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Edited Transcript of CTEC.L earnings conference call or presentation 1-Aug-19 8:00am GMT

Half Year 2019 ConvaTec Group PLC Earnings Call

London Aug 6, 2019 (Thomson StreetEvents) -- Edited Transcript of ConvaTec Group PLC earnings conference call or presentation Thursday, August 1, 2019 at 8:00:00am GMT

TEXT version of Transcript

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Corporate Participants

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* David Shepherd

Convatec Group Plc - President of Advanced Wound Care Franchise

* Frank M. Schulkes

Convatec Group Plc - CFO & Director

* John Crosse

Convatec Group Plc - VP of IR

* Rick D. Anderson

Convatec Group Plc - Executive Chairman & Interim CEO

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Conference Call Participants

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* Amy Lucinda Walker

Peel Hunt LLP, Research Division - Analyst

* Christoph Gretler

Crédit Suisse AG, Research Division - MD in Equity Research

* Hassan Al-Wakeel

Barclays Bank PLC, Research Division - Research Analyst

* Michael Klaus Jungling

Morgan Stanley, Research Division - MD, Head of MedTech & Services and Analyst

* Nils Bartram

Carnegie Fonder AB - Portfolio Manager

* Nyeok Lee

Jefferies LLC, Research Division - Equity Associate

* Patrick Andrew Robert Wood

BofA Merrill Lynch, Research Division - Director in Equity Research and Head of the EMEA MedTech & Services Team

* Paul Cuddon

Numis Securities Limited, Research Division - Director for Healthcare Equity Research

* Sebastian Walker

UBS Investment Bank, Research Division - Associate Analyst

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Presentation

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John Crosse, Convatec Group Plc - VP of IR [1]

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Well, good morning, everybody, and a warm welcome to ConvaTec's interim results for 2019. I'm John Crosse, VP of Investor Relations. The usual housekeeping point before we start. There are no planned fire alarms today. So if the alarm does go off, it's a real one, and please follow the ConvaTec or UBS member of staff out of the building.

 

So without further ado, I will hand you over to Rick Anderson, our Executive Chairman. Rick?

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [2]

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Good morning. It's good to see you all this morning, and I see some familiar faces. First of all, welcome to our interim results presentation. I'm joined by Frank, our CFO; and David, our President of Advanced Wound Care. And I'm encouraged to say in the first half, we see an improving growth trend. Importantly, our Transformation Initiative is progressing well. So we're on track and that's why we're maintaining our full guidance today.

 

Now I'm going to take you through our -- the key points of our first half results, then I will ask Frank to take us through the numbers and operations, then I'll give you an over - a progress update on the Transformation Initiative, and David will tell you more about the turnaround of our U.S. Wound Care business. After that, we'll be happy to take your questions.

 

On Slide 4, here are the key points from our interim results. Group organic revenue grew 1% in the first half and that's excluding the one-off provision as a result of the rebate change that we highlighted in Q1. I'm pleased to say that we saw progress in the second quarter. Group organic revenue growth was 2.1% in Q2, and the growth was delivered across all franchises.

 

Our Transformation Initiative announced in February is on track. We anticipate an annual gross benefit of $130 million to $150 million in 2021, and I'll talk more about this later.

 

We have invested $14 million in the first half in the Transformation Initiative, and we've already seen some green shoots particularly in the U.S. Wound Care business, which David will cover.

 

Adjusted EBIT margin in the first half was 18.6%, and we've maintained our interim dividend. And leverage is 2.6x with continued good cash generation. So we believe we're in a good position to deliver on our plans for the year.

 

So on that note, let me hand over to Frank.

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Frank M. Schulkes, Convatec Group Plc - CFO & Director [3]

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Thanks, Rick. Good morning. So let me take you through our first half results in more detail starting with Slide 6.

 

So our first half numbers were in line with our expectations, and they reflected a more encouraging second quarter as we expected.

 

Group revenue in the first half was $889 million, declining 3.5% on a reported basis and taking out the impact of FX, and M&A organic growth was flat. And excluding the rebate provision, we were up 1%.

 

Adjusted gross margin was 58.6%, 70 basis points lower than last year. However, taking out the impact of FX and the one-off provision, we were flat year-over-year. And that's the result of positive net productivity, which helped offset price erosion and negative mix.

 

Our operating cost as a percentage of sales increased as expected, reflecting the investments related to the Transformation and MDR, which contributed 170 basis points of the total 280 basis points increase. We also continue to invest in commercial areas, regions and IT, partially offset by cost control in other areas. As a result, our adjusted EBIT margin was 18.6%, down 350 basis points from last year. We continue to deliver strong cash conversion reaching almost 90% in the first half, and debt leverage in the business has continued to come down to 2.6x from 2.8x this time last year.

 

Moving to Slide 7. As I said before, the second quarter was an encouraging quarter with growth across all franchises and an improving trend in Wound. Ostomy growth was modest as expected, CCC continued to grow ahead of the U.S. market and we also delivered decent growth in ID.

 

For the first half, organic revenue growth was 1%, excluding the one-off provision, with reported revenue declining 3.5%. And the difference of 450 basis points between the two is driven by 100 basis points from the one-off provision and about 360 basis points of FX headwind with a small offset from M&A.

 

On Slide 8, in Advanced Wound Care, we experienced an improving quarter-on-quarter with organic growth of 3.3%. Excluding the one-off provision, organic growth was flat in the first half.

 

Our AQUACEL Foam and anti-biofilm silver products performed well, but we saw continued challenges in our legacy products, in particular, base AQUACEL dressings and skincare.

 

Overall, in the second quarter, our skincare business was less of a drag to growth compared to the first quarter.

 

In U.S., we have completed our move to a specialized salesforce model, and lead indicators now show good momentum. David will provide more detail on that shortly.

 

AQUACEL Ag Advantage launched late last year has been positively received by clinicians. And although it's early days, we're seeing progress and are excited by the market opportunity for our Avelle disposable NPWT system. Furthermore, we saw a good momentum in markets in EMEA and APAC, while the U.K. market remains challenging.

 

Ostomy organic growth was 0.3% in the second quarter. Excluding the one-off provision taken in the first quarter, organic growth in the first half was 0.6%.

