Embecta - Q2 2023

Transcript

Operator (participant)

Welcome, ladies and gentlemen, to the fiscal Q2 2023 Embecta earnings conference call. At this time, all part-participants have been placed in a listen-only mode. Please note that this conference call is being recorded, and the recording will be available on the company's website for replay following the completion of this call. I would now like to hand the conference call over to your host today, Mr. Pravesh Khandelwal, Vice President of Investor Relations. Please go ahead.

Pravesh Khandelwal (VP of Investor Relations)

Thank you, operator. Good morning, everyone, and welcome to Embecta's fiscal Q2 2023 earnings conference call. The press release and slides to accompany today's call and webcast replay details are available on the investor relations section of the company's website at www.embecta.com. With me today are Devdatt Kurdikar, Embecta's Chief Executive Officer, and Jake Elguicze, our Chief Financial Officer. Before we begin, I'd like to remind you that some of the matters discussed in the conference call will contain forward-looking statements regarding future events as outlined in our slides. We wish to caution you that such statements are, in fact, forward-looking in nature and are subject to risks and uncertainties, and actual events or results may differ materially.

The factors that could cause actual results or events to differ materially include, but are not limited to, factors referenced in our press release today, as well as our filings with the SEC, which can be accessed on our website. In addition, we will discuss certain non-GAAP financial measures on this call, which should be considered a supplement to and not a substitute for financial measures prepared in accordance with GAAP. A reconciliation of these non-GAAP measures to the comparable GAAP measures is included in our press release and conference call presentation. Our agenda for today's call is as follows. Dev will begin by providing an overview of Embecta, our strategic priorities for 2023, and some remarks on the overall performance of our business during the Q2.Jake will then provide a more in-depth review of Q2 financial results, as well as our updated financial guidance for the year. We will then open the call for questions. With that said, I would now like to turn the call over to our CEO, Devdatt Kurdikar. Dev?

Devdatt Kurdikar (CEO)

Good morning, everyone. Thank you for joining us today. The end of the last quarter marked one year since we officially launched Embecta and kicked off a bold new chapter for a company that has been integral to the evolution of diabetes care over the past century. It has been a remarkable year, from ringing the bell at Nasdaq twice to transitioning our global employees from BD's HR systems to our own Embecta systems, moving into approximately 30 offices around the world, attending more than 30 conferences and symposiums, and serving an estimated 30 million people in 100+ countries. For all those milestones, it's that last number, the 30 million people with diabetes who use our products, that motivates our global Embecta team.

As you know, our mission is to develop and provide solutions that make life better for people living with diabetes, and we are proud to have a role in helping them live their lives with fewer limitations. We have been driven by a sense of urgency to accelerate the journey to better diabetes care, something we've been doing for nearly 100 years now. Our accomplishments in the first year since our spin off from BD have made me even more excited for what the future holds for us and for people living with diabetes. Our strategic priorities for fiscal year 2023 are shown on slide five First, we are focused on strengthening our base business while maintaining our global leadership position in the category of insulin injection devices. Second, we want to finish the work to operationally stand up and separate Embecta as an independent company.

Finally, we intend to continue investing in R&D, most notably around our patch pump that is being developed for the type 2 market, as well as seek M&A and additional partnership opportunities. Moving to slide six. During the first six months of our fiscal year, we have made progress in each one of those strategic priorities, yielding results that have exceeded our internal expectations. In terms of solidifying our base business, we have continued to deepen our partnerships with key customers, resulting in winning preferred brand status, implementing growth initiatives, and signing multi-year agreements with major retailers and payers. These strengthened partnerships are in addition to us being awarded exclusive preferred status on the Express Scripts National Preferred Formulary, as well as pen needle and insulin syringe contract wins from the U.S. Department of Veterans Affairs, as noted last quarter.

Additionally, we are helping patients shift behavior to clinically recommended best practices through a dedicated media campaign, educational materials, and retail pharmacy programs, thereby helping raise awareness of the importance of using a new needle with each insulin injection and maintaining an adequate supply of needles. Recently, we held our first industry-sponsored educational symposium at the Advanced Technologies & Treatments for Diabetes conference. Second, we continue to make progress in our separation efforts, as demonstrated by the exit of several transition service agreements as we continue to build up our internal organization, systems, and processes. We also published our inaugural ESG strategy report, providing a summary of how we are managing environmental, social, and governance issues. This initial report sets the stage for how we operate our business, engage with our stakeholders, and drive results that we believe will support the sustainability and strength of Embecta well into the future.

