Owens & Minor Inc (OMI) 2018 Q2 法說會逐字稿

Good morning, ladies and gentlemen and welcome to Owens & Minor's second-quarter 2018 financial results conference call. My name is Ayala and I will be your operator for today. (Operator Instructions). As a reminder, this conference is being recorded for replay purposes. I would now like to turn the presentation over to your host for today's call, Ms. Trudi Allcott. Please proceed, Ms. Allcott.

Thank you, operator. Good morning, everyone and welcome to the Owens & Minor second-quarter 2018 earnings call. I'm Trudi Allcott and on behalf of the team, I'd like to read a Safe Harbor statement before we begin. Our comments today will be focused on financial results for the second quarter of 2018 which are included in our press release.

In our discussion today, we will reference certain non-GAAP financial measures. Information about these measures and reconciliations to the most comparable GAAP financial measures are included in our press release and in the supplemental information posted on our website.

In the course of our discussion today, we may make forward-looking statements. These statements are subject to risk and uncertainty that could cause the actual results to differ materially from those projected. Please see our press release and our SEC filings for a full discussion of these risk factors.

Participating on our call this morning are Cody Phipps, our Chairman, President and CEO, who will provide an overview of the business and an update on the progress we are making on our strategic plan. Robert Snead, our Interim Chief Financial Officer, will provide details on the second-quarter results and more insight into our business performance.

Now I'd like to turn the call over to Cody Phipps who will start things off this morning. Cody?

Thank you, Trudi and good morning, everyone. Thank you for joining us on the call this morning. I will begin with a few comments on our quarterly results and then I will move on to an update on the significant progress we are making toward transforming our Company.

As for the quarterly results, we had anticipated delivering sequential improvement this quarter, but several factors combined to prevent us from achieving that goal. These factors include lower-than-anticipated revenues from existing distribution customers, continued margin pressures in our US distribution business, severance expense related to the recent executive leadership departures and operational inefficiencies in the US and UK leading to increases in overtime and temporary labor costs. These challenges are correctable and we expect to see improvement in the coming months.

In addition to the above items, we recorded impairment charges in our CPS business line, which were detailed in our press release. Robert will provide more detail on these items in his remarks.

Now I would like to provide an update on our two strategic business units and the significant and concrete progress we are making to transform our business and to execute on our strategy. In our Global Solutions SBU, we are making solid progress. Our move into attractive alternate site channels is already delivering results. Our recent acquisition of Byram Healthcare is performing well and is in fact exceeding our expectations.

Byram is the second-largest player in the high-growth direct-to-patient home health space with an established brand, advanced third-party billing capabilities, robust patient expertise and a strong and experienced team. To build on Byram's already strong platform, we are in the early stages of connecting Byram's value proposition to our large IDN customers and the Byram team is having good success in pursuing and finding new customers. In fact, we recently won a major new contract, which will further accelerate Byram's growth.

Turning to our provider solutions, we are bolstering our portfolio of value-added services to strengthen our value proposition to our customers across multiple service needs. Our provider solutions address significant customer pain points on a number of fronts such as inventory management, real-time data capture and procedure costs at the point of care and product selection that drives standardization while reducing costs.

As you know, our provider customers are under enormous cost pressures and they want our help in reducing clinical waste and total cost. Our new solutions are laser-focused on achieving this outcome. In fact, I recently visited with a customer who has adopted our QSight point-of-use technology throughout their system to capture real-time usage at the point of care and to reduce total inventory.

In another situation, we combined our end-to-end supply chain services with QSight and our SurgiTrack perioperative solution to secure a five-year contract renewal targeting new levels of productivity and cost savings. Our early success with Byram and these examples demonstrate that our first two strategies, deploying a more intelligent supply chain and two, expanding across the continuum of care, are delivering significant value to our customers.

We continue to make headway on our third strategy, becoming the preferred outsourcer for manufacturers. In recent months, we have signed a number of new manufacturer customers in the US and Europe who value our advanced logistics services. Both of these business lines are showing top-line growth with a pipeline of additional opportunities.

Our Global Products SBU took a significant step forward with the closing of the acquisition of the Halyard S&IP business three months ago, which is the cornerstone of this business unit. Our teams have done a great job with the carveout and integration of this large products business.

As we move through the integration process, our focus is on exiting the various transition service agreements and on organizing the leadership and talent to drive this business unit. Halyard is off to a good start showing positive revenue growth and achieving early synergies following the April 30 closing date.

