Good day, and welcome to Avanos' second quarter 2022 earnings call. All participants will be in a listen-only mode. Should you need assistance, please dial our conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your touch-tone phone. To withdraw your question, please press star then two. Please note this event is being recorded. I would now like to turn the conference over to Scott Galovan. Please go ahead.
Good morning, everyone, and thanks for joining us. It's my pleasure to welcome you to the Avanos 2022 second quarter earnings conference call. Presenting today will be Joe Woody, CEO, and Michael Greiner, Senior Vice President and CFO. Joe will review our quarter and current business environment, as well as provide an update on our key objectives for 2022. Then Michael will discuss additional detail regarding our second quarter and review our 2022 planning assumptions. We'll 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, current economic conditions, and our industry. No assurance can be given as to future financial results. Actual results could differ materially from those in the 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 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, Scott. Good morning, everyone, and thank you for joining us to review our operational and financial results for the second quarter of 2022. Our operational and commercial teams continued to execute well against a range of macroeconomic challenges, and we remain focused on getting patients back to the things that matter as we meet the needs of our customers. Although we fell short of consensus revenue estimates for the second quarter and are also updating our full year guidance for revenue and adjusted EPS, which Michael will discuss further, we continue to experience consistent demand throughout our product portfolio and remain confident in our ability to execute against our longer-term financial objectives as supply chain and other macroeconomic dynamics improve.
For the quarter, we achieved sales of $203 million, representing 9% actual growth or greater than 10.5% growth excluding the negative impact of foreign exchange. We generated $0.41 of adjusted diluted earnings per share and $23 million of free cash flow. Excluding the negative impact of foreign exchange, our Chronic Care portfolio grew by just under 1% despite a 10% contraction experienced in our Respiratory Health business due to inventory being sold through our distributor channel that had accumulated during later phases of the pandemic. Our Digestive Health franchise delivered another solid quarter with greater than 5% growth versus prior year, excluding FX.
Excluding the impact of OrthogenRx and foreign exchange, our pain portfolio was down 1%, with our interventional pain franchise growing 5% and our acute pain product portfolio lower by a little over 4% versus last year. The pain franchise had a tough prior year comparison and continues to experience slower return to elective procedures due to staffing shortages and patient preferences. Our Hyaluq cid offerings through OrthogenRx posted strong Q2 sales with a rapid adoption of TriVisc, our 3-injection HA regimen, beginning in June. Given our reimbursement position in the market compared to competitors, we will continue to see favorable tailwinds in TriVisc, capturing share from both the 1- and 5-injection segments with account transitions, new account acquisitions, and meeting patient demands. Additionally, we have service differentiators via our direct patient purchase program and HARMOKNEE, an online portal to enhance and streamline the customer experience.
We believe these differentiators will help us retain the new business we are capturing moving forward. We remain confident in generating greater than $70 million of actual net sales for fiscal year 2022 from our OrthogenRx offerings. Separately, we delivered adjusted gross margin of just under 59%, driven by favorable product mix in the quarter, inclusive of OrthogenRx and our plants continuing to incrementally deliver on our manufacturing efficiency strategy. We are very pleased with our gross margin results for the second quarter and first half, but are cautiously optimistic for the duration of the year, given continued headwinds related to raw material availability, inflation across all manufacturing inputs, and shipping and distribution costs that remain elevated. Additionally, our back orders worsened throughout the second quarter after making progress in the first quarter and are currently in excess of $11 million.
Given this continued uncertainty surrounding our supply chain, including access to certain resins, silicone, and Tyvek, and the cost associated with assessing some of these key raw materials for our product offerings, we are not increasing our full year 2022 expectation for gross margin, but are confidently maintaining our annual gross margin expectation between 55% and 57%. Turning to SG&A, as we noted during our year-end earnings call, we identified a range of expenses that would impact our SG&A margin profile in the first half of 2022. Our second quarter SG&A as a percentage of revenue sequentially improved by 240 basis points versus our first quarter to 40.6%. Many of these expenses will not repeat in the second half of the year, as we had previously indicated.
