Q2 2023 Avanos Medical Inc Earnings Call
Participants
Joseph F. Woody; CEO & Director; Avanos Medical, Inc.
Michael C. Greiner; Senior VP, CFO & Chief Transformation Officer; Avanos Medical, Inc.
Scott Galovan; VP of Strategy & Corporate Development; Avanos Medical, Inc.
Daniel Walker Stauder; Associate; JMP Securities LLC, Research Division
Frederick Allen Wise; MD & Senior Equity Research Analyst; Stifel, Nicolaus & Company, Incorporated, Research Division
Kristen Marie Stewart; MD & Senior Research Analyst; CL King & Associates, Inc., Research Division
Matthew Ian Mishan; VP & Senior Equity Research Analyst; KeyBanc Capital Markets Inc., Research Division
Presentation
Operator
Good morning, everyone, and welcome to the Avanos Second Quarter 2023 Earnings Conference Call. (Operator Instructions) Please Note, today's call is being recorded. At this time, I'd like to hand the floor over to Avanos CEO, Joe Woody.
Joseph F. Woody
Good morning, everyone. This is Joe Woody. We've asked the New York Stock Exchange, and they agreed to halt our trading as our results were inaccurately reported by one news outlet and possibly more. Our total results inclusive of respiratory health were $199.8 million in revenue and we delivered $0.37 of EPS. Throughout the day today, we're going to work with the various agencies and news outlets to correct the information. Now I'm going to turn the call over to Scott Galovan to begin our prepared remarks. Thank you.
Scott Galovan
Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to Avanos 2023 Second Quarter Earnings Conference Call. Presenting today will be Joe Woody, CEO; and Michael Greiner, Senior Vice President, CFO and Chief Transformation Officer. Joe will review our second quarter and expectations for the remainder of 2023 as well as provide further insights around the strategy we laid out at our Investor Day in June. Mike will provide additional detail regarding these topics and provide an update of our 2023 planning assumptions given our respiratory health business discontinued operations. We'll finish the call with Q&A. A presentation for today's call is available on the Investors section of our website, avanos.com.
As a reminder, our comments today contain forward-looking statements related to the company, our expected performance, current economic conditions and our industry. No assurance can be given as to future financial results. Actual results could differ materially from those in the forward-looking statements. For more information about forward-looking statements and the risk factors that could influence future results, please see today's press release and risk factors described in our filings with the SEC. Additionally, we will be referring to adjusted results and outlook. The press release has information on these adjustments and reconciliations to comparable GAAP financial measures. Now I'll turn the call over to Joe.
Joseph F. Woody
Thanks, Scott. Good morning, everyone, and thank you for joining us to review our operational and financial results for the second quarter of 2023. We are pleased with our second quarter. We noted in our year-end earnings call and reiterated at our Investor Day in June, our quarterly results for 2023 would be uneven given the timing uncertainties associated with our transformation plan, which included some of the transactions we announced just prior to our Investor Day. The demand for our products remain strong, and although supply chain disruptions have lessened, we continue to experience ongoing product supply challenges and the effects of inflation throughout our supply chain. Coming into the year, we anticipated that 2023 will continue to present supply chain headwinds and pockets of product availability challenges, but that many of these headwinds would ease as we reached the back half of the year. We still believe this to be the case with our anticipated year-end back order levels to be around $3 million, down from over $10 million at the beginning of the year.
As always, our primary focus is on getting patients back to the things that matter as we meet the needs of our customers. For the quarter, we achieved sales of $169 million from continuing operations or down approximately 1% compared to last year. Excluding both the negative impact of foreign exchange and the $5 million impact related to our previously announced decision to eliminate revenue that was not meeting our returns criteria, organic growth was favorable 2.6% for the quarter. We also generated $0.24 of adjusted diluted earnings per share and almost $23 million of adjusted EBITDA from continuing operations during the quarter. While our adjusted gross margin was almost 60% and our SG&A as a percentage of revenue was 45.1%. Actual sales for the quarter, inclusive of our respiratory health business was $200 million or 2.5% growth. Also excluding the adjusted revenue items I just referenced. SG&A as a percentage of revenue was 40%, supporting an adjusted EBITDA margin of almost 16% for the quarter.
