Covetrus, Inc.
Q4 2020 Earnings Call Transcript

Published: 1 Mar 2021

[Operator:]

Good morning, ladies and gentlemen, and welcome to the Covetrus Fourth Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder this conference call is being recorded. I would now like to turn the conference over to your host Mr. Nick Jansen, Vice President Strategy and Corporate Development. Please go ahead.

[Nick Jansen:]

Thank you, Jerome. Good morning and thank you for joining us for Covetrus' Q4 and full year 2020 earnings conference call. 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.

[Ben Wolin:]

Thanks Nick. Good morning everyone and thanks for joining us today. I hope everyone is staying safe and I'm looking forward to the day, hopefully sometime later this year, when we all can spend time again together in person. On the call this morning, we will provide an update on the state of the companion animal end market; highlight our stronger-than-expected Q4 and full year 2020 financial results; detail our investment growth and margin priorities for the upcoming year; and outline why we think 2021 will be another period of growth and operational progress as we capitalize on the opportunity in front of us. Now, starting on slide three with our perspectives on the current state of the companion animal end market. As many of you may already know the companion animal industry is a growing market and has proven to be quite resilient despite the disruption that COVID-19 has caused around the world. Increased pet adoptions, the ongoing humanization of pets, innovation around enhanced standards-of-care, and the expansion of new service channels have raised global demand for our products and services.

[Matthew Foulston:]

