Welcome to the Wells Fargo Healthcare Conference. Before we start, please note that Wells Fargo Securities events are by invitation only. Members of the press or media are not permitted to join. If you are a member of the press or media, please disconnect at this time. Also, please be advised that today's conference is being recorded. Thank you.
Great. Good morning and welcome to the 2020 Wells Fargo Virtual Healthcare Conference. I'm Shagun Singh, part of the medical device team at Wells Fargo, and today I'm pleased to have Integra LifeSciences on this call with us. Joining us from the company are Carrie Anderson, Executive Vice President and CFO, as well as Mike Beaulieu from Investor Relations. Carrie, Mike, thank you so much for joining us today.
That's great. Great to be here, Shagun.
Thanks, Shagun.
Great. So, let's begin with the discussion of COVID-19. Integra saw strong recovery in Q2 from April lows and exited the quarter down 13% year- over- year, and July improved sequentially as well. Carrie, what trends have you seen in your major business segments, CSS and OTT, as well as geographies through September? What can you share?
Yeah, well, I would say that, you know, we started with a range for the quarter of down 5% to down 15%, and that was based on, at the time we did our Q2 earnings call, we had the July numbers under our belt, so we had one-third of the quarter underway when we provided that guidance. I would say that August has continued to show some nice encouraging trends. Generally, I would say that, if you think about the midpoint of that range being down 10%, I would say we're generally comfortable that where the trends have been would give us comfort within the midpoint of that range. And I, you know, I think consensus is around that midpoint.
So generally, with a third left of the quarter to go, September is going to be, you know, a month that will be a large month for us. Just normally, historically, September always has the weighting of the quarter, and it's no different this year, especially with the summer holidays, the European holidays, all of that come behind us. September will be one to watch. And obviously, you know, the feedback from the commercial teams is that generally there's a comfort level that the trends have been encouraging such that we could get comfortable with that midpoint of that range.
I got it. That's helpful. Just, you know, can you help us understand the recovery a bit better? In terms of, you know, early in the pandemic, you had outlined that the segments that you had expected would come back, you know, faster than others. You know, there were certain segments that would come back faster. So by our math, about a third of your business is more urgent, about 50% falls in the moderately urgent category, and 15% to 20% is more deferable. Can you help us understand, you know, where each of those buckets are relative to pre-COVID levels? You know, if you can share a percentage of, you know, how we should think about those buckets in the recovery that's occurring at this point.
Yeah, I likely won't give recovery percentages by product categories, but just generally that graphic that we provided in Q1 on our Q1 earnings call really helped to, you know, that was our best view of how our business would recover. And I would say largely that has played out with a couple of exceptions. You know, let's start with the CSS side of the business. The areas that we saw the, let's say the largest recovery from our April lows were in our neurosurgical area, that was the CSF Management, Neurolysis and Repair, Neuromonitoring, as examples. And so I think that continues to show that's where, you know, where we're seeing some nice recovery as we move from the second quarter to the third quarter. But generally we're not at pre-COVID levels.
You know, again, our guidance range that we provided for the third quarter was not at pre-COVID levels. So generally the portfolio is just not going to be at pre-COVID levels yet, but we're seeing some nice recovery on the neuro side. Instruments, on the CSS side, was a laggard in terms of recovery. Overall, instruments was still down about 35% in the month of June, and so that one maybe surprised us just a little. It acted more like capital than maybe what we expected, but I, you know, we have seen some encouraging trends there in the third quarter as well, but generally, I think it will still lag the average of the portfolio, and then, you know, the Advanced Energy franchise within the neuro side of the business was a bit mixed.
And we talked about that, that there's in that Advanced Energy, it's 50/50 split between capital and consumables, the disposable pieces that go to those Advanced Energy capital units. And so saw some nice recovery on the consumable side, but capital is certainly the laggard that we have in the portfolio, and we would expect that it continues to lag through the balance of the year for sure, as it's gonna be tied more to economic, financial budgets for hospitals. But I would say, then if you move to the OTT side, the really nice surprise was on the ortho side. It certainly was the most deferable and had the greatest declines right out of the gate, down 80%.
