Patterson Companies Inc (PDCO) 2008 Q3 法說會逐字稿

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

Welcome to the Patterson Company's third quarter 2008 earnings call.

At this time, all participant's lines are muted.

Following the formal presentation, instructions will be given for the question and answer session.

(OPERATOR INSTRUCTIONS) As a reminder, this conference is being recorded, today, Thursday, February 21st, 2008.

I would now like to turn the conference over to James Wiltz, President and CEO.

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.

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 this year's fourth quarter in our press release earlier today.

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 our other SEC filings.

We urge you to review this material.

Turning now to our third quarter results, consolidated sales rose 10% to 777 million.

This year's third quarter had one less selling day than the year earlier period.

Including this selling date in our third quarter results would have increased consolidated sales growth by 1 to 2 percentage points.

Third quarter net income increased to 60.4 million, or $0.45 per diluted share from 58.6 million or $0.43 per diluted share in last year's third quarter.

Both sales and earnings growth for this period were consistent with our expectations.

As we stated in this morning's release, our third quarter sales growth was driven in large part by the solid performance of our dental unit.

Sales of consumable dental supplies increased 4%, or by 5 to 6% after giving effect to the reduced number of selling days in the quarter.

Consumable growth at this level reflects a healthy state of the North American dental market.

In addition, third quarter sales of dental equipment were somewhat ahead of our expectations.

Sales of basic equipment rose a strong 14%.

Equally encouraging, sales of CEREC 3D, dental restorative systems, were up 10% on a year-over-year basis making the strongest sales growth of this product line in some time.

Now, that the market transition to CEREC's new software and crown milling chamber is largely behind us, sales momentum is growing for the CEREC system.

The new software and milling units have taken CEREC's performance to a new level and we believe this fact is drawing considerable attention in the marketplace.

We believe the sales progress generated in the third quarter for CEREC systems, as well as for basic dental equipment should continue in this year's fourth quarter.

Turning now to Webster.

Sales of our veterinary supply unit increased 14% in the third quarter to 107.6 million.

Considering that our third quarter marked Webster's seasonally slowest period for such seasonal products as heartworm and flea and tick medications, sales growth at this level is very encouraging.

Webster's consumable supply business continued to perform well during this period, growing 15% year over year.

In addition, Webster is continuing to expand its equipment and [intra-vet] practice management software business.

Our previously announced strategic decision to provide more choices for our customers in several key product categories including vaccines, flea and tick, and heartworm is working as planned.

As a result of this initiative, we now support offerings for Novartis, Bayer, Ford Dodge, Animal Health, Eli Lilly, Shearing, [Reback] and others.

The impact of this action had a modest negative impact on Webster's third quarter gross margins and operating margin metrics.

But by providing more options to our customer, Webster has strengthened its overall position in the veterinary market place.

Patterson Medical, our rehabilitation supply and equipment unit, posted third quarter sales growth of 8% to 84.8 million.

This performance included contributions from the branch offices that have been opened over the past year as part of Patterson Medical's initiative to expand and strengthen its value added business model.

During the third quarter, branches were opened in the Pittsburgh and Cincinnati markets, through [DO] acquisitions, while an office in Atlanta was started internally.

Patterson Medical is now operating 12 branches nationwide.

I would like to comment briefly on the status of our share buyback program.

During the third quarter we returned 264 million to our shareholders by purchasing approximately 8 million Patterson shares.

Under the expanded stock repurchase plan that was authorized on December 24th, 2007, approximately 17 million shares remain available for repurchase.

We will continue to explore strategic acquisition opportunities as the first priority for our cash.

But we would expect to use the share repurchase authorization when acquisitions are not sufficient to consume our free cash.

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

We are forecasting earnings of $0.50 to $0.52 per diluted share for the fourth quarter of 2008 ending April 26th, which reflects the impact of shares repurchased in the third quarter.

We also tightened our full year 2008 guidance to $1.69 to $1.71 per diluted share.

In closing, I would like to say that we're making good progress with the various programs and initiatives that have been implemented over the past year, which makes us optimistic about Patterson prospects.

Thank you.

And now Steve Armstrong will review some highlights from our third quarter results.

Thank you, Jim.

