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Natus Medical Inc. (NASDAQ:BABY)

Q2 2014 Earnings Conference Call

July 23, 2014 11:00 AM ET

Executives

James B. Hawkins – President, Chief Executive Officer & Director

Jonathan A. Kennedy – Chief Financial Officer & Senior Vice President

Analysts

Larry Solow – CJS Securities

Chris Lewis – Roth Capital Partners

Brian Weinstein – William Blair

Jayson Bedford – Raymond James

Operator

Ladies and gentlemen, thank you for standing by. Welcome to the Natus Medical Second 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, July 23, 2014, and contains time-sensitive information that is accurate only as of today.

Earlier today, Natus Medical released financial results for the Second quarter 2014. If you have not received the news release or you would like to be added to the Company’s distribution list, please email your request to InvestorRelations@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: 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 the future performance, results, plans and events and include the Company’s expected results for 2014.

Natus reminds you that the future results may differ materially from these forward looking statements due to a number of risk factors. For a description of the relevant risk and uncertainties that may affect the Company’s businesses, please 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?

James B. Hawkins

Thank you, operator. Our second-quarter results that we released earlier this morning reported revenue of $86.3 million, compared to $82.3 million last year. We also reported non-GAAP earnings of $0.28, compared to $0.21 in our second quarter last year. I am very satisfied with these results, especially the 10.4% non-GAAP net income in the second quarter. This compares to 7.7% in our second quarter last year.

Achieving double-digit after-tax profits in our second quarter is a huge accomplishment for Natus, and we hope to build on this metric in the quarters ahead. We recently established a new long-term annual non-GAAP operating margin goal of 20%, replacing the 13% to 17% annual goal we had communicated in the past.

Our improved operating and net income margin has been driven by increased operating leverage and efficiencies, as a result of integrating our acquisition strategy, along with excellent execution of all our operating – involved in the operating plan by all of Natus.

As we have communicated, establishing consistent organic revenue growth starting in the second quarter was a major goal for Natus this year. I’m extremely pleased to report that in our second quarter, we achieved 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 now positioned to lead our industry segment by developing innovative products that will drive organic growth for Natus.

I am pleased to report that we have established a new product pipeline that we are very excited about. We introduced our first in a series of new products in the second quarter and will continue with additional 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.

Domestic and international revenues were solid in all geographies, and we experienced growth in many of our markets. Our recently launched Hearing Screening Service grew rapidly during the quarter and we ended the quarter with 22 hospitals under contract. We continue to be very excited about this opportunity. We now offer newborn hearing screening tests 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 received 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 start to market this service and develop the market, we believe it will become more meaningful and a significant growth opportunity in 2015 and beyond.

In June, we announced a $10 million stock repurchase program. The primary objective of this program is to offset the dilution from issuances relating to employee stock grants and the Company's employee stock purchase program. In the second quarter, Natus generated approximately $14 million in cash from operations. While our cash balance has decreased by $3.6 million, we reduced our bank debt by $16.5 million and bought back approximately $1 million of our stock in June to net $14 million of cash generation in the quarter.

We look to continue to generate significant cash in future quarters and to pay off our bank debt in 2014. We currently are not planning to do a significant acquisition in 2014. We believe it is important to show ourselves, shareholders, and the medical community the strong leadership company Natus has become and that we are a consistent, organic growing 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 second-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 growth.

We remain committed to driving towards our long-term goal of 20% non-GAAP operating margin in the years ahead, Jonathan?

Jonathan A. Kennedy

Thank you, Jim. Today I will be discussing our financial results on a GAAP basis as well as on 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 6 of today’s press release.

As Jim stated, we reported second quarter 2014 revenue of $86.3 million compared to revenue of $82.3 million for the second quarter of 2013. Revenue from our neurology market increased to $55.7 million or 65% of total revenue during the second quarter of 2014 compared to $52.8 million or 64% during the same quarter last year. Revenue from our newborn care market increased to $30.6 million or 35% of total revenue during the second quarter of 2014 compared to $29.5 million or 36% of total revenue during the same quarter last year.

On a consolidated basis, revenue from devices and systems contributed approximately 61% of total revenue in the second quarter compared to 57% in the 2013 period, while revenue from supplies and services was approximately 39% of total revenue in the second quarter of 2014 compared to 43% in the 2013 period.

Revenue from domestic sales was approximately 60% for the second quarter of 2014 compared to 58% in the same period in 2013. Revenue from international sales was approximately 40% for the second quarter of 2014 compared to 42% for the same period in 2013.

