Covetrus, Inc.
Q2 2020 Earnings Call Transcript

Published: 12 Aug 2020

[Operator:]

Ladies and gentlemen, thank you for standing by, and welcome to the Covetrus Q2 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speakers’ presentation, there will be a question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. [Operator Instructions] I would now like to hand the conference over to your speaker today, Nicholas Jansen, Vice President of Investor Relations. Please go ahead, sir.

[Nicholas Jansen:]

Thank you, Ian. Good afternoon and thank you for joining us for our second quarter 2020 earnings conference call. I'm Nick Jansen, Vice President, Investor Relations at Covetrus. Joining me on today's call are Ben Wolin, our President and Chief Executive Officer; and Matthew Foulston, our Executive Vice President and Chief Financial Officer. Ben and Matthew will begin with prepared remarks, and then we'll be happy to take your questions. During this conference call, we anticipate making projections and forward-looking statements based on our current expectations. All statements other than statements of historical fact made during this conference call are forward-looking, including statements regarding management's expectations for future financial business, operational performance and operating expenditures. Forward-looking statements may be identified with words such as will, expect, believes, should, or similar terminology and the negative of these terms. Forward-looking statements are not promises or guarantees of future performance and are subject to a variety of risks and uncertainties, many of which are beyond our control, which could cause actual results to differ materially from those contemplated in these forward-looking statements. These risks and uncertainties include those under the heading Risk Factors in our most recent annual report on Form 10-K, quarterly report on Form 10-Q and other periodic reports filed with the Securities and Exchange Commission, which are available on the Investors section of our website at ir.covetrus.com and on the SEC's website at www.sec.gov. Forward-looking statements speak only as of the date hereof, and except as required by law, we undertake no obligation to update or revise these forward-looking statements. You can find this afternoon's press release announcing our second quarter 2020 results and the accompanying slide presentation for this call on ir.covetrus.com. We will continue to use our website to distribute important and time-critical company information. The press release and slide presentation also contain further information about the non-GAAP financial measures that we will discuss during this call. Please refer to those documents for a reconciliation of non-GAAP measures to our GAAP financial results. With that, I will now turn it over to Ben to provide the highlights.

[Ben Wolin:]

Thanks, Nick, and good afternoon, everyone. We hope everyone listening in on today's call is safe and managing through the challenges created by this pandemic as well as possible. I hope you are also staying engaged with your community as we all commit to drive real and lasting social change. To start today's call, I would like to first acknowledge and express gratitude to all of the veterinarians and animal health professionals across the globe who have operated as an essential service during these difficult times, worked extended hours and successfully pivoted their businesses all for the well-being of their clients. Their passion is what drives our organization and keeps us energized even in these uncertain times. I am also proud to see our Covetrus team in action, as they continue to adapt and respond to COVID-19 uncertainties, drive forward with our mission and commitment to our customers and their clients and deliver exceptional results in the face of adversity. While there is still much work to do, momentum is building inside our organization and I'm very optimistic about our future. I will review three topics on today's call

[Matthew Foulston:]