Now I'll spend the next few minutes discussing our results at the product category level. On a constant currency basis, our Digestive Health portfolio grew almost 17% bolstered by our NeoMed product line, which posted another strong quarter versus the prior year as we continue to take advantage of the demand for ENFit conversions in North America. Our legacy enteral feeding product line grew double digits globally, primarily driven by the continued expansion of our U.S. CORTRAK standard of care offering. As noted during Investor Day, we continue to deliver above-market growth and leadership in our core digestive health markets and are poised to sustain this momentum through innovations that we plan to launch over the next 12 months, expansion into high potential global markets and actionable M&A targets in large, attractive adjacencies.
Turning to our pain management and recovery portfolio. Actual reported sales were down close to 11% for the quarter, with soft results across our Interventional Pain, Game Ready and 5-shot HA product categories each of which were down at least 5% versus the prior year. Separately, our surgical pain pump business was flat for the quarter, excluding the negative impact of foreign exchange and low growth, low-margin products we are no longer selling in this category.
As I shared earlier, we continue to experience supply headwinds within these businesses, although we expect these headwinds to ease during the second half of this year. Alleviating these supply chain challenges is critical to supporting our pain management and recovery portfolio sales lift in the second half of the year. Finally, our HA portfolio experienced a weaker-than-expected first half. However, this softness was primarily concentrated in our 5-shot or GenVisc products. 5-shot market has specific pricing and competitive dynamics that are not as prevalent within the 3-shot market. TriVisc, our 3-shot offering continues to align with our overarching orthopedic [call] point strategy and is largely meeting our internal performance expectations.
We expect volatility will continue to be a factor in both of these HA markets for the next several quarters as we face strong 2022 comparables and continue to experience the related swings from entering the ASP reporting environment in Q3 2022. Despite this volatility, we believe we have the right strategies in place to capitalize on our HA opportunities. Our pain management and recovery business results have not met our expectations over the last year. However, we are confident in our new strategy outlined during Investor Day. This strategy connects our pain brands across the patient life cycle and sets the stage for sustainable mid-single-digit growth as we enter 2024 with gross margins exceeding 60%. Our investments in the pain management and recovery business will be very selective over the short to midterm as we focus on securing consistent organic financial results.
Now moving to an update on our 2023 priorities and transformation efforts, which includes some of the initiatives that I just described. As we originally outlined in the beginning of the year and further highlighted in June during Investor Day, we have 4 key priorities for the next 3 years that will optimize our go-to-market opportunities and meaningfully enhance our financial profile. These priorities include strategically and commercially optimizing our organization, transforming our portfolio to focus on categories where we have attractive margin profiles and the right to win, taking additional cost management measures to enhance operating profitability and continuing our path of efficient capital allocation to meaningfully improve our ROIC. We continue to execute well against these priorities as evidenced by our recent divestiture and acquisition activity, implementation of our new go-to-market strategy for our pain management and recovery business, margin improvement, additional portfolio optimization decisions and delivery on our transformation program expense savings.
In addition, our Board has recently approved a $25 million share repurchase program. This will not impact our ability to continue to execute our tuck-in acquisition strategy, but rather provides us flexibility to allocate capital towards repurchasing shares that we believe are meaningfully undervalued versus our internally calculated intrinsic value. Finally, I'd like to thank everyone who participated in our Investor Day on June 20 and the subsequent feedback we received from many of you. Now I'll turn the call over to Michael, who continues to lead these efforts in his expanded role as Chief Transformation Officer and will further discuss our second quarter financial results.
Michael C. Greiner
Thanks, Joe. Before providing color on our discontinued operations reporting related to the sale of our Respiratory Health business, I'll first provide additional color and detail around our consolidated second quarter results. Total reported sales for the second quarter on an actual basis was $199.8 million, an increase of 2.5%, excluding the negative impact of foreign exchange, and the impact of low margin and low growth products we have ceased selling. From a continuing operations standpoint, net sales were $169.4 million. Adjusted gross margins were 59.9% and adjusted net income for the quarter totaled $11 million, translating to $0.24 of adjusted diluted earnings per share. Adjusted EBITDA for the quarter was $23 million, in line with prior year. Separately, we ended the quarter with $82 million of cash on hand and a leverage ratio of less than 1.
