Earnings Transcript for CFMS - Q1 Fiscal Year 2022

Operator: Good morning, and welcome to the First Quarter 2022 Earnings Conference Call for Conformis. My name is Michelle, and I'll be your conference operator today. [Operator Instructions]. I would like to remind you that this call will include forward-looking statements within the meaning of the federal securities law, which are made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Any statements made during this call that are not statements of historical facts could be considered forward-looking. These statements involve material risks and uncertainties that could cause actual results or events to materially differ from those anticipated or implied by these forward-looking statements, including those discussed in the Risk Factors section of Conformis' public filings with the U.S. Securities and Exchange Commission. You should not place undue reliance on these forward-looking statements. Conformis disclaims any obligation, except as required by law, to update or revise any financial projections or forward-looking statements, whether because of new information, future events or otherwise. This conference call will include time-sensitive information and is accurate only as of the live broadcast today, May 4, 2022. I will now turn the call over to Mark Augusti, President and Chief Executive Officer of Conformis.

Mark Augusti: Thank you, and welcome, everyone, to our first quarter earnings call. With me today is our CFO, Bob Howe. We had a quarter of steady progress with our Identity Imprint Knee System, our new Platinum Services program and the products in our development pipeline. These will be the cornerstones of our product and service offerings going forward and we believe will be the catalyst for our growth. We achieved several Imprint milestones during the quarter. We successfully completed our 250th Imprint procedure and now have over 500 orders in the queue. The clinical feedback remains compelling, and we continue to see a positive response from the ASC market, which is the primary target for this product. Importantly, Imprint is already on contract at nearly 70% of our existing accounts, an average price that is roughly the same as our total Identity. This positions us well to drive gross margins as orders and procedures ramp. We remain on pace to transition to the full market release in June, at which time we anticipate that we will have Imprint in contract with well over 90% of our customers. To support the full launch, we have a series of training and medical education events planned to drive further awareness and expand surgeon access. The market has reacted very favorably to this new Imprint knee offering, and we expect this to continue as we target the ASC setting. Our new Platinum Services program is also progressing well. This program allows facilities to offer a fully personalized knee system as a deluxe upgrade option for their patients. Since its launch on January 6, interest has been strong from ASCs and hospitals. We are educating all stakeholders about the numerous benefits of the program and the potential to generate additional facility revenue. We developed Imprint and launched our Platinum Services program to address the ASC opportunity while simultaneously providing a premium choice to patients as they consult with surgeons regarding their knee replacement options. We believe that a leading indicator of our success is our ability to gauge the appeal to a broad spectrum of facilities. We are committed to providing additional metrics to help you monitor our progress of our new program through 2022. To date, we've enrolled 18 health care facilities in the Platinum Services program, and the pipeline remains robust, including many competitive accounts. We expect the growth of contracted Platinum Services facilities to be lumpy since contracting with new customers is a very variable experience depending on the size of the customer and the number of stakeholders in the decision-making progress. That being said, our team is energized with the new business opportunities that Platinum Services is creating with current and competitive accounts. And we expect to grow the number of enrolled health care facilities we do business with over the coming quarters. Another favorable achievements to report in the past quarter is the way we are extending our brand presence through a strategic partnership with Synchrony Financial, a leading consumer finance company. Synchrony has added our Platinum Services program to their successful CareCredit offering, which is accepted at more than 250,000 providers in health care-focused retail location and has more than 11 million cardholder accounts. We believe this will provide health care facilities and patients an easy-to-use and readily available financing option to offer patients for out-of-pocket costs related to the personalization service upgrade. We've already noted that the Platinum upgrade is eligible for any health savings and flexible spending accounts. And now with CareCredit, we're making sure patients have increased access and choice in their health care journey. Turning to the macro environment. Elective procedures are still below prepandemic levels and staffing shortages continue to persist across the health care system. On the positive side, Omicron seems to have run its course after peaking in January. As we look to the future, we do not expect an immediate snapback in procedure levels, but we also do not anticipate any further major COVID-related shutdowns. What we do expect is a methodical procedure ramp as clinic visits pick up and hospitals and agencies normalize operations and staffing levels. COVID-related issues, combined with our business model transition, has put our product gross margins under pressure over the past few quarters with a [clean] impact in Q1. The main driver for this is we are operating our manufacturing plant at suboptimal levels due to the challenges caused by higher-than-normal turnover and absenteeism. Constantly changing staffing and shift rotations have negatively impacted our manufacturing efficiency and has triggered higher levels of scrap and longer manufacturing times. Recently, we've made strides at improving staffing level, and I'm pleased to report that we're currently at about 90% of our target levels. It's important for me to point out that we believe these challenges peaked in Q1, and our gross margin will show sequential improvement throughout the year. We forecast that we will be back at our gross margin levels of low 40s by year-end. I'm confident in our ability to do this, especially given that this is a significant area of focus for the newest member of our executive team, Mike Fillion, who started with us on April 1 as our COO. This is a new position for us, but one we planned to add for a while. I'm extremely excited we were able to attract someone as talented and seasoned as Mike to our company. He has 30 years of experience in manufacturing and operations and is well versed in applying Lean principles to make plants run more efficiently. Now I'd like to give you an update on important products in development. Our pipeline of products remain on track as follows

