Ladies and gentlemen, thank you for standing by and welcome to the Integer Holdings Corporation Q3 2020 Earnings Conference Call. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to turn the call over to Anthony Borowicz, Senior Vice President of Strategy, Corporate Development and Investor Relations. Please go ahead.

Good morning, everyone. Thank you for joining us and welcome to Integer's Third Quarter 2020 Earnings Conference Call. With me today are Joe Dziedzic, President and Chief Executive Officer; and Jason Garland, Executive Vice President and Chief Financial Officer. As a reminder, the results and data we discuss today reflect the consolidated results of Integer for the periods indicated. During our call, we will discuss some non-GAAP measures. For reconciliation of these non-GAAP measures, please see the appendix of today's presentation and the notes of the financial statements in today's earnings release, which are available on our website at integer.net. Please note that today's presentation includes forward-looking statements. Please refer to the company's SEC filing for a discussion of the risk factors that could cause our actual results to differ materially. On today's call, Joe will provide his opening comments on the third quarter. Jason will then review our financial results and provide an update on the fourth quarter outlook. Joe will come back on to discuss the impacts of COVID on Integer sales and provide a review of our emerging customer portfolio. He will then provide his closing comments and we'll take your questions. At this point, I'll turn the call over to Joe for his comments.

Thank you, Tony, and thanks to everyone for joining the call today. Throughout the pandemic, we have remained focused on executing our strategy. And one of the best examples of this is our manufacturing excellence strategic imperative, which has positioned us incredibly well to be able to navigate the uncertainty that COVID created. The agility of the manufacturing team has displayed by being able to adjust to the fluctuating demand throughout our manufacturing footprint has been impressive and our associates continue to deliver for our customers and the patients they serve. Our associates that come into our manufacturing plants every day during this pandemic to deliver the products patients need are inspiring and enabling us to realize our vision of enhancing patients' lives. We have also been very focused on protecting the investments in our strategy, whether it's by adding more R&D resources to continue developing new products for our customers or adding additional capabilities that allow us to penetrate faster growing segments. We continue to add strategic talent to the organization that bring with them the skills necessary for us to accelerate our top line growth. From a third quarter perspective, what we communicated on our earnings call back at the end of July is fundamentally what we delivered. We said that our sales would be down slightly from the second quarter and they were, $4 million, right in line with what we expected internally. We also expected and communicated that the margin rate would improve in the third quarter versus the second quarter even though sales were down slightly and that is exactly what happened. We expanded margins by 150 basis points versus the second quarter. We have remained incredibly focused on working capital and driving cash flow. Despite the suppressed sales due to the pandemic, we were…

Thanks, Joe. Good morning, everyone, and thank you again for joining us today. I'll provide more details on our third quarter 2020 adjusted financials, provide an update on our cash flow and liquidity, and conclude with a high level view of our expectations for the fourth quarter and some preliminary thoughts on our 2021 sales. I'll start with our third quarter results, which as expected were meaningfully impacted by the COVID-19 pandemic. Sales decreased by 22% to $236 million. Adjusted operating income decreased 57% to $25 million, and adjusted EBITDA decreased 47%. We reported $17 million of adjusted net income, a decrease of 58%, and adjusted earnings per diluted share declines of $0.50. Though the profitability of the third quarter reflected the rapid decline in volume together with our decision to continue executing our strategy and maintaining the infrastructure to support the return of sales post COVID, it was improved over the second quarter. Consistent with our prior communication, the second quarter saw our lowest level of profitability. Following the third quarter, our focus on manufacturing excellence improved our ability to adjust favorable costs to lower sales volume and better manage the challenges of operating with social distancing. We are confident that having maintained strategic and often long-term investments throughout the pandemic, our customers and the patients we ultimately serve will benefit. Turning to the next slide. We see the graphical representation of the impact of 22% year-over-year reduction in sales had on our income. While improved over the second quarter, our balanced approach to cost management during a temporary but steep reduction in sales is seen in the operational drivers column and contributes a $29 million reduction in our adjusted net income in the third quarter versus last year. Our continued focus on debt and interest rate management as…

