Patterson Companies Inc (PDCO) 2013 Q1 法說會逐字稿

Good day, ladies and gentlemen.

Thank you for standing by.

Welcome to the Patterson Companies first quarter fiscal 2013 earnings conference call.

During today's presentation all participant lines will be muted.

Following the presentation, the conference will be open for questions.

(Operator Instructions)

This conference is being recorded today, August 23, 2012.

I would now like to turn the conference over to Scott Anderson, President and CEO.

Please go ahead, sir.

Thank you, Erin.

Good morning and thanks for taking time to participate in our first quarter earnings conference call.

Joining me today is Steve Armstrong, our Executive Vice President and Chief Financial Officer, who will review some highlights of our first quarter performance following my opening remarks.

Since Regulation FD prohibits us from providing investors with earnings guidance unless we release that information simultaneously, we provided financial guidance for our fiscal 2013 in our press release earlier this morning.

This 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 on our Annual Report on Form 10K and other SEC filings, and we urge you to review this material.

Turning now to our first quarter results.

We reported results that were largely consistent with our internal forecast for this period.

Consolidated sales increased 5% to $889.8 million from $847.4 million in last year's first quarter.

We also reported net income of $47.5 million or $0.45 per diluted share compared to $48.6 million or $0.48 (sic-see correction below "$0.42") per diluted share in the first quarter of Fiscal 2012.

Our net income in this year's first quarter was affected by the absorption of $3.2 million of incremental interest expense related to our debt issuance in last year's third quarter.

We are generally pleased with our first quarter results despite persistently soft economic conditions both in North America and our foreign markets.

Now for the next few minutes I'll briefly review operational highlights for our three businesses.

Patterson Dental, our largest business, reported solidly higher first quarter sales growth of 6% or $567.9 million.

Within this unit, sales of consumable supplies were below forecasted levels, and we are intensifying our focus on this key component of our sales mix; however, the exceptionally strong sales growth of CEREC products and low double digit sales growth of basic equipment more than compensated for the below plan consumable sales.

Our robust CEREC sales were generated in part by strong demand from new users reflecting the ongoing trend towards the digitization of dentistry.

We estimate the CEREC have systems penetrated approximately 10% of the North American dental market, which means this product line has significant sales potential going forward.

We believe sales will receive an additional boost from the recent introduction by Sirona of a revolutionary new camera for the CEREC system.

As the latest technological advancement for the CEREC system, the Omnicam camera, featuring powder free imaging and streaming, photo realistic 2D and 3D clinical images that are displayed in full color.

This new camera, which will be available on new CEREC systems, will make CEREC significantly easier to use and provide for improved clinical outcomes.

CEREC systems equipped with the Omnicam camera will start selling in the second quarter as Sirona ramps up production.

Also last week, Sirona introduced the introduction of the new Schick 33 intraoral sensor which provides the highest resolution of any sensor in the market, improved image management and compatibility with existing Schick systems.

In addition, Patterson and Sirona, the undisputed leader in digital dental technology, recently expanded our exclusive North American Marketing agreement to cover Sirona's complete product line including digital panoramic and cone beam x-rays.

This move further strengthens Patterson Dental's position as the leading distributer of dental technology and other equipment.

Moving on to Webster, we are very pleased with the first quarter performance of our Webster veterinary supply units.

Webster's internally generated sales increased more than 10% in this period.

A change in a distribution agreement for nutritional products late in last years fourth quarter reduced Webster's first quarter sales growth by approximately six percentage points, while the August 2011 acquisition of American Veterinary Supply Corporation added 2.5 percentage points of sales growth.

Reflecting these factors, Webster's first quarter sales increased nearly 6.5% to $191.1 million.

Webster's solidly higher sales were generated by robust demand for consumable supplies.

This growing business is currently implementing a range of strategies aimed at further strengthening its full service platform.

The expansion and training of its field sales force are aimed at boosting sales of both consumables and equipment.

To further spur its equipment business, Webster plans to achieve full national coverage for technical service by the end of fiscal 2013.

In addition, Webster is continuing to strengthen its growing range of technology solutions for veterinarians and their clients.

Reflecting these and other initiatives, Webster is enhancing its competitive position to capitalize upon favorable pet ownership and consumer spending trends, and we intend to continue investing in this growing business.

Before leaving Webster, it should be noted that IDEXXX Laboratories reaffirmed its longstanding exclusive relationship with Webster, and we look forward to continue growing with the industry leading manufacturer of veterinary products.

Sales of Patterson Medical, our rehabilitation supply and equipment unit, declined 3% in the first quarter to $130.7 million, due primarily to weakness in its equipment business.

The impact of negative foreign exchange rates largely offset the nearly 2% sales contribution from Patterson Medical's April 2012 acquisition of Surgical Synergies, a distributer of physiotherapy, rehabilitation and mobility products serving the Australian and New Zealand markets.

