Good day, and welcome to the Avanos' Second Quarter 2021 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask question. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Dave Crawford, Vice President of Investor Relations. Please go ahead.

Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to the Avanos 2021 second quarter earnings conference call. With me this morning are Joe Woody, CEO; and Michael Greiner, Senior Vice President and CFO. Joe will begin with an update on our quarter and then discuss our business environment and progress towards our 2021 priorities. Then Michael will review our second quarter results and update our 2021 planning assumptions. We will finish the call with Q&A. A presentation for today's call is available on the Investors section of our website, avanos.com. As a reminder, our comments today contain forward-looking statements related to the company, our expected performance and economic conditions and our industry. No assurance can be given as to the future financial results. Actual results could differ materially from those in forward-looking statements. For more information about forward-looking statements and the risk factors that could influence future results, please see today's press release and the risk factors described in our filings with the SEC. Additionally, we'll be referring to adjusted results and outlook. The press release has information on these adjustments and reconciliations to comparable GAAP financial measures. Now I'll turn the call over to Joe.

Thanks, Dave. Good morning, everyone, and thank you for your interest in Avanos. As we move into the second half of the year, I'm encouraged by our commercial teams to start to the year and the continued resiliency as they respond to the challenging dynamics brought on by the pandemic. Across our enterprise, we remain focused on getting patients back to the things that matter as we meet the needs of our customers. I will begin with a brief review of our results for the quarter before discussing the current environment and our progress against our 2021 priorities. Sales increased 14% for the quarter to $186 million, while we earned $0.21 of adjusted diluted earnings per share. Our sales results were at the high end of our planning assumption. We not only benefited from the return of elective procedures, but more importantly, execute well against our growth initiatives. Performance for the quarter fell short of our expectations within our manufacturing and distribution footprint, negatively impacting gross margin for the quarter. These higher costs are temporary impacts to our business, primarily pandemic driven being seen across industries and do not indicate a permanent change to our operating structure. My management team and I have made this our top priority, and I'm confident we will show meaningful progress in the second half of the year. Michael will expand further on the steps we're taking in his remarks. I'm pleased with our team's execution, finding additional efficiencies throughout the business to reduce operating expenses. Teams are finding ways to increase productivity and lower our cost structure, which not only is assisting in offsetting some of our in-year gross margin headwinds, but also is positioning us to deliver on our commitment of SG&A as a percentage of revenue being less than 40% on a…

Thanks, Joe. And as you noted, we remain in a challenging environment, especially with regards to supply chain and operations, and yet the team continues to find ways to overcome these challenges. Now let's begin with a review of our second quarter results. Total sales of $186 million increased 14% compared to last year. We saw a 13% increase in volume and a 1% benefit from favorable exchange rates. unfavorable price offset sales by 1% as we saw price movement return within our normal range after slightly higher-than-normal price impact last quarter. Given the $10 million pandemic-related tailwind for Respiratory Health in 2020, Chronic Care sales declined 4% to $116 million in the quarter. Adjusting for the 2020 tailwind, Respiratory Health sales would have been down slightly for the quarter as we saw hospitals draw down their inventory of closed suction catheters and other related products as pandemic-related hospitalizations significantly declined. Although a new wave of pandemic-related hospitalizations appears to be upon us, through July, we have not yet experienced material acceleration of orders from distributors or hospitals. Our planning assumption for Respiratory Health in the second half of 2021 does not include additional benefit from the pandemic, and we also expect a normal start to cold and flu season. Shifting to Digestive Health, we saw above-normal growth as we experienced some pandemic-related disruption last year for our legacy, MIC-KEY franchise, providing a favorable comparison for this year. NeoMed once again grew double digits from the continuation of conversions to our ENFit technology. Moving to Pain Management. We delivered $70 million of sales, 62% higher compared to the prior year, driven by the favorable prior year comparison resulting from the cancellation of elective procedures due to the pandemic. As Joe highlighted, growth has returned faster for our COOLIEF and Game…

[Operator Instructions] And the first question comes from Matthew Mishan with KeyBanc.

