LivaNova PLC

NASDAQ:LIVN

Earnings Call Transcript 2020-Q4

[Operator]

Good day, ladies and gentlemen, and welcome to the LivaNova PLC Fourth Quarter and Full Year 2020 Earnings Conference Call. [Operator Instructions]

As a reminder, this conference call is being recorded.

I would now like to introduce your host for today's conference, Mr. Matthew Dodds, LivaNova's Senior Vice President of Corporate Development. Please go ahead, sir.

[Matthew Dodds, Senior Vice President of Corporate Development]

Thank you, Catherine, and welcome to our conference call and webcast discussing LivaNova's financial results for the fourth quarter and full year 2020. Joining me on today's call are Damien McDonald, our Chief Executive Officer; Alex Shvartsburg, our Interim Chief Financial Officer; and Melissa Farina, our Vice President of Investor Relations.

Before we begin, I would like to remind you that the discussions during this call will include forward-looking statements. Factors that could cause actual results to differ materially are discussed in the company's most recent filings and documents furnished to the SEC, including today's press release that is available on our website. We do not undertake to update any forward-looking statement. Also, the discussions will include certain non-GAAP financial measures with respect to our performance, including, but not limited to, sales results, which will all be stated on a constant currency basis. Reconciliations to the most directly comparable GAAP financial measures can be found in today's press release, which is available on our website.

We have also posted a presentation to our website that summarizes the points of today's call. This presentation is complementary to our other call materials and should be used as an enhanced communication tool. You can find the presentation and press release in the Investors section of our website under News and Events and Presentations at investor.livanova.com.

With that, I will now turn the call over to Damien.

[Damien McDonald, Chief Executive Officer]

Thanks, Matt. And thank you for joining us, and I hope you and your families continue to remain safe and healthy during these challenging times. Welcome to our fourth quarter and full year 2020 conference call.

As you are aware, we have a large employee population in Houston, all of whom were impacted by the storms last week. I'm relieved that everyone is safe and would like to thank all of them for their dedication and ingenuity to keep our operations running.

Today, we will discuss our results and provide recent company updates, including guidance for 2021 and the first quarter. The COVID-19 pandemic has presented unique operating challenges. Many markets around the world have operated inconsistently or shut down for varying periods of time, and this dynamic has continued in the fourth quarter and thus far into 2021.

I'm going to start off by discussing some recent updates to our business and Board structure, then move to sales results, focusing on the primary growth drivers, epilepsy and ACS. Then I will discuss our strategic portfolio initiatives, DTD, heart failure and OSA. After my comments, Alex will provide you with additional details on the results and our 2021 guidance, which continues to include heart valves. Then I will wrap up with closing comments before moving on to Q&A.

In December, LivaNova entered into an agreement with Gyrus Capital for the sale of the Heart valve business. This portfolio will benefit from the ownership of Gyrus and its ability to singularly focus on building a heart valve business. This will enable us to sharpen our focus on the primary cardiovascular and neuromodulation platforms.

As you know, divestitures are complex, and we are currently discussing an amendment to the purchase agreement with Gyrus related to a deferred closing of a subsidiary that is responsible for site management services at the Saluggia campus. We continue to expect the initial closing, consisting of the heart valve operations in Italy and Canada to occur in the second quarter, followed by closings of the sales infrastructure in the second half of the year.

In December, we announced a series of Board leadership changes driven by the Nominating and Corporate Governance Committee. Included in those changes, Todd Schermerhorn was appointed to the Board of Directors. Todd has 35 years of experience in global health care, including 27 years at C.R. Bard, where he held positions of increasing responsibility, which culminated with his 9-year tenure as Chief Financial Officer. He currently serves on the boards of Metabolon and also Travelers Companies, where he is the Independent Lead Director and chairs its risk committee. Todd will succeed Hugh Morrison as Audit Chair upon Hugh's retirement at the 2021 AGM.

Additionally, we will be rotating the Board and 2 committee chairs following the 2021 AGM. We believe all these changes underscore our commitment to leading corporate governance and to help further enhance the Board's independent oversight.