Despite US healthcare regulatory uncertainties and the weak economic environment here and abroad, we believe Patterson Medical, as the only single source of supply in the rehabilitation market, is strongly positioned to take maximum advantage of worldwide demographic trends that will have a favorable long term effect on the rehabilitation market.

Finally, as we stated in this morning's release, we remain on plan toward achieving our previously issued financial guidance of $2.10 to $2.16 per diluted share in fiscal 2013.

In closing I want to say that, although our markets have not yet returned to their historic growth norms, Patterson' businesses are continuing to perform well in a challenging economic environment.

We are proceeding on track for the successful fiscal 2013, and we are optimistic about Patterson's long term future.

Thank you.

Now Steve Armstrong will review some additional financial highlights from our first quarter results.

Before I start, just to clarify, Scott misspoke.

Last years earnings per share were $0.42 per share, not $0.48.

Sorry to do that to you publicly, Scott.

That's all right.

I'll get flogged later.

Thanks, Scott.

I'll begin my remarks with an additional comment or two on sales growth for the quarter.

The impact on consolidated sales from the benefit of acquisitions and the negative changes in currency exchange effectively offset one another in the period.

Each was less than 100 basis points.

As we had previously disclosed and as Scott mentioned earlier, the change in the nutritional product arrangement in our veterinary unit reduced consolidated sales growth by 130 basis points in the quarter.

This change will continue to affect our sales volumes into the first half of the fourth quarter of the fiscal year, but it has a minimal impact on our operating profit as we now sell this product under a national agency commission arrangement.

The primary factor influencing our consolidated gross margin in the quarter was mix.

Gross profit was up 3% in the quarter on the higher sales volume, but our gross margin declined 70 basis points as the trade up activity in the dental segment on the CEREC product and the continued strong seasonal sales of paraciticides in the veterinary segment depressed our margin.

Both of these factors are expected to diminish as we progress through the fiscal year.

Our operating expense ratio improved by 40 basis points on the improved sales volume as we were able to gain leverage on our fixed cost structure.

Two items that dampened this improvement included integration and rationalization costs related to the Australian operations of the medical unit and the cost associated with the continued expansion of the technical service capacity of the veterinary unit.

We do not anticipate these items to be significant as we move through the remainder of the year.

Our first quarter operating margins were 9.8% for dental, 12.6% for medical, and 5.3% for veterinary.

Interest expense in the quarter increased over $3 million as we absorbed the impact of the incremental debt that was added in December of 2011.

Our lower income tax rate reflects the increased benefit from the deductibility of the cash dividend paid to the employee stock ownership plan in the current period.

As you will recall we increased our cash dividend in the fourth quarter of this past fiscal year.

The tax rate for the fiscal year should be in the range of 35% to 35.5%.

We generated cash flow from operations of approximately $60 million in the first quarter compared to $67 million in the year earlier period.

This change was principally due to the timing of tax payments.

I also want to mention we repurchased approximately 1.1 million Patterson shares during the first quarter under our 25 million share buyback authorization that expires in 2016.

Approximately 10 million shares remain available for repurchase under this authorization and depending upon market conditions and other factors, we may make further share repurchases on an opportunistic basis.

A brief review of our balance sheet reveals a certain seasonality of our businesses.

The higher sales levels and resulting increase in Accounts Receivable in the third and fourth quarter of the prior year are generally paid down in the first quarter of the subsequent year.

At quarter end our DSOs stand at 43 days compared to 46 in the prior year while inventory turns are 6.9 compared to 6.7 a year ago.

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

Erin?

Thank you, sir.

(Operator Instructions)

Kevin Ellich, Piper Jaffrey.

First off I was wondering how the $0.45 of EPS compares to your internal plan, and following up on that is how do you see the earnings ramping throughout the remainder of the year?

Should it follow the same progression as we saw last year?

Kevin, this is Steve.

The first part of your question with regard to how did it come against our plans, we were right on our plans.

Our internal plans, as far as ramping, it would be similar to what you've seen in the prior year where the bulk of our earnings come in the third and the fourth quarter, but we would anticipate that second quarter should see some improvement over the first quarter relative performance in the prior year as well.

Got it, okay.

And then how much of an impact did the new Sirona contract have this quarter?

Did you see any disruption with any of the other manufacturers?

No, Kevin, this is Scott.

I don't think we saw any impact in terms of the sales line.

We continue to have strong sales with our partners that compete with Sirona.

If anything, I think it will be a big net positive moving forward as our field is very excited about the opportunity to sell some great products in a very integrated fashion.

But I wouldn't say anything in the first quarter that was out of normal from prior quarters.

Got it, okay.

And then following up on that with the new Omnicam and a lot of excitement and interest by the dentists, how do you think that is going to play out in the coming quarters?

Will you see much disruption as the sales force will have go out and educate all the dentists that weren't at the conference last weekend, and is there enough product on the market where you guys are going to see a lot of sales flow through in the next couple quarters?

Well two things.

