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Avanos Medical, Inc (NYSE:AVNS) 2021 Third Quarter Earnings Conference Call, November 2, 2021, 9:00 AM Eastern Time
Good morning, and welcome to Avanos' third quarter 2021 earnings conference call. [Operation Instructions] After today's introduction is over, there will be an opportunity to ask questions. 【Instructions】
I now want to transfer the meeting to Mr. Scott Galovan, Vice President of Corporate Strategy and Business Development. please continue.
Scott Galovan - Vice President of Corporate Strategy and Business Development
Good morning everyone and thank you for joining us. I am very happy to welcome you to Avanos' third quarter 2021 earnings conference call. In attendance today will be CEO Joe Woody; and senior vice president and chief financial officer Michael Greiner. Joe will start with an update on our quarter, and then discuss our business environment and progress towards 2021 priorities. Then Michael will review our third quarter results and update our 2021 planning assumptions. We will end the call through a question and answer. The "Investors" section of our website avanos.com provides a presentation of today's conference call. As a reminder, our review today contains forward-looking statements related to the company, our expected performance, economic conditions, and our industry. There is no guarantee of future financial results.
Actual results may differ materially from those in the forward-looking statements. For more information about forward-looking statements and risk factors that may affect future results, please refer to the risk factors described in today's press release and our filing with the SEC. In addition, we will refer to the adjusted results and outlook. The press release contains information about these adjustments and adjustments to comparable GAAP financial measures. I will now transfer the call to Joe.
Joseph F. Woody - Chief Executive Officer
Thanks, Scott. Good morning everyone, and thank you for your interest in Avanos. Although we continue to see the impact of the pandemic because it is related to elective surgery, hospital staff shortages and supply chains, we are very satisfied with how our operations and commercial teams respond to the challenging dynamics brought about by the pandemic. Throughout our business, we still focus on getting patients back to the important things that we meet our customers' needs. Before discussing the current environment and our progress on our 2021 priorities, I will first briefly review our results for the quarter. Our sales for the quarter were US$184 million and adjusted diluted earnings per share were US$0.25. Our sales performance is mainly in line with our planning assumptions.
Except for the slowdown in sales of ON-Q due to the launch of elective courses in the Delta variant in the summer, we achieved solid sales performance in every other product category in the third quarter and the first nine months. year. As we pointed out last quarter, we expect gross margins to improve significantly throughout the third quarter. The gross profit margin in August and September was 54%, and the gross profit margin in the third quarter was 52% or 90 basis points higher than that in the second quarter. Our gross profit margin will continue to improve throughout the fourth quarter and stabilize until 2022. However, transportation and other supply chain inflationary pressures still exist, so we cannot be sure how much further improvement we will see in the short term.
As we mentioned last quarter, most of the headwinds affecting our gross profit margin are temporary, mainly driven by pandemics, and are present in various industries. It does not mean that our operating structure will undergo permanent changes. We remain confident in this assessment. Although the gross profit margin has improved and will continue to improve when we exit this year, we are clearly behind our internal forecast of gross profit. Therefore, the additional efficiency of the entire business has been determined to reduce operating expenses. The team is continuing to find ways to increase productivity and reduce cost structure to ensure that we can deliver on our promise to SG&A that the future revenue percentage is less than 40%. With this as a background, let us begin to discuss the current market environment and provide an update on the progress we have made on our 2021 priorities.
As mentioned earlier, we have achieved considerable revenue results in most of our product portfolios. Our Digestive Health business led by NeoMed has grown by more than 2% globally over last year, and by 6% in North America. Our respiratory business has declined compared to the previous year, mainly related to the pandemic-related push we received in the third quarter of last year, which contributed $8 million in additional sales. As a result, we are flat with the second quarter because our standard of care for providing closed suction catheter systems for patients who need to be hospitalized due to the coronavirus has shifted mainly to non-invasive ventilation procedures before switching to mechanical ventilation. In terms of pain management, our interventional pain product portfolio has grown by nearly 5%, while acute pain has dropped by more than 1%. This is due to the delta-related elective surgical suspension that affected our ON-Q franchise. .
