Natus Medical Incorporated
Q3 2013 Earnings Call Transcript

Published: 24 Oct 2013

[Operator:]

Ladies and gentlemen, thank you for standing by. Welcome to the Natus Medical Third Quarter 2013 Financial Results Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded today, October 24, 2013, and contains time-sensitive information that is accurate only as of today. Earlier today, Natus Medical released financial results for the third 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 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 third quarter results that we released earlier this morning reported revenue of $85.4 million compared to $81 million last year and non-GAAP earnings of $0.30 compared to $0.16 in our third quarter last year. I'm very pleased with these results, along with our gross margin that increased to 61% from 57% in the third quarter of the previous year. Both Newborn Care and Neurodiagnostic products had excellent results, as both exceeded our expectations. Domestic and international revenues were strong in the quarter, and Europe had a solid quarter as well. In addition to achieving revenue growth, we also grew our backlog. It is important to note that included in our third quarter revenue last year was $1.2 million of one-time revenue of proprietary product that we manufactured and shipped to CareFusion as part of a supply agreement that was part of the purchase of Nicolet. Our 15% non-GAAP operating margin that we achieved in the third quarter was very satisfying. We have set a longer-term goal of returning to our historical annual non-GAAP operating profit margins of 13% to 17%. And I'm very pleased that we achieved this level of profitability in our third quarter. I am also pleased with the 61% non-GAAP gross margin we reported in the third quarter. Our improved operating margin has been driven by increased operating leverage and efficiencies as a result of our acquisition strategy, along with excellent execution of all operating planned by all at Natus. Our improved gross profit results were achieved through a combination of product cost reduction, the elimination of some lower-margin products and increased revenue that was driven by demand for our quality products. In addition, our outstanding worldwide sales and service organizations have allowed us to attain leadership positions in both neurology and Newborn Care. In the third quarter, Natus had very strong cash flow. Our cash increased by $15 million and we reduced our bank debt by $2.5 million. We look to continue improvements in operating cash flow in the coming quarters and expect to be able to pay off our long-term debt within the next year. For the last few years, our focus has been on top line growth and to build a leadership position in both Newborn Care and Neurodiagnostic products. Clearly, we have successfully achieved both of these objectives. While acquisitions will remain an important part of our business model, our primary focus in 2014 is to achieve solid organic growth, along with achieving our operating objectives, with emphasis on earnings and cash generation. We were pleased to see a rebound in our markets in the third quarter. As the worldwide economy recovers and birthrates increase and return to historical levels, hospitals will again make the nursery and NICU, the neonatal intensive care unit, priorities that will translate to higher capital spending in this area, as well as in neurology. We are confident this will occur and there are signs this trends may be starting. Natus now has the largest neurodiagnostic sales and service organizations in the world. We are also the largest in Newborn Care for the markets we serve. We have increased our focus on organic growth and to further achieve operating efficiencies in 2014. The ability to leverage our product platforms and sales channels in the future will be meaningful and we are encouraged for the opportunities that lie ahead. In summary, we are very pleased with our 2013 third quarter performance and operating results. We look to -- we look forward to finishing the year with strong earnings momentum and cash generation and remain committed to achieving our long-term operating margin goals in the years ahead. 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, restructuring 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. And you can find the reconciliation of our earnings on a GAAP versus non-GAAP basis on Page 6 of today's press release. We reported third quarter 2013 revenue of $85.4 million, an increase of 5% or $4.4 million from revenue of $81 million in the third quarter of 2012. Revenue from our neurology market increased to $55.4 million or 65% of total revenue during the third quarter compared to $50.5 million or 62% during the same quarter last year. Revenue from our Newborn Care market was approximately flat to the prior year's quarter to $30 million or 35% of total revenue during the third quarter 2013 compared to $30.5 million or 38% of total revenue during the same quarter of last year. On a consolidated basis, revenue from the devices and systems contributed approximately 60% of total revenue in the third quarter of 2013, compared to the same level in the 2012 period. While revenue from supplies and services also remained at approximately 40% of total revenue in the third quarter as well as in the 2012 period. Revenue from domestic sales were approximately 60% for the third quarter of 2013, compared with the same level during the same quarter last year. Revenue from international sales was approximately 40% for the third quarter, again compared to the same level, as the same quarter last year at 40%. On a non-GAAP basis, our gross margin exceeded our expectations and increased 4 percentage points to 61% compared to 57% in the third quarter of 2012. Operating expenses were lower than anticipated during the quarter on overall lower spending and labor costs in our third quarter. Non-GAAP operating margin improved to 15% compared to 8% for the same quarter last year. Looking ahead, we expect continued improvements in our operating margins through ongoing continuous improvement in projects and greater integration. Our second quarter non-GAAP effective tax rate was 26.2% and we expect a slightly higher rate in the fourth quarter. On a GAAP basis, net income increased to $6.3 million or $0.20 per diluted share and $8 million or $0.26 increase from the same quarter last year. Non-GAAP net income nearly doubled compared to the same quarter last year to $9.1 million and non-GAAP earnings per share increased to 88% to $0.30. We reported approximately $3.3 million of depreciation and amortization expense, including $2.1 million of amortization intangibles associated with our acquisitions. Equity-based compensation was approximately $1.4 million during the third quarter. Now let's look at the balance sheet. As Jim mentioned, we're very focused on profitability and cash generation. While most of the third quarter's $17.8 million increase in cash and net debt reduction was provided by ongoing operations, we did make significant progress in reducing our accounts receivable by $2.8 million and reduced our DSO by 8 days. Cash increased during the quarter by $15.3 million, and we reduced our total debt by $2.5 million, ending the quarter with approximately $44.2 million in cash and $48 million in total debt. Our third quarter results are just beginning to show the benefits of our efforts to improve profitability and drive increased cash flow. At the midpoint of our 2013 annual non-GAAP guidance, we expect non-GAAP gross margin profit of about 59% to 60% and non-GAAP operating expenses of about 40% of revenue. With these metrics improving into 2014, we expect our non-GAAP effective tax rate to be about 30% for the full year of 2013, absent any discrete and non-GAAP items. We expect the depreciation and amortization expense for the full year 2013 will be about $13 million, which includes about $7 million of amortization expense associated with our acquired intangibles. We expect equity-based compensation to be about $6 million for the year and we expect about $1.8 million of interest expense and other expense for the full year 2013. Our earnings per share guidance is based on expected diluted average share count at year end of about 31 million shares. With that, I'll turn it 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 fourth quarter and full year 2013, all on a non-GAAP basis and make a few closing comments. For the fourth quarter of 2013, we expect revenue of $87 million to $90 million and non-GAAP earnings per share of $0.30 to $0.32. For the full year 2013, we expect to report revenue of $340 million to $343 million and non-GAAP earnings per share of $0.95 to $0.97. Again, I'd like to point out that included in our 2012 fourth quarter revenue, our revenues were one-time shipments of proprietary product to CareFusion. Natus agreed to manufacture this product for CareFusion through the supply agreement as part of the purchase of Nicolet. These one-time revenues totaled $2.2 million in the fourth quarter of 2012. Our non-GAAP earnings per share guidance excludes charges for amortization expenses associated with acquired intangible assets and the cost of restructuring activities. In summary, we continue to execute on our business model and build a world-class franchise in both neurology and Newborn Care. And we look forward to finishing 2013 with record financial performance. With that, we'll turn the call over to questions. Operator?