First, we obviously had a very successful trade up program in the first quarter, and part of our strategy with Sirona, and I think I talked about it last quarter, was to get as many customers on the new software platform with the Bluecam, the 4.0 software.

Because that is the same platform that eventually customers, if they choose to move to Omnicam, will move to.

So, in terms of training of our sales force, I would say our sales force is completely up to speed, because, at the end of the day, the software is a really key part of this.

Part two is we had all of our CEREC specialists in Las Vegas last week.

So they are fully trained on the Omnicam and obviously extremely excited to get out and talk to customers.

From sort of a forecasting going forward, we've been working closely with Sirona on forecast and supply chain issues.

We anticipate that the next quarter will be a quarter of billing inventory and getting demo units out.

We'll concentrate on new users for the majority of the fiscal year.

And then, as their supply chain grows, which we believe it will and can, we will start to work into that backlog we already have of customers who currently own CEREC who want to upgrade.

So, obviously very exciting news.

I think the powder free camera is a big leap forward in technology and, with the Omnicam and with the Bluecam, we feel we have the two best CAD cam products in the world to sell to our customers.

Got it.

And, Scott, in your prepared remarks did you say CEREC penetration in North America was 10%?

It's roughly over 10%.

We're between 14,000 and 15,000 new users.

I always am a little cautious on market share, because it's a little bit how you define the market.

But I think what we were trying to say is there's a very long runway on the CAD cam opportunity.

Okay so is that the difference between I think last quarter you said the penetration was 12% so is it just matter of how you're thinking about the market size?

Yes.

You really want to say over 10%.

It's hard, Kevin, to give you a specific number but it's obviously in that 10% to 15% range but more importantly, as I said, 80% plus of customers do not have the product, and there's high interest for it.

Got it and then just lastly, with the IDEXX announcement with MWI going non-exclusive, just wondering what your thoughts are and that arrangement, and, if they're successful, would you want a similar feel that they got?

Well, you know, I think it's similar if you look traditionally at how we partner on the dental side with the leading manufacturers and bringing great products to customers.

We have great respect for the technology IDEXX has on the diagnostic side and are very excited, and it was our preference as we publicly stated before to continue to grow our partnership with IDEXX.

Got it.

Thanks guys.

Michael Cherny, ISI Group.

I just want to dig a little bit more into the margin progression.

Obviously incredibly strong quarter on the equipment side with CEREC kicking in.

You noted that it had a negative mix issue.

Is there any way to quantify with regards to simply the trade ups -- any of the mix issues?

And then on the other line items, a little more clarity on some of the veterinary related headwinds with regards to gross margins?

Mike, this is Steve.

I don't want to get into a lot of detail as far as gross margin break down.

We've never historically done that, nor do I think we want to do it for competitive purposes.

But I can tell you that the two major items I talked about in my comments that affected the margin in the quarter were the trade up program.

We sold a lot of trade ups during the quarter and they carry a much lower margin than our average product.

Scott also mentioned consumables were a little bit softer than we had anticipated, and so our mix between consumables and total equipment changed.

That had an impact on the margin.

And then the strength of the veterinary business and the mix of their product also impacted the gross margin.

So those three factors pretty much accounted for what we saw in gross margins.

Obviously, as we go forward, you're going to see a mitigation of the seasonal aspect of the parasiticides on the vet business.

You're also going to see, with the new camera now out, you're going to see more new sales or new user sales of CEREC which will carry better margins.

So that should have less dampening effect.

And probably the item that we think about the most is the consumables growth and how do we get that market moving in a stronger direction upward.

And that can have a big impact on the overall margins as well.

Thanks, that's helpful.

And then just quickly turning to the rehab market a bit.

Obviously it seems like their macro pressure continued to impact what the strong market share business.

In terms of kind of incremental data points or inflection points you're looking for kind of what are the key signs, now that we're through Supreme Court decision, is that the potential driver you need to re-accelerate growth in that business, or is it a matter of time in working through the macroeconomic uncertainties.

What are you looking for in terms of your end markets to get a better sense of return to growth in that business?

I think he positive part, Michael, is the core business of consumables in the core rehab market is growing in the low single digits, but we see growth there.

Really the two areas of weakness are the equipment side, where you still have a lot of caution on buyers in terms of sort of figuring out the rules of the road going forward before they make capital expenditures.

And we've talked about it in the past that the UK market with the austerity moves and some of the changes with NHS continues to be a challenged market.

So the rehab story really boils down to right now the equipment piece and the UK.

But as we talked about before and many times in past calls, this is a business and a space that has great underlying growth dynamics in terms of the aging population, and we'll work through this temporary softness and feel we've got a very strong competitive position and exciting story ahead of us.

Okay, thanks guys.

Robert Jones, Goldman Sachs.

Scott, you talked about intensifying your focus on the sales of consumables, specifically within dental.

I guess I was wondering how much of the below internal expectation results were market driven.

If we take a step back and we look at dental consumable results from you guys this quarter and put them together with some of the commentary from the other dental folks this quarter, it does seem like there's a bit of a slight deceleration in the US market.