As we have said in the past few quarters, based on the conversations with our surgeons and hospital administrators and the content disclosed by our colleagues, we still believe that in the foreseeable future, the number of inpatient operations will remain low In its full potential. Having said that, we do expect continuous growth and recovery of ON-Q franchise rights in the fourth quarter, similar to the revenue level in the second quarter. As we enter the last quarter of this year, we will continue to enhance our product offerings to improve the efficacy and ease of use of our care partners. For COOLIEF, we successfully completed the limited release of the next-generation cooled RF probe kit in the third quarter, which has now been fully released in the fourth quarter. The new probe makes it easier for our doctors to perform the COOLIEF procedure while maintaining our premium look and feel.
The manufacturing efficiency related to the new probe has also improved, which supports COOLIEF's already high gross profit margin improvement. Combined with the new generator we launched last year, our new probe kit consolidates our leading position in cooling RF. In our ON-Q and ambIT business, we recently launched Pain Block Pro, a differentiated application and data collection tool that tracks, monitors and improves patients through more direct feedback between patients and doctors The therapeutic effect. The app tracks the patient's recovery to understand satisfaction and pain levels in real time. The app also helps us attract patients to improve their experience by providing education about pumps and providing ways for doctors-to provide positive feedback on the questions that patients may ask.
We also continue to see the momentum brought by our channel cooperation agreement, and we use orthopedic sales partners to reach orthopedic surgeons. Finally, we provide our electronic pump ambIT to the ambulatory surgery environment, which allows us to capture the additional volume of surgery. Turning to chronic care, the positive trend of our digestive health franchise continues. Our NeoMed franchise has maintained double-digit growth, and our CORPAK standard of care strategy is accelerating sales of our CORTRAK hardware to record levels. As I said before, given the tailwind of the pandemic last year, our respiratory health sales have fallen. We have simulated this year's nominal flu season, and in line with this model, we are currently not experiencing any higher level of purchase activity for closed suction catheter products.
Our second focus area in 2021 is related to improving gross profit margin and operating profit margin. Since the beginning of the pandemic, we have remained focused on recovering gross margin losses and made some meaningful progress on these initiatives in the third quarter. We are very satisfied with the improvement in gross margin because we withdrew from this quarter and expect to see further growth throughout the fourth quarter. As mentioned earlier, we believe that these gross margin headwinds are temporary, but we also recognize that there is still a lot of work to be done to restore our gross margin conditions to the highs of the 1950s and the lows of the 1960s. Our third priority is to start generating consistent, repeatable free cash flow. We generated $10 million in free cash flow in the second quarter and $18 million in this quarter. We expect to generate positive free cash flow again in the fourth quarter.
We received $47 million in tax refunds related to the CARES Act during the quarter, part of which was offset by the $22 million we paid to the DOJ to resolve pending litigation. Improved operating performance, coupled with some remaining upside working capital, will support this priority of generating consistent and repeatable free cash flow. Our last focus this year is capital deployment. Our M&A channels remain healthy, and we are in active dialogue with many potential targets, which will leverage our existing footprint, generate synergies, increase our revenue growth and meaningfully improve our profit margins. We will maintain self-discipline in determining goals that both meet our strategic plans and exceed our financial obstacles, ensuring that we generate strong returns on capital.
Finally, in the past four quarters, we have resolved all major pending litigation, including DOJ investigations, compensation disputes with Kimberly Clark, our intellectual property infringement cases with Medtronic and other smaller product liability cases. Positive results. This not only reduces our series of uncertainties, but from the perspective of cash flow, it will also greatly reduce our legal costs. This allows us to be more active in mergers and acquisitions and free up funds to repurchase our stock, while ensuring that we continue to meet each of our internal funding needs. As we complete 2021 and begin to look forward to 2022, we still have the ability to advance our strategy in these four value creation areas. I will now transfer the call to Michael.
Michael Greiner - Senior Vice President and Chief Financial Officer
Thanks, Joe. As you pointed out, we have made meaningful progress in our value creation plan and are preparing for a robust 2022, combining mid-single-digit revenue growth with merger execution. In addition, we will show the improvement of gross profit margin and operating profit margin as well as continuous free cash flow generation. Now let us begin to review our third quarter results. Total sales of US$184 million were basically the same as last year. Volume and currency were flat, and prices fell by about 1%. Given the respiratory health tailwind associated with the pandemic in the third quarter of 2020, chronic care sales fell 2% during the quarter to $117 million. According to the tailwind adjustment for 2020, with the improvement of the entire product portfolio, sales of respiratory health will increase by US$4 million this quarter.