Thanks Ben. Good morning everyone and thanks for joining us today. I will now review our fourth quarter and full year 2020 financial results and provide additional details on our 2021 guidance. The focus of my comments will be on our 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 fourth quarter and full year 2020 GAAP results. As summarized on Slide 11, we finished 2020 with momentum across our businesses with all three reporting segments contributing to our growth and outperformance versus expectations for the fourth quarter. Favorable end-market conditions and our strong operating execution drove a 19% year-over-year increase in adjusted EBITDA and fueled 30 basis points of year-over-year adjusted EBITDA margin expansion during the fourth quarter. Additionally, our net leverage ratio improved to 3.5 times and we ended the year with approximately $590 million of liquidity, including $290 million in cash and cash equivalents on the balance sheet. Turning to the details and starting at the top of the income statement on Slide 12. Covetrus net sales were approximately $1.12 billion in Q4, an increase of 11% year-over-year on a reported basis. Organic year-over-year net sales growth was 12% during the fourth quarter and 10% for the full year 2020, reflecting underlying healthy companion animal market trends that are tracking at or above pre-COVID-19 levels across our major geographies, our improved sales execution and market position in a number of our key markets and the positive trajectory of our prescription management business. While there were some discrete items in Europe that will impact consolidated net sales growth in 2021, which I will detail later, we anticipate another year of strong underlying growth as we capitalize on positive end-market conditions and execute our strategic priorities, while still investing for growth. Turning to Slide 13. Consolidated non-GAAP adjusted EBITDA was $56 million for the fourth quarter of 2020, compared to $47 million in the prior year. The 19% year-over-year improvement reflected strong contributions from our North America and APAC & Emerging Market segments, which more than offset the impact from the divestiture of scil and continued growth in overhead as we complete the build-out of the infrastructure necessary to support our independence as a public company. For the full year 2020, as shown on Slide 14, consolidated non-GAAP adjusted EBITDA was $226 million, compared to our November guidance that quote for $213 million to $218 million in adjusted EBITDA and the $200 million reported in the prior year. I would also note that full year results came in significantly ahead of our initial 2020 guidance offered at this time last year, despite the uncertainty created by the COVID-19 pandemic. The 13% year-over-year growth reflected significant improvements in profitability in our prescription management business in North America as well as the increased earnings contribution from our supply chain businesses in all three reporting segments, which reflected healthy top line performance and the impact of cost-containment actions. This growth was partially offset by the aforementioned increase in corporate overhead to support our transformation as a new public company and the lost earnings contribution from the divestiture of scil animal care. Additionally, there was also a several million dollar year-over-year headwind in 2020 tied to increased bonus accruals compared to 2019 given our stronger financial performance that exceeded internal expectations. Moving to our quarterly commentary for our operating segments beginning on slide 15. North America net sales increased 17% year-over-year on both a reported and organic basis in Q4 and segment adjusted EBITDA increased 25% year-over-year with segment adjusted EBITDA margins expanding 50 basis points versus the prior year. Strong net sales growth in our supply chain business and another quarter of greater than 40% net sales growth in prescription management contributed to our positive performance in the fourth quarter compared to the prior year. Drilling deeper into North American segment trends, starting on slide 16. Our supply chain business organic net sales increased approximately 14% year-over-year in Q4 and 7% for the full year reflective of healthy end-market demand and our improved market position. External third-party data indicated that our US distribution business grew companion animal market share during the fourth quarter relative to the prior year driven by new account wins, our better execution over the last 12 months as well as the benefit from certain manufacturers reducing the number of distributor relationships they utilize in the US market. Encouragingly, we were able to leverage our improved market position and double-digit organic net sales growth to deliver a significant improvement in profitability with supply chain adjusted EBITDA increasing to $37 million compared to $26 million in the prior year period. Our North American software business was generally stable during the quarter and for the full year. As Ben mentioned earlier, we are making significant investments in our software capabilities that we expect to drive growth in 2022 and beyond. Turning to slide 17 and our prescription management business in North America. During the fourth quarter of 2020, net sales increased 46% year-over-year to $107 million and we ended the year with more than 11,100 practices on the platform. Of note, we added approximately 200 net new enrollments during the fourth quarter of 2020 compared to 50 net additions during the third quarter. We have a funnel of good customer prospects and an aligned sales force to drive an increased number of practice enrollments in 2021. The 46% year-over-year prescription management net sales growth delivered in Q4 was an acceleration over third quarter growth rates and once again tracked above our pre-COVID-19 trajectory as the business continues to benefit from new customer and client engagement strategies. Same-store prescription management platform net sales defined as veterinary practices enrolled on the platform in 2018 or earlier increased 26% year-over-year during Q4 and 28% for the full year which was well ahead of the 16% year-over-year same-store sales growth reported in 2019. Impressively, all cohorts experienced double-digit year-over-year net sales growth for the year and the 2019 cohort had the most productive first year in company history. Encouragingly, the early full year data on the 2020 cohort suggests similar strength as our 2019 cohort. We also continue to make progress in scaling the financial performance of our prescription management business, with Q4 adjusted EBITDA of $2 million or $6 million when excluding a $4 million legal reserve taken during the quarter for historic litigation at legacy Vets First Choice, giving us a $3 million underlying improvement versus the prior year. For the full year and when adjusted for the legal reserve, 19% of the year-over-year dollar growth in pro forma net sales dropped down to adjusted EBITDA, which is at the high end of our 15% to 20% target on a rolling 12-month basis. As a reminder, investments tend to be lumpy quarter-to-quarter and therefore, we believe looking at this metric over a 12-month