The Halyard transaction increases our own brand product sales from low single digits as a percent of total revenues to low double digits. This will be a meaningful source of sustainable earnings as we go forward with our stronger, more vertically integrated business model. We now have the platform in place to drive growth initiatives for our own brand products. This transaction also marks a significant step in the transformation of Owens & Minor into a true global healthcare company as we now have significant opportunities for growth in attractive new markets such as Japan, Australia and other parts of Europe.

I am encouraged as I travel and see our two organizations come together to realize the incremental revenue and profits from enhanced product and solution offerings for our customers.

All that we have talked about this morning informs our guidance for 2018 and beyond. For 2018, we anticipate that adjusted net income per share will be in the range of $1.40 to $1.50. As we look toward 2019, we have confidence in our ability to achieve double-digit year-over-year earnings growth resulting from the expected contributions from our Halyard S&IP acquisition and the realization of the acquisition synergies, continued strong growth from Byram and recovery from certain cost challenges arising in our Global Solutions SBU.

Our transformation is well underway. We have made several recent and important moves to strengthen the business into a vertically integrated global solutions provider that reaches across the continuum of care with multiple drivers of growth. The Company now has a stronger, more diversified business model with significant new sources of sustainable earnings and cash flow. We remain enthusiastic about the opportunities we see in the market for Owens & Minor and we are encouraged as we look toward the second half of 2018 and progressing into 2019.

Finally, I would like to take a moment to recognize and thank our over 17,000 global teammates who are dedicated to servicing our customers every day and who are all engaged in the transformation of our business. We know they are our most important asset.

Now I would like to turn the call over to Robert for a review of our financial results. Robert?

Thank you, Cody and good morning, everyone. Today, I will provide an update on our second-quarter results and then spend time discussing our outlook for 2018. For the quarter, consolidated revenues were $2.46 billion, an increase of 8.5% compared to prior year. Revenue growth was primarily driven by our two recent acquisitions with contributions of $128 million from the Byram Healthcare acquisition and $137 million from the Halyard S&IP transaction, which is net of $31 million of intercompany sales.

As Cody mentioned, both of these acquisitions are off to a strong start. For the six months, consolidated revenues were $4.83 billion, an increase of 5.1% compared to prior year. For the quarter, we recorded a consolidated operating loss of $172 million and for the year, a loss of $148 million. These results include a non-cash impairment charge of $165 million. The charge is the result of impairment testing performed during the quarter and is associated with the goodwill and customer lists of our CPS business.

Adjusted operating income for the quarter was $46.6 million, a $5.2 million increase compared to prior year. Year-to-date adjusted operating income was $94.2 million, representing an increase of $5.1 million versus prior year.

For the quarter, we reported a GAAP net loss of $3.07 per share, which includes the impact of the previously mentioned impairment charge of $2.73 on a per-share basis. Adjusted net income for the quarter was $0.32 per share. Results were also affected by severance expenses for executive leadership transitions of $2.5 million or approximately $0.03 per share.

Now I would like to turn to a brief discussion of our segment performance. Before I begin, I'd like to point out a change in our segment reporting. Acquisition-related intangible amortization is now excluded from segment operating income, which is consistent with our new internal measure of segment results and prior year amounts have been recast for comparability.

Starting with our Global Solutions segment, revenues were $2.29 billion for the second quarter compared to $2.23 billion in the prior year and quarterly operating income was $24 million compared to $31.2 million last year. Margin pressures continue to weigh on this part of our business. We are also experiencing lower growth from existing customers and inefficiencies in certain facilities.

As for the Global Products segment, for the quarter, revenues were $280 million compared to $131 million in the prior year. Revenues included two months of Halyard contributions totaling $168 million. Operating income was $22.5 million reflecting an increase of $12.3 million primarily from the S&IP business contribution.

Now let's turn to the balance sheet. Consolidated long-term debt was $1.67 billion at June 30 compared to $901 million at year-end. The increase in debt includes new term loans put in place to complete the Halyard S&IP acquisition, which comes due in 2022 and 2025.

At the time of this financing, our mix of floating-rate debt was approximately 70% of our debt capital structure. Subsequent to the quarter close, we entered into interest rate hedges with a notional value of $450 million, reducing our floating-rate exposure to approximately 40% of our debt capital structure. This move helps to provide greater certainty on our interest expense going forward and additional protection from further rises in interest rates. In light of our increased leverage, we remain highly focused on generating operating cash flow, including managing our working capital to delever our balance sheet.

Turning to our guidance for 2018, I'd like to highlight certain factors that were taken into consideration. First, we now expect to face raw material price headwinds for the Halyard business of approximately $14 million to $18 million for the full year. Second, we anticipate incurring incremental operating expenses of approximately $10 million to $12 million in 2018 related to the development of new solutions and associated customer onboarding costs.

