Arjo AB (publ)

STO:ARJO B

Earnings Call Transcript 2019-Q2

[Operator]

Good day, and welcome to the Arjo Q2 Report Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Joacim Lindoff, CEO and President of Arjo. Please go ahead, sir.

[Joacim Lindoff, CEO, President & Director]

Thank you very much. And hi, everyone. Welcome to this Q2 call for Arjo. Thank you all for dialing in. And I will, together with Jonas, our CFO, take you through the Q2 report that we released just half an hour ago. We'll start by giving you a business update for the quarter and the first half year of 2019 and present some highlights from the business. Jonas will then guide you through the balance sheet. We will, after that, have some words on outlook for 2019, and I'll finish off with a short summary before we open up for questions. As always, we aim at keeping this call to an hour and finish no later at 9. So let's start with an update on the business. And during the quarter, we have continued to perform well on our Arjo 2020 plan, we are now posting our sixth consecutive quarter of organic growth. With a high activity level in the organization, we are reporting a solid 6.5% organic growth for the second quarter of 2019. North America continues to show very good development with growth of 15.8% in the quarter, this time with U.S. as a driver with 18.7% organic growth driven by good execution of the large Kindred medical beds order. In Canada, we continue to see solid growth and favorable development in all product categories. Western Europe declined organically with 1.7%, and the entire decline in the quarter came from the U.K. where Brexit uncertainty still leads to less capital orders than expected. We did experience softer development on some other markets in Europe like Germany. For example, France, our fourth largest market, continues to perform well with a 7.2% organic growth in the quarter thanks to good development, mainly in patient handling. Without the decline in the U.K., Western Europe would have been almost on par with last year. And as before, we still expect Continental Europe, which is the part of Western Europe outside of U.K., to show moderate growth for the full year of 2019.Rest of the World is growing at a healthy 11.6% in the quarter. In Australia, we had an okay quarter with performance slightly below last year's good Q2. The order intake in Australia has now 2 quarters in a row been solid, which gives us good confidence in the plans to grow Australia organically for the full year. A number of other markets in Rest of the World performed favorably -- or I would say very favorably to last year. Here, we should highlight the continued strong performance from our companies in Japan, South Africa, and India. And it's really good to see that our distributor networks in Southeast Asia, Latin America, and Eastern Europe are continuing to show traction and growth, which is well in line with our Arjo 2020 plan and promising for the future. Given the strong start of the year, we now raise our outlook for the full year and estimate that organic net sales growth will be in the upper part of the 2% to 4% interval. The gross margin was 44.1%, and it's slightly lower than last year's Q2. We see areas that we need to continue to improve and areas where we now have good traction. The slightly weaker gross margin in the quarter was due to mainly 2 areas: First, an unfavorable product mix, where we have invoiced almost 50% more medical beds than normal. Medical beds have initially, on the first capital sale, an approximate 15 percentage point lower gross margin than Arjo's average. Medical beds contribute well to aftermarket growth from profitability, but initially, it is a weaker contributor. Secondly, we also, as in Q1, continue to see pressure on our rental business profitability in Europe, especially in the U.K., Germany and also in France. In the U.S., we continue to see a good level of core rental placements. But due to a milder flu season in the U.S. our for gross margin very important Critical Care solutions, have seen significant lower volumes than in Q2 2018. We had continued good cost control in the quarter, and OpEx relative to net sales is improving also in the quarter, well aligned with our plans and guidance. We continue to invest in selling expenses and R&D with efficiency progress in our admin part.We are growing EBITDA in line with our plans, and the quarter saw a growth of 38.8% to SEK 421 million versus SEK 303 million in Q2 2018. Excluding IFRS 16 effects, EBITDA improved by 10.5% to SEK 336 million. We did not have any restructuring cost in the quarter. As during Q1, we have done continuous, smaller changes to our organization booked in OpEx and will continue to do so also going forward. We have, however, this quarter initiated 2 larger