Integer Holdings Corporation (NYSE:ITGR) Q2 2022 Earnings Conference Call July 28, 2022 12:00 PM ET
Company Participants
Tony Borowicz – Senior Vice President, Investor Relations
Joe Dziedzic – President and Chief Executive Officer
Jason Garland – Executive Vice President and Chief Financial Officer
Conference Call Participants
Matthew Mishan – KeyBanc
Jim Sidoti – Sidoti & Company
Operator
Ladies and gentlemen, thank you for standing by. My name is Brent and I will be your conference operator today. At this time, I would like to welcome everyone to the Integer Holdings Corporation’s Second Quarter Earnings Call. [Operator Instructions] It is now my pleasure to turn today’s call over to Tony Borowicz, Senior Vice President of Investor Relations. Sir, please go ahead.
Tony Borowicz
Good morning, everyone. Thank you for joining us and welcome to Integer’s second quarter 2022 earnings conference call. With me today are Joe Dziedzic, President and Chief Executive Officer and Jason Garland, our 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 some non-GAAP measures. For reconciliation of these non-GAAP measures, please refer to the appendix of today’s presentation, today’s earnings press release and 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 an update on the execution of Integer’s strategy. Jason will then review our adjusted financial results for the second quarter 2022, provide additional insight on our product line performance and review our full year 2022 guidance. Joe will come back on to provide his closing remarks, and then we’ll open up the call for your questions.
With that, let me turn the call over to Joe.
Joe Dziedzic
Thank you, Tony, and thanks to everyone for joining the call today, especially the Integer associates who have continued to execute our strategy through these dynamic times.
In the second quarter, we delivered financial results in line with our expectations shared during our last earnings call. Sales grew double-digits versus last year and the first quarter of this year. Our adjusted operating profit grew 28% versus the first quarter and was about flat versus last year as the current labor and supply chain environment had minimal impact on our second quarter results last year. We have increased our full year sales outlook by $14 million to deliver 12% to 14% growth year-over-year.
We expect adjusted operating profit to grow 10% to 16% year-over-year as gross margin improves through the second half of this year. We continue to make progress in executing our strategy to accelerate our top line growth. We are executing structured and disciplined product line strategies to – for sales growth. Integer is uniquely positioned to serve our customers across the full continuum of the product technology life cycle from emerging technology to high growth and finishing with the mature phase. We offer differentiated technology for the emerging phase and scale production during high growth and can vertically integrate and simplify our customer supply chain during the mature cycle.
Our organic and inorganic investments are focused on adding capabilities and capacity concentrated in the higher growth end markets of electrophysiology, structural heart, neurovascular and neuromodulation. We are delivering faster organic growth this year, now 6% to 8% as a result of these strategies. We expect faster second half organic growth from the new product introductions that continue to ramp the rest of this year and into next year. Our acquisitions are delivering as Oscor’s sales are ahead of plan by $5 million, and the integration of Aran is on track. Oscor has a strong pipeline of opportunities and has partnered extremely well with our operations and supply chain teams to deliver more than planned at the beginning of the year. We are generating strong engagement from strategic customers on the combined capabilities of Aran and Integer and are excited about these new opportunities as well as Aran’s existing strong pipeline. We remain focused on executing our strategy to deliver on our financial objectives.
I will now hand the call over to Jason.
Jason Garland
Thank you, Joe. Good morning and thank you again for joining our call. I will provide more details on our second quarter 2022 adjusted financial results, summarize our product line sales trends, and conclude with our updated 2022 outlook.
Integer’s second quarter results were consistent with our expectations to increase meaningfully over the first quarter sequentially versus the first quarter of 2022 sales grew 13% and adjusted operating income grew 28%. At $350 million, our second quarter sales grew 12% year-over-year on a reported basis and 5% on a year-over-year organic basis, which excludes the impact from acquisitions and currency differences.
Our adjusted EBITDA in the quarter was $66 million, up $12 million sequentially versus the first quarter of 2022 and up $2 million compared to last year or an increase of 3%. Adjusted operating income was $50 million, which sequentially grew $11 million versus the first quarter and is down slightly versus the second quarter 2021. As a key driver to the adjusted operating income results, gross margin also improved in the second quarter compared to the first quarter of 2022 and in the second half of 2021, but is lower on a year-over-year basis.
