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Operator
Welcome to the Patterson Company's earnings fourth quarter 2007 earnings call.
(OPERATOR INSTRUCTIONS) As a reminder this conference is being recorded Thursday, May 24, 2007.
I would now like to turn the conference over to James Wiltz, President and CEO.
- President, CEO
Good morning and thanks for participating in our fourth 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 first quarter and full year of fiscal 2008 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 discussed in detail in our annual report on Form 10-K and other SEC filings.
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 fourth quarter results consolidated sales rose 6% to 739.1 million.
On a comparable basis, which excludes the telemarketing operation of the former Accu-Bite business that was closed in early May of 2006 consolidated sales increased approximately 8%.
We are generally pleased with the sales for this period, which were consistent with our expectations.
Fourth quarter net income increased 6% to 59 million or $0.44 per diluted share.
Our earnings for this period incorporated stock compensation expense of approximately $0.01 per diluted share.
As we mentioned in this morning's release, fourth quarter earnings were affected by a reduction in our dental gross margin due primarily to underplanned sales for the quarter of software.
We view this underplanned performance of dental software sales as a short-term situation.
For full year 2007, consolidated sales increased 7% to 2.8 billion from 2.6 billion in 2006 while net income of 208.3 million, or $1.51 per diluted share was up 5% from 198.4 million, or $1.43 per share in 2006.
Our 2007 earnings include stock compensation expense of approximately $0.05 per diluted share.
Now for the next few minutes I will briefly review our fourth quarter results.
Total sales at Patterson Dental, our largest business, generally met our expectations, based by solid sales growth of consumable supplies and a rebound in sales of basic dental equipment including digital radiography.
Sales of basic equipment rose a stronger than anticipated 13% year-over-year.
As expected, fourth quarter CEREC sales were down on a year-over-year basis as we transitioned into the marketplace several important enhancements to this system that CEREC's manufacturer, Sirona, introduced late in our third quarter.
Sirona significantly improved CEREC's software making it much easier to design highly aesthetic and precise restorations while also greatly streamlining the system's learning curve.
In addition, a much faster and more robust milling unit was introduced as an option on new installations as well as an upgrade to all existing CEREC users.
These enhancements, which take CEREC to a new level of performance, represent a significant advancement in dental CAD-CAM technology, and customer interest has been encouraging.
The process of transitioning to these upgraded features is still underway, which could continue to affect CEREC sales in this year's first quarter.
We are very optimistic about the future of the upgraded CEREC line and believe sales should strengthen as we progress through fiscal 2008.
Turning now to Webster, sales of our veterinary supply unit increased 13% in the fourth quarter to 109.7 million.
Webster's core consumable supply business continued to perform at a high level during this period.
In addition, Webster benefited from a 60% increase in sales of equipment and intra-vet practice management software.
Webster's strategic emphasis on expanding its value added platform which encompasses its equipment and software initiatives is clearly starting to pay dividends.
Patterson Medical, our rehabilitation supply and equipment unit, posted fourth quarter sales growth of 16% to 86.9 million.
Excluding the impact of three acquisitions related to the unit's branch office strategy and foreign currency translations, fourth quarter sales at Patterson Medical rose 8%.
This marks Patterson Medical's fourth consecutive quarter of solid sales growth, making us believe that this unit is responding to the strategies that its management team is deploying.
These strategies are aimed at implementing a more extensive value-added business model.
Expanding Patterson Medical sales force is one of the primary ways this is being done.
During 2007, over 45 sales representatives were added, bringing Patterson Medical's sales force to more than 170, which is the largest in the rehabilitation industry by a wide margin.
As part of the effort to strengthen the unit's value-added platform we also are establishing full-service branch offices in selected markets through acquisition of equipment dealers and internal start-ups.
To date, Patterson Medical has branches in New York, Chicago, Greensboro, San Francisco, and New Orleans.
Additional acquisitions and internal start-ups are under consideration.
As a result of these and other strategies, we believe Patterson Medical is making solid progress toward attaining its full potential in the large and growing rehabilitation market.
As we look back over 2007, the past fiscal year was a period of significant investment for Patterson.
We invested in our distribution system to gain operating efficiencies while improving customer service at all of our businesses.
Webster Veterinary and Patterson Medical increased their sales forces and added programs and systems to advance their value offerings.