 

Overall, NPC remains resilient, but we are still seeing a downward trend in the U.S. We are in the process of improving performance of the commercial team. However, progress will take time given the nature of the business.

 

We continue to invest in and grow our me+ direct-to-consumer program, and we see traction with our more recent Convex product launches such as Esteem+ Flex and Natura Accordion. We continue to execute our strategy to return the franchise to consistent growth with a good performance in the second quarter in a number of markets in EMEA, in Latin America as well as Asia Pacific.

 

In CCC, revenue grew 2.8% on an organic basis in the second quarter driven by HDG. And excluding the one-off provision, organic growth in the first half was 3%. HDG continues to outgrow the overall U.S. continence market, albeit at a low level of growth than in prior years. We've seen good volume growth, partially offset by the inclusion of the lower growth in Continence business from Woodbury, which is now in our organic growth numbers.

 

Patient testing of our next-generation female catheter against the market leader generated very positive feedback, and this will be incorporated into our launch activity in Europe.

 

Finally, ID, revenue grew 1.9% in the second quarter and 0.8% in the first half despite a tough comp. We saw a strong order from customers during the first half, driven by continued growth in the insulin pump market.

 

Looking ahead, as we have mentioned before, we expect to see growth below historical market levels in ID in 2019 as a result of our customer, Animas, exiting the market.

 

On Slide 10, you can see more detail on our gross margin and costs in the first half. Starting on the left with gross margin. This was 58.6% in the first half, down 70 basis points from 2018. If you adjust for foreign exchange and the one-off provision, gross margin was flat year-over-year. And as I mentioned earlier, we saw a positive impact from net productivity gains, which helped offset the negative impact of price and mix.

 

Our OpEx grew to 40% of revenues in the first half, driven by the investments in Transformation and MDR as well as continued investments in commercial areas, regions and IT.

 

In the first half, we invested $14 million in Transformation out of an anticipated full year spend of about $40 million, and this was largely booked in G&A. We expect investments to increase in the second half as projects move from planning into execution.

 

Total OpEx as a percentage of sales grew 280 basis points. Transformation and MDR accounted for 170 basis points with the rest, a combination of commercial investments in HDG in China, in IT as well as labor rate inflation.

 

Moving to cash and leverage on Slide 11. Cash conversion in the first half improved to almost 90% from 75% in the first half of 2018. Leverage was 2.6x EBITDA. And for 2019 year-end, we expect leverage to be broadly flat versus 2018 due to the investments in Transformation and MDR. And overall, this demonstrates the strong cash generating ability of the company, and we continue to target 2x leverage over the medium term.

 

Finally, Slide 12, as Rick mentioned earlier, we are maintaining the guidance we outlined in February, which is 1% to 2.5% for organic revenue growth, including the negative impact of the one-off provision. We expect to see the improvement in the top line we experienced in the second quarter to continue in all franchises. And there will, of course, be some quarter-over-quarter movement.

 

For adjusted EBIT margin rate, we continue to expect to land between 18% and 20%, including Transformation and MDR as well as the one-off provision, with FX slightly worse than we planned. As we told you in February, we expect to spend about $50 million across Transformation and MDR in 2019, which is second half-weighted. Therefore, our guidance, excluding these investments, remains 21% to 22.5%.

 

Finally, below the EBIT line, we expect the book tax rate to be about 16.5% and net interest to be a couple of million lower than prior year.

 

And with that, I will hand back to Rick. Thank you.

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [4]

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Thank you, Frank. So to recap briefly, on Slide 14, what we said to you in February that our execution model needed to Pivot to Growth. And these are the principles that we talked about: simplify, innovate and segment. All 3 of these are supported by our commitment to invest in the business.

 

First, simplify. We want an organization that makes quicker decisions, more responsive to the market opportunities and has a lower cost-operating model. In the future, we have more focused franchises in leading positions, and we'll have a clear ConvaTec way of doing business to ensure operational excellence and consistency.

 

Next, innovate. We'll spend more in R&D and spend it better. We'll invest more in value-based clinical evidence to support product development. So in the future, we'll see more consistent pipeline of new products and services.

 

Thirdly, segment. Our goal here is to focus on premium markets, premium segments and attractive geographies. We will back our winners more heavily and be able to focus our firepower on the biggest opportunities, and we'll manage our portfolio more actively.

 

Clearly, this plan requires investment. So we'll increase our investment in key areas such as selling, distribution and R&D. And at the same time, we'll be more efficient and effective with our current spend and leverage our back office to reduce our G&A cost over time.

 

To make all that happen, we launched our Transformation Initiative. We have 4 work streams that we explained to you in February. Each of these is headed up by a member of the Executive Committee. Commercial excellence will drive more effective product launches, improve pricing and ensure we're focused on our customers. And David will take you through the elements of this in his presentation.

 

Operational excellence includes our efficiency program, which is already delivering benefits as Frank outlined.

 

Business service transformation will deliver savings in the back office, and the portfolio optimization will move our focus in the high-growth, high-margin segments and geographies. We said we're going to invest an additional $150 million in Transformation over the next 3 years with a split between OpEx and CapEx, and we expect to pay back over 2- to 3-year period.

 

In the first half, we invested $14 million out of an anticipated full year spend of $40 million. We'll invest more in the second half as project move from planning into execution.

 

Additionally, as we told you in February, we'll also be recurring cost of about $50 million per annum by 2021, building from our current $15 million this year. This will be related to our investment in U.S. Wound; our global catheter launch; our APAC expansion and our next-generation Ostomy products; and in ID, our continued expansion outside of diabetes.

 

Key in delivering our plans has been the setup of our Transformation office as a center of excellence. This is providing support and expertise to accelerate and amplify projects. We put in place clear accountability for delivery of projects and robust governance with detail-tracking of key milestones and weekly reviews of the program by myself, Frank and the executive team. Allocation of investment and resources is tightly controlled and what I'm seeing is a high say/do ratio. When people say they are going to do something, they do it.