Now I'll discuss the core growth drivers, epilepsy and ACS. All net sales results will be stated in a constant currency basis. Epilepsy sales declined 4% globally versus the fourth quarter of 2019. This decrease is attributable to the impact of COVID-19 on both new patient and end of service or replacement implants. Importantly, sales rose sequentially and were in line with our full year guidance range. U.S. epilepsy declined in the mid-single digits and implants continued to improve sequentially over the third quarter. In the fourth quarter, epilepsy sales in Europe reached nearly 90% of our prior year levels with strong performance in the Nordic region and Spain. The Rest of world region grew 11% as a strong growth in the Middle East and Australia as non-emergent procedures recovered.

For the full year 2021, we expect global epilepsy sales to grow 15% to 20%, including strong growth in new implants as patients return to their physicians, and we expect a tailwind in replacement implants related to the backlog created in 2020. We are pleased with the progress of the go-to-market initiative and still plan on adding 3 new dedicated teams in the U.S. during 2021.

ACS sales were $13 million in the quarter, an increase of 50% from the fourth quarter of 2019. Growth was driven by the adoption of LifeSPARC and an increase in acute respiratory distress-related procedures. We continue to expect ACS to grow at least 20% in 2021.

Turning now to DTD. Sales in the fourth quarter were $1 million and $7 million for the full year. In 2021, we expect DTD sales of approximately $10 million to $15 million from a combination of the RECOVER study and the replacement implants for CMS-eligible patients. We continue to expect to reach 250 unipolar patients and/or 150 bipolar patients implanted in their respective RECOVER study arms by year-end.

In heart failure, the ANTHEM-HFrEF U.S. pivotal trial continues to progress with over 265 patients enrolled. We still expect to achieve 300 patients enrolled in the first half of 2021. We continue to make progress in OSA. The confirmatory study was submitted for IDE approval during the fourth quarter. We received some additional questions and still expect to start the study in mid-2021.

For the cardiopulmonary business, sales were $122 million in the quarter, a decline of 10% versus the fourth quarter of 2019. Oxygenators has declined in low double digits globally as a faster recovery in the procedure volumes in the U.S. and the rest of world region was offset by procedure restrictions in Europe. HLM sales declined in the high single digits due to COVID-19 impacts on hospital budgets for capital equipment and all regions improved sequentially over the third quarter.

Moving to heart valves. Sales for the segment were $24 million in the quarter, a decrease of 27% versus the fourth quarter of 2019, including another double-digit growth quarter in Japan, driven by Perceval.

Starting in the second quarter of 2020 and continuing through the year, we reduced costs to offset some of the decline in sales. We continue to reallocate resources to fund priorities. These actions have delivered approximately $65 million in savings in 2020.

Specifically, these 4 key areas included the following: First, we instituted a hiring freeze, participated in government-sponsored work programs and adjusted employee-related expenses, including lower performance-based compensation and a significant reduction in executive leadership short term incentive; second, we reduced spend related to travel, marketing events and field presence and have shifted to working with our customers and stakeholders using remote methods; third, we reduced other discretionary spend related to external consulting and temporary staffing; and fourth, we balanced our manufacturing output to coincide with the anticipated reduction in demand.

We remain focused on disciplined control of expenses as we move through this next phase of the pandemic while still investing in our pipeline initiatives. I'll now turn the call over to Alex for an overview of the financial results.

[Alex Shvartsburg, Interim Chief Financial Officer]

Thank you, Damien. I'm going to discuss the fourth quarter results in greater detail and then provide our 2021 guidance. Sales in the quarter were $270 million and declined 7.7% compared to the fourth quarter of 2019. Cardiovascular sales were $160 million, down 10.1% for the fourth quarter of 2019. Neuromodulation sales were $109 million, a decline of 3.8% compared to the fourth quarter of 2019.

Adjusted gross margin as a percent of net sales in the quarter was 67.2%, down 250 basis points from the fourth quarter of 2019. The margin decline was primarily driven by lower volume from sales and unfavorable manufacturing variances.

Adjusted R&D expense in the fourth quarter was $39 million compared to $38 million in the fourth quarter of 2019. R&D as a percent of net sales was 14.5% versus 13.1% in the fourth quarter of 2019. R&D is increasing behind continued progress of the ANTHEM-HFrEF pivotal trial and the RECOVER study.

