Vapotherm, Inc. (NYSE:VAPO) Q3 2022 Earnings Conference Call November 2, 2022 4:30 PM ET
Company Participants
Mark Klausner – Westwicke Partners
Joe Army – President & Chief Executive Officer
John Landry – Senior Vice President & Chief Financial Officer
Conference Call Participants
Maggie Boeye – William Blair
Jason Bednar – Piper Sandler
Operator
Good afternoon, ladies and gentlemen and welcome to Vapotherm’s Third Quarter 2022 Financial Results Conference Call. [Operator Instructions]
It is now my pleasure to introduce your host, Mr. Mark Klausner of ICR Westwicke. You may begin, sir.
Mark Klausner
Good afternoon and thank you for joining us for the Vapotherm third quarter 2022 financial results conference call. Joining us on today’s call are Vapotherm’s President and Chief Executive Officer, Joe Army; and its Senior Vice President and Chief Financial Officer, John Landry. This call is being webcast live and recorded. A replay of the event will be available following the call on our website. To access the webcast, please visit the Events link in the IR section of our website, vapotherm.com.
Before we begin, I would like to remind everyone that our remarks and responses to your questions today may contain forward-looking statements. These statements are based on the current expectations of management and involve inherent risks and uncertainties that could cause actual results to differ materially from those indicated, including those identified in the Risk Factors section of our annual report filed on Form 10-K for the year ended December 31, 2021 which was filed with the Securities and Exchange Commission or SEC on February 24th, 2022 and our quarterly report filed on Form 10-Q for the quarter ended September 30, 2022 which was filed today and then any subsequent filings with the SEC. Such risk factors may be updated from time to time in our filings with the SEC which are publicly available on our website. We undertake no obligation to publicly update or revise our forward-looking statements as a result of new information, future events, or otherwise unless required by law. This call will also include references to certain financial measures that are not calculated in accordance with generally accepted accounting principles or GAAP. We generally refer to these as non-GAAP financial measures. Reconciliations of the historical non-GAAP financial measures to the most comparable measures calculated and presented in accordance with GAAP are available in the earnings press release on the Investor Relations portion of our website.
With that, it’s my pleasure to turn the call over to Vapotherm’s President and Chief Executive Officer, Joe Army.
Joe Army
Thanks, Mark. Good afternoon and thank you for joining us today. As we’ve mentioned on prior calls, 2022 is a transitional year for Vapotherm. The start of COVID in early 2020 was a significant benefit to Vapotherm because it demonstrated the efficacy of our technology, increased our visibility with customers and dramatically grew our installed base. But the equally sudden drop in hospital admissions resulting from COVID, flu and other respiratory illnesses beginning late in the first quarter of 2022, took us by surprise, resulting in lower-than-anticipated revenue as well as an unsustainable cost and inventory structure even as our underlying post-COVID business continued to grow relative to pre-COVID levels. In response, we launched what we call our path to profitability or P2P plan which is intended to right-size our cost structure while allowing us to continue to invest in future growth drivers.
Slide 3 offers a good summary of our P2P plan which consists of 4 elements: first, driving 20% revenue growth. We expect revenue growth will be achieved through 5 levers, including: one, introducing higher clinical value products, such as the HVT2.0; 2, leveraging our 1H1D strategy to drive disposable turn rates to pre-COVID levels; 3, consistent disposable ASP uplifts; 4, expanding into new core care areas; and 5, our long-term product road map which will introduce additional high-growth products to our respiratory care offerings. We are seeing clear signs that disposables revenue are turning the corner as evidenced by turn rates in our gold accounts progressing towards pre-COVID levels; second, improving gross margins to 60%. We expect to exit 4Q 2023 with 60% gross margins through a combination of our move to Mexico due to lower labor and operating costs and higher ASPs resulting from new product launches. Our gross margin improvement plan is on track and we remain confident we can achieve 60% plus gross margins.
