Patterson Companies Inc (PDCO) 2005 Q3 法說會逐字稿

Good morning, ladies and gentlemen and thank you for standing by.

Welcome to the Patterson Companies third quarter fiscal 2005 earnings conference call.

At this time, all participants lines are muted.

Following today's formal presentation instructions will be given for the question and answer session.

If anyone needs operator assistance at any time during the conference, please press the star followed by the zero.

As a reminder, this conference is being recorded today, Thursday February 24th, 2005.

I'd now like to turn the conference over to Mr. Peter Frechette, Chairman and Chief Executive Officer.

Please go ahead, sir.

Thank you and good morning.

We appreciate your participate in our third quarter conference call.

With me today is Steve Armstrong our Executive Vice President and Chief Financial Officer, who will review some highlights from our recent operating results following my opening remarks.

Also with us is Jim Wiltz our President and Chief Operating Officer.

At the conclusion of Steve's remarks we'll 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 this reason we've included financial guidance in the morning's earnings release.

But it's important to understand that Patterson's actual results may vary from our forecast.

Our guidance is subject to a number of risks an uncertainties which are discussed in detail in our annual report on Form 10k.

Since that information forms the context for what we'll discuss today, we urge you to review this material.

Before I discuss our third quarter results, I want to point out that Dow Jones made an error when reporting this morning's release.

In its wire story, Dow Jones mistakenly stated that our guidance for the fourth quarter of fiscal 2005 of 38 to 40-cents is down from the 65-cents that we reported in the fourth quarter of 2004.

Unfortunately, Dow Jones neglected to take into account our two for one stock split last October which resulted in adjusting last year's fourth quarter earnings to $0.33.

We've notified Dow Jones of this error and they've run a correction.

Turning to our recent performance.

Patterson reported a strong third quarter.

Consolidating sales Rose 22% to $638 million.

As you know, we made four acquisitions earlier in the year.

ProVet and Milburn which are now part of our Webster veterinary supply unit.

Medco, which has been integrated into AbilityOne, and Caesy, which is part of our dental operation.

Excluding the sales contributions from these four transactions, internally generated sales were up approximately 15% in the third quarter.

Net income for the third quarter increased 55% to 50.1 million, or $0.36 per diluted share.

For the next few minutes, I'd like to briefly review the third quarter performance of our three business units.

Our dental business, Patterson's largest, is continuing to perform in a very high level.

Patterson Dental Supply reported sales growth of 18% to $500 million.

Substantially all of this growth was internally generated.

Sales of consumer dental supplies increased 10% in the third quarter.

One extra selling day in the quarter accounted for an estimated one to two percentage points for the sales growth of this period.

But even when you exclude the extra day, which results in a growth rate of 8% to 9% our consumable sales growth was strong.

We believe this growth reflects the effectiveness of our efforts over the past year to strengthen our focus on this portion of Patterson Dental's business.

Sales of dental equipment and software Rose 30% in the third quarter, generated by strong sales of both basic and new technology equipment in the U.S. and Canada.

Demand remains particularly strong for such new generation dental systems as the Cerec 3D, Digital Radiography and related networking systems.

Based on the strong results of our equipment business through the first nine months of fiscal 2005, it remains clear that dental practices are continuing to invest heavily on a wide range of new equipment and software that can strengthen office productivity and improve clinical outcomes.

As the leading distributor of dental equipment, Patterson Dental is well positioned to continue benefiting from the ongoing technological investment trends in this market.

As such, we believe the conversion to new technologies as well as investment aimed at upgrading basic equipment will likely continue for the foreseeable future.

Sales of AbilityOne, Patterson's rehabilitation supply and equipment unit, increased 27% in the third quarter to 67.5 million.

Excluding the may 2004 acquisition of Medco Supply Company, as well as the impact of the additional selling day in the quarter, and currency adjustments related to foreign operations, AbilityOne's internally generated increase was approximately 9%.