Looking at our total results, including respiratory health, gross margin for the quarter was 56.7% or 270 basis points lower than prior year, primarily driven by the unfavorable impact of the Mexican peso as well as unfavorable product mix impact, mostly related to softness in our HA portfolio. Sequentially, gross margin improved by 30 basis points. Separately, SG&A as a percentage of revenue improved by 60 basis points versus the prior year and 160 basis points sequentially, primarily related to our cost savings efforts to streamline the organization and reduce our external spend profile. Adjusted diluted earnings per share were $0.37 and adjusted EBITDA totaled $31.8 million or 15.9%.
Now focusing on our continuing operations results. Adjusted gross margin for the quarter was 59.9% and which reflects the benefits of our portfolio optimization decisions. SG&A as a percentage of revenue was 45.1%, an improvement of 100 basis points versus the prior year and a sequential improvement of 280 basis points. We anticipate SG&A as a percentage of revenue to be approximately 43% to 44% for the full year from a continuing operation standpoint with substantial improvement in 2024 ultimately leading to our 2025 goal between 38% to 39%. Adjusted diluted earnings per share were $0.24 versus $0.26 a year ago with adjusted EBITDA margin of 13.5% compared to 13.4% in 2022. For the first 6 months of 2023, the impact of discontinued operations totaled $19 million of EBITDA reduction. We anticipate the full year impact to be approximately $40 million which also is directionally representative of the annual stranded cost impact for the RH divestiture. These stranded costs include allocations from shared service functions, shipping and freight dyssynergies and loss of scale in our international operations, among other fixed costs.
Through 2024, we will offset a portion of these stranded costs via our transition services agreements with AirLife. Additionally, we are accelerating and expanding our existing cost reduction program to mitigate the majority of the remaining stranded costs, expecting approximately $30 million incremental cost reduction by the end of 2025 meaning an estimated $10 million to $15 million of go-forward dyssynergies. Future M&A, of course, would enable additional stranded cost absorption. As a result of the Respiratory Health divestiture, which we anticipate will close early in the fourth quarter, we expect adjusted diluted EPS between $1.05 and $1.15 for the year, with gross margins around 60% and adjusted EBITDA margins of approximately 15%. Including the current year impact of the approximately $17 million annualized impact of product portfolio rationalization that we previously discussed, company anticipates comparable organic revenue growth to be low single digits for the year. As previously communicated, the cost management aspects of our transformation program will total between $45 million and $55 million of gross savings by 2025.
We now anticipate approximately $20 million of those savings in 2023, with the majority of the remainder to be executed in 2024. These savings do not contemplate the elimination of the stranded cost that I just described, which will be addressed separately. Our preliminary view for 2024 anticipates that we will deliver mid-single-digit revenue growth across our portfolio with adjusted gross margins of approximately 60%. Separately, we expect to reduce SG&A as a percentage of sales to 40% to 42% as a result of our cost takeout efforts and anticipate generating adjusted EBITDA of between $120 million and $140 million. These ranges will be negatively or positively impacted by our ability to accelerate our pain growth story and our cost management efforts. With regards to free cash flow, we now anticipate annual free cash flow of approximately $60 million as a result of higher interest and tax payments and weaker-than-anticipated performance in our pain management and recovery portfolio. This estimate also excludes onetime restructuring cost for this year.
We remain confident in our ability to deliver approximately $100 million of free cash flow for 2025 this assumes $25 million in tax payments, $20 million in capital expenditures and $15 million in interest payments. In closing, we will continue to execute on each of our transformation priorities and have a laser focus on both the digestive health and pain management and recovery business strategies. We believe that execution of these portfolio strategies, combined with our other transformation priorities will support delivering mid-single-digit organic revenue growth, gross margins exceeding 60%, adjusted EBITDA margins greater than 20% and free cash flow generation of approximately $100 million that I just shared. Finally, we will remain prudent stewards of our balance sheet, pursuing margin accretive tuck-in acquisitions and opportunistic share repurchases. Operator, please open the line for questions.