Although the Delta variant spread rapidly in the summer and increased the number of hospitalizations again, we did not see a significant increase in closed suction catheters because the hospital performed first-line care before placing the patient on the ventilator. As we pointed out last quarter, our planning assumptions for respiratory health in the second half of 2021 do not include any additional benefits from the pandemic. We also stated that we expect the beginning of the cold and flu season to be negligible, and we currently Is going through this situation. Turning to digestive health, we saw a 6% growth in North America, which was offset by the decline in our international market, resulting in a global growth rate of slightly more than 2% in the third quarter. NeoMed continues to convert to our ENFit technology, again growing by double digits.
Our out-of-stock impact on NeoMed is currently $1.5 million, and we plan to end it in the first quarter of next year. Turning to pain management, we achieved US$67 million in sales, an increase of 1% over the previous year. This was due to the strong performance of our radiofrequency ablation products Game Ready and ambIT, but was offset by ON-Q. As Joe pointed out, growth in the third quarter was hampered by the impact of the Delta variant and the slowdown in the return of selective procedures. Although these effects have had an impact on the entire Pain product portfolio, ON-Q has been disproportionately affected because in the summer, hospitalization in various regions of the United States experienced rolling stoppages. We partially offset these losses by introducing Pain Block Pro, the growth of channel partners, and expansion into the ASC environment.
With the advancement of these measures and the slow return of the elective program, we are ready to promote continuous improvement in the fourth quarter. In addition, supply constraints and shortages of raw materials have affected our ability to meet Game Ready business needs, and delivery delays still exceed $1 million. We expect these backorders to continue to grow until the end of the year. Although these restrictions will persist in the next few quarters, our supply chain team is actively looking for supplies, and we expect to reduce the backlog in the first half of 2022 to meet this market demand. Move the income statement down. The adjusted gross profit margin dropped from 55% last year to 52%. As mentioned earlier, we are satisfied with the progress of gross profit margin this quarter and expect further significant improvement in the fourth quarter.
Compared with last year, gross profit margin was affected by rising transportation costs and unfavorable combinations. Due to global capacity constraints, shipping costs increase. In addition, the decline in sales of closed suction catheters and ON-Q products adversely affected our product portfolio. These unfavorable factors have been partially offset by this year's lower inventory write-offs. Looking ahead to 2022, we continue to expect a steady increase in gross profit margin due to a series of plans we have implemented throughout our operations. However, we are still aware that the global supply chain environment is still disruptive, and we are currently unable to predict the offsetting effects of inflation and rising transportation costs and the availability of certain raw material components.
Now turn to some bottom-line financial indicators. The adjusted operating profit totaled US$17 million, compared with US$18 million in the previous year. As we pointed out earlier, the slight decrease in sales and gross profit margin was partially offset by the decrease in SG&A and R&D expenses. The total adjusted EBITDA was US$22 million, compared with US$24 million last year. The adjusted net income totaled 12 million U.S. dollars, compared with 10 million U.S. dollars a year ago. Our adjusted diluted earnings per share was US$0.25, an increase of 20% over the previous year. Turn to the balance sheet and cash flow statement. Our balance sheet remains our advantage and continues to provide us with strategic flexibility because we currently have US$110 million in cash and US$130 million in outstanding debt due to revolving credit facilities because we have used the CARES Act to refund Part of the proceeds to repay debt.
We have more than $200 million in usable capacity available for our capital allocation priorities. Finally, although the unpredictability of the coronavirus still exists, we still expect our net sales to increase by 2% to 4% at a constant exchange rate compared to the previous year. In addition, as we pointed out in these prepared comments, our supply chain is still in an uncertain environment, both from a cost perspective and product availability. To partially offset this impact, we managed the cost structure for SG&A and R&D throughout the year, which allowed us to maintain a guidance range of US$1.10 to US$1.20. In view of these factors, we remain committed to and reiterate our guidance range, while also recognizing that the possibility of us falling out of the low end of guidance has now increased.
We have made great progress in 2021 and are ready for success in 2022 and beyond, and we are glad that most of our cash flow uncertainty has now passed. We still believe that we have the ability to execute our strategy and take the necessary measures to drive the improvement of gross profit margin and operating profit margin, and provide more consistent results as we look forward to 2022. Operators, please open the problem hotline.
thank you very much. We will now begin the Q&A session. [Operation Instructions] The first question comes from Matthew Mishan of KeyBanc. please continue.
