Natus Medical Incorporated
Q1 2017 Earnings Call Transcript

Published: 26 Apr 2017

[Operator:]

Ladies and gentlemen, thank you for standing by. Welcome to the Natus Medical First Quarter 2017 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded today, April 26, 2017 and contains time-sensitive information that is accurate only as of today. Earlier today, Natus Medical released financial results for the first quarter 2017. If you have not received the news release or if you would like to be added to the company’s distribution list please e-mail your request to [e-mail]. This call is being broadcast live over the Internet on the company’s website at natus.com and a replay of the call will be available on the website for the next 90 days. The agenda for today’s call will be as follows. Jim Hawkins, President and Chief Executive Officer of Natus, will present opening comments; then Jonathan Kennedy, Executive Vice President and Chief Financial Officer of Natus, will summarize the company’s financial results and then Jim Hawkins will conclude the prepared remarks with comments about the company’s financial guidance for 2017 before opening the call for questions. Some of the information to be furnished in today’s session will constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are those focused on future performances, results, plans and events and include the company’s expected results for 2017. Natus reminds you that future results may differ materially from these forward-looking statements due to the number of risk factors. For a description of the relevant risks and uncertainties that may affect the company’s business, see its periodic reports on Forms 10-K and 10-Q filed with the Securities and Exchange Commission. I would now like to turn the call over to Jim Hawkins, President and Chief Executive Officer of Natus Medical. Mr. Hawkins?

[Jim Hawkins:]

Thank you, operator. Our first quarter results that we released earlier this morning reported revenue of $124.7 million compared to $87.3 million last year. We also reported non-GAAP earnings of $0.30 compared to $0.34 in our first quarter last year and adjusting for Venezuela’s prepaid shipments generated cash flow from operations of $11.9 million. We also repurchased $1.9 million of stock during the first quarter that brings our total cash flow from operations to $13.2 million. While I am very pleased with our record first quarter revenues, earnings did come in below our guidance. Newly acquired Otometrics had a very strong quarter and is ahead of their plan to achieve 10% non-GAAP operating profit margins in 2017. The integration of Otometrics is going well and we continue to believe Otometrics can grow revenues 5% to 10% in the years ahead. Lower earnings were primarily due to a higher operating cost structure in our newborn care business unit as well as reduced margins for Peloton, our hearing screening service. We experienced lower birthrates and a shift by government payers and lower reimbursement in our Peloton business. We are working to expand the services offered by Peloton as well as customer payment sources to improve profitability. In our neurodiagnostic business, I am pleased to report that we received our largest neuro order in the history of the company totaling $3.8 million from a large U.S. hospital. This order is expected to ship in our fourth quarter this year and first quarter next year. As we have previously announced, we closed the acquisition of Otometrics on January 3. Otometrics is a manufacturer of hearing diagnostic, hearing aid fitting, balance assessment equipment and disposables and software. Otometrics revenue was approximately $100 million in 2016 based on the year end value of the Danish currency and with 100% of their U.S. sales subsidiary revenues that we acquired in the acquisition. For those not familiar with our Natus hearing franchise or Otometrics, I would like to review each of these markets and how they fit strategically within our current business. First, let’s review hearing screening. Natus is the leader in newborn hearing screening. The addition of Otometrics hearing screening product line and customer base will broaden our global footprint in this area. Otometrics hearing screeners are used by audiologists worldwide for infant hearing screening as well as hearing screening for all ages. Their lightweight and portable OAE/ABR screener offers an alternative to larger card-based systems like Natus’ flagship ALGO newborn hearing screening system. In hearing diagnostics, Otometrics is an industry leader. Otometrics products serve audiologists in major healthcare facilities and those in private practice. Audiologists use Otometrics’ wide selection of advanced clinical devices and software solutions to diagnose hearing disorders. Together, Natus and Otometrics will have an industry leading product offering for the hospital, clinic and private audiologist practice. Otometrics also brings its world class product line of hearing aid fitting systems to Natus. Fitting systems are used by audiologists to fit and tune hearing aids. As part of the Natus family, Otometrics will be the largest independent provider of hearing aid fitting systems, providing a new model to customers who want to choose Otometrics fitting systems independently from a hearing aid manufacturer. And finally, Natus and Otometrics will have the most complete product line of balance assessment tools used by ENTs in hospitals, clinics and private practice. We believe Otometrics has an exciting future. The growth of hearing diagnostic and hearing aid fitting will be a solid grower for the foreseeable future as the worldwide market continues to expand. We also believe we have an opportunity for further growth in the U.S. market as Otometrics has underpenetrated this market in the past. They also have an exciting new product pipeline. We look to showcase some of these game-changing products at our Investor Day in New York City June 22. All of these factors give us confidence to believe Otometrics will achieve revenue growth of 10% in 2017 and 10% in 2018. Historically, Otometrics has been a breakeven company with business outside North America being nicely profitable, but having losses in the United States. Going forward, we have set an operating profit goal for all of Otometrics of 10% in 2017 and 20% in 2018. As previously mentioned, they are on their way to achieving the 2017 goal. Lastly, I am pleased to say we shipped approximately $9 million of the Venezuelan contract in the first quarter, which finished the product portion of the prepaid $20 million agreement. In summary, we are pleased with the growth of our business as we drive to achieve over $500 million of revenue in 2017 as well as the progress and performance of Otometrics in our first quarter of ownership. By the end of the year, we plan to have our costs back in line with our business model. I will now turn the call over to Jonathan Kennedy, our Chief Financial Officer and Head of our Newborn Care business unit, for a review of the financial results. Jonathan?