I want to use my time to discuss some of the changes we saw in our operating statement metrics during the third quarter despite revenue and earnings performance that was in line with our expectations.

Let me start with our gross margins, which account for the bulk of the reduction in our operating margin for the quarter.

Consolidated gross margins were down 70 basis points, led by the dental segment's 60 basis point decrease compared to the year-ago quarter.

This resulted primarily from a shift in product mix to greater equipment sales versus height or margin consumables and software as a percentage of total sales.

Other factors impacting the dental gross margin in the quarter included our year end equipment financing promotion, which did not run in the prior year, and a price reduction in local currency in Canada to compensate for the strengthening Canadian dollar.

Gross margin of our veterinary segment declined by 80 basis points, the gross profit dollars increased by over $2 million in the quarter due to increased sales volumes.

As Jim mentioned earlier, the change in product mix within the flea and tick and heartworm categories, with more fully distributed products versus agency arrangements and lower rebates resulted in the dilution of the gross margin.

It also needs to be remembered that the veterinary segment generates lower gross margins than our other businesses, and since veterinary is our fastest-growing segment, the overall results is a dilutive effect on our consolidated gross margins.

Gross margins at Patterson Medical were flat for the quarter.

Consolidated operating expense ratio declined by 10 basis points reflecting the veterinary segments's 100 basis point improvement in its operating leverage during the quarter.

Expense leverage at the dental segment did not improve in the quarter, primarily due to the achievement of performance levels under certain incentive compensation programs earlier this year as compared to the prior year.

To a lesser extent, the timing of certain marketing related expenses between years also negatively impacted the dental expense leverage during the quarter.

At the medical segment, the continuing infrastructure investments in both branch operations and information systems are negatively impacting the operating expense ratio.

This impact is expected to dissipate somewhat as we move through the fourth quarter.

But the system conversion will not be completed until the beginning of fiscal 2009.

For the quarter, the consolidated operating margin decreased by 60 basis points with the dental segment gross margin decline accounting for the majority of the change I discussed previously.

Dental operating margin was 13.7% for the quarter.

The veterinary and medical segment's reported operating margins of 5.3% and 13.3% respectively.

Our tax rate in the quarter was slightly higher in comparison to earlier quarters as we had to adjust our estimated effective annual rate to compensate for the reduced non taxable interest income resulting from the use of cash to purchase shares.

Last year's rate included a benefit of $1.7 million due to the release of tax reserves after reaching agreement on the audit of several prior year tax returns.

Overall we would expect our operating metrics in the fourth quarter to return to more normalized levels, and this would include our tax rate.

Looking now to our cash flow, we generated approximately $60 million from operations in the quarter compared to $34 million in the prior year.

The prior year amount was reduced by approximately $21 million of low-interest contracts from the CEREC promotion that had not been sold to our funding source by the end of the quarter.

Our CapEx is expected to be higher in the fourth quarter due to the continuation of the renovations of our California distribution center and our corporate office, and we will close on the purchase of a previously leased distribution center in Kent, Washington.

Total amount of CapEx for the fiscal year is estimated at $30 million.

As Jim mentioned, we purchased almost 8 million shares of company stock during the quarter which accounts for the bulk of the financing activity in the statement of cash flow.

With regard to the share purchases, I would like to clarify that our earnings per share guidance for the fourth quarter removes the full 8 million shares purchased during the third quarter in the determination of the outstanding shares in the EPS calculation.

Our tightened annual guidance reflects only a weighted portion or about 30% of the third quarter purchases in determining the number of outstanding shares.

Turning now to our balance sheet.

Our inventory levels increase from the second quarter, as we took advantage of some year end buying opportunities in dental, while the veterinary unit added stocking levels for new products.

Our DSO's stood at 43, versus 49 in the prior year.

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

Operator?

Thank you, sir.

We will now begin the question and answer session.

(OPERATOR INSTRUCTIONS) First question comes from John Kreger of William Blair.

Hi, thanks, this is Natalie Friedman in for John today.

Just a question about the dental consumables business.

Even after we adjust for the one less selling day, the dental consumables growth was a slowdown from the last two quarters.

I was hoping you could talk about what you think attributed to the slightly lower growth rate?