This level of investment is above past years, so we are highlighting it. The amount of expense will be impacted by the volume of business we bring on under these new solutions as we transition into 2019.

Third, interest expense is expected to be approximately $3 million higher than our original expectations as a result of both higher debt issuance costs and increased interest rates. Last, our assumption for the full-year effective tax rate is now around 30% compared to our previous estimate of around 25%. Our revised expectation is primarily due to changes in the level and mix of income across our tax jurisdictions.

All four of these factors are included in our guidance for 2018. Our guidance is also based on a number of additional assumptions highlighted in our second-quarter slides, which can be found on our website.

As Cody indicated, for 2018, we are targeting adjusted net income of $1.40 to $1.50 per share. The acquisitions we have made, including the identified synergies, have established a strong foundation for growth for Owens & Minor. We expect double-digit growth off our 2018 base in 2019.

Thanks and with that, I will turn the call back over to the operator to begin the Q&A session.

(Operator Instructions). Michael Cherny, Bank of America.

Good morning and thank you for taking the question. I want to dive in first on the composition of the guidance. You just walked through some of the puts and takes on what has changed versus your previous assumptions. As you think about the costs that are being onboarded into the business on the commodity headwinds, other moving pieces, what do you think are areas that are, I would say, more temporal in nature, more tied to the deal specifically versus areas where this is now a permanent part of the cost base, particularly as we think about how to build a bridge for the 2019 numbers?

Hey, Mike, it's Robert. That's a great question; let me expand on that for you. I mentioned four things in my remarks. There were some commodity headwinds that we talked about of $14 million to $18 million. That item I would view as more potentially continuing going forward as we thought about it the second half of the year and even potentially into 2019. Obviously, that is something that we can't predict per se, so it could be a good guy going forward, it could be a bad guy depending on where that comes out relative to forecast.

The investments are something that while they are a negative impact in the second half of the year, that's something we expect to begin to earn a return on that investment as we go forward, so I wouldn't view that as something that would continue onward into 2019.

The interest -- that impact is more here to stay, so to say. From a tax perspective, I would say that's more temporal. This year, we thought we would be at that 25% rate because of the change in both the level and the mix of income in our various tax jurisdictions. We are looking at a 30% rate-ish for this year and going into next year, we would expect to get back more towards that longer-term rate of 25%. So I think that's something that is more temporary.

And then the last piece I'd add is the severance that Cody mentioned is also something that I wouldn't expect to be recurring in nature.

Understood. And then just one other question, you talked about cash flow priorities and paying down debt given your leverage levels. If my math is correct, and please correct me if I am wrong in terms of how you account for it, but I'm at roughly north of 6 times exiting the year based on your implied guidance. How do you think about that related to where you sit in terms of your covenant agreements with the various banks? Did something change when you put in these interest rate locks? And can you update us given the change in operating assumptions on how you expect over the next couple years to delever, at what pace you should be paying down debt?

Yes, that's also a great question. I think the definition of EBITDA under our covenant agreements is perhaps different and there are certain math that goes into that, so I would say you are a bit north of where we are in terms of leverage. But more directly to your question, is our intent over the next few years to delever below the 4x level as we generate cash over that timeframe and that's our expectation going forward.

Okay, thanks so much.

Robert Jones, Goldman Sachs.

Thanks, this is Jack Rogoff on for Bob. Thanks for taking my questions. Can you talk a little bit more about the facility inefficiencies within Global Solutions and what actions you're taking to resolve those?

Thanks, Jack; this is Cody. We've got a very robust operations improvement program underway and unfortunately, in some of the markets that we are in, we've had higher-than-expected turnover, as well as we are onboarding new customer volume. That's created a little bit of a challenging dynamic from which to drive forward continuous operations improvement, so we've had to incur additional overtime and temp labor in those markets. That's been the drag.

The good news is these are correctable issues. It's a top priority for us. I have been out in the market. I was in one of our facilities this week and we are on a positive trend there, but we called it out because it's been a headwind for us thus far this year.

Got it. Thanks.

Sean Dodge, Jefferies.

Yes, good morning, thanks. Maybe starting with Byram, Cody, the major new contract you mentioned winning there is certainly encouraging. Is there any more color you can give us around that? I suppose it was a competitive displacement, but how long was the sales cycle? What were the big decision drivers or factors for the client and then any bookends you can put around maybe size and implementation timing?