[Jonathan Kennedy:]

Thank you, Jim. Today, I will discuss our financial results on a GAAP basis as well as a non-GAAP basis. Our non-GAAP results exclude amortization expense, restructuring, direct cost of acquisitions and certain other charges and all the related tax effects. We believe that the presentation of these non-GAAP measures, along with our GAAP financial statements, provide a more thorough analysis of our ongoing performance. You could find a reconciliation of our financial results on a GAAP versus non-GAAP basis in today’s press release. As Jim stated, we reported first quarter 2017 revenue of $124.7 million, a 42.8% increase from the same period last year, owing to the addition of Otometrics. Revenue from our neurology business decreased slightly to $56.3 million or 45% of total revenue during the first quarter of 2017 compared to $56.7 million and 65% of total revenue during the same quarter last year. Revenue from our newborn care business increased $32.9 million or – to $40.6 million or 33% of total revenue during the first quarter of 2017 compared to $30.6 million or 35% of total revenue during the same quarter of last year. Revenue from Otometrics was $27.8 million or 22% of total revenue during the first quarter of ‘17. In total, revenue from devices and systems contributed approximately 65% of total revenue in the first quarter of 2017 compared to 54% in the 2016 period, while revenues from supplies and services was approximately 35% of total revenue in the first quarter 2017 compared to 46% in the 2016 period. The increase in device mix was driven by the addition of Otometrics, where device revenue was approximately 70%. Revenue from domestic sales was approximately 52% for the first quarter of 2017 compared to 65% in the same period of 2016. Revenue from international sales was approximately 48% for the first quarter of ‘17 compared to 35% for the same period of ‘16. Again, the change in mix was driven by Otometrics, where approximately 75% of the revenue is generated outside of the United States. On a non-GAAP basis, our gross margin decreased by 530 basis points in the first quarter of ‘17 to 57.8% compared to 63.1% in the first quarter of ‘16 as we added the Otometrics business, which has a lower gross margin than the corporate average. We expect our average gross margin to trend upward over the next several quarters as we complete the integration of Otometrics. Non-GAAP operating expenses increased by $16.8 million compared to the same quarter last year and our non-GAAP operating margin decreased to 11.5% compared to 16.3% for the same quarter last year. The increase in OpEx and decline in margin was driven by the addition of Otometrics. Our first quarter non-GAAP effective tax rate was approximately 26%, 3 percentage points higher than guidance. The rate increase was due to higher than expected profitability in the United States. Looking ahead to the full year, we expect our overall non-GAAP 2017 tax rate to continue to be in the 23% to 24% range as we expect our international profitability to increase as Otometrics becomes more profitable. Interest expense was $1 million during the quarter and higher than guidance as we are unable to position our cash as efficiently as expected. We expect interest expense to be approximately $0.9 million in the second quarter and $0.8 million in the third and fourth quarter as we pay down our credit line with cash on hand. On a GAAP basis, net income was $0.3 million or $0.01 per diluted share, an $8.2 million decrease from the same quarter last year. Non-GAAP net income decreased $1.3 million compared to the same quarter last year and non-GAAP earnings per share was $0.30. In the first quarter, we recorded approximately $6.7 million of depreciation and amortization expense. Our share based compensation was about $2.8 million during the first quarter. Now let’s take a look at the balance sheet and cash flow. We repurchased $1.3 million of company stock and our net cash and investments decreased $134.7 million during the quarter. As previously discussed, the acquisition of Otometrics is financed with debt obtained late in the fourth quarter and we closed the transaction on January 3, 2017. We ended the first quarter with net debt of $37 million. Cash flow from operations was $2.5 million during the quarter. Our days of sales outstanding increased 16.8 days during the quarter to 99.6 days due to the Otometrics acquisition. Excluding Otometrics, our DSO decreased 5.5 days to 77.3. Diluted shares outstanding were reduced slightly to 33 million shares versus 33.2 million shares in the first quarter of 2016. With that, I will turn the call back to Jim. Jim?