Matthew Mishan - KeyBanc - Analyst
great. Good morning. Guys, I just want to start with revenue growth first, because last year during the entire COVID-19 period, the sales growth of respiratory health and chronic disease care seemed quite resilient, and this year, your income seems to be at or above the midpoint of your guidance . Considering the typical seasonality of the third and fourth quarters, at this point, what do you need to not enter at a rate of more than 3%?
Joseph F. Woody - Chief Executive Officer
Yes, Matt. First of all, I believe we will get this question, I am Joe. We saw a pretty good start in October, even with improvements in Pain's business. What we are really concerned about is the supply chain projects we discussed, and then just-it all boils down to the speed of program recovery. And I think many other companies have discussed the staffing issues mainly in hospitals, and then how quickly, especially in the southern part of the delta, the procedures will resume. If they do come back faster, it would be better for us.
Michael Greiner - Senior Vice President and Chief Financial Officer
I would also say, Matt, when we look at the actual data for October now, yes, we should reach these goals in the fourth quarter. We still have November and December. We saw exactly what happened to us in the summer. Suddenly the Delta variant soared in the southern United States and had a meaningful impact on ON-Q. Currently, we have some very good trends in the last 60 days of the quarter, but we also want to remain cautiously optimistic.
Matthew Mishan - KeyBanc - Analyst
OK. When you say possibility-the possibility that you may fall below the range of $110 million to $120 million has increased, but you still maintain your guidance. What is the thinking process behind this? I just want to know your opinion on this.
Michael Greiner - Senior Vice President and Chief Financial Officer
Yes. no no. This is a very good question. Therefore, there are a lot of internal debates around whether we completely move the guidance, whether we expand the scope of guidance? We just think there are 60 days to do any of these things, which creates clumsiness in both the disadvantages and the advantages, because as I said, we are going out of October and feel good about where we are. So, suppose we move the guidance range to $1.05 to $1.15, and then we adjust it to $1.16, which feels awkward. If we increase the range by US$0.15 or US$0.20, it does not feel completely appropriate.
So we just think this wording, which I think is unusual for most people, is more suitable for our current situation, if the supply stays, if the trend we saw in October stays the same, if we don’t see the distribution For any other issues in, we should relax in the range of $1.10 to $1.20. If these things change in different ways in the next 60 days, then we may be slightly below and beyond that range.
Matthew Mishan - KeyBanc - Analyst
And then just-when you look at the range, just to hit the low end based on the midpoint of the revenue guidance, which means there will be a pretty meaningful increase in gross margins in the fourth quarter. How do you give people confidence that that is what is happening there, the trajectory you are taking?
Joseph F. Woody - Chief Executive Officer
By the way-I think Michael will accept it, but what I want to say is, to reiterate, we did reach a gross margin of 54% in August and September, and many of these things started to improve for us. But go on, Michael, I know you want to take him there.
Michael Greiner - Senior Vice President and Chief Financial Officer
Yes. No, I want to say that we now expect our overall operating margin to increase by more than 400 basis points between the third quarter and the fourth quarter. A large part of this will be an increase in gross profit margin. As far as Joe is concerned, the trends we saw in August and September will continue into the fourth quarter. So, Matt, your math is very good and we have high confidence. We should be better in the third quarter, except that although the freight rate has improved a lot, about 50 basis points, we think the freight rate will increase even more.
But then the cost of water transportation for the entire third quarter increased fivefold. It's back now, so this will help. As we discussed before, we no longer do overnight shipments, and we have other tailwinds into the fourth and third quarters. Another thing we saw in the third quarter was a slightly different gross margin. Therefore, the way we reached US$184 million was slightly different from what we expected. Some products with lower profit margins, such as oral care products, performed particularly strongly in the third quarter, while ON-Q's performance was slower than expected.
We expect this trend to reverse in the fourth quarter. Therefore, we have many favorable factors to enter the gross profit margin in the fourth quarter. The biggest question we want to raise on the gross margin conference call in the third quarter is the worry that it is embedded, it is more like a permanent change in our operations. Hopefully, what we showed in our August and September results, especially in terms of gross profit margin, is not the case. Therefore, we continue to be confident about where we will bring our gross margin to the fourth quarter and hope to be in 2022.
