Patterson Companies Inc (PDCO) 2007 Q2 法說會逐字稿

Welcome to the Patterson Company's second quarter 2007 earnings call. [OPERATOR INSTRUCTIONS] As a reminder, this conference is being recorded Wednesday, November the 22nd of 2006.

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

Please go ahead, sir.

Thank you.

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

Joining me today is Steve Armstrong, our Executive Vice President and Chief Financial Officer.

We will be pleased to take your questions at the conclusion of our remarks.

Since Regulation FD prohibits us from providing investors with any earnings guidance unless we release that information simultaneously, we have included financial guidance for the third quarter of fiscal 2007 in this morning's earnings release.

Our guidance is subject to a number of risks and uncertainties that could cause Patterson's actual results to vary from our forecast.

These risks and uncertainties are disclosed in detail on our annual report on Form 10-K and on other SEC filings and we urge you to review this material.

As an editorial note to my comments, references to years will be to our fiscal years unless otherwise indicated.

Turning now to our second quarter results, consolidated sales rose 8% to $694.3 million.

Substantially all of Patterson's second quarter sales were -- second quarter sales were internally generated.

Second quarter net income came to 48.2 million or $0.35 per diluted share.

Our second quarter earnings included after-tax stock compensation expense of approximately 1.6 million or $0.01 per diluted share.

We are estimating consumer impact from stock compensation expense in each of the two remaining quarters of 2007.

Now for the next few minutes, I will briefly review the performances of our three business units.

Patterson Dental, our largest business performed at a relatively high level in this year's second quarter, with sales growth of 7% to more than 512 million.

Consumable dental supplies, basic dental equipment, and digital radiography systems and related software all posted solid year-over-year sales growth.

But as we anticipated, sales of CEREC systems were down from the year-earlier level.

CEREC is continuing to make a substantial contribution to our equipment business, but during the past several quarters, we have not been successful in growing the sales of this product category.

We are not overly concerned about this lull in CEREC sales growth.

Based on our conviction that CEREC's advanced CAD/CAM technology represents the future of dental restorative procedures, we remain confident that CEREC systems can eventually penetrate upwards of 50% of all general practitioners, compared to the current penetration level of 5 to 10%.

We believe the market forces that have been driving our overall equipment business in recent years remain fully intact, with dentist investing in equipment that strengthens productivity, offers increased revenue opportunities, and provides their offices with a state of the art appearance.

Now turning to Webster.

Sales of our veterinary supply unit increased 15% in the second quarter of 2007 to 95.4 million.

Excluding the December 2005 acquisition of Intra Corp., the developer and marketer of IntraVet veterinary practice made with software, Webster sales were up a strong 13%.

While Webster's performance continued to benefit from the expansion of its geographic footprint through targeted acquisitions and internal start-up, most of its second quarter growth was generated by its core business.

In addition, Webster's strategic emphasis on veterinary equipment paid further dividends in the second quarter, as equipment sales rose more than 100% from the prior year's level.

The IntraVet practice management software line generated a portion of this strong equipment growth.

All in all, we are very encouraged by the ongoing prospects of our veterinary business.

Patterson Medical, our rehabilitation supply and equipment unit also posted double digit growth with sales rising 10% in the second quarter to 86.7 million.

This marks Patterson Medical's second consecutive quarter of solid sales growth.

Making us believe this unit is in starting respond to the strategies implemented by its new management team.

Taken as a whole these strategies are focused on deploying a more extensive value-added business model, led first and foremost by an expanded sales force.

As many of you know, we are establishing a number of full service branch offices in selected markets.

In June, we acquired our first such location through the acquisition of a full-service dental distributor in the New York market.

This acquisition was strategically important for the additional reason that it gave us access to premium equipment lines that historically were unavailable to Patterson Medical.

Then in the second quarter, we opened a full service branch in Chicago.

We expect to open or acquire additional branch offices in fiscal 2007.

At the same time, Patterson medical plans to start rolling out our Imagine electronic order entry systems to its customers late this year or early in 2008.

This rollout whether will mark another key step in the process of implementing our value-added model.

We believe Patterson medical is heading in the right direction towards achieving its full potential in the large and growing rehabilitation market.

One last item I want to briefly discuss is the issue of operating expenses.

