Invacare Corporation
Q3 2014 Earnings Call Transcript

Published: 23 Oct 2014

[Operator:]

Welcome to the Invacare 2014 Third Quarter Conference Call. I will begin with the customary Safe Harbor Statement that this conference call may include statements regarding anticipated or future developments that are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are those that describe future outcomes or expectations that are usually identified by words such as should, could, plan, intend, expect, continue, forecast, believe, anticipate and include for example, any statements made regarding the company's future results. The actual results may differ materially as a result of inherent uncertainties and risks, including the risk factors described in the company's Form 10-K and other filings with the Securities and Exchange Commission and in the company's earnings release, we refer you those risks factors. The company may not be able to predict and may have little or no control over the factors or events that may influence this financial results. Also of note, except for free cash flow, the financial information for all periods excludes the impact of discontinued operations. Discontinued operations include Invacare Supply Group, the company’s former domestic medical supplies business that was divested on January 18, 2013. Champion Manufacturing Incorporated, the company’s former domestic medical recliner business for dialysis clinics that was divested on August 6, 2013. And Altimate Medical Inc the company's former manufacturer of stationary standing assistive devices for use in patient rehabilitation that was divested on August 29, 2014. Champion was part of an institutional products group segment and Altimate was a part of North America Home Medical equipment segment. On today's call, the management team will focus on highlights of the quarter as opposed to covering all the detail which you can refer to in the release that was issued earlier. In particular, I would refer to investors to the company's earnings release to review the definition of free cash flow and some of the adjusted earnings items which maybe mentioned during the call. You can find the release and access to the company's SEC filings at www.invacare.com. Before I turn the call over to Invacare's Interim President and Chief Executive Officer and Chief Financial Officer, Mr. Robert K. Gudbranson. I would like to remind you that all phone lines have been placed on mute for the first part of the call. After the management overview, we will open the call to questions. This conference is being recorded, Thursday, October 23, 2014. I would like to turn the call over to Mr. Gudbranson. Mr. Gudbranson you may now begin.

[Robert Gudbranson:]