Adjusted SG&A expense for the fourth quarter was $94 million compared to $108 million in the fourth quarter of 2019. SG&A as a percentage of net sales, was 34.7%, down from 37.4% in the fourth quarter of 2019. Adjusted operating income from continuing operations was $49 million compared to $55 million in the fourth quarter of last year.

Adjusted operating income margin from continuing operations was 18% compared to 19.2% in the fourth quarter of 2019. The adjusted effective tax rate in the quarter was negative 0.1% compared to 5.3% in the fourth quarter of 2019. The lower tax rate is primarily attributable to geographic income mix and partial valuation allowance in the U.S. Finally, adjusted diluted earnings per share from continuing operations in the quarter was $0.71 compared to $1 in the fourth quarter of 2019, and was within the full year guidance range.

Moving to cash flow. The cash balance at December 31, 2020, was $253 million, up from $61 million at December 31, 2019. Net debt at quarter end was approximately $505 million, up from $272 million at year-end 2019. These changes reflect the impact of the financing completed in the second quarter of 2020. Our adjusted free cash flow, excluding extraordinary items through the fourth quarter of 2020 was $17 million. Capital spending for 2020 was $35 million, which was $10 million higher than 2019, related to initiatives to support manufacturing, sterilization capabilities and to further develop our epilepsy digital innovation platform. As a result of the heart valve divestiture, we took a charge of $202 million in the fourth quarter related to the anticipated sale of the heart valve business. In addition, we have reserved $42 million for a provision for future obligations of our site management subsidiary related to hazardous substances from former operations at Saluggia, Italy, campus.

Now turning to 2021 guidance. We forecast 2021 sales growth between 8% and 13% on a constant currency basis, and this includes the full year of the heart valve business. If current exchange rates remain unchanged, the company's full year revenue guidance will be positively impacted by less than 1%.

We anticipate the neuromodulation business to grow 15% to 20%. We estimate our cardiovascular franchise to grow in the low to mid-single digits, with strong growth from ACS, largely offset by late-stage replacement cycle of HLM.

We are projecting adjusted diluted earnings per share from continuing operations in the range of $1.40 to $1.90. The share count is expected to be approximately 49 million.

Adjusted cash flow from operations, excluding extraordinary items, is expected to be in the range of $30 million to $50 million. While we don't provide quarterly guidance, sales in the first half are assumed to be lower, while expenses are generally more evenly spread out.

For the first quarter of 2021, we expect net sales to be down 3% to 7%. The first quarter is expected to be the softest earnings quarter, and we forecast a range of $0.10 to $0.20 per share.

With that, I'll turn the call back to Damien for some final comments.

[Damien McDonald, Chief Executive Officer]

Thanks, Alex. While 2020 did not go as expected, we have become stronger, more agile, and remain cautiously optimistic that our execution focus, coupled with expectations of declining COVID-19 infections rates will lead to improving results throughout the year.

As we transition out of the pandemic, we believe customers will continue to reward both our innovation and actions as valued partners with increased trust and market share. As procedures return, we believe the work we've been doing to improve margins will become clearer. We look forward to updating you on our continued progress and delivering on our commitments to drive shareholder value.

And with that, Catherine, we're open for questions.

[Operator]

[Operator Instructions] Our first question comes from Rick Wise with Stifel.

[Rick Wise, Stifel]

Damien, maybe I'll start off just with recent trends. Obviously, we've all been hearing in recent days and weeks about the weakness -- COVID-driven weakness, in general for everybody in late December and into January. Can you give us a little more color on recent trends and just what you're seeing? Have things stabilized? Are you seeing -- is it getting worse or better as you're now 2/3 of the way through the first quarter. Just any additional color, if you could.

[Damien McDonald, Chief Executive Officer]

Yes. First of all, Rick, lovely to have you on. Fourth quarter. Look, the fourth quarter was interesting year-over-year. Look, October was the strongest, and then we faced headwinds, like a lot of people in mid-November that carried into December, especially Europe. I mean, that was the noisiest for us. And you can see that in some of the commentary we just gave.

Sales in the first quarter really continued that trend with the COVID-19 hospitalizations increasing. Comparisons start getting easier in March, but Q1 has been noisy, to say the least.

