Integer Holdings Corp

NYSE:ITGR

Earnings Call Transcript 2021-Q2

[Anthony Borowicz, executive]

Good morning, everyone. Thank you for joining us, and welcome to Integer's Second Quarter 2021 Earnings Conference Call.

With me today are Joe Dziedzic, President and Chief Executive Officer; and Jason Garland, Executive Vice President and Chief Financial Officer. As a reminder, the results and data we discuss today reflect the consolidated results of Integer for the periods indicated. During our call, we will discuss the non-GAAP measures. For a reconciliation of these non-GAAP measures, please refer to the appendix of today's presentation, today's earnings press release and the trending schedules, which are available on our website at integer.net.

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

On today's call, Joe will provide his opening comments, and Jason will review our financial results for the second quarter and provide an update on our full year guidance. Joe will come back on to provide his closing remarks, then we will open up the call for your questions.

With that, I will turn the call over to Joe. Thank you, Tony, and thanks to everyone for joining the call today. Our second quarter results demonstrate continued strong recovery from the pandemic. Our dedicated associates continue to deliver for our customers and patients despite the widely recognized manufacturing, supply chain constraints and accelerating volumes. We continue to invest in the execution of our strategy to drive above-market top line growth and continued margin expansion. Our investments in capabilities, capacity and talented associates will enable us to deliver for all Integer stakeholders.

We delivered 30% sales growth and 130% profit growth versus last year. We also continued to grow sequentially, as the second quarter grew about 7% from the first quarter. Our continued debt reduction and significant year-over-year EBITDA growth reduced our net total debt leverage ratio to 3.1x adjusted EBITDA, which is almost back to pre-COVID levels and well within our target range of 2.5 to 3.5.

The strength of our second quarter supports the increase in our full year guidance for sales, adjusted operating income and cash. This slide summarizes our sales recovery from the pandemic, starting with the quarterly average from 2019 on the far left and then plotting each quarter since the beginning of 2020.

As we previously highlighted, Integer sales were not impacted by the pandemic during the first quarter of 2020. Our customers did not adjust their demand on Integer until the second quarter of 2020. We experienced the bottom of the pandemic during both the second and third quarters of last year, unlike our customers, who largely bottomed in the second quarter and then quickly rebounded in the third quarter. Our recovery started in the fourth quarter of last year and has continued to progressively increase each quarter. Although our second quarter sales of $312 million are about the same as the 2019 quarterly average, we believe some customers accelerated volume into the second quarter this year to mitigate some of the supply chain constraints being experienced across many second and third level suppliers. We believe this happened in the month of June, which saw a 50% increase over last year. This has been factored into our increased full year guidance.

I'll now turn the call over to Jason to cover our financial results. Thank you, Joe. Good morning, everyone, and thank you again for joining our call. I'll provide more details on our second quarter 2021 adjusted financial results, summarize our product line sales trend and conclude with our increased outlook for 2021.

I'll start with our second quarter results. At $312 million, sales were up $72 million compared to the prior year, which is a strong 30% increase. Additionally, sales were up $22 million sequentially compared to the first quarter of 2021. As Joe mentioned earlier, our second quarter sales have essentially returned to prepandemic level being similar to our quarterly sales average for 2019.

Our adjusted operating income was $50 million, up $28 million compared to the prior year, a considerable increase of 130% as we continue to benefit from the leverage associated with higher sales. With adjusted net income at $36 million, we delivered $1.07 of adjusted diluted earnings per share, up $0.75 from last year. Our second quarter financial results represent strong growth versus last year and again, improved sequentially as our recovery from the pandemic continued.

Our adjusted net income increased $25 million in the second quarter of 2021 as compared to the prior year, driven mostly by our sales volume returning to the prepandemic level. We continue to manage our supply chain and our hiring process to meet our customer and patient needs, but we have had to spend to ramp up our volume and our profitability leverage was dampened. We are also seeing the emerging headwinds from direct labor constraints in the current global supply chain environment, and we'll speak to these more in our outlook discussion.