Good afternoon, everyone. Thanks for joining us today. In my first two plus months, since joining Covetrus, I've had a chance to meet virtually with many of you. Looking forward to the day where I can meet with all of our analysts, current and prospective shareholders and other stakeholders in person. I'm really excited by the opportunity we have at Covetrus as we build on the momentum in our business and deliver on our financial commitments to our shareholders. I will now review our second quarter 2020 results. The focus of my comments will be non-GAAP results where applicable as these items provide the most insight into the underlying trends impacting our businesses. Please refer to today's press release for a more detailed description of our second quarter GAAP results. As Ben mentioned and summarized on slide 9, Q2 was a strong quarter for Covetrus across nearly all financial metrics as we significantly exceeded external net sales and adjusted EBITDA expectations. Our operating execution, measured response to COVID-19 and the accelerating growth within our higher margin prescription management business, drove a significant improvement in adjusted EBITDA and fueled 90 basis points of year-over-year adjusted EBITDA margin expansion. Importantly, our financial condition meaningfully improved as we ended Q2 with more than $700 million in available liquidity and net leverage of 3.5 turns. Turning to the details and starting at the top of the income statement on slide 10. Covetrus' net sales were approximately $1.03 billion in Q2. COVID-19 had a negative impact on net sales during the month of April, where many of our customers experienced declining client visits tied to certain global measures designed to slow the spread of COVID-19. Additionally, as previously disclosed, certain customer inventory stockpiling activity that occurred in several international markets during the month of March in connection with COVID-19, pull forward more than $30 million of net sales into Q1 from Q2. However, our customers across most of our geographies began to see an improving operating environment in the latter half of April. And this trend continued through the balance of Q2 with performance during the month of June, particularly strong as demand recovered to at or near pre-COVID-19 levels. The end market recovery, our strong sales execution and the above trend growth delivered in prescription management enabled us to deliver 5% year-over-year non-GAAP organic net sales growth in one of the more challenging quarters in recent memory for the global business community. Turning to slide 11. Total company consolidated non-GAAP adjusted EBITDA was $63 million for the second quarter of 2020 versus $53 million in the prior year period. The 19% year-over-year improvement was driven by an increasing contribution from our higher-margin services, including prescription management and cost containment measures implemented during the quarter in response to COVID-19 uncertainties. Excluding the skill animal care business divested on April 1, the deconsolidation of our Spanish business and the negative impact of foreign exchange, non-GAAP adjusted EBITDA increased 25% year-over-year, reflective of the meaningful progress we have made across our businesses, our focus on executing against our strategic initiatives and cost containment measures. Moving to our operating segment performance, beginning on Slide 12. North America organic net sales increased 10% year-over-year in Q2, and segment adjusted EBITDA increased 28% year-over-year, with margins expanding [ph] 130 basis points versus the prior year. The combination of above-trend prescription management growth, continued stability in our distribution sales and disciplined expense management drove the improvement during the second quarter. Drilling deeper into North American segment trends, our distribution business, organic net sales increased 2% year-over-year in Q2, with improving trends in May and strong performance in June, offsetting the sales decline witnessed in April, tied to COVID-19. Notwithstanding the impact of COVID-19 on the market, we believe our quarterly results demonstrated another quarter of stability in underlying business dynamics and external third-party data indicated that our distribution business market share was unchanged during the quarter, following a more challenging 2018 and 2019. The distribution team continues to execute well. And our focused approach is paying dividends as we work with our customers to drive their businesses forward in uncertain times. Our software business in North America also successfully managed through the adversity created by COVID-19, with good outcomes delivered alongside our telemedicine launch in April. Turning to Slide 13. With the acceleration in growth and profit contribution from prescription management or legacy Vets First Choice, we thought it would be impactful for our investors to better understand the significant progress this business has made since the merger in February of 2019. During the second quarter of 2020, net sales increased 66% year-over-year to $110 million, and we ended June with approximately 10,900 practices on our prescription management platform. Prescription management net sales continue to benefit from the launch of new customer and client engagement strategy. And the business further strengthened above its positive trend line in Q2 due to COVID-19, as e-commerce for prescription and medications spiked amidst the pandemic. In the aggregate, same-store prescription management platform sales, defined as veterinary practices enrolled on the platform in 2018 or earlier, increased 37% year-over-year during Q2, an acceleration versus the Q1 year-over-year