Thank you and good morning. With me on today's call is Lara Mahoney, Director of Investor Relations and Corporate Communications. We will begin this morning's call with a review of four of the company's key activities in the third quarter. First in August we took an important step to improve the profitability in North America HME and Asia-Pacific businesses by announcing a restructuring that is expected to generate $14 million to $15 million in annualized pretax savings in 2015. The restructuring impacted approximately 150 associates and 40 temporary associates. Second we continue to be focused on managing our debt exposure during the third quarter. We announced the sale of Altimate Medical in August and used the net proceeds of $21.9 million to reduce total debt outstandings to 26.9 million which included only 8 million drawn on the revolving credit facility as of September 30, 2014. Third, the company announced an amendment to its existing credit facility on September 30 that provides us with additional flexibility in calculating our financial covenants through the duration of the credit agreement. Specifically the amendment allows for the add-back to consolidated EBITDA of warranty expense accruals upto $10 million and the subtraction of related cash payments when paid. And finally the company continued it's negotiations during the quarter to enter into a new credit facility as it's existing credit facility matures in October 2015. Before presenting Invacare's consolidated results I would like to spend a few moments giving you a background on the $9.3 million warranty expense for three specific product issues. First the company recorded a warranty expense of $6.6 million for a potential field action that is under review related to a component in stationary oxygen concentrators that were manufactured in the company's Suzhou, China facility and sold globally. The component is no longer used in current production. The company is reviewing reports in Europe of four incidents none of which caused any patient injuries. While there have been no reported incidents in the U.S. or elsewhere, we take patient safety very seriously, which is why we are evaluating the need for a field action. The expense was recorded in the European and North American HME segments. Second, the company recorded a warranty expense of $2.1 million for the recall of sieve bed component within stationery oxygen concentrators manufactured during August 2014. This expense was recorded in the North America/HME segment. The third warranty expense of 0.6 million related to the previously announced joystick recall and that was accrued as a result of product mix towards higher cost joysticks. The expense was recorded in North America/HME and Asia Pacific segments. Now I would like to review the company's consolidated third quarter results. Despite the organic net sales decline in the pressure on the gross margin, primarily due to the warranty expense I just described, the company did improve earnings before tax in three segments as we will describe later and generated free cash flow during the quarter for the whole company. In the third quarter 2014, organic net sales declined by 6% compared to the same period last year as increased organic net sales in the European and Asia Pacific segments were more than offset by an organic net sales decline in the North America/HME and IPG segments. Gross margin as a percentage of net sales in the third quarter was lower by 1.6 percentage points compared to the third quarter of last year excluding the incremental warranty expense gross margin as a percent of net sales for the third quarter of 2014 increased by 1.3 percentage points in large part driven by product cost reductions. In the third quarter SG&A expense increased by 0.6% to 98.2 million compared to 97.6 million in the third quarter of last year. Foreign currency translation increased SG&A expenses by $0.8 million or 0.8 percentage points. Excluding the impact from foreign currency translation, SG&A expense decreased by 0.2% compared to the third quarter of last year, despite an increase in regulatory and compliance expenses and an incremental expense related to the retirement of an executive officer. These increased costs were entirely offset by reduced associate and bad debt expenses, excluding incremental warranty expense and the write-down of intangible assets, the European, Asia Pacific and Institutional Product Group segments all showed improvement in earnings before income tax during the quarter. That improvement was offset by continued pressures in the North America/HME segment. Consolidated adjusted loss per share was $0.56 in the third quarter of 2014 compared to an adjusted loss per share of $0.26 in the third quarter of 2013. While the adjusted net loss per share for the third quarter of 2014 was greater than that for the third quarter of 2013 it was impacted by a loss of $0.27 per share related to incremental warranty expenses and the expense of $0.06 for the retirement of an executive. Without those two changes the adjusted net loss per share would have been flat with prior year. However, I want to emphasize that we recognize that we have more work to do to improve the business. Finally, the company reported free cash flow, a positive $14.3 million compared to a negative free cash flow of $17.3 million in the first six months of 2014. The third quarter 2014 free cash flow was primarily driven by decreased accounts receivable and increased accrued expenses, partially offset by the net loss for the period. I'll now turn the call over to Lara to discuss additional financial results for the third quarter.

[Lara Mahoney:]

Thank you, Rob. All the references to earnings for forecast exclude restructuring costs. The European business segment's organic net sales in the third quarter increased 2.7% related to increases in net sales of lifestyle and mobility and seating products. Earnings before income taxes decreased by $1.4 million, this decrease in earnings before income taxes was attributable to an increased warranty expense of $3.4 million recorded in the third quarter of 2014 related to the previously described potential field action that is under review. Excluding this incremental warranty expense, Europe's earnings before income taxes increased $2 million primarily attributable to volume increases and an improved gross margin driven by favorable customer and product mix and lower product costs, including favorable foreign currency transactions. These benefits were partially offset by increased SG&A expense primarily attributable to associate costs. For the quarter-ended September 30, 2014 organic net sales for the North American/HME segment decreased by 14.8% compared to the third quarter last year, driven by declines in all product category, loss before income taxes in the North America/HME segment increased by $9.2 million. The increased loss for the quarter was primarily driven by volume decline and reduced gross margin which was impacted by increased warranty expense of $5.6 million. This increased loss was partially offset by decreased SG&A expense, which is primarily attributable to reduced associate costs and bad debt expense. This was somewhat offset by increased regulatory and compliance costs. For the third quarter 2014, organic net sales for the institutional products group decreased 10.3% driven primarily by declines in bed sales. Earnings before income taxes declined by $7.7 million compared to the third quarter last year. The third quarter of 2014 net loss included an intangible asset impairment charge of $8.3 million, excluding this charge, earnings before income taxes increased by $0.6 million primarily attributable to reduced warranty and associate costs partially offset by volume declines. In the third quarter, organic net sales for the Asia-Pacific segment increased 2.9% due to volume increases at the company's distribution business in Australia. This increase was partially offset by declines in both the company's subsidiary that produces microprocessor controllers and the New Zealand distribution business. For the third quarter, the Asia-Pacific loss before income taxes improved by $0.8 million. The reduction in lost before income taxes is attributable to volume increases and reduced SG&A expense, partially offset by increased warranty expense. Total debt outstanding which includes the convertible debt discount as described in the release was $26.9 million as of September 30, 2014. The company's total debt outstanding consists of $8 million drawn on the revolving credit facility, $13.4 million in convertible debt and $5.5 million of other debt. The company's debt levels as of September 30, 2014 decreased as compared to June 30, 2014 primarily as a result of the application of $21.9 million of net proceeds from the divestiture of Altimate as well as positive free cash flow. The Company's ratio of debt to adjusted EBITDA for the trailing 12 months was 1.8 as of September 30, 2014 compared to 2.8 at the end of the second quarter 2014. The September 30th ratio includes the net positive adjustment to adjusted EBITDA of $9.1 million as permitted under a provision of the recent debt amendment allowing for the added back to consolidated EBITDA of warranty expense accrual up to $10 million and the subtraction of related cash payments when paid. I'll now turn the call back over to Rob for a few closing comments. We then can address questions.

