Integer Holdings Corp

NYSE:ITGR

Earnings Call Transcript 2018-Q2

[Operator]

Good morning, my name is Casey, and I will be your conference operator today. At this time, I would like to welcome everyone to the Integer Holdings' Second Quarter 2018 Earnings Conference Call. [Operator Instructions] Thank you. Tony Borowicz, Vice President of Strategy Business Development and Investor Relations, please go ahead.

[Anthony Borowicz, executive]

Thank you, Casey, and good morning, and thanks to everyone for joining us, and welcome to Integer's Second Quarter 2018 Conference Call.

This call is being webcast live and the repay -- replay along with the copy of the press release and earnings presentation will be available on the Investor Relations section of our corporate website.

The results and data we discuss today reflect the consolidated results of Integer for the periods indicated. During our call, we will discuss some non-GAAP measures. For reconciliation of these non-GAAP measures, please see the appendix of today's presentation and the notes to the financial statements in the press release we issued earlier this morning.

As a reminder, today's presentation includes forward-looking statements. Please refer to the company's SEC filings for a discussion of the risk factors that could cause our actual results to differ materially.

Joining me on the call today to discuss our quarterly results is our Vice -- is our President and Executive Officer, Joe Dziedzic; and our Executive Vice President and Interim Chief Financial Officer, Jeremy Friedman.

Following our prepared remarks, the call operator will come back on the line to direct the Q&A. Now let me turn the call over to Joe.

[Joseph Dziedzic, executive]

Thanks, Tony. Welcome everyone, and thank you for joining to hear about our second quarter results. We've built on the strong momentum from the first quarter, and I'm pleased to report that we delivered double-digit sales and earnings growth in the second quarter.

We successfully completed the divestiture of the Advanced Surgical and Orthopedic business at the end of the quarter, which would not have been possible without the tremendous effort from all of the Integer employees involved who worked so diligently to make this happen. It took the entire organization pulling in the same direction to deliver such strong results, while concurrently completing the AS&O divestiture. The Integer organization is actively embracing and driving a long-term strategy that we introduced earlier this year.

The entire organization is aligned on the portfolio strategy, which defines how we win in the markets we serve and the operational strategy, which defines how we achieve excellence in everything we do. I'm confident that with this type of commitment, we will be successful in earning a valuation premium for our shareholders.

I'm very pleased to report -- now let me provide an overview of the second quarter results, and I'm very pleased to report that both sales and earnings increased by double digits, and we continued to pay down debt within the quarter.

Shortly after the quarter ended, we completed the AS&O divestiture, and we repaid an additional $548 million of debt from the deal proceeds. This had significantly reduced our financial leverage, and we're now at 4x EBITDA leverage and expect to be closer to 3.5x by the end of this year.

The AS&O divestiture is one of the outcomes of our disciplined portfolio strategy. Post the divestiture, we will have higher margins, increased net earnings, greater returns on invested capital and improved financial flexibility. As a direct result of this divestiture, we are raising our full year guidance by $0.15, to $3.35 to $3.65 on a full year proforma basis, that is as if we had sold the business at the beginning of the year.

Jeremy will now provide more discussion regarding our financial results for the second quarter. He will start with the review of our pre-divestiture results. This is how shareholders were analyzing Integer coming into the quarter. Afterwards, I will provide more insight into resetting the business post divestiture and discuss our outline in more -- our outlook in more detail.

[Jeremy Friedman, executive]

Thank you, Joe. Good morning, everyone, and thank you again for joining our call. As Joe mentioned, I will be reviewing our second quarter consolidated financial results, which include the full quarter of our recently divested Advanced Surgical and Orthopedics business.

I will also take you through the performance of each product line. All of my comments will be on a pre-divestiture results basis.

Let's begin with Slide 7. Our strong growth trajectory continued again this quarter as we delivered a record of $403 million in sales, which is up 10% versus last year. Adjusted EBITDA of $89 million increased 15% organically. On a reported basis, we grew 27%, higher than the 15% organic growth, due to a favorable foreign exchange impact of $8 million.