So I'm just curious how much control do you really have around re-accelerating the consumable sales in dental?

Yes, Bob, there's no doubt the total market softened beginning about May, but we also feel that the consumable business is an execution game as well.

So we have many programs under way from a marketing perspective and a customer loyalty perspective as well as an intensification of our new training sales program.

So, yes, it's obvious that there's a big piece of this that is out of our control, but that's definitely not an excuse for our dental team.

And they are taking immediate action to drive that business.

We feel we've got a lot of tail wind on the technology and equipment side, and any way that we can potentially couple that momentum together with the consumable presentations with our customers we'll take advantage of that.

That makes sense and then just one big picture one if I could, Scott, you obviously called out Omnicam.

Seems like you are very excited about the introduction.

Could you maybe give us a better of a sense of exactly how incremental this introduction will be in driving CEREC penetration?

I know you did say that it's approximately 10% of North America currently.

Is this a significant enough step forward that you could see some acceleration within that penetration rate from here?

Absolutely, Bob.

We see this leap forward particularly the leap to powder free as a major step forward in terms of driving new user adoption.

It's another reason for our sales force to present the product again.

And one of the common things you hear from customers who are looking at CAD cam is there's always some sense of fear in terms of implementation.

And now the ease-of-use, the CEREC 4.0 software was a major leap forward that we talked about a year ago, but you couple that with the Omnicam and just how easy it is to take an impression.

And then the visual aspect now to the clinical piece of CEREC, we feel this will be an absolute game changer on the CEREC side, and we're very excited about it.

Sounds great.

I appreciate it.

Lisa Gill, JP Morgan.

I was wondering if you could further comment on the idea of equipment and consumables and your ability to be able to transfer those sales over.

So you talked about consumables being weak and starting in May it got a little bit weaker.

Can you maybe just talk about that?

Equipment seems incredibly strong.

Are you able to track if you have 100% of the consumables from those customers or is there a way to look at that and really target those customers going forward?

Lisa, I think we absolutely believe when you tack a longer view, it's hard to do in 90 day chunks, but one of the biggest issues dentistry will have is greater demand for services as the population grows, patients keep their teeth longer, and the number of dentists, particularly in North America will be fairly stagnant over the next 10 years.

So one of the big challenges/opportunities is increasing the clinical outcomes and proficiency of our customers.

So, as we do that through digital x-ray and products like CEREC, the ability for the dental market to grow because it becomes more efficient is a big piece of the growth story.

So it's an interesting mixed bag of the dental community right now, but when we look at customers who have implemented digital technologies, cone beam, CEREC and others their consumable spend tends to grow faster than those that have not.

And is there still an opportunity within those, obviously consumables are growing but for you to take market share?

My understanding is most dentists use more than one distributer for product.

Absolutely, and that is one of our strategies not only through the implementation of technology but through our customer loyalty program.

And then Steve, can you just update us on what you're seeing currently in the acquisition environment?

I'll let Scott handle that.

He signs the big checks.

Okay.

We just want to make sure Steve was still awake so thanks, Lisa.

I think we can say that we're seeing increased activity on the M&A front, and we've been very public in terms of our capital allocation strategy.

And that's to put our strong cash flows to work in value creating acquisitions as well as returning dividends that grow over time.

And, when we cannot deliver on the acquisition side, to drive shareholder value back through share repurchase.

But there definitely is activity right now in the M&A front.

Okay, great.

Thank you.

Larry Marsh, Barclays.

Okay, thanks and just wanted to congratulate you on the continuation to extend your relationship with IDEXX.

And, Steve, I hope the flogging from Scott isn't too bad.

Actually, it's pretty thick already, Larry.

Okay, so I guess my question is the new Sirona relationship, maybe get your comments on that.

They've obviously stated that part of that relationship has changed commitments in terms of minimums and as well as the exclusivity which it seems like that's going to help you get another I don't know, $30 million to $35 million of annualized sales just in taking share from others.

But I guess is that the right ballpark?

And then I guess, Scott, from your standpoint how would you describe your view of the characteristics of the minimums of the new relationships, the sharing of some of the promotional dollars or anything else of the new relationship that you think is important?

Yes, Larry, that's a great question.

I think we really don't look at it as a new agreement, but really it's an evolution of the partnership we've had with Sirona going back to the days when we became the exclusive distributer on CEREC 2. So one of the things that we've done with Sirona's management is looked at ways at how can we accelerate this digital transformation of dentistry.

And together, we came to the agreement that the integrated story is so powerful between CEREC and cone beam and digital that the ability to, from both the strategy perspective and a sales execution perspective and a service perspective, that that for us to take our relationship up a notch made a lot of sense competitively.

So, in terms of minimums, we have obviously sales targets we need to hit to maintain this relationship.

But even if you fast forward 5, 10, 15 years down the road, regardless of what the distribution of those products are, we will always be a very big part of Sirona's history and their success and vice versa.

