Q3 2021 Avanos Medical Inc Earnings Call
Good morning, and welcome to the Avnet third quarter 2021 earnings conference call.
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Please note this event is being recorded.
I would now like to turn the conference over to Mr. Scott Galloping, Vice President corporate strategy and business development.
Please go ahead.
Good morning, everyone and thanks for joining us it's my pleasure to welcome you to the <unk> 2021 third quarter earnings conference call presenting today will be Joe Woody CEO, and Michael Greiner Senior Vice President and CFO.
Joe will begin with an update on our quarter and then discuss our business environment and progress against our 2021 priorities then Michael will review our third quarter results.
And update our 2021 planning assumptions, we will finish the call with Q&A.
A presentation for today's call is available on the investors section of our website <unk> Dot com.
As a reminder, our comments today contain forward looking statements related to the company, our expected performance economic conditions and our industry.
No assurance can be given as to future financial results actual results could differ materially from those in the forward looking statements for more information about forward looking statements and the risk factors that could influence future results. Please see today's press release and risk factors described in our filings with the SEC.
Additionally, we will be referring to adjusted results and outlook. The press release has information on these adjustments and reconciliations to comparable GAAP financial measures now I'll turn the call over to Joe.
Thanks, Scott Good morning, everyone and thank you for your interest in Avenova.
While we continue to see the impacts of the pandemic as it relates to elective surgeries hospital staff shortages in supply chain, we're very pleased with how our operational and commercial teams have responded to the challenging dynamics brought on by the pandemic.
Across our enterprise, we remain focused on getting patients back to the things that matter as we meet the needs of our customers.
I'll begin with a brief review of our results for the quarter before discussing the current environment and our progress against our 2021 priorities.
We achieved sales of $184 million for the quarter and earned <unk> 25 of adjusted diluted earnings per share.
Our sales results were primarily in line with our planning assumption.
Other than the slowdown in sales, we experienced with on Q as a result of the Delta Varian and pushing out electives during the summer we delivered solid sales results in each of our other product categories. During the third quarter and through the first nine months of the year.
As we noted last quarter, we anticipated a meaningful improvement in our gross margin profile throughout the third quarter.
Gross margins for both August and September were 54% with gross margins for the third quarter exceeding 52% or 90 basis points better versus the second quarter.
Our gross margins will continue to improve throughout the fourth quarter and stabilize into 2022. However.
However, transportation and other supply chain inflationary pressures remain and we are therefore unable to determine how much further improvement we will see in the short term.
As we mentioned last quarter most of these headwinds impacting our gross margin are transitory, primarily pandemic driven being seen across industries and do not indicate a permanent change to our operating structure.
We remain confident in that assessment.
Although gross margins have improved and will continue to improve as we exit this year, we're meaningfully behind our internal projections on gross profit and therefore have identified additional efficiencies throughout the business to reduce operating expenses.
Teams are continuing to find ways to increase productivity and lower our cost structure, ensuring that we can deliver on our commitment of SG&A as a percentage of revenue being less than 40% on a go forward basis.
With that as a background, let's move to a discussion on the current market environment and provide an update on our progress against our 2021 priorities.
As mentioned earlier, we delivered solid revenue outcomes across most of our product portfolio, our digestive health business led by <unk> was up over 2% globally versus prior year.
6% and North America.
Our respiratory business was down versus the prior year, primarily related to the pandemic related push we received in the third quarter of last year, which contributed $8 million of additional sales.
Sequentially, we were flat versus the second quarter as the standard of care with our closed suction catheter systems for patients needing hospitalization due to the coronavirus has primarily shifted to noninvasive ventilation procedures before moving to mechanical ventilation.
On the pain management side, we saw almost 5% growth from our interventional pain portfolio, while acute pain was down a little over 1% due to the delta related pause in elective surgical procedures impacting our <unk> franchise.
As we have stated in the past quarters based on conversations with our surgeons and hospital administrators as well as what our peers are also disclosing we continue to believe inpatient procedural volume will remain below its full potential for the foreseeable future.
That being said, we do anticipate sequential growth and recovery for our <unk> franchise for the fourth quarter.
Similar to second quarter levels of revenue.