Yes, thanks for that, Sean. First, let me just say we are delighted with the progress that Byram has made. We completed that transaction in August of last year and it's exceeded our expectations. It is one of the pillars of our strategy to strengthen and diversify our business model into attractive alternate site channels. So just really super pleased with the Byram team and what they are doing.

We don't comment on specific customers, but what I can tell you is it's a very large contract, very large entity and the sales cycle was months, it was months to go through and the Byram team did that very well and what we are excited about is they are already demonstrating above expectation growth and this is going to fuel that further starting later this year and into 2019. So a real nice win and again, I don't want to comment specifically on the customer.

Okay. Thanks. And then maybe on the core hospital distribution business, we've talked about the challenges you've been facing. I guess with some of these business transformation initiatives you put into place now, is the outlook improving there? I guess if we think about how you feel about that business over the next several quarters now, can you maybe compare that how you felt about it a few months back?

Yes, I think, again, our strategy has been to stabilize that part of our business and then to drive growth through our new platforms -- Byram, Halyard S&IP and then the new solutions as we diversify and strengthen the business model. So the outlook on the core, we have been through significant -- as we've called out, it's been a very competitive marketplace with significant margin pressures.

I do see that moderating somewhat. I think we have been through a lot of the repricing of the business, I think. We have been through a lot of contract renewals. So if anything, we see that stabilizing a bit. It's a little too early to call that ball, but what we are excited about is the efforts we have underway there, but also the new platforms we have to drive sustainable growth and cash flow going forward. That is why we are confident in the outlook for 2019.

Okay, and then just a quick last one for Robert. Can you share with us the expected contribution to 2018 guidance, EPS guidance from Halyard?

Yes, we had put out before that the business was looking to be accretive this year. With the commodity headwinds that we are facing, a lot of that has been unfortunately taken away. The good news, if you look through that, is if you kind of strip out that commodity impact for the Halyard business, the underlying business is doing actually quite well and in fact, it is exceeding our expectations from the original acquisition case when we made the decision to buy the business.

So the fundamentals are north of what we were thinking, but the commodity headwind, unfortunately, has kind of taken some wind out of the sails this year. As we look towards 2019, with more synergies coming on and continuing to drive that business, we do expect it to be accretive in future years.

Sounds good. Thank you again.

Steven Valiquette, Barclays.

Thanks. Good morning, everybody. I guess just within the core hospital distribution business, it might be kind of hard to answer. I'm just curious whether or not you are seeing pricing pressure maybe more in the products where competitors have been self-manufacturing some of those particular SKUs and is that where there is more price pressure or does it just go beyond that; maybe it's just across the board? Just kind of curious if there is any color on that component of the dynamics in the marketplace. Thanks.

Sure, that's a good question. I wouldn't say we would call out on the product side any differentiation in pricing pressure. I mean certainly where there is more -- where there is less differentiation and there is more players in the market, you tend to see more of that, but these products have been under pricing pressure for years and years. So I wouldn't call out a specific big difference between different categories on that.

I would just say the primary pressure we face, Steven, has been on the distribution pricing driven by the bundling of products with distribution.

Okay, all right, great. Thanks.

Eric Coldwell, Baird.

Hey, thanks. Just a few quick ones here. Why exactly were the existing customers' purchases lower than your expectations?

Yes, Eric, good question. When we look at our results compared to last year, when we look at the existing customer growth rates, we had a lower level this year in our numbers than what we were originally anticipating and what we've seen. When we looked at that relative to the broader market, you see some of the public folks that are up, others that are down. A lot of that is driven by two big factors. One is utilization and then the second is some of the M&A activity. As the providers have been consolidating within our channel, as we mentioned in the past, we don't specifically pull that out in looking at our existing customer growth rates.

So my sort of guess between the lines is that reduced level of M&A activity coupled with a softening in utilization is what's driving that.

Okay. I think the fear is always going to be that maybe a new channel is going to be coming in here like the Amazon threat that we hear so much about or perhaps marketshare losses and it doesn't sound like those are either of the items you are citing today.

No, that metric that I am citing in that comment is like-for-like existing customer base. So those wouldn't be factoring into that number anyway.

Okay. So commodities. Which commodities, is it due to the tariff war, is it something else? I'm trying to get a sense of what we should be tracking to maybe get an early read on when perhaps this commodity headwind could revert if it does.

Yes, Eric, another great question. We have two key raw materials that go into the products with the Halyard business. One is nitrile and the other is polypropylene and these are things that Avanos, the former parent, called out as well and those are the two key raw materials in the business and where we have seen price increases in the first half of the year that we are projecting will sustain through the back half of the year.

