Derma Sciences Inc. (NASDAQ:DSCI ) Q2 2022 Earnings Conference Call July 27, 2022 8:30 AM ET

Chris Ward - Senior Director, Investor Relations

Jan De Witte - President & Chief Executive Officer

Carrie Anderson - Chief Financial Officer

Glenn Coleman - Chief Operating Officer

Vik Chopra - Wells Fargo

Craig Bijou - Bank of America

Jayson Bedford - Raymond James

Drew Ranieri - Morgan Stanley

Good day and welcome to the Integra LifeScience Second Quarter 2022 Financial Results Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Mr. Chris Ward, Senior Director, Investor Relations. Please go ahead, sir.

Thank you, Lianne. Good morning and thank you for joining the Integra LifeSciences second quarter 2022 earnings conference call. Joining me on the call this morning are Jan De Witte, President and Chief Executive Officer; Glenn Coleman, Chief Operating Officer; and Carrie Anderson, Chief Financial Officer.

Earlier today, we issued a press release announcing our second quarter 2022 financial results. The release and corresponding earnings presentation, which we will reference during the call, are available at integralife.com under Investors, Events & Presentations and the file name Second Quarter 2022 Earnings Call Presentation.

Before we begin, I would like to remind you that many of the statements made during this call may be considered forward-looking statements. Factors that could cause actual results to differ materially are discussed in the Company’s Exchange Act Report filed with the SEC and in the release.

Also, in our prepared remarks, we’ll make reference to both reported and organic revenue growth. Organic revenue growth excludes the effects of foreign currency; acquisitions, including ACell for the first 19 days of the year; divestitures; as well as discontinued products. Unless otherwise stated, all disaggregated and franchise-level revenue growth rates are based on organic performance.

And lastly, our comments today will include certain non-GAAP financial measures. Reconciliations of any non-GAAP financial measures can be found in today’s press release, which is an exhibit to Integra’s Current Report on Form 8-K filed today with the SEC.

And with that, I’ll now turn the call over to Jan.

Thank you, Chris, and good morning, everyone. Let me start by reviewing our second quarter and first half business highlights on Slide 4. To summarize our performance over the past six months, we started the year strongly with the second quarter building nicely off our first quarter momentum. And despite choppy waters in the macro environments and plenty of disruptions within our supply chain, we capitalized on the recovery of growth in procedures in our markets, while protecting our margins.

Second quarter revenues were $398 million, above the midpoint of our guidance range. Yielding organic growth of 4.8%. And with our strong first quarter performance, this resulted in first half organic growth of just north of 5%. I'm pleased with our sales performance in the quarter as we overcame persistent supply constraints and heightened foreign currency headwinds.

We saw continued strength in our international business, particularly in Japan, China and Europe, along with strong orders from our private label partners and within our US instruments business. Over the course of the second quarter, hospital procedures activity continued to move closer to pre-COVID levels. Our current revenue numbers do not yet fully reflect this market momentum as back-order levels increased over Q1 as a result of ongoing supply challenges, particularly in our neuro business.

Nevertheless, we achieved revenues above the midpoint and delivered adjusted earnings per share of $0.82 at the top end of our guidance range. Just as importantly, we held our first half adjusted margins relatively flat year-over-year, in line with what we communicated during our April earnings call.

We're very pleased with the team's ability to navigate the challenging supply chain and inflationary environment and deliver profitable growth, while continuing to advance our key strategic initiatives. We tend to retain this focus in the back half of the year.

Speaking of key strategic initiatives. We launched two new products in the second quarter. First, we introduced our Aurora evacuator with coagulation capability in the US. This product is designed to be used with our Aurora Surgiscope to safely address and evacuate clot in the brain caused by hemorrhagic stroke. Second, we launched the Natus EVD [ph] system, our first external ventricular drain in China.

The Natus EVD system is manufactured in China by Shanghai Heyu Medical Technology company and commercialized by Integra under an exclusive distribution arrangement. The device is used in the management of Cerebrospinal fluid and is highly complementary to our back to seal catheter and our advanced intracranial pressure monitoring products.

While expanding our resilient portfolio of life-saving solutions, we also continued to streamline the portfolio in order to enhance profitability. In the second quarter, we signed a definitive agreement to sell our Traditional Wound Care business. This business consists of slower growth and lower margin wound care dressings such as sponges, gauze and conforming bandages. We expect this transaction to close by the end of August and our updated '22 guidance that Carrie will detail in a few minutes, reflects the expected impact of this divestiture.

The sale of our Traditional Wound Care business is one of the series of steps we have taken over the past two years to optimize our product portfolio, which has enabled us to focus on Integra's core market-leading products in neurosurgery surgical instrumentation and regenerative tissue and move us closer to achieving our long-term organic growth and profitability targets.

In further support of expanding product margins, we closed a manufacturing facility in France in the second quarter and are in the process of transferring production to our existing facility in Switzerland. In addition, we announced plans to outsource certain back-office finance and customer service activities in order to enhance customer quality, build scale for future growth and capture cost efficiencies.

We expect this transition to be completed by the end of the year. We're extremely proud that our efforts in building a diverse and engaged workforce have resulted in Integra being named one of the 2022 best places to work in New Jersey and recognize that's a great place to work certified organization in China.