 

The Transformation office will provide a model to be embedded more discipline and better execution into the business. And already, the lead indicators are encouraging and a ConvaTec way is emerging. And still early in the program. There's plenty more for us to do. But so far, I'm encouraged by what I see.

 

So what progress have we made with the Transformation Initiative in the first 6 months? We're now fully up to speed. And as I said, during the first half, we've established the Transformation office. We've identified and prioritized opportunities across all 4 work streams. We've begun execution in the first wave of those projects. We have business plans in-flight with clear accountability for delivery of projects and robust governance.

 

Our commercial excellence program is helping us drive more targeted and effective sales force in the U.S. Advanced Wound Care marketplace. There are opportunities to drive contract and pricing excellence to improve focus on top accounts.

 

Operational excellence delivered net productivity, positive productivity in the first half, as Frank mentioned.

 

In supply chain, we achieved $2 million run rate savings on ocean and air freight by changing suppliers and reducing express shipments. Another $2 million run rate savings was achieved in manufacturing through direct material savings.

 

In business services transformation, we've completed a detailed design phase. And in portfolio optimization, the analysis is ongoing with the opportunities identified, and we'll provide further detail in due course.

 

So pulling the Transformation Initiative together on Slide 18. As you know, we're investing $150 million. Overall, we anticipate annual gross benefits between $130 million and $150 million per annum in 2021. And that's an attractive gross return over 3 years of around $250 million.

 

And as the full benefit of all the investments materialize, the annual benefit will continue to grow. For example, in operational excellence, we told you in February, we expect an $80 million annual benefit in 2021 and that's to grow to $120 million by 2023. These benefits, of course, will be somewhat offset by inflation, price, depreciation, the usual headwinds we face every year. You will remember that we're also increasing our recurring OpEx by $50 million per annum by 2021.

 

So we expect our investments to drive margin expansion over the medium to long term, and our aspiration is to be in the top third of global med-tech companies. Currently, those companies have an EBIT range of 25% to 27%.

 

So now let me hand it over to David to give you some more detail of what we're doing in our U.S. Wound business. I've known David for more than 20 years. I was really pleased to recruit him into the business. His decisive leadership is already making a real difference in our Advanced Wound Care business. David?

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David Shepherd, Convatec Group Plc - President of Advanced Wound Care Franchise [5]

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Thank you, Rick, and good morning. I joined ConvaTec 8 months ago with a clear mandate to turn around the performance of our Wound Care business. It's a good business with sound fundamentals that hasn't fulfilled its potential, and my job is to ensure that it does.

 

But before I jump into that, I just wanted to share a little of my own personal background. I spent my whole career in the world of medical devices. Prior to joining ConvaTec, I spent 26 years with the Johnson & Johnson medical device business. In that time, I was fortunate to work across many different regions and in many different medical specialties. Given me a broad insight into the medical device world. My most recent roles was the Area Vice President for Southern Europe, running all of the different Johnson & Johnson businesses from surgery to orthopedics to cardiovascular. And prior to that, I was based in the U.S. for 5 years where I was the U.S. President for the Cardiovascular & Specialty Solutions business and also President of Biosense Webster, the J&J electrophysiology business. So I've got a broad experience, which provides useful perspective on how to address some of the issues at hand at ConvaTec.

 

So moving to the U.S. market on Slide 21. As you can see, the U.S. Wound Care market is a crucial market for us. It accounts for almost 30% of our Wound Care franchise revenues. But in recent years, our performance is not being good enough. We've been too focused on the acute segment at the expense of post-acute, and we've been too reliant on Surgical Cover Dressing.

 

Our commercial model has been deficient with insufficient commercial discipline and insufficient focus on driving end demand in the marketplace. And as a result, we've clearly underperformed in what is a good and growing market.

 

So what are we doing about it? Well, it's very early days in our journey, but I'm pleased to report that we're already progressing well with our plans.

 

Firstly, we've got targeted alignment on our top accounts. We rolled out our CRM tool to ensure we have the teams focused in the right places based on clear criteria about business opportunity and size and on the current contracting status in those accounts. And that allows us the opportunity for quicker wins.

 

We've completed the restructuring of our U.S. field force into specialty-focused teams with a clear channel focus on acute and chronic wounds, and each team has a clear portfolio focus, the priorities, the needs of their customers. So we've got the right people, focused on the right accounts with the right frequency. And we track this on a weekly basis.

 

The combination of the targeting and the new sales structure, along with the increased familiarity of the team to the new model, has already allowed us to increase our call volumes by over 20% from Q1 to Q2.

 

Secondly, we've hired and trained new territory managers to support our new footprint. And our overall field infrastructure is now significantly bigger than at the year-end 2018, driven by those customer-facing positions.

 

Thirdly, a new hire training program has been revamped. We've doubled down on the amount of time spent in-house to ensure that our new starters are better prepared once they reach their territory. And this first training wave completed in June. These new starters are now out in the field completing their field training and transitioning to their new territories.

 

Fourthly, through the Transformation office and our U.S. commercial operations team, we've also been able to drive more focus on pricing and compliance, which is another great area of opportunity for us. Again, we're in the early stage of our journey here, but we have seen a slowdown in our price decline in the first half of 2019. We need to continue to build on this in the second half and beyond as this will be an enduring headwind in the field of medical devices, but we're pleased with the progress.

 

And finally, we're staying true to our focus on our key product priorities. AQUACEL Ag Advantage, which was launched at the end of 2018, is doing very well, driving up overall AQUACEL Silver family at above market growth rates. And here, we still see significant opportunities for further penetration. Customer feedback on the product has been very positive.

 

In Surgical Cover Dressing, we've arrested the decline we saw towards the end of last year. And whilst it's still very early days for Avelle, which we launched at the start of the year in the U.S., I'm excited by this market opportunity.

 

So to summarize on Slide 23, it's fair to say that we are pleased with our early progress. We can see some green shoots, but there is still a lot more to do. We need to continue to build on the current momentum in the second half by sticking to the plan, which we're confident is working, even at this early stage. And as we see the benefit of the extra field force starting to make that contribution, especially in the fourth quarter once they're fully established, we expect to see call rates in our target accounts continue to increase. And again, we will stay laser-focused to track this. This relentless focus on execution is going to be key for us as we drive the business forward. And as we move ahead, we'll track our performance against the pipeline of sales opportunities we've already identified.

