Arjo AB (publ)

STO:ARJO B

Earnings Call Transcript 2023-Q2

[Joacim Lindoff, executive]

Thank you very much, and a warm good morning to everyone, and welcome to Arjo's Q2 2023 earnings call, where I will give you some details on the Q2 report that we just released. Next slide, please.

Today's agenda includes, as always, a summary of activities and results from Q2, balance sheet items and some comments on the outlook for 2023, and then we will open up for questions. And as always, we intend to keep the call to an hour and finish no later than at 9:00.

Next slide, please, and let's start with the business update. And if I can have the next slide, thank you. Following the trend from Q1, we have continued to see good demand during Q2 in most major markets for our solutions as well as capital sales, service and rental. We post a healthy 5% organic growth for the quarter with all regions developing according to plan. In the U.S., it continues to be the conversion from lead to order that is slower than usual due to the continued stressed financial situation of many U.S. health care providers caused by the well-known staffing shortages and increasing costs. The positive lights in the tunnel that we spoke about after Q1 is still there, and that means that we expect a step-by-step improvement of capital equipment order intake in the second half of the year. It is, however, good to see that we are growing organically in the U.S. during Q2 for the first time since 2021.

We continue to see good growth on major markets like Canada, France and Australia, where both capital service and rental developed well. Our gross margin came in slightly better than expected at 42.5%. The gross margin continues to be affected by higher material costs and inflation effects on fuel, energy and now also very clearly on salaries. Given the lower sales of our profitable Patient Handling category in the U.S., we also experienced a continued negative effect versus previous years. On the positive side, the development of transportation cost is slightly better than planned.

We also continue to drive efficiencies throughout the value chain based on the plans that we have put in place, for example, within the supply chain. The high focus also remains on price increases, and we continue to see slightly above-plan performance in this area. We have a lot of work left to be done over the coming quarters on the gross margin side, but we continue our step-by-step improvements and are confident that we will go to where we should be for 2023 and onwards. OpEx was well under control in the quarter. We are seeing an increase mainly related to salaries due to high inflationary effects. Activity levels, as stated before, continue to be high, and I feel comfortable that investments that we are doing will continue to lead to development of profitable sales going forward. Adjusted EBITDA for the quarter was SEK 490 million versus SEK 430 million in Q2 2022, well in line with our expectations. And it obviously serves as a good base for further improvements of our profitability in the coming quarters versus 2022.

Cash conversion in the quarter came in slightly better than expected at 112% with continued improvements in our working capital. We continue to address our operational cash flow in an active way. And with a first half year cash conversion of 86%, we are trending above our full year target of 80%. In summary, we see a continued good development on most major markets. Our service and rental business develops favorably across almost all markets, and we are seeing a high activity level on most markets setting us up for solid growth in line with plans for the quarters to come. Next slide, please.

And we move over to North America, where we grew our business with 3.5% organically in the quarter, again driven by good performance in Canada. But also with U.S. some positive grounds for the first time since 2021. The realignment of our U.S. sales and service organization is now fully implemented, and the new sales setup is starting to gain speed. Activity levels continue to be high, but conversions from pipeline to order intake and capital equipment and outcome programs are still slow due to the continued lack of staff and strained financial situation for many health care providers. As stated previously, there are lights in the tunnel in these areas, further confirming our view that we will see a gradual improvement in capital order intake in the second half of the year in the U.S.

Also in Q2, we had lower sales of Patient Handling in the U.S. than the year before, which continues to be a reason for a negative product and geographical mix for the group on gross margin. Pipeline for the coming quarters in Patient Handling in the U.S. looks promising. But as stated in the Q1 report, we need to see this pipeline translate into orders before we can clearly speak about the change of trend.

Our DVT business in the U.S. continues to perform well and on plan for both pricing and compliance initiatives. Volumes in the quarter are increasing slightly based on better traction on the elective surgery side, a trend that we expect to see also for the remainder of the year.

We continue to see high interest of our pressure injury prevention programs in the U.S. in the quarter. However, the rates of SEM scanner conversion, despite a continued very high interest from customers, is still not on expected levels for the same reasons as explained in the previous reports around the staff shortages and focus on more short-term projects.