Adjusted net income also improved due to continued reduction of interest expense, contributing $1 million year-over-year, driven by our continued focus on debt reduction. Our adjusted effective tax rate was 15.9% in the second quarter. This delivered $1 million in improvement in adjusted net income versus last year as the adjusted effective tax rate in the second quarter of 2020 was 19.2%.

Moving to Slide 11. We continued solid conversion of income to cash in the second quarter, generating $32 million in cash flow from operating activity. This was $4 million lower than the first quarter as we will collect the strong sales growth during the month of June in the third quarter. We generated $22 million from free cash flow, inclusive of $11 million of capital expenditures. As we continue to invest in our strategy, we will still expect the full year capital expenditures to be in the $50 million to $60 million range.

Consistent with our strategy, we further reduced our net total debt in the second quarter by $22 million. Our net total debt leverage ratio is now 3.1x adjusted EBITDA. This is down 0.6 points, which is a significant production from the peak of 3.7x caused by the pandemic.

As a related update, the company expects to refinance the senior secured credit facilities prior to October 27, 2021, when the debt will become due within 1 year.

As a reminder, Slide 13 reflects trailing 4-quarter organic adjusted sales rate. Through the first quarter of 2021, our sales were significantly impacted by COVID. As expected, the trend has reversed as the second quarter represents a return to prepandemic sales levels, driving the significant improvement in our trailing 4-quarter sales growth rate.

Moving to the first product line. Cardio and vascular sales were up 17% organically in the second quarter. This is compared to the second quarter of 2020, which was the beginning of COVID impact on our financial results. The second quarter growth was driven in particular by strength in the interventional cardiology, electrophysiology and peripheral vascular markets. As expected, the trend of sequential improvement continues and sales in our cardio and vascular product line have returned to prepandemic level.

Moving to the next product line. Cardiac rhythm management and neuromodulation grew 67% organically in the second quarter as compared to the prior year. CRMN saw the steepest decline in our Medical segment last year in the second quarter, particularly in the markets impacted by more elective procedures like neuromodulation. This low baseline drives a significant increase in second quarter 2021 versus second quarter 2020. With that said, we experienced very strong growth across all markets, with sales in the CRM market increasing high double digits, and the sales in the neuromodulation market is doubling.

Sequentially, compared to the first quarter of 2021, sales increased 10%, driven by low double-digit growth in the CRM market, while neuromodulation grew high single digits.

On Slide 16, we will cover the final part of our Medical segment. As a reminder, the advanced surgical, orthopedics and portable medical product line shown today includes our portable medical sales as well as our sales under supply agreement to the acquirer of our former AS&O product line, which we divested in July of 2018. Second quarter organic sales declined 4% versus the prior year due to decreased demand for ventilator and patient monitoring components from the pandemic-driven peak during 2020. Sequentially, second quarter sales also increased 15% from the first quarter of 2021. We expect trailing 4-quarter sales to remain flat to slightly declining, partially due to the higher sales of ventilator and patient monitoring component sales in the prior year.

Finally, Slide 17 summarizes Electrochem, our non-medical segment. Electrochem's second quarter sales increased 19% organically versus the prior year, driven by evidence of an emerging recovery in the energy market. The sales run rate continues to remain much lower than our 2019 quarterly sales run rate. The same emerging recovery in the energy market drove second quarter sales to sequentially increase 39% from first quarter of 2021. We expect the energy market to continue to recover in the second half of 2021 and into 2022.

We'll now move in to our expectations for 2021. For the second consecutive quarter, we are increasing our sales and adjusted operating income outlook. We now expect 2021 sales to be in the range of $1.200 billion to $1.220 billion, an increase of 12% to 14% versus 2020. This increases the low end of our range by $25 million and the high end of our range by $15 million. We delivered strong sales growth in the second quarter, growing 30% over the prior year. We expect similarly strong year-over-year growth in the third quarter, but we also expect sales will be slightly lower than the second quarter as we believe customers built some inventory in the second quarter to protect against potential global supply chain constraints.

With our full year sales expected to now be in the range of $1.200 billion to $1.220 billion, we are also increasing our outlook for adjusted operating income, and now expect to be between $180 million to $195 million, reflecting growth of 25% to 36% as we expect to return, to meaning one of the financial objectives of our strategy, growing our adjusted operating income at a rate of 2x that of our year-over-year sales growth rate. We now expect adjusted net income to be between $122 million to $134 million, reflecting growth of 32% to 46%.

