Patterson Companies Inc (PDCO) 2006 Q3 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to the Patterson Companies' third quarter 2006 earnings conference.

[OPERATOR INSTRUCTIONS]

As a reminder, this conference is being recorded Thursday, February 23, 2006.

I would now like to turn the conference over to Mr. James Wiltz, President and Chief Executive Officer of Patterson Companies.

Please go ahead, sir.

Good morning, and thanks for participating in our third quarter conference call.

Joining me today is Steve Armstrong, our Executive Vice President and Chief Financial Officer, who will be happy to take your questions at the conclusion of our remarks.

As Regulation FD prohibits us from providing investors with any earning guidance unless we release that information simultaneously, we have included fourth quarter financial guidance in this morning's earning release.

It is important to understand that Patterson's actual results may vary from our forecast.

Our guidance is subject to a number of risks and uncertainties, which are discussed in detail in our annual report on Form 10-K.

As that information forms the context of what we will discuss today, we urge you to review this material.

Turning now to our third quarter results, consolidated sales roses 7% to 682 million.

Excluding the impact of two acquisitions earlier in 2006, internally generated sales rose approximately 4%.

The third quarter of fiscal 2006 contained one less selling day than the year earlier period, which reduced consolidated sales growth by an estimated 1 to 2 percentage points.

Net income increased 8% to 54 million, or $0.39 per diluted share.

Patterson's improved third quarter results were paced by continued robust sales of dental consumables and another strong performance by our veterinary business.

Sales of consumable dental supplies and printed office products increased 12% in the third quarter.

Excluding the September, 2005 acquisition of Accu-Bite, a Michigan-based dental distributor, consumable sales were up 6%.

These are solid numbers indicating that our consumable business is continuing to grow at or above our estimated market growth rate of 5% to 7%.

Our third quarter performance also benefited from another strong performance by our Webster veterinary unit, whose sales increased 14% in the third quarter.

As anticipated, the December, 2005 acquisition of Intra Corp., one of the Nation's leading developers of veterinary practice management software, marketed under the Intra Vet brand name, had a nominal impact on Webster's third quarter results.

For the past few quarters, Webster's performance has benefited from the expansion of its geographic footprint through acquisitions and internal start-ups, including its Greenfield initiative in California.

The sale of Rimedyl, under our pharmaceutical distribution agreement with Pfizer, has also contributed to Webster's growth this year.

We are particularly encouraged by the strong sales growth of veterinary equipment during the quarter.

Webster has been laying the ground work for expanding its position in the equipment market, and this strategic emphasis is starting to pay off.

This equipment initiative has been re-enforced by the acquisition of Intra Vet software product line, which positions Webster to optimize the benefits of digital radiography equipment, and thus, offer veterinarians a compelling, value-added technology solution, similar to that of Patterson Dental.

Moving on, Patterson's third quarter reflected a generally flat performance in the sale of dental equipment, and this was expected.

During this period, strong sales growth of digital radiography equipment and related software, including the line of K. C. patient education software, largely offset flat sales of basic equipment and modestly lowered sales of CEREC's 3D dental restorative systems.

However, as we stated in this morning's release, we believe our equipment business is in better shape than it would first appear.

We believe the underlying strength of our dental equipment and software business was demonstrated by its ability to virtually equal its extremely strong sales performance in last year's third quarter, when equipment sales rose an exceptionally robust 30% from the third quarter of 2004.

We have implemented programs aimed at returning dental equipment sales growth to more historic norms.

Equipment sales are showing signs of strengthening at this early point in the fourth quarter, but this improvement is not occurring as quickly as anticipated.

However, I want to stress that the dental equipment market remains one of our strongest long-term opportunities.

Demand for dentistry is continuing to grow faster than the overall economy, and the income of dental practitioners is increasing.

We believe that dentists will continue to invest in new equipment that strengthens productivity and provides their offices with increased revenue opportunities and a state-of-the-art appearance.

As the leading distributor of dental equipment by a considerable margin, no other company is better positioned than Patterson Dental to meet these needs, which is why we are optimistic about the long-term prospects of our equipment business.