growth rate of 25%. We are also seeing strong performance out of our 2019 and 2020 cohorts, which are on pace to be our most productive [ph] cohorts based on their current revenue ramp and customer-defined [ph] index. It is clear that the strong relationships that our distribution sales reps have with their clients is resulting in more engaged and productive enrollments. We are also very pleased with how the prescription management business is scaling with Q2 adjusted EBITDA of $11 million, a $12 million improvement versus the modest loss in the prior year and a $7 million improvement sequentially. We plan on investing in this business in the second half of 2020 to position us for further growth in 2021 and beyond. Turning to our European business segment on Slide 14. Organic net sales decreased 2% year-over-year in Q2, as COVID-19 disruption and the pull forward into March of an estimated $27 million of expected April net sales impacted results during the quarter. Organic net sales in the first half of 2020 increased 5% year-over-year, reflecting a healthy market position and the strong sales execution our European team delivered during the first half of the year despite the pandemic. We had strong Q2 net sales performance from our businesses operating in Romania, Poland, and The Netherlands. In the U.K., our largest European market, net sales declined 11% organically year-over-year during the second quarter, as the country's recovery from COVID-19 has lagged other European markets due to the duration of lockdown measures. However, we did experience better sales late in Q2 and remain optimistic about our prospects in this market as well as all of the other markets throughout Europe for the balance of the year. Turning to profitability. European segment adjusted EBITDA decreased 16% year-over-year. Excluding FX and the scil divestiture, segment adjusted EBITDA was relatively unchanged year-over-year, as the modest M&A contribution and cost containment efforts offset the COVID-19 sales disruption and the Q1 pull-forward impact of $3 million. Moving on to our APAC & Emerging Markets segment, as presented on slide 15. Our team delivered a 4% year-over-year increase in organic net sales in Q2, despite an estimated $7 million of customer stocking pull forward that occurred in March in connection with COVID-19. In the first half of 2020, organic net sales increased 12% year-over-year and reflect the momentum the region has generated, as this team continues to execute well and deliver robust financial results. During Q2, we saw notable strength in Australia and Brazil, which offset weakness in New Zealand given the lockdown measures implemented in that market. Segment adjusted EBITDA increased 25% year-over-year during Q2, driven by strong operating leverage from better than expected net sales activity and the benefit from cost actions taken in response to COVID-19. Growth was even stronger when normalizing for the estimated $1 million EBITDA pull forward into Q1 related to the inventory stocking activity. Our total company Q2 GAAP net income was $54 million or $0.40 per diluted share, which includes the benefit of a $70 million after-tax gain from the sale of the scil animal care business that closed in early April. Non-GAAP adjusted net income, which excludes the aforementioned gain as well as other special items during the quarter, was $30 million during Q2 versus $24 million in the prior year period. Turning to our balance sheet on slide 16. We meaningfully strengthened the company's financial and liquidity position during the second quarter through the sale of the scil animal health care business and the issuance of perpetual convertible preferred stock to CD&R, which combined added almost $350 million in cash to the company. As a result of these actions and strong working capital management during Q2, net debt at the end of June improved by $440 million compared to the end of the first quarter. Our reported net leverage at the end of the second quarter was three and a half times compared to 5.9 times at the end of the first quarter. Additionally, we ended the second quarter with more than $700 million in available liquidity compared to $305 million at the end of the first quarter and with 1.7 turns of headroom under our net leverage covenant as defined by our credit agreement. Finally, on slide 17, as we look ahead, we continue to balance short-term uncertainty tied to COVID-19 and the potential impact on our customers and their clients with our desire to build upon our recent momentum and to make the investments needed to execute our strategy and accelerate our sales and profit trajectory. With this framework in mind, we now anticipate adjusted EBITDA in the range of $200 million to $210 million for 2020, which is $10 million to $15 million above our pre- COVID-19 outlook issued in early March before we withdrew guidance in April, amidst the initial uncertain days of the pandemic. This guidance presumes no new major lockdowns tied to COVID-19, any substantial changes to the current environment and the animal care remains an essential business. It does incorporate the normalization of certain expenses that were either eliminated, reduced or deferred in -- given the significant uncertainty at the start of the global pandemic. Additionally, with the growth in prescription management, we are making certain investments in people and capacity to support its trajectory. Our underlying assumptions in the second half of the year also include stability in our global distribution businesses, a gradual return to more normal travel activity and benefits tied to our sourcing initiatives. I will now turn the call back over to Ben for some brief closing remarks.