Rental in the U.S. continues to develop well, and we see an uptick in net sales based on new customer implementation and also further development of existing customer base. In addition, service continues the strong net sales development from Q1 with profitability coming along well. Canada reports a 13th consecutive quarter of growth this time with around 9% organic growth. Rental, Service and Capital Equipment are all developing well, and we've built our overall business, both in acute care and long-term care on this important market in a profitable way for the longer term.

As a summary, a solid Q2 in North America with good performance in Canada and a return to growth in the U.S. There are still uncertainties on the short-term development of the U.S. capital equipment side. But as stated, we forecast a step-by-step improvement from Q3 and onwards.

The SEM scanner sales is expected to pick up in Q3 and Q4, but has been slower than expected during the first half year. Our service and rental and our Canadian business performs yet another solid quarter. Next slide, please.

And moving over then to Global Sales where we then have both Western Europe and rest of the world. The region in total saw a solid organic growth of 5.3% in the quarter, adding to a good start in Q1. We are year-to-date at 5.5% organic growth, which is to be seen as slightly better than some.

In Western Europe, we report an organic growth of 4.2% for Q2 with major markets like U.K., France and Belgium, to mention a few, performing well. We continue to see healthy demand for our products and solutions together with a good development of both service and rental in the quarter. We see good interest on our Pressure Injury solutions also in Europe, but we are experiencing the same conversion trends from pipeline to order as in the U.S.

It is, however, encouraging that we have launched our first Pressure Injury Prevention pilot program in the U.K., and we expect positive results from this in terms of additional interest and sales in the second half year. There are, as before, some uncertainties around capital spend levels in European Healthcare. But based on year-to-date performance on the information at hand and the current pipeline development, we feel comfortable that the short-term net sales development will follow our current expectations. Then on to next slide, please, and some further details on rest of the world. Our business in Rest of the World had a healthy organic net sales growth of 8% in the quarter with good performance across many markets and with continued high activity levels.

In Australia, as an example, we report a solid 7% organic growth, supported by good order intake in all areas. The focus on gradually changing our sales approach towards more outcome programs also on this important market is starting to gain speed.

India, Singapore and also our African region is performing well in the quarter and adding to the solid growth in the region. Our Chinese sales and service activities saw good development, and we are strengthening our pipeline and sales footprint that I strongly believe will support good stable growth in the coming quarters. Japan is behind plan in the quarter due to some project delays. But also here, we believe that we will see an EBIT catch-up in the second half year.

All in all, Rest of the World continues to build on the strong start to the year and the net sales development comes well supported by order intake and pipeline buildup. Next slide, please, and over to the financial development, the next slide.

We have a gross margin of 42.5% in Q2, slightly higher than expectations, higher than Q1 gross margin and for the first time since the beginning of 2022, improving over last year. As you saw in the report, we have restated our gross profit and gross margin for Q2 2022 with SEK 18 million in the quarter and year-to-date with SEK 31 million, and that is related to material cost that was wrongly booked under other expenses last year. This has no effect on overall profitability for the 2022 numbers. It is just done for correct comparison.

In Q2, as in Q1, we continue to have negative product mix effects due to less Patient Handling sales and negative geographical mix as we are selling less percentage-wise in the U.S. We also invoiced older Medical Beds projects in U.K. and Singapore in the quarter with pricing before the main price adjustments took place, which has added to the negative mix in the quarter. Material cost is again significantly higher versus corresponding quarter in 2022 and effective negatively with around SEK 20 million, SEK 21 million for the quarter, alligned with expectations. The trend is improving year-over-year and the delta versus previous year will continue to decline in the coming quarters.

We are experiencing continued stabilization on material sourcing and we are currently not too far away from the situation we saw pre-COVID. This will obviously have positive effects on our ability to manufacture efficiently in the coming quarters. Transportation cost is trending well and slightly better than planned, coming in more than SEK 30 million lower than last year's Q2 on a volume for volume like basis. On top of this, we have had additional lower logistic costs, thanks to the inventory reduction plans and lower inbound deliveries in general. Increase in salary inflation and additional fuel and energy costs are affecting the gross margin negatively in the quarter with SEK 21 million versus Q2 of 2022, a value that also here is in line with the expectations that we had set for the full year of 2023.