Last year, we did not see a meaningful amount of incremental costs and inefficiencies from supply chain and labor constraints until the third quarter and therefore, these costs were not impactful in the second quarter of 2021 comparison period. These constraints have continued for the last 4 quarters, and we remain committed to managing through these challenges to provide our customers and the patients they serve with the products they need, even at higher costs. These higher costs have caused approximately 300 basis points of gross margin headwind and are mostly driven by direct labor from higher-than-normal overtime inefficiencies from delayed material as well as high training costs and the incremental salary for associates we are hiring to support accelerating growth through the rest of 2022.
We continue to believe that the majority of these costs are temporary in nature and though reducing, they are likely to remain through the rest of 2022 and into 2023. Outside of production costs, our total operating expense, including SG&A and RD&E grew year-over-year on a reported basis, primarily due to the addition of Oscor and Aran. They were also impacted by an increase in the annual salaries and higher expenses and stock compensation incentives.
We expect SG&A expense to continue to be higher for the remainder of the year due to the same items and the timing of spend. We expect second half RD&E spend to continue at a similar run-rate as the first half of 2022, but there maybe lumpiness across the remaining two quarters due to the timing of key programs. With adjusted net income at $35 million, we delivered $1.04 of adjusted diluted earnings per share, down $0.03 from the second quarter of 2021. Ordinarily, I would discuss our year-over-year adjusted net income bridge next. However, since there are no meaningful year-over-year changes in any of the elements, we have moved this slide to the appendix for reference.
In the second quarter of 2022, we generated $19 million in cash flow from operating activities and generated $7 million in free cash flow, inclusive of $12 million of capital expenditures in the quarter. You may recall during the first quarter earnings conference call, we highlighted that we grew inventory by $20 million in the first quarter versus the end of 2021 to support our double-digit sales growth in the second quarter. In the second quarter, we increased inventory another $20 million, so a total of $40 million in the first half of the year.
To provide more color, there are four key drivers to this $40 million increase. First, we have been rebuilding general inventory positions from the low point we achieved during the pandemic when we closely preserved our working capital. Second, we continue to increase our raw material stock to match our increasing product demand and sales. Third, we continue to proactively increase our safety stock levels to protect material availability for critical components and see this as an investment to ensure delivery of products to our customers. And finally, we have been impacted by an increase in work in process inventory related to products that are partially built but waiting on delay components.
We believe our aggregate inventory levels are where we need them to support growth in the business and expect improvement in our inventory efficiency as supply chain environment improves. Net total debt increased $127 million to $938 million, as we borrowed $129 million from our revolver in the 1st and 5th April of 2022 and to fund the acquisition of Aran, excluding the new borrowings, we reduced our net total debt by $2 million in the second quarter.
Our debt leverage at the end of the second quarter was 3.9x trailing fourth quarter adjusted EBITDA. This leverage ratio includes the impact of the new borrowings to fund the Aran acquisition. Although we are temporarily above our target range of 2.5x to 3.5x in the second quarter due to the Aran acquisition, we expect to be back within our targeted leverage range by year-end. We will now transition to a discussion of our product line sales. Trailing fourth quarter reported sales grew 16% in the second quarter of 2022 with strong growth across our Cardio & Vascular, CRM & N and Electrochem product lines.
Beginning with our first product line, Cardio & Vascular sales were up 25% in the second quarter compared to the second quarter of 2021. So we still face supply chain constraints. The second quarter growth was driven by our ability to deliver on strong demand in the neurovascular, electrophysiology and structural heart market and also benefited from the acquisition of Oscor and Aran. Trailing fourth quarter sales continued strong year-over-year growth, up 21%, with strong double-digit growth across all cardio and vascular markets.
