Natus Medical Incorporated
Q3 2014 Earnings Call Transcript

Published: 22 Oct 2014

[Operator:]

Ladies and gentlemen, thank you for standing by. Welcome to the Natus Medical Third Quarter 2014 Financial Results Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. (Operator Instructions) As a reminder, this conference call is being recorded today, October 22, 2014, and contains time-sensitive information that is accurate only as of today. Earlier today, Natus Medical released financial results for the third quarter 2014. If you have not received the news release, or if you would like to be added to the company’s distribution list, please email 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, Senior 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 2014 before opening the call up to 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 performance, results, plans and events, and include the company’s expected results for 2014. Natus reminds you that future results may differ materially from those forward-looking statements due to a 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 third quarter results that we released earlier this morning reported revenue of $89.9 million, compared to $85.4 million last year. We also reported non-GAAP earnings of $0.33, compared to $0.30 in our first quarter last year. I am very satisfied with these results, as both revenues and earnings exceeded our guidance, and equally important, we outperformed on all of our important metrics. In the quarter, I’m pleased to report we achieved a non-GAAP gross profit of 63%. This is an increase of 2% over the 61% we reported in the third quarter last year. Also, our non-GAAP operating profit of 19% represents a 4% improvement over the 15% [technical difficulty] combined with our 5% organic revenue growth made for a great quarter. Last year, we established a long-term annual non-GAAP operating margin goal of 20%, replacing the 13% to 17% annual goal we had communicated in the past. This year, our goal was to achieve a 16% operating profit for the full year and we believe we are on our way to achieving that goal. We are driving to achieve our 20% operating profit goal in 2016. Our improved operating margin has been driven by leveraging our market-leading products in both newborn care and neurology, and increased operating leverage and efficiencies as a result of integrating our acquisition strategy, along with excellent execution of our operating plan by all at Natus. As we have communicated, reestablishing consistent organic revenue growth starting in our second quarter was a major goal for Natus this year. I’m extremely pleased to report that in our third quarter, we did achieve over 5% organic growth. For the last many years, our focus has been to build a leadership position in both newborn care and neurodiagnostic products. We have successfully achieved this through an accretive acquisition strategy. As the market leader, we are positioned to lead our industry segments by developing innovative products that will drive organic growth. We have now established a new product pipeline that we are very excited about. Last week, we introduced our first in a series of new products in neurology when we announced our new Vista EMG Ultrasound product. Vista Ultrasound is the first product in the market that enables the use of ultrasound with an EMG workstation. This allows physicians, on a real-time basis using ultrasound, to locate nerves that will assist in the placement of needle electrodes to better perform nerve conduction studies. There is a reimbursement available for using Ultrasound in this manner, and Natus now has the first product that enables ultrasound with EMG. Early feedback from leading neurologists has been positive. We plan to continue to introduce new innovative products over the next 18 months in both newborn care and neurology. In our second quarter, both newborn care and neurodiagnostic business segments performed well. Business was strong in the United States and Asia. Our domestic neurology business was exceptionally strong. Our domestic sales force performed well as they continue to have record quarter after record quarter. Our recently launched newborn Hearing Screening Service business, called Peloton, grew rapidly, as we added 17 hospitals in the quarter and we ended the third quarter with 39 hospitals under contract. Including contracts already signed during October, we have exceeded our 2014 goal of 40 hospitals under contract by the end of the year. We are very excited about this opportunity. Peloton offers newborn hearing screening test to hospitals as an alternative to purchasing equipment and disposables. We look to convert our existing ALGO customers to this new service model as well as attracting new customers to Natus. As a worldwide leader in hearing screening devices, we believe we are ideally positioned to develop this market. Our opportunity is to increase the approximately $10 a baby we receive for our disposable hearing supply to $100 or more for actually performing the hearing screening test. While we do not expect revenue to be meaningful in 2014 as we market this service and develop this market, we believe it will become a significant growth opportunity in 2015 and beyond. In the third quarter, Natus generated $16 million in cash from operations. We look to continue to generate significant cash in future quarters and to pay off bank debt in 2014. We currently are not planning to do a significant acquisition in 2014. We believe it is very important to show ourselves, shareholders and the medical community, the strong leadership company Natus has become and that we are a consistent, organic growing and increasingly profitable business. With that said, acquisitions are an important part of our business model and we look to pursue acquisitions in the latter part of 2015. In summary, we are very pleased with our third quarter performance and operating results. We look forward to the remainder of 2014 as we continue our strong earnings momentum and cash generation, combined with consistent organic revenue growth. We remain committed to driving towards our long-term goal of 20% non-GAAP operating margin in the years ahead. Jonathan?

