Avanos Medical, Inc. (NYSE:AVNS) Q2 2022 Earnings Conference Call August 9, 2022 9:00 AM ET
Company Participants
Scott Galovan – Vice President, Corporate Strategy and Business Development
Joe Woody – Chief Executive Officer
Michael Greiner – Senior Vice President and Chief Financial Officer
Conference Call Participants
Rick Wise – Stifel
Matthew Mishan – KeyBanc
Chris Cooley – Stephens
Drew Ranieri – Morgan Stanley
Operator
Good day, and welcome to Avanos Second Quarter 2020 Earnings Call. All participants will be in a listen-only mode. [Operator Instructions] After today’s presentation there will be an opportunity to ask questions. [Operator Instructions] Please note, this event is being recorded.
I would now like to turn the conference over to Scott Galovan. Please go ahead.
Scott Galovan
Good morning, everyone, and thanks for joining us. It’s my pleasure to welcome you to the Avanos 2022 Second Quarter Earnings Conference Call. Presenting today will be Joe Woody, CEO; and Michael Greiner, Senior Vice President and CFO. Joe will review our quarter and current business environment as well as provide an update on our key objectives for 2022. Then Michael will discuss additional details regarding our second quarter and review our 2022 planning assumptions. We will finish the call with Q&A.
A presentation for today’s call is available on the Investors section of our website, avanos.com. As a reminder, our comments today contain forward-looking statements related to the company, our expected performance, current economic conditions and our industry. No assurance can be given as to future financial results. Actual results could differ materially from those in the forward-looking statements. For more information about forward-looking statements and the risk factors that could influence future results, please see today’s press release and risk factors described in our filings with the SEC.
Additionally, we’ll be referring to adjusted results and outlook. The press release has information on these adjustments and reconciliations to comparable GAAP financial measures.
Now I’ll turn the call over to Joe.
Joe Woody
Thanks, Scott. Good morning, everyone, and thank you for joining us to review our operational and financial results for the second quarter of 2022. Our operational and commercial teams continue to execute well against a range of macroeconomic challenges, and we remain focused on getting patients back to the things that matter as we meet the needs of our customers. Although we fell short of consensus revenue estimates for the second quarter and are also updating our full year guidance for revenue and adjusted EPS, which Michael will discuss further, we continue to experience consistent demand throughout our product portfolio and remain confident in our ability to execute against our longer-term financial objectives as the supply chain and other macroeconomic dynamics improve.
For the quarter, we achieved sales of $203 million, representing 9% actual growth or greater than 10.5% growth, excluding the negative impact of foreign exchange. We generated $0.41 of adjusted diluted earnings per share and $23 million of free cash flow. Excluding the negative impact of foreign exchange, our Chronic Care portfolio grew by just under 1% despite a 10% contraction experienced in our respiratory business due to inventory being sold through our distributor channel that had accumulated during later phases of the pandemic. Our digestive franchise delivered another solid quarter with greater than 5% growth versus prior year excluding FX. Excluding the impact of OrthogenRx and foreign exchange, our pain portfolio was down 1% with our Interventional Pain franchise growing 5% and our acute pain product portfolio lower by a little over 4% versus last year. The pain franchise had a tough prior year comparison and continues to experience a slower return to elective procedures due to staffing shortages and patient preferences.
Our hyaluronic acid offerings through orthogenerics posted strong Q2 sales with a rapid adoption of TriVisc, our three injection HA regimen beginning in June. Given our reimbursement position in the market compared to competitors, we will continue to see favorable tailwinds in TriVisc, capturing share from both the one and five injection segments with account transitions, new account acquisitions — and meeting patient demands.
Additionally, we have service differentiators via our direct patient purchase program in Harmony, an online portal to enhance and streamline the customer experience. We believe these differentiators will help us retain the new business we are capturing moving forward. We remain confident in generating greater than $70 million of actual net sales for fiscal year 2022 from our OrthogenRx offerings. Separately, we delivered adjusted gross margin of just under 59%, driven by favorable product mix in the quarter, inclusive of OrthogenRx and our plan to continuing to incrementally deliver on our manufacturing efficiency strategy. We are very pleased with our gross margin results for the second quarter and first half, but are cautiously optimistic for the duration of the year, given continued headwinds related to raw material availability, inflation across all manufacturing inputs and shipping and distribution costs that remain elevated.