Excluding the impact of stock compensation expense, our operating leverage improved by 40 basis points from last year.

Although more work remains, we believe we are getting a much better handle on operating costs and we intend to maintain our focus on expense management going forward.

The solid performance of these three businesses combined with the positive impact of improved expense control enable Patterson to post good second quarter operating results.

Going forward, we believe the difference between a good quarter and an exceptional quarter may depend in large measure on the performance of our CEREC product.

We remain confident in this product and believe CEREC sales momentum should gradually build up in coming periods.

For this reason, we believe Patterson's performance should start returning to our historic norms as we move ahead.

Turning now to the financial guidance contained in this morning's release.

We are forecasting earnings of $0.43 to $0.45 per diluted share for the third quarter of fiscal 2007 ending January 27, of 2007.

This guidance incorporates stock option expense of approximately $0.01 per diluted share.

Thank you.

Now Steve Armstrong will review some highlights from our second quarter results.

Steve?

Thank you, Jim.

I want to begin with a point of clarification about our revenue growth, both in this quarter and through the end of our fiscal year.

In the second quarter of last year, we completed the acquisition of Accu-Bite Dental Supply in early September.

Accu-Bite consisted of both a field sales organization and a telemarketing group.

We have now integrated the field sales portion of that business into our existing operations.

At the end of fiscal 2006, we closed the telemarketing portion of Accu-Bite and moved as much of that business as possible into our field organization.

As expected, much of the sales volume associated with the telemarketing operations went to dental suppliers who approached the market with a low-price model.

We estimate in this year's second quarter, the closing of the telemarketing operation, which was partially offset by the integration of a field sales business caused revenue growth to be negatively affected by approximately 1 percentage point.

This negative impact will approximate 2 percentage points in each of the remaining quarters of the fiscal year.

Turning now to gross margins, the dental segment margins improved 30 basis points year-over-year.

This result included the negative impact of the 2.9% financing promotion on CEREC that was in effect throughout the quarter.

The gross margins of our veterinary segment also improved by 30 basis points in the quarter due to the sales growth of equipment and software, which carry higher margins than consumables.

Gross margins at Patterson Medical declined nearly 3 percentage points.

As we discussed during our last conference call, Patterson Medical's newly hired sales representative had been given some short term latitude to establish their books of business through discretionary discounting.

This latitude will be phased out as these new representatives meet their sales targets.

Another factor contributing to the margin decline at the medical segment has been compaction resulting from the fixed price contracts with large group customers.

Price increases from our vendors have been substantially higher during this year than in the prior years, due principally to increases in their raw material costs.

As these fixed price contracts come up for renewal over the next few months, we would expect to mitigate most of this margin compaction.

As I discussed in our -- as I discuss our operating expenses and operating margin, I will be referring to the results that exclude this stock compensation expense resulting from the adoption of FAS Statement 123R so the comparisons are consistent between periods.

You will find a reconciliation of the impact of 123R included in the press release we issued earlier today.

Each of the business segments improved their operating leverage during the second quarter.

In addition to the expense control that Jim mentioned earlier, we are starting to see the planned leverage related to the shared service initiatives that we have been pursuing in distribution, information systems, and other backroom functions.

For example, during this current quarter, we closed the medical distribution center in Chicago and moved those operations to our new eastern Pennsylvania distribution site.

As you may recall, we are combining three individual dental, veterinary, and medical DCs into this new Pennsylvania site.

To date, we have relocated the dental and medical operations to this site and our veterinary distribution center will be combined there later this fiscal year.

In summary, we would expect to see additional improvement on our operating leverage through the second half of the year as all of our initiatives continue.

For the quarter, the dental and veterinary segments improved operating profit to 11.9% and 5.5% respectively.

I'll repeat that, dental was 11.9, medical -- or veterinary was 5.5, the operating profit at medical declined to 15.9% for the quarter.

As we have stated previously, fiscal 2007 is a year of investment at Patterson Medical and our performance metrics will reflect the impact of those efforts.

Looking now to our cash flow, we generated $30 million from operations in the quarter compared to 38 million in the prior year.

We announced earlier in the quarter that we were investing in additional $105 million in our employee stock ownership plan and that those funds would be used by the plan to purchase shares of the Company's common stock in the open market.