The third quarter performance of Patterson Medical, though in line with our internal forecast, remains sluggish, while sales rising a reported 3%, or by approximately 5% when currency translations are excluded.

As we reported last quarter, we installed a new management team at Patterson Medical that is charged with the responsibility of driving stronger and more consistent operating results.

As a necessary first step in this process, Patterson Medical's new management is evaluating current operations and is implementing new sales and marketing programs.

These initiatives, which are well underway, are expected to have their initial positive impact in fiscal 2007.

We see substantial long-term opportunities in the global rehabilitation market and continue to believe that Patterson Medical represents a solid growth platform for capitalizing upon this opportunity.

Turning now to financial guidance, contained in this morning's release, we are forecasting earnings of $0.40 to $0.42 per diluted share for the fourth quarter of fiscal 2006, ending April 29.

As a result, we are reducing full-year earnings guidance to $1.42 to $1.44 per diluted share from $1.44 to $1.46 per diluted share.

In closing, I want to acknowledge that Patterson's performance in fiscal 2006 has fallen short of our strong historic norms, and no one is more disappointed in our results than the Patterson management team.

In response, we have taken a range of corrective actions that are expected to strengthen our performance in the coming periods.

We are making progress, and we are optimistic about Patterson's prospects, both near and long term.

Thank you.

Now, Steve Armstrong will review some financial highlights from our third quarter results.

Steve?

Thank you, Jim.

I will begin my comments with a brief discussion of gross margins, which declined by 30 basis points, to 35.3% in the third quarter from 35.6% in the year earlier period.

This decline is principally from consolidating a full quarter of Accu-Bite results where gross margins are not yet up to our history dental level as we continue to integrate this operation.

In addition, the consolidated mix is being impacted by the strong growth of the veterinary segment, because this segment has the lowest gross margin of the three businesses.

We're encouraged by the 80 basis point improvement in gross margins in the veterinary segment during the third quarter, and the increased sales of equipment and software are positively impacting the results.

The decline on our consolidated gross margin was more than offset by the 50 basis point improvement in our consolidated operating expense ratio to 22.3%.

The dental expense ratio improved by 40 basis points due to strengthened operating leverage.

The improvement in consolidated operating expense ratio was also resulted from a lower level of intangibles amortization at Patterson Medical.

On a consolidated basis, our third quarter operating margin improved by 20 basis points to 13%.

In response to a request from last quarter, our third quarter operating margins by unit were 13.8 in dental, 16.2 in medical, and 4.5% in veterinary, and further details of that will be in our SEC filings later.

Turning now to our third quarter cash flow, operations generated cash of approximately $48 million, compared to 66 million in last year's third quarter.

Last year's period benefited substantially from a timing factor in our cash disbursement cycle.

Cash expenditures -- capital expenditures -- totaled approximately $8 million in this year's third quarter.

This amount included investments in a new share distribution center in Lancaster, Pennsylvania, as well as a new distribution facility for Patterson Medical's UK operation.

The new facility in the UK is expected to be operational later in this year's fourth quarter, while the Pennsylvania distribution center is expected to be operational in the first quarter of fiscal 2007.

Our CapEx for fiscal 2006 will approach $45 million as we complete the majority of the first phase of our distribution re-alignment under our shared services initiative.

Future phases of the distribution re-alignment are not expected to require the levels of investment that we have made the last two years.

A quick review of our balance sheet ratio shows our days sales outstanding at 41 days, compared to 42 days at this time last year.

Inventory turns have declined to 7.2 from 8.0 a year ago, as we absorb Accu-Bite's inventories into our dental operations.

In addition, our CEREC inventory is running at a higher level this year, more as a consequence of lower than normal quantities of this product during much of last year.

Thank you.

I will turn it back to the conference operator who will poll you for your questions.

Thank you, sir.

[OPERATOR INSTRUCTIONS]

Our first question comes from Derek Leckow from Barrington Research.

Please go ahead with your question.

Thank you.

Good morning, Jim and Steve.

On the internal growth rate in dental -- would that be impacted also by that 1 to 2 percentage points that you mentioned about the extra day there?

Yes, it is.

Okay.