Moving to the cardiac rhythm management and neuromodulation product line, sales grew 2% in the second quarter with sales growth from our Oscor acquisition offset by labor and supply chain constraints, primarily related to long lead time components. Trailing four quarter sales continued strong year-over-year growth, up 13%. In our Advanced Surgical, Orthopedic & Portable Medical product line, our second quarter sales were flat versus the prior year with a low single-digit decline in Advanced Surgical and Orthopedics and flat year-over-year sales for Portable Medical. Trailing 4 quarter sales declined 6% year-over-year due to a decline in the Portable Medical driven by lower demand for COVID-related ventilator and patient monitoring components versus last year and from Advanced Surgical and Orthopedic sales being flat.
Finally, we will wrap up the product line discussion with Electrochem, our non-medical segment. Though we see strength in our customer demand, our ability to fulfill was constrained by specific supplier shortages impacting approximately $3 million of sales in the second quarter. We continue to work with our suppliers and are addressing these constraints. Trailing four quarter sales grew 15% year-over-year, driven by the recovering energy market. We will now transition to our updated expectations for 2022.
Starting with sales, we are increasing our outlook by $14 million and now expect sales to be in the range of $1,370 million to $1,395 million, an increase of 12% to 14% compared to 2021. On an organic basis, we now expect sales to grow 6% to 8% compared to 2021. Our expectations for 2022 adjusted EBITDA are unchanged. We still expect to be between $273 million and $285 million, which is 13% to 17% year-over-year growth. We are increasing our adjusted operating income outlook by $3 million. We expect 2022 adjusted operating income to be between $206 million and $218 million, reflecting growth of 10% to 16%.
Our updated adjusted operating income forecast incorporates the cost of headwinds from the supply chain and labor environment. Adjusted EPS is now expected to be between $4.20 to $4.50 reflecting a growth of 3% to 10%, but down $0.12 from our prior outlook on both ends of the range. Our adjusted effective tax rate remains unchanged from our previous outlook and is projected to be between 16% to 17.5%. The lower adjusted EPS guidance is driven by an increased forecast in our interest expense, which we have increased by $7 million across our outlook range and now expect to spend between $35 million to $40 million. This is primarily driven by the increasing U.S. interest rate environment and is estimated by using a projected 1-month LIBOR forward rate curve the underlying index for our interest payments.
The low-end of our range assumes the 1-month LIBOR rate will rise to about 2.9% by year-end, and the high end of the range assumes the rate reaches nearly 4.3%, up from June’s average of approximately 1.5%. About 16% of our debt has a fixed rate to the – through an interest rate swap and the rest will move with LIBOR. We subscribe to the view that floating with the market produces the best outcome over the long term, while at the same time we continue to evaluate approaches to reduce interest expense.
As I close, we expect cash flow from operations between $151 million to $166 million, which is $7 million lower than our previous guidance, reflecting the higher interest expense payments just discussed. It is also inclusive of the inventory investment we have made in the first half of the year to prepare for increased sales and continuity of supply.
Consistent with our strategy, we are maintaining our outlook on capital expenditures as we continue to invest organically in the business to drive growth. We still expect to spend between $65 million and $75 million on CapEx and now expect to generate free cash flow between $81 million and $96 million. Most of the free cash flow we expect to generate will be used to reduce net total debt by $76 million to $91 million. We expect to end the year with our leverage ratio between 3.0 and 3.2x adjusted EBITDA, down from our second quarter leverage ratio, which had increased due to the Aran acquisition. This will put us in the middle of our target range of 2.5 to 3.5x adjusted EBITDA.
With that, I’ll turn the call back to Joe. Thank you.
Joe Dziedzic
Thanks, Jason. Our second quarter results were in line with our expectations, including the double-digit sales growth. We increased our full year sales guidance by $14 million and our adjusted operating income guidance by $3 million. Full year sales are now expected to grow 12% to 14% from faster organic growth and our recent acquisitions of Oscor and Aran, we continue to execute our structured and disciplined strategy to achieve our financial objectives I remain confident in our strategy and our associates and our ability 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.
Question-and-Answer Session
Operator
[Operator Instructions] Your first question comes from the line of Matthew Mishan with KeyBanc. Your line is open.
Matthew Mishan
Hi, good morning, guys and congratulations on a really nice quarter.