[Jim Hawkins:]

Thanks Jonathan. Before opening up the call to questions, I would like to review our financial guidance for our second quarter and full year 2017, all on a non-GAAP basis. For the second quarter of 2017, we expect revenue of $121 million to $123 million and non-GAAP earnings per share of $0.32 to $0.33. For our full year 2017, we now expect revenues of $505 million to $510 million and non-GAAP earnings per share guidance of $1.70 to $1.75. We will now turn to questions – call over to questions. Operator?

[Operator:]

Thank you. [Operator Instructions] And our first question comes from Brian Weinstein from William Blair. Your line is open.

[Brian Weinstein:]

Hey guys. Thanks for taking the questions. So we start with talking about the cost structure and your comment that you needed your costs in line with the business, what happened, can you describe kind of where the cost structure got out of whack, why did it get out of whack and what are the specific things that you are doing there to realign the cost structure?

[Jim Hawkins:]

Sure, Brian. It mainly centers around the newborn care unit. As I think everyone knows that we have been under a warning letter at our facility in Seattle. And with that, we are beefing up our organization there to better address those issues. We are probably a little bit in an overkill mode, I would say right now as we ramp some of that up. And combined with the ship holds that we have, the combination of those two things have made our costs, I would say, out of proportion to our business model. Jonathan, do you have any further comment on that?

[Jonathan Kennedy:]

Yes, I think Jim is the right there. It’s just two pieces. It’s the additional expanding that we are doing, as Jim described. But then also as we alluded to in the press release and Jim’s comments, our Peloton service business has seen a shift in reimbursements in terms of what gets reimbursed and how much and that’s throwing our cost structure into question. In other words, at one revenue, it works, at another – at a lower revenue, our cost need to come down. And so we are looking at ways to reduce – both reduce costs, but also ways to increase the revenue per patient in that business. In terms of the long-term, there will be a period of time that we need to maintain this cost structure over the next several months and quarters. But over time and by the time I mean, the next year or so, we will pull it back in line and get the margins back to our model.

[Brian Weinstein:]

Just to follow-up on the comment you just made Jonathan and you talked about with Peloton, you said what gets reimbursed and how much, so are there cases, are you getting pushback from payers that they don’t want to reimburse this anymore. And when you talk about how much, is that simply a mix shift towards the lower paid Medicaid or are you seeing that the private guys are coming down on what they are willing to pay you?

