Earnings Call: Q2 2017

Jul 26, 2017

Summary

Q2 sales rose 6% in local currency, with 3% organic growth and strong prosthetics performance. FX pressure reduced FY17 EBITDA-margin guidance to 18%-19%; integration savings and manufacturing efficiency are expected to support margins.

First, I would like to welcome you to our second quarter conference call in 2017. My name is Jón Sigurðsson, and I am the President and CEO. With me here today is our CFO, Sveinn Sölvason. I will begin by going through the highlights of the quarter. Sveinn will then go through the quarterly financials in more details, and we will end with our guidance for 2017. A question and answer session will then follow. The growth in the second quarter of this year is in line with our expectations. We are seeing healthy organic growth rate for the first half of 2017. But growth in the second quarter is negatively impacted due to Easter shifting between comparable quarters. Sales amounted to $145 million compared to $139 million in Q2 2016, corresponding to 6% growth and 3% organic, both measured in local currency. Year-to-date sales growth is about 5% organically. Bracing & Supports sales growth was flat in local currency and the same organically, while prosthetics growth was good, 15% local currency growth and 7% organic. We therefore continue to see a strong performance in prosthetics with good contribution from the Rheo, Mi and other key products. Gross profit amounted to $89 million and 62% of sales. EBITDA before special items amounted to $27 million or 19% of sales due to depreciation of a few major operational currencies against the USD and appreciation of the Icelandic krona against the USD. Operational results were negatively impacted. Sales by $3 million and EBITDA margin net of hedge by about 100 basis points. In 2016, we further strengthened our market position with the acquisition of Touch Bionics and Medi Prosthetics. The integration of the companies is on track and in line with our business case. If you look at the growth by segments and geography, we see a good 15% growth in prosthetics and 7% organic growth, while Bracing & Supports sales growth was flat. Sales of bionic products in the quarter amounted to 21% of prosthetic component sales. We had good sales growth in EMEA with 8% and excellent results in APAC with 24% growth, while Americas grew 3%. Now let's look further at each market, starting with Americas. Americas sales grew 3%. Growth in prosthetics in Americas continued to be good and in line with market growth rates. The Bracing & Supports sales were, however, soft, which can partly be traced to challenges we are experiencing with our own distribution companies in the U.S. and accompanying restructuring efforts. The direct sales part of our Bracing & Supports business continued to grow. The performance in Europe, Middle East, and Africa was good in the quarter with 8% growth. Sales in the EMEA region was affected by fewer sales days due to Easter holiday shifting between quarters. Even so, we continued to see good growth in most major markets for our Bracing & Supports segment. In prosthetics, we are seeing good organic growth rates in the quarter. For EMEA, we are seeing excellent year-to-date results or 7% organic growth. APAC sales grew 24% and 22% organically, with excellent growth in our high-end products. Bracing & Supports product sales in APAC grew in line with the market after a strong quarter in Q1, and our prosthetics unit had an excellent quarter with all major markets growing and good progress in China. Now, Sveinn Sölvason, our CFO, will go through the finance in more detail. Please go ahead, Sveinn. Thank you, Jon. Local currency growth amounted to 6%. Organic sales growth amounted to 3%. As previously mentioned by Jon, the sales growth is impacted negatively by fewer sales days in the quarter. As a reminder regarding the impact of the acquisitions on reported growth numbers, Touch Bionics is now in the comparable figures, and only the Medi Prosthetics acquisition is contributing to the difference between local currency and organic local currency growth in the quarter. As for previous quarters, we have an impact on our reported USD sales and profits with changing currency rates, especially the profit margins, which I will elaborate on further on the next slide. Net or gross profit margin is 62% compared to 64% in the comparable quarter last year. The main items affecting the gross profit margin are we do have a slight positive contribution from product mix in the quarter. Changes in foreign exchange rates have a negative impact of about 60 basis points. Finally, cost increases in our smaller manufacturing facilities affect the gross profit margin negatively in the quarter. Year to date, gross profit margin is 62% compared to 63% in the comparable period last year. We bring attention to the year-to-date figures due to the shift in working days between quarters. The difference between the year-to-date gross profit margin can, however, also be traced back to the foreign exchange rates and the earlier mentioned higher cost in manufacturing. EBITDA margin amounted to 19% when adjusted for special items of about $2.6 million due to the integration of Medi Prosthetics. Net profit is about $13 million or 9% of sales. If you go to the next slide, please. EBITDA before special items amounted to $27 million in the quarter, which corresponds to a 19% margin. The key items affecting the EBITDA margin between the two comparable quarters are decent sales growth despite fewer sales days. Positive impact from operational leverage with 4% OpEx growth in local currency in the quarter and a decrease in G&A by 3%, excluding one-time costs. Negative impact from gross profit margin, as earlier explained, despite the continued positive development on the product mix side. Finally, currency