As we move into the last quarter of the year, we continue to enhance our product offerings to improve the efficacy and ease of use for our care partners.
For <unk>, we successfully completed a limited launch of next generation <unk> radiofrequency probe kits in Q3.
The full launch now in place for Q4.
The new probes make it easier for our physicians to perform Cooley procedures, while maintaining our premium look and feel.
There is also increased manufacturing efficiencies associated with the new probes, which supports gross margin improvement from <unk> already high gross margins.
Combined with the launch of our new generator last year, our new probe kits to strengthen our cooled RF leadership position.
Within our <unk> business, we recently launched pain block pro a differentiated app and data collection vehicle to track monitor and improve patient outcomes through more direct feedback between the patient and physician.
Attracts a patient's recovery to understand both satisfaction and pain levels in real time.
The App also helps us engage patients to improve their experience by giving education about the pump and providing an avenue for a physician to get give.
<unk> active feedback on questions the patient might have.
We also continue to see momentum building from our channel partnership agreements, where we leverage orthopedic sales partners to gain access to orthopedic surgeons.
Finally, we are delivering our electronic pump <unk> into the ambulatory surgical setting, which is positioning us to capture additional procedure volumes.
Shifting to chronic care the positive trend across our digestive health franchise continues we maintained double digit growth across our <unk> franchise, while our standard of care strategy for core pack is accelerating sales of our courtyard hardware to record levels as.
As I stated earlier, our respiratory health sales were down given the prior year pandemic tailwind we have modeled in nominal flu season for this year and consistent with that modeling we have not currently experiencing any higher levels of buying activity for our closed suction catheter products.
Our secondary focus in 2021 relates to improving our gross and operating margins. We remain focused on recapturing gross margin loss since the start of the pandemic and made some meaningful progress in Q3 on these initiatives.
We were very pleased with our gross margin improvements as we exited the quarter anticipate seeing further gains throughout the fourth quarter.
As noted earlier, we are confident these gross margin headwinds are transitory, but also recognize a significant work remains to get our gross margin profile.
Back up to the high <unk> and low sixties.
Our third priority is to begin generating consistent repeatable free cash flow, we generated $10 million of free cash flow in the second quarter and $18 million in the current quarter and we anticipate generating positive free cash flow again for the fourth quarter.
We received $47 million of cares act related tax refunds during the quarter, which was partially offset by the $22 million, we paid to the Doj to sell our outstanding litigation.
Improved operating results coupled with some remaining working capital upside will support this priority of generating consistent and repeatable free cash flow.
Our last priority for the year focuses on capital deployment, our M&A pipeline remains healthy and we are engaged in active dialogue with a number of potential tuck in targets targets, which would leverage our existing footprint generate synergies enhance our top line growth and meaningfully improve our margin profile.
We will remain disciplined in identifying targets that meet both our strategic initiatives as well as exceed our financial hurdles, ensuring we generate a strong return on capital.
Lastly over the last four quarters, we have resolved all material outstanding litigation, including the Doj investigation.
Densification dispute with Kimberly Clark a positive outcome with regards to our IP infringement case with Medtronic and other smaller product liability cases.
Not only has this reduced to a range of uncertainty for us, but it will also significantly reduce our legal expenses from a cash flow perspective. This.
This positions us to be more aggressive on M&A as well as frees up capital to repurchase our shares while ensuring we continue to meet each of our internal funding needs.
We remain well positioned to advance our strategies across each of these four areas of value creation as we complete 2021 and begin to look towards 2022 now.
Now I'll turn the call over to Michael.
Thanks, Joe as you noted we have made meaningful progress against our value creation initiatives and are setting up well for a solid 2022 that will combine mid single digit topline growth with M&A execution. Additionally, we will show improved gross and operating margins as well as consistent free cash flow generation.
Now, let's begin with a review of our third quarter results total sales of $184 million was essentially flat compared to last year volume and currency was even with price being down around 1%.
Given them the pandemic related tailwind for respiratory health in the third quarter of 2020, chronic care sales declined 2% to $117 million in the quarter.
Adjusting for the 2020 tailwind respiratory health sales would have been up $4 million for the quarter with improvements across the portfolio.