I just first wanted to start with NeoMed. I mean this is an acquisition you made a couple of years ago. It seems to be doing very well from an annualized sales run rate but the gross margin still has been a problem. Can you kind of walk us through kind of where you started with NeoMed? Kind of where you're at now and kind of how you think about the gross margin progression for that business?

Yes, Matt, I'll say a couple of things, and as always, Michael might jump in. But this has been a highly successful acquisition for us. It grows double digits, did again in this quarter. The other thing going on alongside of this is that there is a conversion of, called the infant conversion, which is a global standard happening. It really needs to be complete by customers moving into next year. And so what you're seeing from us is -- and we have -- we manufacture in China, is during the pandemic, increased transportation rates, particularly air where we need to get the product over. We've made a decision to ship air so that we can get the conversions. They have a time line, our customers, that they're up against, and they're going to definitely benefit us going forward as we get the repeat sales associated with that. But it's obviously a headwind to our gross margin. So generally, when I think of the model, I think once we get through the pandemic and some of these temporal items on the gross margin, and we're going to be in really good shape with all the metrics that we've put in place. So a lot like we were pleased with, for example, with CORTRAK. But Michael, I don't know if you want to add anything?

Yes. No, I think, yes, we're making choices here, to Joe's point, to secure these conversions. Even with these headwinds that are impacting gross margin, when we look at our model, the DCF is still very attractive for this business over the forthcoming few years. We never modeled NeoMed, even from the beginning, to have gross margins in excess of our consolidated gross margin set. So NeoMed, when it's in a more normalized state, Matt, will still be below the company level -- slightly below the company level gross margins. It's significantly below right now because of these freight cost headwinds. But even in a normalized state, NeoMed was never modeled to be above our company-level gross margin, if that's helpful.

Yes. But what -- just going back to the question, when you bought it, I think it was at an annualized run rate of about $40 million. Once you finish the in-state conversion, how big of a chunk of businesses is NeoMed for you guys?

I mean, so I see it like a lever similar to international business, but more like COOLIEF where it's a similar size and growing double digit and have some consistency for that in the next couple of years. So we like it quite a bit.

Okay. And then just shifting over to COOLIEF. How -- the new probes that you're going to be rolling out next year, is that -- I mean it's at a higher gross margin, but does that more effectively allow doctors to do this in the ASC or physician office?

We have some of that later on. This is not -- I think what we were talking about in the prepared remarks, and you'll see both upgrade opportunities in new business, we think, driven out of this introduction.

Okay. And then just lastly on the gross margin side. I realize there's a lot of -- there's a lot going on, and people are across the board talking about the headwinds and freight and manufacturing inefficiencies. But when you say significant improvement into 2H, just give us -- can you give us like a sense of what that means? I know gross margins are now going to be below last year, but what should we -- like a little range of what to expect around improvement?

Yes. I'm going to tee up a couple of things, and then Michael, I think, is going to walk you through a little bit of the way we look at H2 and think about it. And we did talk about this on our previous calls and said that we thought Q2, we still see headwinds in gross margin. Obviously, we saw a little bit more than anticipated. When you think about -- and we were just talking about NeoMed, really half the tailwind was reflected in NeoMed, which is why we're saying, look, this is a temporal and not a fundamental change in our business." And I think that there are some things because of the fact that we're dealing with China and air there, airfreight and some of the things we did in Mexico reminding everybody that we had investments in our plans. We're dealing with, obviously, the Mexican government and employees, but also built out the closed suction line so that we wouldn't experience a deferred -- the defense DPA from the government. And so when you put that together, you sort of have 2 unique situations. That said, we've got a completely different line of sight for the second half. I think Michael wants to kind of take folks through that.