Matthew Mishan - KeyBanc - Analyst
thank you very much. I will jump back into the queue.
Thank you. The next question comes from Ravi Misra from Berenberg. please continue.
Ravi Misra - Berenberg - Analyst
Hi. Good morning. Can you hear me okay?
Joseph F. Woody - Chief Executive Officer
Ravi Misra - Berenberg - Analyst
Many thanks. So as we enter 2022, I want to ask a big question. The story here has long been that this company has a lot of heavy work and small jobs to do. It sounds like you have solved one of the problems with the legal solution this quarter and the solution there. As we enter 2022, can you help me think, Joe, how do you and the board consider the key drivers here, and what do you prioritize-it has always been a trio of mergers and acquisitions, organic growth and restructuring types.
Maybe it can help us think about where you will spend your resources in 2022? Perhaps how should investors prioritize these when considering Avanos?
Joseph F. Woody - Chief Executive Officer
Yes. I mean I really like our positioning in 2022 because we deduct a lot of costs from our business during the pandemic. As an example, we have already said, look, we are comfortable with our business with SG&A below 40%. These gross margin challenges this year are indeed related to the pandemic and temporary. We started talking about this very early. I think it will take another quarter to prove more in medical devices, just like in other industries, I think you can see progress.
If you think about the quarter we have just gone through, such as 160 basis points mixed, ON-Q, electives dropped, it will not exist. Therefore, we once again see a medium-single-digit organic growth business, which is very solid when you are not affected by these pandemics. The other thing I want to say is that we have spent a lot of time on M&A targets, we have been discussing two recent acquisitions, and we think we will be able to discuss these acquisitions soon, which will increase business.
This has always been part of the equation that we can increase our gross profit margin. For example, through some of these acquisitions, some EBITDA will obviously gain some growth and synergies. At least these things are additional. If you will, go directly to us. Channel. So we really feel good about entering 2022. I think it all boils down to, once again, how quickly and how quickly the hospital can resolve staffing issues and elective courses-I know they want to come back too, because obviously they are being affected. But I believe that we are ready to enter 2022, which is for sure.
Ravi Misra - Berenberg - Analyst
great. I guess you just touched on my next question about mergers and acquisitions. Can you help us think about what kind of integration you are willing to accept? I mean, would you consider transactions that may dilute gross margin or EBITDA in the short term? Or are you pursuing things that will quickly increase the bottom line. Can you provide some details?
Joseph F. Woody - Chief Executive Officer
I mean generally speaking, I would say that we are currently on the side of housing appreciation. We have made some deals in chronic care, but we have some things we want to do in pain. Similarly, I think from the perspective of revenue and gross margin, they will increase and we will get some EBITDA. Then we also conducted transactions, and we looked at some transactions that did not do so-they didn't add value immediately at first, but they were very strategic. So we kind of covered both sides of the house. But I think they will definitely increase to 2022.
Ravi Misra - Berenberg - Analyst
The next question comes from Rick Wise from Stifel. please continue.
Rick Wise - Stifel - Analyst
Hi. good morning everyone. I just want to start, maybe give us a little more color. Obviously, you are talking about how this quarter started, and the October-October situation was very positive. I just want to make sure that I understand the drivers there more carefully. What I mean is that one seems to be in terms of gross profit margin, Michael, if I understand you, in terms of gross profit margin to reduce transportation costs and reduce manufacturing inefficiencies. But in terms of sales, I don't know what happened. Is it just mixed? Is it the launch of the next generation COOLIEF? Just to help us understand the moving part there.
Michael Greiner - Senior Vice President and Chief Financial Officer
Yes. Therefore, overall, compared to our expectations for chronic care and pain, the October revenue results were overall strong. When all our results are executed in sync with each other, our combination will be improved. Therefore, only when we have made a huge improvement in oral care at the end of the second quarter-the end of the third quarter-and obviously ON-Q has been declining throughout the third quarter, which tends to have a huge impact . However, as our entire portfolio moves forward and continues to grow, net-net will have a positive impact on our portfolio profile.
Joseph F. Woody - Chief Executive Officer
I thought you asked about gross margin. So I think I have to say more.
