Natus Medical's (BABY) CEO Jim Hawkins on Q2 2016 Results - Earnings Call Transcript

| About: Natus Medical (BABY)

Natus Medical Incorporated (NASDAQ:BABY)

Q2 2016 Results Earnings Conference Call

July 20, 2016 11:00 a.m. ET

Executives

Jim Hawkins - President & Chief Executive Officer

Jonathan Kennedy - SVP & Chief Financial Officer

Analysts

Chris Lewis - ROTH Capital Partners

Brian Weinstein - William Blair

Jayson Bedford - Raymond James

Larry Haimovitch - Haimovitch Medical Technology Consultants

Operator

Welcome to the Natus Medical Second Quarter 2016 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 20, 2016 and contains time sensitive information that is accurate only as of today.

Earlier today, Natus Medical released financial results for the second quarter 2016. 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 investorrelations@natus.com. This call is being broadcast live over the Internet on the company's Web site at natus.com and a replay of the call will be available on the Web site 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 2016 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 2016. Natus reminds you that future results may differ materially from these 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 turn the call over to Jim Hawkins, President and Chief Executive Officer of Natus Medical. Mr. Hawkins?

Jim Hawkins

Thank you, operator. Our second quarter results that we released earlier this morning, reported revenue of $96 million compared to $91.9 million last year. We also reported non-GAAP earnings of $0.39 compared to $0.34 in our second quarter last year and generated $13 million of cash flow from operations in the quarter. We also repurchased $7.7 million of stock during the second quarter.

I am very pleased with both our record revenues and non-GAAP earnings per share that increased 15% over last year. Our domestic neurology business led the way with a very strong quarter with record revenues. Many neurology orders that were pushed out from the first quarter came in the second quarter as hoped. Our domestic newborn care business also reported record revenues for the second quarter.

Our international markets in both neurology and newborn care did remain challenged with many countries in the world continuing to face slow or even negative growth and reduced spending. We are not forecasting growth in our international markets for the remainder of 2016. In the second quarter, I am pleased to report Peloton and NicView, both had excellent quarters. As these businesses are relatively new, each only had one or two dedicated sales people as we initially focused on leveraging our newborn sales force to introduce the product and services to hospitals. These businesses have grown rapidly and in the last nine months we invested in additional sales people in both Peloton and NicView.

I am pleased to report, we started to see the benefits of this investment in the second quarter as Peloton signed 15 new hospitals in the quarter and now has 104 hospitals under contract. NicView also had record results and now will have systems operating in 98 hospitals. For NicView, this is up from 40 hospitals 18 months ago.

GND, our neurodiagnostic service initiative also had a record quarter with growth approaching 50% year-over-year. We remain confident or convinced, GND will continue to show excellent growth in the quarter and years ahead. As a market leader in our industry segments, we are well positioned to continue to lead by developing innovative products that will drive organic growth. We have established a new product pipeline that we are excited about. We had also created and entered numerous service business initiatives that are tied to our market leading products and have made doing service as a business a key focus for Natus going forward.

We believe the opportunity exists to provide our customers additional services, rather than only selling them equipment and supplies. In early July, we announced the acquisition of RetCam for $10.6 million. RetCam is the market leader in NICU ophthalmic imaging used in the detection and documentation of retinopathy of prematurity called ROP, and other eye diseases in newborns such as cancer of the retina and shaken baby syndrome. RetCam is also regularly used in a range of research applications, including clinical trials for studies of new diseases affecting the eyes in newborns such as a variety of congenital and acquired retinal abnormalities, central macular birth hemorrhage and recently, the Zika virus.

Adding Natus global sales and marketing to reach the RetCam product line should increase the market penetration and growth potential for this very important newborn technology. We expect annual RetCam revenue of approximately $14 million with $7 million of revenue for the remainder of 2016, $3 million in Q3 and $4 million in Q4 as seasonality is a factor with RetCam. We expect it to be immediately accretive to 2016 earnings.