So, there's a lot to be pleased with as we close out the second quarter and turn our focus towards the second half of the year and beyond. We're tightening our full year organic growth guidance at the bottom end, which reflects our solid first half performance, but also recognizes a mix of opportunities and challenges ahead of us in the second half.

With that, I'm going to turn the call to Carrie now, who will give deeper into our second quarter performance and updated guidance. Carrie?

Thanks Jan, and good morning, everyone. I'll start with a brief summary of our second quarter financial highlights on Slide 5. Second quarter total revenues was $398 million, an increase of 2% on a reported basis. Reported growth was impacted by $10 million of unfavorable foreign currency exchange rates compared to the prior year, representing a 260 basis point impact.

This FX headwind in Q2 was $3 million or approximately 90 basis points higher than when what was comprehended in our April guidance. Excluding the impact of FX and discontinued products, we delivered 4.8% organic growth in the quarter, at the top end of our guidance expectation with global CSS at 4.3% growth and Global Tissue Technologies at 5.9%.

We were pleased with our performance in our international markets, which saw nearly 8% organic growth in the quarter. Japan delivered low double-digit growth, and China and Europe finished in the high single digits. Adjusted EBITDA margin for the quarter was about flat versus the prior year and adjusted earnings per share grew approximately 4% and to $0.82.

If you turn to Slide 6, I'll review the second quarter revenue performance of our CSS segment. Reported Q2 revenues in CSS were $258 million, an increase of 4.3% on an organic basis from the prior year. Global neurosurgery sales were up 3.4%. Within neurosurgery, CSF management increased high single digits and was led by growth in our programmable valves, while Advanced Energy grew mid-single digits driven by CUSA Capital and related disposables.

Sales in neuromonitoring and neural access and repair grew low single digits, impacted by higher sequential back orders in the quarter, which limited our ability to keep up with demand recovery. Total capital sales in the quarter grew mid-single digits, driven by larger capital and CereLink.

Sales and instruments came in better than expected with second quarter organic growth of 7.5%, driven by broad growth in both hospital and office sites of care. Instruments growth for the full year is expected to be closer to our long-term expectation of low single digits. International sales in CSS increased high single digits led by CereLink and our indirect markets in Europe by growth in Asia. As mentioned earlier, performance was strong in Japan with low double-digit growth, and in China, which delivered high single-digit growth.

As a reminder, in China, we sell through distributors, whose orders have been placed prior to the lockdown. We believe, we have adequately captured the impact of continuing rolling lockdowns in China in our third quarter and full year revenue guidance range.

Moving to our Tissue Technologies segment on Slide 7. Global Tissue Technologies reported revenues of $140 million with 5.9% organic growth over the prior year. Second quarter sales in wound reconstruction increased 3.2%, driven by sales in Integra Skin and SurgiMend. Q2 revenue for ACell, which is reported within the wound reconstruction franchise, saw high single-digit sequential growth compared to the first quarter. We completed our plan to hire 30 additional sales colleagues in the first half, which contributed to the better-than-expected results for ACell.

In our private label franchise, sales grew 15%, similar to what we reported in the first quarter. We attribute the strong results to favorable timing of orders. For the full year 2022, we expect private label organic growth to moderate to mid-single-digit range, in line with our long-term growth expectation for this business, as our partners manage their inventories more closely in the second half. And finally, international sales and Tissue Technologies increased low double digits on an organic basis driven by SurgiMend and Integra Skin.

Turning to Slide 8. I'll now review our second quarter and first half key P&L components. Recall that during our April earnings call, I shared my expectation that first half adjusted gross margins and adjusted EBITDA margins would be relatively flat to the prior year. Final results for the six-month period were in line with those expectations.

As we think about margins for the full year, we expect adjusted gross margins and adjusted EBITDA margins to be generally flat compared to 2021. To protect our margins given the prevalent macroeconomic headwinds, including higher freight, material and labor inflation and manufacturing and supply chain inefficiencies, we have implemented price increases, purchasing initiatives and other operational improvements.

We are also focusing on larger organizational cost opportunities that will benefit margins in 2023 and beyond including the two projects Jan talked about earlier, the closure of a high-cost manufacturing site in France and the planned outsourcing of certain back-office activities by the end of this year.

If you turn to Slide 9, I'll provide a brief update on our balance sheet, capital structure and cash flow. Operating cash flow in the quarter was $66 million and free cash flow was $57 million. Free cash flow conversion was 76% on a trailing 12-month basis reflecting higher capital spending compared to the prior 12-month period.

Our balance sheet remains strong with ample liquidity to support our short and long-term plans. As of June 30, net debt was $1.1 billion, our consolidated total leverage ratio was 2.5x. The company had total liquidity of $1.7 billion, including $447 million in cash and the remainder available under our revolving credit facility.

Turning to Slide 10. I'll update our consolidated revenue and adjusted earnings per share guidance. For the full year 2022, we are slightly raising the low end of our organic growth expectations from a prior range of 3.8% to 5.2% to an updated range of 4% to 5.2%. We are pleased with our first half revenue performance, which is why we are leaving the high end of our organic guidance range at 5.2%. However, there are still reasons to be cautious about the second half given the continuing supply chain constraints and prevailing macroeconomic uncertainty.