 

So we look forward to giving you further updates as we continue our exciting journey. Back to Rick.

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [6]

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So just to take a step back. When I was with you in February, I gave you sort of a candid assessment of my view of the business. And if you remember, I said to you that I think ConvaTec is in very, very good markets. We have very good brands, and our challenges have really been around execution. And as our results indicate today, we're making progress there.

 

I would tell you that we've done a ton of work in the last 6 months, and I'm encouraged by how the employees of ConvaTec have leaned in into our effort around Transformation. And we believe that we're seeing the beginnings, the very beginnings of what we believe to be a ConvaTec way emerging of the way that we're going to do business. It's early days, it's very early days, but it's a step in the right direction. We're encouraged by that, and we think that this absolutely sets the stage for Karim's arrival at the end of September.

 

And I would just -- one word of caution, I wouldn't get a -- get out ahead of us here on this because I do think it's early days. We're doing everything that we can to manage our business in a more disciplined way, and because the business that we're running today is a very good business. There's a take in -- we're making a difference in patients' lives around the world and as one foot -- one foot in front of the other. And we're excited about the future for ConvaTec.

 

So with that, we're -- Frank and I and David are happy to take your questions.

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Questions and Answers

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John Crosse, Convatec Group Plc - VP of IR [1]

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Okay. Let's start with Seb in the front row because you know how to use the microphone, so if you can tell us all how to do it.

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Sebastian Walker, UBS Investment Bank, Research Division - Associate Analyst [2]

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I think I do. There we go. Seb Walker from UBS. So 2, if I could. One, on the growth in the second half. So you're expecting continued improved momentum. Could you maybe talk about that within the different divisions? And maybe, David, if you could comment within Wound, I know, the headwinds within skincare was lighter in the second quarter. How do you expect that to develop and when do you expect to start see the U.S. acceleration come through in the second half? So that's the first one, and shall I leave it there and then...

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Frank M. Schulkes, Convatec Group Plc - CFO & Director [3]

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Sure. Yes. Let's not overload our rams. So growth, second quarter, if we just -- second quarter and then translating to the second half. Let's click through the different franchises. So if you look at the change from Q1 to Q2 in Wound, there are really a couple of reasons for that. First, the comps were easier in the second quarter. Okay. Then we saw good performances in several parts of the world, in Asia Pacific, for instance. We see several markets in Europe improving. And at the same time, we also saw a couple of areas being less of a drag than what they were in the first quarter. The U.K., still all good, but less of a drag. If you perhaps remember, we had destocking going on in the first half in the U.K. with a big distributor. That impact was bigger in the first quarter and less in the second quarter, so therefore the drag is less.

 

Skincare, as we discussed, had a 200-basis point drag in the first quarter and that drag normalized to something lower than 100 bps, and this is what we've seen in prior years. So also a normalization there. 

 

And then third, the U.S. business. Although it's still a drag, but it was also less of a drag.

 

So those are the 3 main reasons. An easier comp, good performance in APAC, EMEA some markets and then several areas, less of a drag. So we expect that we're going to see a pretty decent second half, but you have to remember, there will be quarter-to-quarter variability. As a reminder, just 1 million shift is 80 to 100 bps, right? So I prefer to look at the business, not so much from a quarter-to-quarter, but look at sort of 6 months rolling averages, if you take out some of the noise that we always will see.

 

Ostomy Care, low growth. We expect that low growth will continue. We have seen some very good performances in several markets, in -- emerging as well as the smaller markets in Europe. The U.S. is a drag. We are addressing that. But as you know, this is a business that moves at a certain glacial speed, so it will take time. So we are in line with what we said before. It's going to be very low single-digit growth for Ostomy.

 

CCC, about 3% in the first half. We expect that to improve in the second half because, of course, we had the journey hazard testing in the second half last year, which we don't have this year anymore. And we expect a little bit better growth rate in HDG in the second half as well.

 

And then the ID business is a very lumpy business. For the total year, we said -- because of the Animas dynamics that, that business will grow, but it will grow below our historical growth rate of about 4%, 4.5%. And we continue to believe that, that is the right number for the full year. It will be lumpy, one quarter will be negative and then it will be positive. So again, looking at four quarters, that's how we have to think about it.

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Sebastian Walker, UBS Investment Bank, Research Division - Associate Analyst [4]

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And the second question was just on cash. So cash conversion in the first half was very strong, but I think there was some working capital inflows. CapEx was maybe a little bit lighter than what I would have expected. So how does that develop in the second half?

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Frank M. Schulkes, Convatec Group Plc - CFO & Director [5]

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I think that the conversion of 90%, I don't think we will maintain that given that we will see more cash flow in terms of CapEx, for instance, happening in the second half. Key thing here is that our expectation for leverage will be plus or minus similar to what we experienced at the end of 2018. So as I said before, the decline in leverage will sort of slow down because of our investments in Transformation and MDR. And then after '20, I think we will start to delever very quickly.

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John Crosse, Convatec Group Plc - VP of IR [6]

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I will go for Michael and then Amy afterwards. I think Seb is right you have to hold the bottom while you speak on the microphone. Is that it? Yes.

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Michael Klaus Jungling, Morgan Stanley, Research Division - MD, Head of MedTech & Services and Analyst [7]

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All right. I've got 2 questions. So the first question is about the new CEO appointment. We're getting pretty close to him starting. And as a result, the question I have is have you discussed already, to some degree, how you feel about 2020, the probability also of making greater investments in research and development and also in selling? Is that now looking increasingly likely as we move towards the commencement date of the new CEO?

 

And then secondly, on the portfolio. Can you provide an update where you stand with respect to the SKU rationalization, meaning how much organic growth have we lost in the second quarter and how much growth do you think could be impacted also in 2020? And then also on the portfolio CCC, any updates as to whether we will see a divestiture by the second half of this year?