We still anticipate maintaining SG&A as a percentage of revenue to be less than 40% for the full year of 2022. With that as a background, let's review some detail on our product portfolio. The positive trends across our Digestive Health franchise continue, with our NeoMed portfolio growing over 27% and our legacy enteral feeding products growing mid-single digits despite supply constraints impeding even further growth for both product categories. We anticipate continued strong growth for the duration of 2022, assuming no further supply chain disruptions for this product category. Separately, although our Respiratory Health business was soft in the second quarter versus our expectations as distributors rebalance their inventory levels on the tail end of the pandemic, we anticipate growth to revert to historical rates and should benefit from a stronger second half as we approach the 2023 flu season.
Turning to our Pain portfolio, although we experienced a weaker than anticipated overall second quarter, we continued to deliver mid-single digit growth within Interventional Pain, and ambIT also grew by over 50%. As we noted in our first quarter earnings call, we predicted low single digit growth for our Pain portfolio in the second quarter due to a tough prior year comparison, and further indicated that we expected a return to double digit growth for the second half of the year. Throughout the second quarter, we have seen strong demand for capital units in Interventional Pain, which is a key driver of future COOLIEF growth and adoption.
On the Acute Pain side, while supply chain challenges have been an ongoing issue this year, we have been able to mitigate some of the impact by continuing to drive the ambIT reusable pump program, which will remain a key growth engine moving forward. With underlying demand of our products still present, increased momentum in some critical pockets of the portfolio, and a pathway to improving the backlog affecting our Pain products, we are cautiously optimistic that we can return the Pain portfolio to double-digit growth across the third and fourth quarters. Our next priority for 2022 is to demonstrate our ability to generate consistent, repeatable cash flow. As you may recall, we generated $26 million of normalized free cash flow in 2021, excluding a number of one-time impacts, and as I noted earlier, generated $23 million of free cash flow in our second quarter.
We previously communicated that we anticipated generating approximately $90 million of free cash flow for the full year of 2022. However, as a result of higher interest expense payments, slightly lower operating earnings, and growing inventory balances due to inflationary pressures on our raw materials and managing our backlog, we now anticipate free cash flow to be closer to $80 million. Our final priority for 2022 is focused on capital deployment via M&A. Our M&A pipeline remains healthy, and as previously stated, we are engaged in active dialogue with a number of potential tuck-in targets, which would leverage our existing footprint, generate synergies, and enhance our top-line growth. To ensure that our capital availability is optimized to pursue each of our capital allocation goals, we closed on a new $500 million credit facility during the second quarter.
That said, our ability to close potential acquisition targets is incumbent upon disciplined due diligence and valuation that ensures ROIC is meaningfully above our cost of capital. As I noted earlier, we're very pleased with the expansion of our product offerings through the acquisition of OrthogenRx, and its performance to date has exceeded our initial expectations. In summary, even with various macroeconomic headwinds, including but not limited to inflation, currency, and supply chain, we had a solid first half and remain focused on achieving our primary objectives for 2022 relating to organic growth, OrthogenRx execution, gross margin improvement, and material free cash flow generation. Now I'll turn the call over to Michael.
Thanks, Joe. As you noted, even with the uncertainty that persists in the economy globally and the industry-wide macro pressures, we met or exceeded most of our first half objectives. We delivered on our gross margin improvement and free cash flow generation, as well as continued to successfully execute on our OrthogenRx strategy. Additionally, our SG&A spend as a percentage of revenue sequentially reduced significantly in the second quarter, and we remain committed to ensuring full year spend remains below 40% as a percentage of revenue. Even though we have built good momentum across these objectives, we believe it is prudent to update our revenue and adjusted EPS guidance based on the continuing macroeconomic pressures, currency headwinds, and increased interest expense.