restructuring programs: one in the U.K. that we addressed briefly already in the Q1 call; but also an additional program to streamline our rental operations, mainly in the U.S., to get a more stable customer-supportive and cost-effective structure in the future. The cost for these 2 programs will be booked during Q3 and Q4. Based on the above, we saw EBIT growing with 16.2% in the quarter. Cash conversion is gradually getting back on track after a slower Q1. Due to higher sales volumes, we did not see the full effects of the continued improved performance. We have seen a good decrease in inventory in the quarter, well aware that we have a lot of runway for further improvements in this area in the quarters to come. All in all, we feel comfortable with our target to exceed 70% cash conversion for the full year. Finally, after the quarter, we acquired an equity stake in Atlas Lift Tech and are now represented on Atlas' Board of Directors. Atlas provides Lift Coaches who train and assist care professionals in executing patient transfers and lifts. Atlas also offers the LiftTracker software system, which delivers real-time data to enhance the efficiency of and optimize patient handling processes. This collaboration gives us a strong platform to offer a unique end-to-end solution with a mutual goal of reducing caregiver injuries and improving patient care while creating efficiencies for health care facilities. The investments and commercial collaboration is expected to have a positive impact on our net sales, gross margin and earnings per share already in 2019, which will be delivered by the increased growth within the patient handling product portfolio. Summing up this part, another solid quarter with growth, where the U.S. has really proven to be the growth engine that we have planned for. In moving over to North America where we, as previously mentioned, had a very strong second quarter. The business grew organically with 15.8%, with U.S. performing very well with 18.5% organic growth. This growth came mainly from an accelerated installation scheme with the large Kindred order but also through continued good performance in patient handling and service. Rental saw some slowdown both in net sales and gross margin attributed to significantly lower seasonal placements of Critical Care solutions. Our long-term care investment is starting to gain traction, which we see mainly through better sales in patient handling and hygiene. Canada continued their solid performance and grew across all categories in a profitable way. As said before, we have initiated a one-off organizational change in the U.S. rental business to improve business model, drive efficiencies and improve profitability long term. The estimated restructuring cost will be around SEK 25 million for this program with yearly savings of approximately SEK 30 million, mainly on COGS, starting gradually in 2019. We continue to perform on or slightly above our U.S. turnaround time and feel that we are well positioned to perform another solid profitable growth year in North America, establishing U.S. as one of our growth engines. It is also very good to see how the U.S. organization is now set up to handle larger profitable volumes and future larger contracts.Moving over to Western Europe, where we had a 1.7% organic decline in the quarter. As mentioned earlier, U.K. was the main driver of this decline. Sales was held back in the U.K. by 7.3% or around SEK 20 million versus Q2 2018. Brexit uncertainty continues and led to less capital orders than expected in the quarter. As before, this is affecting the entire industry and we do not expect the situation to improve in the short term. As in the last quarter, we also experienced some weakness in our rental business in the U.K. in the quarter. The markets in Continental Europe have developed in line with Q2 2018. We are experiencing some decline in, for example, Germany and Netherlands, but on the positive side, again, France is continuing to grow. The previously discussed Brexit uncertainty and the challenges in the rental business in U.K. will result, as expected already after Q1, in a year-over-year decline in net sales in the U.K. The management is addressing this as we speak with the second part of our U.K. action plan, focusing on mainly restructuring the business from a profitability perspective and adapting to lower sales volumes. The plan is proposed to affect around 70 roles across the organization mainly in our rental business. The restructuring cost will be around SEK 25 million, and we expect yearly savings of around SEK 20 million, evenly distributed between gross profit and OpEx, starting gradually during 2019.Moving to Rest of the World. The organic growth in Rest of the World was strong during the quarter at 11.6%, which is well aligned with