[Robert Gudbranson:]

Thank you, Lara. At this point, I'd like to address our status relating to the consent decree. Since the beginning of August, I've been actively engaged with our quality and regulatory team, which we have expanded over the past few years and developing action plans and next steps related to our quality systems remediation. With the help of the new consulting firm that we engaged earlier this year, we’re working diligently improved functionality and capabilities of certain quality subsystems, most notably complaint handling and capital. We have weekly meetings with our consultant to track the progress. We have also put in place daily and weekly reporting from the internal team to give visibility to the quality system performance and to hold the teams accountable for progress. One improvement that we have made since August was to streamline our complaint handling system. As I mentioned in the second quarter earnings call, we had been entering complaint data into two separate systems. This was resource intensive and not sustainably compliant. Earlier this month all data entry was transitioned into one system which allows us to focus resources and other critical projects. While we’re making progress we have more work to do in order to have a sustainable and integrated quality system. I want to thank everyone for their time and attention on today's call. We will now open the phone lines for questions.

[Operator:]

(Operator Instructions). We will go to Matthew Mishan with KeyBanc first.

[Matthew Mishan:]

Rob could you give a little bit of color around some of the moving pieces in North America/HME. I think in particular you called out the declines in your lifestyle business, but as well as tough comp in home so and you actually exited the scooter business in North America, hoping you could can put a little bit at some numbers around those?

[Robert Gudbranson:]

Sure. You know the first thing I would say is we did have declines as we mentioned in all three pieces of mobility and seating, lifestyles and respiratory. So obviously we have more work to do on all three of the largest decline both in dollars and percents was in respiratory and you're right -- it was -- we had a national account that had a large purchase of Homefills. So we knew that would be a tough comparison. The part we still have work to do on is probably more so than anywhere else is on lifestyles. That's an area where we mentioned in the second quarter, we're seeing some pressure, we've really focused on having product line that was focused on what we called fleet management which is a lot of, let's say, a steel wheel chair, the home care bed. They're primarily rented out by our customers, not by us but our customers, EMD. Our view is consistently been, those are products you want to make sure you have one manufacturer focused on that product, you want to have the ability to use that consistently in our view as you want a low cost for the total life cycle not necessarily say 5 or 10 bucks on short term purchase. I think we found in some cases that our players out there in this environment with national competitive bidding, other pressures who want to have what we refer to as a single user product which means they are more concerned with the purchase price up front. There may be the total lifecycle cost, we've moved some product that way but additionally we're working hard in offering more complete line that we expect to start doing in the fourth quarter to get ourselves better on-track for addressing that part of the market. So I think those are probably the key things. I would also emphasize that we've had some weakness for a while in lifestyles, I think many investors in the sell side realize that we did make a management change in terms of the person who's running that business in North America/HME, it was just change that we needed to make. So I think focusing on the single user products, focusing on new manager we have better faith and we feel good about those steps but clearly we've got to get North America/HME turned around lot of work to do there.