[Ben Wolin:]

Thanks, Matthew. Great first call. Before my closing remarks, I want to take a moment to announce that Nick Jansen, who so many of you on this call have worked with and know so well, has recently been promoted to Vice President, Strategy and Corporate Development. We are extremely enthusiastic that he's decided to take this newly created role where we can leverage his deep understanding of the industry to help shape our path forward. I am excited about the additional contribution Nick will bring to our organization, and we thank him for building out our investor relations program as a newly formed public company. Over the next couple of months, Nick will be doing double duty until we recruit and onboard his replacement with the expectation that the transition will be complete by the end of this year. In closing and as outlined on slide 17, I am extremely proud of our team's exceptional efforts and accomplishments during Q2 to support our customers around the globe during COVID-19. Our strong second quarter financial results demonstrate our progress, and our 2020 guidance showcases the confidence we have in our business. While uncertainties tied to the global pandemic and the pace and recovery of our end market remain, our continued investment in our organizational health, innovation and customer success puts us in a strong position to capitalize on our strategic opportunities and to deliver shareholder value in the quarters and years ahead. This concludes our prepared remarks, and I will now turn the call back over to Nick to moderate the Q&A session.

[Nicholas Jansen:]

Thanks, Ben, for the kind words, and I'm enthusiastic about the newly created role. Now we'll begin the Q&A section of our conference call. We want to take as many questions as possible, so we ask that you limit them to two and then reenter the queue, should you have additional ones. So Ian, please provide instructions, and we are then ready to take the first question.

[Operator:]

[Operator Instructions] Thank you. Your first question comes from line of John Kreger of William Blair. Your line is open.

[John Kreger:]

Thanks very much. Thanks guys. My question, Ben, is if you think about the -- just, kind of, the TAM opportunity in home delivery, given the really good growth you guys have seen, can you give us a sense about how much of the market do you think today is still residing within traditional in-clinic purchases versus what's already migrated to home delivery versus what's migrated, let's say, to the full traditional e-commerce channel? Just trying to see how far it's already moved versus where you guys think it could go over the longer term? Thanks.

[Ben Wolin:]

Sure thing, John, and good to hear from you again. I think that, predominantly, the market is definitely still in-clinic, and so that there is a tremendous opportunity for online prescription management and home delivery. I would point out, however, that all of our data shows that when customer has implemented prescription management and utilizing it, we're actually growing the market and that in-clinic sales stay stable and continues to grow. And prescription management -- our online prescription management is really expanding their market opportunity, driving compliance with patients. So our view is it's not really cannibalistic. It's opportunity to grow the pie and make sure that veterinarians don't get disintermediated by other channels. But in short, tremendous running room from where the business is, both in terms of the number of customers we address, the number of engaged customers that we have and just the adoption of the platform from a global perspective.

[John Kreger:]

Great. Thanks. And then one quick follow-up, the chart where you showed the U.S. market, which is very helpful. From your perspective, have we reached a normalization? Or do you think that, we're still kind of seeing a little bit of a deceleration as we kind of move from June to July into August? Thank you.

[Ben Wolin:]

Yeah. It's obviously a bit hard to predict with COVID. What we've seen is general stability in July and early August. Obviously, there was some pent-up demand that occurred at the end of June and kind of a burst of activity. But our take on the market is that we are at or slightly above pre-COVID levels.

[John Kreger:]

Great. Thank you.

[Nicholas Jansen:]

Operator next question. Operator, can you turn to the next question, please?

[Operator:]

Sorry. My line was on mute. Your next question comes from the line of Jon Block of Stifel. Your line is open.

[Jon Block:]

Great. Thanks, guys. Good afternoon. Great numbers. Matt, maybe I'll ask you a little bit of an obvious one, but I still want to dig into it a little bit. The 1H 2020 EBITDA was, I believe, $111 million versus $103 million in 1H 2019, so call it, up 8%. If I look at your guidance for the year, the midpoint of the guidance implies 2H 2020 down, I think, roughly low single digits versus the back half of 2019. Can you just elaborate on that a little bit? Conservatism, I think you alluded to investment. I think scil is, obviously, rolling off. But maybe if you could just talk to why the implied down 2%, 3% in 2H versus the high single-digit growth you guys experienced in 1H even against the tough backdrop?