Although the delta variance by quickly during the summer and increased hospitalizations. Once again, we did not see meaningful growth in our closed suction catheters as hospitals carried out their first line of care before placing patients on ventilators.
As we noted last quarter, our planning assumption and respiratory health for the second half of 2021 does not include any additional benefit from the pandemic and we also stated we expected a negligible start to cold and flu season, which we are currently experiencing.
Shifting to digestive health, we saw 6% growth in North America, offset by a decline in our international markets, providing total global third quarter growth of just over 2%.
Neilmed once again grew double digits from the continuation of conversions to our <unk> technology.
Our backorder impact for Neilmed currently sits at $1 5 billion, which we plan to work down through the first quarter of next year.
Moving to pain management, we delivered $67 million of sales, 1% higher compared to the prior year driven by strong performance across our RF ablation products.
I'm ready and ambit offset by <unk> <unk>.
As Joe noted growth in Q3 was hampered from impacts brought on by the Delta variant and a return to slowdown in elective procedures.
While these impacts had an effect across the pain portfolio.
<unk> was disproportionately impacted as inpatient therapy experienced rolling shutdowns across various regions in the U S. During the summer.
We partially offset these losses with the introduction of pain block Pro channel partner growth and expansion into the ASC setting.
We are well positioned to drive sequential improvement in Q4 as these initiatives move forward with elective procedures slowly returning.
Additionally, supply constraints and raw material shortages have impacted our ability to meet demand within the game ready business, but back orders still exceeding $1 million. We anticipate these back orders will continue to grow into the end of the year. While these constraints will persist over the next couple of quarters, our supply chain team is actively working to <unk>.
<unk> supply and we expect to work down our backlog in the first half of 2022 to meet this market demand.
Moving down the income statement adjusted gross margin decreased to 52% compared to 55% last year.
As indicated earlier, we are pleased with the progress on gross margins through the quarter and anticipate further meaningful improvement into the fourth quarter compared to last year gross margin was impacted by higher transportation costs and unfavorable mix.
Ocean freight cost has increased due to global capacity constraints. Additionally, lower sales of closed suction catheters and <unk> products that unfavorably impacted our product mix.
These headwinds have been partially offset by lower inventory write offs. This year.
Looking towards 2022, we continue to expect gross margins to steadily improve as a result of a range of programs. We are implementing throughout operations. However.
However, we also remain cognizant of the global supply chain environment that remained disrupted and we are currently unable to predict the offsetting impacts of higher inflation in transportation costs as well as availability of certain raw material components.
Now turning to some bottom line financial metrics adjusted.
Operating profit totaled $17 million compared to $18 million in the prior year slightly lower sales and unfavorable gross margin were partially offset by lower spend across SG&A and research and development expenses as we noted earlier.
Adjusted EBITDA totaled $22 million compared to $24 million last year.
<unk> net income totaled $12 million compared to $10 million a year ago, and we earned <unk> 25 of adjusted diluting diluted earnings per share a 20% increase versus prior year.
Turning to the balance sheet and cash flow statement, our balance sheet remains a strength for us and continues to provide us with strategic flexibility as we currently have $110 million of cash on hand, and $130 million of debt outstanding on our revolving credit facility as we use some of the proceeds from the cares act refunds to pay down debt.
We have over 200 million of available capacity to utilize towards our capital allocation priorities.
Finally, while unpredictability of the Corona virus remains we still foresee our net sales increasing 2% to 4% on a constant currency basis compared to the prior year.
Additionally, as we have noted throughout these prepared remarks, we remain in an uncertain environment with regards to our supply chain, both from a cost perspective and availability of products.
To partially offset that impact we have managed our cost structure with regards to SG&A and R&D throughout the year, which has allowed us to maintain our guidance range of $1 10 to $1 20.
We remain committed to and are also reiterating our guidance range given these factors.
While also recognizing that the likelihood that we fall out of the low end of our guidance has now increased.
We have made great progress in 2021 to set ourselves up for a successful 2022 and beyond and we are excited that much of our cash flow uncertainty is now behind us we remain confident in our ability to execute our strategy and take the necessary steps to drive growth and operating margin improvement and deliver more consistent results as we look towards 2020.
Phil.
Operator, please open the line for questions.