Bob Howe : Thank you, Mark, and good morning, everyone. I'll start with a walk-through of our financial highlights and then close with a few thoughts on our outlook. Product revenue is our most important financial metric, and we had a nice start to the year. We generated $14.9 million of product revenue, which is 8.6% growth over our first quarter last year. This was better than our expectations, primarily due to fewer Q1 scheduled surgeries pushing out to future quarters. The growth over prior year was due to a modest increase in elective surgeries and growth in our ASC channel. Within product revenue, sales of our Conformis Hip System were approximately $800,000, up 18% compared to last year's first quarter. Our hip growth rates are expected to accelerate later in the second half of the year as we expand our product portfolio with a limited market release of our Cordera hip stem and trialing by surgeon resumes in earnest. I would now like to spend time on our product gross margin. As good as we felt about our product revenue results, we had a similar level of disappointment in our product gross margin for the first quarter, which was 34.1%. Although we indicated on our last call that this metric would be under pressure and should be in the high 30s during the quarter, our plant continued to operate inefficiently. We experienced higher manufacturing scrap, and we continue to face macro headwinds, including inflationary pressure, higher input costs, supply chain constraints and labor shortages. Additionally, our cancel case inventory expense was higher than forecasted as this remained elevated during the quarter. Unscheduled surgeries can still occur, and we continue to work with health care facilities to establish procedural dates for these cases. We are focused on improving these issues impacting our product gross margin, although we expect the macro headwinds will remain an overhang. As Mark mentioned, we are now running about 90% of capacity from a workforce perspective, so we have bridged the gap on personnel. Now we are working hard to get our workforce operating as a cohesive unit. By doing so, we will improve labor efficiencies, lower scrap, improve delivery performance and accelerate our inventory builds to support our Imprint full commercial launch. I'm excited Mike Fillion has joined the Conformis team, and I'm looking forward to working with him to get these metrics back in line over the next few quarters. For now, our forecast show product gross margin sequentially improving in Q2 to the mid- to upper 30s and low 40s in the second half of the year. So this is a short-term issue that we believe will correct quickly. Longer term, we believe that as we ramp Imprint and the Platinum Services program, we have a meaningful opportunity to further expand our gross margins. I will now move to OpEx. Our total operating expenses for the first quarter were $20.5 million. This was about $5.2 million higher than the same period last year and related to a few items. We had $1.6 million of higher costs in sales and marketing, which was partly due to the timing of the AAOS trade show, which occurred in the third quarter last year. Additionally, we had higher commission and employee-related expenses as we continue to invest in our commercial team to support our growth strategy. R&D expense increased by $900,000, primarily related to employee and project-related costs required to support our product pipeline. And lastly, we had $2.7 million of higher G&A expenses driven by professional fees related to IP litigation and higher delivery expense as we again relied heavily on expedited shipping methods because of our manufacturing capacity challenges. Our OpEx expectations for the year remain unchanged despite Q1 being a little higher than expected. Accordingly, we continue to expect operating expenses to be between $75 million and $81 million for the year. However, the timing in the buckets may change slightly as we manage to this number. Moving to our balance sheet. It remains strong with cash and cash equivalents of $82.7 million at the end of the first quarter. As highlighted last quarter, we are building our inventory balance on Imprint knees. We expect this build to continue, and we also add the initial inventory production for the Cordera hip over the coming quarters to support our product launch cadence. Net cash flow in the first quarter was $17.8 million use, which was higher than in recent quarters. The increase was driven by lower margins, higher operating expenses, timing of onetime annual payments and changes in working capital. We anticipate quarterly net cash use to improve throughout the year as revenue growth rates improve and product margins improve as well. I will close with our outlook for the second quarter. We expect our second quarter product revenue to be between $14.5 million to $15.5 million. We confirm our full year product revenue expectations of $60 million to $70 million. A couple of things to note on this range. First, sequentially from Q1 2022, it is important to keep in mind that in 5 of the past 6 years, our second quarter product revenue has been lower than the first quarter due to general seasonality trends. Second, I want to remind you that last year's second quarter had significant rescheduled activity from Q1 delayed surgeries during a period of heightened procedure recovery. While our entire business was impacted by this in Q2 last year, our hip business had an even more pronounced level of rescheduled case activity that resulted in a relatively high Q2, making for a difficult comp from a year-over-year perspective. So taking all of this into consideration, like we did last quarter, we've taken a conservative approach to our outlook. Our Q2 guidance does not assume significant improvement in either elective procedures or staffing shortages in medical facilities. We do not expect noticeable recovery in elective procedures until the second half of 2022. With that, Mark and I are happy to take your questions.