[Matthew Foulston:]

Yeah. I mean, good question. And you've hit the nail on the head with the first one that the sale of scil impacts us quite a bit more in the second half and it did in the first. We'll have, if you round it up, about a $5 million headwind from that missing from our numbers in the second half. So think of compared to flat, we're probably up five scil adjusted. And then in the first quarter, we had some well above trend growth in the prescription management business, which we anticipate will return more to trend in the back half. And then we took a lot of cost actions in the first half that included pay cuts, 401(k) matching and almost complete elimination of the travel and entertainment. We put the payback at the start of the second half to normal levels. We'll restore the 401(k) matching. So that will come in. And I think gradually, as we go through the back half, our anticipation is, we stop traveling more as the business comes back to a more footing. So a lot of those things that gave us a nice lift in Q1 won't be quite as impactful in the back half.

[Jon Block:]

Got it. That was very helpful. And then Ben, for you, just a longer-term question, and I mean, looking at a couple of years, again, the EBITDA numbers blew, I guess, everyone away on our side. But all the year-over-year growth, unless I'm mistaken, came actually a little bit over 100% from the prescription management business. And maybe, if you can just talk to your conviction or ability to derive the leverage in the supply chain business as we look out over the next couple of years, is that something where flat is good on year-over-year EBITDA growth, and you just derive most of the future EBITDA from prescription management? Or what do you think about your ability to scale supply chain longer term? Thanks guys.

[Ben Wolin:]

Yeah. Good question. Thanks, Jon. So I think that when you look at the business, especially in Q2, you had a pretty anomalous quarter with a pretty big divot in April. So we actually did – if you could look at it on a month-by-month basis as you came out of the trough in North America, Europe and APAC, you did start to see growth on an EBITDA basis, and on a top line basis in May and June, and we feel good about our ability to grow that business in the future. I think that from a top line revenue standpoint, we would expect mid-single -- low- to mid-single-digits growth in the out years on the distribution business. And as we get better from an efficiency standpoint, whether that be a cost to serve, our sourcing initiatives or taking advantage of our technology footprint, we believe that we can grow the EBITDA for that business over time.

[Jon Block:]

Very helpful. Thanks guys.

[Operator:]

Your next question comes from the line of Nathan Rich of Goldman Sachs. Your line is open.

[Nathan Rich:]

Good afternoon and thanks for the question. Ben, on the prescription management platform, could you talk about how growth kind of trended across the quarter and your expectations for the back half of the year? I think you kind of talked about maybe a little bit of normalization in the growth rate. But I'd just be kind of curious to get a little bit more color on how you're expecting that business to trend over the balance of the year?

[Ben Wolin:]

Yes. There obviously was a frenzy of activity around April and May, where we saw extremely outsized growth. But what we're seeing is that customers on the platform and consumers on the platform are getting retained. And so, we would expect not to see those extreme peak levels that we saw in early Q2, but that we would be at a growth rate higher than where we were pre-COVID. So if you think about growth rate in Q1 and Q4 where we were in the 30s percentile range, we would expect to be above that, closer to 40% or higher, but certainly not in the 60% that we saw in Q2.

[Nathan Rich:]

That's helpful. And then, just sticking with Rx management, on the margins, can you talk about how you feel about capacity and service levels right now? And you talked about needing to invest in that business. I think from a contribution margin standpoint, I think, in the second quarter was somewhere in the high 20% range. Do you think you can kind of maintain contribution margins around those levels, while investing in the growth of the platform, just kind of given the sales that you've seen kind of shift to that channel?

[Ben Wolin:]

Yes. Good question. So I think from a capacity standpoint, while there certainly was a slowdown in early Q2, along with probably every other online retailer out there, whether you are in our category or not, the team really did a great job of catching up and from time from a order to actually delivering the product has improved immensely, and we're on par with the competition. And really, we look at Amazon as the bellwether for any kind of online transaction and feel like we are delivering at similar rates. So we feel good about that. However, the business is continuing to grow. It's not flat lining, as I just suggested and as you asked. And so we need to continue to invest in the business' capacity, not just for the back half of this year, but really for 2021 and 2022. So that is what provides a little bit of that drag on back half EBITDA. But we want to take advantage of the momentum we have and really build that business for the long term.

