Patterson Companies Inc (PDCO) 2004 Q1 法說會逐字稿

Good morning, ladies and gentlemen, and thank you for standing by. Welcome to the Patterson Dental first-quarter fiscal 2004 earnings conference call. (OPERATOR INSTRUCTIONS). I would now like to turn the conference over to Mr. Peter Frechette, Chairman and Chief Executive Officer of Patterson Dental Company.

Thank you. Good morning and thank you for participating in our first-quarter conference call. With me today is Steve Armstrong, our Executive Vice President and CFO, who will review some highlights from our first-quarter results following my opening comments. At the conclusion of Steve's comments, we will be happy to take any of your questions.

Regulation FD prohibits us from providing investors with any earnings guidance unless we release that information simultaneously. For that reason, we have included financial guidance in our earnings release, but it's important to understand that Patterson's actual results may vary from our forecast. The guidance is subject to a number of risks and uncertainties which are discussed in detail in our annual report on form 10-K. And sense that information forms the context of what we will discuss today, we are here to review this material.

Turning now to our recent performance, Patterson reported solid operating results in this year's first-quarter. Consolidated sales rose 12 percent to 433.3 million, while income before change in accounting for goodwill that was adopted last year increased 17 percent to 29.4 million or 43 cents per diluted share. Acquisitions had a negligible impact on the first-quarter sales growth. North American dental sales rose 9 percent, while sales of our Veterinary Supply unit climbed 31 percent. If you exclude the impact of a significant pharmaceutical distribution agreement, the core business of our Veterinary unit increased by approximately 8 percent making a very solid performance by this operation. All in all Patterson has continued to perform at a high-level, and we are very optimistic about our prospects over the balance of fiscal 2003.

In the next couple of minutes, I would like to discuss two aspects of our operating results that affected our first-quarter earnings. First, Patterson's consolidated gross margin declined to 33.4 percent due primarily to a shift in the sales mix as a result of a Webster distribution agreement I just mentioned. While it provided substantial growth in revenue, the lower margins on the pharmaceutical product covered by this distribution agreement reduced Webster's gross margin rate which in turn affected Patterson's consolidated margin.

Second, sales of dental consumables which grew at 5 percent the first quarter also affected our first-quarter results. We believe that our consumables sales growth will accelerate in response to several initiatives which we are now implementing. Most importantly, we are expanding our territory salesforce. This clearly shows us that our consumer sales growth and market share gained share gains are closely related to increases in our territory salesforce. We have added considerable numbers of sales personnel in the past, but many of these additions have are in the common areas of equipment and technology sales.

During this period of time, it has been our strategy to deploy our resources in a way that would enable Patterson to strengthen its industry-leading position in the growing dental equipment market. We have amply succeeded in this undertaking with Patterson's equipment sales now being more than double those of our nearest competitor. As we placed our equipment business on a strong growth footing, we now intend to further strengthen our consumables. We are currently hiring and training additional new territory sales reps, and we expect to realize the initial positive impact from this initiative during our fiscal fourth-quarter.

In addition, we will be rolling out important new sales and marketing programs later this quarter where they are expected to have a positive impact on consumables sales growth going forward. We are designing and implementing new programs to revise advanced training to more experienced sales personnel as well as new tools and programs for our expanding business with existing customers and developing new customers.

I will close out my remarks by reviewing our financial guidance. For the second quarter of fiscal 2004 ended October 25th, we are forecasting earnings of 46 to 48 cents per diluted share. This forecast does not include an estimated contribution from AbilityOne Products Corporation, whose acquisition we announced earlier this week. AbilityOne's earnings contribution will depend upon the date this acquisition is completed in the second quarter, the pricing of the debt that will finance the transaction and the amount of intangible amortization. We intend to provide guidance on AbilityOne's estimated contribution to Patterson's consolidated second quarter and fiscal 2004 earnings at the time we announce the completion of this transaction.

We are generally excited about the opportunity presented by AbilityOne, which is the nation's leading distributor of products for large physical and occupational therapy markets. The acquisition of this growing strongly profitable well-managed company is a logical extension of our value-added specialty distribution strategy. We believe the addition of AbilityOne to our business mix will generate value for our shareholders going forward.