You will see that $105 million reflected in the financing section of the cash flow statement.

The date of stock purchase activity is nearly complete and should result in the plan acquiring 3.1 million to 3.2 million shares.

During the quarter, approximately 2.2 million shares were purchased fairly ratably from mid-September to the end of the quarter.

These shares will be excluded from the earnings per share calculation until they are allocated by the plan.

We anticipate the allocation of the shares will begin in fiscal 2012 and will take place over an estimated 10 to 15 year period.

I also want to mention at this time that we will require -- will retire $70 million of fixed rate debt later this month when it matures.

Inventories came down during the quarter as both the Dental and Medical segment inventories were worked down after the relocations into the eastern Pennsylvania site.

Our DSOs stood at 48, which is comparable to the prior year.

With that, I'll turn it back to the conference operator who will poll you for your questions.

Thank you.

[OPERATOR INSTRUCTIONS] Our first question comes from Glen Santangelo with Credit Suisse.

Just a couple quick questions.

My first question is on CEREC.

Jim, in your prepared remarks, you suggested that CEREC could return to historical norms.

Do you mean in terms of the sales growth per quarter, or do you mean the revenue growth as a percentage basis per quarter?

And then could you give us any sense for the magnitude of how weak the sales are year-over-year?

Your answer to the first question is we think we can get back to the historic percentage growth, if I understand your question properly, Glen.

Yes, that was it.

Second one, I'm not sure that I know the number.

11%, Glen.

Down 11%, Steve, thanks.

Then just on the medical business, obviously this is a year of investment, would you expect the margins to be down a similar basis for the next couple of quarters?

And then start to ramp back up after that?

The answer is, yes, this might be the bottom of that.

It will sort of depend on how quickly and how much success we have with these GPO fixed rate contracts as we renegotiate those.

But as we've told you, we expect their metrics at medical to be down this year.

I don't know that it would be any more severe than it was in this quarter.

And then I know you guys had been holding off on acquisitions in that division until the operations were up to par are you almost at a point where you think you can start to do acquisitions in the medical business?

Yes, we've been pretty actively pursuing for the last four to five months there.

And my last question for Steve, you said you're retiring 70 million of fixed debt.

Could you give us the interest rate on that?

Right off the top of my head, I'm going to say it's about 3.14.

Okay.

With my able-bodied assistant here.

Thank you so much.

I was going to say 1.3, it's 1.4.

Okay.

Thank you so much.

Our next question comes from Lisa Gil with JP Morgan.

Please go ahead.

Thanks very much and good morning.

Good morning.

I was wondering if I could follow-up on CEREC and perhaps if you could just talk about why you anticipate that there will be reacceleration from a sales perspective?

What gives you that insight?

And then secondly, when you talk about 50% penetration, what time frame are you looking at?

I think we're talking about over the next ten years time frame to get to that 50% level.

We think nothing's changed as far as CEREC is concerned, as far as the viability of the marketplace and the modality that represents and so we think long-term that we will get back to the levels we were at historically.

I think there are several reasons for the current agnation of the sales number.

Maybe you can walk through what those current reasons are?

One thing, there's been a lot of noise in the marketplace about a competitive product coming on the market.

We have a lot of customers waiting to see that product.

And I can understand that.

If I were going to make a $100,000 investment, I guess I would like to see everything available in the market.

I think that's probably the biggest factor.

The other thing is that we're currently selling a product that's almost three years old now model-wise, hasn't changed very much.

Great.

Just secondly, if you could maybe talk about acquisition opportunities on the veterinary side and if you would ever think about expanding into the production side of the veterinary business?

The answer to number two, first, no, we are not interested in the production side of that business.

Acquisition, there are certainly some companies out there we're very interested in acquiring.

Unfortunately because of the activity in the public market, most of the owners think that their businesses are worth considerably more than they really are in our opinion.

So acquisition has been somewhat difficult in that segment of the business.

So we've concentrated primarily on greenfield, on opening our own operations and most recently in southern California and currently looking to northern California.

Great.

Thanks very much for the comments.

Thanks, Lisa.

Our next question comes from David Veal with Morgan Stanley.

Thanks.

Just wondering if you can address -- it seems like the growth in CEREC has been a little bit frustrating just given the aggressive promotion that was out there.

