Patterson Companies Inc (PDCO) 2016 Q4 法說會逐字稿

Good day and welcome to the Patterson Companies' fourth-quarter FY16 earnings announcement conference call.

Today's conference is being recorded.

At this time I would like to turn the conference over to John Wright.

Please go ahead.

Thank you, Leanne.

Good morning, everyone, and thank you for participating in Patterson Companies' FY16 fourth-quarter earnings conference call.

Joining me today are Scott Anderson, our Chairman, President, and Chief Executive Officer, and Ann Gugino, our Executive Vice President and Chief Financial Officer.

After a brief review of the quarter and the year by Management, we will open up the call to your questions.

Before we begin, let me remind you that certain comments made during the course of this conference call are forward-looking in nature and subject to certain risks and uncertainties.

These factors, which could cause actual results to materially differ from those indicated in such forward-looking statements, are discussed in detail in our Form 10-K and our other filings with the Securities and Exchange Commission.

We encourage you to review this material.

In addition, comments about the markets we serve, including growth rates and market shares, are based on the Company's internal analysis and estimates.

The contents of this conference call contains time sensitive information that is accurate only as of the date of the live broadcast, May 26, 2016.

Patterson undertakes no obligation to revise or update any forward-looking statements to reflect events or circumstances after the date of this call.

Also a financial slide presentation can be found in the investor relations section of our website at pattersoncompanies.com.

Please note that in this morning's conference call we will reference our adjusted results for both the FY15 and FY16 fourth quarters, which exclude the impact of one-time transaction related costs, deal amortization, and foreign currency.

Additionally, our discussion of results is adjusted to reflect the reclassification of Patterson Medical as a discontinued operation.

A reconciliation of our reported and adjusted results can be found in this morning's press release.

Today's earnings announcement and our discussion also reflect the realignment of our reportable segments.

In addition to reporting our dental segment, our companion animal business and our new production animal distribution business are now reported as our Patterson Animal Health segment.

Our other and more centralized shared functions that were previously embedded within the dental segment are now being reported in a separate corporate segment.

This call is being recorded and will be available for replay starting today at noon central time for a period of one week.

Now I'd like to hand the call over to Scott Anderson.

Thank you, John, and welcome, everyone, to today's conference call.

I'd like to begin my remarks by discussing where Patterson Companies is today from a strategic standpoint, highlight the journey we are on, and put our fourth-quarter and FY16 into some important perspective.

As we've concluded FY15 a year ago and embarked on FY16, we set out on a path to transform Patterson Companies for a future of more sustainable, profitable growth.

Our path to where we are today and where we are going is thoughtful, well planned, and multidimensional.

We know that to fully realize our ambitions it will require strategies designed to transform Patterson in multiple ways.

It involves ensuring that we are technologically advanced to not only serve the customers of today and tomorrow, but to take Patterson to increasing levels of efficiency; fundamentally repositioning our portfolio of businesses around stronger, long-term growth markets and go-to market approaches that are highly compatible; closely scrutinizing our existing operations as part of our portfolio evaluation to make sure we are fully optimized and positioned for the future, even in areas where we believe we are traditionally very strong; and lastly ensuring that as we drive this change, we preserve and enhance the high-performance culture that has made Patterson a leader and employer of choice.

In our 140 years as a company, Patterson has seen its fair share of market changes and has always stepped up to lead our chosen markets.

FY16 was arguably one of the most ambitious years of large-scale change we have undertaken in our nearly century and a half.

We took our initial transformational steps during the fiscal year, beginning with the refocusing of our portfolio on two highly compatible growth focused businesses and consummating the largest transaction in our history.

We move forward with the pilot of our new ERP system, which we believe will lead to whole new levels of operational effectiveness.

We made significant strides in integrating our new Animal Health platform, which is roughly 50% of our business, and capturing the synergies we committed to this fiscal year all while preserving our cultural strengths.

And we strengthened our leadership, attracting seasoned high-level executives to our bench and balancing our Management team with both inside and outside perspective.

Given the scope and sophistication of the initiatives we are pursuing and pressured top line performance in some areas, I am pleased to report that we were able to finish the year strong on the bottom line.

Consolidated sales from continuing operations rose nearly 42% on a constant currency basis to $1.5 billion, reflecting the Animal Health International acquisition.