Now I will ask Steve Armstrong to discuss our first-quarter operating results in some greater detail.

Thank you, Pete. I will start off my remarks with just a couple of words about the improved operating leverage we recorded in this year's first-quarter. The expense ratio of our dental operation improved to 24.7 percent from 25.5 a year earlier, while the (technical difficulty) -- expense ratio strengthened to 12.7 percent from 16.1 percent last year. Reflecting these improvements, Patterson's consolidated expense ratio strengthened by 130 basis points in the first-quarter.

A couple of factors contributing to the improvement of our dental operation were continued operating leverage from the infrastructure acquired through last year's Thompson Dental transaction and the investment in our hard work and networking initiative. The improved expense ratio at out Veterinary operation resulted primarily from the increased sales volume under the distribution agreement Pete mentioned earlier. Earnings to operating margins, the dental margin improved 50 basis points from the year earlier period to 10.8 percent. The veterinary operating margins declined to 7.8 percent from 8.2 last year. Given these factors, Patterson's consolidated operating margin rose 40 basis points to 10.4 in this year's first-quarter.

Now a few words on our cash flow and balance sheet. We generated just over 56 million of cash from operations in the first-quarter. By comparison, we used cash of 12.2 million in last year's first-quarter as we were converting to a new funding arrangement for our financing business. Accounts Receivables declined by $19 million from the end of last year's fourth-quarter due primarily to a reduction in our inventory of unsold equipment finance contracts. As a result, DSOs declined to 48 days from 50 days at the end of fiscal 2003. Inventories increased by 20 million in the first-quarter from the level at the end of fiscal 2003. This increase reflects our normal practice of modestly expanding interim inventories to assist with service levels. We then managed down inventory to fiscal year-end before calculating our LIFO reserves. Inventory turns stood at 7.6 at the end of this year's fiscal first-quarter versus 7.3 at the end of fiscal 2003 and 6.7 for last year's first-quarter. Finally, we ended this year's first-quarter with 274 million of cash and short-term investments, up more than 56 million from the year-end fiscal 2003.

Thank you and now I will turn it back to the conference operator for any questions.

(OPERATOR INSTRUCTIONS). Our first question comes from Larry Marsh with Lehman Brothers.

Thanks and good morning. I guess, Steve, in your press release in commenting about second quarter guidance giving a couple of cents range, but you are not commenting about topline. I know last quarter you alluded to your expectations of growth through the first full year and kind of commented about first-quarter. I wonder if you could give us any comment about expectations for revenue growth excluding AbilityOne in the October quarter?

Sure. Obviously, Larry, with the AbilityOne transaction, my comments would exclude any contribution from AbilityOne. I think the vet and dental business will continue to operate near the low-end of our historical growth range. That is at 10 or 11 percent for the second quarter, pretty much in line with what we guided you at the end of the first-quarter. Since we do have any acquisitions working at this particular point in the dental or vet space.

Okay. Are you anticipating to switchover the vet business from agency to full dollar in the second quarter, and if so, what sort of impact might that have?

There might be some switchover late in the quarter. The contract that Pete alluded to earlier is under review with the manufacturer right now. There is some uncertainty as to what that impact would be. But it would be more at the topline and not at the bottom line because it would switch the agencies as you anticipated.

Okay. And then maybe an elaboration. You have got the territory salesforce expansion. I know historically you guys have said you wanted to put 10 percent more salespeople out every year. Is this accelerating that, and how is this different from what you have already been doing?

I think, Larry, the difference is this. We have historically added a number of sales reps. I think our compound annual growth in the salesforce has been 6 to 7 percent. If you look at the recent history, probably less than half of that growth is coming in our territory salesforce. It has been focused on the equipment technology group. We obviously are now refocusing that sales growth on the territory representative, and it is the territory representative that calls on the customer from the point of view of consumer product sales building that relationship, etc.. So we clearly are going to accelerate the addition of territory sales reps over the near-term.

Is that going to be done starting immediately or starting in the fourth-quarter of fiscal --?

It is under way as we speak, and I think that our statement to you was that we would expect to see some results in our fiscal fourth-quarter.