[Nathan Rich:]

Makes sense. Thanks for the questions.

[Operator:]

Your next question comes from the line of Andrew Cooper of Raymond James. Your line is open.

[Andrew Cooper:]

Thanks, guys. Just, I guess, starting with one sort of on prescription management here and the growth rates like you talked about. I mean is there anything we should think about in terms of folks that are ordering in the 2Q time period that are on maybe six month cycles, and we don't have the same pressing move that would imply a little bit of that deceleration? Because by my math, just to stay flat with the 2Q dollar amount, you're talking about something that's into the 50-plus percent range. So any sort of moving parts as we think about the rush of people that may be ordered in 2Q when they weren't leaving the house versus how we think about what that might look like in 3Q? Any comment there would be useful.

[Ben Wolin:]

Yes. I think there's a combination of factors. I think there definitely was some pent-up demand, and we saw kind of a rush to stock up by the consumer. We also saw a very healthy companion animal category here in the U.S., which some of our peers like Zoetis and IDEXX talked about in their own results. And I think if we just look forward and look at our kind of near-term July and early August results, we know that it's going to dissipate a bit. But a lot of those -- our expectation and early data as a lot of those consumers from Q2 will perform like previous cohorts of consumers and that will have sustained really positive ahead of kind of pre-COVID performance here in the back half and into 2021.

[Andrew Cooper:]

Okay. That's helpful. And then to the distribution side, I guess, maybe just the latest thinking and this is probably a question you're tired of answering, but obviously, you had a big transaction close in terms of the customer base -- the manufacturer base for you and you've had some exciting new products on the preventive side. So kind of the latest update on those two would be great. And if you've seen anything or expect sort of any changes from those, whether it's opportunity with Elanco, Bayer or sort of how you view that as we think about it in the most recent period would be great?

[Ben Wolin:]

Yes. I think if you look at the first half performance and we mentioned this in the prepared remarks that we feel like we held our market share here in the first half, which is an improvement from 2019 and 2018, where we definitely lost market share. It seems like a robust market going forward, a competitive one with some of the new product introductions, definitely some movements here with some of the suppliers, as Elanco has bulked up. But in general, we feel, I would say, optimistic about the environment for distributors here in the back half and going into 2021.

[Andrew Cooper:]

Great. I’ll stop there. Thanks, Ben.

[Ben Wolin:]

Yep.

[Operator:]

[Operator Instructions] Your next question comes from the line of Kevin Kedra of G- Research. Your line is open.

[Kevin Kedra:]

Hi. Thanks for taking the questions. First, I wanted to ask about the -- you mentioned the international expansion opportunity. And really how should we be thinking about that not only in terms of time lines, but geographic rollout? Is that something that you expect to kind of take on a country-by-country basis at this point? Or could we expect a broader rollout across Europe?

[Ben Wolin:]

Sure thing. So it will definitely be a country-by-country rollout focus on both Europe as well as the APAC region. We're building the foundation of that right now and would expect to have some solutions in market in 2021. I think from a P&L impact in 2021, it would actually be a slight negative as we continue to invest and build out the commercial capabilities there and would start to contribute in 2020 -- in 2022.

[Kevin Kedra:]

Great. Thanks. And then I just wanted a clarification on the slide on liquidity and leverage. Traditionally, your reported leverage was usually about 0.5 turn to one turn higher than what it was under the credit agreements that reversed in Q2. Wondering if that's just a function of the cash balance? Or is there something else going on there?

[Matthew Foulston:]

Yes. The definition of leverage caps the contribution from cash. I think it's at $125 million. So cash above that doesn't help lower your leverage under the debt covenant. So we get a little relationship between what I'll call the street calculation and the bank covenant calc.

[Kevin Kedra:]

Okay. Thanks.

[Operator:]

There are no further questions over the phone lines at this time. I turn the call back over to the presenters.

[Nicholas Jansen:]

Thank you for listening in on the conference call. You may now disconnect. I hope everyone as well. Thank you.

[Ben Wolin:]

Thank you, everyone.

[Operator:]

This concludes today's conference call. You may now disconnect.