Adjusted net income grew to $35 million or $1.06 of adjusted earnings per share. This was a 37% organic year-over-year improvement.

Moving to Slide 8. Trailing 4 quarter, organic sales continue a solidly positive growth trend. For Integer, trailing 4 quarter growth was 8% in the second quarter, led by our Medical product lines and builds on strong growth in the first quarter and prior quarters.

As we have stated previously, we believe that a rolling 4 quarter view is a better indicator of our growth trends than any one individual quarter. These trailing 4 quarter views provide a better sense of how we were performing in the market compared to any individual quarter that can contain anomalies resulting from the timing of customer purchases decisions.

Turning to the left-hand side of Slide 9. You can see that second quarter adjusted EBITDA increased $19 million or 27% versus last year on a reported basis.

$16 million of this growth was driven by improved leverage on increased sales. We also had $8 million of favorable foreign exchange impact, which was partially offset by a $5 million headwind from higher-incentive compensations expense.

We expect 2018 incentive compensation expense to be slightly higher than 2017. With the first half being unfavorable and the second half being slightly favorable to 2017.

Turning to Slide 10, I will now take you through our cash flow performance in the second quarter. As we have been doing for more than a year, we continue to pay down debt in excess of our required repayments. Leverage was reduced to 5.1x by the end of the quarter. After the quarter closed, on July 10, we reduced debt an additional $548 million from the proceeds of the Advanced Surgical and Orthopedics sale.

This additional paydown of debt took our leverage ratio down to 4x, further strengthening our financial position significantly.

We generated $21 million of cash flow from operations during the second quarter, which translated into $13 million of free cash flow. These amounts were below our recent levels and were primarily impacted by working capital needs and accounts receivable and inventory to support our increased revenue, particularly in our Cardio & Vascular business.

We remain highly focused on driving strong operated -- operating cash flow to pay down debt.

Now let's turn to review of our product line sales results. Moving to Slide 12, the Cardio & Vascular product line continues to drive strong top line growth with a 13% year-over-year sales growth in the second quarter. This growth was driven by a particularly strong revenue in our peripheral vascular, neurovascular and electrophysiology markets.

Catheter revenue in electrophysiology and both catheter and guidewire revenue in the peripheral vascular and neurovascular markets were particularly strong.

On a rolling 4 quarter basis, the Cardio & Vascular product line continues to show consistent and strong growth with solid market dynamics, helping as we experience solid growth from all our major customers.

We expect second half growth rates to be slower due to strong 2017 second half sales.

Turning to Slide 13, sales in our Cardiac & Neuromodulation product line were up 9% in the second quarter, which was the strongest year-over-year growth we have seen in more than 2 years.

Neuromodulation revenue experienced year-over-year growth of approximately 30% with double-digit increases in nearly all products. Cardiac Rhythm Management grew low single digits from the ramping of new lead components and assembly business along with capacitors.

The rolling 4 quarter sales trend turned to slight growth for the first time in 5 quarters. We anticipate continued strong growth in neuromodulation, but we expect the fourth quarter to be challenging for Cardiac Rhythm Management, as Q4, in 2017, was 13% higher than the average of the other 3 quarters.

As we have mentioned before, the neuromodulation market remains a key driver of our long-term growth for this product line. We are focused on accelerating neuromodulation sales through the active support of our customers.

The last portion of our Medical segment, Advanced Surgical and Orthopedics is shown on Slide 14. While the Advanced Surgical and Orthopedics group had a very solid second quarter. As a result of the sales of this business at the end of the second quarter, this will be the last time where we will show you the results for the business this way.

The Portable Medical business has been reported as part of this group and was not sold with the Advanced Surgical business. Products -- Portable Medical has had a very strong first half with double-digit increases in both the first and the second quarter.

We will continue to serve the Advanced Surgical and Orthopedic markets through our long-term supply agreements with Viant, formerly MedPlast, and look forward to their continued growth.

Finally, on Slide 15, our nonmedical business, Electrochem, experienced a year-over-year decline in sales in quarter 2. Revenue in the energy market remained strong with an 8% sales increase, compared to the same quarter in 2017. However, this was offset by the timing of government-funded military orders that had been delayed.