Our growth strategy along with organic growth is to again look to make accretive acquisitions. For the last few years, we have made smaller tuck-in type acquisitions with revenues of less than $10 million. Starting with RetCam, we will now be opportunistic and acquire companies with revenues ranging from $10 million to $100 million. We will continue to do tuck-in acquisition as well.

With our strong cash flow and balance sheet, we are in an ideal position to leverage our balance sheet for the right opportunity. As always, it is our intent to use pricing discipline when we buy a business. The metric we have always used at Natus is to not pay more than half of the revenue multiple we are trading. For example, if we are trading at three times revenue, we would not pay more than 1.5 times revenue.

For new investors that may not be familiar with our service initiatives, I would again like to briefly review Peloton, GND, NicView, and coordination services. Peloton which started in Q1 2014, offers 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 receive for our disposable hearing supply, to $85 for actually performing the hearing screening test. We expect Peloton revenue to ramp throughout 2016 as we continue to market this service and develop this market.

NicView and global neuro-diagnostics are two new businesses that Natus entered into in our first quarter of 2015. NicView provides streaming video for families with babies in the Neonatal Intensive Care Unit that enables family members and approved friends to see the baby 24/7 from anywhere in the world, from any device. NicView solves a long-standing need in the NICU and hospital nurseries. We believe NicView a standard practice for NICUs and worldwide use in the years ahead. We remain very excited about the growth opportunity for NicView.

GND provides a service that allows patients a more convenient way to complete EEG testing in the home, hospital or physician's office. The service also provides comprehensive reporting and support to the physician. We look to expand GND throughout the United States from their current base throughout 2016. Peloton, NicView, and GND are rapidly growing new offerings to the marketplace that represents the beginning of an expanding service business and positions Natus for revenue growth and record earnings in 2016.

On top of all that, last July we launched coverage on our recently awarded five-year, $32.5 million contract with the State of California to provide hearing screening coordination services. This new contract added approximately $24 million in revenue over and above the existing contract run rate during the five-year contract. We believe additional states and governments may consider an outsourcing model for hearing screening coordination in the future. Natus is well-positioned to benefit if this trend plays out as we anticipate.

In summary, we are very pleased with our second quarter revenue and operating results. We look to continue our strong earnings momentum and cash generation combined with revenue growth in 2016. We remain committed to driving towards our 2016 goal of a 20% non-GAAP operating margin. 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, restructurings, 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. And you can find a reconciliation of our financial results on a GAAP versus non-GAAP basis in today's press release.

As Jim stated, we reported second quarter 2016 revenue of $96 million, a 4.5% increase from the same period last year. And on a consolidated basis, our North American business grew 12% compared to the same quarter last year, driven primarily by growth in our service businesses. Our international business declined about 10%, driven by lower device sales across both business units.

Revenue from our neurology market increased 4% to $61.2 million or 64% of total revenue during the second quarter of 2016, compared to $58.6 million and 64% of total revenue during the same quarter last year. Revenue from our newborn care market also increased 4% to $34.7 million, or 36% of total revenue during the second quarter of 2016 compared to $33.3 million or 36% of total revenue during the same quarter last year.

In total, revenue from devices and systems contributed approximately 58% of total revenue in the second quarter of 2016 compared to 57% in the 2015 period while revenue from the supplies and services was approximately 42% of total revenue in the second quarter compared to 43% in the 2015 period. Revenue from domestic sales was approximately 70% for the second quarter of 2016 compared to 66% in the same period of 2015.

Revenue from international sales was approximately 30% for the second quarter compared to 34% in the same period last year. On a non-GAAP basis, our gross margin decreased by 265 basis points in the second quarter to 60.5% compared to 63.2% in the second quarter of 2015. The decline in gross margin was driven by our newborn care business where a combination of overall unfavorable product mix and a higher warranty cost reduced the overall gross margin. We do not expect the higher warranty cost to continue beyond this quarter.