Joe Dziedzic
Good morning, Matt. Thank you.
Matthew Mishan
I just want to start off, but I heard a number of times throughout some of the early reporters that they plan to consolidate the number of suppliers reduce the complexity of the supply chain going forward. Are you seeing any kind of like movement from some of your customers in starting to execute on those strategies? And I know we’ve talked about it from a longer-term perspective, of winning on the new platforms and new products and how long it takes to kind of move business over. Is that really the plan or are they looking at shortening that cycle?
Joe Dziedzic
That’s a great question and that trend has been there. What is, I think, very apparent during the challenges that have been happening in supply chain is there is an even stronger movement to consolidate to suppliers who have the resiliency and the operating practices, the financial stream and then quite frankly, honor their commitments under existing agreements to ship product at the prices that they agreed to. Unfortunately, there are a number of suppliers who are not doing that. They’re not able to fulfill, and they’re not honoring the prices that they’ve committed to. And that’s clearly creating a list of suppliers, I think, throughout the industry that they’re going to be companies that want to move away from. And I think that’s just accelerating the trend towards moving to stronger, more reliable supply and more strategic partners. And we continue to have high-level discussions with our customers around the resiliency that we have been able to demonstrate in meeting their needs. And we haven’t been perfect at that. We are not immune to the challenges in the industry and in the broader economy. But what we feel that we’ve made the necessary investments. We’ve made the necessary move labor, adding inventory to the business and incurring the cost to fulfill on our commitments to help our customers continue to take care of patients, and that’s been our priority throughout the pandemic. And so I absolutely believe that we’ve demonstrated to our customers our commitment to enabling their success in serving patients and that, that’s going to differentiate us over time and in the long run. And so we do see the interest in continuing to consolidate, continuing to partner with the most strategic suppliers. And we know we’re in that category with most of our customers. They tell us we are.
And to your question about is that happening right now? I think the reality is, in this environment, right now, everyone is working to deal with the labor and supply chain issues. They’re keeping track of who is able to deliver and who’s making the investments and who’s honoring their commitments and who’s not. But to think that in this environment that they can put meaningful resources towards making that changes, it’s very challenging and their focus is on meeting immediate need and near-term demand in serving patients. But I’m confident that they do know who’s delivering for them and who’s serving them today and who is not. And I am confident that, that’s to our advantage because we’re making those investments. We’re incurring the necessary costs. We are making – taking the actions to serve them. In the first half, we’ve added 10% more direct labor associates to our business, and that’s on an organic basis, although sales in the first half have only grown 2.5% organically. The second half, they are going to grow double digit organically. And that labor that we’ve added, once we get them fully trained and fully proficient, it’s going to allow us to deliver on the second half. We’ve added $40 million of inventory in the first half, and that’s specifically to work to minimize and reduce the supply chain disruption from suppliers who are unable to ship on their committed delivery date and that’s going to help us. And these are examples of the kinds of investments that we’re able to make given our financial strength to demonstrate our resiliency and being able to serve our customers and enable them to meet the patient need. And I think that’s the point of differentiation that it’s going to enable us to continue to grow in a strategic partnership way with our customers.
Matthew Mishan
Excellent. And thank you for a really good answer. On the margins, if I am looking at my model correctly and that’s a big if. Second half it looks as if the gross margin should be at the midpoint of your guidance, should be somewhere in the low 30s. And was it mark like a big improvement over where you’ve been in the first half. First off, is that sort of how you’re looking at the second half ramp in your gross margins? And like what’s driving the level of improvement in 1H, 2H if you’re already seeing the manufacturing environment become a little bit easier for you?
Joe Dziedzic
Matt, your model is accurate and your math on the second half margin rate is correct. As we look at and think about the second half, we see the significant sales growth that’s coming from new product introductions that’s giving us additional volume in the second half, and that’s going to help drive the sales into that mid to high double-digit teens when you look at the year-over-year growth rate. When you look at that on an organic basis, it’s going to be high single digit, low double digit on an organic basis on the top line. I would point to what enables us and helps us to improve the margins are that we’ve added 10% more direct labor in the first half that’s versus year-end. And getting those new associates trained and fully proficient and building product is going to allow us to reduce some of the inefficiencies that we’ve been incurring. We’ve been incurring lots of overtime, lots of training costs. We’ve incurred already in the first half incentives for sign-on bonuses, as well as incentives to work overtime, incentives for training. So that cost of bringing on that much labor is going to help us drive greater efficiencies in the manufacturing plant in the second half.