[Rick Wise, Stifel]

I'm sorry, noisy, meaning? Can you give us any more color? Are you feeling a bit more optimistic? Many companies have talked about recovery or some have cited some signs of light at the end of the tunnel kind of thing. Anything else you can share?

[Matthew Dodds, Senior Vice President of Corporate Development]

Rick, it's Matt. So I would say what we're seeing is similar to what you've heard from a lot of other companies. It wasn't as bad in Jan, Feb as maybe it was last year in like April, May. The hospitals were just better situated, especially in the U.S. It has been a little tougher in Europe. Europe didn't rebound as much.

We have seen international remain in pretty good shape from what we came off of in the last -- at the end of last quarter. And I would say there were slightly improving trends in February, but last week and the week before with weather and what happened in Houston, that looked like a temporary setback. So I'd say the next 2 weeks, we'll know a lot more.

[Rick Wise, Stifel]

Okay. And turning to the RECOVER trial enrollment timelines and milestones. If I heard you correctly, Damien, and please correct me if I'm wrong, the 250 unipolar or 155 -- 50, rather or 55, did you say, bipolars by the end of '21. It sounds like enrollment, if I'm hearing you correctly, is very much on track sort of with expectations or guidance or comments we've heard in recent months. Am I understanding that correctly? And to what extent are we seeing headwinds there? Or are you concerned about these timelines?

[Damien McDonald, Chief Executive Officer]

Yes. You are hearing that right, yes. So 250 in the unipolar or 150 in the bipolar or both. We actually thought that the bipolar was not going to recruit as fast because it's just harder to deal with those patients and track them. But it turns out that, that has been a faster recruiting timeline than we anticipated. So it's tracking well.

The implants are progressing well. The consents into the trial have been really progressing well. Again, the limiting factor is just clinics being open to implant, which, as you know, from some of the studies, neurology, psychiatry visit to clinics are lower, whereas a lot of the telehealth is progressing very, very well.

So I like the progression there. The consents are definitely tracking extremely well, and I'm pleased with how the team is doing that study and following up on the existing patients that we've already implanted. We've not missed a titration or follow-up yet.

[Operator]

Our next question comes from Anthony Petrone with Jefferies.

[Anthony Petrone, Jefferies]

Great. I hope everyone is healthy. Maybe just a couple on guidance. The negative 18% -- negative 8% to 13%, all baked in, what is actually baked in there for heart valves? Just trying to get some math as we exclude that.

And then in terms of the neuromod outlook, 15% to 20%. Just trying to get a sense of how much COVID recovery is reflected in that versus new patient starts and then even reimplants from the 100,000 existing base. How much -- how many -- how do you reflect reimplants in that as well?

[Damien McDonald, Chief Executive Officer]

First of all, let me just say, welcome, Anthony. Great to have you tracking us. And I'll pass this to Alex.

[Alex Shvartsburg, Interim Chief Financial Officer]

Yes. So from a sales perspective, heart valves ended 2020 at roughly, call it, $90 million in sales. We expect a recovery from heart valves sort of low to mid-double digits, I would say. So that's kind of a good way to forecast the heart valve business.

And right now, we have it in for the full year. But as we said, we expect to close the transaction sometime in the second quarter.

[Matthew Dodds, Senior Vice President of Corporate Development]

And it's Matt. For neuromod, the 15% to 20%, I would say, look, a little bit of that is DTD. That's up year-over-year. If you look at epilepsy, what we've been saying is at least 5% underlying is our plan, hopefully, a little better, higher OUS because that's a global number. And then don't forget the U.S. is 75%. So it's mostly driven by the U.S.

So if you take those pieces, you can kind of see what the difference is in terms of what we consider to be the snapback. And our thought right now is more of that's going to come from the replacement or under service than the NPI.

[Operator]

Our next question comes from Adam Maeder with Piper Sandler.

[Adam Maeder, Piper Sandler]

I wanted to start with just a couple of housekeeping questions. Just first, it sounds like you gave an incremental update on the pending heart valve divestiture. But I want to make sure I better understand that. So -- and I know the divestiture isn't contemplated in the guide, but how do we think about any potential impact there in terms of dilution once that's final?