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [8]

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So Michael, Karim starts at the end of September. So just to take you back, just a little bit back to what we said in February, which was that we sort of ran a -- not a normal recruiting process. As part of the recruiting effort, Karim had line of sight to the same raw data that Frank and I saw for part of my assessment, and we have shared that with him for a very specific reason. We want to get his insight and his view, as part of the interview process, about how -- what he would think about what we should do about that and specifically what came out of this was the Transformation.

 

So as you know, we're investing heavily in our Transformation effort at $150 million, $40 million of it this year and the rest of it over the next 2 years. And in those investments, we're targeting very much to selling and distribution, to R&D, how we're going to do that. I will tell you that Karim, in the time that I've spent with him, he's passionate about the portfolio, about the products that we'll put in the portfolio, specifically in the area of R&D. So I -- and I leave that to him to talk about when he gets here. He is very passionate about that. And I think that, that -- on the sales and marketing area, he and I have had detailed discussions specifically about -- in the markets where we choose to play, the segmentation that we've talked about as part of Transformation, that we'll not be outmanned, not outgunned in those marketplaces where we choose to play and win. And that's a very much a segmentation -- segmented approach as we described in the Pivot to Growth.

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Frank M. Schulkes, Convatec Group Plc - CFO & Director [9]

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Okay. I guess my mic doesn't work so I'll do it this way. On the portfolio, the SKU rationalization, diagnostic is ongoing. We have not cut SKUs in the first half. We have done a lot of analysis, and we're getting closer. We also have to realize that at the end of every product, there is a patient. So you just can't cut off the SKUs because you can't leave a patient hanging out there. And therefore, you need to expect that whatever we're going to do in SKU rationalization, the impact will be largely a 2020 type impact. And at this moment, I really can't comment on the overall size on that.

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Michael Klaus Jungling, Morgan Stanley, Research Division - MD, Head of MedTech & Services and Analyst [10]

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And a question in relation to the portfolio for a divestiture?

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Frank M. Schulkes, Convatec Group Plc - CFO & Director [11]

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Well, basically, a similar type of answer. We are doing the analytics, and we are not at this moment at a point to get into a decision mode.

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Amy Lucinda Walker, Peel Hunt LLP, Research Division - Analyst [12]

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I have 3 questions, if I can. I might also do those with a break in between them so you don't have to write them all down. But just, Rick, can I pick up on your answer to Michael about R&D? I mean I accept that you don't want to steal Karim's thunder. But just in general terms, where do you see the big return on investment opportunities for R&D investment? Because when we came into the IPO process, there'd been a lot of hole plugging I think in Ostomy, there are obviously a lot of things on the launching pad in Advanced Wound Care. So where are the holes that you think you could get good returns on, please?

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [13]

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Let me answer it by franchise, because I think it actually matters versus get -- sort of give the omnibus answer. If you look in -- and I'll ask David to comment on Advanced Wound Care, in Advanced Wound Care, there -- we think there is a tremendous opportunity given the sort of patient burden and the cost burden associated with that to sort of create a family of products that are smart devices that communicate with caregivers, et cetera. And I'll let David talk about that in a minute. So I'll come back to that.

 

In Ostomy, we are obviously investing in a new platform, and that work is ongoing. In CCC, we have a tremendous opportunity with our next-generation catheters that are targeted to the $800 million European market where that is all blue ocean for us. So we are super excited about what that means for the business. The product is in our pilot market is going head to head with a market leader and doing quite well in that early stages of our pilot. So we're planning appropriately for that. So we're super excited about that. And we think that family of products will be different, well differentiated in the marketplace.

 

And then in ID, the question for us, and the big question we face is that franchise is to grow outside of diabetes, and our teams have worked very hard. We're in the middle of launching new products that are targeted to pain, to epilepsy, to other diseases that use pump technology, and we think that's very, very promising. So we're investing heavily there as well.

 

So in the R&D portfolio, we have lots of opportunities to sort of fill in our -- and our teams have identified clear opportunities. And David, maybe you want to talk about the Wound portfolio.

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David Shepherd, Convatec Group Plc - President of Advanced Wound Care Franchise [14]

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Yes. I think in the short term, just looking in the technologies we have today and how we can leverage more from those, and we have some great platforms where we think we can do more that will give us boost in the short term. And then as Rick said, I think if you look at the world of wound care and the onset of smart or digital technology, that's an area where we see great opportunity. It's a little too early to kind of say exactly where that will be. But that's the kind of the future strategy we say how will wound care take off in the future.

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Amy Lucinda Walker, Peel Hunt LLP, Research Division - Analyst [15]

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Okay. And actually speaking of on -- maybe something that's a bit more tractable near term. When you -- we've highlighted the 20% increase in core volumes. How should we think about what that translates into in terms of growth in the business? Is that 20% uplift already fully reflected in the 3.3% underlying growth we've seen? Or will that -- is that a leading indicator for some follow-on growth? And what else beyond that 20% -- how much more could you do? Could the 20% increase go to 50% just if you could quantify?

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David Shepherd, Convatec Group Plc - President of Advanced Wound Care Franchise [16]

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So I think what we've been able to do is really 2 things. One is on the 20% is driving better efficiency with the base people that we have today. So the current sales team. So it was how do we make sure that they're effective in the right places, that they're familiar with their new territories based on the new structure. I think it would be unreasonable to jump to the conclusion that that's driven the short-term growth because Wound Care is a slow mover. And so the work you're doing today manifests itself further down the line. And then on top of that, we had the new sales team, the new sales force coming in. They were trained in June, but I think will start to contribute and really start towards Q4 and then really give us the boost in 2020.

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Amy Lucinda Walker, Peel Hunt LLP, Research Division - Analyst [17]

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So given the comps are not particularly demanding in the second half, 3.3% is a minimum that we should expect going forward?

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David Shepherd, Convatec Group Plc - President of Advanced Wound Care Franchise [18]

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I wouldn't want to jump to that conclusion. We do have the -- as Frank says, we have the quarterly swings. The comparators do vary, and I think it's too early to call, based on what we've seen, that we could guarantee this. So we're positive about where we are, but I think we wouldn't want to get carried away. We need to make sure that we bed down the execution and keep driving this forwards.