Thanks, Jason. Now let's talk about COVID and the impact that it had on Integer and the industry sales. We believe that whatever impact COVID has on our customer sales, it will ultimately flow through to Integer. But there will be a difference in timing because of where we are in the supply chain and in how the hospitals and our customers build and reduce inventory. We have talked about this dynamic on our last 2 earnings calls, and this quarter will be no different. What is different is our improved understanding of the timing difference between Integer and the industry sales. As we have studied the demand from our customers, it has become clearer to us that during the first quarter of this year, there was more inventory built in the industry than we initially realized. This became very evident as we analyze the demand from our customers for the third and fourth quarters. This caused us to look back at the first quarter when the pandemic had a much smaller impact on the industry sales. We estimate that the industry declined about 6% and Integer grew about 4% creating a 10 percentage point difference in the first quarter. This wasn't as evident to us as we entered the second quarter as we were managing through the immediate impacts of the pandemic. As we studied the demand from our customers and began to better understand the impact that industry inventory levels we're having on our third and fourth quarter sales, the impact from the first quarter became more evident. We believe the industry inventory build during the first half of 2020 is being depleted, potentially to lower levels than pre-COVID. This could be better inventory management or an overcorrection. It's hard to know at this time. One of the…

[Operator Instructions] Your first question comes from Matthew Mishan with KeyBanc.

A lot to take in here. I just first, once we reset in '21, are we still holding you accountable to a market plus 2% growth? Is that still the metric you're looking to achieve, especially with a customer that's insourcing in the out years now kind of creating an additional headwind?

Matt. Thanks for the question. And the answer is yes, absolutely. Our strategic goal is still to accelerate revenue growth to be 200 basis points faster than whatever the end markets that we serve are growing. And yes, Nevro is planning to insource a portion of their finished device assembly. And we have a strong pipeline of customers that we believe is going to help us offset -- more than offset that growth we thought it was important on this call to lay out some of the pipeline of customers and where they are in their evolution. Also, I'll point out with the customer that's going to insource. We also have vertical integration with components with that customer. They're still planning to have a second source for doing finished device assembly. So we'll still have vertically integrated components as well as, hopefully, some portion of the finished device assembly. So we remain confident that we can still achieve the 200 basis points above the end markets that we serve. We have not declared when that will happen. And we have a number of strategic imperatives underway and actions we've been taking to achieve that. But it does remain the goal, absolutely.

Okay. And then besides the emerging companies, so I think it's good to see a pipeline there. What's your understanding of your ability to win business with your largest customers moving forward? Is there still a level of increased outsourcing in the industry post this? And are they still consolidating to the largest, most strategic vendors? I mean just kind of can you give us confidence in the underlying fundamental positives of your business here?

We absolutely see continued growth. In fact, during the pandemic, we have not seen any slowdown in the amount of development work that we're doing with both the emerging customers or our larger OEM customers. We've talked about how we've added more R&D engineers this year than what we had in the budget. So despite the pandemic, we've continued to add more engineers than what we had even planned for this year. The development work and the activity level is still very high. And in fact, we've actually had several customers come to us to accelerate programs during the pandemic. I presume it's -- they've had capacity to accelerate the work -- the development work. And they also want to try to take advantage of this period where there is lower volumes. So we're seeing very strong development work. The quote activity that we see across the whole spectrum of our customer base continues to be very strong. We are improving our sales force excellence, our sales force capability. We've talked about the changes we've made with our sales leadership. We have entirely new sales leadership in all of our business units. And over the past 18 to 24 months, a little more than a 1/3 of our sales team has changed, as we've gone out and recruited additional talent capability, industry knowledge, product knowledge, customer knowledge that we believe is going to be very helpful to us achieving our goal of accelerating revenue growth to be 200 basis points above the market. And I would also highlight, we shared earlier this year that a little more than 2/3 of our revenue is under some point of a long-term agreement. And with the 3 largest customers representing about half of our revenues, that means that they have to be participating…

Okay. That was very helpful. Could you go a little bit more in detail on the minus 8% non-COVID impact in 4Q '20? And what -- and walk us through how you get there?