[Operator:]

[Operator Instructions] Your first question comes from the line of Larry Solow with CJS Securities.

[Lawrence Solow:]

Just a -- couple of just clarifications, the Newborn, excuse me, the neurology revenue number you referred to, the $50.5 million, I guess, that excludes the $1.2 million, right, of one-time sales from last year's quarter? You've given that on apples-to-apples basis, is that correct?

[James B. Hawkins:]

You deduct the $1.2 million out of that.

[Lawrence Solow:]

Okay, if you look back into Q that was the number. And then Grass, do you know -- do you have what that contribution was, just trying to back out, get an approximate organic, sounds like organic revenue, actually eked out a slight gain in organic revenue growth, is that about right?

[James B. Hawkins:]

Yes, I think, Larry, we -- the way we've calculated, it's around 2% organic growth. Jonathan, do you have some detail on that?

[Jonathan A. Kennedy:]

Yes, one thing is final, Larry. So if you're looking at the older Qs or press release we had, we had minor restatements, so you have to go back to the K to get that numbers. So we would have growth in neuro of a nice low single-digit number, but overall growth for the company of about 2%.

[Lawrence Solow:]

So Grass contributed...

[Jonathan A. Kennedy:]

But when you back out the Nicolet transition manufacturing and then Grass is low single-digit millions.

[Lawrence Solow:]

Something goes $4 million last year, so probably in and around that number again in Q3, I assume for Grass?

[Jonathan A. Kennedy:]

Yes.