Additionally, our backorders worsened throughout the second quarter after making progress in the first quarter and are currently in excess of $11 million. Given this continued uncertainty surrounding our supply chain, including access to certain resins, silicone and Tyvek and the costs associated with assessing some of these key raw materials for our product offerings, we are not increasing our full year 2022 expectation for gross margin, but are confidently maintaining our annual gross margin expectation between 55% and 57%.
Turning to SG&A, as we noted during our year-end earnings call, we identified a range of expenses that would impact our SG&A margin profile in the first half of 2022. Our second quarter SG&A as a percentage of revenue sequentially improved by 240 basis points versus our first quarter to 40.6%. Many of these expenses will not repeat in the second half of the year, as we had previously indicated, we still anticipate maintaining SG&A as a percentage of revenue to be less than 40% for the full year 2022.
With that as a background, let’s review some detail on our product portfolio. The positive trends across our Digestive Health franchise continue with our NeoMed portfolio growing over 27% and our legacy enteral feeding products growing mid-single digits, despite supply constraints impeding even further growth for both product categories.
We anticipate continued strong growth for the duration of 2022, assuming no further supply chain disruptions for this product category. Separately, although our respiratory health business was soft in the second quarter versus our expectations, as distributors rebalance their inventory levels on the tail end of the pandemic, we anticipate growth to revert to historical rates and should benefit from a stronger second half as we approach the 2023 flu season.
Turning to our pain portfolio. Although we experienced a weaker-than-anticipated overall second quarter, we continue to deliver mid-single-digit growth within Interventional Pain and ambIT also grew by over 50%. As we noted in our first quarter earnings call, we predicted low single-digit growth for our pain portfolio in the second quarter due to a tough prior year comparison and further indicated that we expected a return to double-digit growth for the second half of the year.
Throughout the second quarter, we have seen strong demand for capital units and interventional pain, which is a key driver of future COOLIEF growth and adoption. On the acute pain side, while supply chain challenges have been an ongoing issue this year we have been able to mitigate some of the impact by continuing to drive the ambIT reusable program, which will remain a key growth engine moving forward. With underlying demand of our products still present, increased momentum in some critical pockets of the portfolio and a pathway to improving the backlog affecting our pain products, we are cautiously optimistic that we can return the pain portfolio to double-digit growth across the third and fourth quarters.
Our next priority for 2022 is to demonstrate our ability to generate consistent, repeatable cash flow. As you may recall, we generated $26 million of normalized free cash flow in 2021, excluding a number of onetime impacts, and as I noted earlier, generated $23 million of free cash flow in our second quarter. We previously communicated that we anticipated generating approximately $90 million of free cash flow for the full year 2022. However, as a result of higher interest expense payments, slightly lower operating earnings and growing inventory balances due to inflationary pressures on our raw materials and managing our backlog, we now anticipate free cash flow to be closer to $80 million.
Our final priority for 2022 is focused on capital deployment via M&A. Our M&A pipeline remains healthy. And as previously stated, we are engaged in active dialogue with a number of potential tuck-in targets, which would leverage our existing footprint, generate synergies and enhance our top line growth.
To ensure that our capital availability is optimized to pursue each of our capital allocation goals, we closed on a new $500 million credit facility during the second quarter. That said, our ability to close potential acquisition targets is incumbent upon disciplined due diligence and valuation that ensures ROIC is meaningfully above our cost of capital. As I noted earlier, we’re very pleased with the expansion of our product offerings through the acquisition of OrthogenRx, and its performance to date has exceeded our initial expectations.
In summary, even with various macroeconomic headwinds, including but not limited to inflation, currency and supply chain, we had a solid first half and remain focused on achieving our primary objectives for 2022 relating to organic growth, OrthogenRx execution, gross margin improvement and material free cash flow generation.
