Owens & Minor Inc (OMI) 2014 Q3 法說會逐字稿

Good morning ladies and gentlemen and welcome to the Owens & Minor's third-quarter 2014 financial results call. My name is Stephanie and I will be our operator for today.

(Operator Instructions).

As a reminder this conference is being recorded for replay purposes. I would now like to turn the presentation over to the host for today's call, Mr. James Bierman, President and Chief Executive Officer of Owens & Minor. Please proceed sir.

Good morning everyone. Welcome to the Owens & Minor third-quarter 2014 conference call. With me this morning are Randy Meier, our Chief Financial Officer, and Grace den Hartog, our General Counsel.

This morning Randy will review our financial results and I will then provide some observations on the market and our strategies. But before we begin Trudi Allcott will read a Safe Harbor statement. Trudi?

Thank you Jim. Our comments today will be focused on financial results for the third quarter of 2014. Which are included in our press release.

In our discussions today we will reference certain non-GAAP financial measures. Information about these measures and reconciliations to GAAP financial measures are included in our press release and in the third quarter supplemental slide presentation, both of which are posted on our website. Also our call today will be archived on our website.

In the course of our discussions today we may make forward-looking statements. These statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Please see our press release and our SEC filings for a full discussion of these risk factors.

Finally, we will be participating in the following investor events in the fourth quarter; The 2014 Credit Suisse Healthcare Conference on November 12, and we will host our annual investor day on Friday, December 5, in New York starting at 8 o'clock in the morning. We look for to seeing you at these events.

Thank you. Jim?

Thanks Trudi. I would like to call now on Randy Meier for his presentation of the financial results. Randy?

Thank you Jim, and good morning everyone. I will begin with a review of the third quarter financial results and then provide an update on the international segment.

First let's look at revenues. For the third quarter consolidated revenues improved 5% to $2.39 billion compared to the same period last year. Consolidated revenues benefited from improvement in both segments, including 4% growth in our domestic segment due primarily to our large provider customers as well as 31% growth in the international segment. Generally speaking about 2/3 of the international segment revenues are derived from fee-for-service businesses.

In looking at consolidated gross margin, we reported $292.5 million for the third quarter or 12.26% of net revenues. This quarter-over-quarter improvement was driven by a $14.5 million increase in the international segment gross margins derived from higher fee-for-service business. Gross margins in the domestic segment benefited from manufacturer product price changes and increased sales volume.

As for operating expenses, consolidated quarterly SG&A expenses were $231 million, or 9.7% of revenues. This $20 million increase over the prior year was driven by expenses associated with serving greater fee-for-service activity in the international segment. In the domestic segment, expenses were higher due to the increased sales volume and legal fees.

Adjusted quarterly operating earnings were $49.3 million, or 2.07% of revenue. This excludes pretax acquisition-related charges of $4.6 million and exit and realignment costs of $9.3 million resulting from the actions taken to support a strategic initiative in the US and in Europe.

On a segment basis, quarterly domestic operating earnings were virtually unchanged when compared to the same period last year. As for the international segment, we reported a quarterly operating loss of $1.5 million due to the factors we have discussed.

On a sequential basis, we are seeing improvement as we effectively cut operating losses by 50% in the third quarter when compared sequentially to the second quarter. While the European platform is improving as a whole, we're also making gains in the UK with the leadership of our Owens & Minor team in Europe, the UK division has made great strides in stabilizing their largest customer and lowering the cost to serve this business.

As we said last quarter, we will continue to focus on integration, stabilization, and overall cost control in Europe. On a positive note, excluding the results of the UK division, O&M Europe was once again profitable for both the quarter and the year to date.

During the quarter the exit and realignment charges in Europe reflect steps taken to flatten and simplify the organizational structure, including closing certain underperforming facilities, preparing for system implementation, and other standardization activities. With a more simplified management structure and improved cost structure and productivity initiatives, we believe we are positioning the platform to achieve sustainable profitability.

As we have said before we intend to leverage the Owens & Minor Europe platform for the expansion of our business overseas. The OM Europe leadership team is charged with overseeing operations, ensuring brand consistency, and establishing a greater presence for us in Europe.

Now turning back to the consolidated results. In September we issued $550 million in new senior notes. Subsequently in October we used approximately $446 million of the net proceeds to fund the early retirement of the $200 million senior notes and to complete the medical action acquisition.