And then the second housekeeping question is just any update or more color you can share on the CFO search and where that stands today? And then I have 1 follow-up.

[Alex Shvartsburg, Interim Chief Financial Officer]

Adam, it's Alex. On the heart valve divestiture, as we stated previously, we expect the full year impact to be about $0.10 to $0.15 dilutive. So that's the way, obviously, given the timeline, I would model it in that fashion, prorated as you see it.

[Damien McDonald, Chief Executive Officer]

And with respect to the CFO search, two things. First of all, the end of year is an interesting time to be recruiting for senior executives because it's bonus reporting [K and Qs] for most companies. So that role has a stickiness that I think is interesting when you're recruiting. Having said that, our partner, which is a large global human resources partnership, has unearthed a really intriguing pack of candidates, many of whom we've met over the last several months.

Having said that, I will say I'm fortunate, and I think we're fortunate as a company, to have Alex being able to step into the role. And he's making a tangible and palpable difference to the function. And so as we continue the search, I'm convinced that we have the right person to be filling the seat.

[Adam Maeder, Piper Sandler]

That's very helpful. And then for the follow-up, just one on the '21 guidance. The EPS guide to me was, I guess, a bit below I expect -- than I expected, and perhaps that's some mismodeling on my behalf. But the guidance range is pretty wide, so it would be helpful to kind of better understand kind of how you arrived at the top and the bottom end of the EPS outlook.

And then maybe just talk about the cost initiatives that you had in 2020, the savings there, what's going to carry over into 2021. And then just talk a little bit about kind of employee morale and turnover.

[Alex Shvartsburg, Interim Chief Financial Officer]

Okay. So from a margin profile perspective, the gross margin is actually increasing in 2021. And then once heart valves are out of our P&L, we expect about 200 basis points of accretion. Relative to 2020, gross margin is increasing on the basis of improved mix from VNS and increased volumes in CP. R&D as a percent of sales is going to increase in 2021. This is largely due to the RECOVER and the ANTHEM trials. Also, just to remind you, in 2020, we had sort of a depressed spending base. So there's a little bit of an increase there as well.

SG&A as a percent of sales is going to decrease in 2021 versus 2020. It's just pure economies of scale as sales increase, and we see some leverage there. Then, I guess, interest expense, we continue to look at $45 million to $50 million and the tax rate in the range of 10% to 15%.

[Matthew Dodds, Senior Vice President of Corporate Development]

Yes, Adam, I'd say, versus consensus, it's a little tricky because a couple of you have heart valves out but what we really try to look at apples-to-apples, I'd say the major differences to Alex's point, it's R&D and s G&A. That's where we see our numbers a little bit ahead of the Street as a percent of sales.

[Damien McDonald, Chief Executive Officer]

Just on employee morale, it's a great question. So first of all, let me talk about data. Sequentially, we saw an improvement in our voluntary turnover rate quarter-on-quarter. So I'm pleased that we're heading in the right direction there.

Secondly, we conducted our virtual growth and leadership conference, which brings together 150 of our senior leadership over 3 days in December and January. And reading the chat line of this virtual conference, I'm convinced we have a highly motivated senior leadership team.

Yes. More broadly, I'd say the organization has faced into the challenges of 2020 and even the start of 2021 with the weather and continued COVID with extreme positivity. And again, I just look at how people reacted with ingenuity to the freezing weather in Houston. And I'm convinced that we've got a team that's highly motivated and really linked to our mission of patients first.

[Operator]

Our next question comes from Michael Polark with Baird.

[Michael Polark, Baird]

I have several follow-ups to some of the prior questions. Just a clarification. I heard on -- in the slides, the slide deck says for cardiovascular revenue, up mid- to high single digits in 2021. And then, Alex, I think in your prepared comments, you said low to mid. My sense is the variance there is with and without heart valves, or perhaps I misheard. So can you just clarify those 2 tidbits for me?

[Alex Shvartsburg, Interim Chief Financial Officer]

Yes. So cardiovascular, we expect to grow low to mid-single digits, kind of in line with the normal growth that you would see from the marketplace. As I mentioned before, we expect the heart valve business to have a larger snapback. So expect somewhere between, I would say, low to mid-double-digit snapback on heart valves. So that's kind of how we adjust for it.