Now I’ll turn the call over to Michael.
Michael Greiner
Thanks, Joe. As you noted, even with the uncertainty that persists in the economy globally and the industry-wide macro pressures, we met or exceeded most of our first half objectives. We delivered on our gross margin improvement and free cash flow generation as well as continue to successfully execute on our OrthogenRx strategy. Additionally, our SG&A spend as a percentage of revenue sequentially reduced significantly in the second quarter, and we remain committed to ensuring full year spend remains below 40% as a percentage of revenue. Even though we have built good momentum across these objectives, we believe it is prudent to update our revenue and adjusted EPS guidance based on the continuing macroeconomic pressures, currency headwinds and increased interest expense.
We now anticipate delivering net sales between $815 million and $835 million for fiscal year 2022 and adjusted EPS between $1.45 and $1.65, primarily due to further projective negative foreign exchange impact and higher interest expense totaling approximately $0.10 as well as slightly lower operating earnings due to lower gross margins in the back half of the year.
Now let’s review our second quarter results. Total reported sales were $203 million, up 8.9% compared to last year with adjusted EPS of $0.41. On a constant currency basis, organic growth was flat. This excludes the contribution from OrthogenRx sales in the second quarter as well as removing Maxter-generated revenue from the prior year second quarter. Chronic Care actual sales were down by $2 million versus last year at $112 million in the quarter, excluding the prior year impact of sales coming from our exited Baxter facility.
We continue to see strong growth in our digestive health business with second quarter growth of 3.5% despite supply constraints impeding even further growth. Within this portfolio, NeoMed grew almost 35% domestically and over 27% globally from the continuation of conversions to our ENFit technology. Separately, as Joe noted earlier, our respiratory health business experienced a 10% contraction in the second quarter, primarily due to distributors selling through their inventory as we exit the pandemic, combined with some supply disruptions.
Moving to pain management. Excluding the contribution of OrthogenRx, we delivered $69 million of actual sales, $1 million behind the prior year, driven by a tough comparable and ongoing supply chain challenges. The Interventional Pain side of the business saw 4% growth as reported in the quarter whereas acute pain declined by 6% and Lance Park, driven by back orders that grew in the quarter as well as lagging and elective procedures that utilize On-Q.
As Joe noted, we are continuing to see positive contributions from OrthogenRx, specifically a high level of adoption of TriVisc, our 3-shot HA regimen as we capitalize on the upside opportunity that will be present through the remainder of the year and into 2023.
Moving down the income statement. Adjusted gross margin improved more than 740 basis points to 58.7% versus last year. As indicated earlier, we are pleased with the progress on gross margins with a combination of better product mix, including OrthogenRx, improved plant performance and lower than forecasted shipping cost. If you recall, last year, to support the business, we incurred significantly higher shipping costs for our NeoMed products to capture the ENFit conversion opportunity.
Although we are very encouraged with our second quarter results with regard to gross margin and across the first half, the global supply chain environment remains disrupted. Inflationary pressures are elevated and the availability of certain raw material components presents a challenge as we work through our existing back order. As Joe already noted, even with these headwinds, we are confident in our ability to achieve our previously stated objective of full year gross margins between 55% and 57%. Adjusted operating profit totaled $28 million compared to $15 million in the prior year. Higher sales and improved gross margins were partially offset by additional spend across SG&A, as discussed earlier, resulting in adjusted operating margins of 14% for the quarter.
Adjusted EBITDA totaled $33 million compared with $20 million last year, and adjusted net income totaled $19 million compared to $10 million a year ago, translating to $0.41 of adjusted diluted earnings per share.
Now turning to our financial position and liquidity. Our balance sheet remains a strength and continues to provide us with strategic flexibility as we currently have over $100 million of cash on hand, with $255 million of debt outstanding post the closing of the OrthogenRx acquisition and completion of our share repurchase programs. Given our post acquisition, pro forma EBITDA, we are levered at approximately one times. Additionally, we generated $23 million of cash for the second quarter. And although we are now anticipating slightly lower free cash flow generation for the full year of $80 million, which includes approximately $20 million of capital expenditures, we have more than sufficient capacity to meet each of our internal and external capital allocation priorities.