[Jonathan Kennedy:]

There is some of all of what you said, so on the – there has always been a portion of those patients where you don’t receive any payment from, whether they just don’t pay you or they are part of a Medicaid and Medicaid program in a particular state doesn’t end up reimbursing Natus. So we are seeing a shift of perks more towards the Medicaid payment. And in many states, Medicaid reimbursements reimbursed the hospital through their DRG or through the overall cost of having a baby. And there is no additional payment to Natus or anyone for the hearing screen. As that mix shift has increased, that’s decreased our average collection from – for a hearing screen. And on a private pay side, we are seeing not as many cases as you see on the Medicaid, but we are seeing more cases where the private payers are also negotiating with hospitals to include testing services, including hearing screen in the DRG. So that’s also adding pressure to our average reimbursement for hearing screening. To combat that, we have just introduced this last quarter a new service where we are going to screen the babies, but then also there is an additional test that we do that will charge the hospital for just a flat fee per baby. So that will expand basically our offering and increase our margin there. And then on the payment front, look we haven’t done anything, either started things right now, but we are looking at better ways to collect from patients that would meet the requirements of the customers as well as meet our requirements to get paid.

[Jim Hawkins:]

Yes. On top of that Brian, we also experienced a rather dramatic drop in birth rates, which certainly affected our Peloton, you take out the number of babies, your overhead structure when it’s built for one set of birth rates and then it drops down, obviously it upsets your cost structure. And just to validate that, I am sure you probably saw Mednax had the same comments in their quarter, surprisingly their visits in the NICU were down rather dramatically as well. And we are all scratching our heads as to why, but those numbers seem to be pretty prevalent throughout.

[Brian Weinstein:]

Okay. And last question for me is on Otometrics, Jim we had talked during the quarter about the seasonality in business and how it was a bit surprising that that was weighted more towards the fourth quarter than kind of what we would have all expected just by looking at the business from the outside, can you talk about the seasonality in that business, you comfort as to kind of maybe reasons as to why you are seeing – why that business does see seasonality and how do you factor that into your guidance? Thank you.

[Jim Hawkins:]

Sure, Brian. Yes, again, just to emphasize, we had a very strong first quarter there and we are very pleased with the way things are going. But seasonality at Otometrics is something that they have had for many years with Q4 being just a blockbuster quarter for them. Historically, the first quarter has been 22% or 23% of revenues. The second quarter, I believe has been around 24%, 25%. The third quarter goes into 23% to 25% range and then the fourth quarter is something in the 30% range. It’s just the way it is in that business. We think those are a few different reasons by countries, but that is the way it is and we expect that to continue. Ideally, we would like to flatten that out, but we will see how that goes. But boy, are we ever excited about the possibilities for Otometrics.

[Operator:]

And our next question comes from Chris Lewis from ROTH Capital Partners. Your line is open.

[Chris Lewis:]

Hi guys. Thanks for taking the questions. Wanted to just start just as a follow-up on Otometrics, the revenues in the quarter, I think you said $28 million that came in pretty nicely above our assumption and Jim just piggybacking your comment about I think 23% of that business in the first quarter. If we do the math, that implies full year revenues of about $120 million, obviously above the kind of the 10% growth target, which would imply $110 million, so can you kind of just talk about your kind of up-to-date expectations for that business this year in terms of sales going forward?

[Jim Hawkins:]

Sure, Chris. Yes, I think it’s probably not quite right to do the math all the way to that $122 million, because it was an exceptional first quarter. And so it was really strong. But certainly, we would look to at this point, feel very comfortable in hitting and most likely exceeding our guidance for Otometrics with that $110 million that we set. So we have given our guidance for the company and I would say one of the reasons we are maintaining our revenue guidance is because of Otometrics outperformance.

[Chris Lewis:]

Can you quantify the impact Otometrics had on the first quarter just from a profitability perspective?

[Jim Hawkins:]

No, except that Otometrics was profitable, which was good to see, not a lot, but at least they were profitable in the first quarter. I think it’s a true statement. It’s the first time they have ever been profitable in Q1.

[Chris Lewis:]

Okay, good. And then going back to Peloton, can you elaborate on maybe what percentage of your installed hospital customer base is kind of facing the reimbursement challenges and maybe for those hospitals that are not receiving adequate reimbursement, you talked about expanding kind of the service offering, but is there a potential that you would need to convert back to kind of the old capital equipment sales model in some of those hospitals that were reimbursement just isn’t up to your expectation level?

[Jim Hawkins:]

Yes. I will start off and then I will hand it over to Jonathan for his thoughts as well. But I think that we certainly believe Peloton is a business that can stay, our customers use it, just love it. I think we have to look to – look at the whole pricing model. If this trend continues, where some of the state Medicaid just decide to eliminate payment and but the hospitals love our service and we believe that many of them are not going to want to give that up. But with that, I will pass it over to Jonathan.