affects the EBITDA margin negatively about 100 basis points, which is net of the positive impact of the partial hedge we have on our ISK cost. The integration of Touch Bionics and Medi has progressed as planned. As mentioned in the announcement, we completed on the 1st of July, certain aspects regarding the restructuring of Touch Bionics, which are estimated to result in about $3 million in OpEx savings on a full year basis from 2018 onwards. We get about $1 million impact in the second half of 2017. We therefore reiterate previous communication that we expect both acquisitions to operate at an EBITDA margin at a similar level as the pre-acquisition business after integration efforts are completed. Looking at the right-hand side of the slide, positive impact from changes in inventory in the quarter is contributing to a strong cash flow from operations, which amounted to $23 million or 16% of sales. Capital expenditure amounted to $5 million or 3% of sales, compared to $8 million or 6% of sales in Q2 2016. Net interest-bearing debt was about $146 million at the end of the quarter, which corresponds to a 1.5 times net interest-bearing debt to EBITDA. Now over to you, Jon, again, please, on the guidance. Thank you, Sveinn. Due to the adverse movements in the currency rates during the first half of the year, mainly the ISK, we are revising our full year guidance for 2017. EBITDA margin before special items is now estimated in the range of 18%-19%, compared to our previous guidance estimate of 19%-20%. At current foreign exchange rates, keeping all other factors constant, EBITDA margin is now expected to be negatively affected by approximately 100 basis points in 2017 compared to 2016. All other guidance parameters remain intact. The financial guidance for the full year of 2017 is therefore as follows. Sales growth in local currency is expected to be in range of 7%-8%. Organic sales growth in local currency is expected to be in the range of 4%-5%. EBITDA margin before special items is now expected to be in the range of 18%-19% of sales. We expect capital expenditures to be around 4% on net sales this year, and the effective tax rate around 26%. Thank you all for listening. We will now go to the question and answer session. Thank you. Ladies and gentlemen, if you have a question for the speakers, please press 01 on your telephone keypad and you will enter a queue. After you are announced, please ask your question. Our first question comes from the line of Christian Ryom from Nordea Markets. Please go ahead. Your line is open. Hi. Good morning. This is Christian Ryom from Nordea Markets. Thank you for taking my questions. A few from me. First, on these increased manufacturing costs, can you elaborate a little bit on where these derive from and whether these are expected to persist? Is this increased wage inflation, and is there any potential actions to mitigate these increased manufacturing costs? Secondly, on the sales growth in Bracing & Supports in the U.S. specifically, what is the outlook for improvement in these Bracing & Supports sales through your own distributors? Finally, on the organic growth momentum in prosthetics, which has been really strong year to date, how sustainable is the current level of growth, considering that you have some more challenging comparison quarters coming up? Thank you. Hi, Christian. This is Sveinn. Let me take the first question on the manufacturing cost, because this is one of the key themes in the quarter this time around. All else being equal, if we were producing at the same productivity as in the same quarter last year, we would have a little over $3 million extra in our operating profit line. This decrease in productivity in the quarter can be traced back towards smaller manufacturing locations. Our main manufacturing units are performing well in the quarter, being Iceland and Mexico. However, there is obviously the currency effect here in Iceland, which is about 60 basis points on our gross profit margin, which is probably close to one-third or 25% of the $3 million gap we have compared to last year. The remaining part can be explained by cost increases we experience mainly in our manufacturing operations in France where we have a compression therapy business, and the manufacturing entity is still in France. Then we have a few smaller entities in the U.S. which in this quarter altogether contributed to the cost increases, which we consider about half to be of a temporary nature because we had to temporarily move some production of a few product lines outside of our own facilities, but will be moved back in now in the second half of the year. While capacity costs were not decreased at the same time, we will take actions to decrease the cost in the remaining part of the smaller facility. I do not expect the same impact to persist in the latter half of the year, not to the same extent as we see in quarter two, at least. The second question was sales growth in Bracing & Supports and the development there. First of all, in the last quarter our growth is certainly below our ambitions, that is for sure. We can say that our Bracing & Supports business is growing in line with the market. Because we are growing our high-end Bracing & Supports products, the lower end is highly competitive, and we have been focusing on the higher end. America has specifically had a soft quarter due to operational challenges. What we have referred to as our own distribution companies in the U.S. Those companies generate their revenue partly by reimbursement or by billing directly to insurance companies, which we believe will have a strategic positive impact on our prosthetics in the years to come. There are some operational challenges there. We are moving locations, those distribution locations or back office of those locations together. That has