Absolutely. The single biggest driver. So let's just summarize. It's 4% for the full year. Two of those 3 items we talked about when we gave our guidance this year. We explained that we had $17 million of new vector sales in '19 that obviously don't repeat in '20 because of their bankruptcy. That impact was primarily first, second, a little bit in the third, not as much in the fourth. We talked about the fewer calendar days. We went to a calendar year for our fiscal year. Previously, we were on a rotation where every 6 or 7 years, we would have 53 weeks. We made that transition at the end of '19 in the full year of '20. So we highlighted that for the full year, we had about $10 million in lower sales in 2020 compared to '19, driven by fewer calendar days. And the way that works out by quarter is the first quarter actually had a little bit of a lift, and the fourth quarter has actually a bigger than $10 million negative impact. So the biggest driver of that 8% is the calendar days on a year-over-year basis. Those are the 2 items we talked about at the beginning of the year. And the third item that we weren't aware of at that time was the energy market contraction. And so that's fairly even throughout each of the quarters when you look at the non-medical business and the year-over-year sales for non-medical. So the biggest driver of the fourth quarter is the number of calendar days. And I would just point to, in summary, on a full year basis, we expect the impact of COVID on Integer to be the same as the industry. And we think the industry will have depleted the inventory that built in the first half. We think it will be depleted by year-end, maybe even a little more than depleted below pre-COVID levels because the inventory levels seem to be aggressively coming down, which is a good thing. It also could be because the industry seemed to have better sales in the third quarter than what they were projecting, which accelerated the inventory depletion. So that for the full year, we think that the difference between us and the industry are these 3 items that we've laid out.

Okay. Understood. And then just two more. First, are your customers managing their inventory differently than they have been in the past? Are they running at lower -- are they planning to lower levels of inventory given the uncertainty that they're seeing over the next couple of quarters?

It's hard to tell, Matt. I wish we had very -- I wish we had clarity on that to give you a direct answer. What is clear is our customers reacted to the pandemic in different ways. Some shut down their manufacturing plants very quickly, very deeply. We all know in April, customers were talking about a 50% reduction in sales due to the shutdown in the U.S. Well, most of our customers did not shut their manufacturing down or reduced manufacturing by 50%. They chose to run at higher levels to maintain some level of efficiency. Well, that was building inventory. That was a very conscious decision we believe they made, which is a trade-off between operational manufacturing efficiencies and building inventory. And so our customers are -- they're in different positions from a financial strength, cash flow liquidity perspective, and they made different decisions on that trade-off of cash flow and operational efficiencies. But what was very clear to us, there was inventory built in the first and second quarter. You see it in their external reported inventory balances. And then it's also clear to us in the third and fourth quarter, they're depleting that. In some instances, what we are seeing is a rapid depletion of that inventory, which will either be a new level of inventory or it will be an overcorrection and it may -- inventory levels may come back up. This is not across the entire industry. It's pockets. But it's why we show on our slide explaining the potential impact on industry and Integer. It's why we show 0% to negative 1% for the impact of COVID because inventory levels might be going a little bit below. I wish I had a direct answer for you. I don't know that they've articulated their strategies in that way. I know everybody wants to reduce inventory control inventory. But I also know that none of our customers want to miss an opportunity to ship a product or to support a patient in need. And so that's why they have inventory turns of 2 to 3x. So like times will tell. But in the end, it's rounding noise when you look at it on an annual basis and on a multiyear basis.

Okay. And last question. I think you're starting to see some long-term fundamental changes in how people view the oil and gas industry. Do you still consider the energy business and the non-medical business is core to Integer?

I like the business because even when it's down, it has a strong margin rate in returns. And when it's up, it has great returns and great margin rates and cash flow. One of the things that we need to do a better job of is we need to better diversify the markets and the regions that we participate in, which would help to mute some of the volatility that we see when there are meaningful changes in that very cyclical industry. That's part of what we're doing internally is we're looking for ways to diversify. 2/3 of that business serves the energy market and then the other 1/3 serves a multitude of other applications, government and environmental applications, and we think there's opportunities to grow there. So I love the profitability and the technology and the position we have in that market. We need to work to diversify it to mute some of the cyclicality of it.

[Operator Instructions] Your next question comes from Jim Sidoti with Sidoti & Company.