And we ended the year with adjusted earnings per share from continuing operations of $2.47.

Looking at our markets, conditions were roughly unchanged compared to the last quarter, but there were some subtle changes in the complexion in our end markets during the fourth quarter that are worth noting.

In Dental we continued to see relative stable but steadily improving conditions.

Looking at market segment conditions affecting our Animal Health segment, the companion animal market like Dental continued to show stable to steadily improving characteristics.

Certainly the milder winter conditions provided some tailwind in our third quarter, however the cooler damper spring conditions we experienced in our Q4, especially in the northeastern United States, weighed on sales of certain products.

We remain confident in the prevailing market conditions that reflect solid employment levels and consumer resilience.

Performance in production animal continues to reflect the softness in the livestock industry, especially in dairy and beef cattle markets.

We are beginning to see some signs of end market improvement, especially in the swine market.

This is part of the cyclicality of the livestock markets, and we anticipate gradual improvement as we head into FY17.

Against this backdrop, I'll now provide some insights into segment performance starting with Dental.

While we were generally pleased with the bottom-line results within Dental for the quarter, our sales performance was mixed, even in spite of the tough comparable, and fell short of our internal expectations.

Sales of consumables were generally in line with market and with the exception and our FY16 third quarter consistent with sales performance trends over the past several quarters.

Sales performance in equipment, Digital Equipment more specifically, is where we were more challenged and also were faced with the toughest comparable.

Overall, equipment sales fell 6.9% in constant currency, driven by lower digital X-ray equipment sales.

In some ways we believe these results are a function of our own success.

These inter-oral digital technologies have penetrated approximately 70% to 80% of the market, and Patterson Dental has garnered the largest market share.

Going forward we see many opportunities across our digital platforms, particularly for cone beam technologies.

As I stated last quarter, the importance of properly supporting these technology investments is critical today and will only deepen as we move forward and dental offices become even more digitized, providing support which helps make technology investments worry free for the practitioner so they can focus on patient care, which will be an increasingly important differentiator for Patterson in the future.

Dental offices that are embracing digital dentistry are looking for partners that can make integrating these technologies into their practice environment and supporting them seamless.

This means investing in and delivering best-in-class training programs and highly effective technical backend support.

The Patterson Technology Center provides our customers with the link to that seamless experience.

The PTC is currently supporting over 100,000 end product users, both in the dental and veterinary businesses.

It took more than 1 million customer interactions annually, or about 5,000 daily, from practitioners who have placed a premium on the digital backbone of their practices.

We fully expect the volume and value of these services to grow.

Turning now to core equipment, sales were largely flat and in line with our internal expectations.

Throughout FY16 we proved our ability to enrich our basic equipment portfolio in a way that gives us a more sustainable long-term platform for future growth.

ADEC has been and remains a very important partner to us, and we had a strong your with them.

Our broader manufacturer relationships, which included the new additions of Pelton & Crane, Belmont, and the Sirona line of treatment centers, helps us to be more flexible and support the needs of a wider range of customers.

Looking now at CEREC sales, our momentum in this category was very strong in the fourth quarter.

Even in spite of the difficult year-over-year comparable, CEREC sales hit record levels.

Clearly there is tremendous enthusiasm for Sirona's new Zirconia workflow for CEREC, and we capitalized on this recent product introduction.

The Zirconia workflow combines CAD/CAM technology support with full contour zirconia material.

The prospects of adding high-strength zirconia material to single-digit restorations has created fresh interest in and demand for chair-side restorations and we do not see this abating.

If there is any source of disappointment within CEREC sales for the full year, it would be in the slower pace of trade ups.

However as we have said in the past, this is a testament to the strength of the Sirona platforms and the high level of customer satisfaction with their products and our support infrastructure.

As we move forward, our focus will be on expanding into new customer segments, seeking fresh opportunities to gain more reach, and intensifying our focus on sales execution.

Turning now to Animal Health segment, during the quarter we posted solid top and bottom line results in both companion animal and production animal that were in line with expectations and reflect current end market dynamics.

We need to keep in mind that while production animal market cyclicality can prompt producers to adjust herd size, producers must continue to manage the health of their animals regardless of market conditions, and we are the market leaders in helping them achieve this important objective.