Third, returning cash operating expenses to pre-COVID levels. While not visible on the 3Q income statement, we’ve already completed the majority of our cost-saving initiatives, including the rightsizing of our commercial organization and facilities, reducing commercial investments in Vapotherm Access and RespirCare and transitioning R&D in-house via the establishment of our new R&D facility in Singapore. Reducing these expenses require difficult decisions but we believe our plan for significantly reduced operating expenses is on track and creates a clear path to profitability. Fourth, improving our financial flexibility. We made significant progress on this in the third quarter which John will discuss shortly.
Before we go into additional detail on the progress we’re making on our P2P plan, I will provide a brief update on our financial performance in the third quarter and the current macro environment. In the third quarter, revenue was below our expectations, largely due to international revenue as these markets continue to digest the large amount of capital equipment sold through COVID and to a lesser extent, slightly lower U.S. disposables revenue. I would note that we are seeing some important trends in the business that give us confidence moving into the fourth quarter of this transitional year. Many of you probably have seen the news stories in the so-called triple demic that could occur in this fall and winter of RSV, flu and COVID are widely spread at the same time and result in higher-than-normal hospitalizations.
Given the rise in RSV cases in the U.S., we have seen an increase in our weekly U.S. disposables revenue since late September with the week ending October 28 being the highest we’ve seen since early January in the midst of the Omicron surge. We’re encouraged by the sequential increases in our monthly disposable turn rate in comparison to their pre-COVID levels, from April through September. Our full-year 2022 and 2023 revenue guidance assumes light, flu and RSV seasons and no impact from COVID.
Turning to Slide 4. As we’ve told you in the past, one metric we watch carefully are disposable turn rates which we define as the number of disposables purchased per month per installed device. With the dramatic increase in our installed base after the peak of COVID, our turn rates dropped as the number of disposables we sold was divided over a much larger installed base. What we have hoped to see, particularly in our gold accounts, are churn rates beginning to return to pre-COVID levels. When that happens or trends in that direction, we know the installed base in our biggest accounts is becoming increasingly productive.
So we watch this number carefully. Exiting Q3, we like the turn rates we are seeing in our gold accounts which are now at approximately 75% of the 3-year average pre-COVID levels for the comparative period and have been trending upwards each month since April on a seasonally adjusted basis. We’re also seeing encouraging trends in our silver and bronze accounts. Not only does this tell us our devices are still actively being used on patients. But because this occurs against the backdrop of lower COVID and flu hospitalizations, it also tells us our devices are likely being used more and more on hypercapnic patients.
These trends strongly suggest our 1H1D program aimed at educating clinicians in gold accounts on the efficacy of our devices in treating all forms of respiratory distress is working. Our field team will remain focused on executing our 1H1D strategy, primarily in gold accounts. which are among the top 1,000 hospitals in the U.S. in terms of the number of respiratory discharges. Gold accounts on the highest patient volume, are highly referenceable and often have multiple key opinion leaders. Gold accounts also represent a significant growth opportunity for us for both capital and disposables, as presently, we are only in 1 to 2 care areas in 70% of these accounts. COVID-19, flu and COPD are not the only conditions which can cause severe respiratory distress. — shock, for example, often requires respiratory intervention.
As a result, we plan to extend our 1H1D program in 2023 to increase awareness of the efficacy of our devices in addressing the respiratory distress associated with shock. It is important to reiterate that the more care areas we are used in, the higher our turn rates have been and we expect will be in the future. We believe we have an excellent underlying business with unique effective products and a strong product pipeline. With the P2P initiatives we are pursuing, we’re confident we can achieve our goals of sustainable 20% year-over-year revenue growth, 60% gross margins and a return of cash operating expenses to pre-COVID levels, leading to adjusted EBITDA positive and a stronger balance sheet.
Our CFO, John Landry, will now take you through the remaining elements of our P2P progress and discuss our financial guidance.
John Landry
Thanks, Joe. Now turning to Slide 5. A crucial aspect of our P2P initiative is our plan to achieve 60% gross margins. In the third quarter, our gross margin was 13.8% due to higher-than-normal inventory reserves and write-offs due to our transition from the precision flow to HVT2.0 and lower-than-anticipated demand and production levels. Excluding higher-than-normal inventory reserves and write-offs, our gross margin would have been 29.5% and — while it will take a few more quarters to begin seeing meaningful gross margin improvement in the quarterly income statement, our plan remains on track.