[Michael Polark, Baird]

Okay. The slide deck, Page 21, says cardiovascular, up mid- to high single digits. So just want to -- that's the genesis of the question. I'm hearing differently from you than I see in the slides, but maybe we can take that offline. And I think I get the components, I just -- several moving pieces. I want to make sure we're anchored appropriately. On heart valves, the earnings, $0.10 to $0.15 of run rate dilution. Let's assume that does divest middle of this year, as you indicated. Does your -- and I know it's in your revenue guidance today, but does your earnings guidance absorb that dilution when it finally hits?

[Alex Shvartsburg, Interim Chief Financial Officer]

No. No, it does not.

[Michael Polark, Baird]

Okay, okay. In the slide deck, on the free cash flow slide, Slide 20, there's -- for the 2021 forecast, there's a dotted line on the gray box, and I want to understand what is that. It seems to be an extraordinary item, and I want to understand what that is and what the number is.

[Alex Shvartsburg, Interim Chief Financial Officer]

It's just a range, really. That's all it is.

[Michael Polark, Baird]

Oh, got it. Okay. So the purple...

[Damien McDonald, Chief Executive Officer]

It's showing the 30 to 50 range.

[Alex Shvartsburg, Interim Chief Financial Officer]

Yes.

[Michael Polark, Baird]

Okay, okay, okay. Understood. On the -- on R&D, I mean, look, it's -- I appreciate that comment. Clearly, Street was, and myself, undermodeling the spend in 2021, peak period for both of those important studies. Can you put a finer point on what is the dollar investment expected? Or what is -- what are your R&D dollars in your model in 2021?

Because I would imagine in '22 and beyond, that we back off if this is indeed peak spend year for ANTHEM and RECOVER. So just trying to -- it's a little bit of a pop in that number and then will fade, I would imagine, in the out years. So if you could put a finer point on that, I think that would be helpful.

[Alex Shvartsburg, Interim Chief Financial Officer]

I'll quote a range of 16% to 17% of sales.

[Michael Polark, Baird]

Okay. All right. Last one. The -- it sounds like the RECOVER recruitment is on track, and then, here, the comments cleared. Does that keep you on pace for the prior timing of the late 2022, early 2023 foot to registry? My guess is yes, but I want to ask the question.

[Damien McDonald, Chief Executive Officer]

Yes, yes. So the short answer is yes.

[Operator]

Our next question comes from Scott Bardo with Berenberg.

[Scott Bardo, Berenberg]

LivaNova, I think, used to provide some EBIT margin range implicit within your guidance. And I know you've just, Alex, given some parts of the pieces. But the nature of my question is your sales guidance looks to be, I think, quite encouraging, highlighting a return to more normalized activities. Yet, if I understand correctly, your earnings guidance implies something like a 13% to 16% margin guidance. I wonder, firstly, can you clarify whether that makes sense?

And following up from that, one of your key strategic priorities, I think, is to optimize operating costs. And it seems a little perverse to me why while your top line recovers as guided, why you're expecting margins to be materially below 2019 even without the divestiture of heart valves, which I think is margin accretive. So I just want to talk about these parts. And I think it is important because Damien, you've highlighted many times, an aspiration to shoot towards a 20% margin bandwidth, which seems achievable given your gross margin. Of course, there's great uncertainty as to a timeline around that. So if you could please help us with those pieces, I think that's important.

[Operator]

One moment. Speakers, please go ahead.

[Damien McDonald, Chief Executive Officer]

Sorry, we lost Scott there.

[Scott Bardo, Berenberg]

Okay. Can you hear me, okay?

[Damien McDonald, Chief Executive Officer]

Yes. Catherine, we've got you back. So Scott, sorry, we lost you there.

[Scott Bardo, Berenberg]

Oh, I'm sorry for that. Okay. So we'll summarize the question again. Your guidance implies good top line dynamic and a recovery of the top line, but it seems to me that your earnings guidance suggests that your margins are going to be below 2019, quite materially below 2019. And that seems a bit of a disconnect given your statements about trying to maximize operational profit and improve efficiencies. So I guess the nature of the question is, can you help us understand what margin is implied within your guidance? And when, in your view, we'd take the path towards back to a 20% margin, which is your current midterm guidance for 2022.