As we head into FY17, we anticipate improvements in producer level economics as animal pricing strengthens and producers look to increase breeding activity, especially in beef cattle.

This quarter in addition to favorable performance in our US companion animal business, we saw encouraging growth once again out of our UK division, NVS.

Sales in our companion animal business grew 8.2% in constant currency during the quarter.

Sales growth at NVS, our UK division, added 5% on the same basis.

We remain very impressed with the management and team at NVS.

Their commitment to execution keeps us optimistic with the momentum in their business.

Sales from the acquisition contributed an additional $404 million to our Animal Health segment in the fourth quarter.

Naturally, our ongoing integration efforts in our Animal Health segment are intense focus and we continue to concentrate on both operational refinement and sales execution across our entire platform.

In terms of synergy capture, today our sales, marketing, and operation support functions are fully integrated, and we are presenting one voice to the industry.

We have fully rationalized all the core functions within Animal Health, and now can move towards optimizing our distribution footprint.

I'm very pleased with the assertive and positive approach the entire team has taken on this.

We recently completed strategic planning sessions for our Animal Health segment, and it's encouraging to see such an intense focus on the customer and open sharing of ideas to better propel the business.

This dynamic, coupled with our success thus far in capturing synergies, gives us optimism that we can further build on the strong leadership position we already have.

With that, I'll ask Ann to review the financials.

Thank you, Scott.

As Scott mentioned our efforts to improve our operational discipline paid off during our fourth quarter and will continue to play an important role as we move forward toward sustained profitable growth.

During the quarter, these efforts were clearly reflected across a number of metrics such as operating margin expansion, improvements in working capital levels, and of course, our bottom line.

We are pleased to have met our annual guidance range for adjusted EPS from continuing operations for a second consecutive year.

As I've done in the past, I will again discuss sales and adjusted results from continuing operations to focus on our current portfolio of businesses.

This past quarter was the third full quarter of contribution from Animal Health international.

So where appropriate I will highlight organic sales which strip out contributions from the acquisition, currency effects, and a change in selling arrangements from agency to buy/sell to provide a more normalized view of results.

Let's start with the top line.

Consolidated sales for the quarter totaled $1.5 billion, up nearly 42% on a constant currency basis.

Organic revenue growth rose 1.6%; again, for this quarter the impact of currency translation moderated slightly.

On a consolidated basis, currency translation reduced sales by approximately 1.1%, which is down sequentially from 1.7% last quarter.

We continue to anticipate that between 15% to 20% of our total revenue will come from international sources.

Turning now to margins.

When examining margins, it's helpful to keep in mind that the core rationale for our portfolio moves over the last past year was to begin to build platforms for long-term growth and return on invested capital in exchange for some margin dilution.

Consolidated operating margin during the fourth quarter reflected that impact declining 80 basis points.

However, with the additional earnings contribution from Animal Health International, our operating income topped $119 million, up 28%, over the prior year.

The fourth quarter was solid in terms of operating margin expansion in both our Dental and legacy companion animal businesses, reflecting a range of factors from changes in product mix, synergy capture, and improved operational discipline.

Finally, on the bottom line we posted quarterly adjusted earnings from continuing operations of $0.77 per diluted share.

Now, let's move on to our segments.

In Dental, sales were essentially flat on a constant currency basis in the quarter.

On that same basis, consumable sales were up 3.3%, growing slightly faster than the end markets in the categories we serve.

As Scott mentioned, equipment sales were mixed, and we had a large year-over-year sales comparable to overcome; 23.3% growth in last year's Q4.

Overall equipment sales declined 6.9% in constant currency on that tough comparable.

The decline mainly reflects lower digital X-ray sales, both in terms of volume and lower price point offerings.

As we discussed during our call last quarter, we expected new product innovation and focused promotional offerings to enhance our Q4 CEREC sales, and we are very pleased with our performance this quarter.

CEREC sales were up low- to mid-single digits, reaching an all-time quarterly high.

Dental operating margins rose more than 50 basis points over the prior year.

Again, this improvement was largely due to a blend of factors including mix, and operational effectiveness.

Last quarter we had forecasted that we were on track to deliver operating margin expansion between 20 and 30 basis points in Dental for the full fiscal year.

We ended the year with 26 basis points of improvement right in the middle of our range.

Now turning to our Animal Health segment.