period is the best way to evaluate our success in driving disciplined growth in this business. Turning to our European business segment on Slide 18. Organic net sales increased 5% year-over-year in Q4 and 6% for the full year, reflecting end-market growth and strong sales execution by our European team, despite the challenges presented by COVID-19. We had healthy Q4 organic net sales performance from our businesses operating in the Netherlands, Ireland and Romania. Strength in these markets helped offset significant weakness in Germany and France. As a reminder, our 3PL transition in Germany has not been as smooth as anticipated and we exited our low-margin supply chain business in France at the end of the year, given market challenges. These two items will collectively reduce 2021 revenue by more than $70 million relative to 2020 levels. Turning to profitability. European segment adjusted EBITDA in Q4 was flat year-over-year at $18 million with margins declining 10 basis points year-over-year to 4.5%. It's important to note that, if we exclude the impact of the divestiture of scil, the noise around our JV in Spain and the impact of FX, European segment adjusted EBITDA increased 15% year-over-year and margins expanded 40 basis points, reflecting solid underlying operating leverage on mid-single-digit organic net sales growth. Moving on to our APAC & Emerging Markets segment on Slide 19. Our team delivered a 14% year-over-year increase in organic net sales for both Q4 and full year 2020 maintaining our recent momentum and reflecting our strong sales execution. We continue to see strong double-digit growth in Australia and Brazil with more modest growth rates in New Zealand. Gross margins expanded 90 basis points year-over-year in Q4, as we continued to make good progress driving our proprietary products. Segment adjusted EBITDA increased 80% year-over-year during Q4 and margins expanded by 280 basis points year-over-year, driven by gross margin improvement and the positive operating leverage from better-than-expected net sales as well as strong cost discipline. Turning briefly back to our consolidated results. Q4 GAAP net loss was $4 million or a loss of $0.04 per diluted share. Non-GAAP adjusted net income, which excludes special items as well as acquisition-related intangibles, amortization and other items was $28 million during Q4 versus $20 million in the prior year period. Now turning to our balance sheet on Slide 20. Our reported net leverage at the end of the fourth quarter was 3.5 turns as compared to 3.6 turns at the end of the third quarter and now sits at the top end of our long-term targeted range of three to 3.5 times. Our cash balance dropped to approximately $290 million at December 31, 2020, as compared to $355 million on September 30, 2020, primarily reflecting our decision to prepay the $60 million in term loan principal amortization for 2021 in December of last year, which will reduce our interest expense by more than $600,000 this year. Underlying cash generation was positive during Q4 and the improvement in adjusted EBITDA year-over-year enabled the sequential improvement in our net leverage ratio at year-end. We ended Q4 with nearly $590 million in available liquidity and with 2.3 turns of headroom under our net leverage covenant as defined in our credit agreement. With our balance sheet now in a much stronger position, we have flexibility in 2021 to fund both internal investments and pursue external growth opportunities. Now turning to our 2021 guidance, as outlined on Slide 21. We continue to forecast adjusted EBITDA in the range of $240 million to $250 million for 2021. This outlook balances the underlying momentum we have across many of our businesses entering the year with planned investments to support future growth, as well as the impact of discrete challenges in Europe. Additionally, our outlook assumes an end-market growth rate that is closer to the historical trend line of mid-single digits versus the above-trend growth rates seen in many of our markets in 2020, driven by COVID-19. With this market framework in mind, our year-over-year organic net sales growth is expected to be 2.5% to 3.5% in 2021. This includes strong net sales performance in North America, which is expected to grow low-teens year-over-year organically, including 30% to 40% year-over-year growth in prescription management and mid to high-single-digit year-over-year growth in supply chain. Europe is expected to decline low-teens year-over-year in 2021 on an organic growth basis. This includes an approximate 30% year-over-year sales decline in the UK tied to a manufacturer and customer loss and the continued challenges in Germany tied to our ongoing 3PL transition, which we forecast will reduce net sales in that market by nearly 20%. Excluding these two markets, our European segment is expected to grow low to mid-single-digits and in line with market growth rates for the region. APAC & Emerging Markets is also expected to grow in the low to mid-single-digits year-over-year in 2021 on an organic basis off a challenging year-over-year comparison. In total and when excluding the discrete headwinds in the UK and Germany, our organic year-over-year net sales growth in 2021 is expected to be in the high single-digits, which is more reflective of our long-term growth opportunity. Other elements of our 2021 guidance including capital expenditures of $55 million to $65 million, of which approximately two-thirds is focused on growth; and adjusted EBITDA to free cash flow conversion between 30% and 40%, which is an improvement versus 2020 performance as we cycle through some of the more significant one-time cash costs tied to our transformation. We continued to target 50% adjusted EBITDA to free cash flow conversion over the longer term. And as we think about the quarterly cadence for 2021, we expect the first half of the year to reflect more challenging year-over-year comparisons given the temporary cost-containment actions implemented last year during the height of the COVID-19 uncertainty, the timing of certain investments in 2020 and the spike in net sales seen in our prescription management business, tied to the start of the pandemic last year. Additionally, the first quarter of 2021 has two fewer selling days year-over-year has faced some incremental weather-related headwinds and will face a more difficult comparison as a result of the COVID-19 inventory stocking dynamics during March of 2020 in many of our international markets. Lastly, we anticipate growth in our prescription management business to track towards the lower end of our 30% to 40% year-over-year growth target in the first half of 2021 and the higher end of the target in the second half of the year, reflective of the COVID-19-related year-over-year comparison dynamics just described, as well as certain discrete factors such as major supplier shortages in therapeutic diets, and some shipping challenges at our primary carrier in the first quarter. Taking these aggregate net sales items as well as the timing of certain investments into consideration we expect adjusted EBITDA in the first half of the year to approximate 45% of our full year 2021 guidance. With that, I'll now turn the call back over to Ben for some brief closing remarks.

