Natus Medical Inc. (BABY) Q4 2018 Earnings Conference Call Transcript

Natus Medical Inc. (NTUS)
Q4 2018 Earnings Conference Call
February 13, 2018, 11 a.m. ET

Contents:

• Prepared Remarks
• Questions and Answers
• Call Participants
  
  See all our earnings call transcripts.

Prepared Remarks:

Operator

Good morning, everyone, and thank you for joining us today to review our results for the Fourth Quarter of 2018. On the call, today from Natus is Jonathan Kennedy, Natus' President and Chief Executive Officer; and Drew Davies, Natus' Executive Vice President and Chief Financial Officer. Jonathan will begin today with a business overview of the fourth quarter and provide guidance for the first quarter and full year 2019, then Drew will discuss the third quarter financial performance. Finally, we will open the call for your questions, to ask a question, please press *1 on your touchtone phone.

Today's call will include forward-looking statements within the meaning of the Private Securities Litigation Reform Act. These statements include management's beliefs and expectations about our future results. Our actual results may differ materially from these forward-looking statements. For a description of relevant risks and uncertainties pertaining to our business, please see today's press release and our periodic and annual reports filed with the SEC.

I would now like to turn the call over to Jonathan Kennedy, President and Chief Executive Officer of Natus Medical. Mr. Kennedy?

Jonathan Kennedy -- President, Chief Executive Officer, and Director

Thank you, operator, and good morning everyone. Today we reported our financial results for the fourth quarter and full year 2018. Revenue for the fourth quarter was a record $141 million, representing 7.3% year-over-year growth. Revenue during the quarter is driven by strong demand across multiple product and market segments, and we saw particular strength in our US neurodiagnostics and international hearing assessment markets. Our gross margin during the quarter was less than expected resulting in lower than expected non-GAAP earnings per share. Cash flow from operations was a healthy $14.1 million during the quarter.

Shipment of Otoscan during the fourth quarter more than doubled versus the third quarter when the product was launched, and we ended the year with over 180 Otoscan devices in the field. We remain very encouraged by the ramping adoption of this new digital ear scanning technology. We also relaunched our neoBlue phototherapy blanket during the fourth quarter. With this launch, all of neoBlue products are now available for customer shipments. And Drew will discuss revenue in further detail in a few minutes.

As you know, a few weeks ago we announced our One Natus initiative. This ongoing effort will make Natus a stronger, higher quality, and more efficient competitor in the rapidly changing medical device market and better position the company for growth. We recognize there are steps we need to take to improve profitability and performance I believe that the new organization will allow us to optimize our proven go-to-market strategies and leverage a common engineering operations and supply chain infrastructure. And just to elaborate, we will retain and build upon our successful go-to-market strategies and serve customers with the same specialized approach and sales teams that we've used for years and are very common in the industry.

The creation of a global chief commercial office will ensure that the specialized teams will have clear and unimpeded access to leadership, critical information, and the resources needed to serve customers. The company will be supported by unified global operations, R&D, and administrative functions. However, we expect to continue reporting our end market revenue and gross margin results as usual. This global support structure is very common in our industry, and it offers a very efficient way to deliver specialized customer care, focus on markets, quality discipline, and internal transparency to company priorities and capital allocation. The Natus team is truly energized by the opportunities that the One Natus represents.

Next, I'd like to provide some insight into our customer supply channel. Our revenue mix is approximately 66% capital devices, 22% supplies, and 12% service. Approximately 80% of our revenue as a result of direct sales to hospitals and clinic customers and 20% of it is sold by distributors. Nearly all of our capital device sales are built-to-order resulting in little to no channel inventory. Direct sales of supplies to hospitals and clinics are usually on a just-in-time basis which results in minimal amounts of inventory stored at the hospital, and our distributors are typically small businesses in small international markets and normally stock less than 30 days of inventory.