And then, as you look at the fourth quarter, is there any calendar issue there?

Does that day fall into the fourth quarter, then?

No.

We actually lose six days, Derek, over the entirety of the year.

Compared to the prior year, we lost five of them in the first quarter, we lose one in the third quarter, and then, we are square going forward.

So, going forward, it's apples-to-apples.

Okay.

Next year, it will be apples-to-apples all the way through the year, as far as I know.

Okay.

And you had the great performance here on the operating margin.

It was quite a bit higher than what I expected and a pretty nice rebound from the second quarter, and it looks like you have quite a nice margin happening in the medical business.

Is that where most of the recovery occurred?

No, actually it was from the second quarter, Derek, it was actually across all three business units.

Okay.

So it was kind of equal, and each one contributed a little bit differently.

Webster is obviously there -- some of their ratios are being impacted as they absorb that software acquisition, but they were up a little bit.

Medical was up, primarily due to that amortization issue we talked about last year -- that big chunk of acquisition amortization declined at the beginning of the year, and then, dental saw some leverage throughout their system despite the fact that they are still absorbing that Accu-Bite infrastructure as well.

So that had some room to move up, I think, in 2007, then -- the dental piece?

Well, we work at it all the time, so--.

Are you guys still anticipating, though, the same rate, or are we seeing margins here that are somewhat topping out where you wouldn't get as much of an impact from leverage, or do you think you still have room from that?

We think we still have room from that.

For next year, then, should we try to look for a 30 to 50 basis points improvement?

Well, for now, Derek, we are not going to give you any guidance on 2007.

We are going through that planning process now.

We typically give you guidance after the fourth quarter, so I think I will reserve any further comments, other than just to steer you back to our general operating model, or historic operating model.

That's what I've been using.

Okay.

That's fair enough.

As it relates to the equipment business, Steve -- or Jim -- the CEREC 3 units -- I know there are some new products there, and as well, I think there is some plan for 2007 -- do you think that some of the softness that you saw in the quarter might be related to a competing product coming out that may have -- may cause dentists to maybe take a longer term evaluation period here before they make a purchase decision?

Derek, I don't think so, but the real answer is I don't know for sure.

We know we had an advance in February, we called it National CEREC Month, and I think that had some impact to the people waiting til all those events took place during the month of February.

Okay.

There is also -- comparisons on the equipment business get easier as we move into 2007, and you mentioned there were some things you are doing there, some initiatives.

I guess do you mean some financing initiatives or some marketing plans?

What can you tell us about that?

Well, the initiative really is a prospecting program, that we put in place about two months ago, and we can see the pipeline filling up.

We just aren't seeing it come out the other end yet.

Okay.

That's good news.

Okay.

Thanks a lot, guys.

I appreciate it.

Okay, Derek.

Thank you.

Our next question comes from Larry Marsh from Lehman Brothers.

Please go ahead with your question.

Thanks.

This is Steven Postal for Larry.

Good morning, Jim and Steve.

Good morning, Steven.

How are you?

I just wanted to ask on CEREC, I know you gave a little bit of color on it, you talked about a rising inventory for that product line.

How many days of inventory do you usually have in CEREC, and how do you anticipate that inventory I guess being worked down over the course of the year?

Well, I don't think we would work it down, Steven.

I think what I tried to communicate, fairly ineffectively, is that we had too low of a level last year.

We were running almost out of CEREC during most of last year.

We've tried to build that inventory up, and currently, we are carrying about a month and a half of the product, and that's what we try to carry.

That help?

Yes, absolutely.

And would you anticipate there to be growth in the CEREC product line in the April quarter?

Yes.

Okay.

You may imagine a change in the dental business, I'm just wondering if you could maybe comment on how that transition has gone?

What additional responsibilities you have in the business?

I know you used to run the business, but how -- are you looking for a permanent manager there, or just update us on the management structure there?

I think the statement that I made that we still have not started looking for a replacement yet.

I am running it myself right now, and will through the end of this fiscal year.

We hope to have somebody internally that we'll be able to promote to that position.

It doesn't add a lot of extra work to me.

Obviously, I've been in that business 36 years.

I know it very well.