Thank you very much.
We will now begin the question and answer session.
To ask a question you May press star and one on your telephone keypad.
If you're using a speaker.
Please pickup your handset before pressing the keys if at any time Youre question has been addressed and he would like to have a Jack question.
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At this time, we will pause momentarily to assemble our roster.
Our first question is from the line of Matthew <unk> from Keybanc. Please go ahead.
Great Good morning.
Hey, guys I just wanted to start with.
Revenue growth first.
Because it seems it seems like the sales growth has been fairly resilient.
And that's throughout.
COVID-19 last year with respiratory health.
And chronic care and this year you seem to be coming in.
At Ash.
At or above the midpoint.
Got it.
What would what would it take for you guys not to come in.
At that 3% plus at this point.
Given <unk> support.
Well seasonality.
Yes, Matt So first of all and I am sure. We will get this question as well as Joe.
We've seen a pretty good start to October with some improvement even in the.
Business the thing that we're keeping an eye on really are the supply chain items that we talked about and then just its all comes down to how fast.
Essentially the procedures come back in I think a lot of the other companies.
I've talked about the staffing issues, primarily at the hospital.
And then how fast and particularly in the South where there was a delta that will the procedures come back in to the extent that they do come back faster then that's better for us.
I would say too that the.
When we look at October actuals right now.
Yeah, we should hit those targets for Q4.
And we saw in November and December were less than we saw exactly what happened to us in the summer.
We're all of a sudden delta variant spiked in the southern part of the United States and meaningful impact on an ICU.
Right now we have some pretty good trends working for the last 60 days of the quarter, but we also want to remain cautiously optimistic.
Okay.
<unk>.
And when you say the likelihood that there is a likelihood that has increased that you could fall below the range of $1 10 to one.
20.
But you still make but you still maintained your guidance kind of what what's the thought process behind.
Behind that I guess I'm, just trying to understand kind of how you think yes, no no no.
Great question. So there was.
A fair amount of debate internally around do we move the guidance altogether.
Do we make the guidance range larger and we just felt like with 60 days left to do any of those things just created clumsiness on the downside and the upside because I know you said you were coming out of October are feeling pretty good about where we are.
And so let's say, we moved the guidance range to $1 five to $1 15, and then we do $1 16.
Clumsy.
We increased the range by 15 or 20 that doesn't feel exactly appropriate either.
And so we just felt like.
This morning, which I think is unusual for people.
Where appropriate with where we are which is if supply maintains.
The trends that we're seeing coming out of October maintained.
If we don't see any other hiccups in distribution.
We should be comfortably in the 110 to 120 range.
Those things turn in a different way over the next 60 days.
Then we could fall slightly below and out of that range.
Okay and then just when you when you look at that range just to get to the low end based upon sort of where the midpoint of the revenue guidance it would imply a pretty.
Meaningful increase in the gross margin.
Into the fourth quarter, how do you give people a sense of.
The confidence that that that that is really what's what's going on there.
The trajectory.
But you're wrong.
And by the way and I think Michael is going to take it but what I would say just to reiterate we did hit 54%.
Gross margin in August and September and a lot of these things are starting to improve horse, but go ahead, Michael do you want to take him through yes, no I was going to say.
We anticipate right now that our overall operating margins are going to improve by north of 400 basis points between Q3 and Q4.
Significant majority of that is.
<unk> is going to be the gross margin improvement.
To Joe's point the trends that we saw.
In August and September will continue into Q4. So you are spot on that with your math and we have high confidence levels. We should have been better in Q3 ex step that although freight was much improved about 50 basis points, we bought freight would improve by even more than that but then over the <unk>.
Water shipping costs throughout the third quarter increased by by Fivefold, that's now coming back down so that helps.
No longer doing the overnight shipping as we had talked about previously.
We have other other.
Headwind tailwind going into Q4 versus Q3. Another thing we saw in Q3 in gross margins was a little different mix. So how we got to our $184 million was a little different mix than we anticipated with some lower margin products like oral oral care, having a particularly strong Q3.
As <unk> was a little bit slower than anticipated, we expect that that trend to reverse in Q4. So we have a lot of favorable tailwind going into Q4 gross margins. The bigger biggest point, we wanted to make on the Q3 call here on gross margins was there was concern about it being embedded in it that it would be more of a permanent change our operations.