Rick Wise - Stifel - Analyst
I will continue to expand the gross profit margin. I mean, obviously, you have seen such a significant improvement in October. I mean this is very encouraging. But when you talk about returning to the highs of the 1950s and the lows of the 1960s, how much of the portfolio today is today's portfolio and returning to a more normal period as the COVID hopes recede? How many of these will be driven by mergers and acquisitions that hope to increase profits?
Michael Greiner - Senior Vice President and Chief Financial Officer
So there are two things. Those high in the 1950s and low in the 1960s did not have any mergers and acquisitions. Therefore, this is entirely an organic conversation around our profit margin-the increase in gross profit margin. Having said that, in our current environment, the work we are doing is really focused on our manufacturing inefficiencies, how we look at freight, our product planning, all these different things, we can do-- -Sorry, 57% and 58% only pay attention to things that are controllable.
However, in order to go beyond this point and return to the lows of the 1960s and always stay at the highs of the 1950s, we will need a more standardized environment for the entire portfolio because of the uncertainty surrounding our price and portfolio and gross margin range. It is of great significance in our product portfolio. Therefore, you do not need to make a lot of changes in any given quarter in the portfolio, depending on the positive and negative factors that have this effect. Therefore, if everything is going on, then our product portfolio is a net positive gross margin environment.
However, when we have things like oral care and ON-Q drops in a certain quarter, this will have a significant adverse effect on us. So we can control, from here we can definitely make meaningful progress. But to stay in the high position in the 1950s and low in the 1960s, we will have to feel a slightly more normalized environment from the overall product, if this makes sense.
Joseph F. Woody - Chief Executive Officer
Rick, also in terms of sales, our purpose is not to be alarmist here. But you do-if you will, we are a $740 million business. So things like Australia, they are blocked, and the access of Japan or the access of Europe will have an impact. As we said on the conference call earlier, the speed of our return is a bit of a yardstick. But again-again to be clear, we achieved strong results in October. Given that this is a pandemic and changes every week, we just remain cautious. but...
Rick Wise - Stifel - Analyst
Yes. Do not. I mean, obviously, as you said, you are not alone. Joe, I'm glad you mentioned international, because this is my last question. I hope you can give us more color about international business. You mentioned a few weaknesses, and you mentioned Australia. What happened more broadly? What initiatives are underway there? What do you think-when we enter the fourth quarter and start thinking about next year, how should we look at internationally? thank you very much.
Joseph F. Woody - Chief Executive Officer
Yes. A few things. First of all, in general, we have been very satisfied with the performance of our international business in the past few years. In Europe, the Middle East and Africa this year, we have been affected to a certain extent in terms of contacting customers. Then, of course, there have been disadvantages of closed attraction since the beginning of the pandemic, and now obviously we have discussed the non-invasive method of different management of patients, and finally the mechanical method.
Latin America is a good grower for us, double digits. We are very satisfied with the work done there. In fact, the Asia-Pacific region has always been strong. We encountered some access and conversion issues during the pandemic in Japan and Australia, and have actually been blocked for about 200 days. So it has affected some growth, but we still think it is a stable median single-digit organic grower. Then it is obvious that what we are trying to do is to have the same success as our meeting with NeoMed and CORTRAK in the United States and to promote it internationally. And I do think that as we enter 2022, and even more so, after the pandemic, if you will, things will improve.
Rick Wise - Stifel - Analyst
Thank you. The next question comes from Drew Ranieri from Morgan Stanley. please continue.
Drew Ranieri-Morgan Stanley-Analyst
Hi Joe, Michael. Thank you for your question. Maybe it's just to Michael first. You talked about the generation of free cash flow in our meeting and through this conference call, but I just want to better understand the company’s capabilities. I think in our meeting, you mentioned that the third quarter may be a representative of future free cash flow. I mean are you still looking forward to it? But maybe just update your working capital, anything, free cash flow more broadly.
Michael Greiner - Senior Vice President and Chief Financial Officer
Yes. So, as Joe mentioned in the prepared comments, we do expect another positive free cash flow quarter in the fourth quarter. This year we have some one-time cash items, which will be cleared. We expect that the conversion rate of free cash flow will be very good in the future, which is mainly due to improved operations, Drew. We have done a lot of work on accounts receivable and inventory. Of course, there is still some working capital increase, between 10 million and 15 million US dollars.