In short, our customer supply channel is very efficient, it carries very little inventory, and is typical for the specialty med device industry. We also announce the exit of our NeuroCom Balance product line and are ambulatory EEG video service, GND. Our decision to exit GND was based on unacceptable financial performance coupled with a challenging reimbursement model. Our decision to exit NeuroCom reflects the market shift toward virtual reality based balance assessment technologies that we addressed with our Otometrics ICS product line. 2018 revenue for NeuroCom and GND combined was approximately $19 million, and neither were expected to be profitable in 2019. As a service, GND does not carry inventory, and we purposely manage the exit of NeuroCom over the past year such that remaining inventory is expected to be used for service and repairs over the life of the product in the field.

We expect to continue to evaluate our product portfolio for profit enhancing opportunities as well as areas where investment will lead to growth. We expect to benefit during the full year of 2019 of approximately $4 million as a direct result of immediate efficiencies gained through the One Natus initiative and additional ongoing annual benefits beyond 2019 that allow us to achieve an intermediate target model of 15% to 17% non-GAAP operating margin. For 2019, we expect operating margin improvement to be visible beginning in the second quarter, but most of the annual benefits to be reported during the second half. We expect operating margins to be in the mid to high teens in the third and fourth quarter and ongoing additional benefits will be achieved steadily over the intermediate term and are produced by the integration of our support teams, consolidation of operations and supply chain and increasing focus of our R&D efforts.

On the regulatory front, we successfully completed MDSAP audit at our Seattle manufacturing facility. This audit result confirms the successful completion of five MDSAP audits on our quality systems during 2018. As a reminder, the Medical Device Single Audit Program, or MDSAP allows a single regulatory audit of a medical device manufacturer to satisfy the audit requirements of five countries including the USFDA, Canada, and Japan.

In summary, we are encouraged with the performance of the business and the opportunities that lie ahead for Natus. We have market-leading positions in many of our products and markets, and we will continue to focus on the profitability of our business with the goal of expanding margins and increasing cash flow.

Before I turn the call over to Drew for our financial review, I want to welcome Alice Schroeder and Tom Sullivan to the Natus Board of Directors. Alice and Tom are joining Natus at an exciting time as we continue to refine and execute our strategy, drive profitability and enhance value for our customers, employees, and shareholders. Natus is committed to regular evaluation of its board and board refreshment. With these new directors, five of our seven independent directors will have joined the Natus board in the past three years, with four having joined in the past eight months.

Now I'll turn the call over to Drew Davies, Executive Vice President and Chief Financial Officer for a deeper dive into our financial results. Drew?

Drew Davies -- Executive Vice President and Chief Financial Officer

Thank you, Jonathan. Today I will be discussing our financial results are a GAAP basis as well as a non-GAAP basis. Our non-GAAP results exclude amortization expense, restructurings, certain other charges in 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 financial results on a GAAP versus non-GAAP basis in today's press release.

As Jonathan noted, we reported fourth quarter 2018 revenue of $141 million, 7.3% increase from the same period last year. Revenue from our neuro business unit was $73.1 million. The neuro business represented 52% of total revenue during the fourth quarter of 2018 compared to $68.2 million and 52% of total revenue during the same quarter last year. The 7.7% increase was driven by an increase in sales in our neurodiagnostic products.

Revenue from our newborn care business unit decreased by 8.6% to $32.3 million or 23% of total revenue during the fourth quarter of 2018 compared to $35.2 million or 27% of total revenue during the same quarter last year. The decline in revenue was attributable to lower Peloton service revenue and vision product sales.

Revenue from our Otoscan business unit for the fourth quarter of 2018 was $35.1 million, a $7.1 million increase from $27.9 million in the fourth quarter of 2017. Full year revenue was $127.6 million that the 25.8% increase in revenue for the quarter was driven by hearing fitting, including the strong ramp in Otoscan products and sales of supplies and service.