[Ben Wolin:]

Thanks, Matthew. In closing and as outlined on slide 22, we have a solid foundation in place after delivering a very successful 2020 and we have good visibility and a clear plan for our efforts to deliver another strong year in 2021. Our end market is healthy and has proven durable throughout COVID-19, and our differentiated value proposition is resonating in the marketplace, which is giving us confidence to further invest in people and innovation to advance customers' growth objectives. We are confident in our strategy and believe we are well positioned to deliver improved outcomes for our customers, their clients and our manufacturer partners and create shareholder value as we capitalize on our opportunity and expand our margins. This concludes our prepared remarks, and I will now turn the call back over to Nicholas Jansen to moderate the Q&A session.

[Nick Jansen:]

Thanks Ben. Now we begin the Q&A section of our 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 Jerome please provide instructions and we are ready to take the first question.

[Operator:]

Your first question comes from the line of John Kreger with William Blair. Your line is open.

[John Kreger:]

Hi. Thanks very much. Hi, guys. Ben, could you talk a little bit more about how you're going to address some of the issues that you've mentioned in Germany in particular? How long will it take to get that fixed? And when would you expect growth in that region to normalize?

[Ben Wolin:]

Yeah. Thanks John. Good to hear from you. The team has, obviously, been very focused on that and we're disappointed with how challenging the transition was. It has started to get better really in Q4 and early into Q1, but I expect it will still be challenging through the first half of 2021. But we do think that our market position will be able to be -- will start to grow again in the back half of next year -- of this coming year, sorry.

[John Kreger:]

Got it. Thank you. And then you outlined -- it sounds like you're investing in compounding with some new fulfillment assets. Any plans to take that to Europe or Asia?

[Ben Wolin:]

Yeah. I think in the long-term that's certainly an opportunity. There's, obviously, as you know different regulatory environments in those different countries. I think for now at least in the short-term the focus is squarely on North America when it comes to compounding. We feel like we really are in a unique place given our sales access, our prescription management platform, our investment in facilities product development. So I think that that can be a big growth driver both on the top and bottom line in 2021 for us.

[John Kreger:]

Okay. Thank you.

[Operator:]

Your next question comes from the line of Balaji Prasad with Barclays. Your line is open.

[Balaji Prasad:]

Hi, good morning, and congratulations on the results. A couple of questions from me. Firstly, on the operating margin side, I find it interesting that APAC and EM at 7.9% is higher than North America at 7.4%. So can you help us understand these dynamics? And also try to get a sense of the underlying EBITDA or optimal EBITDA for both of these of regions. Secondly on VSG, are you in a position to provide some update now since your investment? Any operational changes done, and anything in terms of tangible progress or changes that we can see in the near-term? Thank you.

[Ben Wolin:]

Sure thing. Why don't -- I'll let Matthew answer the first part of your questions on APAC operating margins, and I'll handle the second part of the question on VSG.

[Matthew Foulston:]

Yeah. I think, we enjoy a really nice market position in APAC. We've got a fantastic team down there that's been really delivering tremendously for the last 18 months. And in fact we see nothing, but further opportunity down in that region as we think about the possibility of taking the prescription management platform down there. So I think that's an area where you'll see us focus and we're really proud of the performance. We talked a lot about the work we need to do to improve our margins across the board and drive that EBITDA margin closer towards 10% over time. And a lot of what Ben talked about is our focus in those key areas on that slide around prescription management, around the proprietary brands and around compounding where we do enjoy those premium margins. And that's where the focus of our investments and our efforts are.