As we already shared, our primary objectives in 2022 center around consistent organic growth delivering on our OrthogenRx strategy, making meaningful improvements in our gross margin profile and demonstrating our ability to deliver material free cash flow.
To summarize, Total net sales are expected to be between $815 million and $835 million, with OrthogenRx delivering sales of greater than $70 million. The low end of this range assumes continued challenges with accessing raw materials, unfavorable impact of currency, continued unevenness in the return of elective procedures and other factors, including a less impactful flu season. Annual gross margins are expected to be in the range of 55% to 57%, with the lower end of that range, capturing continued elevated inflation and distribution costs. And our free cash flow target is approximately $80 million as we drive sales and margin expansion, partially offset by higher inventory balances and interest payments on our outstanding debt.
Although the current global macro and industry-specific environment remains difficult, we remain confident in our ability to execute against our strategy and priorities and are taking the necessary steps to drive both gross and operating margin improvement and delivery of significant free cash flow ensuring that we maintain a solid financial position during this uncertain economic environment.
Operator, please open the line for questions.
Question-and-Answer Session
Operator
[Operator Instructions] The first question comes from Rick Wise with Stifel. Please go ahead.
Rick Wise
Lots to unpack here. Maybe help us think through just in a little more detail some of the challenges facing the second half just for starters. The supply chain, yes, everybody in the industry is dealing with it. You’re dealing with it. Where are you, do you feel like, in finding new suppliers? How resolvable is it? Just help us better understand — and therefore, I assume that’s the prelude to working through your backlog as well.
Joe Woody
That’s correct, Rick. It’s Joe Woody. I’ll start and then of course, Mike can add anything that he would like. For us, what we have been mainly seeing in a range of resins and silicone. And that affects the ON-Q business, the Digestive Health business. In the first half, we saw some chip problems and affected COOLIEF generators that looks to be dissipating in H2. And all of that, in turn, also affects the international business. Now, to the extent that, that clears up, and as you can imagine, like other companies, we’re working in a million different pathways to do that. There’s also the potential for upside. But at any given time, just in the supply chain that we’re in right now, other items emerge, whether it be around packaging or things as simple as ink and the list goes on from there. I think in H2, kind of our major issue is going to be around Tyvek. And we’re equally working with Avamed with other companies to try to see how we can get more raw material released for medical device products. So essentially, that’s what you see in the range and in the guidance change. But equally, there’s an opportunity. And if that does improve, obviously, we do much better. But I don’t know, Michael, if you want to add to that?
Michael Greiner
Yes, I would just add to that, that the $815 million to $835 million on revenue, although than FX, which has a meaningful impact, $5 million in the first half of the year, and we’re estimating at least $5 million in the back half of the year. If those back orders clear up, then we have line of sight, getting us to the higher end of that range of that $835 million is very realistic if those back orders we’re not able to secure the raw materials, as Joe just mentioned, that’s needed, then more towards the midpoint, lower end would be possible.
Joe Woody
And I would just clarify that the demand is absolutely there. We could have absolutely done more in the quarter without this type of supply chain challenge. But I think the nature of our portfolio and the size of our company hit sort of a different way, maybe not even as bad as some of the others I’ve seen but certainly for our size of the company and the portfolio we have, it impacted the quarter.
Michael Greiner
Yes. I mean if you look at the first half of the year, right, North America grew organically 3.5% through the first half of the year with — even with these back orders. So it would have been much more substantial. And then international had more of the back order issue plus the FX issue, which obviously had a total impact on our revenue for the first half of the year.
Rick Wise
And turning to OrthogenRx. Obviously, a terrific quarter. You had said on the first quarter, you expected to generate sales in excess of $70 million, you’re reiterating that. And I just wanted to be — make sure I was clear in my own mind now that we’re halfway through the year, it sounds like you’re feeling more confident. But how do we think about it — sort of a two part question now, how do we think about that outlook given the reimbursement change looming for HA and just how you’re thinking about that and what you’ve dialed into that projection? And in a sense, what’s next? It seems like you’re doing better than others. Maybe help us understand why that could, should and will continue to be the case. I’d appreciate it.