[Lawrence Solow:]

Okay. And clearly you guys have done a great job in accelerating sort of the cost cuts sequentially over the last couple of quarters, is there, going further is it sort of just going to be a slow drip? Do you see some near-term over the next few quarters, incremental cuts? And do you think it's more on the cost of goods side? Or more selling, overhead, R&D, does that remain sort of flat at these levels, just sort of any more color on that would be great?

[James B. Hawkins:]

Yes, I think Larry, we've been -- we've communicated that we look to get to the 13% to 17% operating profit margin. And it will be a combination of really a lot of things. We are -- as you can tell, very focused on our gross profit. Our operating cost continue to decrease. And as we look to get organic growth back in focus, that will certainly fall to the bottom line as well. So it will be a combination from all areas.

[Lawrence Solow:]

Okay, last question, just on Newborn. I know first couple of quarters there were some signs of at least a turnaround in the market and the consumables were growing a little bit. Can you maybe just talk about that a little bit more and you mentioned that you see some evidence that we are seeing a turnaround, maybe you can give us a little more of an update on that?

[James B. Hawkins:]

Well, it's a little difficult when you look at the numbers in that -- in our backlog. A lot of that backlog growth was in our Newborn area. So when you look at shipment numbers, it doesn't always tell the story. And so we're just not really trying to slice and dice that. But it was a very solid quarter in the Newborn area and our disposables are doing fine, both domestic and outside the U.S.

[Operator:]

Your next question comes from the line of Chris Lewis with Roth Capital Partners.

[Chris Lewis:]

First question, just on the revenue side, obviously, it looks like Europe has improved since the second quarter. So Jim, can you just talk about what you experienced in the third quarter that changed in that market? And what you experienced since then, I guess, that drove those improvements seen here?

[James B. Hawkins:]

Yes, Chris, it was really across the board in Europe and it started in July and just carried throughout the entire quarter. It wasn't really 1 geography. It was across the board. And we have heard commentary from other companies that have seen the same things. So it seems that just in general, thus, Europe has certainly picked up a little bit.

[Jonathan A. Kennedy:]

Yes, I'd point out too -- this is Jonathan, that relative to our expectations, Europe did little bit better than we thought. But in general, is not like we saw a major snapback from Europe. It's a matter of case where Q2 was artificially low and Q3 became artificially high. It was kind of -- the decline in Europe stopped and it flattened out. So we feel like we're at a bottom in Europe, but that's what our initial expectations were, that maybe continue to decline and that just didn't happen.

[Chris Lewis:]

Okay, great. And then looking ahead, you mentioned the higher backlog at the end of this quarter. Can you provide some more color on what you've seen this quarter to date, I guess, both in Europe and U.S. as well that gives you confidence with your revenue expectations, relative to your guidance for the remainder of the year?

[James B. Hawkins:]

Well our guidance is our guidance. And I think, Chris, it just speaks to itself. We're not going to comment on the current quarter beyond our guidance. But it is guidance that we feel comfortable with. We're looking at our guidance in something that we believe we are going to achieve. And if things go well, we can certainly exceed as we did this quarter. But it is something we are comfortable with.

[Jonathan A. Kennedy:]

I think in the confidence indicator area, we did have a little bit higher backlog than last quarter, moderately higher backlog and so I think that gives us a little more confidence. But most of our orders are real time. We don't typically have a big lead from customers. So we still have several weeks to go left in the quarter, so it's kind of tough to do anything other than what we've already put out in guidance.

[Chris Lewis:]

Okay, great. And then on gross margins, nice upside there in the quarter. As we look ahead, is this sustainable type of level that we can think about for gross margins going forward? And I guess how should we think about gross margins trending into the fourth quarter and into 2014?

[Jonathan A. Kennedy:]

Yes, I think that -- you know the 60% plus level is something that we're looking to hopefully be the new water -- low watermark for us. We have had cost-reduction programs that we have implemented. As we said, we've culled out some lower-margin products that has affected our top line revenue but we just believe that having a business with a higher gross profit, even though it's taken a little top line pressure, is well worth it in the long run, and as we go to next year, a lot of that will be behind us. So it will really be the first year in some time, we'll have real, in our minds, year-over-year true sales comparisons. And so that's why we really are focusing on this organic growth because we are hopeful that it'll be more evident of the good work that our sales groups do out there, along with our position in the marketplace.

[Chris Lewis:]

Good. And then just 1 more, if I could sneak it in, you mentioned an increased focus on organic growth going forward. Can you provide a little more details on what specifically that strategy is there? And how you feel about sustaining positive organic growth going forward?