[Ben Wolin:]

Yeah. And Balaji as it relates to VSG, obviously, we're about one quarter into that acquisition, so far so good. It really is a great asset uniquely positioned as a study group partner for the veterinary industry. And in the coming quarters what investors as well as VSG members should come to expect is more and more innovation coming out of Covetrus that has brought to them in a unique fashion whether that's bringing things like prescription management and compounding combined with distribution together with them in a unique selling model. So it's still early, but we're cautiously optimistic about the progress that we can make on that front.

[Balaji Prasad:]

Thank you.

[Operator:]

Your next question comes from the line of Jon Block with Stifel. Your line is open.

[Jon Block:]

Great. Thanks, guys. Good morning. A long first one and I'll try to keep the second one tighter. But for the quarter the $56 million versus $47 million in adjusted EBITDA so up $9 million, but I just want to make sure scil was a $3 million headwind and the $4 million legal Matthew is in the $56 million call it. And then maybe it depends on how we want to count bonus payments. I guess what I'm trying to get out there is normalized, do we think about year-over-year growth closer to 30% plus versus what you guys printed? And then a tack on to that is how do we think about the corporate overhead in 2021 versus 2020? I think that was a pretty big $22 million headwind in 2020? Thanks.

[Matthew Foulston:]

Yes. Let me start with the legal reserve. That is in that number and was a headwind. And obviously as you mentioned scil was another drag on earnings. So Q4 was a positive surprise for us. We had strength in all three markets beyond what we expected. I think when the market's going to deeper lockdown it seems to drive more activity with people and their animals. And we were pleasantly surprised across all three markets in the fourth quarter.

[Jon Block:]

Okay. Great. And for that charge the follow-up just for the 2021, how we think about corporate in terms of the year-over-year headwind?

[Matthew Foulston:]

Yes. I don't think you'll see anything really material in corporate. It will be up a few million nothing like the progress we had to make in getting off those 72 TSAs in 2020 which took a lot of standup of corporate capability.

[Jon Block:]

Got it. Perfect. And then, sort of, a longer-term question Ben. If you could just talk to I think you alluded to the 10% long-term adjusted EBITDA margins that you drew out there. Maybe if you could talk to the timing behind that and the construct. In other words do we think about a supply chain and software base of call it 7% to 8% or high single-digits; prescription management 15% plus; and then when you weight the two out you arrive at that 10% bogey? Thanks for your time.

[Ben Wolin:]

Yes. I think the -- it really is reflective of a revenue mix shift that is already occurring inside of the business. In my prepared remarks, I mentioned that gross profit on a total basis is now -- 40% of that gross profit is coming from products and services that are unique to the company whether that be proprietary brands or compounding or prescription management. So the driver of going from 5% to 10% adjusted EBITDA margin is that increased penetration of those unique services. We do think distribution revenue will continue to grow, but certainly not grow at the pace of those other efforts. In terms of timing, it's a multiyear ambition, but we think that every year that we can make steady progress in that direction. And I think 2020 was reflective of a kind of a first step on that path.

[Jon Block:]

Perfect. Thanks for your time guys.

[Ben Wolin:]

Yes.

[Operator:]

Your next question comes from the line of David Westenberg with Guggenheim. Your line is open.

[David Westenberg:]

Hi. Thanks for taking the question and congrats on a really great year here. Just can you talk about the prescription management potential in Europe? I know early in the acquisition rationale, it was about the revenue synergy about building on the Covetrus or the legacy Henry Schein business there. And how that kind of -- might help you in terms of your growth in kind of a tough macro in Europe?

[Ben Wolin:]

Yes. Clearly there's long-term opportunity all over the world I think for prescription management. I mean generally the value proposition is one that we think can resonate in every market. For the company what we're balancing is just obviously a wide hot opportunity here in the US and how much capital we should invest in the short-term against international expansion versus US opportunities. So I do think that it can help us in a market like the UK, which we mentioned is under pressure in terms of our value either to customers or manufacturers. But I think in terms of the P&L, we don't expect significantly an impact in 2021 on any international expansion.

[David Westenberg:]

Got it. All right. No. Thank you very much. And then how should we think about the move to the cloud in PIMS? And then, strategically, how we should think about the PIMS business? Should we still think about this as kind of a bridge between distribution and prescription management, or maybe that was how I thought about it, not necessarily how you thought about in terms of a long-term strategic use of -- you have your very high market share in the PIMS and, obviously, that's my last question. Thank you.