Electrochem continues to execute on its strategy and has a number of exciting initiatives expanding its product offering, executing on new business wins and further penetrating the environmental and military markets.

I will now turn the call back to Joe, to help you reset Integer on a post-divestiture basis.

[Joseph Dziedzic, executive]

Thanks, Jeremy. I'd like to take a second and just review the strategic rationale for the divestiture. The divestiture of the Advanced Surgical and Orthopedics business is outcome of our long-term portfolio strategy we introduced earlier this year.

Our strategic review identified the divestiture as the opportunity to unlock significant value. During our strategic assessment, we concluded that the AS&O medical device outsourced market was poised for consolidation, and the market was going to benefit from having fewer and larger suppliers.

As we opportunistically reviewed strategic options, it was important to find a buyer who could emerge as a market leader in the AS&O space. And thus provide ongoing benefits for customers, associates and the patients we serve.

The divestiture to Viant meets this criteria, creating one of the largest MDOs serving this market. The divestiture positions Integer as the market leader in the product lines we serve by bringing differentiating technology to partner with our customers, to drive continued innovation and growth.

With the divestiture, we have a stronger financial profile and greater financial flexibility to accelerate growth. It's also important to note that there was very little overlap between our AS&O customer base and the rest of Integer, with most customers being unique to AS&O. From this perspective, the divestiture has little to no impact on our ongoing customer relationships. Our manufacturing footprint is also improved, with larger manufacturing facilities to have ample room for growth.

I provided color on the transaction rationale. Now let's move on to the financial impact. We developed 2017 pro forma financials as though we had already sold the AS&O business to Viant, and we have summarized the change for 2017 and first half of 2018, on this slide.

For the full year of 2017, Integer pro forma sales would have been lower by $331 million, and pro forma operating profit would have been lower by $31 million.

Had we used the proceeds to pay down debt, pro forma interest expense would have been lower by $42 million. The pro forma earnings per share for 2017, would have increased by $0.27 as the interest expense savings would have been -- would have more than offset the loss of the operating profit.

Looking at the first half of 2018 impact. EPS increased by $0.02. Based upon our prior estimated AS&O operating profit and interest expense savings, our full year 2018 earnings per share estimate increases by $0.15.

The reduced EPS impact compared to last year reflects the improved AS&O performance in 2018 compared to 2017. Earlier, Jeremy reviewed our second quarter results on a pre-divestiture basis. Looking at our results on a post-divestiture basis, both sales and earnings per share increased double digits, growing 11% and 14%, respectively.

Additionally, our EBITDA margins improved to 22% from 20% the prior year, reflecting the divestiture of the significantly lower EBITDA margin AS&O business.

This slide covers the full year, post-divestiture outlook. Given the solid momentum we are seeing, we now expect 2018 full year sales growth to be between 4% and 6% for the year.

This compares to our previous growth estimate of 3% to 6%. For adjusted EBITDA, we expect a range of $255 million to $265 million, an increase of 9% to 13% on a comparable basis to last year.

We are increasing our full year earnings per share guidance by $0.15, as a direct result of the lower interest expense due to the divestiture. And now expect to be in the range of $3.35 to $3.65 per share, which is a growth of 9% to 19%.

Our cash flow outlook remains the same as prior to the deal. With cash flow from operations of $160 million plus and free cash flow of $110 million plus. Our estimated debt payments before the divestiture remain the same as well at $115 million plus.

Adding in the $548 million, attributable to the proceeds from the divestiture, we expect to pay down, at least, $665 million by the end of the year. We expect this will reduce our leverage to about 3.6x.

We have already received an upgrade to our credit rating from Moody's as a result of our improved financial profile. We continue to execute on our long-term strategy that we introduced earlier this year. The divestiture's an outcome of that strategy. Our portfolio strategy, which defines how we win in the markets we serve. We've focused our sales efforts on increasing our market penetration in the higher growth, Cardio & Vascular, neuromodulation and nonmedical Electrochem markets, while preserving our strong cardio rhythm management market leadership.

