Natus Medical Incorporated
Q2 2013 Earnings Call Transcript

Published: 1 Aug 2013

[Operator:]

Good day, ladies and gentlemen, thank you for standing by. Welcome to the Natus Medical Second Quarter 2013 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded today, August 1, 2013, and contains time-sensitive information that is accurate only as of today. Earlier today, Natus Medical released financial results for the second quarter of 2013. 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 Investor Relations at www.natus.com. 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

[James B. Hawkins:]

Thank you, operator. Our second quarter results that we released earlier this morning reported revenue of $82.3 million compared to $61 million reported last year and non-GAAP earnings per share of $0.21 compared to $0.11 in our second quarter last year. I am very pleased with our record second quarter non-GAAP earnings and gross profit margin that increased to 60% from 57% last year. As we previously announced, weakness in international markets, particularly Europe and to a lesser extent, Latin America, led to a second quarter revenue shortfall from the guidance we issued earlier in the quarter. This shortfall was both in our Newborn and Neurodiagnostic product categories. Domestic revenue was within our expectations. I am also pleased to report that Saudi Arabia has adopted newborn hearing screening as a standard of care and have purchased our ALGO hearing screeners. With over 0.5 million births every year, this market will result in a significant ongoing supply business. We continue to be affected by economic weakness in Europe. In the second quarter, we experienced a softness throughout all of Europe and in both our Newborn Care and Neurodiagnostic products. As the worldwide economy recovers and birthrates start to increase and return to historic levels, hospitals will again make the nursery and NICU, the neonatal intensive care unit, a priority that will translate to higher capital spending in this area, as well as in neurology. We are confident this will occur. However, it is difficult to determine the timing. We have, therefore, reflected this softness in our financial guidance for the third and fourth quarter. Our improved operating margin has been driven by increased operating leverage as a result of our acquisition strategy, and reflects the leadership position of our products in both neurology and Newborn Care. We are committed to achieving our 2013 non-GAAP operating margin goal of 12% and our longer-term goal of non-GAAP operating margins of 13% to 17%, consistent with our historical levels. Our second quarter results demonstrate our progress towards this goal. Yesterday, we completed a reduction in force at Natus, where we reduced our workforce by approximately 60 people. This was needed to align our business to current revenue levels and to allow us to continue to drive our operating goals. Natus now has the world's largest neurodiagnostic sales and service organization in the world. And with the business integration now complete, we have increased our focus on organizing the business to achieve further operating efficiencies. The ability to leverage our product platforms and sales channels in the future will be meaningful, and we are very encouraged by the opportunities that lie ahead. Our Newborn Care business remained solid with market-leading positions in newborn hearing screening, phototherapy and brain function monitoring. While our Newborn business has experienced challenges over the last 4 years, with birthrates down in the developed world due to the worldwide recession, we are now becoming more optimistic for this business segment as birthrates are stabilizing in the United States as our economy improves. We have received large incubator, hearing screening and newborn brain monitoring orders in recent quarters in the international markets. If this birthrate trend continues, it will be a positive for our Newborn Care business. While Natus has been consistently profitable over the last couple of years, our focus has been top line growth and to build a leadership position in both neurology and Newborn Care. Clearly, we have successfully achieved both of these objectives. We now believe that it is important to demonstrate our earnings power. While acquisitions will remain an important part of our longer-term business model, our focus now is achieving our operating objectives, with emphasis on earnings improvement and cash generation. In summary, we are very pleased with our second quarter earnings performance in the Nicolet and Grass acquisitions that we completed in the last year. We look forward to finishing 2013 with strong earnings momentum and increasing cash generation. Jonathan?