Hopefully what we've demonstrated with our August and September results in particular on gross margin that is not the case that we continue to.
To be confident in where we're going to take gross margins.
In the Q4, and then ultimately in the 2022 as well.
Okay excellent I'll jump back in the queue. Thank you guys.
Thanks, Matt.
Thank you.
The next question is from the line of Mr. Hasan.
Brian. Please go ahead.
Hi, Good morning can you hear me okay.
We can hear you good morning, great. Thanks, Thanks, Joe Hi, Mike So just.
Kind of a big picture question as we get into 'twenty two.
<unk> has long been about there's a lot of kind of heavy lifting and small lifting to be done with this company. It sounds like you've resolved one of them with the legal.
The legal kind of settlements this quarter and kind of resolution there as we go into 2022 can you just help me think about Joe how you and the board are thinking about kind of the key drivers here. What you prioritize between you know, it's always been kind of the M&A organic growth and restructuring kind of tracks back to here, maybe help us think about where youre going to be spending your resources.
As in 2022, and then maybe how investors should kind of prioritize those as they think about Avenue.
Yeah, I mean, I really like where we're positioned for 2022 because.
We have taken a lot of cost out of the business.
And the pandemic and as an example, we've said look we feel comfortable that.
We are a business with less than 40% SG&A. These gross margin challenges. This year are really tied to the pandemic and transitory. We were early kind of talking about that I think it took it on.
Another quarter for that.
Prove out more in medical devices like it was in.
Other industries and I think you can see the progress and if you just think about the quarter that we just went through something like a 160 basis points of mix on <unk> being down that that won't be there. So we again see kind of a mid single digit organic growing business very solid when you don't have these pandemic impacts the other thing I would say is that we can.
Spent a lot of time with our M&A targets and we've been talking about.
Near term two.
<unk> that we think will be able to talk about shortly.
That'll be asset business, that's always been a part of the equation, where we can improve our gross margin as an example of some of these acquisitions pick up some EBITDA, obviously, you get some growth and get the synergies where these things are.
Bolt ons, if you will right into <unk>.
Our channel so we really actually feel good about going into 'twenty. Two I think it really all comes down to again just.
How fast the.
The hospitals with their staffing issues and the electives and how fast they want to come back to you because obviously they are being affected.
But I believe that we're very well positioned move.
Moving into 2022 for sure.
Great and I guess you just touched on my next question around M&A can you just help us think about what kind of.
Kind of integration Youre willing to stomach here I mean would you look at deals that might be gross margin dilutive or kind of EBITDA dilutive in the near term or kind of are you going after things that are just going to kind of add to the to the bottom line very quickly can you just give some detail on that thanks.
I mean generally I would say that we're on the accretive side of the house at the moment.
And we've done some deals in chronic care, but we've got some things that we want to do in pain.
Again, I think they're going to be accretive from a revenue and gross margin perspective.
Pick up some some EBITDA.
And then we also have done deals that we've looked at some deals that didnt do that werent accretive initially immediately.
But our very strategic so we sort of have both sides of the house covered but I think theyre going to be definitely additive to 'twenty two.
Thank you and at least a question and answer.
Yes. Thanks.
Okay. Thank you. Thank you Ravi.
The next question is from the line of Rick right.
From Stifel. Please go ahead.
Hi, good morning to you both.
I just wanted to start off.
Can you give us a little more color.
You're saying, obviously very positive things about.
The quarter began how October month of October when I, just want to make sure I understood.
The drivers there.
I mean, one seems to be.
On the gross margin side, Michael Party distribute.
Yes.
Lower transport costs.
Fewer manufacturing inefficiencies on gross margin side, but on the sales side.
I wasn't as clear.
About whats happening is it just.
Mix.
The rollout.
Yes.
Nextgen Cooley just help us understand.
Yes.
The moving pieces there.
Yeah. So overall October revenue results across the board were strong versus.
<unk>, what we expected.
On the product care side and the pain side.
When our full results are executing in step with each other.
Sure our mix improves.
So it's just when we have outsized improvements like we did with oral care towards the end of the second or third quarter.