Operator: [Operator Instructions] Our first question comes from Steven Lichtman with Oppenheimer & Company.

Steven Lichtman: I guess, first, I was wondering if you could talk a little bit about the intra-quarter dynamics and what you saw, I mean, obviously, assuming that January was the toughest, but what you saw exiting the quarter and any commentary you can make in terms of how that trend perhaps may continue into April?

Mark Augusti: Yes, you're talking specifically just sort of macro demand sort of elective procedure, that type of thing? Or...

Steven Lichtman: That's correct.

Mark Augusti: Yes. So definitely, Steve, I appreciate the question. Omicron faded away. We saw less impact among facilities and our health care customer, facility customers. And we saw some increased demand pick up through the quarter. April sort of, as I think I pointed out in my comments, Q2 is always going to be down. So April sort of leveled off. And that's why I think what we're saying -- I'm not saying that's because of anything COVID-related. I just think procedures sort of are going to have a slow rise. But for us, we saw a slight improvement as far as in the market, but we're still in that transition phase. And that's why we've sort of given the range for Q2 that we've given as far as how April was.

Steven Lichtman: Okay. Got it. In terms of Imprint, it sounds like feedback continues to be good. What are the sort of the last pieces in your mind to get you guys ready for the full launch? Is there any additional feedback required? Or is it really just building out the inventory? What are these final steps as you move toward the full launch?

Mark Augusti: Yes. It's really -- so the team has done -- the commercial team has done a really good job on getting Imprint on contract. As you know, in medtech these days, access is a big thing. We're very happy with the clinical performance. So there's nothing we have to do there. It's really all operationally getting ready, but there's a couple of components to that. As you mentioned, inventory is the biggest one, and that has been a challenge for us given what we dealt with heading to year-end last year and then, obviously, as we just noted, in Q1. We're getting there. We're making the right strides, but we're not quite ready. And when we say ready, part of our commitment is we want to be able to deliver Imprint in a 3- to 4-week time frame, significantly faster than the 6-week time frame that we do with our custom 5, 6 weeks with custom, depending on the product. So that requires 2 things. That requires having the inventories, as I just talked about. It also requires having our enterprise management system, our software, all the commercial interactions really, really robust and sorted out. So there are some things we've had to do through warehouse software management systems and stuff like that, that we haven't had to deal with, frankly, in the past when we were build to order. So those are just some processes that we're making sure are robust and reproducible so that we can, as I said, flow orders through and deliver reliably in a 3- to 4-week time frame on Imprint. So we're on track for June. I will tell you that we were internally hoping we would be able to be ahead of this heading into '22. But a lot of the macro events conspire to make that more of a challenge. But we've always said outwardly that it would be a 2Q launch. And as we sit today, we still feel comfortable that we'll be able to do that.