Slide 5 illustrates the key drivers that will allow us to achieve our 60% gross margin goal. The most impactful is our plan to relocate our manufacturing operations to Mexico where we can benefit from lower labor and overhead cost structures. I’m pleased to report that this project remains on track and is nearly complete. We have leased a state-of-the-art manufacturing facility in Tijuana, engaged a general contractor to perform the fit-out which is expected to be completed this month, hired 7 employees and relocated some existing employees to manage production and HR at the new facility.
There are always hiccups when undertaking a project of this magnitude and we have built this into our planning and its attribute to our people that we have progressed thus far with very few significant issues. Another driver of gross margin improvement is our exit from our Vapotherm Access and RespirCare operations, both of which negatively impacted gross margin. We made the tough decision to exit these businesses as it was a necessary step on our path to profitability which is presently a primary focus. While we expect to exit these businesses in 4Q, we will, however, use the Vapotherm Access technology to develop digital capabilities for our home device.
The last important driver of our 60% gross margin plan is higher average selling prices. For both capital and disposables, we have seen substantial increases in average selling prices worldwide over the last 6 years as we have consistently delivered more clinical and economic value to customers via our new products. As we look ahead, we expect to drive higher capital and disposable ASPs as we introduce new higher-value products and services. While it is early, we like what we’ve seen with the HVT2.0 launch in the U.S. The standard HVT2.0 capital unit offering is comparably priced to the fully accessorized legacy Precision Flow unit along with the Vapotherm Transfer unit.
In addition, the HVT2.0 disposable patient cartridges or DPCs are optimized for our premium ProSoft Cannula series, resulting in both an ASP increase on the HVT2.0 DPC and a higher mix of ProSoft cannula, resulting in higher disposable ASPs. The HVT2.0 Capital unit and disposables have been added to our GPO contracts and we are tracking to our targeted ASPs which are an important element of our gross margin improvement plan.
Turning to Slide 6. While it is not fully evident in our 3Q income statement, we made excellent progress in reducing cash operating expenses to pre-COVID levels during the quarter. Non-GAAP cash operating expenses in 3Q were $19.5 million, a $2.2 million sequential decline from 2Q and a $4.8 million decline from 1Q. During the quarter, we have taken important steps, including the rightsizing of our commercial organization to focus on our gold and silver accounts, shrinking our facilities footprint in light of the planned relocation of substantial operations to Mexico, exiting the Vapotherm access and RespirCare businesses and bringing our R&D operation back in-house and relocating it to Singapore to take advantage of a highly skilled workforce and government technology subsidy.
We signed a letter of offer to lease R&D space in Singapore and hired 9 engineers, led by a senior engineer who has worked with our Chief Technology Officer in the past. Our challenge is to aggressively remove expenses while continuing to invest in future growth drivers. This is a delicate balance and we are pleased with our progress to date.
Now turning to Slide 7. The final P2P element I’ll touch on is improving our balance sheet and affording ourselves greater financial flexibility by restructuring our debt and decreasing our inventory to pre-COVID levels. During the quarter, we successfully renegotiated our 2022 revenue covenants which modified minimum revenue required for the remainder of the year. As part of this amendment, our lender added a minimum liquidity covenant which requires us to maintain a cash balance of greater than $20 million. There are several initiatives to drive down inventory across the board as we are currently turning our inventory at one time per year.
We have had experience turning our inventory 4 times per year and our plan is to get back to that turn level which will return $20 million of cash back to the balance sheet. While we believe we can execute on this plan, the exact timing of the conversion of inventory into cash is not easy to forecast. Given the new minimum liquidity covenant and challenge of forecasting the timing of converting inventory into cash, we are currently evaluating options to add additional capital to the balance sheet.
Now turning to Slide 8. We continue to believe that we have a clear pathway to adjusted EBITDA positive by late ’23 driven by the execution of our P2P plan. We view 2022 as a transition year and we’ll only see the positive impact on revenue growth, gross margin expansion and our streamlined cost structure beginning in 2023. Based on our third quarter and year-to-date results, we have provided a revised 2022 guidance which you can see in the left-hand column of the table. For 2022, we now expect revenue in the range of $64 million to $66 million.