Okay. Alright. Very good. So you are not quantifying what sort of expansions. You are saying you will be expanding your territory salesforce, and we should just monitor progress based on the number of reps you give us every quarter?

Correct.

Finally, I know you talk about strong CEREC sales, maybe a little bit of an elaboration. Are you continuing to see CEREC sales growing at a much more rapid rate than your overall equipment volume? How is feedback from the 3-D system going specifically?

CEREC sales continue to perform at a rate that exceeds our overall equipment business, Larry. But CEREC continues to gain, to move out of what we call the early adopters stage and into clinical acceptance. But the 3-D software has clearly had a positive positive impact in terms of customer acceptance of the system, and we expect CEREC sales to remain strong.

Very good.

Our next question comes from Suey Wong with Robert W. Baird.

Thank you. Pete, the consumable sales were solid, but they were less than what we were looking for. Was there any kind of unusual competitive activity in the market that was driving this?

There was no competitive activity that we are aware of that has driven this at all. I think it is a function -- obviously the correlation to us is number of more sales reps, and that is the key to us as opposed to a competitive impact.

Okay. You guys have always done such a great job outpacing the industry. Are there any changes in your forecasted outpacing of industry going forward?

No. We are not making any changes, not at this point in time. We continue to believe, for example, that the consumable market is growing 5 to 7 percent. We would probably tell you today that it is at the lower end of the range. The equipment continues to grow double-digit. We are seeing -- we continue to set a target because we want to grow 4 percent faster than market, but as Steve indicated, we forecast for next quarter being at the lower end of that range.

Finally, you are looking for the consumables to accelerate. You talked about some sales and marketing programs to help drive this. Can you add a bit more color to those programs?

I want to be a little careful here from a competitive perspective (inaudible). First of all, we are accelerating training as it relates to our territory salesforce. It is going to be to define and penetrate existing accounts that quite frankly could substantially (inaudible).

Second of all, we are building some specific kinds of programs that allow those reps to know that customers are not purchasing from us in terms of the consumable marketplace. So they are both of a training nature and of a specific kind of program. We have also revamped our Patterson plus program from the point of customer benefits.

Okay. One follow-up question here. Do you have the foreign exchange impact on the consumable sales? I wanted to get a total growth number for consumables.

I think the number was a little less than 1 percent.

Okay. Thank you, Steve.

Obviously all up in Canada.

Our next question comes from Derek Leckow from Barrington Research.

I just wanted to follow up on some of the questions on the consumables business. Pete, you mentioned that you think long-term it grows between 5 and 7 percent. How long do you think we will be at this lower end of that range, and is pricing becoming a factor? What do you think is driving the slow down there?

I think we don't have a whole of information to be terribly specific with you at this point in time. But I think we would tell you a couple of things. First of all, I cannot prognosticate how long we will be at the lower end of the range. But we clearly believe that dentists continue to be busy, etc.. Over the summer, our slowdown was related to some flattening of office visits whether it is related to our territory sales rep placements and some of the things we talked about there, I think it is a combination. But I think we are reasonably comfortable by the fiscal fourth-quarter that we will be back growing faster than the market.

I just had a question on the gross margin. That was a little bit lower than what I was looking for in the quarter. It is there anything I should know about there in terms of the gross margin, or is this more of a sustainable level that you have now, and is it related to some of the software sales you mentioned were being sold at lower margins?

Most of the impact in the quarter was all due to the mix of the Webster activity.

So that seems to me something that is one-time in nature, and you will probably see a rebound in that gross margin next quarter?

I think that is a good probability.

Great. And then your dental business, the operating leverage you mentioned was up 50 basis points which is in line with I think the long-term forecast. How do we think about the vet operating margin improvement as we go forward? How would you characterize that on a yearly basis?

We have been able to sustain an improvement each of the years that we have owned the business, and I would think I would go on record as saying we plan to do that again. It is a little less quantifiable because of some of the volatility with these agencies versus distribution agreements. We knew that going into this business. We are not backing off on our excitement about the industry and the market, but it is something we knew we had to live with for awhile.