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Frank M. Schulkes, Convatec Group Plc - CFO & Director [19]

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Also have the impact of the French reimbursement in the second half. On top of that, I don’t know if you follow the press, but the German Bundestag has basically taken decisions about silver reimbursement in Germany. That is still not 100% worked out in this moment. It is very complicated, but it might go away. And therefore, we -- that's probably going to be official next year where we already expect some behavior in the markets, with doctors that they are going to switch to other type of products, non-silver type products. So those are 2 impacts in the second half that will basically damp overall growth for the business, in Wound specifically.

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [20]

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It's a little bit dangerous to draw a straight line because it's very early days in our execution model. We've seen the x's, the amount of activity that David described, putting firepower on the target. I'm encouraged by that. I'd like to see the y, the outcome associated with that, and it's just early to call that.

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Amy Lucinda Walker, Peel Hunt LLP, Research Division - Analyst [21]

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For one last one, and then I'll give it to somebody else. Just on the step-up in the H2 execution that was alluded to. There are a couple of specific projects mentioned from the first half, $2 million here, $2 million there. Are there 2 or 3 very significant big-ticket initiatives that the big step-up is attached to? Or is it similar sort of order of magnitude many, many, many single-digit million projects?

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [22]

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Let me just make a broad comment and then Frank gives some detail. Look, our Transformation Initiative, if you want to think about it on a Pareto basis of like programs, is more about a lot of small things, so -- versus betting the ranch on -- delivering on 1 or 2 big deliverable projects. That's not to say these are not meaningful projects, they are. But our strategy has been to go after the small things that make a big difference because if we can add the discipline associated with that. So that's a broad comment.

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Frank M. Schulkes, Convatec Group Plc - CFO & Director [23]

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Yes. And in terms of types of projects, we, of course, already have the operational excellence in-flight, so that will continue. And what you will see is more commercial-type programs starting to get into execution phase in the second half, and that will continue into 2020. While business services transformation, a lot of activity is there, a lot of spend there, but that is further out where we will see the benefits. I don't think anything will happen there before the first half of 2020.

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John Crosse, Convatec Group Plc - VP of IR [24]

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I'm going to go to Paul at the back. And then I'd just say there is 2 calls on the line, from Chris and from Hassan. So after we've had Paul's questions, we'll then go to the lines, please. But Paul, go ahead.

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Paul Cuddon, Numis Securities Limited, Research Division - Director for Healthcare Equity Research [25]

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Paul Cuddon from Numis. Two questions, really. You cited a major hospital win in the U.S. Ostomy segment in kind of patient support you're giving through HDG as well. So I was wondering if you are all set up for more of those types of wins integrating with HDG and Ostomy.

 

And then just secondly, on the potential impact of MDR next year on your kind of base AQUACEL-type portfolios and other ranges is a market leader, do you think you would be a net beneficiary of higher regulatory standards?

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [26]

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So it is part of our strategy to go hunt for big game, and the integrated delivery networks in the U.S., it's where that is where you could have the opportunity to partner with that customer at a different level. We believe the HDG opportunity, to provide world-class service to our customer, is a real opportunity inside of our Ostomy business in direct support of that, and they're a market leader in the U.S. by any measure, whether it be by external measures, their service offerings. So we think that that's -- we think that's fertile hunting ground for us to leverage that into the future. David, do you want to comment on...

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David Shepherd, Convatec Group Plc - President of Advanced Wound Care Franchise [27]

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Yes. I don't think we expect to see any major upsides in the short term. I think most of ourselves and our competition are preparing for MDR. And so whilst maybe in the long term, higher regulatory standards will help. I don't think we would see a short-term boost.

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John Crosse, Convatec Group Plc - VP of IR [28]

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Thank you. Can we -- operator, can we go to the lines now? Chris Gretler, I think is first in the queue from Crédit Suisse to ask a question.

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Operator [29]

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So our first question is from Chris Gretler.

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Christoph Gretler, Crédit Suisse AG, Research Division - MD in Equity Research [30]

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Most of my questions actually have already been asked, but maybe kind enough to come back on the R&D. Could you actually -- and I noticed actually the adjusted costs were down year-over-year in the first half. Could you actually discuss where you see this R&D spend as a percent of sales in the medium to long term because, I mean, at least, from my point of view, it looks relatively low compared to your industry? So I was wondering if you could give some indication where you see this going in the medium term.

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [31]

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With that, I will answer big picture. We're -- if you look at our investment in R&D, we think it's light as well. That's part of the transformation of our ability to redirect that. We have articulated that part of our funding strategy is not just transformation but it's also the reshaping of our P&L where we move cost from G&A into R&D and sales and marketing. We're in -- that process is in-flight. We would like to see that number significantly higher. That's part of our planning going forward. If you look at industry average for a company of our size, it's roughly between 3% and 4.5%, and we're -- our plans are to increase that in the future.

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Frank M. Schulkes, Convatec Group Plc - CFO & Director [32]

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Yes. I would like to add as well that we have gone through some purging of R&D as well because there were too many little hobby projects going on, on the side. And for us, it's very important that we are focusing our R&D dollars and our R&D resources on the big projects that matter, and that's where we're going through over the next couple of years, but that's one of the reasons. So we basically cut some R&D that we are going to redirect to bigger programs going forward.

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [33]

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I'll just make one comment and just ask David to comment. Part of the Transformation office's responsibility is this detail-tracking in the investments we're making and the rigor associated with that and the discipline that goes into that. David, maybe you can just talk about your portfolio...

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David Shepherd, Convatec Group Plc - President of Advanced Wound Care Franchise [34]

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Yes. I think it's a -- as a franchise leader it is always great to have more money going into R&D. But I think what that Transformation Initiative is doing for us is driving better efficiency of the money we already have. And so as Rick says, the rigor in execution that the TI is bringing is putting all our current R&D projects through a much more accelerated process, and I think that will help us on top of putting more money into the bank as well.

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Christoph Gretler, Crédit Suisse AG, Research Division - MD in Equity Research [35]

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Okay. That's very helpful. And then maybe if I have you -- basically, could you discuss broader the price dynamics? Actually, you see in -- particularly in the Ostomy and the Wound Care markets at the moment and -- I mean I noticed from some of your comments that basically you'll see kind of particularly also negative mix effect. Maybe could you discuss on that topic?