Patterson Dental made a substantial investment in the CEREC product to bridge the change-over through the enhancements that I discussed previously.
Although these undertakings had a negative impact on our 2007 operating results, we are convinced that Patterson is now more strongly positioned for long-term success.
For 2008, we are targeting our historical financial goals of revenue growth between 10 and 12% and operating margin expansion of 50 basis points.
Turning now to the financial guidance contained in this morning's release, we are forecasting earnings of $0.34 to $0.36 per diluted share for the first quarter of 2008 ending July 28, 2007.
And for the full year of 2008, we are forecasting earnings of $1.73 to $1.77 per diluted share.
Thank you.
Now Steve Armstrong will review some highlights from our fourth quarter results.
Steve.
- EVP, CFO
Thank you, Jim.
I will begin my remarks with some comments about fourth quarter gross margins.
Our consolidated gross margin declined by 40 basis points to 35.2% in the fourth quarter, from 35.6% in the year earlier period.
Our consolidated gross margin was affected by several factors.
First, while the dental segment margins improved 30 basis points in the quarter, they were negatively impact by a lower level of software unit sales as well as lower level of CEREC sales relative to the prior quarter.
While the CEREC performance was generally expected, as Jim discussed earlier, the software performance was below our expectations and caused our margins in dental to be lower than we had projected.
The two primary market drivers for software sales are the ongoing digitization of the dental operatory and the resulting need to add software to manage the electronic data in addition to the need to upgrade the front office practice management system to a more sophisticated solution.
We believe these drivers present a good opportunity to install our EagleSoft brand over the next several years, and we are not concerned by a one quarter fluctuation.
The second factor affecting our consolidated gross margin in the fourth quarter relates to the strong growth of the veterinary segment since it has the lowest gross margin of our three businesses.
While the medical segment's gross margin decreased year-over-year, it did improve 50 basis points from the third quarter.
This is the second consecutive quarter of sequential improvement, indicating that the factors that were causing the erosion earlier in the year are beginning to be effectively addressed.
As I discuss our operating expenses and operating margin, I will be referring to results that exclude the stock compensation expense resulting from the adoption of FASB statement 123R so the comparisons are consistent between periods.
The decline in our gross margin was offset by 40 basis points of improvement in our consolidated operating expense ratio to 21.9%.
We continue to see the benefits of our shared services initiatives as we better leverage the back room aspects of our business.
Our fourth quarter operating margins by business segment were 14.4% for dental, 14.9% for medical, and 6.7% for veterinary.
Turning now to fourth quarter cash flow, operations generated cash of approximately 127 million for the quarter, compared to $47 million in last year's fourth quarter.
For the full year, operations generated cash of $244 million compared to $164 million in fiscal 2006.
We sold approximately $45 million of finance contracts in the fourth quarter that were generated during a CEREC promotion earlier in the year.
This incremental sale of finance contracts contributed to the fourth quarter operating cash flow.
Capital expenditures totaled approximately 19 million this year compared to $49 million last year.
Our expenditures during fiscal 2007 were lower than we had planned.
Although we had exercised -- or initiated the exercise of a purchase option on an additional distribution center as planned, the closing of that transaction has been extended into fiscal 2008.
$49 million expended in fiscal 2006 included investments in a new share distribution center in central Pennsylvania, a new facility for our printed office products operation, as well as a new distribution facility for Patterson Medical's U.K.
operation.
We have now largely completed the first phase of our distribution realignment under our shared services initiative.
Since future phases of our distribution realignment are expected to require lower levels of investment in comparison to what we have spent over the last three years capital expenditures for fiscal 2008 should approximate $25 million while depreciation and amortization should be about $26 million.
Two other items of note impacting cash flow for the year include the investment of $105 million in our employee stock ownership plan which was used to purchase 3.2 million shares on the open market and repayment of $120 million of debt.
The debt retirement includes the prepayment of $30 million of bank term loans late in the fourth quarter.
A quick review of our balance sheet ratios shows that our day sales outstanding are at 44 days compared to 47 days at this time last year.
Inventory turns have declined to 7.2 from 7.3 a year ago.
We are targeting to improve inventory turns in fiscal 2008.
Now that we have repositioned the medical segment's inventory and new facilities.
Inventory turns are also expected to improve now that the CEREC enhancements have been introduced.
Thank you.