[Jonathan Kennedy:]

Hey Chris, your first question about the percentage, it’s a minority of them. I would say, less than 20%, maybe 15% or so but having issued the trend is the trend. And I agree with Jim and definitely the hospitals like the service. In terms of converting them back, I would like to think that that’s not going to happen simply because the hospitals get a better result when they use Natus for hearing screening because they are focused on it. And I think that the hospitals will see the value in paying a premium for this service versus doing it yourself, which would be the way to go backwards. But time will tell, the business is evolving and we will see whatever works out best for customers and for Natus, we will pursue that route. It’s a little bit early in the game to figure out what that might mean.

[Chris Lewis:]

And then in terms of the guidance for the full year, if I exclude Otometrics, it implies a pretty healthy acceleration and just kind of the underlying legacy growth rates in the second half of this year, understanding some of that may vary based on kind of how Otometrics trends during that period and I know you have mentioned a larger order that you expect to start shipping in the fourth quarter, but kind of just given the recent underlying core trends as of late, kind of walk us through the key drivers of what gives you confidence in that implied acceleration in the second half of this year for the core legacy business?

[Jim Hawkins:]

Yes, sure, Chris. I think the newborn care business will continue to be challenging for us while we are under this warning letter and ship holds. So I think to get year-over-year growth there is going to be a challenge. Our neuro diagnostic business though the pipeline of business that we have like we mentioned closing this one large order. There are a lot of other orders in the pipeline. We have a strong position around the world that we believe we are going to see some solid growth in our neuro diagnostic business this year. And so that’s what gives us the confidence that our core business will be stable to grow overall. But then when you look at Otometrics growth coming in, I would say higher than we had in our original guidance gets us to our $505 million to $510 million.

[Chris Lewis:]

Great just one more for me, can you provide kind of the latest update on the ship hold with respect to neoBLUE and the other products in terms of timing of when you expect to release that ship hold and resume shipping on these projects products? Thanks.

[Jim Hawkins:]

Yes. On the neoBLUE, I am happy to report that we did release that products and started shipping in March. And with that, I will pass it on to Jonathan with where we stand and some of our strategies on the other products.

[Jonathan Kennedy:]

Sure. So as Jim said, we did release the ship hold and shipped – began shipping the neoBLUE overhead light in Q1, the last couple of weeks. So that is good news that there. We still have left in the ship hold – major items left on the ship hold list are the neoBLUE blanket which we anticipate will ship beginning next year. And then there is also a number other products that have a secondary effect of not having a warning letter that we are not able to ship internationally. Those we expect to clear as – when that warning letter clears, which at this point is difficult to tell when that would be. It’s not going to be in 2017. It’s more likely sometime in ‘18 that that warning letter will clear and we will be able to release those ship holds as well.

[Chris Lewis:]

Okay, thank you.

[Operator:]

[Operator Instructions] And our next question comes from Jayson Bedford from Raymond James. Your line is open.

[Jayson Bedford:]

Good morning and thanks for taking the questions. Just a couple of follow-ups, just on Otometrics Jim, you used the word exceptional in terms of the first quarter performance, was there anything kind of one-time ish in nature, was this pent-up demand from a slower fourth quarter, what really kind of drove that strength and I am just kind of balancing that with your commentary for the full year?

[Jim Hawkins:]

Yes. No, I don’t think so. I think it was just a very good quarter, no one-time big orders there at all. In fact, we in some countries, when we were transitioning over from GN Store Nord ownership of these subsidiaries, getting them established as Natus and getting registered and licensed in some of these countries to do business and actually had a negative effect. So we got off to a little bit of a slow start in Otometrics, but it ramped up very nicely.

[Jayson Bedford:]

Okay. And I realize you don’t want to get into the productivity of Otometrics, but what’s the gross margin profile that you are seeing in that business right now?

[Jim Hawkins:]

Yes. I think we were around 54% in the first quarter. But Jonathan, I will pass it on to you. I think you have – might have those numbers handy.