It's pretty easy for me to manage it without a lot of extra burden, and Gary Johnson, our Executive Vice President of Distribution and Logistics, is also helping with that.

Okay.

And then, just two clarification issues related to financial items -- Steve, what would you classify normalized capital spending to be?

We typically target capital spending at about our D&A rate, Steven, so right now, we are running D&A of about 24, $25 million.

I would think that -- again, I say we are not really forecasting for '07 yet, but we've talked about this before -- we were making some fairly heavy capital investments during 2005 and 2006 as we moved into this year's service initiative.

That's going to taper substantially.

I think we put up five new buildings, or four new buildings -- four new buildings -- in the last two years, and those are pretty -- well, they are not gigantic expenditures; they are 8 to $10 million a piece plus the furnishings inside.

So, you will see that start to taper back off.

So, I think you are going to see the spending start to come back down towards the mid-20s level, as far as our normal capital expenditures.

Okay.

Fair enough.

And then, for stock-based compensation, can you just clarify there, is that currently included in your financial recording, and, on an annualized basis, how should we think about that?

We have an element of it built in there, Steven, for this year, which is new because we changed some of our executive compensation programs at the beginning of this current fiscal year.

We went from a stock option program to a combination stock option and a restricted stock program, the restricted stock results in compensation expense being required to be recorded.

I would refer you back to the notes to the financial statements in our 10-K as far as the FAS 123R impact, and we are required to begin reporting that in our first quarter of fiscal 2007.

I think -- and just to go one step further -- I think we are anticipating that that expense is still going to be in that two to four range.

We still are obviously like a few other companies that are on the tail-end of this adoption, still analyzing some of the impact of some of the programs.

We want to make sure we get it as accurate as possible under a really ridiculous standard.

We will try to get it as close as we can.

Fair enough.

Thanks a lot.

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

Please go ahead with your question.

Thank you.

I have a question about equipment here.

In the past, you guys had often had the best numbers in the industry for equipment growth.

Could you talk a bit more about your -- the details of your plans to run this business?

Also, given your current pipeline now, what kind of visibility do you see in an inflection point for a rebound?

Well, Suey, a couple of things -- first of all, we stated that we grew in the quarter in 2005 by 30%.

So, just equaling that number, we feel pretty good about it.

Even though it's not our historical performance, it's still a very strong performance in the equipment business.

It's a focus issue, and we got everybody refocused about two months ago on basic equipment, dental chairs, units, lights, and x-rays.

We put out a prospecting program that every sales rep and every brand’s participated in, and as I said, we see the pipeline filling up, and we expect that to impact the fourth quarter a little bit, but, as you know, equipment sometimes is 90 to 120 days out before we realize the billings.

Jim, have you changed the compensation program for your reps at all for equipment?

No, we have not.

I don't know how that rumor got on the street.

Is there -- do you think, in the past, there was too much focus perhaps on CEREC, and diverted attention away from the basic equipment?

Well, I don't know if -- that's a piece of it, Suey.

The other piece of it is you get a lot of people making a lot of money, and they get satisfied.

So, we had a pretty strong performance of some sales reps that became a little complacent, I think.

Just one last question here.

Can you talk about David's plans to implement the branch manager system at Patterson Medical?

Currently, what we are trying to do, Suey, is to find an acquisition that we think fits well with us with a local -- buying up one of the local distributors and building out our model and making sure that that's -- that works for us, and that's the direction where we want to go, and David is very aggressively working at that.

Okay.

Great.

Thank you, Jim.

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

Please go ahead with your question.

Good morning, guys.

This is Matt Jackson in for Bob.

Could you quickly comment on your expectations for working capital metrics improvement going forward, and also, could you comment on any plans for de-leveraging going forward?

I think our historic metric is always -- our balance sheet metric, Matt, and our working capital metric, we start out, and we target to try to get 80, 85% of our earnings into free cash flow.

That would be after our CapEx.

Obviously, with the over spend we are having compared to our historic norm in CapEx, we are spending a little bit of that this year.

The working capital, I think, has confused some people because last year we talked about the fact that we were getting a boost because of some timing coming out of our accounts payable processes, our cash disbursements processes.