Although this is a solid growth rate, AbilityOne sales were below our planned levels.

The unit's third quarter performance, in comparison to the year earlier period, was also affected by modestly lower gross margins and certain unanticipated expenses.

We believe this is a shore-term situation and corrective actions are now underway.

All in all, we remain very confident about the future of this business.

As the number one player in a highly fragmented market, AbilityOne is uniquely positioned to capitalize on any number of promising growth opportunities and continue increasing its market share.

Our Webster Veterinary Supply unit posted a very solid third quarter.

Sales increased 64% to 70.7 million, which included contributions from the acquisitions of ProVet in April of 2004, and Milburn in October.

As previously reported, ProHeart 6, an injectable heart worm medication was voluntarily withdrawn from the U.S. market by its manufacturer in September, 2004.

On an annual basis, ProHeart 6 contributed sales of approximately $12 million.

Excluding the nearly 3 million of ProHeart 6 sales in last year's third quarter, and the impact of the two acquisitions earlier this year, Webster's sales increased approximately 12% in this year's third quarter.

The strong performance is particularly encouraging, since the winter months of the third quarter are typically Webster's seasonally lowest revenue period of the fiscal year.

We believe the rollout of our Emagine Electronic order entry system is one of the reasons for Webster's solid level of internal growth.

Since the beginning of this fiscal year, more than 600 Emagine systems have been deployed and Webster's posting steady growth volumes of orders through our value added tool.

Another positive for Webster during the third quarter was the performance of Milburn, which is operating at above anticipated levels.

As many of you may know, Milburn is the largest distributor specializing in the U.S. equine veterinary supply market.

Most companion pet and large animal veterinarian supply distributors have not served the veterinarian due to the highly specialized nature of this market.

Milburn has capitalized on this opportunity by focusing exclusively on the unique needs of the equine veterinarians.

As much, Milburn provides us with a growth platform for penetrating this attractive niche market.

Two other developments at Webster also merit attention -- or also merit mention.

First, Webster has entered into a new distribution agreement with Pfizer for Rimadyl, a companion pet pain relief drug.

Initial sales of the product under this distribution agreement will start in April.

Second, Webster is expanding into the large California veterinarian market.

We already have several sales reps in the state and based upon their performance thus far, the decision has been made to begin stocking inventory in California.

California has been Webster's largest unserved market and by filling this void, we are even more optimistic about the future of our veterinarian supply business.

I'll conclude my remarks by discussing the earnings guidance contained in this morning's release.

This year's fourth quarter ending April 30, we are forecasting earnings of 38 to $0.40 per diluted share which would make this period another record quarter for Patterson.

Moreover, fourth quarter results at this level, are consistent with our previously issued financial guidance of $1.34 to $1.36 for the full fiscal year.

Thank you and now I'd ask Steve Armstrong to review some highlights of our third quarter results.

Steve?

Thanks, Pete.

I'll begin my comments with some additional comments on AbilityOne our rehabilitation business.

During the quarter of AbilityOne's operating margin declined by 3.7 points in comparison to the prior year's quarter.

This erosion was caused by several factors.

First, as Pete noted, AbilityOne's third quarter sales performance was below our expectations which resulted in loss gross profit.

Second, the gross margin of this unit was all affected as a result of absorbing the Medco acquisition, a business that has lower margins than those of AbilityOne.

In addition to experiencing a sales make shift toward capital goods which carry a lower margin than supplies.

Third, AbilityOne's operating expense ratio was negatively impacted by the revenue shortfall.

In addition, we incurred more catalog expense than planned for the quarter and we wrote off a noncompete intangible asset associated with the late Howie Schwartz which had been recorded with the acquisition of AbilityOne.

We believe we have taken the necessary actions to return this segment to its more traditional operating margin performance beginning in the fourth quarter.

And we continue to be very positive about the potential of this business.