[Jonathan A. Kennedy:]

Thank you, Jim. Today, I'll be discussing our financial results on a GAAP basis, as well as a non-GAAP basis. Our non-GAAP results exclude amortization expense, restructurings and certain other charges. We believe that the presentation of these non-GAAP measures, along with our GAAP financial statements, provide a more thorough analysis of our ongoing financial performance. You can find a reconciliation of our earnings on a GAAP versus non-GAAP basis in today's press release. As Jim stated, we reported second quarter 2013 revenue of $82.3 million, an increase of 35% or $21.3 million from revenue of $61 million for the second quarter of 2012. Revenue from our neurology market increased to $52.8 million, or 64% of total revenue during the second quarter, compared to $30.2 million or only 49% during the same quarter last year. This increase was driven primarily from the addition of the Nicolet and Grass product families, which together accounted for $24.9 million during the second quarter. Revenue from our Newborn Care market decreased 4% to $29.5 million or 36% of total revenue during the second quarter of 2013 compared to $30.8 million or 51% of total revenue during the same quarter last year. The decrease was driven primarily from lower sales of devices and systems, offset by double-digit increase in supplies and services. On a consolidated basis, revenue from devices and systems contributed 57% of total revenue in the second quarter of 2013 compared to 64% in the 2012 period, while revenue from supplies and services increased to 43% of total revenue in the first quarter of 2013 compared to only 36% in the 2012 period. Revenue from domestic sales increased to 58% for the second quarter of 2013 compared with only 56% during the same quarter last year. Revenue from international sales was 42% for the second quarter compared to 44% for the second quarter of last year. On a non-GAAP basis, our gross margin exceeded our expectations and increased 3 percentage points to 60% compared to only 57% in the second quarter of 2012. Operating expenses were lower than anticipated during the quarter on lower labor costs, and our second quarter non-GAAP operating margin improved to 11% compared to only 9% for the same quarter last year. Looking ahead, we expect to continue improvements in our operating margin through manufacturing cost reductions and the favorable impact of the restructuring Jim just discussed. We expect to record $1 million to $2 million restructuring charge during the third quarter, primarily for severance expenses. Our second quarter non-GAAP effective tax rate was 28.2%, and we expect a similar rate for the third and fourth quarters. On a GAAP basis, net income was $4 million or $0.13 per diluted share, a $3.7 million or $0.12 per share increase from the same quarter last year. Non-GAAP net income increased 93% from the same quarter last year to $6.4 million or $0.21 per diluted share. We recorded approximately $3.2 million of depreciation and amortization expense, including $1.8 million of amortization intangibles associated with acquisitions. Our equity-based compensation was approximately $1.8 million during the first quarter -- I'm sorry, during the second quarter. Cash increased during the quarter by $4.6 million, and we reduced our net debt by $2.2 million, ending the quarter with approximately $28.9 million in cash and $50.6 million in debt. Also during the quarter, we replaced our $50 million loan facility with a 5-year, $75-million facility. This new facility provides additional domestic liquidity and financial flexibility in achieving our objectives. As Jim mentioned earlier, our focus is now on earnings and cash flow, and our second quarter results are showing the beginning of our efforts. Looking ahead, we expect to make a continued improvement in working capital as we focus on reducing our days of sales outstanding to the 60-day level. At the mid-point of our 2013 annual non-GAAP guidance, we expect non-GAAP gross profit margin of about 59% and operating expenses of about 47% of revenue, with these metrics improving throughout the year. We expect our effective tax rate will be at 31% to 32% absent discrete and non-GAAP items. We expect the depreciation and amortization expense will be approximately $13 million, including about $6.9 million of amortization expense associated with acquired intangibles. And we expect equity-based compensation to be approximately $5.6 million, and we expect a $1.6 million of interest and other expenses for the year. Our earnings per share guidance is based on an expected diluted share count of about 30.6 million shares. With that, I'll turn the call back to Jim.

