growth against that once that’s all done? And then secondly just on this ON-Q with the shortage, how do we think about your ability to service existing versus new accounts? Can you talk a little bit about the growth dynamics there? I mean, is this limiting your ability to go after kind of new wins here or you just -- as you focus on existing customers, what’s the strategy there?

Ravi, all pump manufactures, anybody that sells pumps they are all being affected equally by this. However, we still believe this is a mid-single-digit growth that has a potential to move over time into high single-digit. And why we say that is because of the eagerness of the conversions and the customers that we are converting. And the ones that we are converting are either dealing with their own pharmacy or they have found another pre-filler they’re able to get drug. It’s more or less about a third of our customers that are impacted. And we’re still converting both incisional procedure surgeons as well as orthopedic surgeons. And the fact we are ahead of our plans there. So as we progress forward and we get more supply back and that sort of gradually comes back, we’ve seen ability for us to pick up again, which is why we are maintaining our thesis of overarching and mid-single-digit grower with more potential obviously as we make acquisition and as we improve our position in areas like international.

Yes, I would just say that as you can imagine the sales force gets frustrated when they’re converting new business and then you hit a supply issue, not being able to supply. And so I think we are all again anxious to get past this so the sales force could be more aggressive, kind of unleash them on some more of that new business. As Joe said, we’re gaining some new business. We wish we’re gaining more. And once this is behind us, we remain very optimistic about the long-term for this business and the pump growth for us in particular.

That’s encouraging to hear about the customer conversions. Can you maybe talk about the geographic mix there? I mean are those coming in the U.S., OUS? And what’s going on just in general broadly speaking OUS, can you highlight may be little bit about the contribution there to grow this quarter?

Ravi, broadly in the U.S., that’s where the Acute Pain business is primarily focused. We’re starting to introduce into both Europe and parts of Asia. And that will take some time. And there’ll be a smaller level of potential there. And again, remind me of the second part of your question there?

I was just curious about just overall OUS contribution to growth in the quarter?

Yes, is the greater part of the contribution.

Yes.

And internationally, you asked about is that we have Arjun Sarkar in place. We’re progressing on new strategy into 2019. And he is forming his team. And just came off of a strategic summit. This year, there’ll be an improvement in that business year-over-year. And there’ll be on or thereabouts on their internal plan. So we’re pleased with that. Today, 70% of our revenue or a little more is through distributors. It makes it a little lumpy quarter-to-quarter. And as we’ve talked about before, we want to go direct in focused markets that we’ll talk to everyone about, probably in on around JPMorgan and change that trajectory. So we have more of a leveled performance in that business. And one that really generates underlying growth.

And then maybe one last one, adjust on COOLIEF. I mean just at least in our model, if I’m thinking about it right. It looks like growth accelerated versus last quarter. Is that the right way to kind of think about this business? Is that correct? And then with the publications that you mentioned, are you planning -- are those going to be submitted to conferences or journals, where should we anticipate those reading about those next year?

So yes, we did have a slight uptick in the growth for the quarter in COOLIEF. And I think that’s based upon the direct-to-patient advertising. It’s just the general growth of the sale of capital and generators. And the -- a good bulk of the clinical studies are going to be available in Q1. We will be bringing those to conferences. But also more importantly, bringing those forward to the private commercial payers. And we’re in a constant dialogue with Medicare as well. And we’ll be working with the recent legislation that kind of bolsters our discussions. So as we said, we really are progressing to 2020 where we think we could have an inflection point in reimbursement.

[Operator Instructions] And our next question comes from Jonathan Demchick of Morgan Stanley.

Wanted to start off first really on what I guess guidance implies into the fourth quarter. Obviously, you have been growing kind of the mid-single digit rates. This last quarter was a little lower. But next quarter’s implied guidance kind of points to, I guess, mid-single-digit declines. Maybe that’s a total of, call it, $15 million of the delta. Obviously we have talked a lot about the issues in Acute Pain. But I was just hoping that you could may be kind of quantify as you kind of view it on how much of this has dropped from the dynamics. In Chronic Care that you talked about how much from the presale disruption? And then how much from the drug shortage? And then I have one quick follow-up.

Yes, maybe I’ll start with that one, and Joe can add commentary. But yes, mid-single digit decline that’s what implied by the guidance, so your math works the same as ours. The drivers, you kind of laid them out between ON-Q and really mid-single lift that we normally get in the fourth quarter because of the constraints on drug supply. And the distributor impact on IV. Those 2 pieces together are the vast majority of the change. Chronic Care does slow down. We talked about it on the -- under prepared remarks. We saw kind of a reversion back to mid-single digits for Q3. We do have some distributor pressures in that business for the fourth quarter. You might recall in the second quarter, we talked a little bit about distributor benefit for Chronic Care. We saw that level out a little bit in Q3. And we think we’re going to be seeing a negative impact a little bit of that in the fourth quarter. But the majority of the change for the fourth quarter is going to be on those 2 drivers in the Acute Pain business. Joe, anything you want to add to that?

No, I think it was good. And the only thing I would say is that Chronic Care business year-to-date is up high single-digit. It’s about 9%. And I’ve listened in on a couple of the other calls and there seems to be a bit of an inventory management, distributors in general. Because in Q1 and Q2, there’s a pretty heavy stocking of inventory through Q2, which frankly was interesting. But pretty much all the distributors continued, so outside of oral care, which we now have the team shifted on with the capacity in place, that’s more of a distributor timing piece. And again, IVP’s going to continue to be double-digit as we move in. So we have -- also have a -- the only thing that Steve didn’t mention is a really tough comparator, frankly, in Q4 because it was an 8% growth last year.