During the quarter we also amended our existing credit agreement, increasing the borrowing capacity to $450 million and extending the term to 2019. These actions have repositioned our balance sheet for the long-term, put attractive fixed-rate financing in place, and increased our flexibility.

As a result of the recapitalization, our interest expense was approximately $900,000 higher for the quarter compared to last year. This expense reduced adjusted net income by approximately $0.01 per diluted share.

Our effective tax rate was 55.8% for the quarter, primarily due to the impact of the international segment, exit and realignment costs on foreign taxes, as well as certain nondeductible acquisition expenses. The increase in quarterly tax rate reduced adjusted net income by about $0.01 per diluted share. For the full-year we are targeting an effective tax rate of approximately 44%.

Operating cash flow for the year-to-date period was $81 million as we funded working capital needs to support strong revenue growth and use cash for acquisition-related and exit and realignment activities. And on a consolidated basis asset management metrics were solid. Inventory turns were 10, reflecting the impact of bringing on significant new domestic customers, and DSO was 21.8 days.

Turning to the bottom line, third quarter adjusted net income was $26.5 million or $0.42 per diluted share, compared with $0.47 per share for the third quarter last year. For the year-to-date, adjusted net income was $79.2 million or $1.26 per diluted share compared with $1.37 for the same period last year.

Regarding the outlook for the fourth quarter, given the number of variables and the timing of the acquisitions, we thought it prudent to wait until Investor Day to provide more visibility on this year along with guidance for 2015. In the meantime let me share some observations about the fourth quarter.

We expect to see continued sequential topline growth and improvement in the international segment operating results. As you may recall, the fourth quarter is typically our strongest due to the variety of factors such as supplier incentives and year-end product price changes.

As we mentioned previously, the full-year tax rate is expected to be approximately 44% for the year, and we will see a full quarter's impact on the interest expense from the new senior notes. We do not expect a significant impact to our adjusted earnings from the two acquisitions given the onboarding efforts and only a partial period contribution.

With that, I want to thank you, and let me turn the call back over to Jim.

Thank you, Randy. Before we turn to the question and answer portion of this call, I would like to share some thoughts on the healthcare market trends and some of the evolution of our strategy. We continue to see the large provider customers dominate the market, and we believe we will continue to see them grow in part through affiliation and consolidation.

We believe that our strategic focus on these large provider customers is being validated, as that is where we see our strongest growth. Likewise, in the healthcare manufacturing sector, we're also seeing what appears to be an uptick in the pace and size of consolidations, as the larger more dominant companies are growing through acquisitions. The BD CareFusion transaction announced this quarter is an example of this trend, as is the Medtronic Covidien deal announced earlier this year.

Some of the same forces driving provider consolidation are also driving manufacturer consolidation. We believe many of the benefits we have seen on the provider side will also be realized by these consolidating manufacturers.

These consolidations will drive efficiencies in the market and will give us the opportunity to expand our service offerings to these customers. Our strategy of partnering with the leading providers is also true of our manufacturer customers, as we play a critical role in their supply chain.

Just as we have worked with providers to develop efficiencies and bring innovation to healthcare logistics, we will do the same for our manufacturing customers, with whom we had strong relationships for many years. After all, we are unique among logistics providers in that we are focused solely on healthcare.

Now turning to our strategic development, we are very pleased with the strong topline growth. We have not seen these growth rates at this level in several years, as healthcare utilization has been a slow to rebound from the financial downturn. We believe healthcare is benefiting from the general improvement in economic conditions.

We see several factors behind our revenue growth rates but think the most significant is our strategic approach to the market. Which, as I just mentioned, is our focus as a pure-play healthcare logistics service provider.

We believe this approach was validated by our new relationship with a large for-profit healthcare system. This provider customer is a strategic one where we believe we can leverage our cost structure in the future as the business grows.

Also since we last spoke with you last quarter, we have completed one strategically important acquisition and signed a purchase agreement with another.

First we closed the Medical Action transaction on October 1. As we have said, Medical Action is a well-known established kitting company that provides custom surgical kits and minor procedure kits and trays to the healthcare industry. Post-closing, our teams immediately began the work of integrating this business.