Moving on, our consolidated third quarter gross margin declines at 35.6% from the year earlier period, but was up 20 basis points from the second quarter.

Year over year decline resulted from two primary factors.

First we recorded a lower gross margin in our dental business due to a shift in our sales mix towards equipment, which generally carries lower margins in the consumable supplies.

More importantly, however, our consolidated gross margin was affected by the margins of the veterinarian and rehabilitation businesses that we have acquired in fiscal 2005.

As we have discussed previously, these acquired businesses carry gross margins that are somewhat below those associated with the historical Webster and AbilityOne operations.

We believe we are making steady progress towards improving the margins of these acquired businesses.

Our consolidated operating expense ratio improved one full point to 22.8% year over year.

Due to the strong improved sales our dental and veterinarian businesses realized significant operating leverage during the quarter.

Which was partly offset by the decrease in AbilityOne.

Our consolidated operating margin at 12.8% was unchanged from last year's third quarter since the improvement in operating expense leverage was largely offset by the decline in our consolidated gross margins.

I will wrap up this P&L discussion with a few words about interest expense.

The weighted average effective interest rate on our debt was approximately 3.3% in the third quarter, which was unchanged from the second quarter level.

We are expecting a similar rate for this year's fourth quarter.

Turning now to cash flow, we generated approximately 66 million of cash flow from operations in the third quarter a net income of $50.1 million.

During the quarter, capital expenditures were $9 million, which was somewhat below plan levels due to the delayed start of the new facility for AbilityOne's home craft division in the UK.

Because of this delay, our total cap-ex for the fiscal year would be approximately $30 million.

During the quarter we also paid down $5 million of debt related to the AbilityOne acquisition.

Quick look at our balance sheet metrics show our data sales outstanding stood at 42 days at the end of the third quarter down from 44 days at the end of the second quarter.

Also down from 50 days at the end of last year's third quarter.

Inventory terms were -- stood at 8, unchanged from the second quarter level and we continued -- as we continued to integrate the inventory this company has acquired in fiscal 2005.

Inventory turns were 8.2 in last year's third quarter.

Those are some of the highlights of our third quarter performance.

Thank you.

I'd like to turn it back to the conference operator who will poll you for questions.

But just to clarify, Pete's in Chicago for the midwinter dental show.

Jim and I are here at the corporate offices.

So you may hear us chat back and forth as we determine who's gonna answer your questions.

So operator, questions?

Thank you, sir.

Ladies and gentlemen, at this time we will begin the question and answer session.

If you do have a question today, please press the star, followed by the one on your push-button phone.

If you'd like to decline from the polling process, please press the star followed by the two.

You will hear a three tone prompt acknowledging your selection.

Questions will be polled in the order they were received.

If you are using speaker equipment today, it will be necessary to lift the hand set before pressing the numbers.

One moment please for our first question.

Our first question comes from Glen Santangelo with Jefferies & Company.

Please go ahead.

Yeah, Peter, just a couple quick questions.

First of all on the dental equipment business your sales were up 30%.

Could you give us sense for how much of that was Cerec and what was driving that growth?

And then secondly, on AbilityOne you had revenue growth of 9% and in your own literature, you suggested that you believed the rehab market grows single digits, so 9% doesn't seem that bad.

What do you think AbilityOne can grow at?

Well, let me try and deal with the AbilityOne question first, Glen, then we'll let Jim relate to the dental equipment question.

We think the AbilityOne business -- and we would obviously be interested in growing that business at a rate greater than market growth, which we believe to be in the 6% to 8% range.

The second statement I would make to you about the AbilityOne revenue growth is that when we take out the acquisitions as we discussed, we're growing at a very nice 9% and we obviously would like to see that move up a percentage point or two, but believe that we can continue to grow the business at a minimum at that rate.

Let me also add a couple of other comments about the AbilityOne situation as it relates to our fourth quarter forecast.

We currently operate -- when we talk about the revenue line.