[Jonathan Kennedy:]

Thank you, Jim. Today, I will be discussing our financial results on a GAAP basis, as well as a non-GAAP basis. Our non-GAAP results exclude amortization expense, restructuring, certain other charges, and 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 financial performance. You can find a reconciliation of our earnings on a GAAP versus non-GAAP basis on page 7 of today’s press release. As Jim stated, we reported third quarter revenue of $89.9 million, a 5.3% increase from the same period last year. Revenue from neurology market increased to $58.7 million, or 65% of total revenue, during the third quarter, compared to $55.4 million and 65% of total revenue during the same quarter last year. Revenue from our newborn care market increased to $31.2 million, or 35% of total revenue, during the third quarter of 2014, compared to $30 million, or 35% of total revenue, during the same quarter last year. On a consolidated basis, revenue from devices [technical difficulty] 61% of total revenue in the third quarter of 2014, compared to 60% in the 2013 period, while revenue from supplies and services was approximately 39% of total revenue in the third quarter of 2014, compared to 40% in the 2013 period. Revenue from domestic sales was approximately 63% for the third quarter of ’14, compared to 60% in the same period in ‘13. Revenue from international sales was approximately 37% for the third quarter of 2014, compared to 40% for the same period in 2013. On a non-GAAP basis, our gross margin increased by 200 basis points in the third quarter to 63%, compared to 61% in the third quarter of 2013. This year-over-year non-GAAP gross margin improvement was primarily driven by higher domestic revenue, where we sell direct, and have higher gross margins, combined with a more favorable mix in product sales. We expect our gross margins to be in the range of 61% to 62% for the fourth quarter. Non-GAAP operating expenses increased $0.3 million, compared to the same quarter last year and our non-GAAP operating margin improved to 19%, compared to only 15% for the same quarter last year, and looking ahead to Q4, we expect non-GAAP operating expenses to be about $39 million. Our third quarter non-GAAP effective tax rate was higher than expected at 32% due to higher domestic revenue and earnings. We expect our Q4 tax rate to increase slightly to about 34% as strength in domestic earnings is expected to continue. Our guidance does not include any reinstatement of the R&D tax credit. Other income this quarter was an expense of $1.4 million. This expense was a result of foreign exchange rate fluctuations, primarily the euro and Canadian dollar. Looking ahead, as usual, we expect other income to be an expense of approximately $0.3 million in the fourth quarter. On a GAAP basis, net income increased to $7.8 million, or $0.24 per diluted share, a $1.5 million or $0.04 increase from the same quarter last year. Non-GAAP net income increased $1.5 million compared to the same year to $10.7 million and non-GAAP earnings per share increased 10% to $0.33. We recorded approximately $2.7 million of depreciation and amortization expense, and looking ahead to Q4, we expect depreciation and amortization to be about the same level. Equity-based compensation was about $1.5 million during the third quarter and we expect a similar amount during Q4. Now, let’s take a look at the balance sheet and cash flow. Net cash increased by $1.8 million during the quarter, and we reduced our long-term debt by $8.4 million and repurchased approximately $2.5 million of Natus stock during the quarter. Cash flow from operations was approximately $16 million. We ended the quarter in a net cash position with $57.8 million in cash and only $8 million in debt. Our days of sales outstanding improved by nine days year-over-year compared to 81 days compared to the same period last year. Our diluted shares outstanding increased to 32.6 million compared to 30.5 million in the third quarter last year, as all outstanding options remain in the money. We expect a diluted average share count of about 32.5 million shares for the full year. With that, I’ll 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 the full year 2014, all on a non-GAAP basis and make a few closing comments. For the fourth quarter of 2014, we expect revenue of $92 million to $94 million and non-GAAP earnings per share of $0.37 to $0.39. We are increasing our full-year 2014 non-GAAP earnings per share guidance to $1.23 to $1.25, an increase from the previous guidance of $1.20 to $1.23. We are also increasing our full-year 2014 revenue guidance to a range between $353.8 million and $355.8 million, an increase from our previous guidance of $347.5 million to $352.5 million. As I reflect on what we have built in neurology at Natus, it is most satisfying. Through a combination of acquisitions, organic growth, and new product development, we have created the number one neurodiagnostic company in the world. Considering we were not in this business eight years ago, it is quite an accomplishment. Through our world-class sales organization, we continue to grow and gain market share in the United States and markets around the world. Now with an exciting new product pipeline, our opportunities are better than ever to grow our business and expand the entire neurodiagnostic market. Combining this opportunity with our rapidly growing Peloton Hearing Screening Service business, Natus is uniquely positioned for an exciting 2015. With that, I’ll turn the call over to questions. Operator?