In total, revenue from devices and systems contributed 75% of total revenue in the fourth quarter of 2018 compared to 70% in 2017. While revenue from supplies and services was approximately 25% of total revenue in the fourth quarter of 2018 compared to 30% in the 2017. The increase in device mix was driven by the previously discussed increase in neurodiagnostic and Otometrics products.

Revenue from domestic sales was approximately 56% for the fourth quarter of 2018 compared to 54% in the same period of 2017. Revenue from international sales was approximately 44% for the fourth quarter of 2018 compared to 46% in the same period of 2017. Again, the change in geographic mix was driven by the increase in neuro-products domestically.

GAAP gross margin increased from 56.4% in Q4 of 2017 to 56.9% in Q4 of 2018. On a non-GAAP basis our gross margin decreased 220 basis points in the fourth quarter of 2018 to 58.2% compared to 60.4% in the fourth quarter of 2017. Each of our business units contributed to the lower gross margins. Higher manufacturing overhead including royalties, inventory reserves, and warranty expense for Otometrics products were the main drivers of the gross margin decreases. These items account for roughly 120 basis points of the decrease.

GAAP operating expenses increased by $26.3 million to $95.3 million compared to the same quarter last year. The increase included $23 million related to the write-off of goodwill and intangibles and restructuring as a result of exiting the GND and NeuroCom businesses as previously announced as well as the end-of-life of our biologics business. GAAP operating loss was $15.1 million this quarter compared to an operating profit of $5.1 million in the same quarter last year. The decrease relates to the intangible write-off.

Non-GAAP operating expenses increased by $2.9 million compared to the same quarter last year. Our non-GAAP operating margin decreased to 14.9% compared to 16.1% in the same quarter last year. The increase in OPEX and decline in margin was driven primarily by higher sales and marketing expenses on higher revenues, increased R&D expenses, both offset by lower G&A expenses. Our fourth-quarter non-GAAP effective tax rate was 20.3%, looking ahead to 2019, we expect the overall non-GAAP rate to be approximately 22% to 24%.

Other expense was $2.2 million for the fourth quarter of 2018, primarily was the result of fluctuations in the euro to the US dollar exchange rate. Interest expense was $1.5 million in Q4, and we paid down $10 million on our revolving line of credit during the quarter. With the expected additional pay down this year, we expect 2019 full year interest expense to be about $4.7 million.

On a GAAP basis, net loss was $11.6 million or $0.35 per share, a $4.5 million decrease from the same quarter last year. Non-GAAP net income increased by $0.5 million compared to the same quarter last year and non-GAAP earnings per diluted share was $0.43. In the fourth quarter, we recorded approximately $8.1 million depreciation and amortization expenses, excluding $8.4 million of intangible and fixed asset write-offs. Share-based compensation was approximately $1.5 million during the fourth quarter.

Now let's look at the balance sheet and cash flow. Net cash increased $9.1 million during the quarter; we ended the quarter with net debt of $48.1 million. Cash flow from operations was $14.1 million during the quarter, our days sales outstanding decreased two days versus the third quarter to 83 days. Inventory and current assets at the end of Q4 was $79.7 million, down $900,000 compared to the previous quarter. The majority of this inventory is less than 90 days old. Days of inventory on hand declined by three days 228 days. Our noncurrent inventory came down from $20.4 million in Q4 of 2017 to $18.1 million this quarter. We maintain this inventory primarily for service and warranty repair obligations. Non-GAAP diluted shares outstanding increased slightly to 33.1 million shares since the same period last year.

Now turning to guidance. We expect our revenues for Q1 of 2019 to be between $111 million and $115 million. The first quarter has historically been our lowest revenue quarter of the year. In addition to the seasonality, this guidance reflects the exit of the GND and NeuroCom businesses of about $5 million, other small newborn care product reductions of $3 million, and we have $6 million of products on hold pending updates to international regulatory registrations. We expect these registrations to be complete by early Q3 of 2019.