We currently operate at AbilityOne out of three facilities in the UK.

We have stretched those facilities in terms of their capacity, so there are some efficiencies in terms of moving product out of those facilities currently.

We historically, in our business, do not build a back log, but as a result of those efficiencies, have built a back log at AbilityOne, and we now have changed some operating procedures, et cetera, and we will begin to see that back log come down as that is billed out here in the fourth quarter.

The second point I would make about AbilityOne is that their new catalog went out the last week in January, so we didn't see any potential margin increases in the third quarter as as a result of that catalog being sent out.

Month-to-date in February, we clearly are seeing gross margin improvement as a result of that new catalog going out.

So, we remain very positive about the AbilityOne organization and our ability to grow that business at a rate greater than the market.

And to return to the historical results that we have expected in the past.

And with that, why don't I let Jim jump in on equipment -- dental equipment question.

Jim?

Sure, Pete.

If I remember your question properly it was Cerec versus basic equipment.

We really Don share specific results of Cerec with the public, but I will say this, that Cerec is growing slightly faster than our core equipment is, both in the U.S. and in Canada.

Hey, Jim, would you think a 30% growth rate is somewhat sustainable?

Do you think there's a possibility that may be calendar 4Q maybe rob some sales from calendar 1Q '05?

No I don't think it robbed any sales from our first quarter of '05.

That wasn't indicated based on what we're seeing right now.

I think it was a very strong quarter because of the tax advantages that exist in the fourth quarter.

We've never felt like that takes away from our first quarter.

Thank you so much.

our next question comes from David Veal (ph) with Morgan Stanley.

Please go ahead.

Hi, this is Alia (ph) calling in for David Veal.

I had a quick question about the AbilityOne business.

You mentioned there was a shift to lower margin rehab capital equipment.

I wanted to know what caused the shift?

Was it a shift in your sales force?

Could you give us more color on the actual shift?

I would say to you, they're simply selling more capital equipment as a result of mix and change.

I don't know what comments you'd want to add, Steve.

I think capital goods are outpacing the consumable growth right now so we're getting a higher percentage.

It's not that there's a deterioration in one versus the other.

Okay.

Also, did you see any impact from the tax incentives in the quarter?

I'll make a comment and then Jim can make a comment.

We, quite frankly, assumed there is an impact there, but we don't, frankly, assess it.

We don't really know how to assess it.

And I don't think that we are seeing anything other than dentists making timing decisions, vis-a-vis the tax impact, but not making buy to sell decisions.

Their decision is they need the equipment either from a productivity point of view, either from the attractiveness of the office, both in terms of patients that and in a working environment.

Then I think the tax question comes into play at that point in time.

Jim, I don't know what you'd add to that.

Well, I think the only thing I'd add to that, Pete, is that for a long history, dentists -- we've had a strong quarter at the end of the year where dentists go, oh my God, I haven't taken advantage of my tax break yet.

Even back to and including when it was much smaller than it is today.

I don't think we see anything significant with the new tax laws even though it's greater -- much greater benefit today to them than it was ten years ago.

Okay.

Alia, this is Steve.

Just to also clarify, making sure that everybody understands where the taxes are.

Obviously, Code Section 168 expired at the end of December.

Bonus depreciation provision, anyway.

But Code Section 179 has been extended and will continue out into -- or to the end of 2007.

But remember to keep in perspective that an average dentist buys less than $100,000 worth of equipment.

So it's only those rare what we'll call major remodelings or expansions that really allow a dentist to take advantage -- or would have allowed a dentist to take advantage of both the code sections anyway.

So probably, as Pete said, intuitively, we know it's had a positive impact, but it is impossible to measure it.

Okay.

Thank you.

Ladies and gentlemen, if there are any additional questions please press the star followed by the one at this time.

As a reminder if you're using speaker equipment today it will be necessary to lift the handset before pressing the numbers.