We are maintaining their two warehousing and production facilities, one in North Carolina and one in Virginia. We will be closing the Medical Action headquarters in New York once we have worked through the transition process over the coming months.

This transaction is a strong complement to our strategy of connecting the world of medical products to the point of care. We see promise in offering this service to both our provider and manufacturer customers.

Likewise, we intend to consummate the previously announced ArcRoyal transaction in the fourth quarter. While this is a smaller deal, the company has a solid market position in Europe and strong customer relationships.

ArcRoyal, with channels into 30 countries in Europe, salutes our manufacturer service offerings and complements our existing business in Europe. We are pleased that we will now have kitting capabilities in both the US and European markets.

Once we close this transaction, the integration process will begin. OM Europe will take the lead in overseeing ArcRoyal and we look forward to welcoming the ArcRoyal team to Owens & Minor.

Together these unitized delivery services represent an important expansion of our service capabilities in the market. We believe these kitting services will provide value to provider and manufacturer customers alike.

Looking ahead, please keep in mind that the transactions are fourth-quarter events. Therefore we do not expect a material contribution to our results from the two acquisitions this year.

I would be remiss if I did not comment upon our performance for the quarter relative to our expectations when we last spoke with you at the end of the second quarter. All in all our financial results this quarter were $0.05 less than our targeted amount. The shortfall was approximately $0.01 in the domestic segment and $0.04 in the international segment.

The variance for the domestic segment is due primarily to the impact and timing of the recapitalization of our balance sheet. During September, we had a window of opportunity to capture advantageous interest rates for our new senior notes and decided to move forward. As a result of the recapitalization you should expect an increase in the associated interest expense.

And in the international segment, we were approximately $0.04 behind our targeted amount. We had hoped to achieve a faster turnaround in the UK. We took aggressive action to bring costs in line and we continue to make progress.

Finally, one aspect of the quarterly shortfall was the increase in the foreign tax rate. Due to the impact of the exit and realignment charges. As Randy has said, despite all of this activity, we were able to reduce the international operating loss when compared to the second quarter.

So as we look at the big picture, and our accomplishments during the first three quarters of 2014, we see that the third quarter was marked by several significant milestones. We reported strong revenue growth in both segments. We have worked through the onboarding of a large for-profit domestic healthcare system.

We have two acquisitions in the works that will give us market share in kitting, a platform for growth, and a new service offering. We made significant progress in realigning our networks both here and abroad and we recapitalized our balance sheet.

Thank you. We would be happy to take your questions. Stephanie?

(Operator Instructions)

Robert Jones, Goldman Sachs.

Good morning guys, it's actually Stephan filling in for Bob. I just wondered if you could touch on the 2014 guidance. It sounds like you're not at the position to give an update today. Just given the two acquisitions. I guess what about the acquisitions makes it so hard to predict what the quarter will turn out to be, given two months left in the quarter?

Hi Stephan, this is Randy. I think we have got a very good handle on what we're doing in terms of the execution of the integration and the prospective timing of the close. However some of the specifics and the timing of when we take those costs and charges are still a little bit up in the air relative to just the 30 days that we've got under our belt. So we just felt that putting off the specific guidance and clarity around year-end results and into next year, we could give you a little bit better color in about another six weeks or so. That's why we thought it would be prudent for us to just give you this guidance.

Great. And just on utilization, we've seen providers report a pickup in volumes and you guys have been pretty clear that ACA is not factored in to this year's outlook. Could you give some update on what you're seeing there and how long you think it usually takes before you start seeing any benefit?

I think as we referred to, we were pleased to see another quarter of continued growth domestically. The components of that growth though, I think are a little more complex than just pointing to the Affordable Care Act. I think there is an impact and I think as time evolves there will be studies to validate that increased access to the market, healthcare services, is a component of the growth.

But I think there is also a component due to an improving economy. I think there is a component that is due to the fact that healthcare demand was pent up for a period of time and that you can defer elective procedures for a period of time but eventually you tend to move towards having those procedures done. I think there is a combination of things that are driving the improvement that we've seen. I think the more challenging issue is the sustainability of that. We look forward to having some discourse with all of you and sharing our views at Investor Day as to how we factor what we've seen this year into our outlook for 2015.

Great, thanks for the questions.

Thank you. Robert Willoughby, Bank of America.