We are, as before, working hard to mitigate the negative effects with continued long-term efficiency gains throughout the value chain. The U.S. Rental Efficiency program is generating expected savings, our continuous improvement plans and supply chain develops well, and we are seeing external factors move both towards stability and, in some cases, lower cost levels, especially in transportation, as I mentioned before.

With that said, we continue to focus on continued price adjustments to compensate for the overall much higher cost environment. The outcome of our price increases are currently well aligned with communicated plans, and we need to continue to focus here to see full mitigation on the additional costs that we have incurred in Q2, and that will also impact the coming quarters. Based on this, I feel confident that we will perform on or slightly above previously community effects from pricing for 2023, adding at least 1.5 percentage points in organic net sales for the full year. Next slide, please. Our OpEx level in the quarter is well aligned with plan. We are on a high activity level and are working with pipeline launch, preparation and investment supporting, for example, our Pressure Injury prevention focus and building that up in a good way.

Additional inflationary cost in OpEx is approximately SEK 14 million versus 2022, and average salary inflation is now clearly visible in both COGS and OpEx with increases aligned again with forecast.

Also in this quarter, we saw a higher IT cost affecting our admin with around SEK 6 million, and that extra IT cost is mainly related to costs for infrastructure and licenses and additional investments done to secure our IT landscape. It should be noted that mainly due to the good net sales development, OpEx as a percentage to net sales is trending slightly better than expected. R&D gross investments is at 2.7% for the quarter, well aligned with our portfolio planning and upcoming launches. Our net R&D cost is approximately SEK 4 million higher than Q2 of 2022 as an effect of this. The adjusted EBITDA, as mentioned before, comes in at SEK 490 million with the adjusted EBIT at SEK 206 million.

Restructuring came in at SEK 20 million in the quarter, mainly relating to the large parts of our U.S. sales realignment and restructuring in our Diagnostics business, which will improve our cost structure in that business going forward. We now forecast approximately SEK 45 million in total restructuring costs for the full year of 2023. Next slide, please.

And over to working capital, where we with a challenging 2022 from an operating cash flow and a cash conversion perspective, it is good to see that the positive trend from Q1 continues. We have high focus on working capital management and see a positive impact from working capital in the quarter. We continued the positive trend on our inventory side and are well on track to meet set targets for the year in this area. We have continued our solid work on receivables management from previous quarters, and we expect this performance level to continue also throughout the rest of the year.

Important to note here is that we have improved on the aging of our receivables in the quarter, only adding to the not due, reducing all other buckets. Working capital days are stable on 101 days. We are expecting our days to decline in the second half year based on current traction on net sales and working capital reduction.

The EBIT level in the quarter, along with the positive impact on working capital, gives an operating cash flow of SEK 528 million versus SEK 158 million in Q2 of 2022. As an effect of this, cash conversion improved considerably versus Q2 of 2022, and we report 112% cash conversion for the quarter and 86% year-to-date. We are comfortable that with current focus and activities in place, we'll exceed our target of 80% cash conversion for the full year. Cash flow from investing activities was SEK 152 million versus SEK 233 million in Q2 of 2022. And it's mainly consisting of investments into our rental fleet, R&D and fixed assets. Next slide, please. Our net debt increased slightly to SEK 5.3 billion, which is SEK 0.1 billion higher than the previous quarter. This increase is mainly due to a revaluation of our U.K. pension fund. Our financial cost has increased substantially compared to the same period last year and reflects the current interest rate expenses that we have and obviously also the debt level. We expect our reduction journey on net debt to resume starting in the second half of 2023.

Our cash position remains strong, and our leverage net debt to adjusted EBITDA came in at 2.8, a slight deterioration of 0.1 versus Q1 of 2023 due to the net debt development just described. The equity ratio came in at 47.7, which is on the same level as after Q1 2023. Next slide, please.