Joe Woody
This is Joe. I’ll get to do that. We are definitely more confident in the full year outlook. We knew with the new allowables, there would be a migration TriVisc. That happens a lot more quickly than we anticipated faster from the five shots. In fact, some of our five shot customers are — a good portion of them want to get into the 3-shot market. We’re seeing competitive moves over to ours. Short term, there is a reimbursement favorability that customers can experience because of the way we strategically went around our pricing, focusing on the wholesale. So we have to maintain a healthy ASP. We intend to add direct reps and nine reps. So we think that we sort of have this window, if you will, of six to nine months, I think, of a pretty positive tailwind in this business where we’re going to see some upside and the strategy is working. We’re definitely meeting the internal model, and that will be helpful. And I think that, that just sort of bodes well for also what we said about year or two and then beyond with that business. So all in all, it’s turned out to be an excellent acquisition for us and one that’s strategic, obviously, alongside other things that we’re doing in other orthopedic areas of our business like COOLIEF and ON-Q.
Rick Wise
Got you. Thanks again.
Operator
The next question comes from Matthew Mishan with KeyBanc. Please go ahead.
Joe Woody
I think we may have lost Matt there. You may come back into the line. Maybe we take another question.
Matthew Mishan
Just a follow-up on the TriVisc question. What specifically about TriVisc allows you to have a better reimbursement position than some of the peers in the space.
Joe Woody
Well, primarily, it’s the way that we priced our product at the wholesale level, not a lot of specialty pharmacies kind of rebating in our business, and that strategically was a way that we focus the business. So we ended up with more favorable reimbursement than all the other three injection products. Going forward, I mean, I think the differentiator is the other portfolio that we have, the conversations we can have in alternate sites or different sites like ambulatory surgical centers or places where we’re selling COOLIEF. And again, we do intend to expand our channel a bit as well. Ultimately, the differentiators are going to come around with servicing, really, we’ve got a portal that we talked about in the script and the way that we service customers and make it easier to do business. And then we have some technology that we’re working on in terms of the syringe that we think will be a differentiator as ultimately, over time, you have to differentiate that way as much of the reimbursement later on in about a year from now will be very similar.
Matthew Mishan
Okay. So you’re expecting to change your favorable reimbursement position to sort of come together with the rest of the industry as you kind of get through the second half of this year?
Joe Woody
Next year through the second half of next year, I think we feel like we’re going to be favorable in the three injection area.
Matthew Mishan
Do you feel like you’ll be favorable through the middle of next year and then it will
Joe Woody
Correct. It could be a little — It could extend a little bit or if I go into eventually a more level field where you have your base of customers, and we’re differentiating through basically our other portfolio the way we service, and then we’re doing some things from an innovation standpoint with our syringe because I think at that point, you have to have a differentiator at that kind of a reimbursement level.
Michael Greiner
And so what’s key, as Joe mentioned in the prepared remarks is we gain all these additional customers, we service them well. And once pricing is less of a dynamic in this market, we maintain the market share that we will have developed over the last few weeks and into the next few quarters.
Matthew Mishan
Okay. I understand that now. And then a question around NeoMed and Digestive. It seems like NeoMed is growing. And I remember this being a larger — from a larger base of sales from you guys. Outside of NeoMed, is Digestive contracting? Or is that still growing as well?
Joe Woody
No. It’s still — we see it as a mid-single-digit grower on a global level. It’s one of those areas affected by, I believe, Tyvek and silicon in H2. There’s absolutely an upside where if we can get the right amount of raw materials, we can even do better in the Digestive Health area, which is where we primarily focus on our MIC-KEY product. But you also see CORTRAK, all that slowed a bit in North America with the staffing shortages and the ICU census. We still think that, that’s a good grower for us inside of Digestive Health franchise. So you peel it all back, it’s a very solid business, mid-single-digit grower with a good runway globally for the future and good actually good margins for us and a big contributor to our cash EBITDA.