And then, but it recovered to mid-single digits by the end of June, and still see some nice recovery coming there as well as we move into the third quarter. Then the other parts of the business on the OTT side, our Wound Reconstruction side of the business, a little bit of mixture there where we saw the biggest recoveries in the Chronic Wound. And that's really great to see because those are the folks that if they don't take care of their wounds can lead to you know, amputations as an example. So very encouraged to see that that came back as strong as it did at the end of the Q2 and continued nice trends of recovery into Q3. And where we saw late in the second quarter, some improvement was in our inpatient area of Wound Reconstruction.
And that's really associated with shelter-in-place restrictions being lifted. Obviously that has continued, that trend has continued in the Q3 as more people kind of get out and about. Then there, the other area within the Wound Reconstruction that was a little bit of a laggard was the Surgical Reconstruction in the breast area and the Hernia Repair area. But still, you know, again, seeing some nice recovery there in the third quarter. Generally the entire portfolio, as we've talked about that range of down 5% to down 15%, the midpoint being down 10% from pre-COVID levels, which I'm referring to as more 2019 levels.
I got it. And just in terms of a clarification there, you indicated that the quarter has the highest weighting towards the September month. And you've noted comfort, you know, at the 10% midpoint range. You know, is that based on what you've seen so far? Like, what are you modeling in for September? How are you thinking? What's your expectation for how September plays out?
Yeah, I mean, I won't get into specifics on September, but again, we have two-thirds of the quarter now under our belt, and have visibility obviously in the top line. And, we're into September. So we do have a pretty robust forecast process with the teams, where they're giving us weekly data points and inputs as to what they expect. And so, you know, that comes from, you know, just the commercial team's input of their views of how the business is coming back and expectations for the month of September. So, that's where we can get some confidence that the midpoint of that guidance range is where we can get comfortable with is because we got two-thirds of the quarter gone and the fact that we've got some good feedback coming back from our field sales teams.
Got it. That's really helpful. So with respect to capital, and I know you touched on that a little bit, but what does the recovery in capital and instruments look like? I think you had indicated that small and medium-sized capital would be the first to recover, and CUSA is, falls within that. You know, what exactly are you seeing? Could you, you know, elaborate a little bit more or provide some anecdotal evidence of what you're seeing in your field?
Yeah, it's not like capital went to zero for us. So I don't want to suggest that, you know, we're not selling any capital whatsoever. We have a compelling value proposition on the CUSA as an example. And as you indicated, you know, CUSA unit's about $200,000, so we're not talking about a $1 million piece of equipment. And when you couple that with, you know, a strong value proposition and you think about it from the OR theater perspective, not only can we save OR time by having a very powerful tool and a very selective tissue ablation device, which can speed the actual procedure time in the operating room, but it also has an incredibly simple setup as well. So between procedures, you have reduced time there.
There is a compelling business case in addition to the extent that our customers are looking for alternate financing options. We can be responsive there. So if they can't get to an outright purchase, we can think about leasing options, rent-to-own options. We'll work with our customers because we do think we've got a really strong value proposition. And I would say as you think about capital OUS versus US, certainly have seen a stronger recovery in outside of the US markets compared to the US. But you know no doubt there's still a laggard effect there. And I would guess that it will continue to lag through the balance of the year. But it's you know the pipeline is strong, Shagun. So it's not for that we're losing anything to competition at this point.
It's just working through that pipeline, getting the customers to find a path that they can finance this. But we're encouraged with the pipeline that we have.
I got it. Just with respect to Q4, I think you've modeled a scenario where revenues could return to pre-COVID level, and part of that is predicated on a recovery or continued recovery in capital and instruments, and you did mention that the funnel is pretty strong. You don't expect a delay for more than six months, so you should expect some kind of normalization later in the year, you know, or early next year. You know, I'm just curious, you know, what are your latest thoughts on, you know, you know, how Q4 shapes out, you know, for, for Integra LifeSciences. I think in general, you've also indicated that procedures that you have exposure to are not deferable by more than 20 to 45 days, so that also points to a more normalized environment, you know, in Q4.
So just curious to get your thoughts on, you know, how you think about, you know, approaching normalization and how you think you might Q4?