Non-GAAP operating expenses decreased by $0.2 million compared to the same quarter last year and our non-GAAP operating margin decreased slightly to 18% compared to 18.5% during the same quarter last year. Our second quarter non-GAAP effective tax rate was about 26.3% and this lower rate primarily reflects the ongoing benefit of the implementation of a more efficient operating structure and the permanent reinstatement of the R&D tax credit. Looking ahead, we expect our overall non-GAAP 2016 tax rate to remain between 26% and 27%.

Non-GAAP other income was $0.1 million for the second quarter. On a GAAP basis, net income was $10.5 million or $0.32 per diluted share, a $0.7 million increase from the same quarter last year and non-GAAP net income increased $1.6 million or 14% compared to the same quarter last year, and non-GAAP earnings per diluted share increased 15% to $0.39. In the second quarter we recorded approximately $4.2 million of depreciation and amortization expense. Our share-based compensation was about $2.1 million during the second quarter.

Now let's take a look at the balance sheet and cash flow. We repurchased $7.7 million of company stock and net cash increased $15 million. We ended the quarter with $10 million in debt. This debt was used to fund our acquisition of RetCam. We expect to pay down the debt by the end of the year.

Cash flow from operations was $13.6 million during the quarter. Our days of sales outstanding decreased by 5.5 days during the quarter to 88.3 days despite an increase in revenue as we continue our DSO reduction efforts. Our diluted shares outstanding decreased to 33 million shares compared to 33.2 million shares in the second quarter of last year.

With that, I will turn it back to Jim. Jim?

Jim Hawkins

Thanks, Jonathan. Before opening up the call to questions, I would like to review our financial guidance for our third quarter and for the full year 2016, all on a non-GAAP basis.

For the third quarter of 2016, we expect revenue of $97 million to $98 million and non-GAAP earnings per share of $0.41 to $0.43. This compares to revenue of $94.6 million and non-GAAP earnings per share of $0.39 in the third quarter last year. For the full year 2016, we expect revenue of $388 million to $390 million and non-GAAP earnings per share guidance of $1.67 to $1.70.

With that, we will now turn the call over to questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] And our first question comes from the line of Chris Lewis with ROTH Capital Partners. Your line is now open.

Chris Lewis

Just wanted to start out on just the general health of the business now maybe versus a few months ago on your last earnings call coming out of, obviously, a surprising first quarter where revenues fell short of expectations. Jim, I was hoping you could just elaborate on where, now that you have had some more time to digest that, where the quarter fell short. You talked about some orders being pushed out that have been realized and fulfilled this quarter. Why do you think some of those orders were pushed out and what are you doing to make sure that doesn't happen again? Thanks.

Jim Hawkins

Thanks, Chris. I think you have covered that pretty well what our view was in Q1. Q2 we were pleased to get those orders mostly in as we went through the quarter. And in fact we actually received a $1.8 million order which was the largest EEG order from a single hospital in company history. So the trend is certainly continuing where we are seeing bigger orders placed more often. And I think it really has to do with a lot of neurology becoming more and more important to hospitals. So we think we are really in a nice little place, especially in the U.S.

Going outside the U.S., boy, we have seen just continued headwinds. Last year was big on currency. The currency certainly hasn’t really gotten worse but it hasn’t really improved. And so it does make it harder for hospitals to go out and buy U.S. equipment when they are buying in dollars. On top of that, certainly the Middle East, we have seen reduced spend there. We have seen it in Latin America. Europe is flattish to down and China is more flattish to slightly up. But all in all, the international markets continue to be a challenge.

What we are doing overall I guess Chris is that we are trying to be a little more conservative in our revenue guidance. And I guess in Q2 I think we guided to the 92, 93 level and we did 96. And so with all this uncertainty out there combined with RetCam having it for the first time and learning that, again we thought being conservative on our revenue guidance was prudent.