We signed a co-promotion collaboration agreement with PolyPhotonix, under which our commercial teams in the U.K. and Ireland will promote PolyPhotonix's sleep mask used for the management of two common sight-threatening complications associated with diabetes, as well as entered into an agreement with Tidepool to help develop automated insulin delivery solutions for people with type 2 diabetes using our proprietary patch pump. Our global team has continued to execute our key commercial programs, which is allowing us once again to raise our guidance for key financial metrics. Before I discuss our revenue performance, I'd like to share some additional details regarding our recently announced partnership with Tidepool. Our collaboration agreement with Tidepool is focused on the development of an automated insulin delivery system for people living with type 2 diabetes, a population that we believe could be better served by an AID system tailored to meet their unique needs.

Under terms of the agreement, Embecta will leverage Tidepool's expertise in diabetes management software to develop an AID algorithm for our closed loop patch pump system that is being designed with the specific needs of people living with type 2 diabetes. The recent FDA clearance of the Tidepool Loop for type 1 diabetes and algorithm technology that started as a patient-led initiative affirms that Tidepool's approach to AID system development combines patient insights with a robust diabetes management solution. We are excited to be able to work with the team at Tidepool and to collaborate on the development of a patient-centric type 2 automated insulin delivery system. Let's review our Q2 and H1 revenue performance in a bit more detail.

During Q2, we generated revenues of $277.1 million, which represented an increase of 0.9% on an as-reported basis and 4% on a constant currency basis. These results exceeded our internal expectations and included U.S. revenues, which totaled $146.4 million and grew 3.6%, as well as international revenues, which totaled $130.7 million and grew 4.4% on a constant currency basis. The year-over-year growth in the U.S. was primarily driven by the contract manufacturing and sale of certain non-diabetes products to BD, which did not occur in the prior year period and accounted for approximately 2.5% of the year-over-year growth. An adjustment to our rebate reserves, which contributed approximately 1% of the year-over-year growth and favorable pricing dynamics.

This was partially offset by the unwinding of the previously communicated timing benefit of certain distributor orders in Q1. Turning to our performance outside of the U.S. During Q2, the year-over-year growth within our international business was primarily due to an increase in product volumes, which were aided by a competitive product supply shortage in certain regions and a timing benefit of certain orders, which we expect to unwind during the remainder of the year. As we have communicated before, it is not uncommon for us to get timing benefits from distributor orders in any particular quarter that get unwound in succeeding quarters.

Turning to our revenue performance for the first six months of the year, we generated revenues of $552.8 million, which represented a decrease of 2.0% on an as-reported basis, but an increase of 2.3% on a constant currency basis. The year-over-year constant currency growth was due to a combination of contract manufacturing revenue, which contributed approximately 1.3%, and our base business performance, which contributed approximately 1.0%. That completes my prepared remarks. With that, let me turn the call over to Jake to discuss our Q2 financial results in a bit more detail, as well as provide our updated fiscal 2023 financial guidance and underlying assumptions. Jake?

Jake Elguicze (CFO)

Thank you, Dev. Good morning, everyone. Before I discuss the financial results for the 3-month period ending March 31st, I would like to remind the investment community that Embecta was spun off from BD on April 1st, 2022, that the financial results during the pre-spin periods were based on carve-out accounting principles and do not reflect what Embecta's financial results would have been had Embecta operated as a standalone public company. Therefore, the financial results for the 3 and 6-month periods ending March 31st, 2023, and March 31st, 2022 are not meaningfully comparable. Given the discussion that has already occurred regarding revenue, I will start my review of Embecta's financial performance for the Q2 at the gross profit line.

GAAP gross profit and margin for the Q2 of fiscal 2023 totaled $189.8 million and 68.5%, respectively. This compares to $191.2 million and 69.7% in the prior year period. The year-over-year decline in GAAP gross profit and margin was driven by the negative impact of inflation. The impact of low margin contract manufacturing revenue that was not in the prior year period. An incremental stand-up and separation costs, including the markup on the purchase of cannula from BD. On an adjusted basis, gross profit and margin for the Q2 of 2023 was $190.1 million and 68.6% respectively.