Okay. And then finally, if I could touch on the issue relating to reimbursement as it relates to payments for expenditures for rehabilitation and so forth. I wondered if you could talk about that industry, and how has reimbursement been an issue in that industry?

As we commented on Monday during the announcement of the AbilityOne pending transaction, AbilityOne really operates one step removed from the direct reimbursement situation. Obviously it is more in human healthcare than it is in animal or dentistry, which you know have been generally devoid of any government intervention or very little government intervention in the pricing.

There can be some impact indirectly. For instance back in the late 90s when the long-term care fees were just as quite substantially, obviously long-term care facilities had to rearrange their budgets, and there might have been some expenditures that might have gone to rehab products that were either reduced or eliminated. With an indirect impact, we looked at that during our due diligence and really thought if there is a trend out there right now, it's probably going to be more favorable to the industry than it would be detrimental. So I think we are not overly concerned about it from our perspective.

Okay. Thank you very much.

Our next question comes from Robert Willoughby with Bank of America Securities. Please go ahead with your question.

Good morning. Sean Harrington in for Robert Willoughby. The organic growth rate in Canada, revenue growth rate in Canada, seemed to take a step back this quarter. Can you elaborate on that at all?

I think it would be an honest assessment to probably say that some of the management changes up there might have impacted the Canadian operations this particular quarter.

And just on the Webster contract, can you provide a little more detail on what exactly that was? In answer to a question, I think you made a reference to that. While it is one-time, it's not a reoccurring in the quarter, there may be more to come in future quarters. Is that correct?

It is a contract -- I will name the supplier. It is Mariel, which makes -- I am going to get this wrong; I think it is heartcard (ph). Jeff will correct me if I am wrong. It is that productline which about six or eight months ago they came to Webster and some of the other distributors, and they asked if they would distribute product as opposed to just selling in an agency relationship. They are now evaluating -- as I said earlier, they are evaluating what they want to do, whether they want to go back to handling the distribution, put it back on a agency relationship or whether they continue to sell it through distribution. So it has added that volatility that we mentioned.

Lastly on AR, you were building up some of those financing contracts over the few quarters, and obviously you have sold a number of them off. Is there more to come on that front, or are you largely caught up?

We are working off a little bit, but as we mentioned before, we are still negotiating with the bank to try to modify their terms a little bit, which would help us even more. But we have been able to work off some of the capacity. It was a learning curve that we were going through.

Our next question comes from David Callas (ph) with Siegel, Bryant and Hammel (ph).

I am just trying to understand going back to the salesforce reorganization of the changes in the territories, are you saying that if you were hiring 100 reps, those reps were more focused on equipment, and now they are going to be more focused on consumables? Because I was under the impression that most of the reps sold both of those. I am little confused on exactly what you are doing, if you are accelerating the actual number of people or just shifting focus a little bit.

No. We are doing two things. It is important to remember we have several classes of sales reps. The territory sales rep is the representative that calls on the customer, responsible for the relationship, selling consumables and bringing to bear other resources the company has vis-a-vis an example would be our other specialty reps. Our other specialty reps include an equipment specialist, Patterson technical representative, CEREC representative, etc..

What we are saying is where our salesforce on average has grown 6 to 7 percent a year, what has happened to us is we have emphasized and wanted to grow our position in the equipment market. More than half of that 6 to 7 percent annual growth rate went into those specialty areas versus the territory rep. We are now going to go back and refocus on the territory rep from the point of view of additional sales reps in that category.

Okay. And then just a question overall about Patterson and inconsistency. You guys have done a great job over the years, but it just seems like over the last several quarters there has been a little more inconsistency, maybe tapping down numbers a little bit here and there on ranges. I am just wondering if the overall growth rates that we are looking at for the outpacing of the dental market is just too big of a hurdle at this point for you guys to get beyond. That 3, 4 or 5 percentage points you have usually set, it seems like you are really pushing on that, and that seems to be things that every quarter or several quarters are coming up short. Could you just comment on that?

First of all, I don't believe we have quarters coming up short. Second of all, we continue to believe the market grows at 7 to 9 percent. Our target continues to be 4 percent faster than the market, and we clearly believe that is achievable. There is no reason for us at this point in time to change those projections. We think the performance of the company continues to be consistent with those projections.