our plan and gives good momentum for the future. Several markets where we have our own infrastructure are performing well on net sales, namely Japan, India, and South Africa. And it is really satisfying that we are performing according to plan and gaining effects on our investments, for example, again in Japan. Australia has stabilized. However, the quarter saw a slight decline on net sales versus a fairly strong Q2 2018. We saw a second quarter in a row with a good increase in order intake, which is giving us good confidence that we will achieve organic growth in Australia during 2019. We also see a number of new distributor markets showing good growth, for example, Southeast Asia, Latin America, and Eastern Europe. The traction is good also here, well supported by our previously mentioned product registration process.If I then move over to the profit development and give you some further details there on Q2 and also on year-to-date. And as stated before, our gross margin was 44.1% in the quarter, slightly lower than last year Q2. We have areas that we need to continue to improve and areas where we now have good traction as previously mentioned. The gross margin development in the quarter was negatively affected by 2 main areas: The first one was an unfavorable product mix, where we have invoiced, as said, almost 50% more medical beds than normal for a quarter. Medical beds also, after the divestiture of Acare, have initially, on the first capital sale, an approximate 15% lower gross margin than Arjo's average. Medical beds, however, contributed well to aftermarket growth on profitability, but initially again, it is a weaker contributor. Secondly, the rental profitability, where we, as in Q1, continue to see pressure on our rental business profitability in Europe, especially in the U.K., Germany and France. In the U.S., we continue to see a good level of core rental placements. But due to a milder flu season in the U.S, our, for gross margin very important, Critical Care solutions have seen significantly lower volumes than Q2 2018 and also lower-than-normal average volumes. With the 2 restructuring initiatives mentioned earlier and other running activities, we intend to accelerate the internal activities to stabilize and increase profitability in our rental operations with visible effects already this year. On the positive side, gross margin was positively affected by higher resource utilization in our production side, thanks to our continued organic growth and good improved profitability in our service business, which is an important focus area for us going forward. Also affecting our gross margin unfavorably are the effects of the current trade discussions and new tariffs from China to the U.S. Our product groups have, until mid-Q2, been excluded from the new tariffs. But with the latest escalation, we now estimate that we will have a full year effect of approximately negative SEK 10 million versus 2018 with SEK 5 million hitting already in Q2. With the above in mind, we still aim to slightly improve gross margin percentage for the year versus the 44.6% we had full year 2018, and we have full focus and activities in place to support this. The OpEx amounted to SEK 806 million in the quarter and is developing according to plan. OpEx in relation to net sales continues to develop well, and the ratio is improving with 0.8 percentage points compared to Q2 2018, well aligned with our full year outlook. We continue to invest in our sales organization, where new initiatives and full year effects from 2018 have impacted selling expenses versus Q2 2018. We also see higher sales commissions due to the higher sales levels in the quarter. On both admin and R&D, we are tracking on plan. Admin in the quarter is affected by approximately SEK 7 million of additional amortization that is related to previous quarter. The first half year is, therefore, a good comparison level for amortization going forward. We report a positive EBITDA development amounting to SEK 421 million for the quarter. We have a good increase, both with and without the IFRS 16 effect, as I commented on before. We did not have any restructuring cost in the quarter, and the 2 restructuring programs described earlier will be booked during Q3 and Q4. And we now estimate that we will see approximately SEK 50 million of restructuring costs for the full year. EBIT, as an effect of the previously said, is up with 16.2% in the quarter. Our year-to-date performance based on 2 solid quarters is now well-above last year. Reported EBITDA, including IFRS 16 effects, has grown more than 50%. Excluding IFRS 16, the increase is north of 20%. And EBIT is growing at 48% in the first half of the year of 2019 versus same period of 2018. With that, I hand over to you, Jonas, to take us through the currency.