Steven Lichtman: Okay. Got it. And then lastly for me, Bob, in terms of the gross margin, you were -- you laid out the specifics on '22, which was really helpful. As we think about over the next couple of years, so can you remind us what are some of the drivers to gross margin expansion in your mind as we look beyond this year and as you start working with Mike?

Bob Howe: Yes. I mean the biggies are obviously Imprint and Platinum Services will have a big contribution there as we grow that to be a larger portion. That's going to have huge benefit for us. So I would say that's probably the single largest element from a product standpoint. But then I would also say, obviously, volume, in general, is going to help us, right? We can leverage the fixed overhead that we have in place. And that, in combination with those 2 items, Platinum Services and Imprint, will be probably the biggest driver. So clearly, we're ramping now, but certainly in '23 I would expect to see even more significant improvements as that becomes a bigger [indiscernible].

Operator: Our next question comes from Josh Jennings with Cowen.

Josh Jennings: Thanks for the download this morning. I wanted to just ask on the Imprint launch and just follow up on Steve's question on moving into full launch mode. How has your kind of surgeon customer base reacted to kind of the mandate to move away from customs outside of Platinum Services and kind of move fully to Imprint? Has there been any pushback? It seems like the transition is going very smoothly, but just wanted to check in on that element of the Imprint launch.

Mark Augusti: Well, no, Josh, this is Mark. It's a great question, and it's an important consideration anytime you do a change to your business model. It can be upsetting to customers, and it's a challenge to change our culture around from that standpoint. I would say that all -- so we're talking about Conformis current customers, right? People that work with us today and know us well.

Josh Jennings: Correct.

Mark Augusti: Those people all see the opportunity almost to an individual and understand the pressures in the market and think it makes keen strategic sense to do it. Having -- and so they understand it. Having said that, there's probably a few, less than 10% that they want -- they just voice that they're going to miss being able to give a true fully custom implant at no charge, right, to their patients. And now they'll have to move to our new model, which is you can get Imprint, which is sort of like, call it, 75% of what we have with Identity. And if they want to go the rest of the way, then it's a patient-pay upcharge or a cash [back charge]. So those guys are not thrilled, but the flip side is they still want to work with us, right? They still understand it. Many other people are fine. They support us in getting access to the hospital. I'd say, frankly, some of them -- we haven't turned them on because we're in limited release. So some of them haven't had access because they're not turned on. And so they're jumping up a bit to get it, so to speak, and want to get it. And what we found is when they start using it, they're actually really happy. They're actually really happy because our modeling suggests that, frankly, only 25% of the patients should even really see the sizing and the shape difference because of the way we've designed Imprint. So that's bearing out as we turn customers over to see Imprint. And then there's the group like 1/3 or so that are really excited about Platinum Services. They see the opportunity to offer a premium product. They see the opportunity to increase their service offerings to their customers. And they're really, really onboard with us because they're looking for something to have a change in this industry to end -- to race to the bottom. They want to have an outlet where they can give their Medicare patients choice, they can give their commercial patients choice. And it's not always just about a race to the bottom on price. So this, to me, is exciting from that standpoint. And that's going to be the key discussion we have over the next few quarters is what kind of uptake we get with Platinum Services. Now this is a long-winded response, but I want to extend it out to other things. This is really to your question about our own customers, right, because it's a change for them. But remember, we're only a couple of points of market share. The vast majority of customers are not Conformis customers. And they really like Imprint. We're about -- I'd say about 1/3 of our limited market volume is competitive. And we think we're going to be able to do that well when we go to full market release. And for them, it's all upside. They get an automatically sized implant. They get an [indiscernible] at a price they want. It's great for their ASC. We're seeing a really good uptake, the ASC and limited market release. So I'll take that positive story any day and the ability to have new discussions, which was always the point we talked about, Josh. And we'll manage sort of the attitudes of our existing Conformis customers because I really like the way the new customers are responding.