Matthew Mishan
Got it. And then just on the OrthogenRx, just the number in the quarter, you back into it, it’s about $22 million. Is that the correct number contribution from that acquisition this quarter?
Michael Greiner
That’s directionally correct, yes.
Operator
Next question comes from Chris Cooley with Stephens. Please go ahead.
Chris Cooley
Just maybe a clarifying question for me to start and then maybe a little bit bigger picture follow-up. Michael, just in regards to the guidance, you mentioned the lower end of the top line did assume continued FX headwinds. I apologize if I missed this in your prepared remarks, but did you call out what you’re assuming there in terms of the incremental headwind there from a basis point perspective or maybe alternatively, could you just give us where your markers were for the major currencies coming into the quarter?
And then just kind of as another offshoot kind of from a — just a clarifying point. When we look at pricing for HA products, the way it gets published out there, I just want to make sure I’m understanding this correctly. When we look at your pricing versus, say, some of your competitors, you’re assuming that discount continues. There’s no additional rebates being added. So that’s just going to be that price differential you think then will continue until the midpoint of the next calendar year because there’s quite a bit of disparity across three to four players here just in terms of published pricing on the HA offerings at this time. Then I’ve got one quick kind of bigger picture follow-up.
Joe Woody
Do you want to do the currency or you want to start with the…
Michael Greiner
Start with that.
Joe Woody
So I think you’ve got the HA please right. We’re not really — we haven’t really structured a lot of rebate type of business or discounted to payers and so forth. The specialty pharmacy is not a big area for us to focus. So we’ve benefited from that with a wholesale price that’s pretty robust. And yes, it should continue into about the middle of next year, and we think that that’s going to allow for us to gain share from competitors fairly significantly during that period. And I think we’ll keep it with the things that we’ve got playing on the innovation side and then the servicing model that we want to go after. And also, one thing I didn’t mention in the prior question was we’re also building a cash business as well that looks like it’s got opportunity for us.
Michael Greiner
And then on your other question, Chris. So we had about a $5 million headwind across the first half related to FX versus our planning model. We anticipate that we’ll probably see five to seven in the second half as well. The reason for the increase is just that we’re going to do $25 million, $30 million more in revenue in the second half. So that obviously has a bigger FX impact. In addition, good portions of our back orders were international related. So we have a bigger ramp in the back half of the year related to international orders. hence, the additional FX impact in the back half of the year.
Chris Cooley
I appreciate the additional color. And then just a bigger picture follow-up there. You alluded to stronger capital demand on the pain management side as we think about the COOLIEF franchise. Any way you can quantify that for us a little bit here in terms of maybe side of service where you’re seeing the incremental demands relative to prior periods. Just trying to get a little bit better granular — more granularity there around just how much incremental demand you’re seeing versus kind of relative levels there.
Joe Woody
Sure, Chris. Yes, one of the things actually there’s a benefit, I think, is that as the chip shortage took hold in the first half, there was an opportunity for the channel in the connect with existing customers and get penetration or bringing active accounts back. I think the other thing that also drives that is the continued study that are coming out, definitely as they published. But also now, as everybody knows, I think we’re in the OA space, so that’s a strong grower for us for those sites that are treating in OA. And the quantification is really that we think there’s a tough comparator as we all came out of the first aspect of COVID and then when we bounced back in this quarter last year, in Q2 last year with procedures, but as we get into the second half, there’s definitely some better comparatives for us. We certainly see that quantifying in terms of double-digit, growth in the teens again for Q3 and Q4, and we just have a big demand for the capital. And so we have a backlog for these units. And I think the team is doing a nice job selling the capital. So that’s where it’s all coming from.
Operator
[Operator Instructions] Next question comes from Drew Ranieri with Morgan Stanley. Please go ahead.