Full year guidance for reported revenue is updated to $1.557 billion to $1.575 billion, reflecting the removal of revenues from the TWC business beginning September 1 and an additional unfavorable 115 basis point impact of FX and for the full year. The unfavorable FX impact is now expected to be $35 million or approximately 225 basis points year-over-year, primarily driven by a Euro/US dollar rate close to parity for the second half and a Japanese yen at 20-year lows.

The revenue impact of the TWC divestiture will be approximately $10 million for the last four months of the year. Full year 2022 adjusted EPS guidance is updated to a range of $3.21 and to $3.29, reflecting an incremental $0.03 headwind on FX and $0.03 impact due to the sale of the TWC business.

For the third quarter, we expect reported revenues in the range of $383 million to $391 million, representing reported growth of approximately minus 1% to plus 1%, and organic growth of approximately 2.6% to 4.8%. Our Q3 revenue guidance reflects the impact of the planned divestiture of the TWC business assuming a close at the end of August, as well as an updated foreign currency outlook. Adjusted EPS for Q3 is expected to be in the range of $0.78 to $0.82.

Now I'll turn the call back over to Jan to provide a brief recap of our 2022 growth catalysts and margin drivers.

Thank you, Carrie. Let's turn to Slide 11, the final slide. Our first half results, delivering greater than 5% organic growth and protecting margins in a tough environment reflect the diversity of our portfolio and our team's resilience in navigating the ongoing choppy waters, as well as our increasing agility to capture new opportunities.

In addition to delivering a solid first half, we continue to advance our key growth catalysts and build towards a long-term organic growth rate in the 5% to 7% range. First, in our international business, we delivered above 6% organic growth in the first half of the year, reflecting deeper penetration in our international markets particularly China and Japan.

You heard me talk six months ago about the road map for building to drive further momentum in our international business. Through that project, we have identified several opportunities within both CSS and Tissue Technologies to further accelerate our growth in the EMEA and Asian markets. These are now being translated into our long range planning.

2022 is an important year for new products, while the immediate revenue contribution of some of these products will be limited, early indicators of their market potential and future commercial success positive. CereLink, our new intracranial pressure monitoring platform, which launched late last year, is continuing to show steady adoption in our global markets with a growing installed base across 25 countries now. Customers appreciate the advanced analytics and the more intuitive user interface.

With a strong sales opportunity, [indiscernible], we're excited about the multiyear global growth trajectory for CereLink. As Carrie mentioned earlier, we expanded our wound reconstruction sales force in the first half of the year and these new sales reps are ramping up their effectiveness with a focus on surgeons new to ACell.

In the second quarter, we added over 200 new ACell users, and we're pleased with our progress building commercial momentum. We believe Aurora, our new Surgiscope technology will drive a step change in the standard of care for minimally invasive neurosurgery and the surgical treatment of intracerebral brain hemorrhage. We are continuing to build out an early adopter base through our mirror registry in US. The Aurora evacuator, with coagulation functionality was launched in many sites, and the initial cases have shown the device works well in conjunction with our surgiscope, further validating the promise of Aurora.

We're continuing to expand reimbursement coverage for PriMatrix. We have now secured coverage by three of the five largest US payers, and we remain focused on further growing the profit population for PriMatrix. We also continue productive engagement with the FDA regarding our SurgiMend breast PMA to address questions and further data requests raised during our October panel meeting.

And finally, Neurogen 3D, our nerve repair product engineered for optimized mid-gap nerve regeneration is making steady progress through early KOL experiences, and we continue to add first-time users and win value analysis committee approvals. In addition to accelerating our growth catalysts, we're keenly focused on securing our operations and margins for the remainder of the year and on driving margin expansion beyond 2022 and as inflationary and supply chain pressures abate.

We continue to take actions to simplify and optimize our portfolio, while driving efficiency in our manufacturing facilities, sales channels and back-office operations. We are managing input costs with our suppliers and in our manufacturing plants. And we're working to keep pace with increasing demands and reducing our back-order levels, while maintaining our focus on price realization to drive long-term margin improvements.

We have a broad set of efficiency levers and we are confident that as the short-term supply and inflationary pressures subside, we will deliver on our long-term profitability targets. In conclusion, the first half of the year has been solid in the face of a myriad of global challenges. We are not – or while we are not in steady waters yet given the continued macro uncertainties. I believe Integra has demonstrated we're well positioned to weather these challenges with our strong portfolio of products, our engaged talent and first leadership. And we expect to continue to deliver solid and consistent growth, profitability and cash flow.

And so with that, I will open the floor for questions. Operator, would you please open the line for Q&A?

Certainly. Thank you, sir. [Operator Instructions] And we take our first question from Steve Lichtman with Oppenheimer. Please go ahead, sir. Your line is open.

Great, thanks. Good morning. I guess to start, I just want to touch on inflation. It looks like EPS guidance didn't change from ongoing inflation pressures. As you look at guidance now versus where you were at 1Q. Would you say your estimates for the inflation headwind has basically the same or has it gone up over the last few months, what you're finding offset in the P&L?