[Damien McDonald, Chief Executive Officer]

Scott, thanks for your question. So our adjusted margin, we're expecting somewhere between 13% to 14%. That's kind of where we're coming in. Again, the major investments in R&D are kind of driving the, I guess, you could call it, the dilutive effect of these investments. We're making good progress in terms of reallocating costs. It's going to take us a little bit of time to work through some of the cost containment initiatives that we've highlighted in the past, so that's kind of the plan at this point.

[Matthew Dodds, Senior Vice President of Corporate Development]

Yes, Scott, it's Matt. Our plan is to improve, obviously, from '21 going forward each year. We're tentatively planning our Capital Markets Day in the back half of this year. And we're going to give you a lot more color on the margin over a longer-term horizon. And then specifically, that 20% number, we'll be very clear on the year we expect to get back to that.

[Scott Bardo, Berenberg]

But I mean, following on for 1 of the questions before then. Is it fair to say we are then at peak R&D on an absolute basis and that, that should normalize going forward? Is that a fair statement?

[Alex Shvartsburg, Interim Chief Financial Officer]

Yes, exactly, Scott.

[Scott Bardo, Berenberg]

All right. And maybe just 1 last question on free cash flow, please. I think that it's encouraging, of course, to see that you're expecting some progression in free cash flow. But the free cash flow numbers being guided are still 25% of the adjusted free cash flow guidance that would have been given this time last year. So why is free cash flow so poor? And when do we actually see a convergence towards your historic free cash flow guidance?

[Alex Shvartsburg, Interim Chief Financial Officer]

So Scott, just want to remind you, in this third quarter, we changed the definition of free cash flow. Our free cash flow measure has essentially -- we stopped taking out a number of adjustments and really streamlined it to a point where it's operating cash flows, less investing activities and only adjusting for extraordinary items like the 3T settlements.

[Damien McDonald, Chief Executive Officer]

I mean, largely in response to a number of discussions we had with people and about clarifying and not sort of exceptionalizing. And I think this is a much more robust definition. Year-on-year, it creates some muddiness. But I think we are at a place now where our cash flow is much more robust. And I think what you could calculate directly from GAAP.

[Scott Bardo, Berenberg]

Okay. Good. Very quickly then. And I guess the underlying nature of that question was, clearly then, you're still seeing some material adjustments this year. When do we get a cleaner set of free cash flow? I mean, do you expect some of these adjustments to significantly abate next year? Can you give us some sense of that?

[Alex Shvartsburg, Interim Chief Financial Officer]

I think for the most part, we've seen a lot of these adjustments coming out even in the latter part of 2020. So...

[Damien McDonald, Chief Executive Officer]

And again, I think if we look at that table in the chart, where you can see there that there's significant differences in a number of the metrics there. And I think that, again, I hope provides a lot of clarity to people as they were modeling what we were taking out. And also going forward, I think you can expect lower merger and integration costs, those sorts of things that have been pretty high for a number of years.

[Operator]

Our next question comes from Matt Taylor with UBS.

[Matt Taylor, UBS]

So I wanted to follow up on an earlier question about assumptions behind the guidance and just see if you could give us some flavor or color on how conservative you think the guidance is with regards to recovery assumptions through the year in some of the different businesses. Have you baked in some haircut? And what does it assume in terms of overall utilization recovery?

[Alex Shvartsburg, Interim Chief Financial Officer]

So I mean, in terms of the overall forecast, we think it's appropriate, given the current COVID situation. We still -- there's still a lot of uncertainty. We're seeing that continue to read through in the first quarter. So we're thinking about the sales forecast in terms of showing glimpses of recovery in the second half. So we're still modeling an essentially depressed market.

[Damien McDonald, Chief Executive Officer]

Yes, yes. So Q1 is the toughest comp, and then we gradually see progression throughout the year. And I think I used the words cautiously optimistic. As procedures grow, the vaccine rollout continues. And patients feel willing to go back -- a number of our disease states require willingness of patients to reenter the clinics, like epilepsy, which skews pediatric, right? So there's 30% of our patients are pediatric, and you need the carrier and the child to go into the clinic. So I think we're very cautious on Q1 with a gradual improvement throughout the rest of the year.