We now anticipate delivering net sales between $815 million and $835 million for fiscal year 2022, and adjusted EPS between $1.45 and $1.65, primarily due to further projected negative foreign exchange impact and higher interest expense totaling approximately $0.10, as well as slightly lower operating earnings due to lower gross margins in the back half of the year. Now, let's review our second quarter results. Total reported sales were $203 million, up 8.9% compared to last year, with adjusted EPS of $0.41. On a constant currency basis, organic growth was flat. This excludes the contribution from OrthogenRx sales in the second quarter, as well as removing [Nexus] generated revenue from the prior year second quarter.
Chronic Care actual sales were down by $2 million versus last year at $112 million in the quarter, excluding the prior impact of sales coming from our exited [Nexus] facility. We continue to see strong growth in our Digestive Health business, with second quarter growth of 3.5%, despite supply constraints impeding even further growth. Within this portfolio, NeoMed grew almost 35% domestically and over 27% globally from the continuation of conversions to our ENFit technology. Separately, as Joe noted earlier, our Respiratory Health business experienced a 10% contraction in the second quarter, primarily due to distributors selling through their inventory as we exit the pandemic, combined with some supply disruptions.
Moving to pain management, excluding the contribution of OrthogenRx, we delivered $69 million of actual sales, $1 million behind the prior year, driven by a tough comparable and ongoing supply chain challenges. The interventional pain side of the business saw 4% growth as reported in the quarter, whereas acute pain declined by 6%. In large part driven by back orders that grew in the quarter, as well as lagging elective procedures that utilize ON-Q. As Joe noted, we are continuing to see positive contributions from OrthogenRx, specifically a high level of adoption of TriVisc, our three-shot HA regimen, as we capitalize on the upside opportunity that will be present through the remainder of the year and into 2023. Moving down the income statement, adjusted gross margin improved more than 740 basis points to 58.7% versus last year.
As indicated earlier, we are pleased with the progress on gross margins with a combination of better product mix, including OrthogenRx, improved plant performance, and lower than forecasted shipping cost. If you recall, last year, to support the business, we incurred significantly higher shipping costs for our NeoMed products to capture the ENFit conversion opportunity. Although we are very encouraged with our second quarter results with regard to gross margin and across the first half, the global supply chain environment remains disrupted, inflationary pressures are elevated, and the availability of certain raw material components presents a challenge as we work through our existing backorder. As Joe already noted, even with these headwinds, we are confident in our ability to achieve our previously stated objective of full-year gross margins between 55% and 57%. Adjusted operating profit totaled $28 million compared to $15 million in the prior year.
Higher sales and improved gross margins were partially offset by additional spend across SG&A, as discussed earlier, resulting in adjusted operating margins of 14% for the quarter. Adjusted EBITDA totaled $33 million compared to $20 million last year, and adjusted net income totaled $19 million compared to $10 million a year ago, translating to $0.41 of adjusted diluted earnings per share. Now, turning to our financial position and liquidity. Our balance sheet remains a strength and continues to provide us with strategic flexibility as we currently have over $100 million of cash on hand with $255 million of debt outstanding post the closing of the OrthogenRx acquisition and completion of our share repurchase programs. Given our post-acquisition pro forma EBITDA, we are levered at approximately 1x.
Additionally, we generated $23 million of cash for the second quarter, and although we are now anticipating slightly lower free cash flow generation for the full year of $80 million, which includes approximately $20 million of capital expenditures, we have more than sufficient capacity to meet each of our internal and external capital allocation priorities. As we already shared, our primary objectives in 2022 center around consistent organic growth, delivering on our OrthogenRx strategy, making meaningful improvements in our gross margin profile, and demonstrating our ability to deliver material free cash flow. To summarize, total net sales are expected to be between $815 million and $835 million, with OrthogenRx delivering sales of greater than $70 million.