And obviously, obviously being down throughout the third quarter that that.
<unk> tends to have an outsized impact when our entire portfolio.
Moving forward and growing that is net net going to have a positive influence on our mix profile.
Yes. Thank you.
Okay.
Go ahead.
I thought you asked about gross margin as well so.
Again I would.
I'll just go ahead and expand on the gross margin I mean.
Yes, youre seeing such a significant improvement in in October already.
Very encouraging.
When you talk about getting back to the high <unk> low <unk>, how much of that is today's portfolio.
Today's mix and sort of returning to more normal times and Covid, hopefully paid and how much.
That's going to be driven.
By M&A and hopefully.
Margin accretive Emma.
M&A.
So two things there's been none of that high <unk> low <unk> has any M&A.
So this is all in organic conversation around our margin gross margin improvements that being said.
With the current environment, we are in the work we're doing.
Focusing on our manufacturing inefficiencies, how do we think about freight our product planning.
All of those different things.
We can get up to the.
Excuse me 50 758 range.
By just focusing on those things that are controllable, however to get beyond that and in back into the low sixties and consistently be in the high Fifty's, we will need a more normalized environment across the portfolio because the lumpiness, we have with our price and mix in the range of gross margin that we have in.
Our product portfolio is significant.
So you don't need a lot of movement within a given quarter across that portfolio, depending on what's positive or negative to have that impact. So again, if everything is firing.
It is a net positive gross margin environment that we have with our product portfolio, but when we have something like oral care up in a given quarter versus on Q down that's going to have significant headwinds for us. So what we can control we absolutely have meaningful progress made from here, but to consistently be in the high fifty's low sixties.
You have to feel slightly more normalized environment.
Our total product offering that makes sense and Rick also on sales our intent is not to be alarmist here.
But you do where 700 or $148 million, if you will business and so things like Australia and their lockdown, Japan access our European access Hasnt impact and where we were seeing earlier in the call. How fast we come back is a bit of a gauge but again.
Again to be clear we've had we've had strong results in October.
We're just being cautious given that this is a pandemic and it changes week to week.
No.
Obviously as you said youre not alone.
Joe I'm glad that I mentioned.
International because that was gas question I was hoping you could give us a little more color on the international business you called out a couple of pockets of weakness you mentioned, Australia, what's happening.
Broadly what initiatives are underway, there and how are you thinking about.
How should we think about international as we head into the fourth quarter and start thinking about next year. Thank you. So much yeah. A couple of a couple of things first of all generally we've been over the past couple of years really.
Happy with the performance of the international business.
This year in EMEA were impacted somewhat with access to customers and then of course there is.
<unk>.
The headwind from closed suction from the beginnings of the pandemic and now obviously we've talked about.
Patients are being managed differently and noninvasive approaches and then eventually mechanical.
Latam has been a good grower for us double digits, we've been happy with the work that we've done down there and really Asia Pac has been strong we just have a little bit of access.
And conversion issue with the pandemic in Japan and in Australia has really been in a locked down for about 200 days. So it's affecting some of the growth, but we still feel it's a solid mid single digit organic grower going forward and then obviously, what we're trying to do the same success that we've met with Nomad and core track in the U S.
Get that rolled into international and I do think as we come.
Into 'twenty, two and more so if you will out of the pandemic.
That should improve as well.
Thanks again.
Yes.
Hum.
Yes.
Thank you.
The next question is from the line of.
From Morgan Stanley. Please go ahead.
Hi, Joe and Michael Thanks for taking the question just maybe for Michael first.
You touched on free cash flow generation at our conference and through.
This call, but I'm, just hoping to get kind of a better understanding of.
<unk>.
It's kind of the company's capabilities I think at our conference you mentioned that third quarter could be a proxy for go forward free cash flow. I mean are you still expecting that but just maybe a broader update on here.
Working capital anything free cash flow. Thank you.
Yeah, So we do anticipate at <unk>.
You mentioned in prepared remarks, having another positive free cash flow quarter in the fourth quarter.
And we had some one time items on cash this year that will clear out.
Anticipate a very nice conversion rate on free cash flow going going forward.
Primarily due to improved operations drew.