So we feel very comfortable with the agreement and see that it was a great I think next step from the prior agreement we had for both Patterson and Sirona.

Okay, but certainly is it fair to say that this gives you -- increases ability of your ability to continue what's obviously a very good first quarter into the rest of this year on not only just CEREC but some of your other equipment lines?

Yes, and we have absolute great respect for the R&D prowess of Sirona, their commitment both to putting money back to R&D but also what is in their skunk works and in their pipelines and what the engineers at Sirona dream about in 5 to 10 years.

And I think Sirona has great respect for our investment in infrastructure, and you look at our technology center in Effingham now with over 400 people there supporting dentists after they buy this technology, it gets us pretty excited about the opportunity over the next decade and beyond.

And then just a follow-up, Scott.

I know at the show last week, a lot of conversation about the ability to if you're a Bluecam user still have that software as part of the Omnicam process.

And you talked about the importance of new users as well as upgrade of current users, but in your mind, as you think about Omnicam as the target market for this really the Redcam users who want -- need to make that leap and if that's the case, what percentage of your installed base would you define still as in that Redcam category?

First, before I get to the Redcam, I would say that the focus and the exciting part obviously is growing the CEREC user base with this leap forward in Omnicam.

It's obvious that the folks that were in Las Vegas are absolute rabid fans of CEREC, and they want the latest and greatest.

So we know we will upgrade a lot of customers to Omnicam over time.

But I think what this really does is it helps us kick into high gear the adoption of CAD cam with CEREC moving forward.

We did the Bluecam trade up in the first quarter, and I said 90 days ago that one of the big reasons we did that, obviously, was we've had such positive response from the 4.0 software.

But what I couldn't talk about 90 days ago is we also knew that a new technology was going to come out.

It was very important for us to give a path for those Redcam users to get on the new software platform and eventually either stay with Bluecam or have the option down the road to get to Omnicam.

So there will be an opportunity for Redcam users still to move to either Bluecam or Omnicam, but that will not be our main focus here in the short-term.

Okay and I guess would you still say that what maybe a third or more of the install base is still Redcam?

Less than that.

Okay.

And then, finally, and it sounds like all this suggests that I think you in the past have said you continue to view that CAD cam category as a double digit grower and obviously it sounds like this quarter was over 20%.

I know you don't want to be too more specific but it certainly as I hear you and the relationship certainly sounds like that's still the case.

So I just want to confirm that, and I guess a final question is really for Steve and that is just a little bit of clarification on the CapEx, you may have addressed in your prepared remarks, it seems a little bit lower.

I guess that's just a timing issue.

Are you still confirming $25 million to $30 million for the full year and the tax rate you're saying 35% to 35.5% Is that lower than the original thought or is that about the same as what you'd been thinking?

Thanks.

I'll take the CEREC question first, Larry.

We absolutely are confident that this space in CAD cam is a double digit grower on average over time.

Obviously you'll have some swings in 90 day periods, but our confidence, and I think we've been very public about this, even in tougher times, selling CAD cam is we are great believers in this space and are very excited about the opportunity over the next 5 to 10 years.

And I would say the same thing for the digital categories as well.

And I'll turn it over to Steve for CapEx.

CapEx, Larry, where we were investing clearly heavily over the previous five years in redoing the distribution center, expanding some of our operations, building the PTC.

Those projects are pretty much complete.

Where most of our CapEx will be going forward is just on replenishment.

And then also we have a goal of spending a fair amount on IT systems over the next three to five years.

So it's just a matter of timing.

I think we're still going to be in that $25 million range for total for the year.

At this point to get it up to $35 I don't think there's a realistic project out there right now, but something may come along.

But we're looking more at the $25 million range right now.

Okay.

As far as the tax rate, you're correct, we're looking at it after we completed last year, filed our returns or did most of the work on preparing the returns for filing, it looks like the rate for this year is going to be in that mid 35%, someplace 35.3% to 35.5%.

Okay, very good.

Thanks, see you guys in September.

Bob Willoughby, Bank of America Merill Lynch.

Scott or Steve, when we've seen these robust equipment sales quarters on a quarterly basis, they're often followed by a very healthy miss the next quarter.

So can you give us confidence that the second quarter sales trends on the equipment side are robust?

I know your enthusiasm for CEREC, but how about that basic equipment?

Is there promotional activity or anything else going on that can keep us confident that these growth rates are in the ballpark for the second quarter?

Sure, Bob.

First on the CEREC front, obviously we're excited, part of the second quarter will depend on product flow from Sirona.

One of the things we've done with our sales force over the last year, in fact we're completing the last event in Atlanta this weekend, is we've been out in front of 1500 salespeople in the last six months to really take advantage of what we believe has been pent-up demand on the core equipment business over the last two to three years.

So, we're confident that we'll continue to drive that.

I think you'll look at our third quarter, the calendar fourth quarter, where we have the potential of section 179 going back to its historic levels.

You have the medical device pack issue looming out there.