This is a reduction from our previous range of $76 million to $81 million, primarily due to third-quarter results and near-term headwinds in the form of longer worldwide capital equipment sales cycles and the elimination of revenue from Vapotherm Access and RespirCare beginning in 4Q. This guidance implies fourth-quarter revenue of $16 million to $18 million which would be our largest quarter since first quarter which was impacted by COVID and assumes a 4Q U.S. disposable turn rate of 60% of the pre-COVID 3-year average which is consistent with our 3Q results.
In 4Q, we expect disposables revenue will account for 70% to 75% of total revenue and 25% to 30% will come from capital and service revenue. We also expect that the U.S. will drive 80% of the worldwide revenue total in 4Q. For 2023, we expect revenue of $77 million to $79 million which reflects 20% year-over-year growth. Our 2023 revenue guidance assumes a full-year U.S. disposable turn rate of approximately 66% of the pre-COVID 3-year average which is what we exited 3Q with and continue to see through October.
We expect U.S. capital unit sales to be near the low end of our 3-year pre-COVID historical average and assume they will be primarily driven by replacements of older Precision Flow units based on historical experience and expansions into existing accounts. We expect gross margins in the range of 22% to 24% in fiscal ’22. Our implied gross margin guidance for 4Q of 16% to 18% includes significant one-time charges we will incur with the move of operations to Mexico, we expect to expense all Mexico start-up costs in 4Q.
For 2023, we expect gross margins of 48% to 50% as the one-time cost set up our Mexico manufacturing operation and higher-than-normal inventory reserves and write-offs due to the HVT2.0 launch behind us. Our manufacturing labor rates in Mexico are 75% last in [ph] New Hampshire and our overhead costs returned to 2019 levels. Lastly, we expect to benefit from an increase in ASPs due to HVT2.0 and a shift in mix to new products. We expect total GAAP operating expenses excluding impairment charges of $94 million to $96 million in 2022. This implies 4Q operating expenses of $20 million to $22 million, a $2 million sequential decrease from 3Q at the midpoint of the range. For 2023, we expect GAAP operating expenses, excluding impairment charges of $76 million to $78 million.
We now expect non-GAAP cash OpEx to be in the range of $83 million to $85 million in 2022. This implies 4Q non-GAAP cash OpEx of $16 million to $18 million, a $2.5 million sequential decrease from 3Q at the midpoint of the range. For 2023, we expect non-GAAP cash OpEx of $60 million to $62 million. Non-GAAP cash OpEx excludes impairment charges, loss on disposal of property and equipment, stock-based compensation, severance accruals, depreciation and amortization and the change in the fair value of contingent consideration. Beyond 2023, we expect to grow revenue 20% per year and improved gross margins by 200 to 300 basis points per year.
With that, I would now like to turn the call back to Joe.
Joe Army
Thanks, John. In closing, let me recap our plan for the remainder of 2022 and 2023. First, we will drive 20% revenue growth by getting disposable turn rates back to historical levels by expanding usage in the 4 care areas in our gold accounts using 1H1D, educating all accounts on use with hypercapnia patients, expanding into shock and launching important new products like HVT2.0, especially into the general care floors. Second, we will improve gross margins to 60% by late fourth quarter 2023 by spinning up a world-class factory in a low-cost Mexico, executing our 3-pronged gross margin improvement plan and burning off the expense of inventory caused by massive one-time costs incurred during COVID to meet every customer need.
Third, we have normalized our cost structure to pre-COVID levels while continuing to invest in future growth drivers, especially HBT Home and the digital opportunities. This 3-point plan executed by the very best team in the medical technology space will drive us to profitability. Lastly, by renegotiating our debt covenants and working to convert inventory into cash, we’re stabilizing our balance sheet which will allow us to continue to support our plan to drive to profitability. As John mentioned above, we are also evaluating options for adding capital to the balance sheet. I want to thank each and every one of my teammates for their dedication and commitment to our customers, patients and each other.
Now, I’d like to open the line for questions.
Question-and-Answer Session
Operator
[Operator Instructions] And your first question comes from the line of Margaret Kaczor from William Blair.