The low end of this range assumes continued challenges with accessing raw materials, unfavorable impact of currency, continued unevenness in the return of elective procedures, and other factors, including a less impactful flu season. Annual gross margins are expected to be in the range of 55%-57%, with the lower end of that range capturing continued elevated inflation and distribution costs. Our free cash flow target is approximately $80 million as we drive sales and margin expansion partially offset by higher inventory balances and interest payments on our outstanding debt.
Although the current global macro and industry specific environment remains difficult, we remain confident in our ability to execute against our strategy and priorities and are taking the necessary steps to drive both gross and operating margin improvement and delivery of significant free cash flow, ensuring that we maintain a solid financial position during this uncertain economic environment. Operator, please open the line for questions.
Thank you. We will now begin the question and answer session. To ask a question, you may press star then one on your touchtone phone. If you're using a speakerphone, please pick up your handset before pressing the keys. If at any time your question has been addressed and you would like to withdraw your question, please press star then two. At this time, we will pause momentarily to assemble our roster. The first question comes from Rick Wise with Stifel. Please go ahead.
Hi. Good morning to you both. Lots to unpack here. Maybe help us think through just in a little more detail some of the challenges facing the second half, just for starters. You know, the supply chain. Yes, everybody in the industry is dealing with it. You're dealing with it. Where are you, do you feel like, in finding new suppliers? How resolvable is it? Just help us better understand, and therefore, I assume that's the prelude to working through your backlog as well. Thanks.
That's correct, Rick. Good morning. It's Joe Woody. I'll start and then, of course, Mike can add anything that he would like. You know, for us, what we have been mainly seeing in our range of resins and silicone, and that affects the ON-Q business, the Digestive Health business. You know, in the first half, we saw some chip problems that affected COOLIEF generators. That looks to be dissipating in H2. All of that, in turn, also affects the international business. Now, to the extent that that clears up, and as you can imagine, like other companies, we're working a million different pathways to do that. There's also the potential for upside.
At any given time, just in the supply chain that we're in right now, other items emerge, you know, whether it be around packaging or things as simple as ink and you know, and the list goes on from there. I think in H2, kind of our major issue is gonna be around Tyvek. And we're equally working with DuPont with other companies to try to see, you know, how we can get more raw material released for medical device products. So essentially, that's what you see in the range and in the guidance change. But equally, you know, there's an opportunity and if that does improve, obviously we do much better. I don't know, Michael, if you want to add to that.
Yeah. I'll just add to that, you know, the $815 million-$835 million on revenue, other than FX, which has a meaningful impact, $5 million in the first half of the year, and we're estimating at least $5 million in the back half of the year. If those back orders clear up, then we have line of sight, you know, getting us to the higher end of that range of that $835 million is very realistic. If those back orders were not able to secure the raw materials, as Joe just mentioned, that's needed, then, you know, more towards the midpoint lower end would be possible.
I would just clarify, you know, that the demand is absolutely there. We could have absolutely done more in the quarter without this type of supply chain challenge. I think the nature of our portfolio and the size of our company, it hit us sort of a different way. Maybe not even as bad as some of the others I've seen, but certainly for our size of company and the portfolio we have, it impacted the quarter.
Yeah. I mean, if you look at the first half of the year, Rick, you know, North America grew organically 3.5% through the first half of the year with, you know, even with these back orders. It would've been, you know, much more substantial. Then international had more of the back order issue plus the FX issue, which obviously had a total impact on our revenue for the first half of the year.
Gotcha. Thanks for that. Turning to OrthogenRx, obviously terrific quarter. You had said on the first quarter, you expected to generate sales in excess of $70 million. You're reiterating that. I just wanted to make sure I was clear in my own mind, now that we're halfway through the year, it sounds like you're feeling more confident. How do we think about it, sort of a two-part question now. How do we think about that outlook given the reimbursement change looming for HA and just how you're thinking about that, and what you've dialed into that projection. In a sense, what's next? It seems like you're doing better than others. Maybe help us understand, you know, why that could, should, and will continue to be the case. I'd appreciate it. Thank you.