GAAP net income is expected to be in the range of a loss of $3.7 million to $6.6 million for the first quarter of 2019 or a loss of $0.11-$0.20 per share. Non-GAAP net income is expected to be in the range of $300,000 to $2.5 million or $0.01-$0.08 per diluted share. For the full year of 2019, we expect revenue to be in the range of $490 million to $510 million with full-year non-GAAP earnings per diluted share in the range of $1.12 to $1.49. We also expect full-year GAAP earnings per diluted share of $0.51-$0.88 per share. Expected non-GAAP earnings exclude $23.5 million of amortization and intangibles and $1.5-$2.5 million of restructuring charges.

Our full-year guidance at the midpoint is $500 million. We ended 2018 with $530.9 million in revenue. The bridge from $530.9-$500 million includes $19 million for the exit of the GND and NeuroCom business and $6 million for other previously determined end-of-life newborn care products and $13.7 million of other estimated revenue declines this calendar year offset by $7.2 million of growth in our existing businesses.

And with that, we will now open it up for questions.

Questions and Answers:

Operator

Thank you, sir. Ladies and gentlemen, if you have a question, please press *1. If your question has been answered or you wish to remove yourself from the queue, please press #key. Our first question comes from Brian Weinstein from William Blair, please go ahead.

Brian Weinstein -- William Blair -- Analyst

Hey guys, good morning, thank you for taking the questions. I guess we'll just start with the commentary on the intermediate term targets of 15% to 17%. Can you define what is intermediate term there and then as we think about what is required to get there, can you be more specific on the steps that you need to take to get to that 15% to 17%?

Jonathan Kennedy -- President, Chief Executive Officer, and Director

Sure, so, intermediate term, to me, is not 2019 but it's not 2021, 2022. So, you should see us in that range certainly the back half of 2019, but for the full year not there. But as we get into 2020, I would think that would be the timeframe of intermediate.

Brian Weinstein -- William Blair -- Analyst

And the specific steps that are required can you just elaborate on what you said in the script a little bit more?

Jonathan Kennedy -- President, Chief Executive Officer, and Director

Yeah, sure. So, we have a number of projects that are ongoing that have the effect of the cost reduction. We have some facility consolidations that we're working on. We obviously have this One Natus initiative that is quite a large project where the organization is being pushed into a single company without the infrastructures that previously existed under the business unit structure. There's a number of, literally dozens of small things add up, but the big items will be the facility consolidations and the change in the managing structure.

Brian Weinstein -- William Blair -- Analyst

And then what are your thoughts longer-term? You guys had given guidance at the Analyst Day previously, I recognize that's kind of suspended or not on the table anymore, but how should we think about what this business can look like longer-term from a margin standpoint? There's still a significant amount of operating expense that looks like over time could be removed. Are you guys looking at plans for that? Where are you in that planning process and any thoughts about where you think you could end up?

Jonathan Kennedy -- President, Chief Executive Officer, and Director

Yeah, I mean obviously, we've had operating target models higher than the 15 to 17, I think as we looked at the model, it makes better sense to talk about what we can achieve in some reasonable amount of time frame than it does to be so far out with our aspirations. So, if you think of 15 to 17, that's not far around the corner for us, that's a big push to get there, definitely not super easy, but to try to put a model that's beyond that out there today is to be a bit rhetorical in the sense we're not there yet. So, our view is let's focus on the intermediate term here; we've got our hands full with the restructuring with the One Natus project. The 15 to 17 would represent a significant increase from where we are today, and I think once we get into that range or get close to that range, we should talk about what would happen after that.

Brian Weinstein -- William Blair -- Analyst

Okay, and then as it relates to the guidance, you talked about the bridge there, you talked about GND and NeuroCom being $19 million, and then you said $13.7 million from other declines. What is that specifically, can you elaborate on that? Thanks.