So you couple all of those things with I think strong execution from our sales force sitting down with customers that gives us confidence that the funnel is building.

The funnel is absolutely building on the equipment side.

And then the CEREC story we think could be the kicker on top of that.

Okay.

And then just as you relate to the veterinary investment to expand the technical capabilities that you do have, I don't know if you've tried to size that -- what that may have been in the quarter.

And then secondarily, is this the final step in terms of emulating the dental business where maybe it would afford you some pricing power on the consumables front that you're not seeing now.

Is it the same strategy?

Why don't you start, Steve, with the technical service expense.

Yes.

The technical service, Bob, we'll continue to invest in it throughout the year.

But the bulk of the investment has been made.

We're off to a very good start there.

Obviously still some to be made.

It will have a lesser impact, obviously, as that -- the revenue picks up from that part of the business.

There is also the ancillary, as you do more technical service, we would anticipate that you're going to get more capital opportunity with that customer to sell them capital goods as you build that confidence.

So there's sort of an ancillary spray paint effect to that.

So that's sort of what we see for technical service going forward.

And we've talked about this before, Bob, but we see in the opportunity obviously on the equipment side to garner more traditional like margins as we build up that piece of our revenue portfolio.

It will be I think tougher to expand the consumable margins, but that obviously will be one of not only I think our goals but all of distribution over time.

Any idea, you can't give me the absolute numbers, the spread between the sales of dental consumables, how profitable they are versus sales of the veterinary consumables?

I assume that spread is bigger than a breadbox still.

Yes.

The consumable dollar on the dental side, Bob, is obviously more nutritious than the equipment for a couple of reasons.

One, the gross margins tend to be 2 to 4 percentage points higher on average and then secondly, there's a higher commission structure on the equipment transaction than the consumable transaction.

So you are correct.

The consumable growth has a much greater impact on the operating line than the equipment would on an average basis.

Comparing consumables for dental and vet, what's the differential there in the margin?

That really depends on the mix, Bob, because, if you look at traditional consumables or supplies, they are very similar.

Gloves, white goods, things like that.

Yes, needles, sutures, that sort of thing.

If you look at the pharmaceuticals, they are probably 50%.

Well less than 50%.

It just depends on the mix.

And that's why you're seeing some margin pressure in the vet business is because the pharmaceutical side of the business with the parasiticides and the heartworm medications and so forth this summer have been growing quite a bit faster than the underlying supply business.

Okay.

And then just lastly, Steve, still planning to pay down the $125 million in debt here with cash on hand?

Yes we are, Bob.

Okay.

Thank you.

And that'll happen, I think it's scheduled for March.

We may jump some of that and pay it a little bit earlier, but we haven't fully decided on that yet.

Thank you.

(Operator Instructions)

Stephen Valiquette, UBS

So, I know in a lot of previous conference calls, the general topic of operating leverage, margin expansion comes up, including on this call.

This is the seventh quarter in a row now you've had operating expense, or SG&A expense, whatever you want to call it, growing faster than gross profit.

And also, 16 in the last 20 quarters, not that I'm keeping track, but the challenge basically seems to go beyond just the sales mix each quarter.

And now you're talking about quote unquote intensification of sales focus, which some people may read into as code for higher SG&A expense even going forward over the next few quarters.

So really just trying to get a better sense for when you think that you may be able to turn the quarter on operating leverage in the overall business.

And also how much this sales intensification may lead to higher SG&A over the rest of the fiscal year.

Thanks.

I'll take the numbers side of that, Steve, and turn it back to Scott for the strategy side of it.

but we actually gained leverage on the operating structure this quarter which, in a first quarter, is not all that typical.

So I thought we made advancement in that area across the Company.

We would expect to see that going forward.

I might remind folks that this business typically gets the greatest leverage in the second half of the year as the sales volumes tend to pick up in the third and the fourth quarter.

So, first and second quarter are typically not great leverage quarters.

I think, if you are looking at the operating margin line, most of it is in the gross profit.

We explained that being the mix in the quarter.

We would anticipate that mix changing somewhat particularly with regard to the CEREC trade up activity and the cost associated with that -- or the lower margins associated with that activity.

And then also with the vet business, as we get into the fall, the vet mix will taper back on the seasonal products which carry the lowest margins.

So I think, looking forward, Stephen, I'm pretty optimistic that you're going to see that margin expansion that we talked about.

Obviously, if something would happen well outside our control with regard to the revenue side of the business, bets would be off.

But we think with what we're looking at going forward this year, there should be margin expansion for the business.

Okay.

The investment, you're right, we're making investments, but we're making investments in the business constantly.

I think what we're trying to tell you is that with those investments, we believe we can help drive the top line which would then give you the leverage that you're looking for throughout the business.

Okay.

It sounds like at least in the short term what you're talking about the sales intensification, it is not necessarily going to lead to higher expense or materially higher than the trend line you are on right now if you're expecting some leverage by the end of the year.

Is that kind of safe to say?