Hi Jim, you mentioned that the manufacturer consolidation may present some incremental opportunities for you. Can you educate me on that? I'm not sure I necessarily follow the logic why the opportunities are better than where they have been before.

Absolutely Robert. What we have seen over a period of time -- and we have chatted about this with you and your colleagues in the past -- is an increase in the interest in large manufacturers in looking at new ways of approaching their supply chain. The motivation obviously is that they are getting compressed on margin, some even domestically are seeing flat topline growth. They are looking now more aggressively at a cost structure in different ways to address that. Although we have seen a pickup in the interest and discussions and the acknowledgment that we have capabilities that can help, we have stopped short of actually seeing a catalyst for change.

And I think as we reflect on what's going on, and particularly as we compare it to what we saw on the provider side, that this consolidation play could really create a situation where there is now a catalyst for change. I think intellectually we have answered the question and demonstrated the benefit. Now we're at a point, a tipping point, where there needs to be a motivation to make that move. I'm thinking in some instances that the consolidation or the prospects of consolidation will cause some of the manufacturers maybe to move a little quicker.

I'm not sure, I guess I wouldn't argue with that. Have you had dialogues with any of the major players that are in process here? Anything you can point to? And if so, how quickly could something flow through the model? I would assume this takes a great deal of time.

Without going farther than maybe my colleagues would be comfortable -- I would say yes we have had conversations with a broad array of major manufacturers in the marketplace. I think the interest in our offering is significant. Again when you compare us to the domestic competitors who are basically manufacturers who distribute as a way to expand their channel, we offer a non-threatening alternative to the manufacturer community and we think, and have heard that, that has significant appeal.

In terms of how quickly amounts when a transaction is reached can actually flow through our results, that's pretty hypothetical. We would need to know exactly what the service and the opportunity is -- size and scale -- to estimate that. But as more and more of these particularly physician preference type manufacturers look seriously at their supply chains, there is going to be more pressure to make changes and improvements quicker, and we feel very comfortable with the infrastructure that we've built to help accomplish that.

That's helpful. And maybe lastly, just how are you positioned with the Kimberly-Clark spin? I assume you are a distribution partner for them. Do you anticipate that relationship changing in any way, shape, or form?

Kimberly-Clark has been a longtime customer of Owens & Minor and we are excited about continuing our relationship with the old Kimberly-Clark and expanding our relationship with Halyard. I think, again, we provide a great opportunity for Kimberly-Clark to efficiently get their product into the marketplace. The transaction with Medical Action is an example of expanding our capabilities to service customers exactly like Kimberly-Clark to get their product in a unitized fashion, packaged and delivered within the four walls of a hospital.

That's great. Thank you.

Thank you. Lisa Gill, JPMorgan.

Thanks very much. First, the question for you Randy. If I look at the tax rate for the year I think you're guiding to 44%, thus far it's been about 40% as we exit the third quarter. What is going to be the big driver in the fourth quarter of the tax rate?

Hi Lisa, how are you? Great question. If you look at the accumulated exit and realignment cost, particularly with some of the actions that we took in Europe, that's really what is driving the increase in tax rate. Once we get these costs behind us we should continue to see a drop-down to what our historical tax rate has been. But the increase from the first half of the year to the second half of the year is being primarily driven by the significant exit and realignment costs from Europe.

Great. And then Jim, you talked about domestic revenue up 4%, the best you've seen a long time. And primarily growth from large healthcare providers. Can you help us dissect the growth between the large healthcare providers in your book of business versus the small guys? Is it that they're going twice as fast? Is it only marginally faster? Would be my first question.

Then secondly your margins were flat year-over-year. Can you talk about the margin differential between the two, and what you're seeing as far as what they are buying and the opportunity for once you get the kitting business, some of those opportunities and some of these larger customers?

Yes, Lisa. You have got a lot going on in that question. Let me try taking parts of it. In terms of the percentage growth, I'm struggling a little bit with the math side of it. I think we are seeing -- and we have seen this and we've talked about this. We are seeing a continual shift decrease in business with small hospital systems. And some of that is because those systems are being acquired by larger systems. The impact within our results, I would say, is significant.

I don't have the math as to whether or not it's a 10%, 5%, 4% shift. In the smaller customers but it is a significant trend. It leads to the essence though of the second part of your question, which is what is the impact on margin? If you look just at the gross margin, the impact of a trend shift is negative. And I think we have acknowledged that before and that is intuitive on at least the surface level.