Hi, Steve. I'll take that call. I would say generally, the good news is -- and I think you read that guidance correctly that we are managing those inflationary pressures. Obviously, we're doing that through a number of initiatives, as I mentioned before, whether that's price purchasing initiatives and other cost elements, improvement actions that we're taking. I would largely say for the bulk of the inflationary pressures, we haven't seen them get any worse. With the exception of a couple of areas, certainly, freight cost and energy costs are probably the two that continue to increase a bit from earlier in the year.

But I think in balance, I think between the initiatives that we have, as well as the general levers that we have a part of our margin improvement, which is new product introduction, which brings better margins actions that we're continuing to do on the portfolio continue to allow us to at least keep our margins this year relatively flat.

Okay. Great. And then my second question, just on the capital environment from your perspective, particularly in the US. Are you seeing any changes there in terms of appetite from hospitals or are things pretty steady on that front?

Yes, I'll start and certainly, Glenn can add some color here. I would say capital came in largely where we expected it to in that mid-single-digit range. But I still see longer selling cycle. So that extended selling cycle trend is still prevalent. We actually saw a little bit better performance out of our larger capital compared to smaller capital in the second quarter where that was a little bit reversed in the first quarter.

So maybe more timing related to anything on some of that larger capital coming through on CUSA in the second quarter, but still some good demand on the CereLink as well in the second quarter. And – but overall, generally holding up. I think as I think about full year, and certainly, that's a reason to be still cautious and certainly, that factors into our overall guidance for the full year is that, we don't necessarily see that capital selling cycle shortening at this point. So looking at a gradual capital improvement as we move to the second half of the year, not a bolus of increase in capital. Glenn, anything you wanted to add there?

I would just say we feel really good about the funnel. The funnel is strong. But as Carrie mentioned, the selling cycles are a bit longer. But even with that, both large and small capital did well in the quarter. I would just highlight though International had really strong performance on the capital front. We actually grew double digits outside the US, a lot of that coming from Japan.

You probably remember about 1.5 years ago or so, we took our business – our capital business direct in Japan and we've built that team up nicely and we're seeing some really strong growth in some of the additional dollars the government is freeing up for capital. So, I would just highlight the strong performance internationally on capital. We did see growth in the US, but not to the extent of international.

Thank you. [Operator Instructions] We are taking our next question from Vik Chopra with Wells Fargo. Please go ahead. Your line is open.

Hey good morning and thanks very much for taking the question. So I guess one perhaps on M&A portfolio optimization. Can you give us an update on how you're thinking about M&A, including a larger transaction at this time, especially with the pullback in valuations? And then I had a follow-up. Thank you.

Thank you, Vik. I'll take this question. So, we finished over the past couple of months, a broad strategic scan both in our Tissue Technology and CSS business, and today have a broad set of opportunities where we think we can organically and inorganically broaden our position in the care pathways and increase our scale. So, at this point in time, we have a very good view of where we want to go, leveraging our M&A capability, leveraging our balance sheet.

We definitely have a number of opportunities in side. In terms of the timing, I think we're still a bit in that phase where, while some of the multiples look attractive, the willingness to transact is not there yet. So that's something that I assume over the next couple of months may start to change.

And I would just add on that to Jan's point on the balance sheet. Obviously, a very strong balance sheet that provides us lots of flexibility as we think about being active on M&A, and that M&A will still remain a top priority for capital allocation. But our net total consolidated debt ratio was 2.5x and our ranges like we target at is 2.5x to 3.5x. And so, we're at the low end of that range, which is great to have that flexibility as we move into the second half and into 2023.

Great. Thank you. And just one follow-up, Carrie, maybe for you. How should we think about growth by segment with the second quarter now behind us? Thanks so much.

Yes. I would say, generally, for the full year, both segments will likely be in that corporate range. I think as I think about the second half, you'll probably see some things to moderate a bit, as I mentioned before in my prepared remarks, private label was a standout, obviously, 15% growth, both for Q1 and Q2. So that's going to move a little bit lower into the second quarter as we move to more of that mid-single-digit range for the first half – or sorry, for the full year.

Same thing with instruments that will moderate in the second half. But generally, I would say, both of them will be in that corporate average mix a little bit of pluses and minuses with TT probably doing a little bit better than the corporate average and CSS doing a little bit less. But generally, CSS still being in its 3% to 5% organic growth range expectations.

Thank you. And we are taking our next question from Ryan Zimmerman with BTIG. Please go ahead. Your line is open.

Good morning and thanks for taking the question, Jan, Carrie and Glenn. I want to talk about guidance for a moment, if we could. I appreciate the color on the third quarter and can see -- you on the street is kind of sitting I think a little bit higher at 3.99 [ph], but when your account for FX and the divestiture, you come in line closer to the third quarter.

But if we think about the fourth quarter guidance implied from that. I think you're looking for something in the streets that are around 4.21 [ph], but when your account for the higher FX and the divestiture, you're still leaving a little bit of room, I think, between the implied guidance, which comes out, I my math around or maybe 4.05 [ph] or maybe 4.07-ish [ph]. So help us understand, Carrie, kind of the puts and takes as you think about the contribution or the organic growth contribution of the business in the implied fourth quarter guide now coming out into the third quarter?

Yes. And in terms of our full year guidance, again, I think we have a lot to be reasons to be optimistic on our markets and capabilities to capture growth, and that's why we left the top end of our full year guidance at the 5.2% organic growth. But there are still reasons to be cautious.

