Perrigo Co PLC (NYSE:PRGO) Q3 2022 Earnings Call dated Nov. 08, 2022.

Meet the Key Corporate Leaders at Perrigo:

Bradley Joseph — Vice President, Global Investor Relations and Corporate Communications

Murray S. Kessler — President and Chief Executive Officer

Eduardo Bezerra — Executive Vice President and Chief Financial Officer

Insights from Financial Analysts on Perrigo’s Performance:

Elliot Wilbur — Raymond James — Analyst

Christopher Schott — JPMorgan — Analyst

Jacob Hughes — Wells Fargo Securities — Analyst

Welcome Message from the Conference Operator:

Operator

Good morning, and thank you for joining us for the Perrigo Third Quarter 2022 Financial Results conference call. We appreciate your participation. Please note that everyone will be in listen-only mode during the presentation. [Operator Instructions] This event is being recorded for future reference. I would now like to transfer the call to Brad Joseph, VP of Investor Relations. Please proceed.

Bradley Joseph — Vice President, Global Investor Relations and Corporate Communications

Thank you, Anthony. Good morning, everyone, and welcome to the Perrigo Third Quarter 2022 Earnings Conference Call. I trust you have reviewed the earnings press release we issued earlier today. The earnings release and presentation materials for our discussion are accessible in the Investor section of the perrigo.com website. Joining me on the call today are our President and CEO, Murray Kessler, and CFO, Eduardo Bezerra. As a reminder, during this call, we may make forward-looking statements. Please refer to the important information for shareholders and investors and Safe Harbor language regarding these statements in our press release issued this morning. Before we dive into the details, I’d like to note a few important items. First, unless specified otherwise, all financial results discussed are based on continuing operations, excluding contributions from the divested RX business which was recorded as discontinued operations prior to its sale. Additionally, adjusted profit measures, such as adjusted EPS and adjusted operating income, exclude certain costs incurred in the previous year related to the RX business, which we reported in continuing operations. For further details and reconciliations of all non-GAAP financial measures presented, please refer to the appendix of our materials.

Second, organic growth figures exclude acquisitions, divestitures, and currency impacts for both comparable periods. Third, the management discussion will focus primarily on non-GAAP results, unless stated otherwise. All comments regarding constant currency eliminate the effects of currency translation compared to the prior year, using the exchange rates from the prior year’s financial statements. With that, I will now turn the call over to Murray Kessler.

Murray S. Kessler — President and Chief Executive Officer

Thank you, Brad, and good morning to everyone. Today, I will highlight Perrigo’s impressive double-digit growth in both the top and bottom lines for the third quarter, compared to the previous year, attributing this growth to our robust business fundamentals. Following that, I will address the macroeconomic factors that led us to revise our adjusted EPS guidance and share exciting updates on our strategic initiatives aimed at keeping us aligned with our financial goals for 2023, despite ongoing volatility in the macroeconomic environment. After my comments, Eduardo will provide a detailed overview of our Q3 financial performance.

Perrigo’s third quarter and year-to-date results were commendable across all key metrics. Our constant-currency net sales surged by 12% for the quarter and 14% year-to-date. Organic net sales growth significantly surpassed our long-term target of 3%, achieving growth rates of 8% in the quarter and 11% year-to-date, excluding the double-digit organic growth from HRA during the same timeframe. The strong topline growth was primarily driven by the net benefit of the HRA acquisition, offset by the divestitures of our operations in Mexico and ScarAway. We also saw market share gains across all US business units and major categories, as store brands continued to capture market share from national brands. Our European market share expanded, particularly with the newly-acquired Compeed brand. Additionally, we experienced significant growth in e-commerce and benefited from strategic pricing actions across our global portfolio. Notably, consolidated organic growth was fueled by both positive volume and pricing, contributing 2% and 6%, respectively. Our gross margin improved by 210 basis points compared to last year. This gross profit flow-through resulted in a constant-currency adjusted operating income growth of 32%, despite a $36 million increase in input costs driven by inflation and other macroeconomic challenges. Constant currency diluted EPS for the quarter reached $0.65, reflecting a 44% increase year-over-year, despite higher year-over-year interest expenses and a slightly increased share count.