That was not going to be repeated.

We are back to a normal cycle there.

We've had some acquisition impact this year that we are absorbing.

So, I think what I would do is send you back to the historics and say we would intend to try to get 80, 85% of our earnings into free cash flow, and if we manage our balance sheet by trying to get a day out of our days sales each year and get our turns up by about a half a turn of inventory, we should be able to manage to that level.

Our expectations would be no different than that.

It's a long answer to your question, but--.

Okay.

And on the expectations for de-leveraging?

I think, at this particular point, we had talked about maybe taking down some of the debt late last year -- calendar year.

We decided against that because of some of the building projects and so forth we had going on, but I would think over the next 12 months -- 18 months -- if we see nothing different, we have part of that debt -- actually coming due about 70 million of it I think actually reaches its maturity date in November of '06.

So, that will cause some change there.

Whether we elect to take any more of it down at that point, Matt, will depend on where we are from investments in the business and so forth, acquisition opportunities, between now and then.

That's fair enough.

Thanks.

Our next question comes from David Veal from Morgan Stanley.

Please go ahead with your question.

Hi.

Good morning.

I'm wondering given the strength that we've seen in digital radiology, if you can talk to the outlets that lies for that business in terms of what kind of growth rates you would expect given the penetration, and any competition you might be expecting, and so on?

Well, there's plenty of competition out there.

I don't think we see any real change in that.

We are penetrated to about 25% in our opinion, and we think there is still a lot of runway in digital.

We think it's still the number one thing that a dentist thinks about acquiring, so we think the growth would be quite strong in digital x-ray.

If had you to put a number around what you think that number is growing at, where would that come out?

Well, people say the market is growing at 50%.

I don't agree with that.

I think the number is probably more like 25% or 30%.

Okay.

Great.

Thank you.

Our next question comes from Glen Santangelo with Credit Suisse.

Please go ahead with your question.

Yes, thanks.

I had a quick question on the medical business.

In the past, we've talked about a long-term growth rate in the mid to upper-single digits in this division.

Obviously, the Company had a little bit of a lower number this quarter.

Could you give of us maybe a sense -- is it more of a competitive issue, some internal operational issues?

What do you see to get that business back on track?

And also, in the past, you talked about a mix shift to lower margin products within that business, so maybe you can just give us an update on what the recent experiences have been, that would be helpful?

Thanks.

Well, we think the major issue was a management issue at the medical company.

Obviously, we made that change, and we feel quite good about that.

The other thing that we did, we intentionally put a no acquisitions in the last 12 months in that business because we weren't confident in prior management.

So, I think will you see us start to get more active on the acquisition front, which will help fuel that growth in that business.

And as far as the mix, the capital equipment is around 13% or 14% in that business, which is a lower margin piece of business than the consumables are.

It's continuing to grow a little bit faster than the other piece of business, but it's not a huge effect on the business.

Jim, so are you suggesting that potentially the operational issues may be being dealt with by the new management in that division, and you've green-lighted that division to go ahead and do acquisitions again?

That is correct, as well as add several sales reps in the next quarter.

And I think you had talked about when you originally acquired Ability One, that it was three to four times the size of its next largest competitor.

Is there anything of any size or any sizeable properties in that business or--?

There are no real big ones, but there are an awful lot of small ones that are ripe for roll-out.

Okay.

Alright.

Thank you so much.

Our next question comes from Richard Tortoriello from Standard & Poor's Equity Research.

Please go ahead with your question.

Good morning.

Can you tell me what the cash from operations number was again?

48 million.

48 million.

And on the Webster business, can you talk about how the consolidation of your distribution facilities might help the margins and any other plans that you have for margin improvement for that business?

Just globally, what we are doing with the distribution business is trying to put all three of the businesses under one roof and take advantage of the efficiencies that we can get out of that process.

Longer term, there’s other opportunity there as well, but not a major focus at this point.

I would put it into broad terms, Richard, that if you look at the distribution cost today for the three businesses, and in matters of degree, maybe $0.06, $0.065 per revenue dollar for the dental business, $0.08 to $0.085 in the medical business, and between $0.09 and $0.10 in the veterinary business.