[Jonas Lindqvist, Chief Financial Officer]

Thank you very much, Joacim. To begin with transaction effects. It's been a quarter without major changes in the currency. And the spot FX rate are, as an average, at approximately the same point as when we entered the quarter. And the exchange rates have actually converged to a point where all our main currencies have strengthened to the Swedish krona at around 4% compared with the beginning of the year. Currency effects on the quarter have a minor impact from transactions of minus SEK 3 million, and the hedge degree is on approximately the same level as in the previous year.On the right-hand side of the slide, you can see the relative importance of our currencies in relation to the Swedish krona, when -- where we get the transaction effect -- sorry, translation effect. That is the U.S. dollar, the euro and the British pound, and they account for almost 80% of our sales. The translation effect on different levels and the profit and loss accounts can be seen down on the right-hand side. And as you see, the net sales impact of translation effect is positive by SEK 106 million compared with the same period last year. Cost of goods sold has a negative impact of SEK 55 million and operating expenses are impacted by SEK 31 million.Moving over to the balance sheet. The story here is that in the quarter, the balance sheet is stable with the equity ratio of 42.5%, excluding IFRS 16, slightly higher than in the same quarter of 2018 when it was 42.0%. The only major difference compared with the previous quarter in the balance sheet is that we have made an issue under our commercial paper program in euro at the end of the quarter. The money raised from this issue will be used to pay back bank debts in the third quarter in order to lower our interest costs. The amount issued is EUR 50 million and appears as increased cash and increased financial debt in the balance sheet. But as I said, this will go down as we progress into the third quarter. Also just to remind you, we have an effect from IFRS 16, the accounting regulation for leasing, that impacts our balance sheet as of 2019 by SEK 1.2 billion. This is shown under separate lines in the balance sheet.We have seen an increase in working capital in the quarter, which can also be seen in the cash flow statement that I will come back to in a minute. Inventory, however, has gone down and the increased focus and work on this area is beginning to pay off. To reduce inventory, there are a number of actions taken in different areas of the organization such as reducing safety stocks, reducing levels at which items will be rebilled in inventory as well as agreeing on which items that can be stocked centrally instead of locally. Direct shipment from production to customer is another way to reduce inventory levels that we are implementing. We have high focus on this, and working capital is an area which is covered with local and regional management every month and in specific working capital reviews in between.Accounts receivable have gone up in the quarter following the strong sales. However, the level of overdue debt continues to decrease, and there is good traction now in the U.K. regarding collecting overdue debt. The same goes for the U.S., but the tremendous effect that we saw in the U.S. last year cannot be repeated. Overall, we do not see an increased risk in accounts receivable. Accounts payables have gone down in the quarter. And this is, to a large extent, the consequence of the Kindred beds order in the U.S. that had been delivered during Q2. Much of the materials for this order was delivered earlier this year to Arjo and kept as accounts payables over the end of the first quarter in 2019 and paid in the second quarter, hence the reduction in accounts payables in the quarter. Moving over to cash flow then. Cash flow before changes to working capital increased by 72% in the quarter compared to the same quarter last year and 28% excluding the IFRS 16 effects. However, the net working capital increased in the quarter as well as investments in the rental fleet. The increase in working capital is temporary and relates to a great extent to the Kindred deal. Within the working capital, we have seen a reduction in inventory, as I just mentioned, in the quarter of SEK 40 million. And part of this is a result of our increased focus on working capital and specifically inventory. Receivables increased by SEK 35 million following this strong quarter. And regarding payables, this has gone down in the quarter much as an effect of saving the supplies for the Kindred order. The reported cash flow from operations was SEK 255 million in the quarter, and excluding the effect from IFRS 16, the cash flow from operations was almost on par with the same quarter last year despite the increase in working capital. The cash conversion in the quarter amounted to 60.7%, which is an increase from the previous quarter of 43.6%, but still below the target of 70%. In the quarter, we see the effect of Kindred bed business that has led to both increased accounts receivables and the reduction of accounts payables in this quarter. However, I do not see any reason why we will not reach and exceed the target 70% for the full year. Regarding investments -- or rather capital expenditure. We believe that the level we have previously communicated for the full year will hold. We have said that we will be at approximately the same level as last year, around SEK 580 million. Thank you.

[Joacim Lindoff, CEO, President & Director]

Thanks, Jonas. I will now take you through the slightly revised outlook for 2019 and sum up this presentation before we open up for questions.Moving over to outlook. And given the good net sales development in the quarter and the good backlog for the rest of the year, we now feel comfortable to increase our guidance for organic net sales growth from approximately 3% to the upper part of our interval 2% to 4%. On the cost side, we expect our operating expenses to somewhat decline as a percentage of net sales in 2019. And as stated before, the absolute OpEx number will increase between 2018 and '19, mainly driven by further investments in sales activities that over time will drive profitable net sales. And of course, we will do further investments into R&D. We also expect to see continued negative effects on OpEx from translations effect as we have seen this quarter. We will, of course, continue to work with all cost lines, supported by the now 2 initiative -- initiated restructuring programs that we have kicked off to make continuous improvements to support the guidance on OpEx. All in all, including details presented over the last 25 minutes, we feel comfortable to fulfill the new 2019 guidance, and thereby, our midterm financial targets also in this year. So let me then just make a short recap of the presentation. We put a very strong net sales quarter behind us with especially good performance in the U.S. The professional execution of the large Kindred order is proving that we have established a good platform in the U.S. for further growth, and I'm looking forward to see how we can continue to develop both in other product categories and in rental and service in the U.S. Canada continues to perform in a solid way and contributes overall job performance. We are seeing some decline in Western Europe, mainly related to our U.K. business. We have initiated action plans to realign our business for continued profitable performance in the U.K., and we'll focus on making our rental and capital sales structure well aligned with future demand. Continental Europe is on par with last year from a strong market position. Rest of the World is showing healthy growth with a number of markets driving a positive development on or above plan. It is good to see that we stick to our plan in Australia, and the good order intake in Q1 and Q2 gives good credibility to the plan to turn this market back into growth already in 2019. Our OpEx and EBITDA are developing well in the quarter, in good alignment with our plans and financial targets. And overall, I am pleased with our performance in the quarter. The activities initiated as a part of the Arjo 2020 plan are showing results. We address problems when they occur in a proactive way to ensure further or future profitable growth, and the global teams are engaged and ready to deliver on targets during 2019 and beyond. So with that, thank you for the attention. And moderator, we can now open up for questions.