Okay. Thank you.

Our next question comes from Matthew Berg (ph) with Wafer Management (ph).

Can you comment a little bit about your share buyback program? Were you active in buying back shares over the quarter?

I am sorry. Could you repeat your name again?

This is Matthew Berg (ph) from Wafer Management (ph).

We did not participate with any -- with the AbilityOne transaction during the quarter, we really were precluded from being in the market at all. We still have about a $1.1 million open authorization out there. I am sorry, shares not dollars.

I guess in the financing of the AbilityOne, I think you said that you were going to finance 375 million or 400 million with debt of the total purchase price. Has there been a significant cash flow generation this quarter? And the low interest rate, would it be possible that you finance more of this with the cash in your balance sheet?

That answer is still up in the air. I am not ready to go on record as to how exactly we are going to finance the AbilityOne transaction, what the mix will be yet. There will be some element of debt put on our balance sheet, but we have to check pricing and so forth as we get closer to the close date.

Thank you very much.

Our next question comes from Lee Azil (ph) with Elm Ridge Capital. Please go ahead with your question.

Thanks for taking the question. A few questions. What is the balance of receivables sold, and what were the receivables sold during the quarter?

I am not sure I have got that information with me. I don't know what was sold. I know we sold about $15 million of our backlog if you will during the quarter. Our receivables were down about $19 million.

So the total balance of Accounts Receivables, so it will be up $15 million from the 194 last quarter?

No, not necessarily because you have got net activity in there.

Right.

I am sorry. I don't have those statistics with me.

Accounts Payable seemed to be a big boost to cash flow, and they were very high as a percent of inventory. How do you do such a good job there?

Actually there is some dating terms in there as well as the fact as the inventory billed through the quarter, we were able to hold some of it in the payables. So it was not anything Herculean or extraordinary that we were doing. It is just sort of the normal flow of the business. Last year's first-quarter I think is a little bit deceptive if you look on a quarter over quarter basis because we actually had some dating terms in the 2002 year-end payables that we were paying out in the first quarter 2000.

I am just trying to get a normal level of payable to inventory. You are now at '93. You were at 72 a year ago. Before that, two years ago you were 74 in the same quarter.

I think you are really looking at a more normalized level right now. It might be a little bit on the high side, but it's fairly normalized right now.

Two quick questions. On the other current assets, they were up in the quarter, and they were fairly high as a percent of revenue on -- they were up 1 million on the decline in revenue. What is behind that?

In our other current assets?

Yes.

I would speculate some of that had to do with the AbilityOne transaction, but I don't know specifically. But I would guess some of it had to do with the expenses on AbilityOne.

But that has not closed, so how is that?

Because they are suspended. The expenses are suspended until the transactions is definitive. It will be capitalized as part of the purchase price.

These are banking fees?

It could be banking fees; it could be lawyer fees, adviser fees. Pretty normal activity. The other thing could be just due to some insurance expenses.

The last two questions are, other long-term assets. They were up as well. I thought these were related to Accounts Receivable, some retained interest, and now if you sold more, they should have gone down; they went up.

No. When we sell more, they go up because we have more retainings with the bank.

Initially when you book it, it stays on your books, right? And then would you sell it, it should go down. You said you could not sell some, so the retained interest increased.

When we sell -- when we are financing a customer, that activity goes into our current Accounts Receivable. We sell it to the bank. There is a retaining to 10 percent. It is held back. That goes into the the non-current.

So this is up as percent of revenue? That is because you are financing more, you are selling more or you are retaining more? Which one is it?

All of the above.

All of the above.

It is driven by the sales.

Sorry?

It is all driven by the sales.

(inaudible) versus last year or last quarter, it's a lot more, so I guess you sold a lot more?

No, it's not up a lot more from last quarter. It's at the same level.

It's up $1.2 million, right?

Well, the activity. We are always financing more, yet you are building and it is a finance base.

Let me ask it another way. The revenues are down, so did you finance more of your revenue of your sales this quarter than previously?

You mean on a quarter over quarter basis revenues are down?

Yes.