Maggie Boeye
This is Maggie Boeye on for Margaret today. I wanted to start on Q4 guidance maybe and just what’s all assumed there, obviously, can appreciate that you’re assuming the light flu season as well as no COVID in that. But can you talk about what’s assumed for maybe the RSV levels that you’ve been seeing so far in the disposables and just parse that out for us?
John Landry
Sure, Maggie. This is John. So from a guidance perspective for the fourth quarter, we modeled in light flu and light RSV seasons for the fourth quarter. We haven’t factored in any COVID into the fourth quarter. So our assumption from a U.S. disposable turn rate perspective in regards to the recovery rate versus our pre-COVID 3-year historical average. We’re targeting a 60% recovery rate and that’s assumed in our guidance for the fourth quarter with regard to U.S. disposables. We haven’t seen similar impact with regard to flu or RSV in other markets in Europe. So right now, it’s largely a U.S. issue with regards to light flu and RSV seasons.
Maggie Boeye
Okay, got it. And then just as we’re starting to think about 2023, obviously, I can appreciate that you guys are expecting 20% growth. But can you walk us through what all is assumed in that with the execution of 1H1D and as you improve gold account utilization, I know you guys referenced what you’re expecting for your disposable rate for the full year. But if you can just walk us through what you’re expecting throughout the year, that would be great.
Joe Army
Maggie, this is Joe. I’ll take that one. So really, how are we going to keep driving to how are we going to drive 20% growth in 2023 and beyond? So in the next year, we expect a recovery in the U.S. disposable turn rates to drive growth over 2022, even if we see only modest improvements in the fiscal ’23 rate versus our third quarter ’22 rate of 60%. Second, we expect that launch of HVT2.0 is going to drive capital demand back to pre-COVID levels after a year of absorbing all their equipment purchased during COVID. So we expect this to happen by replacements in existing accounts or expansions in existing accounts and that’s what we’re seeing. And the increased ASPs that go with it, given its ability to treat patients in areas in the hospital that don’t have pipe and air. And remember, 50% of all hospital beds in the United States don’t have pipe and air.
The other thing around it is the ease of use is turning out to be pretty important for Finley-staffed RT departments. We’ve locked in higher ASPs to contracting with our critical GPOs and our tiered pricing model. And lastly, we see a shift in mix to higher clinical preference products such as the aerosolized disposable patient circuit, as well as our ProSoft Cannula globally and the Oxygen Assist Module in Europe is driving higher ASPs. So in the international markets that we’re going direct in 2 new EU markets, Spain and Belgium this year which we also expect to drive revenue growth. And in 2024 and beyond, we’re going to drive it by pulling these same levers and we’ll be launching that home product which really greatly increases that TAM by 3 exercise of the hospital market. And our goal is making that home device easy to use, including the HCE digital capabilities, it’s going to be able to connect to our Vapotherm Cloud Solution. and that drives the longitudinal look at a patient’s baseline. We have a lot of levers to drive that growth.
Operator
[Operator Instructions] Your next question comes from the line of Jason Bednar from Piper Sandler.
Jason Bednar
Maybe I’ll pick up a little bit on the prior question there but focusing maybe on the capital side, just wondering if you can help us out elaborate on what you’re seeing with the capital sales cycle right now. Is it really an outright delay in purchasing potential customers saying they’re waiting until 2023 or later? Are you seeing smaller orders that you once thought were going to be larger? Really, just, I guess, trying to understand what you’re seeing and hearing, again, regarding that U.S. and international capital environment, what visibility you have to it improving from here?
Joe Army
Are you going to do that one? Go ahead, John.
John Landry
Yes, I can start. This one, you can fill in as well, Joe. So in regard to the capital sales cycle, what we’re seeing, Jason, both in U.S. and international markets. As so the markets, we saw some turmoil in the markets in the third quarter, threatened recession, interest rate hikes, continued talk of interest rate hikes going into next year which increased the customers’ cost of borrowing. We saw hospitals start to slow down the approval process, especially for larger deals and in some cases, even smaller deals, especially in the respiratory space, given the amount of equipment that they purchased more recently. Our expectation is that stabilize and return to more normal respiratory CapEx purchasing patterns which is how we’ve been thinking about it and we modeled in our forecast the next year and guidance for next year.