But we will see that most of the future generation is, a. These one-time costs are in the law, SAP implementation, and other projects that we have internally, and are now in the rearview mirror, so we will have a cash flow generated from operations. Much cleaner, and then the opportunities for working capital will improve throughout 2022. But the more important part is just the consistent execution of our operating results.
Drew Ranieri-Morgan Stanley-Analyst
understood. Then as far as SG&A is concerned, you talked about it before the sales volume fell below 40%. But I mean where do you reduce spending? I mean, will you sacrifice any future growth opportunities in 2022 and beyond? But-want more colors.
Joseph F. Woody - Chief Executive Officer
Let me give some qualitative, and then jump when you want. But we have clearly learned that some marketing initiatives need to return, and some do. Then we have things like short-term incentives, and we need to increase some people in the business. But in general, we still have some smaller ones. If you want, we can do some structural things in our channels, where we can help. So we are committed to less than 40%. Michael, you might want to add?
Michael Greiner - Senior Vice President and Chief Financial Officer
Yes. Drew, the only thing I want to add is last year's COVID. Everyone must look at their SG&A and R&D, and then say, what is meaningful and what is unreasonable? But also make sure that, as far as you are concerned, we will not cut ourselves for future investments. Then just like us-so we got some new discipline in 2020, which I think is overall healthy. As we enter 2021, we definitely expect the overall SG&A USD to increase from 2020, but in the end we encountered these gross margin headwinds.
So we want to solve this problem. Therefore, the disciplines that we started around our views on SG&A in 2020 will continue until 2021. So we are very deliberate about what aspects can we cut. From the perspective of backfilling, what talents can we reduce, and think about some of our talents in a different way. What roles must we eventually change, and what roles can we delay? In Joe's opinion, which project revolves around the marketing plan?
Therefore, we believe that we have not done anything that will affect our 2022 or forward. According to some of the plans we withdrew during 2021, perhaps the R&D work here and there has been delayed by a quarter. But it doesn't make any sense to our final income situation or our profit margin situation.
Drew Ranieri-Morgan Stanley-Analyst
understood. Then there is the gross margin in 2022, so I heard you speak loudly and clearly about the step size of about 400 basis points in the fourth quarter. So we should consider, for 2022, should the whole year be better than the fourth quarter?
Michael Greiner - Senior Vice President and Chief Financial Officer
Yes. I don’t know how much this will make sense, Drew, but it should be in the north of our fourth quarter, of course, throughout the year, yes.
Drew Ranieri-Morgan Stanley-Analyst
understood. Thank you for answering the question.
Thank you. [Operator Instructions] The next question comes from Chris Cooley from Stephens. please continue.
Chris Cooley-Stephens-Analyst
Good morning, thank you for your question. If you can help me-it's just that I am a bit confused about some of the top-line related comments, and I hope you can help us overcome these offsetting forces. Therefore, we have clearly seen the reiteration of the top line in the company guidelines, and you commented on two different backlog areas that are accelerating and are expected to continue to accelerate in the second half of the calendar year and until we enter the early 2022 calendar .
So I think I want to make sure that I fully understand the message here is that you said that the basic business of these two main product lines is really, do you see that type of acceleration to offset your backlog, see growth? I just want to make sure that I can convey the information correctly. Then, as a supplement, can you help us better understand the reasons that really limit your ability to solve problems in the first half of next year-or should I say, before the first quarter of next year?
Joseph F. Woody - Chief Executive Officer
Yes, Chris, you are right, we think we will solve most of the problems in the first quarter of next year. Once again, from my point of view, Michael can give you his, which is unpredictable, such as Australia or Japan, or we are talking about Europe, the Middle East and Africa, or elective courses are restored in our hospital environment How fast is the focus on ON-Q gives us a little uncertainty. But again, we had a strong start in October.
We can easily do better instead of queuing here. But what we have seen in the pandemic is that many different things can happen. But you are already-you are thinking about it in the right way. The backlog is improving. We can improve our position from the backlog. So I don’t want to be too confusing or, as I said earlier, too alarmist, but it’s worth mentioning when we are in a pandemic. Michael, do you want to add?
Michael Greiner - Senior Vice President and Chief Financial Officer
Yes. Chris, I think your point about the signal we are sending is that natural needs exist. Even with these delayed orders, we are still confident of the steady performance in the fourth quarter, but this also shows that the supply chain environment is still disrupted. Take Game Ready as an example. The reason why we have a backlog is actually because one component is included in the entire product of many components. So these are-this is what we are trying to signal and make connections is, hey, strong demand, that's good.