Chris Lewis

Understand, and maybe a question for Jonathan on gross margins. You talked about mix and warranty costs, bringing that down a little bit in the quarter. Can you break out the impact and quantify the impact driving gross margin from each of those factors and then looking ahead, where do you think gross margins tick back up to as those warranty costs roll off?

Jonathan Kennedy

Yes. The warranty costs were in the million dollar range. Warranty and a couple of other scrap items that are unusual to hit in one quarter. So the combination of that plus the lower gross margin, the lower gross margin from mix, probably added about two points of margin. So if you recall, we had a ship hold on our neoBLUE products almost all of the last part of last year and early this year. And we got the 510(k) and started shipping those products. Unfortunately those products don’t have the same average gross margin that we see on newborn care, which is typically north of 70. They are down below the corporate average. So pushing that out the door along with the warranty expenses, lower gross margin for newborn care business unit, which affected the rest of the corporate average.

On the neurology side, the gross margin remains strong in the mid, in the mid to low 60s, as it normally does. So if we are looking forward, we are probably looking at going back up to 61, 62 in the third quarter, fourth quarter.

Chris Lewis

Pretty good. One more from me and then I will hop back in queue. Jim, some M&A commentary from you indicating that you are starting to broaden the opportunities, I guess, in terms of larger acquisitions. I guess can you elaborate on that? What's kind of changed on the M&A front or strategy there? Why are you looking to potentially larger acquisitions? And I think, just finally, if you assume $100 million in sales of a potential asset that you're acquiring and assume the kind of traditional half time sales multiple, that would imply up to $150 million in a total acquisition price. So, how would you plan to fund an acquisition of that magnitude? Thanks.

Jim Hawkins

Yes. So, Chris, maybe just a little history. Over the last 12 years I think we have built Natus from this $30 million business to where it's almost $400 million through a combination of organic growth and accretive acquisitions. Certainly the most measurable part of that has been through acquisition. Over the last three years, we decided to really focus back on profitability and getting Natus running efficiently. By doing that, we have done a lot of integrations of all these acquisitions that we have done over the last 12 years. And then we also put in Oracle to get everybody on the same IT platform. That was a lot of work and we really wanted to get that done along with getting into the new service business.

So we have been really focused on more organic growth with the new service initiatives, and then just doing some tuck-in acquisitions. We now feel that we are in a great position again to go back and to look at larger acquisitions. And we have sort of put up a fence around that in the $10 million to $100 million range. If we were to do that, we think we have the strong balance sheet that we alluded to. That we are generating a lot of cash plus to be able to fund something, $100 million, $150 million, $200 million, kind of debt we can take on, should not be a problem. So with that said, there is nothing that I can say is going to be announcing here in the short term. We are just going to really be opening that door again but we feel if we can buy things at the right price, getting it into our sales and marketing organization and getting that business to Natus operating metrics which we have always been able to do in the past, it can create a lot of value for shareholders.

Operator

And our next question is from the line of Brian Weinstein with William Blair. Your line is now open.

Brian Weinstein

So, I want to go back onto the gross margin discussion for a second. I think at the beginning of the year, maybe at the end of last year, you talked about a 62% to 63% sort of target for 2016. Is that still the right way to look at it? And then, digging into gross margin a little bit more, is there anything else going on here? Can you talk about, is there any price that you guys are giving up anywhere? Is there any kind of manufacturing or scale up issues? We would think gross margin would be a little bit higher due to the growth that you have seen in some of the service businesses. So, can you just give us any more color on that and kind of what the target is for the full year?