We believe it’s achievable, given the much larger installed base we have and the opportunity to expand further, deeper and wider into the gold accounts. in the U.S. as well as the international markets. But I think what we’re seeing near term is the capital demand is resulting in longer sales cycles. I think the receptivity to our HVT2.0 product has been and continues to be very positive. I think from a macroeconomic landscape, it’s slowed up the process a bit, both here in the U.S. and abroad.
Jason Bednar
Okay. And maybe a clarifying question for Joe on that topic. If I heard you right, it sounds like you expect capital to grow next year. I just want to confirm that’s your baseline assumption for 2023 as we think about the buildup to that 20% growth that you’re looking for next year.
John Landry
Yes. That’s right, Jason. Yes, we do expect it to grow over 2022. I think from our perspective, we’ve thought about what our pre-COVID 3-year average was before. We’ve contemplated in terms of unit sales, the lower end of that range from a pre-COVID perspective. And given the fact that we have a much larger installed base, a large installed base of older Precision Flow units going into this product launch that we had when we launched a Precision Flow Plus back in 2017 versus a classic. There’s a natural replacement cycle to these. And we believe that based on our historical replacement rates of that equipment, plus our ability to go deeper and wider and a much larger footprint of accounts across the U.S. that will provide us the opportunity to grow our capital equipment revenue over this year and more commensurate with pre-COVID levels, both in the U.S. and in the international marketplace.
Joe Army
Jason, this is Joe. One interesting thing that we’re seeing is we have offered a trade-in program to help rationalize fleets, both our equipment as well as competitive equipment. And we’ve been surprised to this point where we’re really not seeing the hospitals that are taking up the HVT2.0, they’re using it to really expand their fleets. So we’ve done an order in this week for 30-plus units from a hospital system down in the southern part of the United States. And I really thought we would see a trade in there and they were very clear that they’re actually using it to expand their fleet. So that’s a little surprising to us.
Jason Bednar
Okay, that’s helpful and good color, Joe. Maybe one more for me. Just as we think about, again, 2023 with that 20% growth, you’re — that’s not changed but the absolute numbers obviously changed we’re building off of a smaller base than maybe where we were when we add saw some longer-term guidance from you. But the margin targets aren’t significantly different. They’re lower but not significantly lower. So are the margin targets you have out there just not as overly revenue-dependent as maybe at least myself thought they might have been? And then you can just — maybe just remind us, I’m sorry if I missed it, just how everything is coming together next year, capital growth versus disposables growth to get to that 20%.
John Landry
Sure. Yes, Jason. So starting with the last piece, as we think about our capital equipment revenue next year in disposables, we think our disposal recurring revenue is going to be in that COVID at 75% [ph] of the total revenue year-over-year. So 75% of total revenues. So that will drive nice growth there as well as on the capital equipment side, it’ll return to the 25%-ish level as well. So we’ll see growth in both of them from a growth driver perspective, probably a little more growth driven from capital given the lower base that we had here in 2022 as we recover that side. So that’s the split there. When you speak about gross margins, I think we’ve made nice progress on the gross margin improvement pathway here by spinning up operations in Mexico from a facility perspective, hiring perspective, the thing is where we’re identifying the team that we need there and on target from a costing perspective.
So as we have gone forward, we’ve tried to reduce the overhead burden as a part of the total cost of goods pool. So that way, we don’t have as much of it being volume-dependent going forward and it’s more tied to the drivers of revenue as opposed to volume plays on overhead. So we’ve made nice progress in that regard and have a plan in place to drive our overhead spend back to our pre-COVID levels which will help reduce the overhead content as a percent of revenue going forward which minimizes the impact of core volume on gross margin improvement.
Operator
And there are no further questions. I will now turn the call back over to Joe Army, Vapotherm’s President and CEO for some final closing remarks.
Joe Army
Thank you all very much for listening in on the call today and we look forward to coming back to you with our fourth quarter results in the next 3 months.
Operator
This concludes today’s conference call. Thank you for your participation. You may now disconnect.
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