What we have also talked about, and I think it harkens back to our conversation at Investor Day a year ago, is the fact that the breadth of the services we can offer -- incremental services -- really are focused at the larger systems. And so even though the baseline offering may be at a lesser margin, when you look at the totality of the service offerings we should be able to close that gap. That being said we have seen certain instances and trends of strata of our customers where that thesis is absolutely playing out.

That mix shift though has been a challenge, quite candidly, in 2014. I think as we sit here now at the end of nine months -- and this is a qualitative observation, we expected a more robust gross margin situation for 2014 domestically then we have been seeing. Now we will talk further about this at Investor Day in December when we talk about 2015.

The last point I would make on this, and again, I think you know this well, but for others on the call, is that the thesis has always been that it is a more efficient delivery system and warehousing system for the larger customers than there is for the smaller customers. Not the least of which is that there is a greater tendency for standardization of the products that are available to a large hospital system. We believe at the operating margin line we should continue to see improvement with this migration. But we will have to work through it and there are some trends and some anomalies that we've seen that we should chat about in a broader context when we get together at Investor Day.

And I appreciate that. I will have questions at the investor day as we think about how to think about the margins going into 2015. I appreciate the commentary.

Very good.

Thank you. Sean Dodge, Jefferies.

Good morning. Thanks for taking the questions. With the international revenue being up almost $6 million sequentially, can you give us a sense of how much of that was a result of your stabilization efforts and how much came from the ramping of the three new clients? And then are those three new clients fully ramped now or should we expect some incremental contribution from them in the fourth quarter?

Hi Sean, this is Randy. I think you have got a couple of questions there. These are customers that we have been in the process of preparing to onboard for some time so we were fairly aware of them before hand. Each of the three started being onboarded at various times throughout the third quarter so we will probably still see some incremental run in the fourth quarter. But all three of the customers are onboarded and doing nicely.

These three customers are over in what we would characterize more specifically as Continental Europe, so again, already contributing to the already profitable segment of our business over there. Again, we would expect to see some continued growth. We don't have as much onboarding in the fourth quarter, so I would not expect to see as significant an uptick as we did in the third quarter. But again I think as we get into Investor Day we will give a little bit more clarity around where we are positioning Europe for the remainder of this year and into next.

Great, thanks, and my last one. With crude oil prices where they are at now, what kind of bearing if any does that have on product price increases over the coming year?

That's a great question. Historically we've seen, in a rising price environment we've seen the manufacturer market react pretty quickly. We haven't really seen an environment where there have been decreases in pricing in the commodity costs, and therefore a corresponding quick decrease in pricing. I think to a large degree the manufacturers have held back on in the past several years of increasing pricing and therefore the margins have been squeezed. One might speculate that the decreases may be relatively sticky as they come, but we will wait and see that play out. Great question though.

Very good. Thanks again.

Thank you. David Larsen, Leerink.

Hi, could you talk about what the costs were to bring on those large clients in the quarter, and I'm assuming those costs landed in SG&A? Is that correct?

Sure. I think when we've typically seen onboarding of customers usually we take on some incremental costs in our distribution centers ahead of that to prepare for those customers. There is both -- and then we also take on some incremental inventory as well ahead of that and then that begins to work itself through. We will continue to see some costs as we continue to onboard some of these customers through the end of the year. Over in Europe with of the onboarding of customers we have the same phenomena where there is cost incurred ahead of the onboarding just to prepare facilities and do some things. We don't incur inventory costs over there because predominantly that's a 3PL situation where we're not having exposure to inventory costs. Most of that related to the three customers that we've on-boarded is behind us, but again as we take on new customers we would expect to see some of that.

So those costs should alleviate somewhat going forward? Those costs tied to those three customers, which should help the international margin, is that correct?

That would be correct.

Okay great.

Domestically I think the essence of your question is absolutely correct, that -- and we have said during the course of the year, we have carried excess capacity, if you think of it that way, with anticipation of onboarding this very significant for-profit customer in the United States. And so as we move forward I think we will see a more efficient optimal kind of a structure but there won't be dramatic costs that are eliminated from the system. I think the better way to think about it is we have been carrying somewhat of a suboptimal cost structure during the course of the year in anticipation of the transition that occurred in the third quarter.