I will turn it back to the conference operator who will poll you for questions.
Eric.
Operator
Thank you, sir.
(OPERATOR INSTRUCTIONS) Our first question comes from John Kreger with William Blair and Company.
- Analyst
Thanks, it's [Natalie Friedman] in for John today.
My first question is about the basic dental equipment growth.
What do you believe led to the much stronger performance this quarter?
- President, CEO
Natalie, I think it's the same thing we've been talking about the last four quarters.
It's a matter of focus and getting the field sales people focused back on the core equipment issue.
- Analyst
Okay.
Great.
And how have the specialists and general practitioners reacted to the 3-D imaging technology?
- President, CEO
The new CEREC?
- Analyst
Yes.
- President, CEO
Okay.
Well, the 3-D is actually the old technology what.
What was introduced as a new software that makes the process dramatically easier, but the response has been very good.
We've had it at four shows now, and I think that it's fair to say that the professionals are impressed with the new enhancements and improvements to the CEREC.
- Analyst
What about some of the other new products like Galileos?
Have you seen interest there as well?
- President, CEO
Yes, we have.
It's fairly early on in Galileos life, but its 3-D x-ray in general is creating a lot of interest, and I think the Galileos is one of the leading machines that are on the market.
- Analyst
Thank you.
Operator
The next question comes from Lisa Gill with JPMorgan.
- Analyst
Thanks very much.
Good morning.
Steve, I was wondering if maybe you could talk about your expectations around the operating profit drivers.
You said that you anticipated that it would be 50 basis points improvement over this year.
Would you anticipate that gross margins are going to improve, or is this going to continue to be taking costs out?
And then just secondly, if you could just talk a little bit about the new CEREC product and the different price point versus where it is today, and what you think will be the driver to adoption of some of the newer products.
Thanks.
- EVP, CFO
I will take the first part of that question, Lisa, on the drivers, and I'll let Jim talk about the CEREC pricing and the reactions there.
Generally looking forward, as Jim said, we're looking for 50 basis points of improvement at the operating line, and I think that's -- our look at it today says it's going to be pretty traditional, maybe 10 to 20 points coming out of the gross margin, and the remainder of it coming out of the operating leverage.
I think we started to see that operating leverage pick up through the second half of the year.
We had a lot of duplication costs in the first half of the year as we were repositioning the distribution system.
Those should go away.
We got rid of some inefficiencies in some operations which Jim had talked about that we sold one back at the beginning of the year.
Had a dribble effect into the early part of last year.
But I would say it's pretty traditional what we've talked about in the past.
10 out of gross margins, maybe 20 out of gross margin, then 30 to 40 out of the operating expense.
- Analyst
If I could just ask another question on the gross margin, when we think about the gross margin, is this just shifting from one of your businesses to another?
For example, do you anticipate that dental and rehab will grow faster than veterinary, and that will help to drive it, or is it that you believe that you can get better pricing or do something else on the gross margin side, just so we can understand this from a modeling perspective?
- EVP, CFO
I would tell you that it's a combination of all of that Lisa.
We don't spend a great deal of time looking at it.
I would think that the gross margin is going to be primarily mix.
If we're right about CEREC, that's going to have a positive impact for the year in the mix.
The other businesses, as I mentioned in my comments, medical is starting to get their gross margin issues under control, and we would expect that to continue through 2008.
We have to be a little bit careful because as Webster grows, while their margins will improve, they're still the lower gross margin producing business of the three, so that if they tend to outpace the other two businesses, that may cause it, on a consolidated basis to dilute a little bit, but I don't know what more color I can give you on that at this particular point, Lisa.
- Analyst
No, that's very helpful.
Thank you.
Jim, any thoughts around new pricing on CEREC and competition?
- President, CEO
Well, first of all, there is no competition, Lisa.
- Analyst
Not at this point, right.
- President, CEO
Correct.
The pricing of the -- first of all, the acquisition unit is the same as it was before.
There's new software in the acquisition unit today, which all of the current users will also be updated to the new software product that belong to the CEREC service club at no charge.
And what we would call the historic acquisition unit and the milling chamber that we've had for the last five years is going to -- actually has come down slightly in price to $89,000.
And the new milling unit, which is the difference in the price between the two, since the acquisition units are exactly the same, is approximately $15,000.
- Analyst
Okay.