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Frank M. Schulkes, Convatec Group Plc - CFO & Director [36]

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Yes. So price in Wound. I already mentioned that we will experience a reimbursement cut in France, which is in line with plan. It's just a little more compressed. So I think the overall impact for us will be something like 3.5% cut on Wound prices in France. We see in some other markets, Portugal, Poland, also some price pressure, and we talked, of course, about the U.K. market where there is continuous price pressure. However, all of these price pressures are factored in, in our overall 1% to 1.5% of price reduction that we see every year, which is about a 40-basis point impact on our gross margin rate. So nothing really out of the ordinary. There are certain markets that will go through a reimbursement one year, and then you won't see anything for a couple of years and then other markets will go. So it all is captured within that 1% to 1.5%.

 

Within Ostomy, we see a lot less price erosion. So the majority of the price erosion is typically in the Wound markets and a lot less. There is a little bit of Ostomy price erosion in France as well as part of the exercise that the government went through in the last 6 months or so. And I think that Ostomy decrease is, what is it, John, 4% to 5%-or-so. But it's, for us, a very small impact because Ostomy in France is not a very big business.

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John Crosse, Convatec Group Plc - VP of IR [37]

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Staying on the line...

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Operator [38]

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Our next question today...

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John Crosse, Convatec Group Plc - VP of IR [39]

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Go ahead. I think it's Hassan from Barclays.

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Operator [40]

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Yes. Our next question is Hassan Al-Wakeel from Barclays.

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Hassan Al-Wakeel, Barclays Bank PLC, Research Division - Research Analyst [41]

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I've got 3, please. And if we can go through them in turn. Firstly, could you please comment on the recent launches in continence from Hollister which looked to be contributing to strong growth at the company? Given Hollister and Coloplast are firing on all cylinders here, what gives you confidence of ramping this business in Europe and how should we expect the scaling is -- as your female catheter launch going forward?

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [42]

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I'll take that one. So first of all, we should take it back to why we're excited. First of all, we think this is a terrific marketplace in general and specifically in Europe, given our -- both position today in the marketplace, which is very nominal. This is all blue ocean for us. We think there's plenty of room for competition. We like the way our product is differentiated in the marketplace, in head-to-head sort of settings. We've run a very detailed and thoughtful pilot program. And to be candid, given our track record of execution the way that we product -- we've launched products, Frank and I, we've made a decision that we will -- this will be a very controlled -- a way to come to market. We want to make sure that we understand the pilot. We ran our pilot, we've expanded our pilot, we've learned from that, and that will be applied in the launch planning as we go forward, as we compare to what I might describe is less than optimal planning for product launches in the past. So we're looking forward to entering that -- in that marketplace, we think there's plenty of room for growth for all involved.

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Hassan Al-Wakeel, Barclays Bank PLC, Research Division - Research Analyst [43]

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Great. And then secondly, could you please comment on your expectations for full year interest and earnings, please? I asked because your company's combined consensus shows adjusted EBIT of $350 million for the full year and adjusted PBT is $319 million, implying interest of $31 million when I believe it should be higher. I appreciate that there are likely to be many adjustments in the mix. But could you please confirm if you are happy with consensus adjusted net income of $264 million given close to $110 million in the first half?

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Frank M. Schulkes, Convatec Group Plc - CFO & Director [44]

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So let me correct that, indeed. We looked at the interest numbers, and I wish we could borrow at those type of rates that we find in consensus. I think that would be more than world-class. So those numbers are wrong. You can see that as well in our first half. We have about $31 million, $32 million of interest for first half. So you can basically double that for the year. So I think that needs to be corrected by some of the analysts in their models.

 

And furthermore, the other element, of course, as part of this is our adjusted book rate for tax, and we can confirm, as we said in February, that we expect that to be about 16.5%. So you can also update the models with that if you were not at that level, and that will then result into I think an earnings picture that will be much closer to reality.

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Hassan Al-Wakeel, Barclays Bank PLC, Research Division - Research Analyst [45]

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And so just to follow up on that -- the earnings picture. I mean are you happy with the $265 million? Or do you think that the lower interest number should translate to a lower earnings number relative to that consensus number?

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Frank M. Schulkes, Convatec Group Plc - CFO & Director [46]

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As I said, I think the interest number is wrong. And we don't guide on net earnings. Our guidance is EBIT 18% to 20%. And we provide you some additional technical guidance here that the interest number is a couple of million lower than 2018. So you can do the math. And the effective -- sorry, the adjusted book tax rate is 16.5%, and that's sort of where I want to keep it and leave it.

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Hassan Al-Wakeel, Barclays Bank PLC, Research Division - Research Analyst [47]

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That's very helpful, Frank. And then finally, if you could just elaborate on U.S. Ostomy following your efforts to flatten the organization and segment the market here and really whether we should expect any meaningful improvements here ahead of the new platform launch 12 to 18 months away.

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [48]

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So in Ostomy, the good and the bad news about this business, it moves in a glacial pace. But we've executed the same tactics that David has described in the Advanced Wound Care business and the Ostomy business as well. Where do we go, who we're calling on, how often we see them, what are we saying to them and we're -- our newer offerings are doing quite well in the marketplace in the U.S. Specifically outside of the U.S., we're seeing good steady growth in targeted markets where we're targeting our resources and our firepower. So we think we're -- we think we'll see sort of steady improvement in our Ostomy business. But I will just put it into context, we're not calling out nor are we expecting any type of change in the sort of extraordinary growth profile. So you can expect that we will continue steady, and that's our expectation for the business.

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John Crosse, Convatec Group Plc - VP of IR [49]

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Back in the room. I think Patrick and then Kit at the back.

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Patrick Andrew Robert Wood, BofA Merrill Lynch, Research Division - Director in Equity Research and Head of the EMEA MedTech & Services Team [50]

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Just one from me. When you're thinking of the return structure, and Hassan kind of touched on it, but the return structure from the OpEx program, you've got most of your competitors putting extra money in R&D. Smith & Nephew is doing that, BD, Hollister. Most people are investing at this stage. When you are thinking of the returns in those programs, did you factor and then think how did you think about the competitive landscape? Is it this category growth for everyone can accelerate? Or do you assume that there's a net loser out of that?