So I think you closed the Stuttgart office and there's been some staff realignment in the international division. Some margin of that, I'm assuming, will improve consistent with the comments you just made, right James?

We have done a variety of things in Europe which included the shutting of the Stuttgart office and a number of facility closures, and some headcount rationalization and a dramatic change in senior management. And we should begin to see the full impact of that as you go into the latter half of the fourth quarter. Which again is part of the reason that we are looking out at guidance, we are going to give you some updates at Investor Day related to the full year.

Okay. And quickly, on the tax rate in order to get to a 44% adjusted rate I'm looking at a 54% tax rate in the fourth quarter, is that consistent with your internal plan?

That's what we I think captured in our comments, the prepared comments, the quarter was I think 53.8%, so you're right on the money at 54%.

Okay. And my last question, could you maybe talk a little bit about the ArcRoyal acquisition and what sort of topline impact there will be towards your business? And also Medical Action, will that be a positive earnings contributor in the fourth quarter or will that ramp in the first half of 2015? Thanks, and I will stop there.

We're not sharing the ArcRoyal amount at this time. It is a private company and we think that it needs to be better understood within the context of how we and everyone thinks about next year. Medical Action business as we said in our prepared remarks both ArcRoyal and Medical Action combined because of the timing and getting things ramped up, we would not expect it to have a material contribution to the fourth quarter.

I did want to add one thing. The 53.8% was a third-quarter number. We are expecting the full-year number to be 44%, just to create some clarity there, I did not want to confuse people with that.

Okay. The 53.8% was not an adjusted tax amount, is that correct?

That's correct.

Okay. So the 44% is not an adjusted tax percent amount? That's more of a GAAP, is that correct?

That is a GAAP number.

Great, thank you.

Thank you.

(Operator Instructions)

Steven Valiquette, UBS.

Thanks. Good morning. I apologize if I missed this, but of the roughly $75 million sequential uptick in the domestic revenues in the third quarter, is there any color on how much of that came from the one big new publicly traded customer in the segment whose name we're not supposed to mention contributed to that increase? I'm guessing they're probably most of the sequential increase, is that a safe assumption to make without having to quantify it?

No. I don't think that's true. I think it was a nice component but I would not say it was most. To be honest I don't think we're comfortable going any further in parsing that. I think the opening comments talked about good solid growth in the core aspect of our customer base. And that was really the driver for what we saw in the market.

Okay that's fair. And just for the 3PL business, I think asked this question a couple of quarters ago. But I was wondering if you could remind us again what the long-term expectations are for EBIT margins in the 3PL business? And let me just say that obviously you seem to be winning a lot of new contracts and I am taking a step back and wondering is there any chance you are maybe being perhaps a touch aggressive on price to win some new revenues and new customers and as you are getting further into the weeds in this segment maybe it's just not as profitable as you had hoped for. I'm just trying to triangulate a lot of contract wins and a lot of topline growth but still red ink on the bottom line.

Yes Steve it's a great question. I think we are still very comfortable long-term with the broader franchise and what we are doing in Europe. We continue to see strength in continental Europe as we win new business and as we've indicated that broader part of the business continues to be profitable.

We are really working through the specifics with a single customer right now. And that single customer we're in the process of renegotiating our agreement with them. We're going to -- it is going to be fairly binary. We are either going to end up with a profitable sustainable situation with them or we're going to figure out a way to exit the transaction in a reasonable fashion.

Outside of that we continue to see pretty good interest out there, a fair amount of activity. I think Jim's comments related to what's going on in the manufacturing side with consolidation, the manufacturing side struggling with new product introductions, as well as pricing and their own cost structure, all as providing tremendous opportunity for our manufacturing-facing activities and that includes the opportunity in Europe as well. So we continue to be positive about our ability to win contracts that will be profitable going forward.

We've never given any operating margin guidance and certainly as we move in towards Investor Day that is a topic we will begin to look at in terms of what the outlook is for next year. So I guess the answer to that would be stay tuned for Investor Day.

Okay got it. Thank you.

There are no further questions at this time. I will now turn the conference back over to Mr. Bierman for closing remarks.

Thank you everyone for your time today and we look forward to seeing everyone at our Investor Day in December. Thank you very much.