On a non-GAAP basis our gross margin decreased by 50 basis points in the second quarter to 59.3% compared to 59.8% in the second quarter of 2013. The reduction in gross margin was primarily the result of unfavorable product mix. Non-GAAP operating expenses were $0.1 million lower than the same quarter last year and our non-GAAP operating margin improved to 13.3% compared to 11.5% for the same quarter last year.

Looking ahead to Q3, we expect non-GAAP operating expenses to be approximately the same level as Q2 between $39 million and $40 million. Our second quarter non-GAAP effective tax rate was lower than expected at 27%. We expect this slightly lower rate to continue for the remained of the year.

Other income was a benefit of $0.8 million during the quarter. This non-cash benefit was a result of adjustments to foreign exchange gains on certain international-company loans. And looking ahead, we expect other income to be an expense of approximately $0.1 million to $0.2 million.

On a GAAP basis, net income increased at $7.7 million or 24% per diluted share, a $3.7 million or $0.11 increase from the same quarter last year. Non-GAAP net income increased $2.5 million compared to the same quarter last year to $8.9 million and non-GAAP earnings per share increased 33% to $0.28. We recorded approximately $2.2 million of depreciation and amortization expense.

Amortization expense during the quarter was lower than normal by approximately $1.1 million as we reported a correcting adjustments to the carrying value certain intangible assets. Looking ahead to Q3, we expect amortization to return to its normal level of approximately $2.5 million and depreciation to be approximately $1 million. Equity based compensation was approximately $1.6 million during the quarter and we expect a similar amount during Q3.

Now let’s take a look at the balance sheet and cash flow. Net cash decreased by $3.6 million during the quarter. We reduced our long-term debt by $16.5 million and repurchased approximately $1 million or 36,000 shares of Natus Stock. Cash flow from operations was approximately $14 million. We ended the quarter in a net cash position with $56 million and then $16.4 million in debt.

Our days sales outstanding improved by 17 days to 80 days compared to the same period of last year and improved by 5 days compared to last quarter. We expect to continue improving DSO throughout 2014. Our diluted shares outstanding increased to $32.4 million shares compared to $30.5 million in the second quarter of last year, as all outstanding options are now in the money.

We expect a diluted average share count of approximately 32 million shares for the second quarter and the full year. 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 the third quarter and full year 2014 all on a non-GAAP basis and make a closing comment.

For the third quarter of 2014 we expect revenue of $86 million to $89 million and non-GAAP earnings per share of $0.28 to $0.32. We are increasing our non-GAAP earnings per share guidance for the year to $1.20 to $1.23 which is an increase from our previous guidance of $1.18 to $1.21. We are also increasing our full year 2014 revenue guidance to a range between $347.5 million and $352.5 million, an increase from our previous range of $345 million to $350 million.

In summary, we continue to execute on our business model and growing a world-class franchise in both neurology and newborn care. We are excited about our growth opportunities and look forward to the second half of 2014.

With that I’ll turn the call over to questions. Operator?

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Larry Solow with CJS Securities. Please proceed.

Larry Solow – CJS Securities

Hi, good morning. Hi, good morning. Jim, you had a pretty nice growth domestically, almost 10%, while international was close to flat. Is there anything we should read into that? Are trends improving that much domestically, and international markets remain sort of flat? Or is it just sort of a timing type thing?

James B. Hawkins

Yeah, overall, Larry, we had a very strong quarter domestically, international was good as well. One thing that I guess our numbers don’t show and unfortunately I don’t have it at hand but we did grow backlog in the quarter as well. And so in sometimes bookings can be different in shipment and I think that was the case. Our international business overall continued very solid. Latin America continued to be sort of the weaker link, but everywhere else we were very happy with.

Larry Solow – CJS Securities

Okay. So going forward, perhaps this discrepancy won’t be as large. Or is your outlook sort of pretty similar across markets? Or is that fair to say?

James B. Hawkins

Yeah, they are. We see growth pretty much in the future being uniform both in the U.S. and outside the U.S.

Larry Solow – CJS Securities

Okay. And I know you mentioned one product was introduced this quarter and you had several more coming. Can you shed any light, any color on types of products that you’re – the one you launched this quarter and maybe what areas you’ve planned to launch several more over the next 18 months.