Not a lot of work on accounts receivable and inventory.
There's still some working capital upside for sure 10% to $15 million, but the majority of what youre going to see generating going forward as a onetime cost on legal on SAP implementation.
On other.
Items that we had internally those are now in the rearview mirror a lot a much cleaner set of cash flow generation all of operations and then some improved opportunities set and working capital throughout 2022, but the bigger part of it is just going to be consistent execution on our operating results.
Got it. Thank you and then just on SG&A, you you've talked about it before being sub 40% of sales.
Kind of going forward, but I mean, where are you pulling back on spending.
Are you sacrificing any future growth opportunity in 2022 and beyond.
I would like a little bit more color there. Thank you.
Let me do some quality and Jim Jim that we want to but we have obviously learned that some of the marketing initiatives.
Didn't need to come back and some did and then we have things like short term incentive and there'll be some some head count that we need to add in the business, but generally.
We also have still some.
Smaller if you will structural things that we can do inside of our channels that can be helpful. There. So.
<unk>.
We're committed to the below 40% Michael you may want to add something I would add to that drew is last year was COVID-19 everybody had to kind of look at their SG&A and R&D and say what makes sense what doesn't but also in short to your point that we werent cutting ourselves short for future investments and.
And then as we so we got some discipline.
2020 that was somewhat which is which I think was healthy across the board we came into 'twenty one.
We definitely expected overall SG&A dollars to increased versus 'twenty.
And we ended up with these gross margin headwinds and so we wanted to manage around that and so those disciplines that we started in 'twenty around how we think about SG&A just continued into 'twenty one.
So we're very thoughtful about where can we cut what heads.
From a backfill standpoint could.
Could we reduce and think differently about some of the talent we have internally.
Which rolls will we ultimately have to replace what we could delay for a little bit which project.
To Joe's point around <unk>.
Marketing initiatives.
It doesn't feel that we have.
<unk> done anything that would impact our 2022, our go forward, perhaps there is an R&D things here and there that gets delayed by a quarter based on some of the programs as we pulled back on here.
During 2021, but nothing meaningfully significant to our ultimate revenue profile or where we're headed with our margin profile.
Got it and then just on 2022 gross margins.
So I hear you loud and clear about the fourth quarter step up of about 400 basis points should we should be thinking that for 2022, there should be a proven above the fourth quarter rate on a full year basis.
Yes, I don't know how meaningful that will be drew.
It should be north of where we are in the fourth quarter for sure for the full year, Yes, alright.
Alright, Thank you for taking the questions.
Thank you.
Okay.
Thank you.
Participants if you have a question please press star and one.
The next question is from the line of Chris Cooley from Stephens.
Defense. Please go ahead.
Good morning, and thanks for taking the questions.
If you could just help Greg.
Morning.
I'm a little confused on some of the commentary as it pertains to the topline and I was hoping you could kind of help me help us walk through these countervailing forces so.
You've seen the reiteration, obviously of the corporate guide for the top line.
You commented.
Two different areas of backlog.
Accelerating and expected to continue to accelerate.
Here in the back half.
The calendar year and not be worked through until we get into early calendar 'twenty two sorry.
I guess, what I'm trying to make sure I fully understand the messaging here about as Youre, saying that the base business ex those two primary product lines.
Youre seeing that type of an acceleration to offset the backlog that you see growing I just want to make sure I'm getting that messaging right and then maybe as an adjunct to that.
Could you help us better understand.
What what's really there.
Limiting your ability to.
Get that resolved prior to the first half of or I should say the first quarter of next year.
Yes, Chris you are right and we are thinking that we will get a good portion of it resolved through the first quarter of next year and again from.
From my perspective, and Michael can give you his.
Things that are not predictable economic Australia, or lack of Japan, or what you were talking about in EMEA or how fast the electives I'll come back in the hospital setting where we.
Our focus with on Q.
Gives us a little bit of.
<unk>.
Uncertainty, but again, we've started off strong in October we could just as easily do better than.
And then we're aligning out here.
But what we've seen with the pandemic is that a lot of different things can potentially happen, but you've got youre thinking about it the right way the backlog is improving we can improve our position from the backlog.