Our next question comes from Robert Willoughby with Bank of America Securities.

Hey, this is Matt Jackson in for Willoughby.

One quick question.

Are there any plans for where the growing cash reserves will be deployed going forward?

Other than what we've said previously in terms of public discussions, and that is that we continue to believe we can invest those earnings in terms of future opportunities for our share holder and the continuing business.

Steve, do you want to make any comments?

Without stating any specific, I think you're probably going to see us over the next six to nine months unless there's a major acquisition development in the business, we're going to start to move some of that debt back off of our balance sheet.

There's no sense having both the debt and the cash on our balance sheet.

We're past the one year, no call provisions of the data agreements.

So now we can start managing that debt down off of our balance sheet.

But, as Pete said, our first priority is to invest it back into the business.

Thanks.

That's it.

Thanks, Matt.

And our next question comes from Jeff Johnson with Robert Baird.

Please go ahead.

Good morning gentlemen.

Just a couple follow-up questions here.

Going back and being sensitive to what's been said already on the dental equipment side, were you running any specific deals at the end of calendar '04 for dental equipment -- positioning any equipment at all to the dentist with expiration of 168?

Nothing that was out of the ordinary.

Every year we have some kind of a promotion we're running in that fourth quarter just to remind the dentist of the tax advantage that they have before the end of the year's over with.

So I wouldn't attribute it anything different to this third quarter than last year's third quarter and the one before that.

Fair enough.

Thanks.

Second question here, probably for Steve, Steve, is the three acquisitions, three out of the four anyway, roll off at the end of fiscal Q4 '05 here in knowing you haven't given '06 guidance yet.

Should we assume that once those three acquisitions roll off, we can get back to seeing maybe the normal 30 to 50 basis points operating margin improvement?

Jeff, I think that would be our expectation.

We have -- you know, we'll struggle through a little bit of integration yet with Milburn because we still have to get that one into the Webster operations.

But we'll start to see some of those traditional metrics start to reappear, I believe.

Knowing that Milburn really will only obviously affect this year, Q3 and Q4 '05 and still have the two quarters into early '06 then.

Can you remind us how big is that relative to maybe the other three acquisitions as far as the impact that it might be having on margins?

It will be obviously less.

It's about a 40, $45 million business right now.

It's growing very nicely, as we stated, I think, previously it was growing about 20% before we bought it.

And as Pete mentioned, moving into California, that's a huge horse market as my compatriot, Mr. Wiltz can attest to.

He has some hobby horses out there.

So we think it's a good market and it will continue to grow.

The real issue is how quickly we can start to take advantage of some of the back room opportunities to increase their leverage and work on their margins little bit.

Great.

I guess more specifically I was asking more does Milburn impact margins more so than the other, I guess if you exclude Caesy out of that discussion, Milburn more so than Medco or ProVet?

Milburn and ProVet were similar type margin businesses when we bought them.

So I wouldn't say that it was any more or any less.

They're running slightly less than Webster's historical margins.

So we've got some opportunity to work on those margins.

Great.

I appreciate it.

And our next question comes from Larry Marsh with Lehman Brothers.

Thanks, this is Steven Post (ph) in for Larry.

Last quarter you talked about seeing a much bigger impact in the new [INAUDIBLE] product line.

Can you talk about that specific product line and how that may have contributed to equipment growth this quarter.

This is Jim.

I think we can safely say that it is continued to contribute to our growth of basic dental equipment.

It's a very popular line with the dentists.

Obviously, being the only national distributor of that product, we have a fair amount of benefit from that.

And I think we will continue to see, for probably another couple quarters, above average growth in basic equipment because of it.

This is Pete, Jim.

Would I be out of line by adding that what we're seeing is strong double digit growth?

No.

That's accurate, Pete.

Okay.

That's great.

And then maybe for Steve, year to date, you're obviously the big cash generator.

Is it -- should we anticipate that you will be a cash generator in the fiscal fourth quarter?