Let’s delve into the fundamentals driving our business performance. The robust top-line growth observed, adjusted for currency fluctuations, is not merely an isolated incident; it represents a consistent trend. To provide context, net sales excluding currency effects grew by 7%, while organic sales surged by over 4% on a three-year compound annual growth basis. This growth trajectory has persisted despite the volatility caused by the COVID pandemic. Analyzing our revenue for the quarter reveals strong contributions from both CSCA and CSCI, alongside the positive impact of HRA. Notable growth was evident across our major product categories. For instance, women’s health saw a remarkable 100% growth primarily due to the HRA brand, which experienced increased emergency contraception demand stemming from public concerns related to the Roe v Wade decision. Furthermore, skincare products experienced a 28% increase, driven by the addition of Compeed and Mederma, alongside the continued growth of our ACO brand in Europe. Additionally, we recorded a 19% growth in upper respiratory products, attributed to elevated cough and cold instances in Europe, as well as market share gains against both national and store brand competitors in the US.

While our cough and cold sales could have been even stronger, labor shortages in the US hindered our ability to meet the heightened demand. In the allergy segment, we saw growth driven by US market share gains and the successful launch of NASONEX 24HR, even as the total allergy-affected population declined by 11% compared to the previous year, according to IQVIA FAN data. Our Nutrition business experienced an 18% increase, driven by heightened demand for infant formula due to a national brand shortage. We have been operating our facilities at 117% of normal output to help mitigate the shortfall. Unfortunately, this intense operation of older equipment led to a significant amount of formula being placed on quality hold during Q3, as it did not meet our stringent standards. In response, we temporarily paused operations at the Vermont facility for three weeks to perform necessary maintenance. The facility is now back in operation, but Q3 shipments could have been higher without this constraint. This situation highlights one of the primary reasons behind our acquisition of the Gateway facility from Nestle, which I will elaborate on shortly. Lastly, our Oral Care sales increased by 8% in the quarter. Earlier this year, this segment faced challenges due to supply chain disruptions linked to ocean freight delays from China and a significant rise in inbound freight costs along with higher demurrage fees. I am pleased to report that over the past few months, we have received a considerable amount of back-ordered inventory from China, enabling Perrigo Oral Care to resume shipping without constraints. Additionally, it’s worth noting that ocean freight rates have returned to pre-COVID levels. While Oral Care faced profitability challenges this year, we anticipate a substantial recovery in 2023.

As we discuss market share gains, it is important to note that Perrigo has increased its share across nearly every category and segment in which we operate. We have gained share in total US OTC, US store brand OTC, US e-commerce, European e-commerce, US Oral Care, US Nutrition, and total European OTC. A positive trend observed during the quarter was the consumer shift from national brands to store brands in the US OTC market, reminiscent of previous periods of impending recession or high inflation. Although we are successfully gaining market share, it is essential to consider that the overall growth rate of the largest category we compete in, total US OTC, has returned to more normalized pre-COVID levels. For context, in the first half of this year, total US OTC grew by 13.4%, while total Perrigo US OTC experienced a growth of 9.1%. Analyzing the latest 13 weeks, which correspond to Perrigo’s third quarter, total US OTC omnichannel dollar growth decreased from 13.4% to 2.3%, despite significant retail price increases. We estimate national brand price increases of approximately 8% to 9% this year, suggesting a 6% volume decline in total OTC. Perrigo’s retail growth also slowed but still outpaced the overall category, with an increase of 5.8%. Perrigo’s pricing of 6% in the quarter indicates that our retail volume remained relatively flat year-over-year. We had initially forecasted US OTC growth to remain consistent with the first half, but this did not materialize in the third quarter. Encouragingly, we observed a rebound towards the end of the quarter, with the total OTC category increasing by 7% in the final four-week period, supporting our fourth quarter OTC estimates.