[Ben Wolin:]

Yes. No, I think, it's a good way to think about the business. It's clearly kind of a nexus for the other parts of the business. And while it hasn't been a big top line grower, it's obviously a very significant EBITDA contributor. And on top of that, it's a real gateway to our other products and services. So one of the things that we mentioned in the script is we are now surfacing prescription management opportunities embedded into AVImark and eVetPractice. And that's just kind of one of many different things that we'd look to do in terms of using our PIMS footprint to drive adoption of other Covetrus products and services. So the investment in the cloud is really all about both, a modernization of that system, which should be a benefit to both our customers in terms of ease of use, maintainability, access to upgrades, as well as an ability for the company to do faster integrations of various products and services across the Covetrus family.

[David Westenberg:]

Thank you.

[Operator:]

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

[Nathan Rich:]

Hi. Good morning. Thanks for taking the questions. I guess I wanted to start off with the EBITDA guidance and trying to kind of marry it with the top line outlook that you gave. It seems like, when we think about the growth in the prescription management business, that seems to be the primary driver of the EBITDA growth year-over-year. And I guess -- Matt, I guess, I'd be curious just to kind of get your view. When we look at kind of the underlying businesses across the different regions, do you feel like that the kind of growth in kind of North America and APAC is kind of balanced by the headwinds that you called out in Europe, so we should think of that kind of the supply chain business is relatively flattish and the prescription management business is kind of driving the incremental growth in EBITDA year-over-year, if that makes sense?

[Matthew Foulston:]

Yes, I think, in a general sense, that's a good way to look at it. Clearly, dropping down 20% of the incremental revenue to EBITDA in that business, as we've consistently shown now, is a nice driver of profit going forward. We think the distribution business is going to be strong in North America and we think it will be pretty strong again in APAC. Europe does present a bit of a drag here, both in the U.K. and Germany. As Ben said earlier, we think we can see a path to things improving in Germany in the back half. But I think that's sort of the broad strokes. I think you got it right.

[Nathan Rich:]

Okay. That's helpful. And Ben, maybe looking a little bit longer term. It's interesting, the slide that you guys had on sort of the incremental gross margin across the different businesses. When we think about like the software services business, that growth seems to have been relatively flattish. I guess what do you feel like it's going to take to drive growth in that segment? And what type of growth do you think is reasonable kind of over the long term? Because if you can grow that business, obviously, very accretive from a margin standpoint. So I would just be curious to get your outlook for that segment there.

[Ben Wolin:]

Yes. 2020 was such an interesting year on so many fronts. I think on products and services that require the customer to make significant changes to their business, we saw a huge pullback. And I think you hear about that from other peers in our category as well. So software, clearly, fits into that category. And I think that we're just not in a position to want to make large wholesale changes to their practice. So we do think that business can reaccelerate into kind of a mid-single digits grower. I would also just point out though that, for us, and David Westenberg kind of alluded to this in his questioning, the PIMS is really this great gateway to other parts of the business. So like in the U.S., where we're close to a 60% market share for that business and with prescription management sitting at around 1/3 of market share, the combination of those two software assets together, from an end-user standpoint provides this great on-ramp for prescription management. So, when I evaluate the success of that business, I think about both -- it on a stand-alone basis how much revenue and EBITDA is it producing as well as its ability to drive other incremental products and services for Covetrus. And certainly in 2020 and 2019 we would have never had the prescription management growth that we did, if it weren't for the installed base of our PIMS business.

[Nathan Rich:]

Make sense. Thank you.

[Ben Wolin:]

Yeah.

[Operator:]

I am showing no further questions at this time. I would like to turn the conference back to Nick Jansen.

[Nick Jansen:]

Thank you so much Jerome. And thanks for everyone for attending today's call. We hope to connect with all of you in the coming months, at several investor conferences. We'll talk soon. Thank you.

[Operator:]

Ladies and gentlemen, this concludes today's conference. Thank you for your participation. And have a wonderful day. You may all disconnect.