[Operator:]

Your first question comes from the line of Chris Lewis, Roth Capital Partners. Please proceed.

[Chris Lewis:]

Congrats on the solid quarter here. I guess first I just wanted to start on the revenue growth in the quarter [technical difficulty] growth once again came in above our expectations. So, Jim, can you talk about the primary drivers that led to that better-than-expected growth here in the quarter, whether it'd be specific segments or geographies? And going forward, how should we think about the sustainability of this level of revenue growth?

[Jim Hawkins:]

Sure, Chris. Yes, it was a real solid quarter throughout, led by our U.S. and Pacific Rim business, and then the superstar in the quarter was our domestic neurology business. They just really rang the bell. We really think these kind of trends can continue, and as we go forward, our model is, as we’ve guided, we feel quite comfortable being able to continue with a 1% to 3% organic growth, but we have goals of higher, of 4% to 5%, and we certainly slightly beat even our goal this quarter, but that’s what we drive the business to, but we feel quite good about being able to sustain organic revenue growth.

[Chris Lewis:]

On the newborn services screening business, congrats on achieving your goal already for the year, 40 hospitals under contract, what’s driving the growth there and the traction? And do you have any examples from some of the earlier hospital customers on their initial feedback and what they like and what they don’t like, that has already implemented the service?

[Jim Hawkins:]

It has gone very well. The feedback, of course, has been good. It’s a long conversation to get into all the little whys, but it certainly makes their job easier. They are able to outsource a product or a service that really just makes a lot of sense for them and it’s something that our equipment is number one in and we really are the company to do that. When it comes to that opportunity in the market, it’s really a big opportunity. With 4,000 birthing hospitals, we think our market is probably 3,000 because we’re only playing in hospitals that birth 1,000 or 1,200 babies or more, but it’s something that we think we can continue to grow for many, many quarters and years to come.

[Jonathan Kennedy:]

Chris, this is Jonathan. From a CFO’s mindset, it’s a choice between buying capital and paying nothing. And so for a hospital, the economics are quite simple, you either write a check or don’t. So that’s one of the reasons I think that the adoption rate has happened so quickly. 50 hospitals in one year is a lot of hospitals. I don’t think anybody else has done that from a conversion, because the selling process inside of a hospital is not simple. So to get 50 in less than a year is quite an achievement.

[Chris Lewis:]

In terms of the end markets, it seems capital equipment spending has shown some encouraging signs here over the past few quarters in the U.S. I think there continues to be some uncertainty in Europe. Can you comment on what you are seeing in terms of end markets in those two segments?