I wonder if you could speak to why that might be?

And then secondly one for Steve, just wondering what's in the other assets bucket on the balance sheet?

Seemed like that ticked up sequentially fairly meaningfully?

David, I really just answered that CEREC question, but I'll go through it again.

I think there are a lot of customers out there waiting for the introduction of the competitive product to come on the marketplace.

And secondly, the current product that we're selling, it's about three years old now.

There have been no changes to speak of of that product for the past three years.

Okay, thanks.

And Steve?

The other asset category, the click-up in this quarter, David, was due to the 2.9 financing contracts that we issued on CEREC.

That was also why the second quarter cash flow was a little less than last year.

We're going to hang on to those contracts as opposed to liquidating them and probably carry them out to their maturity.

We'll treat those contracts as a cash investment, if you will.

We carry excess cash on the balance sheet, we'll just treat that as an investment.

And so those will be down there for a number of quarters here going forward, working their way back off again.

We'll add a little bit more -- the promotion actually ended at the end of October, which was the second quarter, but the customer could still take delivery up through the end of this week and qualify under that promotion as long as their application was in.

We'll have some more contracts under that promotion into the early part of the third quarter here.

But rather than going through the exercise of moving those into the finance portfolio and some of the difficulty they cause with the lowering our overall performance in the portfolio, we decided to hang on to them as long as we had the flexibility to do that.

Sounds great, thank you.

Our next question comes from Derek Leckow with Barrington Research.

Good morning, Jim and Steve.

Good morning.

Can we just talk a little bit more about the dental equipment segment?

Give us some additional color on what's going on there?

It seems like you had pretty strong growth in some of the other products excluding CEREC.

Maybe we can separate the two so we get a better idea how the equipment business has turned around.

Well, we've really had good growth in all segments except CEREC.

Do you care to flush it out a little bit, Jim, or?

I don't care to break it down much further than that, I don't believe.

All other segments would include basic equipment, digital products, and software products.

Is it fair to say that that business has been fairly stable now?

Is it facing easier comparisons?

How should we think about the growth rate in equipment as we look ahead to next year?

We see nothing changing there.

We think that the growth will continue at the levels it's currently at.

We're coming up on some somewhat easier comparables than we had a year ago.

All right.

Just looking at next year, how important is CEREC to your operating goals?

It seems to me that you're trying to get back to that 15 to 20% EPS growth rate level.

And I wonder how important is CEREC to that objective?

Well, as I said in my prepared remarks, I truly do believe that going forward that the difference between a good quarter and a great quarter is going to be CEREC sales.

So you're saying that it's pretty important to next year's -- if we look at next year, just trying to get a gauge how important that is to the overall?

It is.

It's become very important.

It's a large product segment for us.

It affects us in several different areas and it's critical that we keep our growth there at a historic level.

And have you been in touch with Sirona yet in terms of their product evolution plans?

I know they've got some products both in terms of their basic chairs and so forth.

Are you going to be talking about any of those new products at this time?

No, not currently.

We're not prepared to talk about any of the new stuff just yet.

Okay.

Thanks a lot, guys.

Appreciate it.

Okay, Derek.

Next question comes from Suey Wong with Robert Baird.

Please go ahead.

Jim, I can understand how dentists are sitting on their hands here, waiting for the E-40 system to come out to compare.

Do you anticipate putting any kind of special promotions in the field to help incent the sales force to move CEREC or any other special programs along the lines of financing or product waves or et cetera?

Well, we've had promises all along here, Suey.

Unfortunately we've trained the customers, I've said in many of the past conference calls to buy on promotion.

We have continued promoting the product heavily.

We just had a finance promotion that went off the end of October, which really carried through until actually today.

Today's the last day that they must take delivery of the product to participate in that.

And we currently have a rebate offer out there in the field available to customers that are purchasing.

So you don't -- I take it you don't plan on putting anything to incent the sales force to try to move more product?

I think the sales force has plenty of incentive right now, Suey.

They're paid pretty handsomely to sell that product.

Do the consumable reps still get a kicker for referring someone -- referring a CEREC sale?

It's not really a kicker, Suey.

It's been there since day one.

They get a portion of the commission off of the CEREC sale.