[James B. Hawkins:]

Thanks, Jonathan. Before opening up the call to questions, I would like to review our financial guidance for our third quarter and full year of 2013, all on a non-GAAP basis, and make a few closing comments. For the third quarter of 2013, we expect revenue of $80 million to $82 million and non-GAAP earnings per share of $0.18 to $0.21. For the fourth quarter of 2013, we expect revenue of $84 million to $88 million and non-GAAP earnings per share of $0.22 to $0.25. For the full year, we expect to report revenues of $332 million to $338 million and non-GAAP earnings per share of $0.76 to $0.82. Also I'd like to point out that included in our 2012 third and fourth quarter revenues were one-time shipments of proprietary product to CareFusion. Natus agreed to manufacture this product for CareFusion through a supply agreement as part of the purchase of Nicolet. These one-time revenues totaled $3.4 million, $1.2 million in the third quarter and $2.2 million in the fourth quarter of 2012. On a non-GAAP basis, earnings per share guidance excludes charges for amortization expense associated with acquired intangible assets. In addition, our non-GAAP earnings per share guidance excludes the effects of restructuring charges that we expect to occur in 2013 associated with recent acquisitions, the amount and timing of which have not yet been determined. We are not, at this time, providing GAAP earnings per share guidance because of the uncertain nature of the restructuring charges. And as usual, our non-GAAP guidance excludes the impact that any future acquisitions might have on our results of operations. In summary, we continue to execute on our business model and build a world-class franchise in both neurology and Newborn Care. We look forward to achieving record financial performance in 2013. With that, we'll turn the call over to questions. Operator?

[Operator:]

[Operator Instructions] Please stand by for your first question, which comes from the line of Chris Lewis at Roth Capital Partners.

[Chris Lewis:]

First, just on the guidance for the year. The second quarter EPS actually came in above your original guidance range, even in the face of the revenue pullback, but you still brought down that full-year EPS outlook. So I was hoping you could just walk us through the progression there and the approach you're taking in setting that revised guidance for the remainder of the year.

[James B. Hawkins:]

Sure. Certainly, on the revenue side as we said, we expected -- we now expect continued softness in Europe. And we just really wanted to, I would say, make sure we get it right. And so with that, we really brought down our revenue in a big way because we just feel it's appropriate to do that. On the earnings side, we were pleasantly surprised with our 60% gross profit. It was something that we've been striving to get back to. And through a combination of product mix and some other cost initiatives, we were able to achieve that. That's really a big factor when you look at profitability and, really, I think, valuing the business. And so it's a metric that we've focused on and happy to hit. Going forward, we're going to continue to strive for that. But on the earnings side we think, with that reduction, to still have full year guidance of $0.76 to $0.82 is really quite commendable with the conservative approach we're taking to revenues.

[Chris Lewis:]

Okay. And then going off your comment about non-GAAP gross margins of 60% in the quarter. How much of that was attributable to the product mix, perhaps with international being a lower percentage of sales? And what other factors played into that increase there? And then going forward, is this a sustainable level that we can model?

[James B. Hawkins:]

Yes, so it was probably around 1%, Chris. I would say by -- as you know, we sell into Europe through distributors for the most part, which we give a discount to. Since that was the lighter side of the sales for this quarter and where the shortfall occurred, it did, overall, have a positive effect on GP. But with that said, with having lower revenues, still achieving that -- a GP of 60% is, like I said, we feel very good about. Going forward, I think Jonathan mentioned 59% is what we're guiding towards on a GP level. And we're certainly hoping to achieve that and hopefully do better.

[Chris Lewis:]

Okay. And then in terms of the company goal of 12% operating margin, non-GAAP operating margins for the year, can you kind of just walk us through what gives you the confidence that the company can still get there despite of the revenue headwinds? And what needs to be done in the second half to achieve those levels?

[James B. Hawkins:]

Jonathan, why don't you go ahead and take that one?

[Jonathan A. Kennedy:]

Sure. Thanks, Jim. So with the gross margin closer to 60%, that's a pretty nice tailwind for us. And we started the year lower than that and had a more favorable product cost in Q2. That looks like it's going to continue in Q3 and Q4. So that's a big tailwind for us. The other side of it is, the operating spending came in -- OpEx came in lower than we thought it was going to in Q2. And then with the restructuring that we completed yesterday, we're going to have a tailwind going into Q3 and Q4. So when you combine growing -- stronger gross margins, lower operating expenses, a higher mix of supply revenue, which is higher gross margin, it gives a little more confidence that we can hit this model. So at the high end of our range, you would get something pretty darn close to 12% non-GAAP operating income for the year.