Yes. Matt, we were -- Joe alluded to, we were about 200 basis points in Q2 below where we thought we'd be. So kind of a starting point. When we think about where we're going in the back half of the year, a couple of things that are just part of the math. So we won't have the revaluation impacts that we had in the first half of the year. That's about 200 basis points. Price/mix, we anticipate, will improve by about 150 basis points. Part of that is some of these price increases that we're passing along with our customers. Some of it is the continued slow-but-steady improvement in our ON-Q business that we've been seeing, the day rates that we referenced. Another 200 basis points relates to plant performance, some related to the reduction in the workforce by 10% as well as reducing the write-offs that we've incurred in the first half of the year. And then another 50 basis points on freight, primarily to NeoMed. Now that, we thought, would be a little bit higher, but what we're seeing is increased freight from a water line standpoint, but obviously significantly cheaper than the air freight that we have been doing in the first half of the year. So that gives you about 600-plus basis points of very specific items, and then we have some other items that we're working through as well. So that kind of walks you -- your question was, how significant? We think very significant. Unfortunately, because Q2 was 200 basis points below, we're going to be within or slightly below where we were in 2020, which obviously was not our plan coming into the year.

The next question comes from Chris Cooley with Stephens.

This is actually Ross Osborn for Chris. So I guess -- so starting with the top line, can you kind of just walk us through the puts and takes of what you guys assume in the lower and upper bound of revenue guidance?

Yes. So I mean I'll just maybe say some -- a couple of things upfront about just the quarter, and then Michael might want to comment a little bit more on what we see going forward and the guidance piece. But we saw continued sequential progression in our pain business and more so in Game Ready and COOLIEF. And we think that's because of, obviously, the hospital outpatient department and where they've performed. And we've talked a little bit about ON-Q, although that was slightly below '19. It did also progress, but then some of the procedures in the hospitals haven't come back as they have in the ambulatory surgical setting. We think that Chronic Care is, in terms of our plan internally, has a trajectory for the mid-single digit for the full year that we talk about in that business. And then obviously, we're seeing some of the comparator issues in respiratory and closed suction from COVID last year. So as a specific example before I hand off to Michael, I think everyone should be thinking about $12 million that was part of respiratory sales in 2020 that won't be a part of 2021. That goes into some of our thinking anyway about the guidance for the second half. So Michael?

Yes. I think the upside to Joe's point would include ON-Q continuing to improve and accelerate as electives come back, while on the respiratory side, we have a normal respiratory season. To the downside, you would see ON-Q kind of level off here, not continue to have electives come back because of the variants, while treatment protocols no longer necessary to look for closed suction catheterization. So we would continue to get a normalized respiratory, but we wouldn't get that extra benefit. So we'd have normal respiratory ON-Q coming back down because electives are coming back down, that would put us more on the low side. On the upside, both of those are actually moving forward where we get hospitalization and closed suction catheter being part of that treatment protocol, while the electives don't pull back like they did in the previous period last year.

Got it. That's really helpful. And then kind of just a bigger picture question. So guidance for the full year is 2% to 4% x 100 bps from currency. I guess what's holding back top line from approaching kind of mid-single digits growth on an organic basis?

Yes. I think Michael touched on some of it. We should touch on it just a little bit again. We've got a $12 million comparator in respiratory that won't be with us. That's one thing. And then there's a little bit of uncertainty still, although we have not seen this regionalized discussion of electives being affected by the Delta variant and how that also may impact any of our international business, which, by the way, is primarily Chronic Care. So I mean, there's -- obviously can be affected by that being less of an impact. But certainly, the Respiratory, Chronic Care piece is there. I don't know if there's anything else you'd like to?

And Ross, I mean, it's a fair question. And if you do look at 2019 Q2 versus 2021 Q2, we do have organic growth of over 7%. So that does get you in that mid-single digits. I think we're just being appropriately cautious in the back half of the year, just not knowing exactly how the new variant is going to play out and exactly, how hospitals and other treatment protocols will react to that.

Okay. Fair enough. And then just kind of a clarifying question. Just to make sure you have the cadence right for the rest of the year. So lower gross margin and then that will hopefully be offset by greater OpEx reductions?

That's right. That's right. And just to clarify on that question, Ross. We took down the top end of the guidance not necessarily indicating that $1.17, $1.18 is not achievable, right? So $1.10 to $1.25. We'd like to -- not we, but what kind of happens in the community, as you take the midpoint, that gives you $1.17. Our move from $1.25 to $1.20 was just signaling $1.25 is not possible. That doesn't mean that $1.17, $1.18 is still not possible. We just -- we're trying to be intellectually consistent with the lower gross margins. The OpEx is going to help offset that. But with that gross margin headwind, we just -- $1.25 just isn't something that seems to be in the cards. That does not mean that $1.17, $1.18 can't be achieved.

