Integer Holdings Corporation (NYSE:ITGR) Q3 2022 Earnings Conference Call October 27, 2022 9:00 AM ET
Company Participants
Anthony 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
Operator
Good day and welcome to the Integer Holdings Corporation Third Quarter 2022 Earnings Release Conference Call. Please note today’s conference is being recorded. [Operator Instructions] Thank you. At this time, I will turn the conference over to Anthony Borowicz, Senior Vice President of Investor Relations. Mr. Borowicz, you may begin your conference.
Anthony Borowicz
Good morning, everyone. Thank you for joining us and welcome to Integer’s third quarter 2022 earnings conference call. With me today are Joe Dzedzic, President and Chief Executive Officer and Jason Garland, Executive Vice President and Chief Financial Officer.
As a reminder, the results and data we discuss today reflect the consolidated results of Integer for the periods indicated. During our call, we will discuss some non-GAAP measures. For a reconciliation of these non-GAAP measures, please refer to the appendix of today’s presentation, today’s earnings’ press release and the trending schedules, which are available on our website at integer.net. Please note that today’s presentation includes forward-looking statements. Please refer to the company’s SEC filings for a discussion of the risk factors that could cause our actual results to differ materially.
On today’s call, Joe will provide his opening comments, and an update on the execution of Interger strategy. Jason will then review our adjusted financial results for the third quarter 2022, provide additional insight on our product line performance, and review our full year 2022 guidance. Joe will come back to provide his closing remarks, and then we’ll open up the call for your questions.
With that, I will 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. We thought it would be appropriate to start by providing an update on the supply chain challenges that we highlighted on our October 5 preannouncement. Since that time, we have eliminated additional sales risk related to the two medical component suppliers, because we have received all the material needed to meet our fourth quarter outlook.
For our non-medical products, we have line of sight to component supply from more consistent supplier performance and our dual-sourcing strategy for critical components. We continue to intensify our management of the supply chain to reduce operational risk. We have increased the frequency and depth of managing supplier risk, including more frequent tracking, faster escalation of delays and shortages, and executive level engagement with suppliers. We are also accelerating our proactive measures, including executing in-sourcing and dual-sourcing strategies where appropriate. Also, our updated guidance includes an even more cautious risk adjustment based upon existing supplier performance.
Integer’s third quarter 2022 financial results were in line with the preliminary view that we released on October 5. Our third quarter sales grew 12% versus third quarter 2021 and adjusted EBITDA grew 5% year-over-year. Integer’s 2022 financial outlook remains unchanged from our October 5 release with 11% to 13% year-over-year revenue growth and adjusted operating income of $180 million to $196 million.
The next slide summarizes why the fundamentals of our growth strategy remains strong despite the sales push out caused by the recent supply chain challenges. Integer’s growth strategy has not changed, and we are excited about our growth prospects. We are well-positioned in a recession-resilient industry, where demand has returned to pre-COVID growth rates. Customers tell us that we are performing better than our competitors despite supply chain challenges, and we believe we will benefit from supplier consolidation trends.
We expect above-market revenue growth of 7% to 9% in 2023 due to strong customer demand, a significant backlog, accretive growth from the Oscor and Aran acquisitions, and new product introductions concentrated in electrophysiology, structural heart- and neuromodulation. We expect margin expansion in 2023 from volume leverage, higher prices and the $8 million in annualized savings from eliminating SG&A positions.
Our direct labor environment is improving. We reduced turnover by approximately 17% in the United States and 9% in Ireland during the third quarter. We have achieved our targeted direct labor levels in most of our sites and remain focused on fully training our workforce to operate more efficiently and fulfill the strong demand from customers. Given this progress, we anticipate that a fully staffed and trained workforce will deliver productivity in our operations in 2023 and drive our expected margin expansion.
I will now hand the call over to Jason.
Jason Garland
Thanks, Joe. Good morning and thank you again for joining our call. I’ll provide more details on our third quarter 2022 adjusted financial results summarize our product line sales trends and conclude with our 2022 outlook.
Integer’s third quarter results were consistent with our October 5 preliminary view. At $343 million, our third quarter sales grew 12% year-over-year, with currency being about 100 basis point drag, mostly driven by the euro. Excluding acquisitions and currency, we are up 6% year-over-year. As a reminder, our third quarter sales would have been approximately $15 million higher if not for the deteriorating deliveries performance and missed commitments from primarily three suppliers. Our adjusted EBITDA in the quarter was $63 million, up $3 million compared to last year, which is an increase of 5%. Adjusted operating income was $46 million, slightly below third quarter 2021.