As we look at our second half outlook, we expect to grow profit with sales, but not at a full variable profit margin for 3 primary reasons. First, as we had mentioned previously, the impact of the year-over-year increase of incentive compensation will ramp during the year as it returns to normal levels. 2020 variable compensation was commensurate with the reduced pandemic-driven payout. Second, to support our volume growth, we are adding back some of the discretionary costs that we curtailed in 2020. And third, we are managing through the increased costs associated with the direct labor shortages and global supply chain constraints in order to support customer demand.

This may include increased direct labor overtime, cost of hiring and training resources, higher transportation costs and some temporary inflation and costs that expedite the receipt of material and supplies required. We'll continue to prioritize serving our customers and patients and believe we are taking the long view. We expect to be able to manage these costs out over time. Despite these headwinds, we have increased our 2021 outlook and now expect to see a 160 to 250 basis point year-over-year increase in our adjusted operating income as a percent of sales for the total year.

And finally, commensurate with our increased outlook in income, we are also increasing our cash flow outlook and expect to generate between $150 million to $170 million in cash flow from operations. Free cash flow is now estimated to be in the range of $95 million to $115 million, and with net total debt reduction remaining at the previously expected range of $90 million to $110 million. The difference between free cash flow and debt paydown may withholding on -- withholding taxes on restricted stock units, acquisition earn-out payments and the estimated cost of our pending debt refinance. We have returned to meeting another financial objective of our strategy as our leverage ratio is back within our targeted range of 2.5 to 3.5x adjusted EBITDA, and we expect to continue to improve as the quarters with COVID reduced EBITDA have a diminishing impact on the leverage calculation.

With that, I'll turn the call back to Joe. Thank you.

[Joseph Dziedzic, executive]

Thank you, Jason. I'd like to reiterate the message we shared last quarter, which is that we believe now is a good time to be an Integer shareholder. We have a clear vision, a compelling strategy and strong values, combined with the most talented associates amongst all medical device outsourcers. The industry dynamics of mid-single-digit growth and high barriers to entry, combined with Integer's breadth of product portfolio, creates a very resilient business model. Integer's world-class research and development capabilities, our global manufacturing footprint, combined with our deep customer relationships, creates a compelling growth strategy. Our commitment to our associates and investment in their growth, coupled with our focus on building leadership capability to deliver performance excellence, creates a performance culture that is creating a competitive advantage.

Finally, our track record of delivering on our financial commitments and generating strong cash flow reinforces our financial strength.

To wrap up, we delivered strong year-over-year results and continued sequential growth during the second quarter, while reducing debt leverage almost back to prepandemic levels. We've increased all financial metrics in our guidance. I remain confident in our strategy, in our associates and our ability to execute our strategy to earn a valuation premium for our shareholders.

Thank you for joining our call this morning. I will now turn the call back to our moderator for the Q&A portion of our call.

[Operator]

[Operator Instructions] We have our first question comes from the line of Matthew Mishan.

[Matt Mishan, analyst]

Joe, I'm just trying to get a sense of the commentary on June. With your sense that some customers maybe built inventory, what are they telling you about the recovery? Is it better or worse? Or are they just adjusting -- are they just building inventory because they're worried about second half supply chain issues?

[Joseph Dziedzic, executive]

Matt, thanks for the question. So June was a particularly strong month for us on a year-over-year basis. And we expected it to be strong because if you rewind back to when the pandemic really started to impact the industry in March of last year, it took some of our customers, many of our customers a month or 2 to adjust their manufacturing schedules before that did impact our sales. So our April sales, I think we're only down 20% last April on a year-over-year basis. And so it really wasn't until May and June that we began to see a meaningful impact, a more meaningful impact from the pandemic. And I think we had communicated, June and July, those 2 months were the bottom of our sales when you look at it from a run rate standpoint.