And talking about your competitor and their delay in coming to the market, do you think that that's pushing off sales in any way?
Decisions by dentists around this type of product?
- President, CEO
Lisa, I think it has in the past.
We believe that it may not with the new enhancements that we have now with the new software and the new milling chamber, because those were some of the issues that they were claiming strength with, so we think that we've addressed some of the issues that they were raising in the marketplace, but I don't think we'll really know until we get through this first quarter, but I do think customers are only going to wait so long.
- Analyst
Thanks for the detail.
Operator
Next question comes from Steven Postal with Lehman Brothers.
- Analyst
Thank you and good morning, Jim and Steve.
I just wanted to drill down to start on CEREC.
You mentioned that customer interest has been encouraging, obviously some of the comments from Sirona have been about some manufacturing glitches, as they've termed it.
Can you just maybe flesh out some of your comments with some of theirs?
Are you seeing some issues with getting the product to market, and how has the customer response been in terms of the -- of getting CEREC orders filled?
- President, CEO
Well, I think the customer response has been very good.
I think that the problems that we're facing are normal in the early life cycle of a new product, particularly one as complicated as CEREC is.
I spent a fair amount of time yesterday on the phone with the CEREC folks in Germany, Fisher, and I feel very confident that they understand all the issues and they have the fixes underway for all of them.
We had a conference call with virtually our entire field force of CEREC specialists and CEREC service technicians and the issues appear to be the issues that Sirona understands and has the fixes underway for.
So I feel pretty good about where we are.
I think by the time we get to the end of the first quarter that we should be in the mainstream of the new CEREC MCXO.
- Analyst
In the context, I think, Jim, you said 10 to 12% revenue growth guidance.
Obviously the dental business is the majority of the Company.
What are the drivers there for that?
If you look back, you haven't had that type of organic growth for a couple of years.
Is that organic, or are you including some acquisitions in there?
- President, CEO
Well, I don't -- we never really count on acquisitions in the dental business anymore but we do count on internal addition to the sales force.
We train about 120 new sales reps a year, and historically we get about 50% of that number as an addition to our sales force every year, so we're looking for an add of somewhere between 60 to 75 sales reps internally, and that will account for a fair amount of that growth.
And frankly, getting our equipment business back on track is where we're really looking for that, the majority of that to come from.
- Analyst
Okay.
Then onto the medical business.
Steve, you mentioned that some of the gross margin issues there have been resolved, and I think a couple of the issues that you talked about in the past, the issue of fixed price contracts, and then also allowing new sales reps to use margins to gain a book of business, can you just maybe drill down to those issues, how you're dealing with them, and have they fully been resolved?
- EVP, CFO
Well, I think the maturation of the sales force, the longer they're in the marketplace, and, if you will, the management of that process is what's causing some change there.
The fixed price contracts were through basically the renewal season.
That issue has been taken care of.
The operation, you said they're fixed.
I'm not sure they're fixed yet.
We're working on some of them yet.
Medical has seen a fairly substantial impact from freight over the last 12 months.
That's a combination of dealing with market forces as well as that organization learning to work with multisited distribution versus more of a single-sited distribution system.
So we've got things to learn there.
So I think you're going to continue to see improvement.
We're not done there by any means.
- President, CEO
I'd like to make a comment about the sales rep issue of medical.
I think if you look at all three of our businesses, the young sales people always tend to lead with price in all three of our businesses because they haven't gained the confidence yet in themselves, and I think the only reason that it's come to light in medical the way it has is the fact that we've added such a large number of new sales reps percentage-wise into their sales force over the last 12 months.
- Analyst
Then just a question on Webster.
Obviously a great performance over the past year in that business.
Jim, what would you say are some of your initiatives for the next fiscal year?
Do you think you have all the resources and things there that the business will just keep growing nicely?
- President, CEO
Well, we really do.
We're very comfortable with the culture that exists at Webster, and, if you will, the value-added -- they embrace the value-added model that we have at dental.
We still have just -- scratching the surface on the equipment initiative there which I think is a huge one when you consider we're the only people in the business that are going after the capital goods side of the veterinary market, and that, coupled with our new software platform and hardware for the software, we see some real nice growth there as well as growing our consumable business quite nicely.
And I think that as we keep that mix of equipment growing, why that helps our margin problem a bit.
- Analyst
Okay.
Thanks a lot, guys.