The supplier delays reduced adjusted operating income by approximately $12 million, with $8 million of that driven by the lower sales volume and $4 million from higher manufacturing costs. Manufacturing costs are higher due to increased wages, freight and adding 5% more direct labor in the third quarter, in an effort to deliver the high end of sales guidance we had provided in July. As an offset to higher manufacturing costs and cost of goods sold, we saw lower SG&A expense in the third quarter from a year-to-date benefit to align incentive compensation with our updated guidance.
That said, we expect the fourth quarter SG&A to be higher than the third quarter and similar to second quarter levels. Though the fourth quarter includes a benefit from the annualized savings from our restructuring actions, our fourth quarter is typically the highest quarterly SG&A spend in the year as it includes end-of-year costs and services. With adjusted net income at $32 million, we delivered $0.95 of adjusted diluted earnings per share, down $0.10 from the third quarter of 2021.
I will give some more color on our adjusted net income on the following slide. The third quarter adjusted net income decreased $3 million compared to the third quarter of 2021, primarily driven by higher interest expenses partially offset by a $1 million benefit from the currency due to the stronger dollar. The $3 million in higher interest expense is impacted by the increasing U.S. interest rate environment but also from an increase in our principal amount of debt outstanding being more than $300 million higher than last year due to the Oscor and Aran acquisitions. Although approximately 11% of our debt is fixed through an interest rate swap, the rest moves with LIBOR and therefore, we expect interest expense to continue to increase through the rest of the year. That said, we subscribe to the view that floating with the market produces the best outcome over the long-term.
Our adjusted effective tax rate was 13.6% in the third quarter of 2022 compared to 13% in the third quarter of 2021, creating a year-over-year headwind of roughly $0.01 per share. The third quarter 2022 rate benefited from discrete items in the quarter. We project an increase in the fourth quarter rate and a total year adjusted effective tax rate of 15.5% to 17%.
In the third quarter of 2022, we generated $28 million in cash flow from operating activities, up 47% sequentially from the second quarter. Inventory has grown $55 million through the first three quarters, with $16 million being added in the third quarter with the single biggest driver being the products that we did not ship because of the supplier delays. We expect inventory to reduce in the fourth quarter. Our $22 million of free cash flow, third quarter year-to-date reflects the impact of the $55 million of inventory increase and the $42 million of year-to-date CapEx spend as we continue organic investments in capabilities and capacity for growth.
We still expect to spend between $65 million and $75 million in capital expenditures in 2022. With our net total debt balance peaking in the second quarter following the acquisition of Aran Biomedical, we decreased it by $13 million since that time to $925 million at the end of the third quarter. Our debt leverage at the end of the third quarter was 3.8x trailing four-quarter adjusted EBITDA, down slightly from the second quarter. Although we are still temporarily above our target range of 2.5x to 3.5x in the third quarter of 2022 due to the Aran acquisition, we expect to improve our leverage again in the fourth quarter and expect to be between 3.4x and 3.7x leverage. We will now transition to a discussion of our product line sales. Trailing four-quarter reported sales grew 12% in the third quarter of 2022 with strong growth across all product lines.
Beginning with our first product line, Cardio and Vascular sales were up 14% in the third quarter compared to the third quarter of 2021. As we have previously discussed, we continue to face a challenging supply chain environment that ultimately caused sales to be pushed out of the quarter. Despite this impact, we grew double-digit on strong demand and backlog in the high-growth Electrophysiology and Structural Heart markets. We have also seen strong performance from both the Oscor and Aran acquisitions, which continue to accelerate our Cardio and Vascular sales growth. Trailing fourth quarter sales continued strong year-over-year growth, up 18%. We expect this momentum to continue throughout the year.
Moving to Cardiac Rhythm Management and Neuromodulation, sales grew 8% in the third quarter, with sales growth primarily from our Oscor acquisition. This includes the impact of the supplier delays that affected our neuromodulation products as previously discussed. Trailing four-quarter sales posted year-over-year growth of 7%. In our Advanced Surgical, Orthopedics and Portable Medical product line, our third quarter sales were up 17%, driven by the beginning of our multi-year portable medical exit plan as we work with our customers to provide the products they need to transition production. We also generated low double-digit growth in the Advanced Surgical and Orthopedics business in the third quarter. Trailing four-quarter sales was roughly flat year-over-year.
Finally, we will wrap up the product line discussion with Electrochem, our nonmedical segment. Third quarter sales increased 24% driven by strong demand across the environmental, energy and military markets despite sales being lower than they could have been in the energy market due to supplier delays. Trailing four-quarter sales grew 18% year-over-year, driven by the continued recovering energy market.