On the operational strategy, we continue developing and implementing the multiyear plans to achieve excellence in everything we do, from safety, to quality, to on-time delivery, to how we manage every business process. We will run the company based on this portfolio and operational strategy, which we believe will drive a valuation premium for our shareholders.

In summary, we have delivered strong first half results that are consistent with our full year guidance. We have completed the Advanced Surgical and Orthopedic divestiture, paid down more debt and increased our earnings per share outlook by $0.15.

Our clear strategy, both from an portfolio and an operational perspective is gaining momentum within Integer and positions us to deliver on our growth objectives.

We will continue to measure our financial success through 2 key metrics: sales growth above the market; and profit growth at least 2x sales growth. I remain confident we have the right strategy and the right team in place to deliver for our customers and to realize our vision of enhancing patients' lives. Casey, let's open it up for questions.

[Operator]

[Operator Instructions] You're first question comes from Matt Mishan with KeyBanc.

[Matt Mishan, analyst]

I'm just trying to understand the sustainability of the growth here, because the last couple of quarters have been very strong. Overall, volumes for your customers are kind of very good. Are they having a tough time keeping up with their own manufacturing? And are you getting overflow from what they can't keep up with? Or is this, really, truly business that you're going to be able to kind of stick with for a while?

[Joseph Dziedzic, executive]

I wouldn't characterize our growth as overflow from our customers, we feel we're incredibly well positioned to serve them and support their growth. And we are capitalizing on that. We've had a strong, sustained growth over the last 6 quarters.

Last year, we were at 5%, this year we're looking at 4% to 6%. We believe it's very sustainable when you look at it on an annualized basis. No business is perfectly linear, so any given quarter, maybe stronger or weaker than the rolling 4 quarter average, but we believe we're solidly in mid-single digits trajectory, and we're working to accelerate that to be sustainably above what we think the end markets are growing, which is the low to mid-single digits.

[Matt Mishan, analyst]

Then how should we be thinking about the quoting activity from your customers? That's -- as it's kind of progressed through last year. Has anything changed as far as kind of size of contracts? Length of contracts? And how they're looking at Integer?

[Joseph Dziedzic, executive]

I, Matt, I'd frame that in the context of the last 2 to 3 years, where we have dramatically -- the management team, the presidents of the businesses have dramatically improved our customer relations. And we feel we are competing for all opportunities, whether they're small or big. And we do have a number of opportunities in the pipeline across the full continuum of size of opportunities. And we -- we're very excited about the pipeline of deals. And a lot of our customers are looking to consolidate their manufacturing operations as they grow what they're looking at, what they want to continue manufacturing and they consider core compared to what they feel they should be outsourcing.

And we're continuing to see a lot of activity on that front, and we think we're incredibly well-positioned to support their strategy to reduce their manufacturing operations. And we're working to be an extension of not only their manufacturing, but also their growth, their innovation and their technology roadmaps.

[Matt Mishan, analyst]

Okay. That's helpful. And then I wanted to dig in to the operational excellence. This was a fantastic quarter as far as the volume lift and the contribution down on the margins. Can you talk through the confidence moving going forward for like, operating margin? Or EBITDA margin lift on increasing sales versus, especially on just -- on volumes? And then maybe breakout what you can control as far as margin improvement from programs that you're implementing around operational excellence.

[Joseph Dziedzic, executive]

Matt, thanks, for asking the question about manufacturing excellence, because that is what I think is one of the keys to success for Integer. It's been a bed rock of who we've been historically, our ability to manufacture and deliver for our customers. But I see tremendous opportunity in this area because we have the a potential to draw even higher quality, greater on-time delivery in our operations. And I'm confident that as we improved in those areas, we're going to drive increased efficiencies in our business. We're working -- we launched 2 weeks ago our manufacturing excellence strategic comparatives with the manufacturing leadership team and the operating leadership team. We had a couple of day session kicking this off and laying out the multiyear plan is to go across the business and do lean diagnoses of our operations, developing and fully implementing the Integer production system that's going to leverage things like kaizen practices and in ocean planning that's going to drive sustainable improvement in operations.