had a negative impact. We believe that even though last quarters have been lackluster in the organic growth and in this specific field, we believe that when we get that on track, we can continue to grow very nicely. Again, our direct sales, which is our legacy businesses, is growing according to the market, which we think is growing about 3%-4%. Referring to the third question, the sustainable prosthetic growth or whether the prosthetic growth is sustainable, it is hard to say. We are growing substantially higher than the market, and I guess you can't continue doing that forever, I guess. But we believe that we have a very compelling market position in the market in prosthetics. We have very good products out there. We believe that we can grow quite nicely in the next quarters. But of course, as you pointed out yourself, the comparison is starting to be tougher, but the run rate is pretty good as we speak. So we are very bullish on the next quarters. Great. Thank you. The next question comes from the line of Thomas Bowers from Danske Bank. Please go ahead. Your line is open. Yes. Thank you. Just actually a few follow-ups on these questions from Christian. I just want to address the prosthetics first because, well, it's quite clear that you have seen some very nice organic growth the last many quarters, I guess, ever since the regulatory auditing and also very strong growth in EMEA. I'm just wondering, are you also seeing some sort of a trade-off to better products in general? Because you could be taking market shares, but are there any trends towards higher-end product lines here also? Then maybe just on the B&S, again, well, given that you are sort of keeping your organic growth guidance for the full year, should we sort of see this as a hint that the prosthetics is doing better than you expected in the beginning of the year and maybe the issues here with the Bracing & Supports in the U.S. and then distributors has been maybe worse that you had anticipated? Maybe just give me some color on what you expect for the second half on B&S for the distributors. Then maybe just my last question is just wondering a little bit on the margins, earning margins for the longer term. We see, of course, the material FX pressure, and I guess no one really knows where that will go. If we are assuming some fixed rates here and also on product mix, do you actually think that +20% EBITDA is sort of reachable in the next two, three-year timeframe from continued scale and also continued production optimization? I think that's it. Thank you. Yeah. Thank you, Thomas. Regarding the prosthetic organic growth. Well, in general, you basically nailed it when you said the technology trade-off, a trade-off to a higher priced product. That is the foundation for our growth, Thomas, and has been for very many years and maybe for the last 20 years. The market is trading off, and that is the reason why we are growing faster than the market. There's no question about it. That will continue, and that is the reason why our technology trade-off strategy is so important and has served us so well. If you look at the usage of those expensive products, there's nothing that indicate that or the penetration of those products are quite low still. We believe that relatively low volume growth in the overall market is actually helping the reimbursement system to accept this technology trade-off. We have no reason to believe that that will stop. That is on the prosthetics. On the Bracing & Supports, you were asking about whether prosthetics was performing better and Bracing & Supports worse. No, I would not say that. The growth both in Bracing & Supports and the prosthetics is basically according to our expectations. What is changing is the currency movement. The position we have taken all along is to guide on the currency as it is when we issue the guidance. Maybe we should have known that the Icelandic krona would appreciate, but this is our position. We do not want to speculate in the currency movement up or down. So the sales are basically on our expectations. Regarding the last question on margins, looking forward. The margin story is unchanged as we see it. We continue to expect to grow in line or slightly above the market. We continue to expect the prosthetics business to grow slightly faster than our bracing business, and all else equal that will lead to positive, let us say, product mix impact on our gross profit margin. Also within the Bracing & Supports business, our high-end products are growing faster than the rest of the range, again, leading to positive impact on the gross profit margin from a product mix standpoint. We do expect to or do see opportunities in the manufacturing part of the business to continue to seek more manufacturing efficiency, decreasing unit cost, then we absolutely expect to be able to leverage our cost base to a large extent, leading to these gradual margin improvements which we have had in the business over the last few years. But if you look at especially the last two years with two dilutive acquisitions, which we are communicating today that we are bringing back, let us say, up to the average margin in the Embla Medical business with clear cost synergies. Then we have had the currency headwinds, which have sort of neutralized the margin gain that has been in the business. So you ask whether it is realistic for us in the short to medium term to get back to 20%. I am absolutely confident in that. That sounds great. Thank you very much. The next question comes from the line of Felix Wienan from SFO. Please go ahead, your line is open. Yes. Good morning, all. Good morning, Sveinn. It's Felix Wienan from SFO. Hi, Felix. Just a quick question on Asia, which has had a tremendous performance for the second quarter in a row. I think in the last quarters you've talked about changing