Yes, Rick. It's Joe. I'll go ahead and do that. We are definitely more confident in the full year outlook. We knew with the new allowables, there would be a migration to TriVisc. That happened a lot more quickly than we anticipated, faster from the five shots. In fact, some of our five-shot customers or a good portion of them want to get into the three-shot market. We're seeing competitive moves over to ours. Short term, there is a reimbursement favorability that customers can experience because of the way we strategically went around our pricing, focusing on the wholesale. So we have to maintain a healthy ASP. We intend to add direct reps and 1099 reps.
We think that we sort of have this window, if you will, of six to nine months, I think, of a pretty positive tailwind in this business where we're gonna see some upside and the strategy's working. We're definitely beating the internal model, and that'll be helpful. I think that just sort of bodes well for, you know, also what we said about year two and then beyond with that business. All in all, it's turned out to be an excellent acquisition for us and one that's strategic, obviously, alongside other things that we're doing in other orthopedic areas of our business, like COOLIEF and ON-Q.
Gotcha. Thanks again.
Yeah.
The next question comes from Matthew Mishan with KeyBanc. Please go ahead.
You there, Matt? I think we may have lost Matt there. He may come back into the line. Maybe we take another question.
Matthew, you are on the floor.
Oh, there he is. Hey, Matt. Joe Woody here.
Sorry. Sorry about that.
Michael's here as well, obviously.
Hey, just to follow up on the TriVisc questions. You know, what specifically about TriVisc allows you to have a better reimbursement position than some of the peers in the space?
Well, primarily, it's the way that we priced our product at the wholesale level, not a lot of specialty pharmacies kind of rebating in our business. That strategically was a way that we focused the business, so we ended up with a more favorable reimbursement than all the other three-injection products. Going forward, I mean, I think the differentiator is the other portfolio that we have, the conversations we can have in alternate sites or different sites like ambulatory surgical centers or places where we're selling COOLIEF. Again, we do intend to expand our channel a bit as well. Ultimately, the differentiators are gonna come around the servicing, really.
We've got a portal that we talked about in the script, and the way that we service the customers and make it easier to do business. We have some technology that we're working on in terms of the syringe that we think will be a differentiator as ultimately over time you have to differentiate that way as much of the reimbursement, you know, later on, you move out a year from now, will be very similar.
Okay. You're expecting the change that your favorable reimbursement position to sort of come together with the rest of the industry as you kind of get through the second half of this year?
Next year. Through the second half of next year, I think, is where we feel like we're gonna be favorable in the three injection area.
On a reimbur-
So it's-
You feel like you'll be favorable through the middle of next year, and then it really-
Correct
Okay.
It could extend a little bit or.
Right
... go into eventually a more level field where you have your basic customers and we're differentiating through basically our other portfolio, the way we service. We're doing some things from an innovation standpoint with our syringe, because I think at that point, you have to have differentiator at that kind of a reimbursement level.
What's key, as Joe mentioned in the prepared remarks, is we gain all these additional customers, we service them well, and once pricing is less of a dynamic in this market, we maintain the market share that we will have developed over the last few weeks and into the next few quarters.
Okay. Got it. I think I understand that now.
Good. Good.
Then question around NeoMed and Digestive. It seems like NeoMed is growing. I remember this being a larger base of sales from you guys. Outside of NeoMed, is Digestive contracting, or is that still growing as well?
No, it's still. We see it as a mid-single-digit grower on a global level. It's one of those areas affected by, I believe Tyvek and silicone, in H2. There's absolutely an upside where if we can get the right amount of raw materials, we can even do better in the Digestive Health area, which is where we primarily focus on our MIC-KEY product. You also see CORTRAK, you know, although it's slowed a bit in North America with the staffing shortages and the ICU census, we still think that that's a good grower for us inside of the Digestive Health franchise.
You peel it all back, you know, it's a very solid business, mid-single digit grower with a good runway, globally, you know, for the future and good, actually good margins for us and a big contributor to our cash EBITDA.