And then moving over to outlook. And the outlook for the year remains, and we therefore expect, based on our current visibility of the market, the organic net sales growth for 2023 to be within the group's target interval of 3% to 5%. We expect to have continued favorable development in our organic net sales also in the second half of the year. We have started the year better than expected, but we still lack that full visibility around the expected step-by-step improvement of the U.S. capital equipment and also the SEM scanner conversion ratio in the second half year.

Given the slower development also in Q2 in the SEM scanner area, we now forecast sales of around SEK 130 million to SEK 140 million for the full year in that area with major parts coming in the second half year. We still expect overall capital sales volumes to grow slightly for the full year with a forecasted positive development in Patient Handling and Pressure Injury Prevention for the coming quarters. We also expect our service and core rental business to continue to develop well during the remainder of the year. As previously communicated, price increases are still expected to add at least 1.5% organic growth across the group for the full year, which is the trend that we are currently following. From a gross profit and margin perspective, we expect material prices to stabilize on a high level and be only slightly above versus last year in the second half of the year and coming in line with the full year expectation that we had after Q1.

The positive trend on transportation cost is expected to continue. And based on current trends, we believe as before that we will compensate the higher material costs with lower transportation costs for the full year. We expect energy and fuel to remain on today's high level, which means that the effect versus Q3 and Q4 2022 will be more or less neutral. Inflation effects on salaries now have -- is now clearly visible in costs, both in manufacturing, but also in Service and Rental. And our continued focus on price adjustments and internal efficiency work will have to continue to mitigate factors and mitigate those increases.

As communicated before, we expect OpEx as a percentage of net sales to increase for the full year of 2023 and then start to decrease again from 2024 and onwards. Also in this area, the significantly higher than normal salary increases are now clearly visible in the Q2 outlook numbers.

In summary, we continue to expect 2023 to be a year with net sales and profitability improvements versus 2022. Based on the stable start to the year, we feel confident that we can meet our guidance of the 3% to 5% organic growth and make sure that we continue the journey to improve our profitability in current year. Next slide, please.

And over to a very short summary, where I would like to summarize that this quarter, we are reporting a solid Q2 with a 5% organic growth and with the year-to-date performance at 4.6%. Our underlying business is developing well in most areas, and we are following our plans and forecast well. We see good effects of our initiatives around price increases and internal efficiencies, areas that will contribute to a positive development of our gross margin and overall profitability in the second half of the year.

Despite continued volatility, especially on the U.S. capital equipment market, we feel comfortable with our outlook of 3% to 5% organic growth based on the solid start. We look forward to continue to develop Arjo in 2023 on both top line and profitability versus 2022.

And with that, I would like to open up for questions. So moderator, please go ahead.

[Operator]

[Operator Instructions] The next question comes from Rickard Anderkrans from Handelsbanken.

[Rickard Anderkrans, analyst]

So I have 2, please. So first, a question on the U.S. Have you started to see any signals or pickup in actual orders heading into Q3 now? Or is this something we should primarily expect for Q4 on the U.S. capital side Patient Handling?

[Joacim Lindoff, executive]

The very short answer there, Rickard, is yes, we are starting to see those small positive signs, and that has also started to translate in smaller pickups in order intake, which is obviously positive. But again, confirming our view around Q3 and Q4.

[Rickard Anderkrans, analyst]

All right. Could you comment anything on sort of book-to-bill or anything that could help us sort of quantify that dynamic of the expectations here?

[Joacim Lindoff, executive]

No. I would probably comment it with that order intake in the U.S. in the latter part of the quarter was slightly better than expected, and we obviously hope that, that is a good sign for the coming quarters on capital equipment. Service and Rental continues their good growth in the quarter, and we have all reasons to believe that, that development will also continue in Q3 and Q4.

[Rickard Anderkrans, analyst]

All right. Great. And the second question, you mentioned in the presentation that there was some sales of older or sort of outdated pricing contracts. Could you quantify anything on sort of impact on gross margin or the top line magnitude, and if there are any additional old pricing contracts left to deliver in the second half?