Absolutely.

And I would echo that we're very proud of the fact that we are extremely efficient in terms of our expense structure and are an industry leader in terms of the profitability we can turn on each dollar.

And we also have the largest sales force, particularly in the dental industry.

So this is not about incremental expense addition.

This is about some focus on the assets we already have in the Company.

Got it.

Okay, all right, thanks.

Jeff Johnson, Robert W. Baird.

Scott, hearing your comments just on the dental consumables business, and, obviously, we started to see some softness in May.

June was particularly soft, from what we're hearing.

Is it worth even trying to talk about exit trajectory?

Did July pick up which is what we're hearing happened?

Does that give you any added confidence in consumables now maybe picking up over the next couple quarters or too volatile at this point to really comment?

Probably a little too volatile to comment on, but it's a very similar scene that's happened the last three summers where the air has come out of the balloon a bit in terms of the total market.

The confidence I have is just when we look at how our customers are looking at the future and starting to reinvest in their practices and how open they are to looking at technology.

And the fact, when you look deeper in sort of the micro categories, the market is still very stable.

Patient flows are decent and what we saw, and I think the whole industry saw was a little bit of softness in areas like crown and bridge and impression material, more the restorative dentistry that happened.

And that tends to -- and we've seen it throughout the last four years since 2008.

When that softens up, it usually does come back because those are mostly deferred decisions by patients.

Okay, great.

And then, Steve, just on the margin front, hear your comments there on expecting to see some improvement later this year.

I mean as I look through segment by segment, you gave some real nice margin expansion in the second half of '12 on the rehab side so those comps do get a bit tougher.

Webster sounds like you're talking about this full list of service investments that on the technical side that might continue to pressure there a little bit.

And dental equipment sounds like it's going to be the biggest growth driver on the dental side over the next few quarters, which obviously has the lower margin.

So I still struggle to see where your confidence or where our confidence should come from on margin expansion over the balance of this year.

Well, I think it's a combination, Jeff, of things we've already touched on as far as this trade up activity has a definite affect on the dental margins.

And, even getting back to the impact on the dental business, even has a gross margin -- or results in a gross margin less than the average equipment transaction.

So, as you get back to the averages even for equipment, that's better than what we're seeing coming off of those trade up programs.

So that's one aspect of it.

As we get into the vet business, as I stated, I think it was Bob asking the question, you get an ancillary effect if these investments that we've made in technical service and looking at changing how we do business and trying to do more business in the equipment side of that business, that part of the business carries a much higher margin than the pharmaceuticals.

So you're trying to change the mix of that business as well.

And so those are two items specifically that will have, we believe, a fairly positive impact on the margin as we go into the second half of 2013.

Okay, and I know you guys wouldn't typically comment and may not today on product specific margins, but we do know Omnicam sounds like it's going to be one of your bigger equipment -- dental equipment growth drivers here over the next few quarters.

Sirona has been pretty that that Omnicam system for them is probably going to be a slightly lower gross margin percentage -- similar gross margin profit dollars but lower gross margin percentage product relative to Bluecam.

Just will that impact you guys at all?

Does that have any impact, or can you guys sell that at a price and what you purchased from Sirona?

Did those dynamics translate differently in your P & L?

No, they will be a positive to our P&L, Jeff, and I think the demand for Omnicam gives us a runway to sell the product with very little promotional expense.

So sort of coupling on what Steve just said, we see that as not only a great revenue opportunity but also a margin opportunity.

But just so I understand, Scott, then your point is Omnicam, relative to a Bluecam sale, Omnicam should be a higher gross margin percentage sale?

It will be in the ballpark of what the Bluecam is.

Fair enough.

Thanks guys, I appreciate it.

John Kreger, William Blair.

This is [Ravi Fadah] in for John.

I just had one more question on the Bluecam versus Omnicam.

This is the first time you have a two product strategy in this market.

How do you think the sales split between the two is going to work out over time?

And in the near term, is there any risk that as the lack of product as a manufacturing process ramps up could hurt Bluecam sales?

Well, I think it's too early to tell, Ravi, and I don't want to make any public predictions on what the split will be other than just to state the fact that we are extremely excited about both products.

And, as I talked about before, the underlying software, the 4.0 software, runs both products.

And I think that us and Sirona will be in a very strong position with the Omnicam potential but also having the Bluecam be a product that we believe will be in the market for a long time.

Got it.

Are the incentives put in place for your salespeople for each product, are they basically the same or is there more of an incentive to sell one camera over the other?

No, they are the same.

Whatever the customer decides there wouldn't be any additional incentive for our salespeople to move product one way or the other.

Great.

Thanks very much.

Mike Hamilton with RBC.

Scott I'm in the area.

Can I come over and help you flog Steve for a while?

Absolutely.

Good.

Just one basic question off of fourth quarter guidance.

You had gone into some detail on outlook and consumable equipment, med, vet, etc.

Are you changing your views at all in nuancing as we're getting into the year?