Hi, Natalie, good morning, this is Steve.

The selling days in the consumable business is like a retail business.

Selling days can have an impact.

What happened because of the way the holidays fell, while we technically only lost one day, you could say we probably maybe lost two days because both of the Christmas and New Year's Eve falling on Monday this year, and we didn't see as much activity because of those two days.

But the combination of technically losing one day plus the timing or the day that the Eve's fell this year versus last year when they were both on Sunday's.

Okay.

That is good.

Can you give us an update on the sales rep totals?

And also, if you have seen any improvement in the productivity of your sales rep?

The sales rep count within the dental business, I think the number we typically give is about 1566 at the end of the quarter.

Okay.

Webster had about 175 at the end of the quarter.

Okay.

Thanks.

You bet.

Thank you.

Our next question comes from Lisa Gill with JPMorgan.

Please go ahead.

Thank you and good morning.

Steve, I think that a few weeks back at our healthcare conference you talked about the economic impact on equipment sales, and then this quarter, obviously, equipment sales coming in much better.

Can you just talk about what has changed over the last couple weeks, in your opinion?

And then, secondly, as we look at the margins, how much of the dental margin was due to any kind of promotions on the equipment side as well as just equipment generally being less profitable than consumable?

Lisa, this is Jim, first of all,really what has changed, nothing has changed.

I think, if you will recall, the last two or three calls, we talked about our execution in the equipment business and the unsettling in the field because of all the management changes that have taken place.

Lisa, I think, in my opinion, we have got those things behind us now, and the pipeline is starting to fill back up in our equipment prospecting.

We reaped the rewards of that in the last part of this third quarter.

And so, you have pretty good visibility as far as sales go into the fourth quarter as well, Jim?

Well we do as best we can.

I think we've talked before about our system not being the best as it relates to forecasting on equipment side, which is one of the projects we have underway.

We feel very confident about the fourth quarter continuing to be strong.

And so, as far as the economic or any kind of recession having any kind of impact on these individual dental practices, not as much as perhaps, maybe, you saw even last quarter?

Is that what we're looking at?

Well, Lisa, I don't think anybody understood my comments in the last call, and I am sorry I ever made them.

(laughter) I don't think what's going on in the economy has had any impact on the patient visits or the revenue in the dental office.

My comment was strictly pointed at the fact that, whenever there is so much negative press out there, I think that just human nature, whether you are a dentist or otherwise, about ready to make a large purchase for a small business, you think twice about doing that.

Now, having said that, I think that it has been going long enough now that the dentist over time they quit paying attention, because their practices continue to thrive, and so they jump back into the marketplace.

That is only a minor part of what is going on with our equipment business.

One last question.

I think that Stephen made the comment that operating metrics should be more normalized in the fourth quarter.

As we think about, and I am not asking you to give 2009 guidance, but as we think about things going forward, would it still be your target to have margins improved by roughly 50 basis points year over year?

Is that still a long-term target for Patterson?

Yes, it is, Lisa.

Okay, great.

Thank you.

Thank you.

And congratulations --

Thank you.

Oh, sorry, go ahead, sir.

Lisa just had a baby.

We are congratulating her.

Our next question is from Steven Postal with Lehman Brothers.

Please go ahead.

Thank you.

And good morning, Jim and Steve.

I just want to ask a question on CEREC.

There has been some discussion that there's improved demand for the CEREC MC3.

Can you talk about having, kind of, a dual product strategy, what you're seeing in terms of demand for both, the upgraded version and the older version?

And just the general environment surrounding that category?

Steven, I think we talked about a little bit on the last call, that we weren't getting much activity on the smaller milling chamber.

And I think that we saw happen in this third quarter, we had [read] a promotion during the period of time when there was a $5,000 price reduction on that lower end unit.

And I think what we found out was, there is some demand out in the marketplace which we had not anticipated.

We were quite pleased with the number of those units that we were able to sell in the third quarter as well as the new MCXL chambers.

Okay.

In terms of some other key equipment that has been discussed, the 3D cone beam, what are you seeing there as the competitive environment and the number of products hurting demand, lengthening sales cycles or has something changed there?