Nothing more than that?

No, it hasn't changed since day one.

Then just lastly, have you seen any kind of impact from dental supply contributor consolidation in the U.S.?

I don't think anything I'd care to comment on just yet.

I think it's too early on in the game, Suey.

Okay.

Thanks, Jim.

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

Please go ahead.

Jim or Steve, is the medical business a 5% grower going forward or is it a closer to the 10% number you reported?

We're looking for double digit growth off medical going forward, Bob.

Okay.

Did you raise pricing on consumables in the quarter?

In the dental arena?

Nothing significantly, no.

We routinely pass on any increases from the manufacturer, but to my knowledge, it was nothing out of the ordinary during the quarter.

Is there any effort in the second half on that front that you will look to raise pricing?

I don't think anything off the ordinary.

Bob, we get most of our price increases from our vendors during this part -- this time of the year, historically.

I think publicly, dent supply -- in fact at the end of the first quarter, dent supply price increases had already started to be published.

So we're routinely adjusting our pricing book more actively this time of year, but as Jim said, throughout the year.

Okay.

And why does -- Steve, why does the debt reduction make sense here?

You're not terribly levered here.

Why not throw 70 million into the share repurchase and refinance the debt?

When we put the debt program in place, Bob, this piece matured in its -- in the normal course three years after we put that original deal back -- or in place back in 2003.

We are currently investigating our entire capitalization upon the completion of the ESOP transaction, so we may do something again in the debt market, but we didn't really have much choice on this 70 million that was due and payable, so we'll pay it off.

Okay.

And just lastly, the tax rate was a bit lower than what I thought.

What are you modeling for the second half of the year?

The tax rate is a booger to talk about anymore these days.

Basically, we're still looking at about a 3. -- or a 37.1%, what I'll call average rate.

The problem we get into in the environment that we're in today is that if we have any kind of tax settlements, if we have to adjust our tax reserves as a result of those settlements, if we get an unusual assessment that we weren't predicting, we have to flush those through the quarters.

And so the rate bounces up and down a little bit as we take care of that activity, Bob.

As a third factor or the second factor that pulls it off, what I would refer to as a predictable rate, is this whole stock compensation accounting, because a lot of that is not -- you can't tax affect it through the accounting of it.

So we end up with a little bit more volatility in our rate.

I would advise if you're trying to model it, do 37.1, 37.1%.

It's going to be above and below that modestly.

Okay, thank you.

Next question comes from Steven Postal with Lehman Brothers.

Please go ahead.

Thanks.

Jim, I'm just wondering another few questions on CEREC and the promotion, but you've mentioned -- you've articulated some perspectives about the value of promotions.

I was just wondering if you can maybe update us on how you view promotions in general and how you view that specific promotion in terms of its success?

First of all, any time you have an exclusive on a product, marketing the product and promoting the product ought to be two totally separate things.

Unfortunately over the years, I think we have moved to a point where we kind of mix marketing with promoting of the CEREC product.

And my point that I was trying to make earlier was that we have trained the customer over the past two or three years that if they wait along enough, we're going to have a promotion available to them so it behooves them to wait until we have a promotion out there to buy the piece of equipment.

And I think that's our fault.

I think we've trained the customer to react that way.

My point was, we've continued to do these promotions and we will continue.

Unfortunately, we're caught in the trap I don't believe we can get out of.

I think that it somewhat may change when the competitive product hits the marketplace and we're really comparing products not just comparing what this promotion compared to the last one.

Fair enough.

Moving on to the vet business.

Jim, can you remind us where you think that equipment can go in terms of total percentage contribution to the business and perhaps the time frame to get there?

Well, I think over time -- and I'll put that time frame out there as somewhere probably in the next 5 to 7 years where there's no reason in my mind why veterinary can't produce the same percentage of total sales and in capital goods that dental does, which is currently somewhere around the 30% number.

Okay, fair enough.

Just one financial question.

Steve, in terms of the share count, in terms of modeling it, is it fair to say it should go down sequentially with the share buyback related to the ESOP?

Yes, sir.

Can you quantify maybe how much?

It's going to be -- no, I can't for you.

The difficulty is going to be that we don't have all of the shares purchased at a point in time, so it averages in.