Question and Answer Session
Operator
(Operator Instructions) Today's first question comes from Rick Wise with Stifel.
Frederick Allen Wise
Thanks for all the detail and the clarity and a lot to absorb and thank you, but you gave us a lot of good data. I want to start off just -- Michael, you said it very clearly in giving us a first look at 2024, that pain growth acceleration or reacceleration, cost reduction are the 2 critical pillars. If I understood your words, correct me if I'm wrong, to achieving that growth. Maybe take us through -- I'm going to guess cost reduction is more in your control. Just give us even more detail about why you're confident that you can achieve your goals and some of the specific actions so we can understand that. And maybe just -- I'm just looking at your Slide 7, where you talk about the pain portfolio being challenged. If you'd be so kind, take us through each piece and help us understand your action plan that's going to -- you wouldn't say it if you didn't have a plan and didn't believe it, I'm confident that's going to help us more credibly understand and believe that pain growth can reaccelerate in '24. And that's sort of my first and second question.
Michael C. Greiner
Thanks, Rick. And I'll just -- I'll turn it over to Joe in a second to talk about the pain strategic approach and tie that back to what we shared on Investor Day and why we are confident in our ability to execute mid-single digit next year. What I was trying to convey on the EBITDA and the cost and the pain growth, $120 million to $140 million is our current preliminary early view of 2024. The lower end of that range would mean we didn't execute as well as we wanted to on the pain growth and/or the cost management efforts, which I agree are in our control, maybe we're a little bit slower. Maybe there were some things that occurred through the transition agreements that has distracted for a short period of time in the early half of the year.
And so we had to get at some of those cost management efforts and the back half of 2024. So these 2025 targets, we feel really good about because one, we have programs in place like you just described, and the 2024 range, we feel really good about. But whether we're at $120 million or $140 million will be entirely dependent upon our ability to grow mid-single digits in the pain category, which Joe will talk about in a minute and the quickness at which we get at these cost management programs. Those programs will happen, Rick. It's just can we get it done in March or do we get them done in July.
Joseph F. Woody
And Rick, this is Joe Woody, just to kind of pick up on the pain growth for 2024. I mean if you think about this quarter, the company either way, we're about sort of 2.5-ish percent organic growth when you remove all the noise, and what we've said is this, we've unfortunately continued in IVP and acute pain with pretty significant supply chain issues. This is before we talk about the new initiatives. So we're almost sort of without those kind of at a 4 or 5-ish type of growth as an overall Avanos, in the new Avanos go forward the continued operations if you look at it that way. The other thing I would say is we're very confident in bringing Diros in, and that's going to give us an opportunity to play in the ambulatory surgical center. It's also going to give us the ability, we think, to take share in the standard RF market, which is going to be good for us. And then we've got some things going on in the business. So internationally, we've got a positive reimbursement in Japan.
We've got NICE in the U.K. coming out for COOLIEF, talking about -- giving us the ability to expand our reimbursement in Europe. And really from a strategic perspective, being completely different with an approach with the ambulatory surgical center primarily the orthopedic [call] point, and we are changing a lot of people out and a lot of distributors. So I think frankly, we'd pretty much be there if we didn't have some of the -- it's not the whole story, but if we didn't have the supply chain issues, we've been pretty [doggone] close. And frankly, we're going to have pretty easy comparables. So -- but even beyond that, what we're pointing to is we feel that we really can get to a sustainable mid-single-digit growth because we're participating now in the places that we can win.
Frederick Allen Wise
Yes. Got it. I lied, I'll ask a half. And the likely or the potential of Diros contribution? And then...
Joseph F. Woody
Yes. So this year, it's going to be sort of, call it, $6-ish million in revenue.
Frederick Allen Wise
And to '24? And how are you thinking about '24 and '25.