I don't think anything has changed very much there, Steven.

I think we're still finding that there is a high level of price resistance to all of the machines.

Okay.

And, Steve, a question on SG&A, I would have thought with one fewer -- one less selling day that, perhaps that SG&A line wouldn't have been as impacted.

Can you help me out there?

I don't think I can offer anything more than what I said in my prepared comments.

It was mostly due to the timing of some dental expenditures, particularly in the [incentive] comp in the marketing areas.

I don't have any other great pearls of wisdom to offer to you, Steven.

And Steve, would one less selling day, shouldn't that, theoretically, impact as SG&A as well as revenues?

No, because you pay your people 52 days -- 52 weeks out of the year.

Actually hurts you more than it helps you, Steven.

You lost that revenue but your expense structure doesn't really change that much.

But aren't your sales there, Steve, on commissions?

You have a variable aspect of it sure, but doesn't really count.

That is only a small part of it, Steven.

(inaudible)

Okay.

Final question on the medical business.

You mentioned this investment systems, how much do you think that impacted the operating margin?

And I just want to clarify your remark, you are saying that you wouldn't expect more normalized margin in medical until fiscal 2009?

Starting in May of this year.

The investments that we're making in the medical system really didn't affect our margin at all.

These are all planned CapEx expenses at corporate, changing their platform out from their old platform and Ability One to the current platform that the dental and vet business run on.

The issue there, Steven, is you have got people tied up, you've got contractors coming in, it all flows through.

The other part of that but you can't get out is, you continue to add these branches, there is inefficiency because you are really running multiple platforms, and you can't, if you will, tuck them in, quite as well as you can when you have one platform running the business.

The other problem we have, Steven, is we consolidate their inventories into our distribution centers, we have a problem with managing the freight and the pricing, again, because they are not up on that platform yet.

That is why we are anxious to get that going.

Okay.

And Jim, you mentioned, I believe you said you now have 12 branches there.

Are there plans to continue that, more branches over the next year?

We have -- we certainly are not going to stop what is currently planned.

I don't know the exact number of that this morning, Steven, off the top of my head is two or three, I think.

But we're probably going to slow down for a while now and see how well the model really is working.

We are seeing some slight differences in the businesses we purchase versus the ones that we are starting up, Greenfield.

Okay.

Thanks a lot.

You bet.

Thank you.

Our next question is from Bob Willoughby with Banc of America Securities.

Please go ahead.

Hi.

Jim or Steve, maybe on the medical business there, what -- did you break out the margin for that business in the quarter?

I know it was off with the expansion, but, what was it?

And can you maybe comment on the ultimate target for that business from a margin perspective with a -- in a decentralized infrastructure here, I guess I couldn't assume it gets back to its former profitability, can I?

Well, first of all, Bob, I think it was 13-4 that Steve --

13-3.

Excuse me, 13-3.

We do expect to make some gains.

Whether we get it clear back to where it was originally, I doubt it, because product mix is affecting that and the bigger the business gets, the more capital goods that go into the process, and then the medical business, those are more margin items as they are in dental.

Ability One was a 20% margin business at one point, do we get halfway back there?

Any sense at all?

I think that's probably a decent guess, Bob, half way back.

Okay.

And, on the M&A front, obviously, nothing in the quarter, looking forward, is it just general discuss for valuations out there, or is there just really nothing that you feel fits the model?

What really is the thought process there?

We are continuing to look.

We are having discussions all the time, Bob, in the M&A area.

I think we stated the last call that we really haven't looked outside of our core businesses, and still haven't done that.

So, opportunities but just pricing seems egregious.

Well, but different in the vet world, pricing is -- because of some of the public -- well, MWI because of their multiple -- pricing gets pretty high in that arena.

Medical, I think is simply a matter of how quickly or slowly we want to go with that.

And dental, it's a matter of being able to execute when the opportunity comes.

Okay.

And just, Steve, plans for the short term debt of 130 million, will you term that out or is that likely to disappear?

It probably will disappear, Bob, it's due in November, that is the last of the Ability One acquisition debt.

Our plans today are to take it out in November.

Okay.

That's great.

Thank you.

You're welcome.

Thank you, Bob.