We will now transition to our updated expectations for 2022. The full year outlook is consistent with our October 5 update. Starting with sales, we are forecasting sales to be in the range of $1.35 billion to $1.38 billion, an increase of 11% to 13% versus last year. This includes the noteworthy sales performance from our Oscor and Aran acquisitions. And on an organic basis, considering the $35 million sales delay, we expect sales to grow 4% to 6% compared to 2021.
As previously shared, our updated adjusted EBITDA and adjusted operating income forecast was impacted by approximately $25 million with $17 million from lower sales volume due to the supplier delays and $8 million of higher manufacturing costs from increased wages, freight and additional direct labor. With these impacts, we expect 2022 adjusted EBITDA to be between $244 million and $260 million, which is flat to 7% year-over-year growth. We expect our 2022 adjusted operating income to be between $180 million and $196 million, reflecting a decline of 4% to a growth of 5%.
Adjusted EPS is expected to be between $3.57 to $3.97. Our adjusted EPS outlook includes the impact of the delayed sales, higher manufacturing costs, higher interest expense and our latest view of adjusted effective tax rate, which as mentioned earlier, is projected to be between 15.5% to 17% for the year.
As I close, we now expect cash flow from operations between $110 million to $125 million. This estimate is inclusive of the inventory investment we have made through the third quarter as we continue to execute strong demand and the impact of supplier delayed shipments. It also includes our latest adjusted EBITDA outlook. Consistent with our strategy, we are maintaining our outlook on capital expenditures as we have continued to invest organically in the business to drive growth. We still expect to spend between $65 million to $75 million of CapEx, and now expect to generate free cash flow between $40 million to $55 million. Most of the free cash flow we expect to generate will be used to reduce net total debt by $35 million to $50 million. We expect to end the year with our leverage ratio between 3.4x and 3.7x adjusted EBITDA, close to within our target range of 2.5x to 3.5x.
With that, I will turn the call back to Joe. Thank you.
Joe Dziedzic
Thanks, Jason. We have intensified our supply chain management to deliver for our customers and patients. Our financial outlook is unchanged, and we expect to end the year with 11% to 13% year-over-year sales growth despite supply chain challenges. In 2023, we expect sales growth of 7% to 9%, which is approximately 300 basis points faster than the markets we serve. We also expect margin expansion in 2023 from volume leverage, higher prices and efficiencies from a more fully staffed and trained direct labor workforce.
We remain focused on executing our strategy. We have our largest ever new product development pipeline. Customer demand is at an all-time high. We have successfully added the direct labor needed to fulfill on this demand. We are positioned to deliver strong sales growth in 2023 with margin expansion. As we stabilize labor and supply chain, we remain confident in our ability to deliver on the financial objectives of our strategy to grow sales 200 basis points faster than the market, grow profit twice as fast as sales and maintain debt leverage between 2.5x and 3.5x adjusted EBITDA.
Thank you for joining our call this morning. I will now turn the call back to our moderator for the Q&A portion of our call.
Question-and-Answer Session
Operator
[Operator Instructions] Your first question comes from the line of Matthew Mishan with KeyBanc.
Joe Dzedzic
Good morning Matt.
Operator
Matthew, your line is open.
Matthew Mishan
Good morning. Sorry about that, I am on mute. I just first wanted to start off on margin as well, and you guys have given the 7% to 9% revenue growth for next year. Without giving initial guidance, how should we think about some of the moving pieces of margins next year, like headwinds and tailwinds and maybe some of the company-specific initiatives you guys are implementing at this point that should help improve?
Joe Dzedzic
Sure. Thank you for the question, Matt. So, as we look at 2023, we are confident we can expand margins. I will start with we are going to go from this year and our prior years having priced down with customers to next year, it’s going to be price increases. So, that’s an immediate impact that changes the trajectory of a core element of what we have been doing in the last 5 years. So, that will be a positive. We have added significant direct labor this year, significantly more than we have been able to increase output. We are focused right now on training our workforce. We do not anticipate adding – increasing our direct labor headcount in the fourth quarter. We feel we have the level we need to run for some period of time into 2023. And our focus is on training the workforce to get the proficiency and the manufacturing operations to drive the efficiencies. So, we believe that’s going to be a meaningful contributor to helping us. And with 7% to 9% sales, you get volume leverage on that direct labor that we do not anticipate needing to increase in the near-term. We also get volume leverage on the overhead in the facilities and volume leverage on the operating costs, which we have already taken specific actions to lower our SG&A costs next year by an annualized $8 million. We implemented that at the end of the third quarter. So, we see those as positive trends. We also have new products that we are introducing. And we all know new products typically, that’s the highest price you are going to see in the marketplace when you launch them. And so that’s going to help also. We have got strong growth and we continue to drive meaningful synergies in Oscor, the acquisition we did at the end of 2021, who are performing better than we expected this year. They are driving meaningful efficiencies and the synergies with customers has been significant. And we see significant growth and additional synergies there. So, those are some of the very integer specific things that we expect to drive margin expansion next year. The supply chain environment remains challenging. That’s the fact. But I think we are all in the same boat. You have seen that with most – everyone’s earnings announcements this quarter, the pressure is there. We feel that we are managing those effectively. We obviously had some gaps in the third quarter and we need to improve on those, and we have. We are getting much deeper with suppliers. We are escalating issues faster and I am personally engaging with the suppliers that are challenging as are our other leaders – other members of leadership teams. So, we think there are some very specific Integer actions that we have taken that will ensure we expand margins next year and that we will be able to manage in this continued volatile difficult supply chain environment.