[Joacim Lindoff, executive]

I wouldn't be able to quantify it. But the category of Medical Beds, obviously, a part of our capital side is in the quarter on very low integrated margins because of projects that we have secured have had for planned deliveries really since 2021, when pricing and also cost levels were completely different. So I can't elaborate further on the details there, but it has significant effects on the Medical Beds capital side for us.

We are obviously delivering out step-by-step everything that I consider to be owing backlog, and we should be very close to be in a situation where we now have -- I would put it like that fresh backlog, at least when we are moving into the latter parts of the year, let's say, end of Q3 and into Q4.

[Operator]

The next question comes from Mattias Vadsten from SEB.

[Mattias Vadsten, analyst]

I mean the slower conversion progress from high interest in the SEM scanner also in this quarter. So maybe if you could again state the expectations for the full year 2023. And what do you see will drive the uptake for the second half of the year? And if you see any reason to be more cautious long term for the product, that would be the first one.

[Joacim Lindoff, executive]

Yes. The -- what we are saying is that we're indicating that it's still a tougher-than-expected conversion market, but the reduction we are talking about here is not dramatic. We are -- after Q1, we said that we were going to end up at around SEK 150 million. We believe that we will now be around SEK 130 million to SEK 140 million for the full year, and that is mainly because of the slower invoicing in -- that we have seen in Q2.

The reason why I do believe or rather feel comfortable around that number is obviously the activity levels and the contracts that we have and are signing as we speak. And I believe that, that will generate the needed drive to get us to that number of around SEK 130 million to SEK 140 million.

It is obviously with some uncertainty because we can't control the conversion rates from the customer. We can work with our customers as hard as we can. And the interest, as I said, is still very high. And I have no doubt that we, together with BBI, will make that product as support of our Pressure Injury Prevention approach, a success going forward, but it is slower than what we had expected.

And as we have stated on many occasions before, it is not an off-the-shelf product. It is very much something that we have discovered. It's only sold in our outcome programs, and they buy the full, take longer time to implement. The same thing -- I mean, we have the same thing with our outcome programs in caregiver injury, we are in Patient Handling in the U.S. where -- and that is kind of the main reason why we have a lower order intake and a lower net sales of Patient Handling, that is also the slowness of these type of projects on the U.S. market.

And I believe that when we will start to see traction on the Patient Handling side, we will also start to see traction on the outcome programs in Pressure Injury Prevention. So they are tightly connected.

[Mattias Vadsten, analyst]

That makes sense. And second one, on the gross margin. I mean we know Q3 is a weaker gross margin quarter from a seasonality perspective. But you will have some potentially helping factors with more price increases, better U.S. Patient Handling sales potentially. But do you see the gross margin coming down Q3 sequentially before climbing in Q4? Or how should we look at it?

[Joacim Lindoff, executive]

As we have said after Q1, I see rather stable level of gross margin in Q1, Q2 and also into Q3. Remember, it is vacation time and we do have slowness in some areas in Q3 and then a pickup that, in my view, will start really from September and onwards and help us do a quite healthy Q4 that we usually have. And that is through the factors that we have said. We are cleaning up, or not cleaning up, but we are delivering out on backlog, if I may say that. The price increases are given the needed effects. We can see that in our P&L when we follow, the internal efficiencies are there. And; with the higher order intake in the U.S. around Patient Handling, we will have a better product mix going into especially the latter part of the year.

[Mattias Vadsten, analyst]

Good. And maybe 1 more for me. I mean as you said, it's a slower quarter in Q3, we have the vacations. It's typically taking down activity. Do you expect this to be even more accentuated in lower activity now this time around as staffing situation remains stretched and we have seen some sort of strikes also now lately? Or how should we think of it?

[Joacim Lindoff, executive]

No, I don't see any signs that we would have a necessarily slower net sales quarter in terms of growth in Q3 than what we have seen in Q2. We have a high activity level. We have a high interest of customers. And there is, I would say, a step-by-step gradual improvement of the demand and also the willingness to put orders for our products. So I'm expecting an active Q3 as well.

[Operator]

The next question comes from Kristofer Liljeberg from Carnegie Investment Bank.