(OPERATOR INSTRUCTIONS) Our next question comes from Jeff Johnson with Robert W.

Baird.

Please, go ahead.

Good morning, how are you?

(multiple speakers) A couple questions here, if I could.

Sustainability of dental equipment beyond the fiscal fourth quarter, I guess is where I would like to start, obviously your comments sound good for the fourth quarter, you have got the new decades plus (inaudible) that seems to be doing well, CEREC momentum may be returning a little bit, but as we look, maybe, into '09, and again, not asking for '09 guidance, but, the momentum that has returned this quarter, do you think that's sustainable as well?

Jeff, I will answer it this way, the metrics in the marketplace haven't changed at all as it relates to the equipment business.

And, as I've tried to explain many times, I think it's simply a matter of whether we're executing properly or not.

At this point in time I feel very good with all the programs and systems we have in place, and I might note, the management structure.

And we are very optimistic about the equipment business.

All right.

Great.

And then, on CEREC, just a couple, I guess, detail questions here.

Amortization in the quarter, I know you're kind of doing a matching as opposed to a straight line, so, any insight there under what that amortization expense was?

How much that maybe weighed on gross margin in the dental side?

And then, where are we on the upgrade side?

Any plans for a new upgrade program?

And how far are we through the current program?

Let me hit the quantitative part of that and I'll turn it back to Jim.

The amortization in the quarter was about 1.2 million, Jeff, 1.3.

It had some impact on the margins, but we already baked that into the guidance we provided.

So, I think we are managing it well.

CEREC was a bit dilutive to the margins in the quarter, only from the standpoint that by the time you put all the pieces together, between the amortization, and some pricing changes in Canada, and the sort of mix of the equipment versus consumables, it did pull down the margins a little bit, but it was pretty much what we expected for the quarter.

Nothing out of the ordinary.

As it relates to how far we are through delivery on the upgrades, I am not sure I have the proper answer for you, Jeff, so I would just as soon not even try it this morning.

About one quarter of it left right now.

Steve says about a quarter of it left, Jeff.

A quarter?

I'm sorry, a quarter as in 25%, Steve, or maybe one more quarter?

Yes, about 25% left.

Got it.

Thank you.

And as it relates to an upcoming new [tradium] offer, that seems to have come from some analysts report that was written, I'm not sure where they got that information, but it didn't come out of here.

We have no plans currently.

No plans currently, okay, great.

And then, Steve, going back to the 1.2 million amortization, that's about have of what it would be, I guess, straight lining it, is that any indication where CEREC new system sales are?

Maybe below expected even though it sounds like the number's good, I'm just having trouble reconciling maybe why amortization was at the 1.2, 1.3 million level?

You're right.

I mean, if you took it straight line, you'd obviously have a different path with that, and a different curve for the amortization.

We never intended to take straight line.

If you're going to hold us to straight line you're probably going to see differences until, probably somewhere 1/3 to halfway into that contract, because the contract calls for escalating volumes and that is the way we plan to recognize the amortization.

That's fair.

That's a good point.

And then, last couple here, on vet equipment, second quarter here in a row where we've been up, maybe, mid single digits on the equipment side.

Is that kind of the normalized growth we should be thinking here in the near to intermediate term?

And then also on dental consumables, comfortable that the economy is not having an impact at this point, and that [we're thinking] about selling days and what have you, we should kind of be in that 5, 6% range, near to intermediate term as well?

Yes, we think that is the consumable growth today right now.

We think that number is solid going forward.

The vet equipment side?

The equipment side that will continue to accelerate, Jeff, you have the current number, Steve?

I don't have the current number.

Yes, I think it was up about 5%, 5% in the quarter.

But, Jeff, what is happening there is that as we expanded, you got the burst, but, as you continue to expand it you have got to watch the metrics, they're being very careful on their metrics..

That is going to slow it down periodically, as they sort of grandfather in some of the burst, and then -- but there's nothing fundamentally changing there, we still expect that to grow very nicely over the next several years as we continue to build out that platform.

The other thing, Jeff, you have to keep in mind, that's a gradual process of adding the people and the resources to drive that business.

Okay.

Great.