Jim Hawkins

Yes, Brian. Before, I will let Jonathan handle the majority of that. Just one factor that I will add is that, you know the dollar situation is such that, especially in Canada, we had a situation for a lot of last year. I believe the dollar was -- or sometime over the last 12 months, was in the 1.35 to 1.45 range and now it's around $1.30 or the reverse of that, however you want to look at the dollar. So with the dollar being weaker there, it has affected our cost. So there is a little factor there on that side. But that’s a small factor. For the remainder of it I will let Jonathan go into some more detail.

Jonathan Kennedy

Yes. As Jim pointed out, whenever the dollar fluctuates, typically we benefit by stronger dollar because we have more cost outside the U.S. and foreign currency than we have revenue. When the dollar weakens than the opposite is true. So that’s a little bit of fluctuation. This quarter really though, as I said in my prepared remarks, had to do with warranty reserve accrual we took in our newborn care business unit for a couple of specific products. We don’t see that as a systemic issue. We don’t see it as an ongoing issue. But that definitely had an impact on the quarter of about $1 million. The lower margin push through of the backlog for the neoBLUE, that had a unique effect for the quarter. We just don’t typically see our newborn care business drop margins that quickly for any particular reason. There is nothing on the price side. And then really most importantly on the neurology side, the margin held very well. And remember, neurology is about two-thirds of the business. So we might have a little bit of speed bumps in the newborn care business but the big balance of the business is remaining pretty stable.

And then your question about for the rest of the year. Yes, I think the 62%, plus-minus, range for gross margin is still on for the full year, although having Q2 drop down just below 61% makes it more difficult but I still think we can get to that 62% mark. Could we get up to 63%? You know it's harder when we have a quarter like Q2 on gross margin but I think we can totally do it.

Brian Weinstein

And then the guidance implies a little bit of a step up in the fourth quarter on the revenue line, in particular versus kind of Q3. What kind of visibility do you guys have at this point to justify more of a fourth quarter weighting that is maybe a little bit stronger than what we have seen from you guys in the past?

Jim Hawkins

Yes. Brian. As you mentioned, fourth quarter is definitely our biggest quarter of the year and we would expect that to happen again. Q3 is typically sort of flattish to Q2. And mainly the driver there is outside the U.S., that as you know the holidays are pretty well taken in many European countries at that time. And when they go on vacation, they go on vacation. But September is usually real big month, we walk to a real good start here domestically in July and we feel real good about our guidance.

Brian Weinstein

Okay. And then last one for me is international. Obviously, you have macro headwinds that you're dealing with, but what is the specific strategy that you guys are putting in place to deal with these macro headwinds? I am assuming that it's not just sort of, okay, we are throwing our hands up and there's nothing we can do about it. So, what are you guys doing to try and offset this? Is there more aggressive bundling, more aggressive pricing? How do you strategically deal with the fact that your end markets are just a little bit slower O-U.S.? Thank you.

Jim Hawkins

I think certainly we are putting a real effort in our countries where we are selling direct, Brian. We have seen, I would say average to down results in both France and Germany. And we are really going to be working with those teams there. Looking at all factors including different marketing schemes, different selling strategies. And I would say, even consider price when appropriate. We have had a very hard line on pricing and we still plan on keeping that but I think the longer the dollar stays here and it's not a blip, I think we then have to also get to the reality that maybe this is the condition that’s going to be for a few years. So I think we are going to be dealing with that a little more aggressively.

Operator

And our next question is from the line of Jayson Bedford with Raymond James. Your line is now open.

Jayson Bedford

Just to clean up the international commentary. Down 10% is a big number, are you seeing more competition out there in these end markets?

Jim Hawkins

Not in the majority of them, I would say, Jayson. Latin America is a big market for Natus. We have on the newborn side, our Medix business down there. In Argentina, I think I mentioned in the last conference call, although a lot of great things are happening there, they are having an austerity program when it comes to spending because they want to try to reduce inflation and have their peso really be stable on the world market and have really cut back on their deficit spending. Because of that it has had a effect on hospital spend and it is one of our bigger markets. So that certainly is something there.