I think we're good today, but I think there's tremendous opportunity to further differentiate this area. It starts with safety and having an incredibly safe work environment for our associates. And then it goes to having the highest quality in the industry that differentiates us. And then it goes to on-time delivery. If we do all of those things in an excellent manner, it's going to drive significant efficiency and productivity in the business, and we see tremendous opportunity to improve off of what's already a good position, but we want to be differentiated in the area and use that to drive the growth with our customers

[Matt Mishan, analyst]

Just following up on that, what -- over a multi-year period, what do you think that -- on an operating margin or EBITDA margin basis, what do you think those programs can do for your margins? If you can quantify the impact of that? And how much of that are you -- do you think you're going to be able to keep versus give back to your customers?

[Joseph Dziedzic, executive]

That's a great question, Matt. We have historically experienced 1% to 2% selling price decrease. Looking backwards over many years, we expect that to continue. As we think about margin expansion in big, big picture macro, here's how we think about it. We look at the selling price pressure that we know exists, it exists with the doctors and hospitals as pressure from the government payers as well as company's putting pressure on the healthcare providers, they in turn put pressure on the Medical device OEMs, which then in turn translates to us and trickles down to our supply chain as well. So we're looking at and planning for the historical 1% to 2% price pressure.

We know in order to maintain a competitive offering for our associates that we have to give wage increases competitive with the market, so we know those 2 variables are going to drive margins down every year.

We have to generate enough productivity and efficiency through our 2 cost strategic comparatives, manufacturing excellence and business process excellence. Business process excellence focuses on everything outside of manufacturing operations, all business processes.

We have to drive enough productivity to at least offset the selling price pressure and the wage inflation that exists. If we do that, and then grow at sustainably above the market averages, the contribution margin that falls through on that revenue growth will yield operating profit growth at twice the rate of the sales growth, that gives us the margin expansion.

So we know what we're trying to solve for in terms of the level of productivity required to allow us to expand margins on a sustainable basis coming forward. Productivity must meet or exceed selling price and wage inflation, we have to grow the revenue sustainably above the market average, which is low to mid-single digits. We do that, we'll get our -- we'll achieve our financial objective, which is operating margins growing -- operating dollars growing at twice the rate of revenue, that will give us our margin expansion.

[Operator]

And your next question here comes from the line of Glenn Novarro with RBC Capital Markets.

[Glenn Novarro, analyst]

Joe, 2 questions. 1 on the revenue for the quarter, the Cardio [indiscernible] beat our number by $11 million Cardio [indiscernible] modulation by $9 million. I'm just wondering, were there any [indiscernible] timers or chunky orders in the quarter that you can discuss, and then I had a question on strategy?

[Joseph Dziedzic, executive]

Glenn, I would not characterize our continued strong growth in Cardio & Vascular to be driven by any individual product or customer driving an aberration. We've been experiencing very strong growth in this segment. Our catheters and guidewires continue to perform incredibly well. We're seeing growth across most of our product groups. If you look at our rolling 4 quarter average, it continues to accelerate into the high single-digit now that we've been into the low single -- low double-digit for the last couple of quarters. We think we're performing very well in Cardio & Vascular.

Our long-term objective in Cardio & Vascular is to continue to deliver double-digit growth on a sustainable basis. We feel we're well-positioned to do that. So I -- it's continued strength in our end markets and penetration in the higher-growth submarkets. We do expect -- as we look at the second half of 2018, we do expect the growth rates to slow simply because the second half of '17 was so much stronger than the first half of '17. So looking at second half, third and fourth quarter discrete, we expect to see lower rates, but we think it's important to look at all of our product lines on a rolling 4 quarter basis. It gives you a good indication of the trajectory of the business, because we're not running the company on a 3-month basis, we're running it to deliver sustained out performance over time.