As you know, Ryan, still supply constraints persisting in macro uncertainties. I would say that fourth quarter, specifically as you kind of back into that from the third quarter and the full year guidance, would obviously -- usually is the strongest quarter of the year as we think about end of fiscal year for many of our hospitals. So, I still believe that capital will normally, it's the strongest quarter of the year.

And so, I would expect to see that normal tick up in capital as well. And obviously, continued momentum in other areas of the business like some of the new products that Jan talked about, Neurogen 3D, ACell, we've got it moving in the right direction. So I think the combination of those things and more stability out of China as we move to the fourth quarter kind of emerging from some of these lockdowns. All of those things, I think, bode well for continuing momentum as we move into the fourth quarter.

Okay. And then just – as we think about -- I'll squeeze two quick ones in here. One, if you think about the legacy Derma Science business, which is now part of the Tissue Technology business, you're getting rid of that old that divested TWC business. What's the growth profile of kind of that legacy AWC business with the divested TWC business off the books now? And what kind of margin impact are we talking about that you should see as a result of the divestiture?

Hey Ryan, it's Glenn. Good morning. So, I would say the profile of the Derma business, excluding TWC, is in the mid-single-digit range. And again, we're talking about Advanced Wound Care products such as MediHoney, our amniotic portfolio that we're still keeping in our core to our business.

So, call it mid-single digits, in some cases, could be a little bit higher, but -- that's the way I would frame out the growth. One of the reasons why we divested the TWC business was, it was not growing, number one. Second is the gross margins are very low, and you can think of that as in mid-20s range. And so, from a gross margin perspective, it would obviously be accretive to us.

It did have EBITDA positive dollars, and that's why it was somewhat dilutive by divesting it. I think we've still got some work to do to get some of the stranded costs out for 2023. But on the whole, it should help our overall profitability metrics help our growth rates and hopefully, that gives you a good indication about the go-forward portfolio with the Derma Sciences business we bought back several years ago.

Thanks for taking the question guys. I will hop back.

Thank you. And we are taking our next question from Joanne Wuensch with Citi. Please go ahead. Your line is open.

Good morning and thank you for taking the question. I was interested if you can give us an update on where SurgiMend is for the PMA for breast reconstruction?

Hey Joanne, thanks, it's Glenn. What I would say is we continue to work with the FDA on their questions regarding our PMA submission. And really, we're probably not going to have any updates until the end of the year. We can give you some more guidance about what the expected approval looks like, any open questions or items with the FDA. So I don't have any real update other than we're working with the FDA and probably later this year, we'll give you a more detailed update.

And it doesn't impact our ability to sell SurgiMend. Obviously, we cannot promote for a specific indication in breast, but we do have a general surgical plastic and reconstructed indication and therefore, still can see very nice growth coming out of SurgiMend.

Thank you. And we take our next question from Sam Brodovsky with Truist. Please go ahead. Your line is open.

Hi. Thanks for taking question. Sam on for Rich here. Just first one, I just kind of want to tease out the pricing commentary a little bit. How should we think about the timing of pricing increases getting into the P&L? And sort of in terms of scale, should we think about that mirroring inflation or maybe being a little bit lower than that?

So, pricing actions we actually took earlier in the year. So this was a body of work that we undertook in the fall as we prepared for our budget for 2022, knew that those inflationary pressures were going to be present and those trends there. So, the teams worked very closely with all of our commercial leaders to basically put in a round of price increases, which those went into effect. And in some cases, we're moving on additional price increases as we move to the back half of the year. So it's a continual process.

And form of price increases, think about it as a number of different ways that we can affect price, getting to the same end goal which is additional gross margin opportunity, is you have obviously opportunities to raise list prices you have the ability to change the level of discounting that you're doing off those list prices. You have the ability to think about raising new prices to brand-new customers, introducing new products that have higher prices, better margins as well.

On enterprise contracts, some of those -- a portion of those are contracts that you can't open up. They have longer-term multiyear contracts that go for two to three years. And so obviously, when those contracts come up for renewal, we're obviously looking at opportunities to increase price.

But even the contracts that are not up for renewal, the opportunity that you have there is to look at volumes. So, in most cases, there is a volume commitment that you have with the hospital on those and you have the right to audit that to ensure that you're getting the volume that contractually you were entitled to. And so that's an opportunity to open up negotiations.

But in addition, as I mentioned, it doesn't stop there. It also -- you're also doing purchasing initiatives. So as supplier price increases come into the door, pushing those back obviously, leveraging our supply base, looking for opportunities to move volume to other suppliers to gain synergies there. And also working within the factory, whether it's reducing waste in our factories, improving yields – all of those things, we have hired more continuous improvement, black belts, green belts in our factories to go after more manufacturing inefficiency. So, all of those kind of are brought to bear on the things that we do to protect our margins.

Thanks. Great. And then second one from us. Just thinking more longer term and around the LRP goals, any changes from the beginning of the year, whether it's top or bottom line, either in terms of how quickly they can be achieved or what target and what the target may end up being?

So Sam, Jan here. I'll take this one. As you heard me say probably in the beginning of the year, when I looked at our long-term 5% to 7% growth range target with increasing profitability. I mean those remain very valid and the deeper. I get into the business, understanding the levers and strengthening the levers, the more confidence I feel about that trajectory.