[James B. Hawkins:]

Sure, Chris. Well, first, we really have a great sales force out there that does a great job. We have, we believe, the best field in customer service in the industry. And that being #1, it's really a place where customer should want to buy their both Newborn Care and neurology equipment. With that, we think there are a lot of opportunities, both in the United States and outside the U.S. to expand on our already solid market share. And we just look to really drive that as we go forward into 2014. Operator, any other questions?

[Operator:]

Yes sir, your next question comes from the line of Jayson Bedford with Raymond James.

[Jayson T. Bedford:]

Just a few to follow on. You mentioned pruning some lower-margin products. Can you quantify the dollar amount of those products? And how long has this been going on?

[James B. Hawkins:]

Jason, it's something that has almost been continual with all of our acquisitions. Sometimes we eliminate products. Sometimes we take the approach saying hey, we'll do big price increases just to get them to our margin, and if we sell them fine, and if we don't, so be it. But we're -- we really take an approach, we just don't want to take some of these lower-margin products in the organization. So it's something that we've been doing really for years. And what we think we'll be able to show in 2014 is really a true year-over-year organic revenue model that -- as a lot of this is behind us, if that makes sense.

[Jayson T. Bedford:]

Okay. So just to understand, outside of Grass, you haven't done a deal in about a year. Can we assume that the pruning is pretty much done now?

[James B. Hawkins:]

Yes, I would say, as we go through Q4, going into next year -- for the most part, you never want to say forever, but we feel the vast majority of that will be behind us by the end of the year.

[Jonathan A. Kennedy:]

Jason, it really kind of has 2 prongs to it. There's the stuff that you might cull immediately after an acquisition. But keep in mind, the lifecycle of a medical device is very, very long. So there are product platforms that we have, that are merging into a fewer product platforms. So you'll take -- you can lose lower margin business -- lower margin products that way too. It's just the evolution of a product line. So in that respect, it can take several years post acquisition to really get the full benefit of eliminating -- I'll call it duplicative products and overlapping products and things like that. And that's been core to the acquisition strategy that company is to take these portfolios, and not just grow revenue, but to grow profitability is really the key piece of it. And to do that, you have to integrate and simplify the product portfolio. And that's why we've been in the process for doing for the last several years. But we're seeing a little bit faster acceleration because of the size of the last acquisition and just the size of the company.

[Jayson T. Bedford:]

I guess the takeaway there though is that this pruning has probably had a bigger impact on organic growth than we probably realized before?

[James B. Hawkins:]

Yes, I think that's probably right. I think that's a true statement.

[Jayson T. Bedford:]

On the gross margin, obviously, very strong. When I look at kind of the revenue level in the third quarter, very similar to the revenue level in the first quarter, yet gross margins are nearly 300 basis points higher. So can you just walk me through what kind of compares third quarter versus first quarter, and what's changed in the gross margin side?

[James B. Hawkins:]

Yes, I think it's a combination of some of the things we've talked about. We continue to have cost initiative programs to take out cost. We are, I think, being very disciplined in our pricing when we sell product. And I think, with this really the market-leading products, there really is not as much of a propensity to discount, perhaps. And so we're just really trying to drive the business back towards profitability. I think we've gotten a little bit away from that as we were going through acquisition and with all these integrations. With a lot of that settled down, we are able to really now focus on the operations of the business and thus get back to the profitability levels we historically have been.

[Jonathan A. Kennedy:]

We definitely -- we get a riff of restructuring in August and so that has some benefit. We've had a couple of site consolidations and more integration steps that are benefiting the overhead side of the COGS side equation too.

[Jayson T. Bedford:]

On that restructuring, that was done in August, so you didn't see the full benefit of that in the quarter?

[James B. Hawkins:]

That's correct.

[Jonathan A. Kennedy:]

A lot of it, but not all of it.

[James B. Hawkins:]

I think, Jayson, what we see is that we've been able to, through our acquisition strategy, really come from nowhere to be #1 in Neurodiagnostic products. And we think it's a great business to be in. We've been able to take this industry. It used to be at a 48% gross profit kind of business, to now where it's over a 60% gross profit business. And it's just really the discipline we've had, the driving of quality products and taking products to the marketplace. So we think it can continue. We think it's a great business to be in. And I think we're excited to be able to show the world the excitement in neurology and neurodiagnostic products in the years ahead.