[Matthew Dodds, Senior Vice President of Corporate Development]

And the last thing I'd say, Matt, is on neuromod epilepsy in general. That's the one that gets a lot of attention. What we're forecasting is that for NPI, the funnel has been delayed, not backlogged. So there's just been kind of a lag on that. But for replacement or render of service, we do think that there's going to be an OR backlog. So we're going to recapture patients in 2021. But we've even modeled some of them end up in 2022.

[Matt Taylor, UBS]

Okay. Thanks, Matt and Damien. So 1 follow-up on epilepsy. I think everything you've said about the impacts here the last couple of quarters has really been around COVID. I was curious, are you seeing any drug headwinds or impact from recalls or anything else that is hampering that business?

[Damien McDonald, Chief Executive Officer]

No, we included in our modeling, the impact of drugs. We've continued to monitor all of that very closely. We're not seeing specific headwinds in any specific geography or for any drug impact.

[Matt Taylor, UBS]

Okay. And sorry, just 1 more follow-up. I wanted to be really explicit about this because I got a little confused by the comments. When you're giving this EPS guidance, midpoint is $1.65, so that includes heart valve this year. So basically, you're saying if you do divest it in the second quarter, we should take out a prorated amount of $0.10 to $0.15. So basically, your underlying guidance midpoint is below the $1.65?

[Alex Shvartsburg, Interim Chief Financial Officer]

That is correct.

[Operator]

Our next question comes from Mike Matson with Needham.

[David Saxon, Needham]

This is David on for Mike. Just a question -- you listed some cost containment measures you're taking, hiring freeze, executive comp, et cetera. Did you make any cuts to the sales force across any of the businesses? And with these measures continuing into 2021, what gives you confidence that it's not going to impact the growth profile over, call it, the next 12 to 18 months?

[Damien McDonald, Chief Executive Officer]

Yes. Good question. No, we didn't cut the sales force. That's not where headcount freezes have occurred. And going into 2021, we're actually increasing headcount slightly in those areas.

ACS, for example, we've talked about hiring 20 additional people into the team in the U.S. We've already started that in Q4, and that will continue through the next couple of quarters. And similarly, in epilepsy, the pod teams, we're committed to hiring at least another 3 of those in the year, and we've started recruiting for that. So the sales organization has not been impacted by this.

[David Saxon, Needham]

Okay. And then just a quick question on the balance sheet. I think you said you had just over $500 million of net debt and you'll get some cash from the sale of heart valves. So how are you thinking about the balance sheet?

And then if I could sneak one more in. You talked about a backlog of VNS replacements. It seems like you guys could probably have some visibility into that. So could you quantify that backlog?

[Alex Shvartsburg, Interim Chief Financial Officer]

So from a balance sheet perspective, that's correct. We ended 2020 with $250 million roughly in cash. We -- we are, obviously, we've stated this before, kind of in the cash preservation mode at this point in time. So there's no plans for any major capital deployment initiatives other than normal investments behind base business and CapEx.

[Matthew Dodds, Senior Vice President of Corporate Development]

And then for the EOS backlog, it's not perfect math, but we're estimating that today, there's about 1,000 to 1,500 patients in the U.S. who should have already come back for the replacement. And again, as we talked about before, we have a pretty high capture rate on replacement. So nothing's changed to suggest they're not coming back. It's more a matter of timing. And as we've said, you can wait at least 6 months, maybe a little longer to have your battery replaced. But we're seeing some of the people that held off in 2020, in the first half of the year, kind of April, May, June, were coming back. So we feel pretty confident in that number.

[Operator]

Thank you. There are no further questions in the queue. I'd like to turn the call back to Damien for any closing remarks.

[Damien McDonald, Chief Executive Officer]

Well, thanks, Catherine. Thank you, everyone, for joining us. We look forward to updating you on our Q1 call in a couple of months. And I just want to thank all of the team globally for their continued passion for our business, and thank you for your interest in our company. Bye.

[Operator]

Ladies and gentlemen, that concludes our conference call for today. Thank you for participating, and you may now disconnect. Everyone, have a great day.