Jonathan Kennedy -- President, Chief Executive Officer, and Director

Yeah, so you know, these are all forecast numbers, and you're trying to put together something that makes sense. We have a pretty large portfolio and, in that portfolio, things are coming, and they're going. So, the $13 million is the midpoint of the range of products that we think will suffer a decline., Yeah, the mix there we have our Peloton Hearing Screen Service business where there is pressure on reimbursement rates. We have our business down in Argentina, Medex, that has been having pressure on revenue and shipments just because it does a lot of business in the South American market that's under a tremendous amount of pricing pressure from currency exchange and then other pieces of newborn care.

Most of this has a newborn care look to it, but we tried to forecasts in a way that gives us the midpoint that's achievable and then as Drew pointed out, offset by overall growth of the business of 7.2. I think the goal here is to show you some details on how we bridge from what we achieved in 2018 and where we see 2019 going and give you some sense of the risk that's in our forecast.

Brian Weinstein -- William Blair -- Analyst

Hey, and the last one for me, and I apologize for getting three in here, but why is there such a big range on the earnings number for next year? What are the factors that get to the high and then the low end? It's much bigger than what we've typically seen out of Natus. I recognize that there is a little bit more uncertainty right now and you're going through this transition, but can you talk about how you get high-end, how you get low-end? Thanks.

Drew Davies -- Executive Vice President and Chief Financial Officer

Yeah, hey Brian, this is Drew. Yeah, so we've got a fairly wide revenue range. So, that's part of the driver and then also we've anticipated there that at the higher end of our guidance that we can have some gross margin improvement. So, we've baked that in there as well on the high-end of the guidance and some additional savings from the One Natus initiative and some of the consolidation that we have of our supply chain and are purchasing and procurement group. And so, that's kind of the difference between the low-end and the high-end. A little more gross margin on the high-end and some additional savings in OPEX.

Jonathan Kennedy -- President, Chief Executive Officer, and Director

In 2019 is a year for us that's going to have some risk and lots of change. We've already seen a lot of change in the last couple of months internally; you see it externally with the businesses that we've exited. We continue to look at business and products and markets for ones that, as I said, either aren't profitable or conversely, the ones that could benefit from some investment. And so, just the nature of really going through a product through as broad as Natus, just the nature of it, outputs a pretty wide range 11 months from now. So, it's not as simple as we would love it to be, but today, there does represent some risk there.

Brian Weinstein -- William Blair -- Analyst

Appreciate it, thank you.

Operator:

Thank you. Ladies and gentlemen, if you have any questions at this time, please press *1. Our next question comes from Jayson Bedford from Raymond James, please go ahead.

Jayson Bedford -- Raymond James -- Analyst

Good morning and thanks for taking the question. So, a few here. Just to reconcile the revenue guidance, if we strip out the discontinued products, you're assuming at the midpoint revenues down about $7 million year-over-year, right? Is $14 million of identify declines and then $7 million of identified growth drivers, is that fair?

Jonathan Kennedy -- President, Chief Executive Officer, and Director

Yeah, I think that's right.

Jayson Bedford -- Raymond James -- Analyst

Okay, can you talk about the growth drivers? Where does that $7 million stem from?

Jonathan Kennedy -- President, Chief Executive Officer, and Director

So, again, I'll remind everyone these are forecasted numbers, and there is a judgment on how you get to the $7 million, so sometimes you don't look at all the details. Obviously, we have our list, but you have to kinda judge that. We have the Otoscan device which has, as I pointed out in my prepared comments, has done quite well for us over the last couple of quarters. We expect that to continue. We have a new RetCam product that will come out late this year. We have a new NICU camera system that's already been released. We have a neoBlue Blanket that we just released last week that will, once we finish shipping the recall portions of that, will hit revenue again.

So, there's a number of items in there that quite frankly probably add up to quite a bit more than 7.2, but from a forecasting perspective we wanted to make sure that we baked in enough uncertainty and risk into that, but those are the items that can come in there. We have a number of products that could surprise us.