The key question is a bit, how has COVID and some of the microenvironment the jalopies today, how does that affect some of the timeline and when we exactly get there? At this point in time, we're not giving ‘23 or longer guidance yet, that's going to be focused in the second half of the year to really translate a lot of the strategic initiatives we have now, whether it's international, whether it's broadening our scale and breadth in our two divisions. We're translating that into a longer-range plan. And we'll be sharing our views – updated views on that timeline end of the year, beginning next year…

Yes. The other thing I would add to Jan's comment is on the margin side. Obviously, in 2022, the margin opportunities are hidden because of some of the FX headwinds. But all those levers are there. And so hopefully, as evidenced by some of the things we talked about on our call today, you see that the Integra team is hard at work and really driving those margin levers, so that as those inflationary pressures abate, you'll start to see that margin expansion.

And working on big projects. So not just what I would say the day-to-day kind of fighting off those inflationary pressures, but really fundamentally driving longer-term margin opportunities by continuing to optimize our manufacturing footprint. Obviously, the TWC divestiture, closure of an expensive plant in France, as well as moving on some SG&A initiatives like outsourcing back-office activities. All of those are focused on driving that long-term margin expansion that will provide that hopefully you'll be able to see those things start to take hold in the margins as those inflationary pressures abate.

Thank you. We take our next question from Matt Miksic with Barclays. Please go ahead. Your line is open.

Thanks so much for fitting me in. So I had a follow-up question on the wound care business, if I could. Just the work that you're doing there to kind of expand coverage – just help us understand if you could, when and if it starts to show an inflection here, during 2022 or just remind us how you expect that to affect the business over the longer term? And then I have one follow-up.

Good morning, Matt. It's Glenn. Thanks for the question. So when we talk about our expanded sales force. We're really referencing some of the actions we took to get better sales field coverage for the ACell portfolio. These are more general wound care reps, but obviously, ACell as part of the portfolio. And for the first half of the year, we added about 30 incremental resources.

And so, the good news is we already are seeing the momentum here in the second quarter. We gave in our prepared remarks some color around ACell with sequential improvement from Q2 from Q1 into Q2, which is a very positive sign. We actually added over 200 new users in the second quarter. I think the thing that's really positive, though, is we're still onboarding and training a lot of these reps. They wanted full productivity until later this year, probably around Q4.

So have really good momentum now with ACell, saw a nice sequential improvement. I would also tell you we expect better second half performance versus first half performance. So, on the whole, feel really good about the ACell business. And even on the overall tissue business, we had a really strong quarter overall which we feel quite good about it. So putting up the numbers we’ve put up here, strong second quarter expect stronger performance in the second half of the year with our tissue business, including ACell.

Great. And one follow-up just on the portfolio and growth drivers in general, and it just comes from a question that, I think investors have asked over the years and other folks may have gotten the same question is, just looking for sort of that standout growth driver. I think everyone appreciates the portfolio management and the additional acquisitions and operational management that you've delivered in as you pointed out in the slide, solid delivery execution. But just what can you point to maybe in the next 12, 18 months that you'd say this look for this to be an important growth driver and something we're excited about?

Yes. I'll take that one, Matt. I mean several things we're excited about. But -- it's all about – the standouts are about where we expand our current markets. I mean, one is international, where we have a good track record, but the work we've done over the past months shows there's several more opportunities in Europe and outside of Europe to build more market presence, not just in our neuro business, but even more in our tissue technology business. So that's one, okay.

And you'll see us focus on several specific opportunities in specific countries and China, Japan, definitely are the key in there. And then you have the near-term catalyst as we call them, whether it's ACell, CereLink, Aurora, Neurogen 3D, which all are opportunities to really capture either market share or capture new adjacent markets.

And so, it's focused this year to make sure we execute well. We get into markets, we get the first users, we get the KOLs behind us to, as of next year, see real commercial momentum behind these products. And then the third aspect is more on the inorganic side, where we continue to look for accretive -- growth accretive opportunities in adjacencies around our two divisions.

Yes, the only other thing I would add Jan is obviously, we're dealing with some very challenging items in supply. And so, I think as we look at our back order situation, while we don't expect much improvement this year. Certainly, we'd expect improvements in 2023 to be a nice tailwind for us.

And again, these are orders we have from customers that will ultimately be delivered. But again, I think we'll see more of that benefit in 2023 versus this year. And then our procedures getting back to more of a normalized rate in many of these places like China and other parts of the world will be a nice tailwind for us as we go into next year.

Thank you. We take our next question from Craig Bijou with Bank of America. Please go ahead, sir. Your line is open.

Great. Good morning, everyone. Thank you for taking the question. Maybe just a couple of follow-ups. Specifically on backorders, Jan, I think you said that back orders got a little bit larger than they were relative to Q1. So wanted to see if you guys would be willing to quantify that. And then how are you thinking about back orders in the second half? Do you expect the supply chain to still pressure back orders and maybe increase even from where they were in Q2?

Hey Craig, it's Glenn. I'll take this one. I think the positive is customer demand remains really strong, but it is a very challenging supply environment. And so, we did see slightly higher back orders in the second quarter versus Q1. And the way we describe it is, we're essentially meeting normal demand, but we're not producing enough yet to meet surge capacity requirements from the procedure recovery.