I want to be too confusing or as I said, a little bit early too alarmist, but it's worth calling out while we are in the pandemic and Michael Youre going to add yes, Chris I think the point you made on what we're signaling there is that natural demand is there and even with these back orders, we still feel confident in our solid fourth quarter.
But but also an indication that the supply chain environment remains disrupted.
And game ready for instance, where the literally the reason that we have a backlog there is because of one component that goes into the entire product of many many many many components.
And so those are the that's what we were trying to signal omit. The connection is hey demand is strong that is good and the supply chain availability concerns remain.
And if we can get those fixed sooner rather than later to Joe's point, we have further upside we just.
Scouring the world as everybody else is to try to find some of these raw material inputs, sometimes we get lucky in a given week and sometimes we just don't have the same level of success.
Understood appreciate the color there and if I could just to one other quick follow on here maybe similar.
In nature.
You talked about obviously, a very strong sequential step up in gross margin.
Right.
The vast majority of that step up being in your direct locus of control, but we still have higher inflation costs bleed on seeing freight go down that much from what we can see in the channel.
I'm just curious when you think about these these transitions from COVID-19 related costs.
These related inputs are these now becoming more structural in your mind and so youre actually getting better operating leverage are you implicitly steadiness. These headwinds abate as we go through the fourth quarter.
And we get back to a more normalized.
Environment in the first quarter, where you can contract in the spot market at lower rates on freight and assembly, we see declines in inflationary pressures on raw material and labor.
Yes, I think.
It ties back to the other question around our exit rate in Q4, and where we think we can take the gross margins into 2022. The reason why we're being a little cautious on calling any sort of meaningful upward trends in the 2022 is for these factors that you're identifying so inflationary pressures remain.
Some of these freight cost pressures remain.
And until we see better visibility with those lifting.
Our improvements on gross margins will be.
You eliminate.
On top of that as we stated earlier.
If we get back to more normalized revenue environment that will also help our gross margins just by virtue of the positive mixed component with some of our larger selling products. So.
Those are two factors that we just don't quite have visibility to yet so.
That's why we're not saying, hey, 59% 15, 5% in 2022, because those factors would have to lift in order for that to be the reality, but we also know that as far as the embedded conversation. We're not a 50, 253% gross margin player right and so that's where we're kind of finding right now we're getting to that more.
Normalized state in Q4 and into the early part of next year and then as these other factors lift we'll get back up to the high Fifty's again.
M&A.
Thank you for the clarification.
Thank you Chris.
Thank you have a follow up question from the line of Matthew <unk> from Keybanc. Please go ahead.
Okay.
Hey, Michael just a quick one following up on free cash flow I think previously you had indicated that you would do seven year $80 million of free cash flow in the year. It seems like most of the moving pieces as far as the Doj.
And tax refunds.
Two have already kind of come through for you how should we think about <unk> and <unk>.
Related to that to that step up into that.
Free cash flow.
Yes, great.
In Q4 to that point, Matt tying back to an earlier question.
Should give a good feel assuming we execute as we are feeling coming out of October 31 <unk>.
It should give a good feel for okay. What is the normalized free cash flow look like.
And we should generate.
Somewhere around $15 million of free cash flow in Q4, primarily due to operations, but also with some slightly better working capital management as well so.
You should have a decent Q4.
Im not saying that that is the best we can do I think there is upside potential to that but that should give you a decent feel for our free cash flow conversion.
Okay. Thank you.
Yes.
Thank you.
Ladies and gentlemen, this concludes our question and answer session.
I would like to turn the conference back over to Joe <unk> for closing remarks, Thank you and over to yourself.
I want to thank everybody for their interest and Novelis, we feel we're continuing to execute well in a very uncertain environment, we are committed to creating shareholder value and I'm confident the priorities that we've detailed combined with our market leading portfolio in the attractive markets that really do position as well.
For growth and margin expansion and positive free cash flow as we exit 'twenty, one and go into 'twenty two.
Michael will be presenting at the <unk> conference upcoming and will both be attending the Stifel Conference and look forward to talking to everybody more there thanks and have a great day.
Thank you very much.
Ladies and gentlemen, the conference has now concluded. Thank you for attending today's presentation you may now disconnect.
Yeah.