The adjusted gross margin performance during the Q2 was better than we previously expected due to a greater than anticipated benefit from pricing as well as favorable product mix. Additionally, adjusted gross margin during the quarter was also aided by two items that are not expected to reoccur during the H2. These two items relate to the adjustment to our rebate reserves, which Dev mentioned, and a year-to-date true up of certain charges from our former parent that, when taken together, positively impacted adjusted gross margin by approximately 200 basis points as compared to our previous expectations. Turning to GAAP operating income and margin. During the Q2, they were $55.6 million and 20.1% respectively. This compared to the operating income and margin of $98.9 million and 36% respectively in the prior year period.

The decline in year-over-year GAAP operating income and margin is primarily due to an increase in selling and administrative expenses associated with separating and standing up Embecta to operate as a standalone publicly traded company, as well as an increase in research and development expenses, including amounts paid in connection with the collaboration agreement signed with Tidepool to develop and commercialize an interoperable automated glycemic controller to complement our insulin patch pump currently in development. On an adjusted basis during the Q2 of 2023, operating income and margin totaled $84.9 million and 30.6% respectively. The adjusted operating income and margin performance was better than we previously expected due to the overachievement at the gross profit and margin line that I referenced earlier. Turning to the bottom line.

GAAP net income and earnings per diluted share was $14 million and $0.24 during the Q2 of fiscal 2023. This compares to $79.6 million and $1.38 in the prior year period. As I mentioned at the outset, because the financials for pre-spin periods were prepared on a carve-out accounting basis, the comparisons of pre-spin to post-spin periods are not meaningfully comparable. One example of this is the additional operating expenses necessary for us to operate as a standalone entity, while another is interest expense, which burdened our PNL in the current year by $26.8 million, but was only $4.9 million in the prior year period. While on an adjusted basis, net income and earnings per share were $43.3 million and $0.75 during the Q2 of fiscal 2023.

Lastly, from a PNL perspective, for the Q2 of 2023, our adjusted EBITDA and margin totaled approximately $96.7 million and 34.9%. Like our adjusted operating profit, due to the revenue and gross profit overachievement in the quarter, our adjusted EBITDA during the Q2 also exceeded our previous expectations. Finally, with respect to our balance sheet and financial condition at quarter end. As of March 31st, 2023, we held approximately $346 million in cash and cash equivalents and approximately $1.64 billion in debt, which, taken together with our last 12 months adjusted EBITDA, resulted in a net leverage ratio of approximately 3.1x. That completes my prepared remarks as it relates to Embecta's financial results for the Q2 of fiscal 2023.

I'd like to discuss Embecta's updated 2023 financial guidance and certain underlying assumptions. Beginning with revenue. Given our performance during the H1, we are once again increasing our constant currency revenue guidance range as we are now calling for full year 2023 constant currency revenue growth of between 0% and 1%. This is an increase as compared to our previous guidance range, which had called for a decline of 1.5% on the low end to 0.5% of growth on the upper end. This new range translates into a H2 constant currency revenue range of between flat to down approximately 2%.

The low end of our new constant currency revenue range assumes no additional contract manufacturing revenue during quarters three and four, which would result in a headwind of approximately 3% during the second half of fiscal 2023. As you may recall, we generated approximately $15 million of contract manufacturing revenue during the second half of fiscal 2022. The headwind from the lack of additional contract manufacturing revenue is expected to be somewhat offset by our base business growing at approximately 1% or consistent with the performance achieved during the H1.

While the high end of our new constant currency revenue range assumes a modestly smaller headwind associated with contract manufacturing revenue and a slight improvement during the H2 in terms of our base business performance as compared to the H1, largely attributed to our anticipated performance in both the US and China. While we continue to make progress in this area, our updated constant currency revenue guidance range continues to assume an immaterial amount of revenue associated with any recently announced partnership agreements. Turning to our thoughts on FX. They remain unchanged from our previous expectations, and as such, our updated guidance continues to call for a foreign currency headwind of approximately 2.5% during 2023. Our updated FX assumptions were based on foreign exchange rates that were in existence in the early May timeframe.