Jayson Bedford -- Raymond James -- Analyst

Okay. And you mentioned in talking about the neurodiagnostic business that neurodiagnostic grew, did the neurosurgery piece of that grow it all?

Jonathan Kennedy -- President, Chief Executive Officer, and Director

No, most of the strength was we had our best quarter ever in EEG. The neurosurgery business was down slightly year-over-year, and so we did not see growth there. But also, in the sleep business and the international markets did decent as well and as I pointed out, on the hearing side, the audiology side, from Otometrics products, we did quite well internationally there.

Jayson Bedford -- Raymond James -- Analyst

Okay. A couple margin questions. I think he said to Q2 will see some up margin improvement, can we just assume that's year-over-year or was that quarter over quarter?

Jonathan Kennedy -- President, Chief Executive Officer, and Director

Yeah, I think it's -- I intended to say quarter over quarter and year-over-year you should see that improvement.

Jayson Bedford -- Raymond James -- Analyst

Okay. And then what's the assumption around gross margin in 2019? That was a bit of a, obviously, a soft spot in the fourth quarter.

Jonathan Kennedy -- President, Chief Executive Officer, and Director

We have a little over 60%, plus or minus, as the midpoint of our model.

Jayson Bedford -- Raymond James -- Analyst

Okay. And then, I'll sneak one more in. In terms of your cash flow outlook for the year and maybe what you're doing to improve your working capital metrics, where do you see some of those metrics exiting the year, just in the context of your cash flow outlook for 2019?

Jonathan Kennedy -- President, Chief Executive Officer, and Director

Yeah, so, we believe under the operating income at midpoint we think will be in the $70 million a year range and that would have a $10-$15 million benefit from working capital. The rest is depreciation, stock, tax, interest expense from an operating income number. And that should tie fairly closely to where we would end up with a non-GAAP pre-tax income.

Jayson Bedford -- Raymond James -- Analyst

Okay, and sorry Jonathan, is that an operating cash flow number or free cash flow?

Jonathan Kennedy -- President, Chief Executive Officer, and Director

Operating. Free cash flow-wise, we spent a little more money this year than we normally have, we built a new warehouse and operations facility in Ireland as a landing pad for a number of things that will eventually end up there. And so, CAPEX this year was a little under $8 million I would say 2019 turns out to be the typical $3-$4 million range. So, take that out of the $70 million and as of May were 65 on a free cash flow basis, 66.

Jayson Bedford -- Raymond James -- Analyst

Thank you.

Operator

Thank you.

Jonathan Kennedy -- President, Chief Executive Officer, and Director

I think our intention, Jayson; really on the cash flow side and on the operating margin, those two numbers should be closed. Operating income and also non-GAAP earnings should tie into cash flow. As we go into 2019, we intend to clean up some of the historical non-GAAP issues, and for starters, a lot of the projects are completed, so, though should fall off. But when you look at 2019, even though will have restructuring that mostly will be amortization and severance benefits, things like that, the rest of the sort of extraordinary items we've had over the last couple of years have really sort of faded away. I wouldn't expect to see those in 2019.

Operator

Thank you. I show no further questions in the queue. At this time, I'd like to turn the call back to Jonathan Kennedy, Natus' President and CEO for closing remarks, please go ahead.

Jonathan Kennedy -- President, Chief Executive Officer, and Director

Well, that concludes today's prepared remarks and Q&A so, thank you, everyone, and have a great day.

Operator

Thank you, ladies and gentlemen, for attending today's conference, this concludes the program. You may all disconnect. Good day.

Duration: 31 minutes

Call participants:

Jonathan Kennedy -- President, Chief Executive Officer, and Director

Drew Davies -- Executive Vice President and Chief Financial Officer

Brian Weinstein -- William Blair -- Analyst

Jayson Bedford -- Raymond James -- Analyst

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