[Glenn Novarro, analyst]

And then a follow-up is on strategy. So you've paid down a significant amount of debt, and in the slide deck, you talked about investing in faster growing market. And so you're in neuromodulation, you're in electrophysiology, can you talk to us about market that you're interested that's currently outside of where you are today? And would that require internal investment or external investment or both?

[Joseph Dziedzic, executive]

Great. Thanks, Glenn. The -- I wouldn't characterize our investments today as looking at markets that we're not in. We see ample opportunity to accelerate growth for the markets that we're already in. Where we do have an opportunity in certain areas is to expand our capability, whether its specific with a specific technology or a manufacturing capability. We do see opportunity to invest. We may do that organically in some cases where we think that's the better approach -- it's going to deliver better returns over time. There could be some opportunities, smaller in nature, where we could acquire some capability. Any acquisitions that we would do would be very targeted and very specific to manufacturing capability or technology that continues to build out our capability in our portfolio, but right now we're very focused on the higher-growth submarkets, particularly structural heart electrophysiology that you referenced, peripheral vascular, neurovascular. We still see significant opportunities to grow in the markets we're already in.

And our focus over the next couple of years is to execute our strategy to penetrate those higher-growth submarkets faster, organic and inorganic as well as to drive the operational strategic comparatives, which we believe we can bring even greater differentiation in our quality, in our delivery for our customers that leads to increased innovation and ability to hit our financial objectives.

[Operator]

Our next question comes from Jim Sidoti with Sidoti & Company.

[James Sidoti, analyst]

Can you hear me?

[Joseph Dziedzic, executive]

Yes, Jim.

[James Sidoti, analyst]

Great. Just want to confirm based on the guidance you provided today and factoring in the divestiture, you're looking for revenue of about a $580 million for the back half of the year? Is that right?

[Joseph Dziedzic, executive]

If that lands in our mid-point, yes, within our range.

[James Sidoti, analyst]

Right. So, I mean, if we look at Q1, which was around $290 million and then the guidance at the back half of the year, looks like Q3 and Q4 will be roughly like Q1 was. Q2 came in about $20 million ahead of that. What was responsible for that?

[Joseph Dziedzic, executive]

So we saw a very strong growth across all of our end markets in our Cardio & Vascular segment. And you saw the strong growth in cardiac and neuromodulation as well. When we look at our quarter splits, we really began to get meaningful traction in the second half of last year and our fourth quarter last year was the strongest of the year by a significant amount. We were $35 million higher sales in the fourth quarter last year versus the first quarter last year. So we think we've got a really good trajectory running around the $300 million level every quarter this year, which gets us to the $1.2 billion forecast. So we -- no business is perfectly leaner, and we think the rolling 4 quarter's the right way to look at the business and any given quarter can be moved a few percentage points in either direction by some one customer managing inventory or dealing with the -- their variability in their forecast and then their demands. So we think we're on a very good trajectory to hit the $1.2 billion range of our outlook for revenue for the year.

[James Sidoti, analyst]

Okay. And as terms of interest expense, you reported about $15 million in the quarter. So that -- I assume that factor's in the debt paydown? Or what did it look like going forward? Is that a good number for Q3 and Q4?

[Joseph Dziedzic, executive]

Absolutely, the only variable there would be how quickly we can continue to pay down more debt, which we do expect continued debt paydown in excess of the required payment, and what happens with interest rate as well.

[James Sidoti, analyst]

Okay. And then last question, in the neuromodulation space, it's been some patent litigation news recently, does any of that impact you? Or do you care who wins that?

[Joseph Dziedzic, executive]

Naturally, we do have higher share wallet with certain customers, so it does have an impact on us. When we look at the market, we're here to serve all of our customers in the market, and we continue to work to increase our share of wallet with all of our customers. We feel we're incredibly well-positioned to serve both the well-established OEMs on a component basis and the early-stage companies on a complete device basis from idea all the way to full-scale manufacturing.

We think the recent news with some of the players in that space does not impact or change our outlook in that space or our outlook for the year at all.

[Operator]

[Operator Instructions] And there are no further questions coming into the queue at this time. Ladies and gentlemen, thank you very much for joining the call today. This concludes today's conference call. And you may now disconnect.