On a combined basis, we are raising our full year as reported revenue guidance from a range which called for a decline of between 2%-4% to a new range, which calls for a decline of between 1.5%-2.5%. In dollar terms, this equates to a revenue range of between $1,101 million and $1,113 million. Lastly, concerning revenue, we currently anticipate a sequential decline from Q2 toQ3 in terms of our as-reported revenue dollars due to the timing benefits and rebate reserve adjustments that positively impacted Q2 that are not expected to reoccur during the third quarter, coupled with lower contract manufacturing revenue. Moving to margins.

Based on the performance that was achieved during the H1, we are raising our expectations for adjusted gross, adjusted operating, and adjusted EBITDA margins, as we now anticipate that our adjusted gross margin will be approximately 64.5%, up from our prior guidance of approximately 63.5%. Our adjusted operating margin is expected to be approximately 28%, up from our prior guidance of approximately 26.5%. While our adjusted EBITDA margin is now projected to be approximately 32.5% for the full year 2023, up from our previous guidance of approximately 31.5%. Consistent with the comments we made on our first quarter earnings conference call, this implies a step down in our margin profile from the H1 to the H2.

It's due to a combination of factors, including the revaluation of our inventory that occurred at the beginning of our current fiscal year, which we will sell at a higher standard cost during the H2. Positive of absorption that was achieved during the H1 as we manufactured additional products in advance of our planned temporary suspension of our manufacturing operations in our facility in Suzhou, China, later this year that are associated with the corresponding regulatory approvals and transitions t here. As well as total operating expenses as a percentage of revenue that during the H2 are expected to be similar to that which occurred during the Q2.

Continuing down the PNL, we currently expect that our net interest expense will be approximately $113 million or slightly favorable as compared to our previous expectation, which called for interest expense of approximately $115 million during 2023. Our assumptions regarding our non-GAAP tax rate and weighted average shares remain unchanged at approximately 25% and 57.7 million shares, respectively. At the bottom line, this translates into our new full year 2023 adjusted earnings per diluted share range of between $2.50 and $2.60, which is an increase from our previous range of between $2.20 and $2.35, or a raise of approximately $0.27 at the midpoint.

In closing, during the H1, Embecta made good progress in each of our three major strategic priorities, including strengthening our base business, separating and standing ourselves up as an independent entity, and investing in growth. We generated solid financial performance during the H1, and we are pleased to be able to raise several of our financial metrics yet again. That said, we are mindful that we're only halfway through our first full fiscal year as an independent entity. As we look ahead, we still have some important separation activities in front of us, including the implementation of our ERP system, managing through the anticipated temporary suspension of manufacturing operations at our facility in Suzhou, China, and setting up our own distribution network. That completes my prepared remarks, and at this time, I would like to turn the call over to the Operator for questions. Operator?

Operator (participant)

Thank you. To ask a question, you'll need to press star one one on your telephone and wait for your name to be announced. To withdraw your question, press star one one again. Please stand by while we compile your Q&A roster. Our first question comes from Cecilia Furlong with Morgan Stanley. Your line is open.

Cecilia Furlong (VP of Equity Research)

Great. Good morning, and thank you for taking the questions and congrats on the quarter. I wanted to ask specifically, as we think about just 2Q, some of the benefits you called out, whether it was OUS competitor dynamics or competitor issues, as well as some of the stocking dynamics that you called out, how we should think about the impact 2Q to 3Q and into the back half of the year. Coupled with that too, just any updates how you're thinking about timing associated with the China manufacturing shutdown, and impact both top line as well as gross margin?

Jake Elguicze (CFO)

Yeah. Thanks, Cecilia. While our Q2 results were certainly aided by some things which we don't expect to reoccur in the H2, you know, we were really pleased with the performance by the team in the Q2. You know a third of our constant currency revenue growth in Q2 was due to the combined impact of the rebate reserve adjustment and the timing of orders from distributors internationally. In the quarter, we booked a rebate reserve adjustment of about $5 million. In the Q2 of 2022, we booked a rebate reserve adjustment of about $4 million. The net impact was only about $1 million year-over-year.