Michael C. Greiner
It will be double-digit growth, no doubt about. It will be an uplift, but obviously on a lower base. So the impact on the mid-single digit for pain will be somewhat de minimis.
Operator
The next question comes from Matthew Mishan with KeyBanc.
Matthew Ian Mishan
I just wanted to start off with the new baseline for 2023. The $1.05 to $1.15 of EPS and the $100 million to $110 million of EBITDA. Those are clean numbers, excluding the divestiture. There's no necessarily revenue coming out and costs that are kind of stuck in the P&L. Those would be exclusive completely of the divestiture.
Michael C. Greiner
Well, they are -- there are -- there is that $30 million of trapped costs that still remain in there that we will be getting at over the next 12 to 18 months. So they're clean, but there are fixed costs that are trapped, stranded, whatever words you guys want to use, post that, and that doesn't include that. So however, when you get to the '24 and '25 numbers, those include our ability to get those costs out, if that makes sense, Matt.
Matthew Ian Mishan
No, no, it makes complete sense with how you're looking at it. And then if you think about the progression to 2024, it's about at the midpoint on the EBITDA of about $25 million of improvement year-over-year. Just can you help us kind of walk us to how you're getting there. It seems like a lot of that is going to be just from cost reductions that you have an opportunity and have a pretty good handle on.
Michael C. Greiner
Yes, I think it's -- so 2 things. Absolutely, a good portion is cost reductions. And then it's the mid-single-digit growth. combined against a higher gross margin profile, right? So our gross margin profile next year will be going up versus this year meaningfully. Our SG&A as a percentage of revenue will actually be up next year a little bit versus this year, but we'll be slowly be coming down to our -- ultimately, our end targets of 38% to 39% in 2025. So it is a mix of good mid-single-digit growth, better mix of product portfolio dropping to the bottom line, plus working on our transformation cost efforts that you just mentioned and also starting to lean in on the additional cost takeout post the divestiture, the full divestiture of RH, right? We're going to be entangled with AirLife for the better part of the year post closing as they do some manufacturing for us, we do some manufacturing for them. The two plants that they will take over, we get out of and condense our footprint, which is what we shared on Investor Day.
So it's a combination of both. I think the point you're making there, Matt, which I totally agree on is all of that, we have control over. Now do we have exact control over whether it's the second quarter or third quarter next year, I mean, that's tough to tell, right? And this is why these are very preliminary 2024 numbers. As we get to the back half of this year, as we get beyond the close date, which we hope is going to be the early part of the fourth quarter, we're on track for that. We will have -- for fourth quarter earnings, we will have a much better defined runway of how quick we can get at each of these costs and what next year looks like. But yes, we feel good about these ranges because to your point, a majority of what's in there for next year and in the '25 is very much in our control, assuming we execute on the pain strategy.
Matthew Ian Mishan
All right. Excellent. And then last question, just on the HA market. As you think about the ASPs coming closer to parity, between Orthogen and some of the competition kind of where is that in getting closer to parity? And kind of when do you expect that to converge completely?
Joseph F. Woody
Matt, this is Joe Woody. I think we have several quarters, I maybe even said in the prepared remarks, but I can't remember exactly, but I think it's about several quarters. You move into '24, we're going to settle out a different base. And then we're very confident that we can get a low single-digit growth out of that business on a go forward.
Operator
The next question comes from Kristen Stewart with CL King.
Kristen Marie Stewart
Congratulations on a good quarter when you look at the numbers in totality. I was just wondering if you could go through the Digestive Health business. You had a really strong quarter there. How should we just think about the sustainability of that franchise?
Joseph F. Woody
Yes. So Kristen, thanks for your comments on the quarter. I think that we had a very strong NeoMed performance at very high double-digit, good CORTRAK, really good in our legacy business. We think NeoMed has the type of growth that we've been experiencing double-digit anyway, at least in the next 12 months. And we've got some great global opportunity in the legacy side of our business. But that said, obviously, we'll have tough competitors next year. Nonetheless, we still see it as a really rock solid mid-single-digit grower across the board. And then, of course, as we said at the Investor Day, we're going to be additive with M&A bolt-ons there, too.