Additionally, in the first half, we’ve added $40 million of inventory and that’s all-in and work in process. The finished goods inventory is basically flat with where we were at the end of the year. And we have done that on purpose to help minimize some of the disruptions from suppliers. And so you have heard a lot of companies talk about manufacturing inefficiencies from the suppliers’ inability to meet delivery dates or meet the committed to delivery dates and having to reschedule the factories. So the inventory we’ve added helps us to mitigate it. Maybe it won’t eliminate it because there is still critical components that we weren’t able to build inventory with, and we’re working to close those gaps. But the extra inventory is going to help us manage the facilities in a more efficient way in the second half of the year.
The third thing I’d point to is some of the long lead materials that we struggled to get enough of in the first half. We’re getting more of those in the second half and some of those products are higher margin than the average. And so we do get some favorable mix in the products we’re shipping in the second half compared to the first half and that will give us favorable margin mix. So there’s a combination of variables that drive the margin improvement. It’s the additional headcount that get them fully trained to be able to reduce overtime and some of the other inefficiencies additional inventory helps with scheduling and running the plants more efficiently into a schedule and then the favorable sales mix.
And quite frankly, we think we’ve made a reasonable judgment on what our suppliers’ delivery commitments are for the second half we feel really good about the top line. In fact, we – if we can get – even get our associates even more proficient or faster, we get them to do more be proficient faster in the second half, and we can get some help from supplier deliveries, we can even exceed the high end of our sales range because the demand is there. We’ve dialed back the sales forecast to match what we think we can ship and the materials we can get. But if we can get some help from supplier delivery and get training faster, we could ship more than the high end that’s going to probably come at lower margins, though, if we get to the higher end of the sales or even exceed the sales because of the cost to get there. But our patients – our customers and their patients, they’re looking for the products, the demand is there. And so we are going to be working to get as much product to our customers as we can, but it will be dependent upon on getting all of those factors and variables I mentioned. So we feel great about the demand and the top line and possibly getting to the high end or even higher, but it likely will come at lower margins. But on balance, it will meet what our customers need, and that’s ultimately our goal.
Matthew Mishan
And do you feel comfortable that as you exit ‘22 with that 30% plus gross margin with the composition of business you have and the new acquisitions that that’s a good run rate going forward and assuming we’re in a more normalized market growth kind of environment?
Joe Dziedzic
Yes. I’ll qualify to what you just – to the key point you just said. If we’re in a more normal stable environment, absolutely, 30% gross margins and then continuing from there to grow operating profit at twice the rate of sales in a more normal environment. I don’t know when we’re going to get to that more normal environment. But we’re confident when we get to a more normal environment, we can grow profit twice as fast as sales given the pipeline of new products we have, given the Integer production system that we’re executing and the investments that we’ve made in driving some of the efficiencies and they’re adding the capacity, the operating leverage we’ll get. So in a more normal environment, we absolutely are confident 30% gross margins and growing profit twice as fast as sales. I can’t predict when we get to that more normal environment.
Matthew Mishan
Okay, thank you very much, guys.
Joe Dziedzic
Thanks, Matt.
Operator
[Operator Instructions] Your next question comes from the line of Jim Sidoti with Sidoti & Company. Your line is open.
Jim Sidoti
Good morning and thanks for taking the questions. So you beat my top line estimate. You raised top line guidance, but I heard the word supply constraint come up on several of the product lines. So could sales have been higher if you didn’t have these constraints? And are they starting to improve at all?