From operations I think that's a pretty safe bet, Steven.

Okay.

If Mr. Wiltz or Mr. Frechette decide to sign a big check for something we've got in the pipeline, I can't guarantee you one way or another.

Steve, maybe the way we ought to put it is, without acquisitions, we clearly will be a cash generator in the fourth quarter.

Okay.

Fair enough.

Then to the point of operating margins, I know we'll get the disclosure in the 10Q but can you just provide color in the dental business.

Is it fair to say you're still seeing the operating margins in the dental business increasing year over year?

Yes.

The operating margins in the dental business were very good for the quarter.

Is there any specific goal for the dental business or you're still going stick with that broad 30 to 50 basis point improvement?

I would characterize the goal, Steven, is we don't run these as three separate businesses from the standpoint of all the operating metrics.

We look at it as a consolidated business.

That's the guidance we give on metrics.

So we don't -- and won't get into a situation where we're giving out individual guidance for the operating margin of each of these business units.

We have too much going on behind the scenes to leverage each of the three.

It's too hard to keep them sorted out.

Okay.

The improvement in the consumable sales line.

You guys have talked a lot about training and focus on the sales force.

Could you just elaborate on what recent initiatives you've had.

We could expect to see acceleration there or at least consistency in what you did last quarter?

I think two things you'll continue to see.

We started last fall with sales meetings in each region for the entire sales force.

Those will continue.

And the second thing that's going on is also continuing.

We've increased the number of trainees that we put through the training facility here in St. Paul.

We're now training 120 to 130 trainees annually.

With the vast majority of those being territory sales reps today versus DTRs (ph) or Cerec specialists or equipment specialists.

So we're actually putting more feet on the street than we were previously.

That's part of the impact you're seeing.

And that 120 to 130 number you mentioned, that is the number we should continue to be the expected increase in the sales force?

No.

We have some attrition every year.

You should expect half of that to be an increase every year.

Understood.

Steve, you mentioned the DSO, I think you said 42 days versus 50 days a year ago.

What's driving that big decline?

Highly effective underpaid management as Pete always says.

If you remember a year ago, Steven, we had a buildup of contracts on our financing business because of some arrangements and some volume.

And we sold most of that off in the fourth and first quarter, fourth quarter of last year, first quarter of this year.

So that is the primary driver of -- we really were at a high point with the 50 last year and we're working that back down again.

So the 42 is more indicative of where we've been in the recent history of this business.

Okay.

And then maybe just back to the sales portion, what Jim was talking about.

Regarding attrition, have you seen any big change in attrition?

I guess specifically have you seen any change in your competitors trying to recruit away some of your sales people?

No, we have not.

As a matter of fact, we've seen less activity where competitors are trying recruit away.

Most of the attrition comes in the new sales reps that have been hired in the previous two years.

Okay.

I'll try for one more question here.

The Canadian market, used to talk about that a little bit.

Can you just update us on the competitive environment there?

Obviously one of your competitors trying to be more visible there.

And how that market has evolved since you made a management change a couple years ago.

Well, as you may know, Schein Arcona, in Canada, acquired Ash Temple, which made them the largest distributor in the Canadian market.

And so far we don't see a lot of change from that.

But they haven't really changed the way they operate.

They seem to be operating as two separate companies.

But you really need to ask them about what changes are going on up there.

Our growth is still good and we see it as a good market.

We're pleased with performance up there.

Okay.

Thanks.

Thank you, Steve.

We have no further questions at this time.

Please continue.

We remain very, very positive about our fourth quarter and the opportunities that exist for our business.

And we appreciate everybody's continuing support and we will speak to you at the completion of our fiscal year.

Thank you so much.

Ladies and gentlemen, this concludes the Patterson Companies third quarter fiscal 2005 earnings conference call.

If you'd like to listen to a replay of today's call please dial in at 303-590-3000 and enter the pass code of 11024161.

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