The total amount, which we didn't expect coming into this quarter, was about $5 million during the quarter. In terms of the distributor impact, the orders internationally, you know, that was around $3 million, benefiting us in the quarter. That again, we would also expect to unwind in the third quarter of the year. The other third, I would say, of our constant currency revenue growth in Q2 was due to the contract manufacturing revenue. That's really just a function of the fact that, you know, we generated about three and a half million dollars of contract manufacturing revenue in the Q2 of this year, and we didn't have any of that in the Q2 of last year. The remaining one third of our constant currency revenue growth was due to our base business, which is performing better than we had previously expected. I'll turn the call to Dev, maybe he can answer the question that you had on Suzhou.

Devdatt Kurdikar (CEO)

Hi, Cecilia. As you remember, China was a deferred entity for us at close. As we go through the process of transferring the Suzhou entity from BD to us, there's a variety of steps we have to go through to get a variety of manufacturing and business licenses, quality audits and so on. During that process, the plant has to cease operations for a period of time. It can come back up to produce product, the manufacture of that plant that is used for markets outside of China, but it does have to shut down for a period of time. What we are planning to do is implement our ERP solutions at the same time, taking advantage of the fact that the plant is going to be shutting down. Obviously there's a connection between Suzhou transition and ERP implementation.

Our plan right now is to implement that ERP, not just when we are technically ready, but certainly when customers are ready, as well. That's some of the things that we are working through. What we have done though, is we've built up inventory that we need to accommodate the transfer of the plant and the shutdown of the plant, and all of that has been incorporated into guidance. With respect to specifics on timing, you can imagine it's a bit of a sensitive topic, both from a competitive reason, but also we don't want to get ahead of the regulatory authorities here. We'll provide an update on that at an appropriate time, Cecilia. Suffice to say that our team has been working pretty hard, both locally in China as well as from an ops perspective to do what we can, to have a pretty smooth transition.

Cecilia Furlong (VP of Equity Research)

Great. Thank you for that. If I could follow up too on your pump program as well, just the announcement, in partnership with Tidepool, how we should think about next steps, what you'll disclose from a timing standpoint and also just from a pipeline standpoint, is it the open loop system first followed by closed loop? Just any color broadly would be helpful. Thank you for taking the questions.

Devdatt Kurdikar (CEO)

Sure, Cecilia. Yes, we are still thinking about an open loop system first and a closed loop. We are pretty excited about our partnership with Tidepool. Tidepool, as you may know, recently got 510k clearance for their algorithm, albeit it was for type 1. As we looked at of our options and as we looked at the fact that certainly we wanted to develop a closed loop system as well after an open loop system, it seemed like the right time to combine, if you will, forces with Tidepool. They bring a patient centricity as well as, you know, expertise in diabetes management software, so that together we could work on an algorithm that was really specific for the needs of type 2 people. In fact, our teams are already collaborating with each other.

With respect to timelines, you know, Cecilia, respectfully, I'm going to stick with what we've said and what we've demonstrated today. We'll make announcements when we hit critical milestones like we did with Tidepool. For now, all I'd say is, you know, we'll still stick to our previous commentary about not having any revenue included in the projections that we had laid out pre-spin all the way through 2024, fiscal 2024.

Cecilia Furlong (VP of Equity Research)

Great. Thank you for taking the questions.

Jake Elguicze (CFO)

Thank you.

Operator (participant)

Thank you. One moment for our next question. Our question comes from Marie Thibault with BTIG. Your line is open.

Sam Eiber (VP of Equity Research)

Hi there. Good morning, Dev, Jake, Pravesh. This is Sam Eiber on for Marie. Thanks for taking the questions this morning. Maybe I can start, Jake, on gross margins. Very high this quarter, even after taking into account the 200 basis points of non-recurring items there. I guess, how should we think about that for the rest of the year? More specifically, the, you know, three dynamics between the China shutdown, any inflationary pressures and then also the revalued, higher cost inventory.

Jake Elguicze (CFO)

Yeah, sure. Thanks, Sam. You're right. I mean, gross margins came in, you know, again, very strong, for the Q2 in a row, sort of in the upper 60s. You know, if you recall on our first quarter earnings call, we had told the investment community that we expected our adjusted gross margins to sort of trend into the mid-60s during the Q2 of the year, and then into the low 60s in the H2. Really, the only change from our standpoint is what occurred in the Q2, and that really has to do with the one-time benefits that we saw from the rebate reserve reversals as well as some of the cost true-ups that we had in the quarter from our former parents. You know, absent that, adjusted gross margin would have been, you know, around 200 basis points lower, you know, probably still slightly favorable as compared to what we had previously thought, largely due to the fact that we continue to execute well on pricing initiatives, which seem to be sticking, as well as the fact that we benefited from some favorable product mix.