And so second half of the year, I'd say we still expect to see elevated back order levels. And if we do see any improvement, it's going to be gradual. So, I don't expect to see significant reductions in back orders, if anything it would be just gradual. But certainly going to be at elevated levels through the rest of this year and then probably any significant improvements would be in 2023.

But on the whole, we're doing our best to manage through the situation. It's just slightly higher than Q1. And I think we called out $15 million type number in Q1. So, I don't think we're going to continue to give a number, but it is slightly higher than Q1 number.

Got it. Thank you for that Glenn. And maybe a follow-up on ACell, maybe for you, Glenn. Obviously, recognize the sequential strength that you guys saw there. I believe that means it's kind of mid-single-digit growth year-over-year. And obviously, with the productivity ramp in the second half. I was wondering if you guys could maybe refresh kind of thoughts on growth rate for ACell. Can you get to the high single digits in the second half and longer term, how should we think about the growth of ACell specifically?

Yes, I'll start with that, and Glenn can add some comments in, Craig. So, I would expect for the full year that we would see high single-digit growth year-over-year. And remember, obviously, that in Q3 last year, we kind of stabilized at that $16 million level. And then for Q3, Q4 and Q1, we were in that $16 million level. And then from there, we reported high single-digit growth from Q1 into Q2.

And as Glenn has already mentioned, building some momentum there such that the second half should show sequential growth from the first half. And as I think about the first – the whole year compared to what we did in 2021, it should be high single-digit growth. And then I think from their long-term expectation would be that it continues to support tissue technologies, long-term organic growth rate goal of being in that 7% to 9% organic growth.

Great. Thanks for the color.

Thank you. And we take our next question from Matthew O'Brien with Piper Sandler. Please go ahead. Your line is open.

Hey, this is Phil on for Matt. Can you hear me all right?

Thanks for fitting me in here and taking my questions. I'll keep it just to one. I understand you mentioned this in your prepared remarks, but could you characterize what you're seeing in China given the recent lockdowns, COVID spikes? And maybe specifically on capital side, how does this OUS environment and specifically in China, how does that look given some of these headwinds alongside some recessionary headwinds in there? Thanks.

Thanks, Phil. This is Glenn. So relative to China, I think, first and foremost, I would just highlight the performance in the second quarter being strong growth. We were still high single-digit growth in China, despite some of these challenges and the lockdowns.

If I look at procedure rates, obviously, traumatic brain injury was way down when you look at early in the quarter. So, April with the lockdowns, you can think of it as almost 50% of normalized procedures that improved in May and then we're probably 85% to 90% of normalized procedures in June. You don't see the full impact, though, in our results some of the points that Carrie made earlier, we do sell through distributors and logistic providers. And so a lot of our orders are already kind of committed to for Q2. So we'll see some impact in Q3 and Q4.

But even with that impact, we are seeing really strong growth in China with these lockdowns. And so, I feel really good about the momentum we have there. A big part of that is obviously capital and so capital continues to do well. Just keep in mind, when we talk about capital in China, we have not launched CereLink in that market, that will still be several years from now because of the long regulatory pathway. So really, it's CUSA when we talk about capital, and that continues to do quite well.

But as we look forward, we continue to hear more and more about growth coming from China, which is likely going to be our largest market by revenues outside of the US probably in 2023 with the growth profile that we see and is a huge opportunity for us over the next decade.

So that's the way we frame out China kind of -- obviously, you've got some headwinds right now with the lockdowns. But even with that, still seeing really strong growth overall. And what that translates to for the total international business, I have to say this with all these challenges, international organically grew 8% in the second quarter and we did over 6% for the first half of the year, it’s been a really challenging environment. Maybe my team members on the call, I want to give them kudos and acknowledgement of the great work that’s gone on the business and our growth there. Thanks for the questions.

Thank you. And we take our next question from Jayson Bedford with Raymond James. Please go ahead. Your line is open.

Good morning. Can you hear me, okay?

Okay. Thanks. I apologize if I missed these. But couple of questions. First, maybe just to dovetail on the last question on the capital environment. It was solid sales here in 2Q, but just wondering more on the US side, just given the economic environment higher level of wage pressure. Are you seeing any softness that’s flowing on the order growth on the capital side?

I would say, again, capital came in where we expected it to and certainly that, even our larger capital CUSA did very nicely both in the US as well as internationally. I would say that at, what we continue to see, which is factored into our guidance expectations, is longer selling cycle.

So, Jayson to your point, yes, there has been an impact, but it's not that the funnels are changing. The funnels are very, very full. The competitive landscape has not changed. It's just putting a longer selling cycle that you need to account for in your guidance, and we've done that. I think the normal patterns are still there as we move through the balance of the year. I would expect the normal tick up in capital in the fourth quarter. But certainly, within our guidance, we've accounted for that extension of that selling cycle there.

Okay, that's clear. On private label, up 15%, quite strong. I think it was mentioned favorable order timing. I'm just wondering if you quantify this and then maybe talk about private label growth for the rest of the year. Thank you.