[Operator]

[Operator Instructions] We'll take our first question from Kristofer Liljeberg from Carnegie.

[Kristofer Liljeberg-Svensson]

I have a couple of questions. First one I would like to ask is about the operating leverage. Of course, EBITDA is up some 11% year-over-year adjusting for IFRS. But if you look at the EBIT line, it seems pretty flat, adjusted for nonrecurring items, despite the fact that reported sales is up 11%. So maybe could you spend a little bit of time explaining what's happening with depreciation that seems to go up quite a bit? That's my first question.

[Jonas Lindqvist, Chief Financial Officer]

We have seen an increase in depreciation and amortization. Depreciation is coming from our rental fleet where we're seeing an increase. And we also, in amortization, see an increase from IT that was moving to Arjo from Getinge as of the third quarter last year. Those are the major items there.

[Kristofer Liljeberg-Svensson]

Okay. And -- but the current levels, are they expected to remain? And when it comes to the rental fleet, the reason for the high depreciation, has that -- anything related to the weaker demand you see in Europe?

[Joacim Lindoff, CEO, President & Director]

Let me take that. The levels will be on the level that we have now seen both for D&A. And as I said during my presentation, I believe that the first half year is a good level. When it comes to the increased depreciation in rental, it has nothing to do with the lower demand because what we do is we always rejuvenate our rental fleet. And we have seen a large demand from the market to rejuvenate our rental fleet possibly in a higher speed than we expected in the beginning of the year, something that we have done to meet customer demands because we are actually selling quite well when it comes to rental, especially in Europe. But there is a price pressure on the market that has been there and that we have been discussing for quite some time. In the U.S., the decline in the U.S. has nothing to do with the -- or has only to do with a milder flu season. So we have not placed anywhere close to as many so-called RotoProne systems in the market than what we usually do. And these RotoProne system is something that we already have in the fleet, and the placement of those systems, given that the clinical performance of those systems, are a lot higher both when it comes to net sales and also profitability. So obviously, it's something where we have little influence when it comes to flu season in the U.S. But on a normal -- I would say, in a normal year, that figure would have been higher for us. But it has nothing to do with the depreciation. Hello?

[Kristofer Liljeberg-Svensson]

Yes. And then when it comes to -- sorry, could I continue?

[Joacim Lindoff, CEO, President & Director]

Yes, please.

[Kristofer Liljeberg-Svensson]

Okay. And within amortization, how much of that is M&A-related? Is it still around SEK 25 million?

[Jonas Lindqvist, Chief Financial Officer]

As an average, Joacim referred to -- and I think that we have adjusted in this quarter. And year-to-date, it is SEK 59 million and should be half of that [ occur ] -- that it almost SEK 30 million by quarter.

[Kristofer Liljeberg-Svensson]

Okay. And my last question. When it comes to operating costs, they improved a bit more than what I expected at least in the second quarter. Would you be able to give some kind of level -- or how to think about operating costs for the full year? That would be helpful.

[Joacim Lindoff, CEO, President & Director]

As described in the outlook, we believe that OpEx will decline as a percentage to net sales for the full year. We believe that the momentum that we have seen now in both Q1 and Q2 is something that we will continue to build on. I don't necessarily expect that to go up or down in any dramatic way so probably around that level would be a fair assumption.