the distribution, or you've been working on changing the distribution setup there. Probably you can just get us some more color on this again. I know that it's probably a bit early, but given that the margin in APAC has been declining over the last couple of years, what trend are you seeing so far year to date? Is it improving? Should it remain on the same level? Any qualitative comments around that will be appreciated. Thank you. Hi, Felix Wienan. Just the APAC, we have excellent performance in APAC in the quarter, and that is largely driven by our, let's say, successful turnaround of the business we have in China. As last year we communicated we were doing some restructuring regarding the way we go to market in China. We are very much back to business there, and that is the principal driver for our excellent growth rates in the APAC region in this quarter. Regarding profitability on our business in that part of the world. Let's say we sell the same roughly product mix in APAC as we do in the rest of the world, and our margins are no worse than they are in our main market. We see no trends as such in that regard, except that we see relatively stable profitability from our business in APAC. All in all, we are quite happy with how that is trending. Yeah. I would like to point out as well, that our strategy in APAC is pretty much the same as in the Western world. That is, trading of technology. That is the reason why we are not competing head-to-head with a very low price competition there, extremely low price competition. We believe that is our strength, and we are playing our strength there. We will continue to do that. So the margins in Asia are, as Sveinn Sölvason said, are no worse than the rest of the company. We should also point out that in Asia, or we call APAC, Australia and Japan are typical Western markets. We are developing very nicely there, especially Australia, which is a fantastic market for us, and we are in a very strong position there. Excellent. Well done. Good job. Thanks, guys. Thank you. The next question comes from the line of Niels Leth from Carnegie. Please go ahead, your line is open. Niels Leth from Carnegie, you can now ask your question. Your line is open. Yes, good morning. My first question would be about the FX situation. In the beginning of the year, you guided towards a negative impact of about 60 basis points from FX. Where would you estimate the FX impact to arrive given the current FX levels? My second question would be about your bionic share of revenue. Why did that ratio decline in this quarter compared to quarter 2 last year? Thank you. Hi. On the first question, yes, when we set the guidance in the beginning of the year, we said that at the prevailing exchange rates, we would expect about 60 basis points negative impact year-over-year. To where we are today with the appreciation of the Icelandic krona, we are estimating about 100 basis points negative impact if we compare to average rates in 2016 compared to the average rate we expect for the remainder of the year. So it is about 100 basis points, compared to the 60 in the beginning of the year. Will there be any carryover impact of this into 2018 as it looks right now, given the hedging contracts that you have in place? The hedging contracts we put in place, we put in place in the beginning of the year. The hedging contracts are, let's say we hedged approximately half of our expected ISK cost here in Iceland. Then we roll that forward on a 12-month rolling basis. So at end of each month, we extend one month at the other end. What this effectively does is that it evens out the volatility of the Icelandic krona changes on our cost base. We have received some questions on the same topic, so we'll, let's say in our communication going forward, we'll try to be more transparent on the exact impact of these hedging contracts on our ISK cost base. I think this is roughly how you should think about it, is in the sense that we will continue to, let's say, buy 12 months forward, approximately half of our expected Icelandic krona usage here in Iceland. Of course, on the long-term effect of our currencies, of course, we are looking at how our footprint is going to be in the future, and we hope we can give you a better view on that on our Capital Markets Day. Just to add to this discussion briefly, because this has obviously been a big theme for us. Every quarter, we are talking about the impact of the Icelandic krona on our profit margin. I think we need to look at it such that, this is a small currency which fluctuates quite a lot. It currently hardly ever been stronger. Is it the right way to extrapolate that current cost level into the future? I think that is debatable. Yeah. I think it is unfortunate, obviously, that we have such a relatively large part of our cost base in a country where the currency is so volatile. I think it is important that we look at this slightly from a longer term perspective, because the volatility in the short term can be quite expensive. Nils, on the decrease on the bionic share or the decrease on the Rheo can mostly be explained by the addition of the Medi Prosthetics product and good performance in our high-end mechanical prosthetic solutions. Excluding Medi, we are at 23%. If we exclude both Touch and Medi, we are at 16%, which is comparable to what we used to be. Yeah. Okay, great. Thank you. Thank you. Ladies and gentlemen, as a reminder, if you do have any further questions for the speakers, please press 01 on your telephone keypad now. As there are no further questions registered, I will hand the call back to the speakers. Please go ahead. Then I would like to thank you all for the participation. Again, I would like to remind you of our Capital Markets Day, which will be in Copenhagen, September 27. I hope to see you all there. Thank you very much.