Turning to currency impacts, like many multinational corporations, Perrigo faced significant challenges due to unfavorable currency translation this year. We anticipate that the strengthening US dollar will adversely impact our full year 2022 net sales by approximately $230 million and adjusted operating income by over $43 million by year-end. Moreover, we expect gross inflation to increase our cost of goods sold, labor expenses, and distribution costs by more than $210 million for the full year. Our Oral Care and Nutrition business units in the US experienced the most severe impacts during the quarter. We have worked diligently to mitigate these inflationary costs through strategic pricing actions and other cost-saving measures. However, we will be implementing additional pricing adjustments to address significant cost pressures as needed.

Regarding our guidance, we have reaffirmed our net sales and organic net sales forecasts. Our updated adjusted EPS outlook for 2022 is projected to be in the range of $2 to $2.10, reflecting a negative $0.10 impact from unfavorable currency movements and a negative $0.15 impact from other business factors, including the infant formula purchase relative to our previous estimates. With that, I would like to discuss the synergies from HRA and two additional strategic initiatives that we believe will contribute significantly to our growth in 2023.

The integration of HRA remains a fundamental aspect of our growth strategy. Since the acquisition closed in May, the business has demonstrated remarkable performance, achieving double-digit growth. We are now raising our total synergy estimate to EUR50 million by the end of 2024, up from our previous estimate of EUR40 million and the original EUR30 million estimation at the time of the deal. Eduardo will provide further details, but we anticipate a $0.18 impact on 2023 adjusted EPS, equating to $30 million in operating income for a one-time cost related to transitioning HRA from distributor sales to our direct sales force. It is crucial to emphasize that this cost does not affect the strong fundamentals of the HRA business or its underlying growth trends, but rather facilitates the ongoing cost benefits.

Next, let’s discuss our gross margin expansion plan. Consistent with our expectations, Perrigo’s gross margin has trended upward throughout the year. While we experienced relatively flat margins in Q3 compared to Q2, we still anticipate exiting the fourth quarter with gross margins exceeding 37%. Our third strategic initiative is the Supply Chain Reinvention Program, which is projected to contribute $50 million to $70 million in incremental operating income next year. The acquisition of the Gateway and Good Start brand infant formula is the primary driver of this initiative, along with our portfolio design and SKU optimization efforts. To reiterate, we expect these strategic initiatives to offset the lost operating income from the second half of 2022, excluding the one-time costs associated with achieving the HRA synergies and any further currency impacts.

Now, let’s turn to the infant formula segment. My Nutrition team has been actively working to address our infant formula capacity constraints for several years. You might recall that in 2018, the Perrigo Board of Directors authorized an investment of up to $300 million to expand our formula capacity through a greenfield project that ultimately did not materialize. The acquisition of the Gateway facility effectively resolves this capacity issue at nearly half the cost.

To recap the specifics of this transaction, we are making a strategic investment of $170 million in our infant formula network. This includes a $110 million expenditure for the Gateway manufacturing facility and the US and Canadian Good Start branded businesses. These investments are crucial for Perrigo as they strengthen our existing facilities and bolster the infant formula manufacturing industry in the US by enhancing industry capacity by 7 million pounds, or over 100 million 8-ounce bottle equivalents, within the next 18 months. This acquisition is expected to be highly accretive, contributing more than $50 million in operating profit in 2023, split evenly between the Good Start brand and the additional volume we can now process through this network to support our current customers.

In summary, I remain optimistic about our future. Our fundamentals are solid and continuously strengthening as we gain market share, expand gross margins, and make strategic investments necessary for driving profitable growth in 2023 and beyond. To clarify, aside from the one-time costs associated with bringing HRA distribution in-house and the foreign currency translation impacts, our adjusted EPS goal for 2023 remains unchanged. With that, I will turn the call over to our CFO for a more detailed financial discussion. Eduardo?

Eduardo Bezerra — Executive Vice President and Chief Financial Officer

Thank you, Murray, and good morning, everyone. I will begin by reviewing our third quarter financial performance based on continuing operations, followed by further details regarding our updated HRA synergies and associated one-time costs.