Yeah, I think that's all what everybody wants is normalization and what defines the new normal at this point. And for fourth quarter, there's still a lot of uncertainty out there. And that's the reason why we talked, maybe more generically about the fourth quarter, that there's lots of scenarios that could play out. And certainly one of those scenarios, which is the scenario that we hope will play out, will be a fourth quarter in 2020 that gets us back to, you know, 2019 levels. But I think we'll obviously be able to provide more clarity on that once we do have the third quarter closed. And so we'll talk more about that on our October earnings call.
You know, I would expect that, you know, we would have more clarity on whether or not the pathway of the vaccine, on what's the timing of that. Certainly as all the schools are back in session, understanding if there's any resurgence concerns there, whether it be universities, you know, going back to classes, all the lower educational levels going back to classes, everyone returning from Europe, returning from vacations here in the U.S., after post-Labor Day. So really understanding if we see any material hotspots emerge, you know, in the last month here that would give us any pause for the fourth quarter. And also, you know, understanding how capital and instruments performed in September will give us some clarity on what Q4 could look like for us. But, I'd say just be a little bit more patient with us.
We'll provide you some clarity just like we did in the third quarter. We'll give you more clarity on our fourth quarter expectations in the October earnings call.
I got it. And just, in terms of approaching normalization, let's see what the audience have to say. So we do have a polling question. Josh, if you could please put it up on the screen. So what, so when do you expect Integra sales to return to pre-COVID growth levels? And this is on an underlying basis. If everyone could please log their responses. So the options are by Q3 2020, by Q4 2020. I think Q3 is, you've indicated that that might be the case, but Q4 or by Q1 2021, Q2 2021, or thereafter. Josh, do we have the responses?
Yeah, we still have a few more coming in. I'll let it go for another five seconds or so.
Sounds good.
I won't share what my answer was.
Okay. So this is interesting. So about 41% have indicated that by Q1 2021 and another 35% by Q2 2021, and this is normalization on an underlying basis. Carrie, any, any reaction there?
No, I mean, again, you know, I think for the most part, I encourage folks to be prudent. I wouldn't call it conservative. I'd say, you know, there's still a lot of unknowns and we're all searching for the same answers and the same clarity in the impacts to the global economy as well as, you know, to our business here at Integra. And we're encouraged by the signs we're seeing definitely and hope that we can get back to 2019 levels just as quickly as possible. But that, you know, it doesn't surprise me.
I got it. And, you know, a couple of questions on 2021. So I guess consensus is looking for about flattish growth in 2021 versus the 2019 levels, and you know, it does look a little bit conservative, but, you know, it seems like investors are expecting a normalization in the first half. But I'm just curious to know, as we think about the growth story of Integra, you know, what do you think the street is missing? And, you know, what percentage of your business is really related to that trauma, traumatic injury, segment that you've indicated will not return and has lost revenue?
Yeah. And it's not that it won't return. It you know, obviously it's traumatic injuries that caused the incident to happen to need our product. And so certainly that piece is not a pent-up demand characterization. But with restrictions being largely you know, eased in terms of shelter-in-place restrictions, you know, we would expect to see the traumatic injuries increase as a result of that. And in fact, we started to see that at the end of Q2 and again, seeing encouraging signs in the third quarter of activity increasing just generally as restrictions in shelter-in-place restrictions have been eased. Regarding your question on 2021, I'll use the word again. I think generally consensus and analysts are prudent, not conservative.
Until we have more visibility, I would encourage us to be a bit more prudent in those numbers and then wait to take them up until there's more clarity there. There's just no sense at this point to get ahead of our skis on these things. I would say we'll provide you as much insight as we get comfortable with that as well. But we're looking at the same indicators that you are and from an external perspective on the global economy.
I got it. That's, that's fair enough. But, how should we think about the margin recovery relative to sales recovery, you know, next year or even in the back half of 2020?
Let's start with this year. And you know, Q2 performed exceedingly well above my expectations given revenue declines of 30%. You know, certainly we had not had experience in that low of a revenue environment. And the team just did an incredible job of doing what it needed to do to reduce cost and to control expenditures. So you know, really pleasantly surprised with the gross margins that we were able to put up in the second quarter, which is around the 66% range. So it was very, very encouraging. And so as we think about third quarter, we talked about gross margins incrementally improving from the second quarter and likely somewhere in between Q1 and Q2 levels is likely where we would expect gross margins to be in the third quarter, because revenue will likely be in between Q1 and Q2.