Absent that, I think it would largely have been maybe just slightly favorable to what we had previously expected. You know, kind of consistent with our prior thoughts, you know, the H2 guidance range, you know, really sort of indicates and implies, you know, low 60s around a 61-ish% or so adjusted gross margin in the H2, which is all very consistent with our previous thoughts. If you think about what the sequential drivers are of that margin shift from the first half of 2023 to the second half of 2023, it really does come down to those previously mentioned items, the inventory revaluation being the largest component of it. I would say the rebate reserves, that and cost true ups that positively impacted our adjusted gross margin in the Q2 is probably the next largest item. Then, you know, lastly, it's the favorable absorption from manufacturing the product in advance of the temporary shutdown in Suzhou. I would rank them really in that order.

Sam Eiber (VP of Equity Research)

Got it. Yeah, that all makes sense, and I appreciate the added detail there. Maybe I can ask my follow-up here on the TSAs. Sounds like you guys are making some progress here in this quarter. I guess, is $60 million still about the right assumption in terms of TSA expense for this year? Does 2024, March 2024 still feel like the right timeline to work through most of these TSAs?

Jake Elguicze (CFO)

Yeah. I would say, you know, the $60 million number for TSAs is still something that we think is a reasonable number for the entirety of this year. You know, in the Q2, you know, the way I think that you should sort of think about the trend of the TSA expense, you know, we generated, you know, probably around $17 million or so in the first quarter of the year. You know, that stepped down into the Q2 of the year to probably around $16 million. In the H2, obviously we continue to expect the TSA expenses to continue to trend lower than the H1. Now that's gonna get offset by some additional, you know, stand up cost of our own that's gonna impact our P&L. I still feel like a $60 million-ish number for the entirety of 2023 is the right TSA amount.

Sam Eiber (VP of Equity Research)

Great. Thanks for taking the questions.

Operator (participant)

Thank you. As a reminder to ask a question, please press star one one on your telephone and wait for your name to be announced. Our next question comes from Travis Steed with Bank of America Securities. Your line is open.

Travis Steed (Managing Director and Equity Research Analyst)

Good morning, everybody. Maybe Jake, I'll start with a high-level question. Investors, you know, still learning your guidance philosophy as a new company and, you know, early. I don't know if it's a reflection. You've had two good quarters in a row. It's more of a reflection of early on, things are just harder to predict, like the contract manufacturing revenue or things are just going a lot better than you expected. Is this more of you making sure to set a kind of conservative guidance at this point? Just kind of high level, how you think about the guidance and the upside the last couple of quarters. Then longer term, you know, the margins beyond 23. I'd love to kind of high-level thoughts on how you're thinking about some kind of regular cadence of operating margin expansion or more of a reinvestment phase, if you will.

Jake Elguicze (CFO)

Yeah. Maybe I'll start with the last question first, Travis. You know, I think nothing has changed right now in terms of our thoughts as to what the longer term kind of fiscal 2024, you know, financial objectives are for the company as compared to what it is that we would have put out there, you know, sort of pre-spin. We remain very committed to the achievement of those targets, including an adjusted EBITDA number of 30%. That remains consistent with even the pre-spin periods. You know, I'm gonna refrain from talking about how we did, if you will, in comparison to sort of consensus estimates.

But rather I sort of answer your question by saying that I think we are a new management team who wants to develop a track record of consistency, you know, with the street in terms of, you know, meeting the previously provided financial objectives that we would have put out there. I think that's very important to us and certainly not lost on us. You know, in relation to our updated guidance, I'd say that, you know, from a revenue standpoint, we certainly increased the midpoint of our full year constant currency revenue range by about 1%, you know, or $11 million. Again, about half of that was due to the sort of the one-time rebate reserve adjustment.