Starting with our GAAP to non-GAAP summary, the company reported a GAAP loss of $52 million for the third quarter, equating to a loss of $0.39 per diluted share. On an adjusted basis, net income was $76 million, resulting in adjusted diluted earnings per share of $0.56 compared to $0.45 per share in the same quarter last year. A series of adjustments to the quarter’s pretax non-GAAP P&L totaled $100 million, including: $59 million in amortization; $20 million in restructuring charges primarily related to our Supply Chain Reinvention Program; and $12 million in acquisition and integration-related expenses mainly linked to the HRA acquisition. Full details can be found in the non-GAAP reconciliation table attached to this morning’s press release.

Non-GAAP tax adjustments for the quarter amounted to $28 million, primarily driven by the tax effect of non-GAAP adjustments and the interim tax accounting requirements. Consequently, the adjusted effective tax rate for the third quarter was 21.8%, slightly higher than the third quarter of 2021. From this point forward, all monetary figures, basis points, and margin percentages will be presented on an adjusted basis unless stated otherwise.

Examining our gross profit, Q3 saw an increase of $43 million, or 22.3% on a constant currency basis, driven by inflation-justified pricing, higher sales volumes, and the absence of two product recalls that had occurred in the prior year quarter. The addition of HRA also contributed to this growth, which more than offset the inflation-driven cost increases, resulting in gross margin expansion of 310 basis points on a constant currency basis. Operating income grew by $21 million, or 32.2% on a constant currency basis, as favorable gross profit flow-through was partially offset by increased operating expenses due to the inclusion of HRA and elevated distribution costs. Consequently, these factors led to adjusted operating margin expansion of 190 basis points on a constant currency basis.

In the CSCA segment, net sales increased by 4%, or 7.3% organically, driven by: first, inflation-justified pricing actions; second, strong performance in infant formula; third, the launch of Nasonex; and fourth, increased manufacturing capacity and demand for the store brand version of MiraLAX, benefiting the digestive health category. Importantly, as highlighted by Murray, we achieved market share gains across all three businesses.

In the quarter, gross profit increased by $10 million, or 5.4%, as pricing and higher sales volumes offset cost of goods sold inflation and lower profitability from contract sales related to the divested RX business. Adjusted gross margin expanded by 50 basis points compared to the prior year on a constant currency basis, and increased by 30 basis points sequentially. Operating income for the quarter remained flat compared to last year, as gross profit flow-through was offset by elevated operating expenses, including the addition of HRA, a 30% increase in distribution expenses driven by higher logistics and demurrage costs in our Oral Care business, and the impact of divested businesses compared to the previous year. The cumulative effect of these two factors resulted in an $8 million impact on operating income.

Moving on to CSCI, reported net sales increased by 8.4% on a constant currency basis, with a significant rise of 28.6%, including $71 million from HRA. Organic growth stood at 8.3%, driven by ongoing demand for cough/cold and skincare products. Constant currency gross profit surged by 41.5%, propelled by the addition of HRA, strategic pricing, and increased sales volumes. These factors drove a 480 basis points increase in adjusted gross margin compared to the prior year. Operating income rose by 66.8% on a constant currency basis, as favorable gross profit flow-through more than offset higher operating expenses primarily arising from the inclusion of HRA and increased administrative and R&D costs.

Now, turning to cash flow, cash on the balance sheet totaled $469 million at the end of Q3, down from $485 million at the conclusion of Q2. Year-to-date operating cash flow amounted to $121 million, representing a conversion rate of 68%, which is lower than our expectations. Let me explain. Year-to-date operating cash flow includes impacts of $79 million due to increased inventories primarily in our US Oral Care business and CSCI segment, as well as $90 million from restructuring expenses. Given these factors, we now project a 75% operating cash flow conversion rate to adjusted net income for the full year. Additionally, we invested $70 million in capital expenditures and returned $107 million to our shareholders through dividends during the first nine months of the year. Although the acquisition of the Gateway infant formula plant occurred after the end of the quarter, I want to provide some insight into how we financed that $110 million transaction.

When we refinanced our debt prior to closing the HRA acquisition earlier this year, we borrowed in US dollars and utilized cross-currency swaps for euros. Given the