For the sake of clarity in this discussion, organic sales metrics exclude the contributions from the acquisition and currency, but include the benefit of the change in selling arrangements for certain products from agencies to buy/sell.

Please note that this change will continue to impact sales results going forward.

Organic sales in the segment rose 8.2% for the quarter, driven by solid sales performance in both the US and the UK.

Specifically, sales from the legacy US companion animal business were up 10.5%, and UK sales grew by 5% in constant currency.

US sales reflected that change in selling arrangements which added 2 to 3 percentage points of growth to consolidated Animal Health results.

The sales contribution from the acquisition during the period totaled roughly $404 million.

With that contribution, sales for the consolidated Animal Health segment more than doubled from the prior year.

The production animal market continues to be impacted by softness in some markets, particularly beef and dairy cattle.

We anticipate some end market strengthening as we move into FY17, especially in the back half of the fiscal year.

Operating margin, excluding the acquisition and our legacy companion animal business, improved nearly 50 basis points, primarily reflecting higher sales levels and synergies.

After factoring in the acquisition, consolidated operating margin within the Animal Health segment increased nearly 10 basis points.

We expect operating margins to continue to expand going forward.

For the full year we had forecasted operating margins on an adjusted basis of 4% to 5% in this segment.

Adjusted operating margins rose 24 basis points to 4.6%, which is right in the range.

Regarding synergies, we made good progress, and we estimate that our synergy capture came in on target for the year.

Our synergy focus in FY16 was on the integration of our companion animal sales forces, reducing our facility expenses, and lowering logistics costs.

Moving into FY17, our focus will turn to more effectively leveraging our supply chain across both of our businesses, and further consolidation of our back office functions.

We remain on track to achieve our stated goal of capturing between $20 million and $30 million in annualized synergies over a three-year period.

Now a look at a few balance sheet and cash flow items.

Last quarter we said that working capital levels should come down over the next few quarters, and we finished the year strong.

During the quarter, we more effectively managed working capital and generated solid cash flow.

Net cash provided by operating activities from continuing operations was over $242 million in Q4, an improvement over the first nine months of the year.

For the full fiscal year, we generated cash flow from operations of about $195 million, compared to $205 million during the last fiscal year.

We remain confident in our ability to generate growing cash returns on our business, and expect to return to converting between 85% and 100% of net income into free cash flow in FY17.

CapEx totaled $22 million in Q4 and included investments for normal replacements as well as our corporate-wide information technology initiative.

For the FY16, total CapEx came in at $79 million.

A quick look at tax rates.

Our adjusted effective tax rate for the quarter was 33.3%.

While we did see some benefit during the quarter from a [true book] contingency reserve, for the full year our adjusted tax rate was unchanged compared to FY15.

Looking ahead, we anticipate an uptick in the rate next year to around 35%.

In terms of shareholder return, year to date we have returned a total of $291 million to our shareholders through a combination of $91 million in dividends and $200 million of share buyback.

I'll wrap up with a discussion of our FY17 guidance.

First I'd like to echo Scott; Patterson is in midstream in a process of repositioning itself for larger growth goals ahead.

In FY17, we will continue to move through a period of intense execution on a range of initiatives that we believe are critical to top- and bottom-line expansion.

It is also helpful to consider the market dynamics we expect to face.

As we head into FY17, we currently expect the Dental market to continue growing at a pace of 2% to 3%.

In companion animal we anticipate 4% to 5% market growth, and in production animal we are expecting underlying market growth of roughly 2%.

The guidance range we are providing today does include, as we began to discuss last quarter, a pretax $25 million step up in operating expense associated with the ERP implementation.

As we explained, this investment will start depreciating as we move further into broader implementation during the fall.

During this period, we will essentially be running redundant systems to help ensure a seamless transition to our new platform.

This step up in expense, which will begin in the late fall, includes cost for depreciation, rollout, and infrastructure support.

We believe our new ERP platform will lead to new efficiencies.

However, some of them cannot be realized until the platform is fully implemented.

That said, we believe we have a sound process in place for migrating to our new system in a way that ensures business continuity and high levels of customer support and leads to significant future efficiencies once the transition is complete.

I'd also like to provide some framework on operating margin expectations.