Joe Dziedzic
Jim, absolutely sales could have been higher. We quantified it somewhere in the range of about $15 million. We highlighted about $3 million in our Electrochem battery business in the neighborhood of $10 million to $12 million in the cardiac rhythm management neuromodulation business. So yes, we could have shipped more. And quite frankly, that was could have shipped more of what we had scheduled. There’s even more demand than that, but we weren’t planning to shift more than that given the material availability. I can’t say that things are getting better. I think they’re at about the same level. I think we’re getting better at being able to manage some of the challenges. The inventory addition helps a lot because now we’ve got a lot of inventory that helps us. The challenge becomes – as you know, you can’t ship a product until you have all the components. And so we have a lot of the components for most of the products, but we’re still missing some critical items where we’re hand to mouth on some critical items that allow us to finish shipments which we think could potentially drive higher sales, particularly in the fourth quarter as some of our suppliers are able to ramp up and deliver more of those products.
And so when you look at our sales outlook, we think the third quarter is going to grow a little bit over the second quarter, a relatively small amount. But in the fourth quarter is where we would expect to see even stronger growth. And our range that we have a $25 million sales range, we would expect that range that variability to be in the fourth quarter. And that’s because as we fully train our new associates and get them fully proficient. Some of our suppliers are able to ramp and give us more product. We think the fourth quarter could be a really strong fourth quarter and that range of ours that we gave in the guidance could – is going to be reflected in the fourth quarter. But I wish I can say that it’s getting better. I think the actions we’ve taken are helping by adding more resources and adding more inventory that helps, but the environment still remains very, very challenging. And that’s – it’s consistent with what we’re hearing from talking to others in the industry and customers. And I think you’ve heard that fairly clearly in the industry earnings calls this week and last week.
Jim Sidoti
Alright. And looking at the balance sheet, you addressed the inventory issue, but your accounts receivable went up I think around $20 million as well. Is that related to the acquisitions?
Jason Garland
That’s a piece of it, Jim, but we also just can see the quarter-over-quarter sales, John, right, that – and with a lot of that as it normally would coming towards the end of the period. So that’s more driven by the timing of sales, but the acquisition is a omen of that.
Jim Sidoti
Alright. And then last one from me. Now that you have the Oscor and Aran in the mix, what impact do you think that will have on your organic growth rate in 2023 and 2024?
Joe Dziedzic
I think it absolutely helps the organic growth. Let me recognize we’re talking to $71 million of the Oscor sales this year. And on an annualized basis, we’ve got about $21 million or $22 million of Aran’s sales. So call it round numbers, $90 million, $95 million of sales. So even if $95 million of sales is growing 300 to 500 basis points above kind of the Integer or the industry average, it adds $3 million to $5 million of organic sales to $1.4 billion. And so maybe it adds 20 bps of faster organic growth. But as those businesses grow and continue to grow at faster rates, it helps. It absolutely helps. And that’s part of what we were looking for from those acquisitions is they have very strong pipelines of growth and pipeline – development pipelines, and we would expect them to continue to grow at above average rates. So it definitely helps. Oscor is performing incredibly well. We raised our sales forecast for Oscor by $5 million over what we had at the beginning of the year.
The teams are collaborating incredibly well. There is great sharing and teamwork and we’ve been able to help them and we’ve been able to learn from Oscor as well. The margins are getting better as well, and we’re also super excited about Aran and some of the early strategic discussions we’re having with customers. We’ve seen strong interest exactly where we thought we would, which is Integer brings the ability to scale and vertically integrate across a number of products and therapies and Aran’s differentiated technology really, really kind of helps finish out the capability, round out the capabilities that we have. So the early discussions with customers on Aran and the growth opportunities are exciting.
Jim Sidoti
Alright. That’s it for me. Thank you.
Joe Dziedzic
Thank you, Jim.
Jason Garland
Thanks, Jim.
Operator
There are no further questions at this time. I will now turn the call back over to Mr. Tony Borowicz.
Tony Borowicz
Great. Thank you everyone for joining today’s call. As always, you can access a replay of today’s call on our website. We appreciate again your interest in Integer, and we look forward to answering any follow-up questions you may have. Thank you. Have a good day.
Operator
Ladies and gentlemen thank you for participating. This concludes today’s conference call. You may now disconnect.
Be the first to comment