[Matthew Mishan:]

And your decision to exit the scooter business, can you give some idea what kind of headwind that’s going to look like for the next several quarters.

[Robert Gudbranson:]

Not dramatic. I think our bigger issues are clearly what we just talked about it. It's a business that we were never particularly begin.

[Matthew Mishan:]

Okay. And then just moving to Europe which is based on what we calculated, I think we had the euro relatively flat year-over-year as far as the average euro price, but it looks like you guys had 2% to 3% of currency gains coming through that. Is there a little bit of a delay in the impact there and how should we think about the impact of the euro on the quarter?

[Robert Gudbranson:]

An active question, couple things just to remind you and investors, we do have one month lag in Europe. So actually the final month in the quarter was August. So there was some benefit if we just focus on the euro as just an example and we do have exposure to sterling all the Scandinavian currencies among others. But if we focus on the euro, third quarter 2013 euro for us was about average rate we use was 1.32 and this year third quarter was 1.35. So there was some slight benefit. Going forward fourth quarter last year, the euro was about 1.35 and right now today I think it's trading around 1.26. So there's 6%, 7% headwinds on that front if we just look at the euro alone.

[Matthew Mishan:]

Okay. So we should we looking at on a translational basis or with this potentially have more (indiscernible) impact on margins?

[Robert Gudbranson:]

Good question. In general there is a lot of manufacturing, we actually still do it, I think or I should say really more assembly we still do in Europe. Additionally, where we are purchasing from overseas whether that be Eastern Europe or China, we are typically hedging transactions 60% to 80% to 90%. So there's a little exposure on transactions, but the biggest issue is purely translation. So I think I can answer by saying generally (indiscernible) I would focus on translation.

[Matthew Mishan:]

Okay. And just last question. I think in the press release in the May was mentioned on last press as well in regards to we do in the credit facility, we knew in the credit facility. You said you are kind of reviewing options related to your capital structure. I just what you're thinking about the various possibilities are?

[Robert Gudbranson:]

We're still thinking through a number with the banks particularly with our H&M [ph] and P&C. I'd say we've looked and we'll continue to look at maybe using an asset based lending facility. Those typically give you less of a focus on financial covenants and more of the focus is as it shows on your asset values. I think that's probably in this near-term, a good situation for us for the bank group for the agent. So we'll continue to look at that, that's the most likely, but again still working on that facility.

[Operator:]

And we will now go to Bob Labick with CJS Securities.

[Bob Labick:]

Wanted to start with the consent decree. Rob, you said in a little more time and gotten more intimately involved in it than previously. It sounds like it's been a bit of it a little change of course from maybe previously doing workarounds or patchworks for the system to fixing the entire system, I mean you talked about the streamlining just moments ago. I want to know A, is that accurate? And B, please walk us through the process, globally speaking. I know you don't want to give a timeline, but of the steps going forward to in your view now with more insight to get into full compliance.

[Robert Gudbranson:]

Just a couple of comments. One, I don't want to say that we had patchwork in the past. I would just say that I think as we've gone through the process and made some changes, there have been cases where we've looked back and said for instance the two systems were we are entering complaints into two separate systems, without going through a lot of detail, there was a logic to that at one point. The danger is that, that’s throwing a certain amount of people at it. I think we've found since, I think it was October 6th, that we put in the one system, it's made a number of people both in customer service and down the chain, very happy with the change because it's easier and less resource-intensive. So I wouldn't want to say we had patchwork, I'd say more. I think we're making continued improvements to make sure that it's sustainable and I think the other piece we found which is why we brought in the consultant is that, we probably looked at some of the sub-systems little more as standalone capabilities. I think what we really noticed is we need to think about some of the key sub-systems tying in. So we don't find out that we have additional issues when we get to either the third party auditor or the FDA. So again, I think it's constant improvement. It's not patchwork and then I just add one further thing, you mentioned global I know you didn’t mean it, but we're really focused at this point on the consent decree, which is really for Taylor Street and corporate. That's not to say we won't be using in all facilities worldwide that -- then products or -- have product in the United States but to start with, I want to make sure to focus -- the listeners for the first time that it's one plant in Elyria, Ohio and our Taylor Street plant in our corporate facility which supports that.