And then just a quick follow up on margins. Obviously, they were a bit stronger this quarter from the gross margin and the manufacturing benefits. You said, but kind of thinking into, I guess, 4Q and into next year, how should we be thinking about, I guess, synergies kind of stacking into the overall margin profile? And then also with the headwinds from ON-Q, is it possible to maybe quantify the type of margin headwind that could be moving forward?

Yes. I don’t know if I’ll -- I’ll kind of take the question of the second piece, and I’ll give you more specifics on the ON-Q. In fact, obviously, ON-Q is a profitable business. So that has an effect on the gross margin side that we have to overcome. Obviously, we’re able to do that in Q3 and for the full year as well with the guidance that we’ve provided. We’ll get more color on gross margin for 2019 as we get the -- have the fourth quarter earnings call. But you’re exactly right. We expect to see cost savings layering in. We didn’t have as much longer-term, to call it, restructuring cost savings in the 2018 plan. We do have more of that in the 2019 plan. This year, we’ve got dissynergies rolling through. We’ll have some of those roll through and get annualized into the 2019 gross margin as well. But we’ll begin to see some of those restructuring savouring’s layered on top. And so again more guidance to come on next year as we give that at the beginning of next year. But the big moving pieces are the ones we have talked about in the past.

Our next question comes from Kristen Stewart of Barclays. Please go ahead.

I wanted to maybe just walk through. I know, and I kind of appreciate that, maybe you don’t want to give guidance right now for 2019. But there just seems to be a lot of headwinds that are admittedly outside of your control going on now that it sounds like are going to impact 2019. And the numbers, if I just look at the third quarter performance or rather the second half performance, you’re looking at earnings that are roughly around $0.57. So that doesn’t necessarily annualized out so close to where the Street’s at for next year. So what are some of the puts and takes that we should be considering for 2019 in terms of your ability to perhaps offset some of these headwinds that are outside of your control or inability to do that? Any particular color that you could offer to help us get a little bit more comfortable on the outlook would be appreciated.

So, Kristen, welcome back, and happy to answer those questions. I’ll start. I think Steve will pick up a little bit then I’ll come back on some of the headwinds, what we are doing about that Acute Pain. So essentially, we’re going to give guidance in February for the full year. But I will say this, just at a high level, we expect continued momentum in IVP to be double-digit, and obviously, we talked about the reimbursement, and that area improving. Chronic Care, a mid-single-digit grower. It’s 9% year-to-date. It’s not really a business that’s going to stay at high single-digit. It’s more of a mid-single-digit going forward. It does have a tough comp though in Q1 because of the flu season. And then in Acute Pain, just to spend a moment, we absolutely see that as a mid-single-digit grower. We are -- our point-of-contacts together like Leiters with other fillers, we’re looking at more innovative approaches to the supply chain. Just reminding everybody, we sell the pumps. We don’t really sell the drug at all, and we don’t manufacture drug. And we don’t pre-fill. And so we sell the pumps. And these are regulatory issues that are moving targets. As I think everyone is probably aware with FDA warning letters, and when manufacturing is shut down. But essentially, we’re looking to broaden our supply chain and reduce the risk. And we have some innovative approaches that we think would help customers fill in a different way. They are more mid and longer term. And I do think the supply will come back. It’s already coming back. But it’s gradual because it was so severe, both on the drug and the pre-fill side. The last thing I’ll say is that, we’re going to have a good improvement in our international growth year-over-year. We put a new leader in place. And that’s the other opportunity for us, which is why we kind of come back to thesis intact. We feel very confident. I’ll let maybe Steve pick up on a couple of your other -- the elements of your question, Steve?

Yes, just on the margins and earnings side, I think as we’ve talked about in the past, we’re not giving guidance on 2019, but the fundamental dynamic inside the business of a portfolio where we get some natural accretion in gross margin over time with the mix of our products, of course, that’s impeded little bit right now with Acute Pain. But as Acute Pain comes fully back online over the course of next year, you’ll see more of that gross margin drop through. And then in addition, the next stage, the cost-saving program will also benefit next year. And a portion of that’s in the manufacturing area. And a portion of that will be throughout the rest of the business. And so we do expect to continue to see margin progression over time in this business. That’s a key plank of our strategy. And the transformation initiatives that support that are all on track. They don’t all get fully implemented in 2019. But we will begin to see some of those benefits roll through in 2019.

So the phasing of the cost savings over the next couple of years are still intact and you still feel good about the longer-term objectives as you outlined back in June, I guess it was?

We do. Yes, we will have more color on 2019 when we get closer. But absolutely, the fundamental thesis is the same. If you think about a -- again, as Joe mentioned earlier, a business where over time we can take mid-single-digit growth to high single-digit growth with the organic portfolio, the ability to drive leverage through the P&L on the back of the cost savings and that natural margin uplift that we’ve talked about at the gross margin levels. And then third, live capital deployment, particularly on external growth opportunities that ultimately are accretive to the margin structure. And so that fundamental thesis notwithstanding the challenges that we have right now in Acute Pain remains intact.

This concludes our question-and-answer session. I would like to turn the conference back over to Joe Woody, CEO, for any closing remarks.

I’d like to thank everybody for their interest in Avanos. As you can tell, I’m very confident in the business outlook, and our ability to achieve the goals that we have set for ourselves. The fundamentals of the business are solid. We’re well-positioned to continue to deliver value for our shareholders. And I do want to remind everyone that I will be presenting next Tuesday at the Stifel Healthcare Conference in New York. And information about how to access that presentation can be found in the Investor Relations section of our website avanos.com. Thank you, everybody.

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