[Operator]

We'll take our next question from Sten Gustafsson from Nordea.

[Sten Gustafsson, Senior Analyst]

This is Sten Gustafsson from Nordea. A few questions. Firstly, on the Kindred order. How much of that was delivered in Q2? I'm not sure I picked that up from your remarks. And also is there a risk that we will see continued gross margin pressure also in Q3 as you continue to deliver, as I assume, on that order? That would be my first question.

[Joacim Lindoff, CEO, President & Director]

Thanks for the questions, Sten. We have actually delivered more or less everything out of the Kindred order. The Kindred delivery scheme, as I commented very shortly in my presentation, was agreed with the customer, where the customer clearly stated that "If you are not executing well, then we will delay installations and wait until you can perform. But if you are performing well, then we will ask you to accelerate." And I'm very pleased with the performance of the U.S. organization and the implementation of that because the customers asked us to accelerate the implementation based on a, from my perspective, a very professional way of doing this from the U.S. So we have actually put more or less the entire Kindred order on the market. As we only have so much capacity in the organization, there are obviously other activities that has been moved out to Q3 and consequently into Q4. We have no lost orders or anything like that. It's just that when it comes to installation and clinical support functions, we can only do so much. So that move has obviously meant that a few things is going into Q3 and also into Q4, which will have good effects when it comes to those 2 quarters. So the margin pressure from selling out 50% more medical beds in the quarter than we usually do will not be there in Q3 and Q4. We will move back to a much more normal product mix, my view, in Q3 and Q4, where we believe that, for example, categories like patient handling will see a nice development during the latter part of 2019.

[Sten Gustafsson, Senior Analyst]

All right. That's very helpful. But -- yes, but there's a bit of a seasonality if I'm -- remember this correctly, that the gross margin is typically lower in Q3 on a normal level. But that's good. Also, if you could remind me on the timing and the potential savings from the 2 different restructuring initiatives. I'm not sure I fully captured that in your remarks. If you could repeat those, please.

[Joacim Lindoff, CEO, President & Director]

Absolutely. First, giving you a 110% right on the seasonality on gross profit. That has been the same pattern for the last -- or from my last 20 years in med-tech. So that is correct. On the restructuring, if we take the U.K. part, it's a restructuring cost of SEK 25 million that will be booked during Q3 and Q4. We expect yearly savings of SEK 20 million out of that. And again, it's proposed to influence 70 roles in the U.K. organization. But it is an estimated yearly savings of SEK 20 million on a yearly basis that we will then now see gradually starting already in 2019. For the U.S. restructuring, it is a restructuring cost also here of SEK 25 million, where we see the savings of -- yearly savings of SEK 25 million gradually kicking in during 2019, yearly savings of SEK 25 million.

[Operator]

We'll take our next question from [ Magnus Burnett ] from [ Direct News ].

[Unknown Attendee]

My question was answered. I just wanted a clarification on the savings. So a total savings of SEK 45 million, as I understood it?

[Joacim Lindoff, CEO, President & Director]

Exactly. On a yearly basis. That's correct. And maybe just adding on that one, that the U.K. savings will be more or less evenly divided on OpEx and COGS. And the U.S. restructuring program is mainly versus a reduction in COGS, to cost of goods sold.

[Operator]

[Operator Instructions] It appears there are no further question at this time. I'd like to turn the conference back to the speaker for any additional or closing remarks.

[Joacim Lindoff, CEO, President & Director]

Thank you, moderator. Very, very shortly, just finishing off and summing up, we put a very strong net sales quarter behind us. And it's really good to see the good net sales performance in the U.S. where we have now established, I would say, U.S. as one of the growth engines of the future journey of Arjo. Also very good to see the development in Rest of the World where we continue to see very good tractions on a number of the investments that we have done. So with the uplift in our outlook for the year on net sales, we feel comfortable that we will meet those targets, and we look forward to perform also in Q3 and Q4 of 2019 and obviously onwards as well. Thank you very much for your attention, and I'm going to speak to you all soon. Thank you.

[Operator]

That concludes today's conference. Thank you, everyone, for your participation. You may now disconnect.