Is it tariff war stuff? Is it reduction in the number of manufacturers?

No, no, it's pure -- the underlying longer-term driver of some of these prices are derivatives of oil and I would say they are kind of two derivatives from oil itself. If you look just at oil, it's probably not the right commodity to look at, but over the long run, it's certainly correlated because these are byproducts of the oil processing process and so that is more the driver. It's not taxes or tariffs.

And I would just add that the Halyard S&IP business does not -- where we are vertically integrated, we don't produce in China. So as we've looked at the tariff issue, not as big of an issue for us at this point.

Okay. And then how much of the raw material costs can you pass on to customers?

Another good question. In general, and in the short term, it tends to be more limited because of the nature of the contracts. If you think about -- if I look at a longer timeframe for that business and what's happened to it over a longer timeframe, margins have compressed and then they have expanded back out or they have expanded and they compress back in depending on which way the commodities are moving and it takes a while for that to sort of cycle through the business.

Last one, I promise. So probably the number one question I get is sustainability of the dividend and your interest in maintaining the dividend given another year of profit pressure here. I'm just curious if you have any updated thoughts on that.

Part of me thinks maybe you would be better off just getting it done with and ripping the Band-Aid, but I know the Company has had a very long history with this dividend so I am curious what the internal thoughts are at this point.

Yes, first of all, we are very excited about the new business model and the new sources of cash flow generation and that's why you saw the optimism in our outlook for 2019. And we remain committed to the dividend.

Got it. Thanks, guys.

(Operator Instructions). Jonathan Bentley, Leerink Partners.

Hi, this is Jonathan on for Dave. I just had a quick question. A lot of questions I had were already answered. But you just mentioned that where you are vertically integrated with the commodities you are not producing in China. Where is most of your production located?

So we have a number of manufacturing plants; a lot of the material is produced here in the United States, in North Carolina and the other big facility is in Thailand where a lot of our gloves are manufactured. And some of the product is converted into finished goods in Mexico and Honduras.

Okay, great. Thank you. And then also just wanted to touch on the management team that you have in Europe. Do you feel like you have the right people in place or are you looking to make any changes over there? Just any thoughts would be great.

We have got a good team in Europe. We are always looking to add new talent. In fact, we've had some recent additions; we will talk more about that in the future. But we like the team there and they have had some recent wins as well and so we are looking to add to that team and drive that business forward.

And Cody's comments were predominantly related to the solutions side of our business. When we think about the products side and the carveout from Halyard, we've got a good complement of teammates that came over with the acquisition. That was a heavily negotiated item across the board, the whole company, so we are happy with the leadership that we have in place and we were able to secure a number of key personnel as part of that transition process, not just in Europe, but in Asia-Pac as well.

Okay, great. Thank you very much.

Anne Samuel, JPMorgan.

Hi, guys. Thanks so much for taking the question. I was hoping, as we think about bridging to double-digit earnings growth next year, you outlined a lot about the margins, but how should we be thinking about the revenue growth as well?

Yes, that's not a metric we are putting out. Obviously, at the appropriate time, we will put out formal guidance for 2019 and in that, we will give you a lot more granularity into some of the components of the P&L. But I would say at this time, it's certainly sufficient to support the double-digit earnings growth that we've put forth and I think where we see growth going forward is in areas like Byram that Cody mentioned and areas like our Global Products business where we have synergies that we are going after that should help on the top line.

And the only other one I'd add is we've had some recent wins in our manufacturing solutions business both domestically and in Europe so that will be kind of a green shoot area for us as well on the top line.

That's very helpful. Thanks. And then should we assume kind of a similar operating environment as you are seeing right now or do you foresee any improvement next year just as we kind of think about the top line?

We have called out the challenging operating environment primarily on the acute distribution side. What we are excited about is our new business model and the new growth opportunities. So Byram is growing very well for us. The Halyard S&IP business is a good start. So really the optimism that you are hearing in us is about the new business model and the new sources of revenue and profits that we have going forward. So it doesn't -- we are not calling out a major change in the operating environment.

Great, thanks very much, guys.

I am showing no further questions. I would now like to turn the call back to Cody Phipps for any further remarks.

Thank you, operator. As I've said, we are excited about the progress we've made in transforming our business and we are laser-focused on improving our operating performance. Our new business model is stronger and more diversified, which allows us to generate incremental and sustainable profit and cash flow. We are encouraged as we head into 2019 and we look forward to updating you on our progress during our third-quarter call. Thank you.

Ladies and gentlemen, thank you for participating in today's conference. You may now disconnect. Everyone have a great day.