Probably would have two-thirds of the impact in the third quarter by the time you get it into the averages.

So if I told you this morning that we were going to buy back between 3.1 and 3.2 shares it looks like right now -- million shares -- so about two-thirds of that would be averaged in in the third quarter and then it should all be in the average for the fourth quarter.

That help?

Yes.

Thanks a lot.

You bet.

[OPERATOR INSTRUCTIONS] Our next question comes from [Lynn Seuer] with Raymond James Financial.

Steve, I wanted to ask a question about the sales force.

You mentioned that your expense on ramping up or integrating sales force for this last quarter, is that pretty much completed now, or are you still in the process of running that kind of an expense?

Well, I think we have the bowling ball through the snake, so to speak, at this point.

We added a large number of them at one point in time, which would have been the last quarter of last year and the first quarter of this year with the expense still affecting us into the second quarter.

We will continue to add to that sales force that I'm speaking now primarily about medical.

And we will continue to add, but it won't be at the same rate that you saw us add in that fourth quarter prior year.

What percentage of the sales force was it then and what do you see going forward as far as your new additions?

Well, our goal has always been at medical to double that sales force every three years.

So if we keep that number in mind, unfortunately we had gotten to the point 18 months ago where growth went to zero.

We were adding sales reps, but they were simply replacing weak salespeople.

And so in the fourth quarter of last year, we added about 25 sales reps, almost all in the quarter, which was a very large number for us.

Normally would have been only about a third that amount in the quarter.

And we don't see that repeating, but we will continue to add and grow that sales force with the goal continuing to be doubling every three years.

Thank you.

One last question to add on to your explanation of the ESOP purchase.

You said you're predominantly three quarters of the way finished with the purchase for ESOP?

No, no, well beyond -- better than 90% at this point, Lynn, as of today.

Okay, thank you.

Our next question comes from [Afi Guton] Sapphire Capital.

Thanks for taking my question.

I wanted to follow-up a bit more on the equipment side.

Maybe if you could remove CEREC and talk more about the market for just the basic and for the higher tech equipment, what are you seeing in terms of market growth there?

And maybe can you comment on how you guys are doing relative to that market growth?

Well, there are two main pieces in the part that you're talking about that we consider, digital would be one of them, which considers digital x-ray and of course our software and computer hardware business.

That piece of business, we see growing in the high teens, low 20s.

We think that will continue for the foreseeable future, simply because of it's still the number one product that's on every practitioner's mind as far as acquisition.

The second piece is the core dental equipment and really, we will continue to see that in the low double digits.

It's our opinion that we'll see that in the low teens, growth continue there.

We don't see anything changing as far as the need to keep increasing their ability to increase productivity in their dental practices and that's one of the biggest ways they can do it is to keep updating their jobs.

Okay, thank you very much.

Our next question comes from [Gregg Powell Furnishing Value Equities].

Please go ahead.

Hi.

Did you give the level of CEREC sales for the quarter?

No, we did not.

Okay, you don't disclose that?

We don't break that out separately, no.

And then did you give the amount of receivables associated with the low-cost financing?

It was -- for the quarter, we did not.

I don't mind giving it to you, it's about $25 million.

Is that for the quarter or is that cumulative on the balance sheet?

That was cumulative for the quarter -- or to the end of the quarter.

Okay.

And then what's the term on that?

Most of those contracts are written for 60 months.

Okay.

Some will pay out earlier.

I doubt many of these will pay out earlier, but that's the choice of the customer, not ours.

Okay.

And those are in long-term receivables?

Yes, the -- anything beyond 12 months would be down in the other category.

Okay.

Thanks a lot.

You bet.

Gentleman, there are no further questions in the queue.

Please continue with any closing remarks you may have.

We appreciate everybody joining us today.

We know it's a busy time of the year for most folks and we appreciate it and hope you all have a very happy Thanksgiving and a safe and joyous holiday season and we'll see you next year.

Ladies and gentlemen, this does conclude the Patterson Company's second quarter 2007 earnings conference call.

If you would like to listen to a replay of this call you may do so by dialing 303-590-3000 and entering pass code 11076446 followed by the pound sign.

Once again, for replay of the call, the dial-in number is 303-590-3000 and pass code 11076446 followed by the pound sign.

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