The other half was just due to the fact that I think our team is really doing an excellent job just strengthening that base business, which is really one of our key, you know, kind of strategic objectives for 2023. That's both in terms of the U.S. and international. Then from a margin standpoint, you know, I'm really pleased with the performance that we've been able to exhibit, you know, for the first six months of the year. You know, we've been able to raise, you know, from our original guidance ranges, we've been able to raise our adjusted gross margin, and adjusted EBITDA margin by about 250 basis points, each, and our operating margins, by about 300 basis points. You know, I think we're doing a nice job in the first, you know, year, first full year, I should say, post-spin of trying to manage, you know, that cost base.

Devdatt Kurdikar (CEO)

If I may just add a little bit of color, right, with respect to where we are versus where we thought we would be when we first gave our guidance for the year. Besides the fact that it was a new management team, you know, certainly when we first gave guidance for the year, you remember China, which is an important part of our emerging markets growth story, had just lifted COVID restrictions. We weren't quite sure how that was gonna play out. We weren't quite sure how inflation was gonna moderate, which obviously has an important impact on our results. Finally, we are, have been, and will be for a while in the midst of a lot of separation work. We try to take all those factors into account.

Having said all of that, obviously very pleased with where we are and what we've done in this new updated guidance just thematically, is to take all the overperformance in Q2 and just sort of roll it forward with the guidance. The second thing I would say we've done thematically is, you know, tightened our range of expectations towards the mid to upper end of our expectations. That's what we've tried to do. Obviously pleased that we've been able to do that.

Travis Steed (Managing Director and Equity Research Analyst)

That's super helpful response. Thank you. On, on the Tidepool, maybe a little bit of additional color on kinda what's required to do the type 2 algo if you're converting the Loop algo or you're starting fresh, and the FDA path, if that pathway can go a little faster than the Loop pathway did. If it's fair to think that if you're working on algo integration, if the hardware pump design is mostly complete at this point.

Devdatt Kurdikar (CEO)

Travis, we literally just signed the agreement, so I don't wanna get too far ahead of the team in terms of what the regulatory pathway would look like. I think suffice to say, what we do expect is to be able to use the expertise they had in developing the loop type 1 algo towards an algorithm that is gonna be designed specifically for type 2. Our teams have just started collaborating. You know, as that work progresses, we'll certainly provide more updates on that. I appreciate the question on, you know, the status of the pump design, but respectfully, I'm gonna refrain, Travis, from answering that. I have said, and I said on this call too, it is still our intent to do the open loop before the closed loop. I must say, I continue to be very pleased with the progress that we are making.

Travis Steed (Managing Director and Equity Research Analyst)

Right. That's fair. Then one quick kind of modeling clarification question. The one-time restructuring standup costs in the quarter, you know, just a little bit of color on that and how that's gonna play out going forward. Then the CapEx requirements for the new ERP system. I think before we were thinking like $90-$100 million. Kinda curious what CapEx requirements are gonna be on that.

Jake Elguicze (CFO)

Yeah. As far as the one-time costs are concerned, I would say that, you know, largely they're coming in or around what it is that we would have previously expected. You know, no real change in terms of, you know, the one-time cost in a material way from what we had previously thought. In terms of the CapEx associated with the ERP implementation, you know, and really any of the kinda standup activities. You know, I would say during the course of, you know, 2023, you know, we may spend and use anywhere from, you know, $125-$150 million or so of cash, you know, associated with these kind of one-time activities. You know, I would tell you that probably about half of that during the course of 2023 is gonna be, you know, sort of one-time OpEx that we would then kind of add back for non-GAAP purposes. Then, you know, the other half is the CapEx associated with a lot of the stand-up activities, probably most notably the ERP system.

I think that's one thing that I think the investment community should be aware of, is that when looking at our net leverage levels, you know, and certainly the free cash flow that we generate, I mean, this is a very strong free cash flow generating business that I think this year in 2023 is gonna be you know, somewhat masked by the fact that we do need to spend, you know, a fair amount of cash on these separation activities. That, you know, moving forward, that free cash flow generation will then largely just fall to the balance sheet, which we can then use for our own capital deployment. I'll pause there.

Travis Steed (Managing Director and Equity Research Analyst)

No, that's perfect. Thanks, everybody, and I'll drop.