And then in the fourth quarter, we talked about on the earnings call that, you know, we could see gross margins definitely near that Q4 2019 mark, or maybe even a little higher depending on what the revenue scenario kind of plays out in the fourth quarter. So the whole gross margin story has really been intact in terms of the mix shift change. And, you know, I'm seeing that play out definitely. And it, there's two levers within that mix story. One is the favorable mix shift that you get from our new products growing and being a greater percentage mix of the portfolio. These are faster growing, higher margin type products. So that has a favorable gross margin impact.
And then you couple that with our SKU rationalization program, getting out of SKUs that are lower growth, lower margin type of products that just has a nice impact on the overall portfolio mix and really seeing that bear out. We talked about it and now we're definitely seeing that. And as revenue increases, obviously, you know, that helps with factory utilization as well. So, you know, I think the gross margin story is pretty intact. And I'm pleased to see the performance even in a very low-volume environment unfold.
That's really helpful. You know, just speaking to gross margins, how should we think about, you know, the contribution of the Regen capacity ramp and the mix shift there? You know, how should we think about the, the contribution there as well as the benefit from the TMA rolloff in 2021?
Yeah. And I'm glad you brought that up, Shagun, because that itself is part of the mix story. The Regen products carry gross margins in the 80% range. Remember that in 2019, we were capacity constrained. The demand was there. We just could not meet the demand from a supply standpoint. We talked a lot about this on multiple calls in 2019. It takes a long time to get incremental capacity online with all of the regulatory approvals that are required. It's not like you can just make the investment one month and have the capacity online. That investment was really focused in the second half of 2019. We started to see the benefits pre-COVID in the first quarter of 2020.
Really were encouraged by a very strong start in our Wound Reconstruction business with that supply easing. Obviously then COVID hit. So there were a couple of our facilities, Memphis and Boston in particular, where we kept those facilities going. In other facilities, when demand came down with COVID, we went to furloughs. We went to shift reductions. But in those two facilities where we were at safety stock levels that were below where we wanted them to be, we were still working in those facilities to bring inventory levels up to the right level that we were comfortable with so that as the business did recover, we could respond. So we do not have any capacity constraints coming out of those facilities anymore.
So that's the great news that as that you know the recovery happens in the business related to post-COVID recovery, we should be able to meet that demand, and it has a very attractive margin profile.
And what about the.
And then what? Yeah, you asked about the TMA. So let me. Yeah, we haven't quantified the TMA numbers, but we expect to be off of the TMA completely by the end of 2021. So that is a phased approach. It's not a cliff impact. It's not like all or nothing. We will start to transfer manufacturing from the J&J facility over to our Mansfield, Massachusetts facility over the course of 2021, and our expectation is that we should be able to extract ourselves from that TMA at the end of 2021. And that's a cost- plus arrangement. So you get rid of the plus, for sure. And so that's an incremental benefit to gross margins that we'll fully realize in 2022, but you'll have some incremental impact in 2021.
You know, how should we think about your LRP targets, which were previously for 2022, to get to gross margins in the range of 70% to 72%, EBITDA 28% to 30%, and EPS growth of +12%? How should we think about the LRP targets, you know, today given the COVID environment? Has it been pushed out by a year? How should we think about it?
Yeah, I would say I won't comment on exact timing, because we are going through our own internal strategic planning process right now and, you know, don't have the answers for that right now as we go through that, our own plan and review with our Board of Directors. But let me just say that the LRP goals themselves, there's those still are intact. There is absolutely no reason that our business can't reach those goals, just because of what I just shared with you. So I, you know, went through the gross margin levers that we have that should allow us to get to that 70% to 72% gross margin. Those are still intact.