[Jayson T. Bedford:]

Fair enough, then lastly for me and then I'll get back in queue. You talked about your goal of 13% to 17% operating margin. You're at the midpoint. It sounds like there's still good things to come here. What would cause that margin to trend to the lower end of that range?

[James B. Hawkins:]

Well, that's -- I think, we -- I don't want to comment too much, but we plan to continue to drive expansion of operating margins in the years ahead. It can always be a softness in the economy. Products mix issues. Maybe more international than domestic where you go through distributors, when you discount more, but we really look to maintain these kind of profitability levels going forward.

[Jonathan A. Kennedy:]

There's an element of time to it. How long it takes you to get there. If we can't get the efficiencies and integrations fast enough then you have the natural progression of labor cost and other expenses. So a delay in time, weakness in the economy that sort of stuff could cause us to drift back to the lower side of that range. Intervention would be the key.

[Operator:]

Your next question comes from the line of Brian Weinstein with William Blair & Company.

[Brian Weinstein:]

Question for you on the end markets. Is it fair to say that you guys are trying to characterize these a little bit as just kind of not getting worse at this point and stabilizing or are you actually seeing right now that the end markets are actually improving?

[James B. Hawkins:]

Well, we had -- little difficult to say, it's certainly stabilizing, our organic growth was 2% overall and we did add to backlog. So just looking at the facts, for us, things have certainly stabilized and gotten a little better. It is difficult to say, the future, if that's going to continue or if we picked up market share or -- and all those kind of things, but altogether, it was a very firm quarter throughout. Business seemed to flow and we feel encouraged. But it is hard to say. It's not like there's a lot of public company competitors in our area that we can see exactly what the market was doing. But it was good for us.

[Jonathan A. Kennedy:]

And then if you just do the math on the near term, the Q3, so we had a little bit of growth in Q3. If you look at the Q4 guidance, that would imply a decline, depending on how robust Q4 turns out to be, it could come back up. But I mean, I would say, from where we're to today, it looks like we're at a bottom, and that not getting worse is probably too far down the path, you're down the pessimistic path, staying where it is or getting better as probably where its biased towards.

[Brian Weinstein:]

Okay. And what kind of -- what kind of visibility do you guys think you really have on revenues at this point. The guidance that you've given now is still $20 million below the original guidance midpoint for the year. We've had a lot of different kind of movements around in these numbers. The backlog certainly helps, but your confidence in our your ability to kind of predict not just along the quarter, but as we look to '14 and when you give your '14 guidance, how much confidence do you guys think that you have in being able to really understand that visibility at this point?

[James B. Hawkins:]

Yes, Brian, I think the tack we're taking with our guidance is to give guidance not at what we're -- our plan is, but really at a confidence level that we are very comfortable and maybe you could say confident that we're going to attain. We don't really want a misguidance anymore. We had a long streak of never missing and it hasn't been that way in recent times. So we're getting back to driving the business the way we used to drive it. And that is to ideally always, at a minimum attain our guidance.

[Brian Weinstein:]

But you do feel visibility is improving here?

[James B. Hawkins:]

Yes, I think visibility is improving and -- but we've also had, I don't want to say conservative, but put guidance that we feel that we're going to be able to attain.

[Brian Weinstein:]

And you talked about 2% organic growth, what kind of EPS growth can you sustain with the end markets, let's say, if that's where we sort of bottom out here, not just bottom out but that's where end market growth looks like over the next kind of 12, 24 months, what kind of EPS growth do you guys envision that being able to support?

[James B. Hawkins:]

We'll give our 2014 earnings guidance. But we typically do it the 1st week of January, Brian. And we really won't speculate on that at this time. But certainly, we have a lot of earnings momentum going at Natus right now.

[Jonathan A. Kennedy:]

Yes, with a 60-ish gross margin, you got -- quite a bit falling to the bottom line, I don't think that the company necessarily has to add any sort of OpEx to support that growth rate. I'm very confident about that. So you can do the math on a 60% gross margin.

[Operator:]

Ladies and gentlemen, this will conclude the question and answer portion of today's conference. I would now like to turn the call back over to Natus.

[James B. Hawkins:]

Thanks, operator. And I'd like to thank everybody in participating. We remain very excited with the direction that Natus is going, with our earnings growth, our gross profit and really most important our cash generation. It's very exciting to be generating, I think it was almost $18 million this quarter. We think cash can continue to be generated at very high levels here. And look forward to finishing the year strong and very excited about 2014. Thank you very much.

[Operator:]

Ladies and gentlemen, this concludes today's conference. Thank you for your participation. You may now disconnect. Have a great day.