So we knew June was going to be strong. It came in stronger than we had anticipated. And as best we can decide for, again, because our customers carry a lot of inventory and there's always movements. It felt like our customers pulled a little bit of inventory sooner than they had originally anticipated. And I say originally, I'm gauging this based on the beginning of the quarter for us. And we interpret that as, they just wanted to make sure that they had inventory in case there were supply chain constraints where they saw a spike in demand. I would characterize it as within the range of normal variability volatility.

But I know with the intense focus on the rate of recovery, what happens each quarter, each month drives the interpretation of it. So the way we interpret it is, the quarter was a little better than what we had anticipated at the beginning, but I think we had said something like modest improvement in second quarter versus first. Obviously, a $22 million improvement is more than modest. And we do think there were some that came out of the third quarter into the second. We still raised our full year guidance on both the top line and the bottom line.

So we think things are better than where we had thought in aggregate entering the second quarter. And this is just part of the normal variability that we have within the industry. I think, by and large, our customers remain optimistic, but also aware of the potential impact of the Delta variants on procedure volumes, although I think it's been universally stated that the hospitals are in much better position to manage through any potential increase in COVID patients than they were before and there's cautious optimism across the board, and we share that.

[Matt Mishan, analyst]

Okay. Excellent. And I'm happy we're not going to have to argue about the definition of modest. And I believe I heard you correctly when you -- I think I heard that you thought that second half profit growth would be lower than the second half revenue growth. Can you kind of -- could you elaborate a little bit more on the reasons there? What's going on there?

[Joseph Dziedzic, executive]

Sure. When we look at -- I'll use the midpoint of our guidance for the full year, as an example. If you look at the midpoint of our revenue and adjusted operating profit guidance, on a year-over-year basis, our sales are up 20%, and our adjusted operating profit is up about 45%, on a year-over-year basis. So we think on a year-over-year basis, there's very strong operating profit fall through on the growth on a year-over-year basis. You might be pointing to the -- maybe the sequential profit and the adjusted operating profit margins.

And quite frankly, we're looking at the -- trying to be objective about the supply chain pressures, the direct labor hiring pressures. And as we rack and stack, the impact of all of those, we do see some cost pressures. We believe they're very manageable, and we're still delivering meaningful year-over-year growth and the trend line, we think, is very positive. But we do feel an impact from some of those costs. And we think we will for the rest of this year.

As soon as some of those constraints relent a little bit, we were confident we can manage those costs out. We're confident over time, we're going to be able to overcome the impact of those costs. But I would also point that, we're still growing meaningfully on a year-over-year basis and believe that our manufacturing excellence strategic imperative will, in fact, manage these costs effectively, and we will overcome them over time.

[Matt Mishan, analyst]

Okay. And last question. Can you talk a little bit about the increase in the number of engineers that you're hiring? I think that's probably the best leading indicator of kind of how you're expecting growth into the out years with your developmental pipeline. Just talk a little bit about where you're at with the number of engineers and the pipeline you're developing for long-term growth?

[Joseph Dziedzic, executive]

Matt, it's a very insightful question. You're absolutely dived in to a leading indicator for what's going to fuel our ability to achieve our above-market growth. And when we look at the number of engineers we have at the end of the second quarter compared to the end of last year, we're up 7%. We've added 7% more engineers in the first half of this year. You don't see a meaningful increase in the total R&D spend, although it is up and we expect it to continue going up, and that's because our customers are paying for the development work we're doing.

We have more than doubled the number of development programs in the business in the last 3 years. And that is because we've got customer demand for the innovation that we're delivering. And when you look at where we're focusing those engineers, where we're focusing our efforts to grow, it's in the faster-growing end markets. And we talked a lot about this, but in cardiovascular, almost all of our development programs and certainly all of the growth are in the faster-growing end markets like structural heart, electrophysiology, peripheral vascular. And so the engineering spend, the R&D investment, the customer demand and the innovation we're delivering are in faster-growing end markets that will deliver faster growth once these products come to market and begin to be commercialized.

We talked about the cycle times on those development programs, some of them can be as short as a few years. Others can take as much as 5, 6, 7 years if there's clinical trials involved. We view the number of engineers, the number of development programs and the end markets that we're supporting innovation for -- with our customers as a great sign towards the progress we're making in achieving our market growth. And we have confidence that we will get there, but the development cycles and time lines are what they are in the industry.