Kristen Marie Stewart
And just on the M&A environment, is there anything that you can share with us in terms of anything proceeding?
Joseph F. Woody
No. As you can imagine, we're heads down on execution right now on integration. And all the things that you saw in the release, but we do think that as we move into '24, we'll start to open our aperture again there.
Michael C. Greiner
Yes. The only thing I would add, Kristen, to that, obviously, we just have a lot to absorb right now and we really want to execute on what we just laid out today over '24, '25 and it ties back to what we shared on Investor Day. We are very focused going forward though. We're not adding a third leg. We'll be very focused primarily in the DH space. We've done a couple of nice things, we believe, in the pain space. We've got to go execute organically there. So should we do anything actionable over the next 12 months, you most likely would see that come from the DH space.
Operator
(Operator Instructions) The next question comes from Daniel Stauder with JMP Securities.
Daniel Walker Stauder
So just first one would be on gross margin. I mean, you talked about 60% both today and during your Analyst Day and you're almost there right now with earnings, but you talked about 59% for the full year. But really just looking out, I just wanted to ask about how do some of these new products play into that? I think you had talked about them being accretive to margins upon full ramp. But I just wanted to ask, post launch of some of these new products in the next 12 months, how long will it take to really add to that gross margin and add some even more power there.
Michael C. Greiner
Yes. So I think you're referring to a couple of launches we have in DH, plus, obviously, adding the Diros technology. They will be, over time, Daniel, they will be additive to gross margins, which could provide some upside to our 60% to 61% that we have previously disclosed. But we also have those inflationary headwinds that we described, which some may argue were conservative that we shared on Investor Day, it was over 400 basis points of inflationary headwinds. So we still feel very comfortable the 60% to 61%, but as you see the numbers already roll up at 59.9% and what we're looking at. You can make other assessments that perhaps 60% to 61% is too conservative. But we're comfortable with that range right now until we see how the inflationary environment in Mexico plays out over the next 12 to 18 months and ensuring that these launches occur successfully and that Diros is what we strongly believe it will be for us.
Daniel Walker Stauder
Great. And then just one more for me on pain management. You mentioned that the softness was due to some supply chain issues. But I really just wanted to ask about the underlying procedure demand here. How has that trended throughout the year? And then as far as the supply challenges, what was the main issue there? It seems interesting to us that the headwinds were so broad based. So any specific thing you can give would be helpful.
Joseph F. Woody
The underlying is trending up, and we're in a situation with backorder where we're sort of having to allocate to our top 200 accounts, and we can't take advantage to your point, of the upswing in procedures. We think that's going to close out as we move into the fourth quarter, really more towards the mid part of the fourth quarter and as we go into 2024, so we can take advantage of those, which is why we're feeling a little bit more positive around that. The actual areas are around chips and components in some of our CRGs, some of the supplies that are part of the COOLIEF or the RF procedure. And then we have a catheter issue that we're dealing with on a supplier to really that affects the ON-Q growth in particular. So it's really holding us back. We're frustrated by it. We worked our way through it. We again, have said, we think we'll be through it by the end of the year, and that's when we'll start to jump in and take advantage of some of this natural procedural growth, which is there.
Operator
This concludes our question-and-answer session. I would now like to turn the call back over to Joe Woody for his closing remarks.
Joseph F. Woody
Thank you. I think everybody can get the feeling that we're focused on execution and delivering this plan and all the things that we outlined at Investor Day. So this year, already, we've executed on product exits, divested our RH business, acquired what we think is a valuable technology in Diros and approved an additional share repurchase program, and we're delivering on most of our financial objectives. Our feeling is these results have established a necessary foundation for us to deliver our midterm financial commitments. We're confident that the transformation priorities and our market-leading portfolio in attractive markets position us for sales growth and the margin expansion that we're talking about, and of course, meaningful free cash flow generation. So I know we'll be talking to a number of you going forward. Thanks for attending the call and your continued interest in Avanos.
Operator
The conference has now concluded. Thank you for your participation. You may now disconnect.