Operator (participant)

Thank you. One moment for our next question. We have a question from Anthony Petrone with Mizuho Securities. Your line is open.

Anthony Petrone (Managing Director and Equity Research Analyst)

Hi, thanks and good morning. Thanks for fitting us in here, and congrats on the execution out of the gate. One question on utilization is pen needle and safety needle utilization. Dev, you mentioned it in your comments. Maybe just overall where that sits per user today. What are some of the initiatives to get utilization per needle down? You know, what should we be thinking about just in terms of timing of some of those initiatives taking hold in the PNL? I'll have one follow-up. Thanks.

Devdatt Kurdikar (CEO)

Thanks, Anthony. You're referring to the reuse rate, which we've mentioned previously, and the fact that even though pen needles are single-use devices, they are often reused. What we are doing there is a couple things, Anthony. One is working on a, if you will, a direct to patient, direct to consumer media campaign to remind folks of the need to use one needle per injection. That is absolutely the appropriate thing to do. The second thing we are doing is working with certain retailers, especially in the U.S., so that when a patient goes to the pharmacy and gets a supply, a month's supply of insulin, they leave with an adequate supply of pen needles as well. You know, we provide almost 8 billion devices around the world. Half of our sales are outside the U.S.

Almost half of them are outside the U.S. In terms of when we can actually see these initiatives play out into the PNL, Anthony, I'll tell you, I mean, it's gonna take some time. We are talking about changing human behavior. In some of the pilot work that we've done in the U.S., the results have been fairly encouraging. You know, our approach is to try a few things. We are changing human behavior, so try a few things, pilot, then, you know, gradually expand that. That's where we are in the process.

Anthony Petrone (Managing Director and Equity Research Analyst)

The follow-up here would be on the M&A comments. We've seen some activity from Embecta. The debt ratio sits a little bit north of three. Maybe just a refresh on the M&A strategy, you know, the types of assets potentially that would be good adjacencies to the core insulin delivery business. Then maybe just scale of deals. It sounds like certainly it'll be, you know, tuck-ins are on the table, but would a scale transaction actually be also something that Embecta contemplates? Thanks again.

Devdatt Kurdikar (CEO)

Yeah, absolutely, Anthony. With respect to our M&A slash, you know, business development strategy, we are looking for assets that allow us to use some of the strengths that we have, right? High volume manufacturing. We have a world-class operations team that, you know, produces high quality, 8 billion units a day in three plants around the world. Second thing is we have a well-established retail channel in multiple countries around the world. Third is, certainly for a company of our size, we have great emerging market infrastructure. The needs in emerging markets for people with diabetes are somewhat different in the products they use because of cost and affordability concerns. We wanna be able to leverage one of these three things. In the partnerships that we've done so far, we've been leveraging our sales channels.

The PolyPhotonix one that we announced today is really a good example. It's very specific to the U.K. just because of the way NHS and general practices work in the U.K. These are the kinds of things that we are doing to leverage one of, you know, one of the three strengths that we have. With respect to M&A specifically, you know, obviously we wanna be careful of the capital constraints of the balance sheet that we have. Tuck-ins are likely, but you know, you never say never. This is a fast evolving space. We are in a great position with the infrastructure we have with we almost 650 now commercial people all around the world. We also wanna be mindful of the work we have to do in front of us, right? We have a lot of separation work to do, implementing a new ERP, implementing a new distributions, network. While we are vigorously looking for M&A, we are gonna be thoughtful with respect to the work we have in front of us, with respect to our capital constraints, as well as making sure that we leverage the strengths that we have.

Anthony Petrone (Managing Director and Equity Research Analyst)

Thank you.

Operator (participant)

Thank you. I'm showing no other questions in the queue. I'd like to turn the call back to Dev Kurdikar for closing remarks.

Devdatt Kurdikar (CEO)

Thank you, Catherine. Before we conclude the call, I would like to express my gratitude to all my Embecta colleagues for the immense amount of work they have been doing over the past year to stand up Embecta as an independent company, even as they fulfill our mission of developing and providing solutions for people with diabetes. Thank you all for attending the call and your interest in our business. Happy Mother's Day this coming weekend to all of you and the mothers in your lives. Thank you.

Operator (participant)

This concludes today's conference call. Thank you for participating. You may now disconnect.