James B. Hawkins

Sure. What we launched this quarter was product – a newborn hearing screen product, mainly for the international markets, we call Echo-Screen III, it’s a sort of a simpler product than our ALGO line. It is priced for the international markets and we look forward to do very well, especially in the developing countries. We also have a product that we announced at the end of the quarter called the BiliCare and it is a bilirubin point-of-care diagnostic device to tell the bilirubin levels of babies at the – in the nursery.

It also – this is a new product for us, a new product category area that we think has big growth opportunity. Other products that will be coming out, we’ll have a series of neurodiagnostic products that we don’t really want to talk about but we’re very excited about but I might add all these products have a very good margin on them. They are innovative, market-leading and we think we’re going to be able to get a very good price because of the value they give our customers, so we think as these roll out, it will help our gross profit throughout.

Larry Solow – CJS Securities

Okay, then just two housekeeping questions. You said the credit from the foreign currency, that was $1 million, is that what –? I just didn't hear the number, in the other income –

Jonathan A. Kennedy

Yeah, the total of that line I said was a $100,000 for other income.

Larry Solow – CJS Securities

Right, but it offset I guess a little bit of interest expense, I guess, right?

Jonathan A. Kennedy

That’s correct. I was going to say, there is also some offsetting adjustments to that up in OpEx too, that mitigate the total impacts of that adjustment. But for the quarter, it definitely was an income item, where typically, everything goes normal, we would see an expense there.

Larry Solow – CJS Securities

Got it. Then the tax rate, I assume it’s just higher R&D credits that is driving that down. You said, I guess, it is sustainable for this year. Is that you think a rate that could be even sustainable as we look out to 2015 and beyond?

Jonathan A. Kennedy

Yes, I think – so the tax rate was a little lower than we had guided. You do your tax rate planning based on where you think your profits are coming from in the U.S. versus international throughout the year and we’ve seen our foreign profits a little bit higher than we originally had anticipated. Profit, not revenue. So we had a little bit lower rate that we think as sustainable for the rest of the year and the 27% range, little bit lower than I thought mainly because of the increased profitability outside the U.S.

But we’ve also had some discreet items that are benefitting us for the rest of the year that we helpful but what’s not in there, that’s still an opportunity is the R&D tax credit. That is not in our rate. That is not current law today, but if it were to be reinstated later in the year, we get a benefit from that and that would be – that would lower the rate even further in the quarter in which it happened in and true up for the year.

James B. Hawkins

Larry, we should let other s ask –

Larry Solow – CJS Securities

Absolutely. Thank you so much.

Operator

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

Chris Lewis – Roth Capital Partners

Hi, good morning, guys. Thanks for taking the question and congrats on the quarter here.

Jonathan A. Kennedy

Thanks, Chris.

Chris Lewis – ROTH Capital Partners

First question is just on the revenue growth, hoping we can dive into that a little bit. I think 5% this quarter came in above our expectations and above I think where most of the Street was. Third quarter implies another quarter of solid growth of 1% to 4%. So really two questions there. First is, can you talk a little bit more about what drove that 5% increase in the quarter, whether it be specific product segments or possibly the newborn service opportunity?

Then second, just longer-term, I think many of the Street expectations have kind of been assuming a low single-digit growth profile for the company over the coming years in that 1% to 2% range. But with this quarter and with the guidance next quarter, how should we think about that longer-term growth profile? Is this more of a mid-single-digit grower, or is it maybe too early to assume that at this point? Thanks.

James B. Hawkins

Yeah, Chris, well, let’s see. I’d say, going through your questions both newborn care and neurodiagnostic products had very solid quarters had good growths through out. Especially when you throw the backlog growth in for each of those categories we are very pleased with those results.

Going forward, I think we’ve try to communicate that on our guidance we want to guide some may call on a conservative basis for guiding or we do not want to miss, thus our 1% to 4% revenue growth. We have really changed the dynamics at the company by as we have completed vast majority of the integrations or focusing on organic growth.

We are not culling products where we use to in the past and people are really seeing what we have sort of known that they are really is organic growth in our markets and our business. And so we are guiding to this 3% to 4%.

Do we think it could be at the high end, or higher? Yes, we do. But we certainly don’t want to guide there because there is a lot going on in the world. Russia, for example, we are all do business a little bit of business there, and we are concerned about revenues there. We have gone through the Middle East with Egypt that was an area that we used to do nice business in, not so much now.