Yeah. And Jayson, I did share this in my prepared remarks, so you can certainly go back for color on that as well, but I'll reinforce that, that private label, our long-term expectation for private label is mid-single digits. And I think for the full year, you should assume mid-single digits for the full year.

First half has been at 15%. So, you can kind of do the math and what that implies for the second half. But growth is going to – is obviously going to moderate. It's going to go lower – much lower in the second half in order to get to mid-single digits for the year. And think about our discussions on supply chain constraints.

Those supply chain constraints often impact our private label partners as well. So they're all doing what everyone is doing, which is, looking at safety stock levels, managing their own inventory levels to ensure that they have a continuity of supply.

So, I think what we've seen is the benefit in the first half with some timing of orders and as we think about the second half, our expectation is that our partners will more closely manage that inventory, and that's why we would expect it to moderate to mid-single digits for the full year.

And a lot of our private label partners are in the dental and in the spine area. And so, as you think about trends in those businesses, they tend to go with – we tend to align with that spine and dental market trends in the private label business.

Okay. And was there a dollar amount assigned to the favorable order timing?

No. But certainly, as I think about the guidance for the third quarter, Jayson, it's comprehended in that. So, as we think about the updated guidance for the third quarter for the balance of the year, we've assumed that for the full year that private label growth moderates to mid-single digits for the whole year, which implies negative growth for private label in the second half and that is embedded in our guidance range.

Thank you. And we take our next question from Drew Ranieri with Morgan Stanley. Please go ahead. Your line is open.

Hi everyone. Thanks for taking the question. Maybe Carrie for you. Just hoping to kind of get a better sense of where free cash flow should shake out for the year and maybe what your expectations are there. I think you're running kind of in the low 80s for free cash flow conversion. I think the LRP was something to get to like 90% over the longer term. But just how are you kind of thinking about free cash flow this year and maybe into the future?

Yes. For free cash flow, I would say that last year, we had record cash flow. So, I don't expect to be at those levels as we were in 2021. So lower than that, but better than the prior year. So, I'd say probably very similar to where we did for 2019. And CapEx, as they think about operating cash flow, the free cash flow, your CapEx requirement is going to move up higher from 2021, as some capital was constrained in 2021 by our own decisions, but also just to constraints on capital.

Just when you order things, you weren't getting it when you needed to. So that pushed some capital into 2022. And so we would expect the second half to see higher capital spending levels compared to the first half and spending likely to be in that $65 million, $70 million type of range for the full year. But a nice cash flow year, all things considered.

Higher spending as it relates to EU MDR. That's the other thing to think about as we think about operating cash flow that's different from 2021 to 2022. A lot of the peak activity from many of the companies that need to be compliant with EU MDR in the timelines over the next couple of years, that activity will start to peak here in 2022 into 2023. And so, the cash requirements for that remediation move up for many companies like Integra.

Got it. Thank you. And maybe this might be for Glenn. But you talked about adding 200 new ACell users in the second quarter and kind of the productivity ramp that you're expecting in the back half. Just kind of curious, as you're looking at maybe those 200 new ACell users, were they legacy Integra users at all? And maybe how do we think about the overall cross-selling opportunity as you're ramping up the ACell sales force? Thank you.

Yes. I think many of them are current users of our skin products, IDRT, PriMatrix. There is some subset. I don't have the split out, but there is some subset that doesn't use our current product, but actually are now using outside of the Wound Care. And so, it's a mix. I don't have the split, but I think we are seeing some leverage in cross-selling synergies, certainly from our current portfolio. And then this expanded coverage is also having a benefit by getting to new users.

Thank you and we are moving to the last question for today. That's a follow-up question from Sam Brodovsky with Truist. Please go ahead. Your line is open.

Hey, thanks for squeezing me [indiscernible]. Just a broader one on Wound Care as it relates to the new proposed PFS rule. I know Integra is a little more inpatient focused, but any thoughts on whether there could be a shift in site of care with the new PFS rule on reimbursement for skin substitutes and whether that could be a long-term benefit for the industry?

Sam, thanks for the question. I think first and foremost, you have to nail on the head. It's a current proposed rule that's really only for the physician office setting and is not having any to do with the inpatient or even outpatient hospital setting. And that's obviously where the bulk of our business is, we have a very small presence in the physician offices.

So for us really, very minimal impact to our portfolio. I think if anything, there may be a benefit to us given our broad portfolio, our lower pricing as the playing field is leveled in this space. So, I think we view it as a positive change for us in our business, but we don't expect it to have any short-term impact on our Wound Care business.

Yes. Maybe one thing to add, Sam, I look at it as a further shift towards paying for outcomes being for value, which is suggested. And as Glenn said, at this point in time, it's mainly in the physician office. But yes, if I look at our portfolio and the quality of the products we have and quality defined as delivering real outcomes. This type of shift plays to the strength of Integra. And so, while it doesn't affect us directly in the markets where we play, it's definitely a trend, which I think over the long term, should help companies like Integra.

Thank you. And with that, I'm handing the call back over to our panel of speakers for any additional or closing remarks.

Yes. We'd like to thank you all for to joining second quarter 2022 earnings call. This concludes our call. You can follow up on our website or to Investor Relations with any follow-up questions. Thank you.

Thank you. And that concludes today's conference call. Thank you for your participation, ladies and gentlemen. You may now disconnect.