[Lara Mahoney:]

And just to add to that and regarding some of the changes we made are improvements we made, Rob has put into place but the team daily, weekly reporting to get better visibility to where we've some of our quality systems data and that type of visibility is better whole, you tell are accountable to our quality systems progress. So that's just another improvement and another product the maturity that we're seeing in thought process.

[Robert Gudbranson:]

It's a good point Lara and then Bob maybe to try to answer your question, you're right, we're not going to mention timeframe because many of these things are ultimately out of our control when we look at the third party auditor and we look at the FDA but I think our next steps are to put in additional work with this consulting firm. More importantly, I should emphasize, this being driven by our team here in Invacare, consulting firm is helping us but our quality and regulatory team are driving the improvements particularly on these core sub-systems, when we get to those drill and we've made those changes, improvements, at that point we'll make sure we verified that they're effective once we're comfortable they're effective. We will be aligning up and arranging for the third party auditor to come back and maybe just to be a little more clear on that point I think as we get close to seeing that we can verify that we're truly effective on the changes we're making to make this more sustainable, more integrated, well contacted third party auditor and get them lined up because this is a busy industry and we need to make sure we give them a little notice they can't show up on the dime.

[Bob Labick:]

And then you're looking at the impact on this, obviously, I think you mentioned in your remarks that Taylor Street facility output was roughly flat year-over-year, so you have kind of reached that plateau, but it's obviously materially down from before the consent decree. Can you just remind us and tell us, you know what you're doing out there in the market to stay in contact with customers and to create new product that will be ready for launch once you get into compliance and you know how that process is unfolding?

[Robert Gudbranson:]

Sure, we'll be glad to, a couple of things, one I want to emphasize our sales force is -- generally the sales force. So our sales force in North America and the U.S. in particular is focused on respiratory, mobility and seating and on lifestyles, in other words they do all three lines. Additionally, I'd emphasize to you that there are products in mobility and seating that are not impacted by the consent decree. So our sales force is still talking to our mobility and seating products as customers we're still talking about power wheelchairs and then finally as you pointed out with the verification of medical necessity, our customers are still buying products from Invacare power wheelchairs from -- that are impacted by the consent decree and I think that was about 11% of the volume compared to going back two years ago. So again, much lower volume, but we're in front of these customers talking about products that aren't impacted by the consent decree, custom manual, lightweight built order product, we're still talking to them about power wheelchairs and they are still ordering in certain cases both replacement and product is really critical for our customers to have Invacare capabilities. So those are the things that we do with the sales force. Now you mentioned new products, I would emphasize that we do have a new product that we're working on right now, we're getting -- we've got a 5, 10-K in, and we're answering questions as TDX SP2. So there are things we're doing to make sure that when we get through this as quickly as possible, if not right when we're there, we're ready to put that new product out there and make sure that it's not just the sales force can go back and say I'm ready to sell you the product you used to buy but a new and improved products, maybe I'll stop there and see if that helps Bob.

[Bob Labick:]

Just jumping on to the -- you discussed your pre and post-audits and the effect on the North American business, is that kind of a onetime step down effect and then leveling off of business or is there continuing decline or we too early in that process, where do you see that, how do you say that playing out?