[Jim Hawkins:]

Sure, Chris. And then we should – thanks for your questions. We should turn it over for additional questions. The end markets in the United States is quite good. It’s, I would call it, robust. We’re seeing – our quoting is very strong, orders of large magnitude of $300,000 or $400,000 or more continue to come in and we see a very good action in the Pac Rim as well led by China, which continues to grow 10% to 15% consistently, and we expect that to continue. Europe is sort of flattish, and that’s in our forecast. We don’t expect a big growth there, but it’s certainly stable and not a problem. It’s just not having the growth that we would like to see and I’m sure they would like to see as well.

[Operator:]

Your next question comes from Jayson Bedford of Raymond James. Please proceed.

[Jayson Bedford:]

Thanks for taking the questions, just a couple. On the neuro business, there's two straight quarters of 6%-ish growth off a tougher comp this quarter. I'm guessing that this growth wasn't really impacted by some of the new products that you've mentioned. You've got new products coming out. I'm just wondering what would prevent growth from being sustained at this level, or even faster, with some contribution from these new products?

[Jim Hawkins:]

Yes, Jason, that’s a good question, and that’s why we do have our own goals outside of our guidance because we think there is an opportunity to certainly upside our guidance, but these are new products, they do take time to get into the market. Hospitals have buying cycles, and we just don’t really want to try to forecast what that might be, but we can certainly get excited about some very nice growth coming here over the next one to two years, like you said, with the neurology pipeline of new products combined by Peloton and the birth rates stabilizing to going up in general really aligns things quite well.

[Jayson Bedford:]

And maybe without going into too much detail, can you just give us an idea of the cadence of new products? I realize you introduced one last week, the Ultrasound product, but when [technical difficulty] products come out over the next 18 months?

[Jim Hawkins:]

We don’t want to get into too much detail there, but many times it’s often two phased. We get the introduction. We’ll introduce it outside the United States while we’re waiting for FDA. So, this cadence will be both in newborn and neurology. They’ll be starting really in the first quarter of next year. We’ll start having some products. There is also products that we look to maybe partner with that could be a private label kind of situation too that we work with the company on to develop but our R&D capabilities in-house are only so much, so we do outsource some of this. So there is a pipeline of products that I would say potentially are four to six to eight products over the next 18 months that will be regularly coming out.

[Jayson Bedford:]

That’s helpful. And just a last one from me, I realize that the operating margins are higher on the Peloton business, but are the gross margins additive to corporate gross margins?

[Jim Hawkins:]

Yes, they are. Right now, we’re starting in the Peloton business, the ramp up of revenues will – the gross profits will improve because right now if you can imagine, we’re having to hire people, get them trained before we even start the program, so we’re having costs without necessarily having the full revenues. So as we get into next year especially, we think margins will improve in this area, which will have an influence as Peloton grows on our corporate GP as well.

[Operator:]

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

[Larry Solow:]

Just a quick follow-up on the question Chris asked in terms of domestic versus international. International has basically been about flat last two quarters. So as the growth in the Pacific Rim I guess obviously has been strong, so has Europe actually been a little bit negative?

[Jim Hawkins:]

Europe, I think is flat over the last couple of quarters. We’ve seen some slowdown in Latin America that has affected us somewhat. Overall, we think Europe overall flat. Is that about right, Jonathan?

[Jonathan Kennedy:]

It’s flat.

[Larry Solow:]

Is there any major differences between neurology and newborn? I know you said domestically it sounds like neurology was up very strong. So it sounds on the flip side --?

[Jim Hawkins:]

Newborn had a very solid quarter, good growth, but domestic neurology really carried the water.

[Jonathan Kennedy:]

Newborn was up for the quarter, year-over-year quarter, and it was strong in the U.S., led a little bit by Peloton, our new product. But the weakness, if you want to call it, weakness flattishness in Europe was across the board. Strength in Asia is across the board and weakness in Latin America, we primarily are newborn care in Latin America and that was just generally weaker across that product line.

[Larry Solow:]

And just touching on Peloton, the 17 new customers, obviously a pretty nice number, a pretty good ramp. Is there something you think -- is that sustainable? Obviously I guess early on maybe there's some more low-hanging fruit, but it's still a pretty big opportunity, and you barely touched in terms of penetration. So, adding 15 a quarter, is that something that is a feasible or attainable type of a goal over the next couple of years?