- President, CEO
You bet.
- EVP, CFO
Thank you, Steven.
Operator
Our next question comes from Virgil Willoughby with Banc of America Securities.
- Analyst
Virgil Willoughby, that's a new one for me.
Steve, I think you mentioned a D&A in the neighborhood of 25 million or 26 million which doesn't reflect much of an uptick over the course of the year.
I would have thought if the CEREC sales were ramping up we would have seen a bit more on the amortization front.
- EVP, CFO
No, I think the D&A, we've got a combination of things going on.
We had some acquisition intangibles that were being written down.
That's starting to wind its way out of the numbers.
Then you have the amortization coming in.
That amortization, Bob, does not, I repeat does not include the amortization of the CEREC contract because that's caught up in the gross margin.
- Analyst
Oh, really.
- EVP, CFO
Yes.
- Analyst
Okay.
So your margin expectations up 10, 20 basis points does reflect some step up in amortization?
- EVP, CFO
Absolutely.
- Analyst
Okay.
And did you do any special promos on the basic equipment front in the past quarter or was this just better execution as you indicated?
- President, CEO
We had a promo in Panoramic x-ray machines, which impact it some but I think it's just better execution overall.
- Analyst
And maybe lastly, I mean, you had a tremendous cash flow quarter here, yet you still put absolutely nothing to work here.
When do we -- when do you kind of speak to or leverage this competitive advantage in the balance sheet either from an M&A standpoint or any type of more meaningful capital structure initiatives than what we've seen to date?
- EVP, CFO
I get to answer that one?
- President, CEO
I'll leave that to Steve.
- EVP, CFO
Bob, we're looking all the time.
You know that.
And as I mentioned to you, I think on the last call, we've got some discussions underway with the Board on the capitalization, if you will, of the business.
But we have to keep in mind that we have opportunities we're pursuing.
We're trying to invest that money in the business before we do something more exotic with the balance sheet, and I think I'm just going to leave it at that.
- Analyst
I guess I could argue, though, a year has gone by, Steve, and the answer hasn't really changed.
When is the Board accountable for not really living up to fiscal responsibilities of generating productive returns?
- President, CEO
Bob, let me jump in there, I think that probably this next 12 months that that's going to have to be addressed if we don't have significant acquisition opportunities to go to the Board with.
- Analyst
In terms of your appetite for tuck-ins versus newer businesses outside, new growth legs, can you characterize any sentiments there?
- President, CEO
I'd say right now we're concentrating on tuck-in, Bob, would be the best way, but we certainly aren't going to ignore any offer or any opportunity, excuse me, that comes down the pike that's outside of our current model.
- Analyst
All right.
Thank you.
Operator
(OPERATOR INSTRUCTIONS) Our next question comes from [Kyle Doherty] with Morgan Stanley.
Please go ahead.
- Analyst
Hi, guys.
I'm in for David Beadle today.
Just had a quick question around CEREC.
Is there any chance you could maybe quantify what the decline was in the quarter?
- President, CEO
Do you have that number, Steve?
- EVP, CFO
Yes.
The mathematical decline was 23%.
- Analyst
Okay.
And then on the medical side, seems to me that kind of the organic revenue numbers around 8%.
Is that kind of what you see longer term, even as some of these younger sales people get ramped up?
What's your perspective around that?
- President, CEO
I think somewhere in the 8 to 9 range is what we're looking for out of that medical group, and, once again, that is the -- tends to be the most acquisition-rich business that we're in.
There are a lot of businesses out there that are able to -- that seem to want to put themselves up for acquisition, and so we're concentrating quite heavily on acquisition in the medical business as well as trying to add organically to our sales force.
- Analyst
Great.
Thanks.
Operator
At this time I'm showing no further questions in the queue.
Please continue with your presentation.
- President, CEO
Well, if there are no further questions, I would like to thank everybody for joining us today for the call, and I would just like to say in closing that we feel very confident in the management structure and the people changes over the last 18 months that have taken place and the strategies that they have employed and put in place that we feel very confident that we will get back on track here to our historic performance that we've had in the past.
Again, thank you very much for joining us today.
Operator
Ladies and gentlemen, this does conclude the Patterson Company's earnings fourth quarter 2007 conference call.
If you would like to listen to a replay of this call one is available by dialing, 303-590-3000, and entering passcode 11090468.
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