[Operator:]

Your next question comes from the line of Larry Solow at the CJS Securities.

[Lawrence Solow:]

In terms of just the difference in the U.S. and Europe, was the U.S. about flat on an organic basis? And is that sort of what you're building in as you look out in the back half and most of the weakness, where it was this quarter, continuing?

[James B. Hawkins:]

No, no, I think our U.S. was a little softer than flat, but it was in the range that we were expecting. We had expected some continued softness...

[Lawrence Solow:]

Because it was -- because it had been about flat in Q1, right? You had sort of gotten -- or close to it, right?

[Jonathan A. Kennedy:]

Yes, certainly on the supply business. And the supply business, again, was stable in our -- across the board. It's just in the Newborn section, area, where capital equipment purchases are still rather weak, unfortunately. And one of the things, though, too, that we're quite excited about here is that we're just confident, as this economy gets better, hospitals will spend again in these areas in a big way. And by having our cost structure where it is, we can -- we get very excited about the future financial performance here.

[Lawrence Solow:]

Okay. But you're building in, I guess -- most surprising on the sales side is -- or basically all of it, was Europe and a little piece of Latin America. Is that what you're sort of building into your cuts in the back half? Or have you also revised your outlook in the U.S.?

[James B. Hawkins:]

We've -- also in the U.S. We just thought that, based on this performance, we just want to position ourselves where, let's say, we don't want to miss. And so we put guidance out there that we plan on attaining, and that's how we're going to be guiding, we think, now and in the future. We're going to sort of get back to the ways we've always done it in past years.

[Lawrence Solow:]

And how was -- I realized Nicolet, when you make acquisitions, it's not always that easy to decipher and break it out. But how has that been performing on the sales side? Has it been sort of similar with the existing Neurodiagnostics business? And the cuts that you just announced, are they coming more from the new acquisition side or the legacy side?

[James B. Hawkins:]

No, I'd say the realignment at the company here is across the board, going both divisions and at corporate. So we just really look to try to get more efficiencies, and we're driving that. On the revenue side, I think your question, Larry, was -- can you repeat that?

[Lawrence Solow:]

The revenue, just a question of -- I realize sometimes when you make acquisitions, you may stop putting -- paying attention to one product line or another, so it's not always an organic way to -- easy way to look at organic sales. But just in terms of how Nicolet is performing, and Grass, so it's a little in the early days relative to the rest of the businesses, are sales doing better, worse or sort of similar to the...

[James B. Hawkins:]

No, I'd say we're very happy with Nicolet. We've had them now for a year. We've accomplished a lot there. It's performed, I would say, beyond our expectations. And so we're very happy with Grass -- with that. Grass is relatively new. If you remember, Grass is still acting as a contract manufacturer for us at this point. So it's more, we're just doing more sales and marketing there right now. And obviously, some engineering, but that's performing well also.

[Operator:]

Your next question comes from the line of Jayson Bedford at Raymond James.

[Jayson T. Bedford:]

Just a few. Maybe to start on gross margin. I appreciate the comment around mix. But structurally, have you done anything differently to drive gross margin, because even if I back out the 100 basis points of kind of geographical mix, it still seems like a nice bump up given the revenue performance?

[James B. Hawkins:]

Well, Jason, I think we have had some cost initiatives that -- throughout the organization in the cost of goods area. And we also think, being a leader the way we are, we're able to certainly -- we're trying to position the company in Newborn Care and in neurology in our product areas that, buying from Natus is really who you should buy from. We have the best products. We have the best service. We react faster than our competitors. And for that, we would try to price ourselves at the appropriate pricing for that kind of service and capabilities that we're showing. And so it's something that we're trying to drive.

[Jayson T. Bedford:]

So pricing is sticking, is that fair?