Josh Jennings: Understood. That's helpful to think through. And just on pricing strategy for Imprint, I mean our understanding is that to be relative parity to other off-the-shelf implants from competitors. But just wanted to check in there on any changes to the pricing strategy as you're moving into the full launch of Imprint?

Mark Augusti: No, no change. I mean we are going -- we think we've got a better implant, right? And we also have a great cost saving story with our implant-in-a-box. So that's great for us. So we're just now able to be more flexible and be able to meet price volume opportunities. So frankly, we just couldn't meet, Josh, with our fully custom Imprint. Because the simple fact is, when you make a standard implant that's "off the shelf" and has only a standard number of sizes, you have lower cost of goods because everything is standard and it's all inventory. You don't have to run anything away, all that other stuff. So that gives us good pricing flexibility, and that's what's going to get us both these products, whether the customer buys an Imprint from us, it's going to be margin accretive. Or if we end up doing the Platinum Services, then due to that scenario the way the funds flow, that's margin accretive, too. So this is a smart play for us. But it's also a smart play for the market and our ability to address the market because now we're offering something that has value to, as I said, to these customers that are high-value customers or who can never play that want, lower price and now they want to get into the ASC. So that's number one. And then number two, now the opportunity to actually have a revenue-generating opportunity, which never existed before, in getting into a deluxe service business is a great discussion that we're having with people. So we reported out 18 facilities. So take that for what it was, it was 0 forever. It's disruptive. Nobody is doing it. It's early days. We expect that number to grow, and we'll talk more about that over the coming quarters.

Josh Jennings: Great. And just a quick follow-up on Platinum. This 18 kind of -- it was great to see you're seeing really fairly interested in demand in facilities. Are they mostly historic Conformis customers or a mix of new and old?

Mark Augusti: Mix.

Josh Jennings: Great. And then lastly, just any update on the Stryker agreement for PSI and that partnership?

Mark Augusti: No, thanks for asking. Stryker still -- Stryker agreement still remain. Good partnership, good dialogue. As we said, we can't really comment on where it's at. I think it's still not, as far as I understand, fully -- completely lost or maybe that's a misnomer, maybe it's "fully available", but I still think they still have a lot of training to do, still uptake. So I can't speak to that. But from what I can tell, the product works. It's there. It's just like anything else, trying to get incremental dollars in this inflationary environment and trying to deal with the cost pressures that hospitals have. That's a tough road. So it is what it is. But look, it's all good. We're delivering and they're able to order, and we feel good about the partnership.

Operator: This concludes the question-and-answer session. I'd like to turn the call back over to Mark Augusti for any closing remarks.

Mark Augusti : Thank you, operator. Well, once again, everybody, thanks for joining us here this morning. We haven’t typically done a call in the morning. We’ll evaluate if we want to continue with that going forward, if we’ll move back to the afternoon. A lot of it will be based on what our analysts tell us. We work for them. But thanks to the team for helping put this together. We’ve got our Annual Meeting here later this afternoon. I want to thank everybody for their interest and investment in Conformis. We really do have a unique and compelling strategy that is bringing choice back to patients. We understand what we’re doing is difficult and it’s disruptive because it’s never been done before in orthopedics. But if you actually take the time to look around, it’s been done in a lot of other subspecialties. And so we’re excited to bring this forward to orthopedics. So we look forward to giving an update on how it’s progressing on our next call in August. So thank you, everybody, and have a great rest of your day. Take care.

Operator: This concludes the program. You may now disconnect.