That really -- I don't know --.

There are timing issues here that could account for that.

I am sorry. I am just comparing versus last -- (multiple speakers).

If you go back to last year, that asset was being built as we went into this new arrangement. All you are doing is seeing the normal activity. If I had $10 million more of receivables I sold this year in the first quarter, I am going to have $1 million that is going to get hung up on my balance sheet. I don't think you are seeing anything other than abnormal financing activity or normal financing activity in this.

Okay. Thanks a lot.

Our next question comes from Allen Metrani (ph) with Copper Beach Capital.

Thank you. Your receivables -- just focus on this for a second -- grew 4.9 percent year-over-year. I guess your sales were up 11 plus percent. Do you think throughout the year you can keep as good a cash flow management as you have been doing?

I would like to say yes we could. We worked on it very hard.

Also, could you give us your range for CapEx spending for this year for your fiscal year? Can you give us a sense as to what that will be?

As we said at the end of the fourth quarter, we are probably going to be in the $18 to $20 million range. We are looking at a major expenditure out on the East Coast as we replace the warehouse facility in the system. So it is going to add incrementally somewhere around $6 to $8 million.

Great. And following up on the question asked before regarding the financing at AbilityOne. You do have a lot of cash on your books; interest rates are low. If you use a convert as opposed to a piece of it as opposed to regular debt that you may have to pay anywhere between 4 and 6 percent interest rates depending on the maturity, your interest expense will be significantly lower. Can you talk a bit about your thoughts regarding a convert for a zero-coupon convert?

I don't want to rule out anything as far as what kind of a financing vehicle we might place on a more permanent basis in this transaction. I think as we discussed with the Board as far as our strategy with financing is concerned, I don't think the convertible would be something that would be high on the list because we are effectively just using equity in the longer-term. So I think if we are trying to change the weighting of our capital cost a little bit, I don't think we would look at something that is heavily weighted towards an equity security versus a debt security.

Is it likely -- you said you were not looking to sell public debt. Is it likely you would do something you could pay down incrementally as you generate cash?

That is one of the key components that we are looking is the flexibility we would have with whatever debt we would put on the books.

Smith & Nephew, which owns a piece of AbilityOne, thinks this deal is going to close in September. You guys mentioned in your October quarter more leaning toward the October, what exactly has to happen outside of the financing to close the deal because there does not seem to be any antitrust issues and you are not in the business now. Why can't this thing close in two or three weeks?

I think people are reading something into when we say the October quarter. September does fall into our October quarter. We have to wait for an HSR ruling. The size of the deal requires a filing, so we have to go through that process. But other than regulatory review, there are not a lot of hurdles to completing the deal.

And then lastly, can you give us some sort of rule of thumb as to what percent of the deal could be amortization, and how many years you would amortize that over?

No, as we said during our conference call and our press release, that is one of the variables we are not ready to commit to at this particular point.

What about in general when you normally make an acquisition, how many years do you amortize the amortization over?

That varies. In some transactions, we have no amortization. It just depends on the mix and the type of company that you are buying. In the dental business, you are probably buying very little in the way of identifiable and amortizable intangibles. AbilityOne happens to have patents, licenses, trademarks and so forth, so there will be a little bit more.

You can't write that up as goodwill and then not have to amortize it?

No. The identifiable intangibles have to be amortized. The goodwill bucket or the leftover bucket would not be amortized under current standards.

Lastly, you are not backing off from your full year guidance in terms of April sales what you gave of $2.00 to $2.02, correct?

We are not backing off of that. Our guidance continues to be for the full year, the $2.00 to $2.02 range, that we talked about in our last conference call.

Is that exclusive of AbilityOne?

Correct.

Gentleman, at this time, there are no additional questions. Please continue.

Again, we appreciate everybody's continuing support. Thank you very much for participating in our call, and we look forward to talking to you at the end of our second quarter. Thank you.

Thank you, sir. Ladies and gentlemen, this concludes today's Patterson Dental first-quarter fiscal 2004 earnings conference. If you would like to listen to a replay of today's conference, please dial 303-590-3000 followed by access number 548568. We thank you for participating. You may now disconnect.