Well, first off, you seem to be right on the forecast you put out 3 months ago. And even with the pandemic, you've been able to hit the numbers that you put out, which is a big change from 2 or 3 years ago. What's responsible for that?

Jim, I'd start with -- I believe we've done a really good job of getting our arms around what our customers' needs are and then meeting those needs, and better understanding those needs on both a short and a long-term basis. And I think we're partnering with our customers really well to understand those needs and be able to meet them. I would say very specifically in the last 3 to 6 months -- or the last 3 months with the pandemic, what we've seen is a stabilization of our customers' short-term needs. We've done, I think a really good job of getting our arms around the next 90 to 120 days, and what our customers need in understanding that. There is fluctuation in that window. But outside of a pandemic like event, we think that visibility is pretty good, and we think our customers' manufacturing plants, which ultimately drive the demand on us is pretty good. And we've been able to dial that in in the last 3 or 4 months. I also think that the amount of inventory our customers have had has given them a buffer to not need to make meaningful changes in the third quarter or even maybe the fourth quarter of this year when they get back to maybe more normal levels of inventory in a steady state, we may go back to seeing a little more of the previous normal variation that we had. But I think it gets down to how we're running our business. The manufacturing excellence strategic imperative has helped us to develop that predictability. And I think the closeness with our customers has also improved dramatically and is also helping us.

Right. And then a couple of questions on Nevro. Does that announcement affect anything you're doing for them right now? Or is that future generation products that they've decided to build in house?

Great question. Great point. It's future generation product. The current generation is still under contract with us. And they also were clear that they plan to have a second source for the future generations. We are working to ensure that we are vertically integrated with our high technology components on that -- those future generation devices. And we're also working to ensure that we're the second source doing the finished device assembly.

So even if they start to build some of those products themselves, you still expect Nevro to be a customer in 2022, 2023?

Jim, we'll be their primary provider probably '22 and beyond for a number of years. They communicated their plant should be qualified in 2022, which means they'll start to ramp sometime in 2022 and 2023 and recognize they don't -- they don't do any manufacturing or assembly today. And so there will be a ramp period. So 2023 and 2024 is when we think we'll see the impact of that. But at the same time, it's future generation product and the future generation product isn't in the market yet. So we believe we still got a nice runway here. We're also partnering with [ Belmond ] on the vertical integration of components and being the second source. So we think it's 2023 and beyond, Jim. We also thought it was important to highlight the pipeline of customers that we have that are now entering the product launch phase and the revenues that we think they will generate in 2022. And then the success of those therapies will dictate how much they grow beyond that.

All right. And then the last one for me. You're obviously not the only company affected by the pandemic, and you've -- there is a lot of smaller private suppliers that probably been on the balance sheet you have and the flexibility you have. Are you able to pick up some of that business or maybe even pick up, do some acquisitions as a result of COVID?

Great question, Jim. I can't say that we've seen any acquisitions given that our focus has been very clearly on differentiated technology that fits into our portfolio and helps us accelerate growth and penetration into the faster growing end markets. So because we're so maybe laser focused on the technologies that we want, I think those other companies that might have been negatively impacted by the pandemic are less within our scope. And so I think that hasn't been a focus area for us. In terms of the pandemic, our financial strength I believe has absolutely helped us. The customers look at the landscape, and they see the differentiation of a player like us that's got the breadth and the scale, the capability across multiple end markets and the breadth of technologies we have. We all know every one of our big customers has said they want to reduce the number of suppliers. They want strategic partners. They want people that can do development work for them that they can rely on as their primary outsourced partner that gives them -- it makes it easier for them to manage their supply chain. We think that's a strength of ours is managing the supply chain, and our vertical integration we think differentiates us. So we think this just reinforces what we believe is our strength, and it just accelerates what's been a long-term trend to consolidate the supply base into your stronger, more capable partners, and we think that represents us.

There are no further questions come up at this time. I'll turn the call back over to Anthony Borowicz.

Great. Thank you, everyone for joining us on today's call and your continued interest in Integer. As always, this conference call will be available for replay on our website. Again, thank you, and that concludes our call.

This concludes today's conference call. You may now disconnect.