[Kristofer Liljeberg-Svensson, analyst]

I have 3 questions. First, coming back to U.S. order conversion in the second half. Could you maybe say a little bit about your confidence level here and how big earnings risk you view this to be for the second half of the year? Then on the SEM scanner, this tougher-than-expected conversion. Could you maybe tell us a little bit why you think it has been tougher? And also previously, there were some discussions about the software needed for that sales to pick up. What's the status there? And finally, on the gross margin comment. You said you expect a stable gross margin in the third quarter. What's the definition of stable here? Is it stable year-over-year or sequentially? And also given that the gross margin is down here, first half of the year, do you still expect gross margin to be higher for the year 2023 versus 2022?

[Joacim Lindoff, executive]

Yes. If I miss something here, Kristofer, you need to remind me. But the U.S. order conversion in the second half year, I rather see -- I think that we have planned our second half year in a realistic way. So I would probably rather see that if we have a better uptick than expected, that there is some potential of doing slightly better. That's probably how we'd put the risk level of that. We have been cautious around on how we look at the U.S. market and need to continue to be that. And as I've said before, I want to see the orders into the books before I say that the positive lights that we have in the tunnel are really positive and can start to quantify that. So I want to see the orders in the books.

On the SEM scanner, as I said before, the main reason for that being slower is twofold, both the situation with U.S. healthcare providers, staff shortages, you don't have time to focus on anything else than just short term and make sure that elective surgery and the process around that is working. You don't have time to do things that has a significant payoff, but still a payoff that comes later. You want to focus on something that drives revenue and cash flow here and now. We very much believe that we will come back to a more normal situation there, and that will help both Pressure Injury Prevention and our caregiver injury side. And the second part is that we are, as I've stated before, the SEM scanner is not an off-the-shelf product. It is a product that in a very good way helps our overall Pressure Injury Prevention solutions where we need to sell our customers larger programs, outcome programs where we guarantee an outcome. So it's a little bit of a change to what we had initially, where we thought that we were going to sell the SEM scanner just as a standalone, but it is -- customers are now very much focusing, as they do in the caregiver injury side, focusing on a guaranteed outcome in this area. And that takes longer time for us to together with the customers change their protocols in a way that we can ensure that.

And again, the changing protocol comes back to the soft shortages, which is difficult to do when they don't have enough staff. On the gross margin side, I would like to see that as a sequential stabilization versus Q2. And I am absolutely confident that we will be able to increase our gross margin for the full year versus the full year of 2022.

[Kristofer Liljeberg-Svensson, analyst]

Could I follow up on the gross margin? So we were at 42.5% in the quarter. Last third quarter margin dropped quite significantly sequentially. So if you're going to be stable, that means you should improve gross margin 2 percentage points year-over-year in the third quarter. Is that...

[Joacim Lindoff, executive]

We believe that we can -- yes, we will be hovering around -- as I can see it now, there's no reason for me to believe that with the activities that we have, with the price increases, with transportation trending in the right way, that we should not be able to be around the same level as we have been now for Q2 in gross margin. And maybe just adding shortly to that, obviously, and that is something that is important. We are seeing a high pressure on the inflationary side on salaries. And that is affecting our gross margin that we have to mitigate. But it's also obviously going to continue to affect our absolute OpEx line. So please keep that one in mind as well.

[Kristofer Liljeberg-Svensson, analyst]

But given that normally in the third quarter, you have this seasonally weaker gross margins. If you could keep the gross margin flat versus what you had in the second quarter, that's an underlying sequential improvement then.

[Joacim Lindoff, executive]

Let's stay with that I believe that we have good reasons to believe that we will be able to have a gross margin that is around the same level as we have had in Q2.

[Operator]

[Operator Instructions] There are no more questions at this time. So I hand the conference back to the speakers for any closing comments.

[Joacim Lindoff, executive]

Thank you very much, and thanks for dialing in and listening in. And it has been good to report a stable Q2 for Arjo with organic growth of 5%, and we are now year-to-date at 4.6% and continue our journey towards improving both our organic growth and also our profitability in 2023. So thank you, and have a very good day.