So you have to be conservative with everything going on, and we think this 1% to 4% guidance we have given is conservative but we are very hopeful and optimistic especially when you combine the newborn hearing screening service business in there, that we have a lot of opportunities to grow over the next 18 months. So yes, we are excited. Thanks.

Chris Lewis – ROTH Capital Partners

Great. Thanks for the color there. Turning to the newborn services opportunity, looks like it continues to gain adoption, with 22 hospitals. Maybe you can talk about the backlog of potential customers and quotes you have out there in that area. And what you think you can kind of exit third quarter and maybe this year in terms of hospitals under contract.

James B. Hawkins

Yeah, we don’t want to put out a forecast on quarter-by-quarter on the number of hospitals that we look to sign up. But we certainly look for continued rapid growth there. We have a large number of quotes out there, a big amount of hospitals that are wanted to explore this opportunity for them. And it’s a pretty gone faster and more traction and activity than we anticipated at this early time. So without getting into too much detail we certainly look for continued rapid growth in the hearing screening service business. But we don’t want to actually forecast hospital by hospital going forward.

Chris Lewis – ROTH Capital Partners

Understood. And then the long-term operating margin goal of 20%, you referenced it in the press release and your prepared remarks. Can you provide an update on how you see the company trending towards that goal? Is that realistic in 2015, or does that materialize over a longer time period?

James B. Hawkins

Yeah, I will address the 2015 and then I will pass it on to Jonathan for some detail. Yeah, what we are seeing for 2015, we haven’t given guidance – we are saying it’s a long-term goal. But for 2015, we are thinking that we can get that 18% to 19% operating profit margin range, that’s probably where will be comfortable in talking about. Is there an opportunity to do better? Sure, but I don’t think we’ll be looking to guide there and may be for little more color on that I’ll pass it over to Jonathan.

Jonathan A. Kennedy

Yes, so Chris, I think Jim's comments are right on that for 2015 probably not the year we are going to achieve for the full year 20%. Might we exit 2015 at a run rate that sets us up for 2016 or 2017 at that rate, probably the case. I mean the details behind that really are when revenue grows. So revenue growth will help us get there faster. But then too, is just continuing to make the company operate at higher level. We are continue to implement new ERP system, we are probably in the seventh or eighth inning of doing that. By this time next year will be complete with the implementation of the ERP system that will set us up for increased operating efficiency and allow the company to really operate in a more uniform fashion across the board, and that, in and of itself will wring out costs. But to the speed at which we achieved that will be dependent on execution on the operation side, but then also revenue growth.

Chris Lewis – ROTH Capital Partners

Great, thanks for the time.

Operator

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

Brian Weinstein – William Blair

Hi, good morning. Thanks for taking the question. Jim, can you talk a little bit about the level of R&D spending that you guys have today? Historically, I don't think we have seen kind of the efficiency in R&D that you would have been happy – that you were happy with. Just kind of curious if you can talk about that particular line item within OpEx, and where you are as far as happiness in terms of the efficiency that you are seeing out of that at this point. Is there room to still maybe move that area down in terms of overall spending? Or is this going to be where we are going to be for a while on R&D side?

James B. Hawkins

Yes, Brian, thanks for the question. On the R&D side there is been a lot that has transformed here at Natus over the last year or so. One is that from all these acquisitions we had numerous product lines that we were having to constantly maintain, update. And as we have gone forward we have been able to consolidate or eliminate some of these products which takes a nice chunk out of sustaining engineering spend that we were doing. Rather than spending on sustaining engineering we have been able to eliminate some cost.

But we’ve been able to redirect that to new products. And so we think that the spend amounts that we have we do not see going down but as revenues grow we look for that percentage to shrink. We think there is just a big opportunity not only on the top line but as I tried to allude to, that these new products were going to have very good gross profit margins and so it’s really a win-win.

And we see it as a real strong positive position for Natus now as we focused on organic growth to really have an R&D spend on innovative products. So it’s a little bit of a change when we were doing acquisitions it was really – certainly getting the profitability but we needed as a public company as a medical device company to really get some mass, and we did that to become number one leaders in our market. Now, we’re still looking to grow as we talked about, through acquisition towards the end of next year. But it’s really to focus on organic growth and gross margin and profitability consistent improvements.

Brian Weinstein – William Blair & Company

Okay, great. Thanks for that answer. Going back a couple – over the last couple years, you guys had previously talked about large orders that were on the sidelines, or that had come in, and those would skew your results in any given quarter. Was there any large order this quarter that either came in or did not come in? And are there any larger orders that are baked into your guidance for the rest of the year?