So, the opportunity is to move those two higher cost businesses down towards the dental business, in addition to leveraging the opportunity at the dental business as well because you put more volume in, and you should lower that overall cost as well.

That's the opportunity we are looking at.

It's going to take us three to five years to achieve the totality of what we are seeing today, but we will keep working at it.

We've accomplished two vet and dental combinations -- one in Columbia, South Carolina, the other in Kent, Washington -- as the operation in Lancaster comes up in the first quarter of 2007, as that building is completed, you will actually see all three product lines go into that facility, and over the last 12 months, we have added medical products to two of the central distribution centers -- Jacksonville, Forth Worth, and Dinuba, California.

So, we are moving forward on all fronts, and it's just a continuation process.

You can't do it all at one time.

We just don't have the resources to do that.

Sure.

And can you talk briefly about what you see as other opportunities for margin improvement in the vet business?

I know that you are facing some margin pressure just because of expanding your market share and some price competition, but can you talk about specifically what you are looking at to improve margins in that business?

Well, the major change that we are trying to make is to build out the same model that we have in dental in the veterinary business.

We are well underway to doing that.

We acquired a software business for the -- practice made look for the veterinary in this past year, and digital x-ray is as hot in the vet business as it is in the dental business, but you have to have a software package to be able to sell that effectively.

And unlike the dental business, in the vet business, the margins are much higher on capital goods than they are on soft goods.

So, we see a huge amount of opportunity, and we've seen some results in this quarter of them increasing their percent of total business in the capital equipment business and software business.

Great.

Thank you very much.

You're welcome.

[OPERATOR INSTRUCTIONS]

Our next question is a follow-up question from Larry Marsh with Lehman Brothers.

Please go ahead with your question.

Hi.

It's Steven again.

Just a couple of follow-up questions -- just wondering if you could go through, in the Webster business, obviously, you emphasized that equipment was strong.

Can you just maybe detail what some of the long-term goals are there with equipment and where you think equipment could be in terms of a percent of the entire vet business?

I'm not sure that we know the proper number because I'm not sure we know enough about it because nobody in the vet business has been in the capital equipment business other than a bunch of small players, but we anticipate that it will be at least as good a mix as it is in the dental business.

We are starting to do office design, or hospital design, if you will, for the veterinarians just as we do in the dental business, and we would like to see that mix get to the 25, 30% ratio of their total sales.

Okay.

I just wanted to clarify the CEREC issue -- I don't want to beat it to a pulp, but your view on that product line is that demand is still good for CEREC, and that it could have been a comparison issue, and also, the February event that you have?

Correct.

We see the demand still very strong, and we think that the fourth quarter will be very strong in CEREC.

Okay.

And then, Steve, you have a share repurchase authorization, I believe.

Could you just talk about what your sensitivity would be in terms of using a part of that authorization?

Historically, we have used that authorization just to keep the dilution out of the share count.

We haven't used it really since, I think, December of '02 or '03 -- I think it's '02, mostly due to the times -- having acquisition opportunities facing us at the time, and we have four windows that we can use during the year.

I talked about, in the past conference calls, about the possibility of putting a 10B.51 plan in place.

We may do that.

It's not that high on the priority list, but we will use that strictly to try to take the dilution out.

We don't have any intentions of trying to do any financial restructuring or anything with that share count at this point.

If we ever get into that type of a strategy, we will certainly let everybody know, so it's transparent to the entire community.

Okay.

Thanks a lot.

Thank you.

Management, at this time there are no further questions.

Please continue with any further remarks that would you like to make.

At this point, I would just like to thank everybody for joining us today, and we'll look forward to seeing you on our fourth quarter call.

Thank you.

Ladies and gentlemen, this concludes the Patterson Companies' third quarter 2006 earnings conference call.

If you would like to listen to a replay of today's conference, please dial in to 303-590-3000, and using the access code of 11054185.

Once again, if you'd like to listen to a replay of today's conference, please dial in to 303-590-3000, and use the access code of 11054185.

We thank you for your participation.

You may now disconnect, and thank you for using AT&T teleconferencing.