[Operator Instructions] The next question comes from Ravi Misra with Berenberg.

So one, if I can just start on ON-Q and the elective rebound. Are you still kind of under the current parameters? Is this a business that can kind of finally return to growth for the full year? And sort of -- or do we need -- it sounds like you're a little bit more cautious on the elective outlook there. Just if you could help me kind of think about how to kind of model this thing going forward from a -- what's implied from a procedural growth perspective?

Yes, that would be the big driver, the electives being the biggest lever as to growth. We're seeing our initiatives work. A couple that we're really focused on as a channel partnerships with large orthopedic 1099 groups. We're happy with what we're seeing on the ambIT acquisition and how we're now having an electric pump offering, and that's working well from us from a portfolio perspective. The Pain Block Pro from some of the initial rollout of that, we're seeing success, and customers are very interested in that being able to track the outcomes of not only our product, but against other approaches to pain management. And we're happy with what Bill Haydon has done under his leadership to kind of point that business in the right direction. And then obviously, we've just come out of a strategic Board meeting where we've talked about some future products, in particular, the electronic nerve block that we think can be a big game changer in that space. So we're happy with where we are. We think, again, the biggest lever on whether or not you get the growth and how fast it comes is the elective procedure. So to the extent Delta doesn't quell a lot of things, then we can do better.

And Ravi, electives has become a big word in med device over the last 16 months. When you look at Game Ready and COOLIEF, as Joe talked about in the prepared remarks, those are back and above where we were. So that definition of electives has worked well, and we've captured all that's appropriate there. But obviously remember, it's generally for very specific types of procedures, multi-day stay often are definitely multi-day recovery. And so those types of electives have not come back as quickly.

Okay, great. And then just on the gross margin, sorry, I don't want to harp on -- keep harping on it, but I'm curious, your mix kind of shift this quarter was pretty significantly tilted towards the Pain Management business. And you're calling out this NeoMed kind of freight, higher freight costs. How -- just help us calibrate maybe, I don't know if you called out kind of the actual quantification of that freight cost. I mean if that wasn't there, would you have been at that kind of -- 53 sounds like where you were targeting internally? Or was there more to it than that? Because I would assume that the mix shift into Pain Management would have more than offset some of that.

Right. So the freight was a portion of it. It basically offset the mix shift. And then, to your point, we had an additional amount of planned performance -- underperformance from an efficiency standpoint, that was the additional 100-or-so basis points that we underperformed by. So you are right. Freight was a portion of it, but we also then have the planned underperformance in 2Q, which we've now done some steps in mid-July to rectify for.

Great. And then maybe one last one, Joe. Just on kind of opioid safety in that project there. What should we be kind of thinking about here for the rest of the year? Or is this now a 2022 event?

I'm sorry, I didn't hear the first part of your question, Ravi.

The novel technology, the opioid product.

The go -- yes. So actually, we're actually rolling that product out now. We'll continue throughout the second half. And so this will be something that as we end the year going to '22, we'll be rolling that, Pain Block Pro, it's called.

Okay. That is the software that -- okay. Got it. Okay.

As we have no further questions, this concludes our question-and-answer session. I will now turn the conference back over to Joe Woody for any closing remarks.

Thank you. As many of you may know, and have been talking to Dave Crawford after 9 years from the spin of Halyard to Avanos, Dave is going to be moving on. He's been our Treasurer and obviously, our Head of Investor Relations. We definitely want to thank him for his service to the company, but I would say that his business guidance and consultation, partnership have really been outstanding. And so we wish Dave the best, and we'll definitely stay in touch with him. And I thank all of you for your continued interest in Avanos. We continue to execute well in an uncertain environment. We remain really committed to creating shareholder value. I'm confident we've got the right queries detail, combined with our portfolio, and we think we're in attractive markets. We're positioned well for sales growth, margin expansion and the free cash flow that we want to generate. So look forward to chatting as we go forward. Thank you all.

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.