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [51]

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I think -- well, first of all, if you look at our markets growing, if you blend it, right, across and you have to look at it by segment, if you look at it on a blended basis, we're roughly growing. The markets are growing between 4% and 5%, so these are good markets, structurally sound. And there are issues in places -- U.S. -- U.K. Wound, that there's things moving around. But the truth is we're in very good markets, so there is plenty of room for that. We have -- as part of our analysis, we did look competitively about who is investing what. And that's not to say that we are interested in getting in an arms race with anybody associated with investment, associated with either sales and marketing and/or R&D. I think our focus has been on fixing our house and doing that and doing that extremely well as compared to try to figure out how to put forward investing against our competition. And we have plenty of opportunity to be able to do that.

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Frank M. Schulkes, Convatec Group Plc - CFO & Director [52]

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Yes. I can add as well, and we've talked about this before that, if you look at our OpEx profile as a percentage of sales, we're way too heavy in G&A. And part of the Transformation Initiatives are focused on moving cost down in the enabling functions and reinvesting that in sales and marketing and R&D. So therefore, you will see our G&A moving to single digits, while we're going to see our sales and marketing moving from the lower 20s to the higher 20s. And that's how you have to think about. So there is a sort of a self-funding going on over the next several years.

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Nyeok Lee, Jefferies LLC, Research Division - Equity Associate [53]

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Two questions from me, please. I guess firstly, just to come back on product launches, how should we think about the impact for the second half? Are you still going to be in limited market release? Or should I expect a slightly more meaningful impact from, for example, Avelle over the next-gen catheter launched in Europe?

 

And the second question is on the Ostomy Care business. Can you just remind us of the GPO renewal contract timeline? When is Premier going to decide on the next round? And what's your stance on that? And can you say the same for the other 2 contracts as well, please?

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [54]

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So on the product launches, I don't think we're going to share the exact timing of our product launches. But in the back -- in the second half of this year, we have products in the Advanced Wound Care as well as in the CCC that will be entering the marketplace. So without getting into the exact timing, it will be in the sort of early stages of launches. So on the material basis, and I wouldn't look at that as some kind of catalyst of some kind; it just allows us to enter and to continue to build our businesses on a normal course.

 

As it relates to Ostomy and Premier, that contract is coming up right after the first of the year in the first quarter. We've been in discussions with them. Our view on the U.S. GPO marketplace is that it is an important license to hunt in the U.S. marketplace to be on contract. We have seen from our competitors who are not on contract, they've had just as much success contracting directly with IDNs. We have an entire effort in the U.S focused on the IDNs as well, and we think that is very fruitful for our business to be closer to our end-use customer and we have our teams deployed to be able to do that. What that I think that translates to is that there is less dependence from our perspective on the GPO contracts overall, and specifically, the fees that we pay to GPOs and the benefit that we get. We're taking a really hard look at that.

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John Crosse, Convatec Group Plc - VP of IR [55]

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Can we just go quickly back to the phones? I see Nils from Carnegie is on to ask a question.

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Nils Bartram, Carnegie Fonder AB - Portfolio Manager [56]

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My first question would be about the U.S. hospital contract when you announced. It is a sole-source contract or is it a dual-source contract? And could you also inform us, which company used to have this contract?

 

Secondly, when it comes to your testing of your next-generation catheter. Could you elaborate on some of the aspects of this testing? So where is it that you actually see a positive feedback when it comes to the use of your new catheter?

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [57]

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I'll take the dual-source contract. Just specifically, Nils, you're asking about the Ostomy contract, correct?

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Nils Bartram, Carnegie Fonder AB - Portfolio Manager [58]

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That's right.

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [59]

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So dual-source, without getting into who the customer is, et cetera, it is a dual-source contract between us and one of our competitors to support that customer. Like most contracts in the Ostomy world, most of them are dual- or triple-source, because we still have physician and caregiver preferences. We think that's actually the trend in the marketplace, which is that we're going to see the less, sort of dual-source probably more -- the 3 of us will be on contract in those markets. It's just sort of a trend in contracting that we see.

 

And then secondarily, the base of the competition of that will be both product and service. And that's why we believe our HDG capabilities add tremendous value to the discussion that we are having with our IDN customers. We hope that we can build upon that in the coming -- going forward, but in the second half and also into 2020 and beyond. So that's on the Ostomy piece.

 

If I understand your next-generation catheter business, you're asking us for sort of general feedback on the pilot. Is that correct?

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Nils Bartram, Carnegie Fonder AB - Portfolio Manager [60]

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Yes. That's correct.

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Frank M. Schulkes, Convatec Group Plc - CFO & Director [61]

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We're basically doing these pilots in 1 big European market. And the pilot is as follows. We have the product in the patients. In some cases, it's new patients and other cases, it's patients who are using competitors' products. And we are gathering feedback and input from those patients about the different characteristics of the product and the usage of the product. We've received feedback, and as Rick mentioned, it was very positive feedback we have received. But it is a pilot. So every time we receive feedback, we go back, work with the R&D team if necessary and make some changes, and we're going through a very thorough process here before we're going for commercial launch. And as part of that, we are ramping up the sales force. So we're going to be -- when we get the green light, we will be ready to roll.

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Nils Bartram, Carnegie Fonder AB - Portfolio Manager [62]

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And just a follow-up question on the U.S. hospital contract. Was this contract at sole-source contract before you entered the contract?

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John Crosse, Convatec Group Plc - VP of IR [63]

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I think the question was the dual-source contract we have in the U.S. on Ostomy. Was that a single-source before we came on board or...

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Rick D. Anderson, Convatec Group Plc - Executive Chairman & Interim CEO [64]

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It was a dual-source contract, and this is new for us. This is new for us.

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John Crosse, Convatec Group Plc - VP of IR [65]

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Okay. Thanks, everyone. I think we'll bring it to a close there. Thank you for coming. As ever, myself and Mark and the IR team will obviously be happy to take any other questions you have. But have a good morning. Thanks very much.