Middle East, we have definitely seen tenders be reduced in size and delayed and just things of that nature, I would say. So it's just really across the board. But those two areas are probably where we have seen the biggest drop.

Jayson Bedford

Okay. And, Jim, maybe can you remind me, international markets, are those more capital heavy versus disposable or is the mix consistent with the entire business?

Jim Hawkins

Yes. I would say overall it is more capital intensive. We see, especially in the developing world, where disposables are reused more often than say domestically, and thus the disposable business is a lesser percentage on an ongoing revenue.

Jayson Bedford

Okay. Jonathan mentioned the impact of neoBLUE on gross margin. What was the size of the stocking related to neoBLUE in the quarter?

Jim Hawkins

Jonathan, you want to discuss that?

Jonathan Kennedy

Yes. Jayson, we don’t normally break out piece by piece but just in this case we will talk about it just because it was unusual. We shipped about $1 million, little over $1 million worth of neoBLUE products towards the end of the quarter when we got the approval to do so. We had a pretty big backlog throughout last year for those so we pushed this harder to get them out the door.

Jim Hawkins

Yes. I think, just to add some color to that too Jayson. I think historically it's been about a $3 million a year business. And so rather than shipping say $700,000, maybe we shipped $1 million in the quarter, if you would annualize that. So it wasn’t like $1 million out of nowhere when you go back through our history.

Jayson Bedford

Right, okay. And then, maybe you can just touch on the RetCam deal and specifically what is involved in the integration process?

Jim Hawkins

Yes. So it's quite a unique acquisition we did. It's only about 2 miles away from our offices here in Pleasanton, California, and we have known RetCam for some time. Right now we are looking at the best way to integrate some of that to try to make it more efficient and more customer facing with our big sales force, how to best integrate all that. But we think there are a lot of opportunities in the months ahead.

Operator

And the next question is from the line of Larry Haimovitch with HMTC. Your line is now open.

Larry Haimovitch

Jim, you touched on it briefly, the Argentina situation. Of course last year, late in the year, you announced some exciting news there. Can you give us an update on where that stands? Have you received any business at all? And if not, do you hope to get any business from them the rest of this year?

Jim Hawkins

Yes. Thanks, Larry, for the question. As I think everyone noticed, the Venezuelan order through our Argentina subsidiary was not mentioned, I don’t think, in our press release or conference call script as we are not putting it in our guidance. With that said, there certainly is a lot of need in Venezuela to have this newborn equipment and the ministry of health down there has continued to work to try to get this contract operating. But we have not received our down payment yet. The talk is certainly there that it's going to be coming but we are certainly not figuring on it in our guidance.

Larry Haimovitch

Okay, and then on another topic, the RetCam. You and I talked about this briefly after the acquisition. There are new competitors coming in the market. Can you discuss their possible impact on RetCam business?

Jim Hawkins

Yes. RetCam has been the worldwide market leader in their products that they serve and certainly we look for them to continue to be. There are talks of competitors coming out. We haven't seen anyone in the marketplace yet that I am aware of. I am here in the United States. We feel that we have the leading product. We are in the vast majority of the hospitals in the United States and we are going to be continuing to develop new products that will, we believe, enhance our market position over time.

Operator

And I am showing no further questions at this time. I would now like to turn the call back over to Mr. Jim Hawkins for any closing remarks.

Jim Hawkins

Well, thanks, operator and thanks everyone for participating. At Natus we really feel that our business is back on track after a little stumble there in our first quarter. The momentum is back, our earnings are back and our revenues are back. We really look to continue with this momentum, to continue throughout the remainder of this year and also with the acquisition opportunity that we have now opened the door of again to do larger acquisitions, we think there is just a big opportunity here to create shareholder value in the years ahead. So with that I would like to go ahead and also that we would like to thank everyone for participating on today's call and your continued interest and support. Thank you very much.

Operator

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may now disconnect. Everyone have a great day.

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