[Jim Hawkins:]

In our model, we have five to 10 a quarter, and officially I guess that’s what we’re staying with, but I got to say we are encouraged, we have a pipeline of quotes out there that are probably 80 to 100, I think Jonathan of pipeline of quotes, and so -- but at the end of the year too, we’re not sure how the last couple of weeks of order getting Peloton going with holidays and all. But overall it definitely could have some upside.

[Larry Solow:]

And I realize it’s still a pretty small customer base, but I guess I would imagine you reached sort of a breakeven pretty relatively soon and then it could actually be accretive in ’15? Is that a good way of look at it?

[Jim Hawkins:]

It’s sort of breaking even, making a little bit of money now I think.

[Jonathan Kennedy:]

I think the real math for those who use spreadsheets like me, we’ve got 50 hospitals and the target model is say $150,000 a year per hospital. This quarter’s revenue was a little over $0.5 million. At full swing, those 50 hospitals, is 50 times a 150.

[Jim Hawkins:]

If we end the year at 50. We’re just over 40 now, but if we were to get to 50 --.

[Larry Solow:]

So [$8 million] in revenue or so.

[Jonathan Kennedy:]

That’s right.

[Larry Solow:]

Higher margin, the operating margin on that is, I imagine, pretty substantially higher than your corporate average.

[Jim Hawkins:]

I would say that’s correct.

[Jonathan Kennedy:]

Yes, that’s correct. So my point being is while the hospitals under contract is one count, the thing that’s so exciting is you’ve got 40 hospitals today doing a $150,000, right, that’s $6 million in revenue, that’s not even in the P&L but it’s contracted. That’s the exciting piece.

[Larry Solow:]

Just last question. I know you took a – you had a $2.8 million restructuring charge, [indiscernible] is that something for additional cost cutting, manufacturing, consolidation?

[Jim Hawkins:]

We did a small restructuring last week, and so the break out of that $2.8 million is about $700,000 for severances and the remainder is a facility that we’ve vacated and is now in held-for-sale, so you have to mark-to-market, so that delta is to mark, that facility to market.

[Larry Solow:]

Is that -- any ballpark on idea of how much this will lead in terms of savings going forward? Is that something you could share?

[Jim Hawkins:]

In total, part of the restructuring was the announcement of a closure of a warehouse facility that we have in the East Coast and part of it was administrative roles, and I think the combined is around $1.5 million a year.

[Jonathan Kennedy:]

Larry, maybe we should let someone else ask questions.

[Operator:]

Your next question comes from the line of Brian Weinstein of William Blair. Please proceed.

[Brian Weinstein:]

So it looks like you raised your fourth-quarter revenue number from a guidance perspective, but you did take $0.01 off of it. It looks like the bottom end of the EPS range, was that simply because of the higher tax rate, or is there some other thought that I should be thinking about there?

[Jim Hawkins:]

Yes, Brian. The tax rate is a little bit higher in Q4 than we thought it would be mostly because of the stronger domestic performance. So, as many of you know, we’re working on making the company’s tax position more efficient and that will take some time. For now, we still have a pretty strong domestic business and that’s where taxes are the most onerous. So, for now, that’s what is going to happen.

[Brian Weinstein:]

And the gross margin of 63%, you guided that down for the fourth quarter. Can you talk about why? Is that just a mix issue? What are you seeing there that would cause that to come down?

[Jim Hawkins:]

We’re highly dependent on mix. When we hit a peak like a 63%, that’s a historical high, it’s just not a prudent move to think that’s going to happen quarter after quarter. It is dependent on mix. We do have programs in place that are ongoing to help reduce our manufacturing costs, but that’s going to reoccur in the fourth quarter is just not something we’re willing to put out there.

[Brian Weinstein:]

And then on the screening-as-a-service business, you've talked about 1,500 as the kind of hospital, but I know you signed one that was at least 6,000 births in Southern California. Can you talk about what you've seen as far as the average size of your first 40 or so hospitals?