And, I think, to be fair, it was the highest revenue quarter you had in vet equipment ever, if I am correct (multiple speakers), so it was a good quarter, just asking on the growth.

Thanks, guys.

You are welcome.

Thank you.

Our next question comes from David Veal with Morgan Stanley.

Please go ahead.

Hi, Steve, just a couple questions on the financing side of things.

Has there been any change, I've asked this before and you said no, but any change recently in the availability of financing from your banks or the willingness of dentists to finance equipment?

No, we have had no problems on -- either from our funding sources or from the dentists.

As the rates came down here, we did lower our field rates again during the quarter.

And we saw financing rates, percentages of equipment financed very similar to what we have seen in the past.

So, I don't see any changes there, David.

In the past when rates of gone up or down, you tend to realize either modest tailwind or modest headwind from the changes, can you quantify that for us this quarter and how it would look going forward?

Yes, it was, there was some impact in the quarter.

The thing I would tell you is that some of that, if you just did, from a macro perspective, it was mitigated because we've got derivative setting against some of those low rate contracts from prior years it's going the opposite direction.

It was not nearly as beneficial as you might think it would be, just looking at the macro aspect of that portfolio.

Okay.

That was helpful, thank you very much.

Thank you.

Our next question comes from Chris Sassouni with Eagle Asset Management.

Please, go ahead.

Yes, I was just curious, in the past, when we have gotten capital equipment tax credits, as we now have with the economic stimulus package, and I guess, this one is listing it for like 125,000 to 250, have you seen, at the margin, an interest in dentists to purchase equipment when they get that kind of write off?

You know, it is really too early to see any of that, Jeff.

Typically, we see that in the last calendar quarter of the year when their accountant starts talking to them about how to minimize taxes.

The other comment I might make about that, at $125,000 is what it currently is, really covers a lot of the playing field that we play in price wise, for products.

I'm not sure how much impact the increase 125 is going to have, it certainly isn't going to hinder it, it's going to help, but, and not as much as it might in some larger businesses.

Thank you.

Thank you.

Our next question comes from Jon Wood with Banc of America Securities.

Please go ahead.

Thanks.

Steve, can you give us an idea of the monthly sales trajectory currently?

No.

Only because I won't.

That is never given how.

Okay.

Was there a buy-in ahead of the price increase on the new unit?

Have you seen an uptick in orders related to that price increase at the end of January?

No.

From the customer's point of view?

Yes.

No.

Performance is pretty consistent, Jon.

Okay.

And on the MC -- the smaller, the compact milling unit, is the 83,000, is that the new level for that unit going forward or is it going to revert back to -- I mean, the 5,000 benefit goes away?

Yes.

That was a special price during the promotional period.

That is over at this point?

Correct.

And then, did you build any CEREC inventory in the quarter?

This quarter, no.

No, we actually brought the inventory down, Jon.

Okay.

All right, thanks a lot.

Are you asking for us or are you asking for [Serona]?

(laughter) Just kidding, Jon.

You don't have to answer that.

Bob is still there, isn't he?

(laughter)

That's accounting humor, by the way, Jon.

Thanks a lot.

Thank you.

(OPERATOR INSTRUCTIONS) And we do have a follow-up question from Jeff Johnson with Robert W.

Baird.

Please go ahead.

Sorry, guys, I thought I took myself back out of the queue.

Chris asked the question on the tax breaks.

But, I guess, to further that question, are you planning any promotions or any kind of, at least marketing materials out on the field over the next few months to at least get the tax breaks in front of dentists and try to stimulate some demand that way?

Yes, we are, Jeff.

As a matter of fact, I think that marketing propaganda is already done and is either on its way to the customers or will be shortly.

I know it's been sent to our field people.

All right.

That is all I have, thanks, guys.

Thanks, Jeff.

Than you.

There are no further questions at this time, I will go ahead and turn it over to management for any closing remarks.

Thank you very much, we appreciate everybody participating in our third quarter call and we look forward to being back with you on our year end call.

Thank you.

Ladies and gentlemen, this does conclude the Patterson Company's third quarter 2008 earnings call.

If you would like to listen to a replay of today's conference, you can dial 303-590-3000 and enter pass code 11108940.

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You may now, disconnect.