[Operator]

[Operator Instructions] We have our next question comes from the line of Jim Sidoti.

[James Sidoti, analyst]

So in the news, we're hearing lots about increased cases of the Delta variant, at least here in New York. Are any of your customers concerned about that? Or is the fact that the vaccines are out and hospitalizations are down, is that offsetting the increase in cases? And is there any risk that cause the procedure rates slow down again in the back of the year?

[Joseph Dziedzic, executive]

Great question, Jim. I think we probably share the universal view that hospitals are so much better equipped to manage through any surge in patients. And I think when you look at the guidance that most people in the industry have given, there's a little bit of maybe caution in the guidance with maybe month-to-month may not be as linear as we would all like it to be. But by and large, I think there's optimism that the hospital network can handle it. And so we continue to see positive optimistic outlook for the second half. We have confidence in our guidance and we believe our guidance.

For the rest of the year is very much aligned with what our customers are seeing, and they're certainly correlated to the demand that they've placed on us, the orders and the backlog that they've placed on us. We've talked about -- we've got pretty good visibility to the next 60 to 90 days, so we feel good about where we sit for the rest of the year. And we think it's very much aligned with customers' expectations. And they're obviously closer to hospitals and doctors and patients than we are, and so we believe the second half is going to be strong.

We expect to have a really strong third quarter. When you look at what our sales were last year, the bottom for us was the second and third quarter. So our third quarter of this year should be another order of magnitude, 30% year-over-year growth. And so we feel good about the trajectory that we're on and our ability and the industry's ability to support that growth.

[James Sidoti, analyst]

So you're pretty confident that all those new product launches that they have postponed because of the pandemic, those are back on track, and those will continue throughout the second half of 2021?

[Joseph Dziedzic, executive]

Absolutely, Jim. But I think many of those product launches will spread out over the next 6, 12, 18 months. I wish they were fully back on track to where they were prepandemic, but there definitely was an impact on those launches. But we're seeing those launches now reengage and start to be executed, and that will be a contributor to our growth with the development programs that we're working on with our customers.

[James Sidoti, analyst]

And then you mentioned you're likely to refinance the debt over the next few months. Should we expect interest rates and covenants say about where they are now? Or do you anticipate any changes there?

[Joseph Dziedzic, executive]

Yes. We're still actively evaluating our options and working with our partners, Jim, and we'll share when we can, but we'll certainly be able to follow where the market is and rates are and optimize with that.

[James Sidoti, analyst]

Right. And then you talked about your customers' inventory levels and how they might be adding inventory ahead of the possible supply shortages. But I'm looking at your inventory level, it's below where it was in 2018. Is that just because you're better at doing things? Or do you anticipate having to add inventory over the back half of the year?

[Joseph Dziedzic, executive]

Jim, I think we're definitely better at how we're running the plants compared to 2018, 3 years ago. I think our manufacturing excellence strategic imperative has a number of focuses on inventory management and efficiency and the optimization of our supply chain. And I think we -- the team has done a really good job of that. I also think some of our second quarter inventory balance was, we had product ready that we thought was going to probably go in the third quarter that our customers decided to take a little bit early. Again, I attribute that to just the normal ebb and flow and maybe this quarter, the customer said, I'll take it in case there is a spike in demand or to make sure that they had their hands on the product, if there were any supply chain constraints they felt other places. But by and large, we are definitely much more efficient at how we're managing not just inventory, but all working capital, but I think our manufacturing excellence strategic imperative is definitely having a positive impact on cash flow, and you're seeing it in the working capital numbers.

[James Sidoti, analyst]

Okay. Just checking because it's a $1.2 billion business, and you know, Jason's handling the cash. Just making sure you're not running out of inventory just to run it.

[Operator]

[Operator Instructions] There are no more phone questions. I'll turn back the call over to you, Tony. Please go ahead.

[Anthony Borowicz, executive]

All right. Great. Thank you, everyone, for joining today's call. As always, a replay of this call is going to be available on our website as well as the presentation that we just covered. So thank you for your interest in Integer. And that concludes today's call.

[Operator]

That does conclude our conference for today. Thank you all for participating. You may now disconnect. Have a great day.