[Robert Gudbranson:]

A couple things, one, it's been going on for a while. So I want to be clear that it's not something that happened in the last quarter or two I'd say at some point. I would assume there would be a little more stable results from that. It has an impact on our customers in terms of both the delay of getting being shipped thorough in terms of getting approval for product and then potentially to maybe at least a little less utilization. I think at some point that will potentially stabilize. It will depend a little on how tough the audits are, they change in terms of becoming tougher in that - a little less count. So again hard to say exactly, but at some point, we would expect that the impact would be more stable and we wouldn't be able to say that impacted from last year.

[Lara Mahoney:]

And I mean it's worth noting that a lot of the RAC audits that are taking place, we know auditors that are incentivized to find issues as they are looking through the (indiscernible) equipment provider files and past information and I mean the industry is learning improving as a lot of education as a position through writing the prescription lines, very precise level of detail that needs to be part of all of the documentation. So it's a lot of work. It's still very aggressive, because of one I mentioned. So it just continues to be something that our providers have to give that.

[Bob Labick:]

And then finally, just on the warranty accrual, you explained in a nice detail. I appreciate that. Obviously respiratory has been a good driver over the last several quarters. So it sounds like it may have been on not Homefill which I think had been a bigger driver. Can you just talk a little bit about has this affected in anyway your competitive positioning or the future sales in respiratory related to this new warranty accrual?

[Robert Gudbranson:]

A couple things, one, we mentioned three accruals. One was in power wheelchair; we will put that aside for a minute. Two were on respiratory you’re right. I want make sure we referenced both the first one and the second one is related to the stationary action constitute itself. They were not related to Homefill just to be clear on that point. Secondly, I'm not going to try to predict how customers will respond. I think our view is what we take very seriously as I think our customers want us to and ultimately patients want us to take care of issues that are out there. If we see an issue, like for instance to suit [ph] that issue in August of 2014, the answer is we're going to move quickly, we're going to take care of that and we're going to move on. So my view would be I think the customers know we make a quality product and we stand behind it. If there's an issue we will take care of it and we'll fix it, make sure that our customers and their patients can move on. So I don't think it will impact our competitive position, but obviously the time will tell and the customers will respond accordingly. But I want to emphasize patient safety is critical and we stand behind the product.

[Lara Mahoney:]

And just to add to that, I want to emphasize that the stationary oxygen concentrator component that we are currently reviewing, no decision has been made on that just yet and it is related to past production. This is not part of current production. I wouldn't impact any business going forward.

[Operator:]

(Operator Instructions). And we will now go to Jim Sidoti with Sidoti & Company.

[Jim Sidoti:]

Would you characterize the pressure or the scrutiny on your providers is more aggressive this quarter than last quarter or is it started to level off?

[Robert Gudbranson:]

My gut is and again this will be total anecdotal, it's comparable to the past. I don't think there is a big change up or down from what we're hearing from the field.

[Jim Sidoti:]

Okay. And on the institutional products, one of the issues you had was, I guess a lack of new products. Are you really close to there to launching products there?

[Robert Gudbranson:]

We're focused on a couple different things there, but in terms of exact timeframe on new products, no, I think we still have the premier bed in the long term care industry. I think for our customer base, particularly directly to the nursing homes and long term care facilities still the best product in industry. So I think we're still in the right spot there and we'll continue to look in improvements.

[Jim Sidoti:]

Okay. And then on the consent decree, just has the number of auditors or the prior stage auditor [ph] you still on the same people that were there three months ago. Not auditors consultants, I'm sorry, consultants.

[Robert Gudbranson:]

This is same team. It's a good team, both internally and we have involved from the consultants and no we've not changed that.

[Operator:]

This does conclude our question and answer session. Mr. Gudbranson, I would like to turn the call over to you for any additional or closing remarks.

[Robert Gudbranson:]

I would like to thank everybody on the call for their time and attention during today's call. And I would emphasize as always, Lara and I are available for any follow-up questions. Have a good day.

[Lara Mahoney:]

Thank you.

[Operator:]

This does conclude today's conference. Thank you for your participation.