And as the business recovers to pre-COVID levels and we get back to what we would expect is 5% to 7% organic growth, then, you know, there's nothing wrong with achievement of those types of gross margin numbers there. And I fully expect that we those are achievable. And the same thing with the EBITDA margin. Obviously, a big piece of that is going to be the gross margin coming through. And then you talk about as you scale your business, you will drive more efficiencies in the SG&A lines. And certainly, we could talk a little bit about this maybe later is, you know, that COVID does have an opportunity to act as a catalyst in some areas of SG&A that will be incrementally helpful to us as well.
I got it. And if I could ask a follow-up on the Regen capacity and expansion, you know, how should we think about, you know, the ramp in volumes? You know, how should we think about the demand out there and your ability to now meet it? You know, what's the impact to volumes? How should we think about, you know, the incremental, I guess the revenue impact out there and the opportunity here?
Mike, you can correct me if I'm wrong, but we had talked about, you know, the impact to growth in 2019 as a result of some of the capacity constraints. We had talked about it. It was probably somewhere between one to two points of growth for us that cost us. Mike, is that right?
That's right.
Yeah. So, you know, if you think about, you know, the demand was there and we couldn't meet that demand. It cost us about that 1 to 2% of organic growth for us. So, certainly with capacity now back online, we should be able to go chase that growth as the demand for the product recovers post-COVID.
Okay. That's, that's really helpful, Carrie. Thank you. Let's move on to M&A. So, Carrie, I think, Integra has indicated previously that they're looking for scale acquisitions on the Regen side, and technology tuck-ins on the neuro side. And I think based on the restrictive governance you have around M&A, you know, we estimate that the deal capacity is about maybe $250-$300 million, in the back half of this year, maybe $700 million or so in 2021. Correct me if I'm wrong. But the question is, you know, you know, how are you thinking about, you know, the focus on neuro tuck-in? It seems like that's probably the next area just given the restrictive governance. And where do you see portfolio gaps?
Yeah. Well, maybe I'll start with the first part there as a comment. I think your numbers are a little low in terms of the amount of debt capacity that we do have. The base EBITDA definition is different than the adjusted EBITDA we report. So, under the bank EBITDA number, understanding that our max leverage is five times, we did get relief on an amendment to go up to five and a half times with COVID, but from M&A purposes, it's still a max of five times. You know, we have, we certainly have some incremental room there. And M&A has been and always will be an integral part of Integra's strategy. So we are going to be, you know, we are continuing to look opportunistically at opportunities out there.
And certainly on the neuro space, as you talked about tuck-in opportunities, we made two small acquisitions there at the end of 2019. Certainly looking for opportunities, continuing with some, you know, technology opportunities, but also perhaps distribution partnerships as well, particularly in our Asia markets. But we think that there are some nice developing opportunities there in the neuro space that may be more distribution type of partnerships that we'll be looking at. And then I would say on the OTT side, you know, the area that we've talked a lot about is the TT side, the Tissue Technology piece, where we have probably one of the broadest portfolios in the industry. But we lack scale in certain areas.
And that's where we want to understand, is there opportunities there to bring some scale to the business. And so that will be an area of focus for us as well.
And just as a follow-up to the Regen m arket, it's actually a very fragmented market. Do you think COVID-19 could drive further consolidation, you know, in that market? Are you seeing any signs of it? And, you know, I'm just curious to see, you know, get your thoughts on how aggressive you think, you know, you can be given the opportunity that it may present itself, you know, just given the environment.
Yeah. I think it's a, yeah, it's a good question, Shagun. And, and I think that maybe it's a little too early to, to be able to say that COVID will act as a, as a consolidator in the marketplace. Again, that's an area that we are quite interested in and, you know, would, would be looking to add some opportunities on the M&A side front there. But I, I would say that, you know, you know, notwithstanding the, the M&A track, which again, we would, we would be, you know, encouraged to look at and, and, and certainly interested to look there. We have, again, one of the broadest portfolios there.
So if you think about kind of who falls out and who kind of bubbles to the top, I think will be one of those that are very successful as we think about being the having one of the broadest portfolios and certainly can weather something like this, a COVID-19. And we've weathered it pretty well. So very confident in our Tissue Technology portfolio and our ability to grow that.
Got it. Thank you so much. I think we are out of time, but I appreciate you joining us today. Thank you so much.
Thank you.
Thanks, Shagun.
Bye-bye.