Matthew Mishan
Is it fair to assume as a starting point for next year that you get back to your two-to-one op income growth to revenue growth, or should we be a little bit more cautious to start the year given the supply chain environment?
Joe Dzedzic
So, we are not prepared to give that level of granularity for 2023. That’s absolutely our goal as we look long-term. And we are confident, when we get to a more stable labor and supply chain environment, we are confident that we can continue to grow profit twice as fast as sales. We are not ready to give 2023 guidance just yet, but we think we have taken some meaningful actions to ensure margin expansion. The price increases as opposed to decreases, the meaningful amounts of direct labor we have added this year and our focus is on training them. We have got – we have increased inventory meaningfully and now we believe we are going to be able to start to reduce some of that inventory where we built up maybe more safety stock than what we need. So, we do expect to be able to expand margins next year. We are just not ready right now to tell you what that guidance is going to be. We will provide that on our fourth quarter earnings call.
Matthew Mishan
Okay. But how should we be thinking about your $200 million to $250 million target for M&A on an annual basis. That program was implemented before some of these supply chain issues before like interest rates have risen. How are you adapting that M&A program to the current environment?
Joe Dzedzic
Yes. Great question, Matt. We continue to look at the opportunities that are aligned with our strategy. We think we have been very transparent and we are looking for tuck-ins, we are looking for acquisitions that expand our capabilities to enable us to offer a more vertically integrated solution to our customers in those higher growth end markets. So, we have been very targeted, very specific. We think the Oscor and Aran acquisitions are great examples where we have either added new and differentiated capability to further vertically integrate and serve our customers. We think Oscor is an expansion of what we already do, that’s in our wheelhouse, where we can generate significant synergies and offer more to our customers. And so we continue to look at that. Obviously, we remain very committed to our 2.5x to 3.5x leverage. That doesn’t mean that when you do an acquisition, you might bump up into the high-3s. But we have a very near-term plan to get back within 2.5x to 3.5x. And so we remain very active in looking at opportunities. We don’t get to decide where the seller sells. If we were to incentivize them, that probably would require an above market price. And so we are not doing that. But we remain very active and also very committed to our 2.5x to 3.5x leverage. We think the results that we have been able to deliver with Oscor, and we think Aran will also demonstrate this over time, we think that demonstrates that our strategy and our ability to both acquire, integrate and drive the synergies. We think we demonstrated our capability there and we feel that this is an important part of our strategy going forward. But it’s tuck-ins, and it’s within the framework of our leverage target.
Matthew Mishan
Okay. And I think it will be helpful for investors to understand how you think about your exposure to neuromodulation. I mean I would probably guess like legacy Integer was more focused on spinal cord stimulation. But it’s a little more about some of the areas that are growing faster are outside of that. How should we think about where you are exposed at this point?
Joe Dzedzic
Certainly. So, today, our sales are more – lean more towards the spinal cord stim for sure. But our pipeline and our emerging customers lean much more towards those emerging therapies, whether it’s sleep apnea or incontinence or treating epilepsy, [indiscernible] applications or heart failure. There are a lot of non-spinal cord stim therapies that are in development and are part of our pipeline. So, although spinal cord stim is getting some news today around reimbursements and around the growth rates, maybe it’s mid-single digits instead of high-single digits, our pipeline is not only – it includes spinal cord stim, of course, but it’s also much more heavily weighted outside of spinal cord stim. So, we are confident in that pipeline and those therapies. We have a number of customers that are in various stages of the development phase and remember they are launching the revenue generation phase. So, when you think about us in neuro, think about the pipeline is heavily weighted towards non-spinal cord stim.