James B. Hawkins

Yes, big question Brian. We have seen some large international orders that pop in for a $1 million to $2 million to $3 million at times, that do make for a good quarter but then make for a tough comp. I don’t know if it’s good or bad news, but we did not receive any of those large orders in Q2 and we do not have any of those large orders forecasted in our Q3 or Q4 of this year. Could one or two of those happen? Yes, but it would be upside is how we are giving our guidance.

Jonathan A. Kennedy

I would say that our internal process would be to exclude any of those from any sort of guidance just because it’s too lumpy.

Brian Weinstein – William Blair & Company

Okay. Thanks, guys.

Operator

(Operator Instructions) Your next question comes from the line of Jayson Bedford with Raymond James. Please proceed.

Jayson Bedford – Raymond James

Good morning and thanks for taking the questions, guys. Just to piggyback on a few earlier questions, the sources of leverage going forward, you've kind of given us some implied margins for the second half of the year. You talked about some margin targets for next year. Where will we see the leverage? Obviously, you'll get some from some better top-line growth. But is it more on the cost of goods line, or is it more on the OpEx line?

James B. Hawkins

I’ll let Jonathan expand on that a little bit. Certainly top line, if you look it on an incremental basis as revenues grow, a good portion of that drops at the bottom line for us. So that’s one area of leverage, especially when you look at some of these newer higher margin products and are Hearing Screening Service gets to be a bigger part of the business that’s going to naturally improve the growth profit as well. Going to the operation side, I’ll let Jonathan review some of those opportunities.

Jonathan A. Kennedy

Yes, I mean, I think it’s important to note that Natus is still not only growing revenue, but we’re still an evolving, growing operational company. And we’re still in the process of making the company a little more contemporary and way it operates. Like we mentioned the ERP system, operational efficiencies, and things like that. So, if you ask where would the leverage come from? It is going to come from everywhere.

It will come from cost of goods sold. It will also come in the operating expenses over a period of the next several quarters. It’s difficult to put your finger where it's going to be bigger, because I think as opportunity in OpEx and in gross margin, but I think you can do the math, extrapolate out to 20%. You put some revenue growth on there, you can figure out where it has to come from. But it is at least equal opportunity between COGS and OpEx.

Jayson Bedford – Raymond James

Okay, and just maybe for the second half of the year, implied in the guidance is there a bump up or a trend upward on gross margin over the next couple quarters?

James B. Hawkins

Yes, I would say, that’s correct. We’re looking to – we like to be able to hit 60% plus gross profits in our Q3 and certainly Q4.

Jayson Bedford – Raymond James

Okay, that’s helpful.

Jonathan A. Kennedy

And the back half tends to be a heavier revenue time period for us. So as revenue goes up on our fixed cost structure remember we make almost everything ourselves so we get the benefit in gross margin as we produce more products in the second half.

Jayson Bedford – Raymond James & Associates

Okay. Last one for me and I will let someone jump in. You saw some good domestic growth, strong growth in devices. You guys are unique in that you have a little more exposure to capital equipment than most. So I am just wondering if you are seeing a change in attitude toward the capital equipment environment, specifically in the U.S. And then, is this a trend that you expect to continue over the next few quarters?

James B. Hawkins

Yes, Jayson, I would say without a doubt as far as we are concerned we have seen hospital spend certainly become easier I would say for the hospitals the number of larger orders has definitely ramped up year-over-year and it appears by looking at our forecast those trends are continuing. I’m not sure if it’s just the settling down of ObamaCare and the combination of the economy getting better, but we’ve definitely seen more larger dollar orders domestically than we have over the last couple of years.

Jayson Bedford – Raymond James & Associates

All right, thank you.

Operator

There are no further questions in queue at this time.

James B. Hawkins

Well, I would like to thank everyone for participating. I’d also like to give a little shout out to all of our employees at Natus, it’s been quite a remarkable turnaround and in our earnings that we’ve shown over the last really 18 months and it’s really due to the hard work of everyone at Natus. Our sales force, as we’ve talked about, is we believe best of class and I think they are showing that and by giving them these new products I think it will even be more so.

We are very excited as we approach the back half of our year. We look to continue to show solid, organic, consistent growth and we are very excited about 2015. So with that, I’d like to thank everyone for participating on today’s call and your continued support and interest. Thanks, again.

Operator

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

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