[Jonathan Kennedy:]

I do. That’s right Jim, 54% is where they landed in the first quarter. And then in terms of overall profitability, it depends on how you measure it. But as Jim said, it was slightly profitable for the quarter, which is – when I say slightly, it’s barely, but definitely a first for Otometrics to have at least a positive number at the bottom line.

[Jayson Bedford:]

Okay. And where are…

[Jim Hawkins:]

And maybe just add some color to that, Jason. We – our goal was to do 10% pre-tax profits for the year at Otometrics and we know you may have stronger beliefs that, that will happen.

[Jayson Bedford:]

Okay, that’s helpful. In terms of RetCam and I apologize if I missed it, what did RetCam do in the quarter?

[Jim Hawkins:]

Jonathan, do you have that or do we report RetCam?

[Jonathan Kennedy:]

Yes, Jayson, you didn’t miss it. We didn’t give detail at the product line level, but RetCam is on the same path. We acquired that business was about $14 million a year and it continues to clip along at that rate. It’s actually performed quite well for us and profitability is maintained from the day we bought.

[Jayson Bedford:]

Okay. And I think you may have given the breakout for international and domestic on Otometrics. What was – if I back out Otometrics, what was the growth rate of the international base business? Is that because I think you have made – you have kind of signaled at least in the last quarterly call that, that was starting to stabilize a bit. So, any color there?

[Jim Hawkins:]

Jonathan, do you have that data? I know last year, our first quarter was our best by far international quarter, so it was a little bit of a tough comp for us, but we were very pleased overall with our internal goals on the international business.

[Jonathan Kennedy:]

Yes. In the script I broke out international by those totals. I don’t have that in front of me, Jayson, but definitely the data, the pieces are there in the script. I can add that up for you and catch you offline that as the pieces are in there.

[Jayson Bedford:]

Okay.

[Jonathan Kennedy:]

Yes, I am not trying to avoid the question I just don’t have it calculated in front of me.

[Jayson Bedford:]

No, I understand that. In terms of the Peloton business, do you have an update in terms of the number of hospitals and I am just wondering with kind of this reimbursement dynamic, is it maybe more favorable from an economic standpoint to pullback from some of these? Are you still kind of keen on growing that business?

[Jim Hawkins:]

Yes, that’s a real good point, Jayson. I think, Jonathan, do we have 9 new hospitals in the quarter or was it 7? I can’t quite remember.

[Jonathan Kennedy:]

We did 9 new hospitals in the quarter. I think it’s – we have to look at the overall profitability of that business and when it makes sense to pursue a service model or pursue a hardware and supplies model and that’s going to be in the hospital by hospital case, Jayson. I don’t think it will be fair for us to say on wide swap on what we are going to do and what we are not going to do there. But be important to make sure that customers have their needs taken care off first before we end up making a change one way or another. Obviously, we have contracts with customers. So, there is an obligation for Natus to perform really hard. And I just wouldn’t want to have any situation where a hospital wasn’t being taken care off in terms of meeting their hearing screening needs.

[Jayson Bedford:]

Okay. And last one for me just to circle back on the gross margin, is it fair to assume that the added costs related to dealing with the warning letter show up on the COGS line versus more of the SG&A line or R&D?

[Jonathan Kennedy:]

Well, a lot of it’s in R&D. Lot of the issues we have as we have talked about before are in design control and that’s part of the R&D process, so many of the cost – most of the costs show up in R&D. There are some in COGS, but I would say at least two-thirds of it are R&D increases.

[Jayson Bedford:]

Okay, thank you.

[Operator:]

And at this time, I am showing no further questions. I would like to turn the call back to Natus for any closing remarks.

[Jim Hawkins:]

Thanks, operator. Well before we leave the call, I would like to invite professional analysts and investors – I am sorry, invite the professional and the analyst investor community to save the date to attend our Analyst Day to be held on June 22, 2017 at the Sofitel Hotel in New York City. You will receive more information on the details of the day’s event as the date approaches. So in closing, we look forward to an exciting 2017 and reaching the $500 million revenue milestone for Natus. Thank you for participating in today’s call and for your continued interest and support.

[Operator:]

Ladies and gentleman, thank you for your participation in today’s conference. This concludes the program. You may now disconnect. Everyone, have a great day.