Matthew Mishan
Okay. And just last one, you mentioned that you have secured the components and supplies to meet your guidance in the fourth quarter. I am assuming that you are talking right at that midpoint of the guidance, given the range. And we will see how the supply chain evolves from there as far as – whether or not that’s up or down.
Joe Dzedzic
That’s absolutely correct, Matt. We put the products that we had the supply chain issues with and that we discussed during the pre-announce. We said, let’s only include what we have physically on hand so that we de-risk those products on the medical side. We are confident on the non-medical given the dual sourcing and given the performance of those suppliers. We have been working on ensuring that the pipeline of those products are flowing and committed for 2023 volumes now that we have taken care of the fourth quarter for those as well as the other suppliers. There is other suppliers we continue to work with as well to address the supply chain. Most of the issues when we talk to suppliers, it points back to labor. And I can highlight in the U.S., our labor turnover improved by 17%, which is a positive. And I think that’s some of the actions we have taken, and also we have heard that the labor environment, I wouldn’t say that it’s good, it still remains challenging, but it does show signs of improving. We also improved labor turnover in other places around the company as well. And we think we are hearing that with some of our suppliers that they are also improving their ability to supply, and we think it’s pointing to an improving labor environment in some places, but it still remains very challenging. I think you have heard that across the board on earnings calls this quarter.
Matthew Mishan
Okay. Thank you very much.
Joe Dzedzic
Thanks Matt.
Operator
Your next question comes from the line of Jim Sidoti with Sidoti.
Jim Sidoti
Hi. Good morning. Thanks for taking my questions.
Joe Dzedzic
Good morning Jim.
Jim Sidoti
First thing, I think you said organic growth was about 6% in the quarter. So, I just want to confirm that Oscor and Aran sales are in the $18 million to $19 million range. Is that right?
Jason Garland
From a growth rate, Jim?
Jim Sidoti
Just what were Oscor and Aran sales in the quarter?
Jason Garland
We haven’t shared all those on a quarterly basis. But yes, their organic is 6%, and so there would be the difference in that growth rate.
Jim Sidoti
Yes. Okay. Alright. And then looking at the annual guidance, just the fourth quarter left, it’s a $0.40 range there. What are the factors that get you to the high end of that?
Jason Garland
So, we are continuing to certainly manage the supply chain environment, and that has been the biggest variable for us, obviously, as we have looked at the impact in the third quarter and the fourth quarter. And so we are certainly driving the team and the sites to deliver more, as we have talked about, the customer demand is strong. And as much as we can continue to get the materials we need, or more than maybe what we are expecting, that will deliver and feed the pipeline to help us to be able to deliver more on the high side of the sales. That’s going to be the biggest driver, Jim, to get on the higher range of the EPS.
Jim Sidoti
So, it sounds like you are confident the demand is there. The biggest issue is being able to supply to meet that demand, is that correct?
Jason Garland
Absolutely. Alright. We have talked a fair amount about how strong that demand is, both in our backlog as well as in certainly the conversations we are having with customers and forecasts that they are giving us. And so this is about having material on hand and getting that through our shops out to our customers.
Jim Sidoti
Alright. And then last one. You didn’t give an implicit gross margin guidance, but you did indicate that sales and SG&A expense is going to be up relative to the September quarter. So, it seems like you are expecting an improvement in gross margins in the third quarter – in the fourth quarter compared to the third quarter. Is that because these labor issues have improved, or supplies improved, or what’s driving that improvement?
Jason Garland
Yes. Just to think about in the third quarter, most, we dropped about 100 basis points from the run rate over the first half and that was certainly impacted by the stranded labor we talked about, right, as we lost sales from our suppliers. We had stranded labor and then the other costs that we have talked about as well. In the fourth quarter, as we get volume higher, we get the benefit of that leverage as well as continuing to really manage our costs the best we can. There is certainly, again, the environment we are facing and the inherent pressure that we are still – that we have talked about in manufacturing, but we believe that with the higher sales, we will be able to absorb a bit of that. And to your point, the guidance has this increasing in the fourth quarter.
Jim Sidoti
That was it for me. Thanks again for taking the question.
Jason Garland
Thanks Jim.
Operator
[Operator Instructions] And there are no further questions at this time. I will now turn the call back to Anthony Borowicz for any closing remarks.
End of Q&A
Anthony Borowicz
Thank you everyone for joining today’s call. As always, a replay of this call is available on our website as well as the presentation that we just covered. Thank you again for your interest in Integer and it does conclude today’s call.
Operator
Thank you for participating. You may disconnect at this time.
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