Drew Ranieri
Maybe just the — keep it on the HA topic for my first one. But Joe, I’d be kind of curious to hear more about some of the innovation that you’re putting behind the product. I know that there was eventually like a single injection product coming. But can you go into a little bit more detail about what you precisely mean by innovation and the service model? And also as the cash pay, kind of, struck me. Just kind of curious how that would work in the HA market? And then I had a follow-up.
Joe Woody
So we’ve talked a little bit in the script about the Harmony portal just making it easier for customers to do business with us to order to get reimbursement assistance, that’s one thing. I mean the next thing that we’re doing on the differential side and innovation after sort of the reimbursement changes is technology that going to allow for the injection to be guided more precisely into the areas of the need to get the best effect. And so it’s sort of known that if you’re not in the right space when you make this injection, you get less of an impact, which is why sometimes I think patients experience may be no pain relief for just a couple of weeks, what others experienced two months or more of pain relief. So I think that will be a differentiator.
And then the other thing I think is just where we can go with some of the access and sites. And then I think that a lot of the folks that are believers in HA are going to want to have the ability to have patients come in that want relief and want to pay cash for that relief. And so there’s opportunities there really in most all of the sites where we are for that. And we’ll be talking a little bit more about that as it sort of unfolds towards the end of the year. But that’s where we are on that.
Drew Ranieri
Okay. And just maybe on the injection for accuracy. Is this going to be just around using kind of ultrasound and improving like the needle, the injector or anything else there?
Joe Woody
It’s more related to a guidance of the needle.
Drew Ranieri
Okay. And then maybe for Michael, a couple of questions here. But when we kind of look at your organic guidance, for EPS. I mean I get that some of this is FX, some of this is interest. But when you’re looking at the change from the prior guidance, the 2-point organic guidance reduction. Can you maybe just talk about how that flows through into EPS and maybe what the change is there. And also on gross margins, I mean, it looks like it’s going to be flat year-over-year in the back half. Could you maybe just give us a bridge between second half and first half of how you’re thinking about the macro factors? And maybe where could there be like a specific relief area that you can control versus just kind of the macro uncertainty?
Michael Greiner
Yes, fair questions. So on the EPS side, the biggest reason for the call down was the higher interest expense, the FX impacts and then a little bit on the lower operating earnings. And those lower operating earnings are primarily through the lower gross margin in the second half. We will offset the lower revenue organically that you just referenced. We will offset that through OpEx challenging and OpEx savings. So revenue down on the organic side, offset by more favorable OpEx. The other piece is then that relates to the ultimate EPS guidance change were higher interest expense, FX and a little bit of the lower gross margin. Does that help with that part of the question, Drew?
Drew Ranieri
Yes, it does.
Michael Greiner
And then when you think about the march from first half to second half gross margin, the biggest piece of that is inflationary factors. So if you noticed on our balance sheet, our inventory is up about $19 million. That’s more than we anticipated. That obviously has an impact on free cash flow as well, but we — as we have opportunities to buy raw materials, we’re doing that in pockets that we know don’t have dating concerns. So we’re — we’ve been a little bit looser on that. But also that inventory that is now capitalized. That’s going to — as we sell and work through the back order in the back half of the year, we are going to be releasing in the cost of goods sold, higher priced inventory, and therefore, that’s going to have a big impact on our gross margin in the back half of the year. Now as we work through that, and we start to have a little bit more normalized raw material purchasing as we enter into 2023. That drag that’s not capitalized on our balance sheet, obviously reverses meaningfully.
Operator
This concludes our question-and-answer session. I would like to turn the conference back over to Joe Woody for any closing remarks.
Joe Woody
Thanks. I just want to thank everybody for their continued interest in Avanos. And while we’re very pleased with our overall execution this quarter, given the uncertainty in this environment, we are committed to creating meaningful shareholder value and believe our 2022 results are building the foundation to deliver on that commitment. I’m confident that the priorities that we’ve detailed combined with our market-leading portfolio and attractive markets position us for consistent sales growth, margin expansion and significant free cash flow generation as we enter the back half of 2022, and we’ll probably see a lot of you in the fall investor meeting. So thank you very much. Bye-bye.
Operator
The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.
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