Okay. Got it. Just on the OrthogenRx, just the number in the quarter, you back into it's about $22 million. Is that the correct number contribution from that acquisition this quarter?
That's directionally correct, yes.
Okay. Thank you very much.
Thank you, Matt.
Next question comes from Chris Cooley with Stephens. Please go ahead.
Good morning, and thanks for taking the questions. Just maybe a clarifying question for me to start and then maybe a little bit bigger picture follow-up. Michael, just in regards to the guidance, you mentioned, you know, the lower end of the top line did assume continued FX headwinds. Apologize if I missed this in your prepared remarks, but did you call out what you're assuming there in terms of the incremental headwind there from a basis point perspective? Or maybe alternatively, could you just give us, you know, where your markers were for the major currencies coming into the quarter? And then just kind of as another offshoot, kind of from a just a clarifying point. You know, when we look at pricing for HA products, the way it gets published out there, I just wanna make sure I'm understanding this correctly.
When we look at your pricing versus, say, some of your competitors, you're assuming that discount continues. There's no additional rebates being added. That's just gonna be that price differential you think then will continue until the midpoint of next calendar year. Because there's quite a bit of disparity, you know, across three to four players here just in terms of published pricing on the HA offerings at this time. I've got one quick kind of bigger picture follow-up.
Do you wanna do the currency or do you want me to start with?
Start with the HA.
I think you've got the HA piece right. We haven't really structured a lot of rebate type of business or discounted to you know payers and so forth, especially pharmacy is not a big area for us to focus. We've benefited from that with a wholesale price that's pretty robust. Yes, it should continue into about the middle of next year. We think that that's gonna allow for us to gain share from competitors you know fairly significantly during that period. I think we'll keep it you know with the things that we've got planned on the innovation side and then the servicing model that we wanna go after.
Also, one thing I didn't mention in the prior question was we're also building a cash business as well that looks like it's got opportunity for us.
Cash pay.
Cash pay.
On your other question, Chris. We had about a $5 million headwind across the first half related to FX versus our planning model. We anticipate that we'll probably see $5 million-$7 million in the second half as well. The reason for the increase is just that we're gonna do, you know, $25 million-$30 million more in revenue in the second half. That obviously has a bigger FX impact. In addition, good portions of our back orders were international related. You know, we have a bigger ramp in the back half of the year related to international orders, hence the additional FX impact in the back half of the year.
Appreciate the additional color. Then just a bigger picture follow-up there. You alluded to stronger capital demand on the Pain Management side as we think about the COOLIEF franchise. Any way you can quantify that for us a little bit here in terms of, you know, maybe site of service where you're seeing the incremental demand, relative to prior periods? Just trying to get a little bit better you know, more granularity there around just how much incremental demand you're seeing versus kind of relative levels there. Thanks so much.
Sure. Sure, Chris. Yeah, one of the things actually there's a benefit, I think, is that as the chip shortage took hold in the first half, there was an opportunity for the channel to connect with existing customers and get penetration or bring in active accounts back. I think the other thing that also drives that is the continued studies that are coming out, definitely as they publish, but also now as everybody knows, I think we're in the OA space, so that's a strong grower for us for those sites that are treating in OA.
The quantification is really that we think, you know, there was a tough comparator, as you know, as we all came out of the first, you know, aspect of COVID, and everyone bounced back in this quarter last year or in Q2 last year with procedures. As we get into the second half, there's definitely some better comparators for us. We certainly see that quantifying in terms of double-digit growth in the teens again, you know, for Q3 and Q4. We just have a big demand for the capital, and so we have a backlog for these units. I think the team's doing a nice job, you know, selling the capital. That's where it's all coming from.
Thanks for the additional color.
Yep.
Again, if you have a question, please press star then one. Next question comes from Drew Ranieri with Morgan Stanley. Please go ahead.