These supply chain availability issues still exist. If we can solve these problems as soon as possible, as far as Joe is concerned, we have a further advantage. We are just-we search around the world like everyone else, trying to find some of the raw material input. Sometimes we get lucky in a given week. Sometimes, we just don't have the same level of success.
Chris Cooley-Stephens-Analyst
Understood. Appreciate the colors there. If I can do another quick follow-up here, maybe it's similar in nature. Obviously, you talked about very strong continuous growth in gross margins. Most of the boost is within your direct control, but we still have higher inflation costs. I really didn’t see the shipping cost drop as much as we saw in the channel. When you consider these COVID-related costs and the transformation of these related inputs, I am curious whether these are now becoming more structured in your mind, so you actually get better operating leverage?
Do you implicitly say that as we enter the fourth quarter, these headwinds weaken, we will return to a more normalized environment in the first quarter, you can contract with lower freight rates in the spot market, and we also see inflationary pressures Decline regarding raw materials and labor.
Michael Greiner - Senior Vice President and Chief Financial Officer
Yes. I think-I will connect it to another issue related to the exit rate in the fourth quarter, and where we think we can bring the gross margin to 2022. The reason we are cautious about any meaningful upcall is the 2022 trend for the factors you are identifying. Therefore, inflationary pressures still exist, and some of these freight cost pressures still exist. Before we see that these listings have better visibility, our improvement in gross profit margin will be limited.
Most importantly, as we said before, if we return to a more normalized revenue environment, this will also help our gross margin, because some of our larger-selling products have a positive blend of ingredients. So these are two factors that we don't know yet. So that's why we don't say, hey, 59% and 58.5% in 2022, because these factors must be improved to become a reality. But we also know that in terms of embedded dialogue, our gross profit margin is not 52% or 53%, right?
This is where we are fighting now. We will enter a more normal state in the fourth quarter and early next year. Then with the improvement of these other factors, we will return to the high level of 50% again outside of mergers and acquisitions.
Chris Cooley-Stephens-Analyst
Thank you. We have a follow-up question from Matthew Mishan of KeyBanc. please continue.
Matthew Mishan - KeyBanc - Analyst
Michael, just a quick follow-up of free cash flow. I think that before, you have stated that you hope to get $70 million or $80 million in free cash flow this year. As far as the Ministry of Justice and tax refunds are concerned, it seems that most of the motions have been resolved for you. How should we view the fourth quarter and the situation related to increasing free cash flow?
Michael Greiner - Senior Vice President and Chief Financial Officer
Yes. great. So in the fourth quarter, Matt, returning to the previous question, should give people a good feeling-assuming we execute after October 31st, it should give people a good feeling, well, What a standardized free cash flow looks like. We should generate about $15 million in free cash flow in the fourth quarter, mainly due to operations, but there are also slightly better working capital management. So we should have a good fourth quarter. I am not saying that this is the best thing we can do. I think this has upside potential, but it should give you a good feeling about our free cash flow conversion.
Matthew Mishan - KeyBanc - Analyst
Ladies and gentlemen, this concludes our Q&A session. I want to turn the meeting back to Joe Woody's closing remarks. Thank you, and then leave it to you, sir.
Joseph F. Woody - Chief Executive Officer
I want to thank you all for your interest in Avanos. We feel that we continue to perform well in a very uncertain environment. We are committed to creating value for shareholders, and I believe that our detailed priorities combined with our leading portfolio in an attractive market, we are indeed prepared for growth and profit margin expansion as well as positive free cash flow As we leave 2021 into 2022. In other words, Michael will be attending the upcoming Berenberg meeting, and we will all be attending the Stifel meeting, and look forward to having more conversations with everyone there. Thank you and have a nice day.
Scott Galovan - Vice President of Corporate Strategy and Business Development
Joseph F. Woody - Chief Executive Officer
Michael Greiner - Senior Vice President and Chief Financial Officer
Matthew Mishan - KeyBanc - Analyst
Ravi Misra - Berenberg - Analyst
Rick Wise - Stifel - Analyst
Drew Ranieri-Morgan Stanley-Analyst
Chris Cooley-Stephens-Analyst
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