Yes, I wouldn't change our views right now because we have gone through a summer slowness the last three years and seen the market come back.

I would say we're probably, just because now that we have the Omnicam out and such a positive launch, that probably are a little more confident in the equipment opportunity.

But I wouldn't really change the underlying market observations we made in the fourth quarter.

Thanks, one other question.

From a technical standpoint, where is your focus in medical at this stage?

Our focus continues to be to drive our North American strategy as the true leader in one stop shop, supply of rehab, supplies and equipment, as well as expanding our international presence.

We've got we think a great business down in Australia, strong management team that's battling a very tough market in the UK right now, but we still see ourselves as a Company that has great opportunity in the rehab space.

As we've talked about before, it's a space where we also own some manufacturing and own brands and so the vertical integration opportunities to not only drive market share but protect and drive margin are exciting to us.

Thanks very much.

Charley Jones, Barrington Research.

I had a follow-up on consumable -- dental consumable.

I was wondering if you could go into a little bit more detail about what you thought impacted the quarter and was curious if a few things potentially are impacting that business line, whether it's the economic environment kind of making the CEREC sales a little bit longer or more interested if competitors are more aggressive on promotions or price, and I guess finally I'm curious whether or not you have any gaps in your product portfolio or if you've seen any competitive products that have caused that.

And then, finally, just what are your plans, sounds like some marketing to be able to change the trajectory there, but are you thinking about adding reps, a little bit more there maybe?

Sure, Charlie.

I'll start with the pricing environment, it's obviously always a competitive market, but we do not see any irrational activity in the market.

And, as I said in the prior question, we really do see the market as stable.

When you look at products that are tied to patient visits, we see more of the softness short-term and more of the elective procedures and feel those will come back as pent-up demand.

I don't feel we have any gaps in our product line.

Our main focus is on the independent general dentist at this time.

And, in terms of execution, we're always looking to add to our sales force, our sales force headcount right now is about flat to where it is prior year, but we have initiatives to continue to grow that.

Part of what we always work on in our branches and we're very decentralized is focus on all products and, sometimes when we get into launches of exciting products like CEREC, it can move the sales force maybe a little too far in one direction or the other so our sales management team in the field is really working with our salespeople to be very holistic in their focus towards the customer.

Just a quick follow-up.

Are there any quarters, Steve, that we should be looking for a difficult comp or an easy comp in either vet or dental over the next three quarters?

And finally do you guys have any take on why vet is growing so much stronger than dental?

Do you guys think it's just a different competitive environment out there or pricing or the weather or are we just more willing to spend on our pets than our teeth?

I think part of it on the vet side is its been an incredibly strong flee and tic season with the mild winter and then the weather that's gone on.

But I also think the underlying dynamics of the dental business and the vet business are very similar and we think have a great story as we look forward.

So I don't think there's any real great change between the two markets.

That's helpful and any difficult comps over the next three quarters in either of these businesses?

Apparently they're all difficult.

Yes, all right.

Well thanks a lot guys, appreciate it.

Robert Willoughby, Bank of America Merill Lynch.

Hi.

This is Erin Wilson this time with a follow-up.

Just a couple questions on veterinary.

Did you see a significant shift going to I guess the weather trends from the first quarter to the second quarter with regards to parasiticide utilization?

Our calendar first and second quarter, Erin, or our first?

Oh, yes, sorry, calendar.

No, I think that everybody was anticipating the early Spring.

It was obviously in our fourth quarter or first calendar quarter that things started to warm up, and there were already predictions I think that were causing the vets to stock up.

Second quarter was strong.

I would anticipate that you're going to see some mitigation of that as we get into now the third calendar quarter or our second quarter as the leaves start to fall and the temperatures start to drop.

But no, there was a fair -- I think actually the second calendar quarter was the strongest from a usage perspective but I think the revenues were actually more in the first quarter because of the stocking that was going on.

Now the other thing to remember in the vet business that we haven't talked about is you had sort of a mix change within the sourcing of some of these parasiticides, too, that has helped drive some of the revenue of all of the distributors and that is that the Elanco products, which are sold by cell, have probably benefited at the expense of Novartis, which has basically been shut down since I think last December, November or December, because of some contamination problems they had at their packaging plant.

So that's basically taken Sentinal and Interceptor off the market.

So I think that -- which were sold on a commission basis, an agency Commission.

So that had a positive effect on everybody's revenue lines, and that will start to mitigate as Novartis comes back online for next season.

So [Trisectis] was a huge driver then?

Absolutely.

And also on the reuped relationship with the IDEXX, have any of the specific terms changed materially with that, or is it just a renewal and we should assume everything is status quo as far as the relationship goes with IDEXX?

Erin, I would assume status quo.

Okay.

Thank you.

Ladies and gentlemen, this does conclude the question-and-answer session.

I would like to turn the call back to Management for any closing remarks.

I'd like to thank everyone for taking their time, and we look forward to updating you on our progress in 90 days.

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