Hi, everyone. Thanks for taking the questions. Maybe just keep it on the HA topic for my first one. Joe, I'd be kinda curious to hear more about some of the innovation that you're putting behind the product. I know that there was eventually, like, a single injection product coming, but can you go into a little bit more detail about what you precisely mean by innovation in the service model? Also the cash pay kinda struck me, just kinda curious how that would work in the HA market. Then I had a follow-up.
We talked a little bit in the script about the HARMOKNEE portal, just making it easier for customers to do business with us to order to get you know reimbursement assistance. That's one thing. I mean, the next thing that we're doing on the differentiable side in innovation after sort of the reimbursement changes is technology that would allow for the injection to be guided more precisely into the areas of the knee to get the best effect.
It's sort of known that, you know, if you're not in the right space when you make this injection, you get less of an impact, which is why sometimes I think patients experience maybe no pain relief or just a couple of weeks, while others experience, you know, two months or more of pain relief. I think that will be a differentiator. The other thing I think is that just where we can go with some of the access and sites. I think that a lot of the folks that are believers in HA are gonna wanna have the ability to have patients come in that want relief and wanna pay cash, you know, for that relief.
There's opportunities there really in most all of the sites where we are for that. We'll be talking a little bit more about that as it sorta unfolds toward the end of the year. That's where we are on that.
Okay. Just maybe on the injection for accuracy, is this going to be just around using kind of ultrasound or improving like the needle, the injector or anything else there?
It's more related to a guidance of the needle.
Okay. Maybe for Michael, a couple of questions here. When we kind of look at your organic guidance for EPS, I mean, I get that some of this is FX and some of this is interest, but when you're looking at the change from the prior guidance, the 2-point organic guidance reduction, can you maybe just talk about how that flows through into EPS and maybe what the change is there?
Also on gross margins, I mean, it looks like it's going to be flat year-over-year in the back half, but could you maybe just give us a bridge between second half and first half of how you're thinking about the macro factors and maybe where could there be, like, a specific relief area that you can control versus just kind of the macro uncertainty? Thank you.
Yeah, fair questions. So on the EPS side, the biggest reason for the call down was the higher interest expense, the FX impacts, and then a little bit on the lower operating earnings. Those lower operating earnings are primarily through the lower gross margin in the second half. We will offset the lower revenue organically that you just referenced, we will offset that through OpEx challenging and OpEx savings. Revenue down on the organic side, offset by more favorable OpEx. The other pieces then that relate to the ultimate EPS guidance change were higher interest expense, FX, and a little bit of the lower gross margin. Does that help with that part of the question, Drew?
Yes, it does. Thank you.
When you think about the march from first half to second half gross margin, the biggest piece of that is inflationary factors. If you noticed in our balance sheet, our inventory is up about $19 million. That's more than we anticipated. That obviously has an impact on free cash flow as well. As we have opportunities to buy raw materials, we're doing that in pockets that we know don't have dating concerns. We've been a little bit looser on that. Also that inventory that is now capitalized, that's gonna, as we sell and work through the backorder in the back half of the year, we are going to be releasing in the cost of goods sold, higher priced inventory.
Therefore, that's gonna have a big impact on our gross margin in the back half of the year. Now, as we work through that, and we start to have a little bit more normalized raw material purchasing as we enter into 2023, that drag that's now capitalized on our balance sheet obviously reverses meaningfully.
Thanks for taking the questions.
Thank you.
This concludes our question and answer session. I would like to turn the conference back over to Joe Woody for any closing remarks.
Thanks. I just wanna thank everybody for their continued interest in Avanos. While we're very pleased with our overall execution this quarter, given the uncertainty in this environment, we are committed to creating meaningful shareholder value, and believe our 2022 results are building the foundation to deliver on that commitment. I'm confident that the priorities that we've detailed, combined with our market leading portfolio and attractive markets, position us for consistent sales growth, margin expansion, and significant free cash flow generation as we enter the back half of 2022. We'll probably see a lot of you in the fall investor meeting. Thank you very much. Bye-bye.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.