[Jonathan Kennedy:]

Overall, if you throw out a couple of big ones, I think we have a 4,000 one in there, maybe a 3,000, but there are times, Brian, where we do take 800 or a 1,000 when that’s a multiple hospital chain that might have two or three or four hospitals. We’ll have to tag along an 800 birth hospital. So I think that 1,500 is probably a pretty good average for us if you throw out those two big ones.

[Brian Weinstein:]

And then, Jim, you mentioned that U.S. neuro was the superstar, you said rang the bell. Is there anything in particular that drove that? You said it's likely to be continuing. But can you be a little more specific about what it was that they did in the quarter, and why you're confident that it's going to continue at that kind of a pace? Thanks, guys.

[Jim Hawkins:]

Sure, Brian. I think the overall theme is we have really created a strong number one position in neurodiagnostic products. We think we have the best products out there. We have the best and largest service organization and it’s almost to the point of where – why wouldn’t you buy Natus and I think customers in the industry is starting to get that. We also are spending less time doing demos as our products are being spec-ced in, it’s getting to be a more efficient and productive sales force. So it’s really working as you draw it up on paper and it’s a beautiful thing. So, we think that’s going to continue and these trends, we don’t see them slowing down.

[Operator:]

The next question comes from the line of Larry Haimovitch of Haimovitch Medical Technology Consultants. Please proceed.

[Larry Haimovitch:]

Congrats on all the progress, Jim. I wanted to touch base with you on the buyback. You did continue to buy back stock in the third quarter. Is the buyback still on for the fourth quarter, and how large is the total buyback authorized by the Board?

[Jim Hawkins:]

Jonathan?

[Jonathan Kennedy:]

Hi, Larry, it’s Jonathan. How we bought back about $2.5 million in the third quarter, the buyback is still on. The Board has authorized $10 million for the year for share buybacks. We’re about half way through that and we started late in the year, but we’re about half way through, but it’s still on.

[Larry Haimovitch:]

What was the average price of the buyback in the latest quarter?

[Jonathan Kennedy:]

About $28.

[Larry Haimovitch:]

With your stock hitting an all-time high yesterday, congrats on that, that's the highest it's ever been, do you anticipate buying stock in Q4?

[Jim Hawkins:]

I think our goal for buying back shares is to eliminate the dilution from employee equity issue, not so much to be opportunistic and reduce the share count that‘s there today, but just to keep it from going up. So I would look for us to execute the $10 million and eliminate dilution.

[Larry Haimovitch:]

And the cash flow in the quarter was very impressive. I would assume that's probably the biggest quarter you've ever had of generating positive cash. [technical difficulty] Jonathan, you're paying down debt, I'm assuming that gives you a nice war chest as you go into next year, and your desire to start buying companies again. Is that the basic plan?

[Jonathan Kennedy:]

Yes, that’s the basic plan. We’ve stated we have this 20% non-GAAP operating margin goal and that just as a guidepost is about what free cash flow would be on a normalized basis. So, if we’re doing $350 million in revenue, just to do easy math, we’re generating $70 million in cash. So that definitely puts some war chest, as you say, on the book. For now, we’ve been paying off debt, but we’re down to the last $8 million of that, which we’ll take care of this quarter. So, going into ’15, the cash flow is just going to add to the bank balance. And what we do with that, I mean I think what Natus has always done is go out and look for opportunities to create value through acquisitions that are accretive.

[Operator:]

There are no further questions in queue at this time. I would now like to turn the call back to Natus.

[Jim Hawkins:]

I would like to thank everyone for participating on our third quarter conference call. As I think you can imagine, we are quite enthusiastic on the progress Natus has made and really even more excited about 2015 as we continue to introduce new products, gain market share, and improve our margins throughout the income statement. So, with that, look forward to our next call. Thank you very much.

[Operator:]

Ladies and gentlemen, this concludes today’s conference. Thank you for your participation. You may now disconnect.