[James B. Hawkins:]

I guess you could maybe put it that way as well. We try not to look at it like that. We're providing, we think, top-notch service, and we should get paid for that.

[Jayson T. Bedford:]

I guess the gross margin trends, going forward, Jonathan mentioned that 59% for the year. Do you have other initiatives in place to expand gross margin beyond 2013? You mentioned Grass. I seem to recall an opportunity there.

[Jonathan A. Kennedy:]

Sure, yes. We've got a number of cost -- materials cost reduction programs that are happening now, and those will kick in over time. And then just on the overhead side, there's still a decent amount of opportunity that we'll take as time goes along to decrease operating costs in the manufacturing environment. And so, yes, there's still opportunities beyond pricing, beyond mix, for us to bring in our cost of goods.

[Jayson T. Bedford:]

On the revenue side, you've had a chance to kind of digest what happened in that second quarter. Can you just give us a little bit more flavor here on whether it was a market share dynamic, whether it was a pricing dynamic? Just a little more detail on why 2Q was so much different than 1Q. And then secondly, can you -- besides the contribution from Saudi Arabia, what are you going to do differently to turn this business around to drive organic revenue growth?

[James B. Hawkins:]

So let's see, so going to the second quarter, the shortfall was mainly Europe. And we just saw, across the board, hospitals pushing out orders. Tenders not being executed as we had -- were led to believe that they were going to be awarded. And even the private pay hospitals, we just saw a general across-the-board slowdown, and that's why we reflected that in our guidance.

[Jayson T. Bedford:]

And you don't think you lost share at all?

[James B. Hawkins:]

No. No we don't. We feel quite good about that. And as you mentioned, picking up Saudi Arabia is a big win because, first, it's one of -- in recent years, it's one of the countries that has stepped up and adopted newborn hearing screening. And to win that, we just think it shows we're still the leader in this industry without a doubt. And in neurology, we're very strong. We just don't believe we're losing market share. We don't -- when we do lost business reports, it's just not showing up.

[Jonathan A. Kennedy:]

The number of tenders we saw out of Europe versus a normal year, it was down significantly. So the business just is -- the market is just not there right now. You can't go forever and not buy any capital equipment, so we believe it's going to turn back up at some point. As Jim said in his prepared remarks, it's difficult to tell when. But there doesn't appear to be any sort of major lost business. We haven't had any product issues or anything that's changed the market dynamics. And for the moment, we're just -- the medical device business that we're in just doesn't react that quickly, typically, to begin with. So this is a market dynamic that we're confident in will turn. And for now, I would say, from -- you asked about growth and turning the business around. I mean, we have to be honest about the growth prospects out there, and I think we're trying to be that in our guidance and keeping things in line with where we are today and setting the company's spending levels to the revenue that's available to us. But as the economy turns upward and capital equipment ages, we will see a pickup at some point, just difficult to see where.

[Jayson T. Bedford:]

The guidance for the third and fourth quarter assumes an environment much like 2Q. Is that fair?

[James B. Hawkins:]

That's a very fair statement to make.

[Jayson T. Bedford:]

Okay. And just your visibility into the third quarter and then, I guess, generally from a forecasting perspective, you kind of hinted that you're trying to be a little more conservative. Can you share any details as to what you're doing differently from a forecasting perspective?

[James B. Hawkins:]

Well, I think, we're just being a little more cautious and a little more suspect as we roll up our forecast, especially in Europe, but we feel that we've forecasted for this environment. And as I said, we've tried to put the right amount of risk in this marketplace into our forecast. So we think we're where we need to be on that.

[Operator:]

We have no further questions for you now, gentlemen.

[James B. Hawkins:]

Okay. Well, I would like to thank everyone again for participating in the call. We're very excited about driving our business and, certainly, the medium and long-term growth prospects at Natus. We feel we're in some very key dynamic product areas that as we move forward, not only in the U.S., but outside the U.S. in the emerging markets, we're well positioned to take advantage of that growth. So we look forward to future calls to update you on our progress. Thank you very much.

[Operator:]

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.