For FY17, we expect consolidated operating margins to be flat to down slightly after absorbing the $25 million step up in ERP expenses, the majority of which will be allocated back to our business segment.

In Dental we are targeting our operating margins between 13% and 13.5%, and for Animal Health we expect operating margins to be flat with FY16.

With all of this in mind, we're establishing our FY17 guidance range for adjusted earnings per diluted share from continuing operations at $2.60 to $2.70 per share.

Our guidance range assumes stable North American and international markets and excludes the following: The impact of additional share repurchases, new acquisitions and transaction related costs, integration, and business restructuring expense, and deal amortization.

Lastly, we anticipate that the additional earnings per share that we expect to generate in FY17 will be relatively evenly distributed across the fourth quarter -- across the four quarters.

With that, I will turn it back to Scott for some further comments.

Thanks, Ann.

As I mentioned at the beginning of our call, Patterson will celebrate 140 years as a company in FY17.

We have achieved countless milestones in that time and intend to reach many more as we move ahead.

In FY16 we topped $5 billion in annual sales for the first time.

We confidently met our first-year synergy goals for the integration in our Animal Health segment.

Last quarter we began the first pilot implementations for our next-generation systems initiative.

This involves six branches, two fulfillment centers, and several corporate functions directly involving more than 1,000 employees.

The volumes in these branches are testing well, and we continue to refine the system weekly.

I believe we are well on our way to establishing a stable, modern, scalable ERP platform that will better allow us to succeed in any growth environment.

In Dental we are bullish on the opportunities that lie ahead.

We have built a product and technical competency in Dental that I believe will provide substantial differentiation and value for customers, especially those who strive to transform their patron experiences.

However, we need to find ways to more effectively shape our approach to today's market and better address the needs of our customers.

And in Animal Health, we are headed towards completing our first full year after adding Animal Health International to the Patterson family.

We can clearly see when you compare the customer profiles and their needs across both of our business segments, that our customer profiles are evolving toward small, midsize, and large customer categories.

Each has unique needs and different definitions for value, and our business model is well-suited to address all of them.

Finally, we remain committed to our three-prong capital allocation strategy.

We believe there are more acquisition opportunities out there that can allow us to build on the platform we have created in a capital efficient way.

We will continue to explore these opportunities along with supporting our dividend and share repurchases.

Now we'd like to take your questions.

I'll turn the call back over to Leanne.

(Operator Instructions)

Robert Jones, Goldman Sachs.

This is Nathan Rich on for Bob this morning.

First, if I could start on dental equipment, just looking at the year as a whole, sales were about flat on a constant currency basis.

Scott, I think this is probably somewhat disappointing, just given the end markets seem to be pretty healthy and dentists seem willing to invest in equipment, and I feel like you do have the right channel partners.

So, just wanted to get your perspective on performance for the year and any changes you think that need to be made on just how you go to market.

I know you touched on looking at new customer segments and sales execution, could you just give us a little bit more detail there?

Sure.

Thanks, Nathan.

I think when we look at the full year, and I'll put it in some context, we're, as I said in my prepared remarks, I think we're very pleased in how we transitioned to a more expanded portfolio of traditional equipment partners.

We have a fantastic partner, legacy partner in ADEC, and when we looked at the transition and put our internal projections together we actually exceeded those internal projections.

And looking forward instead of looking backwards, we're really excited about the upcoming year.

ADEC has some significant new product launches.

In fact, our entire equipment sales force is in the process of being trained on these products at ADEC factories in Oregon.

And I say bottom line with the portfolio as we have more access to more customers.

That's the constant feedback I have.

I would say we were disappointed as we looked at our third quarter, which is the calendar fourth quarter that the Section 179 issue did not get resolved, but are very excited that that is resolved and is part of the discussion today with our customers.

So as we look forward, we think the fundamentals are building and the foundation is building for dentists to actively invest in their products, and Patterson is always taking a leadership area in terms of technology and equipment sales.

Appreciate the color there.

And then maybe just moving over to the Animal Health business.

On the production side, end market seemed to still be challenging.

I was just wondering if you'd be willing to share what organic growth for the Animal Health International business looks like for the quarter, and how that maybe compares to the 2% guidance you gave for FY17?

And then if you could just comment on synergies, where we are as you exit the year and what is baked into guidance for next year.

Sure.

I'll start and then I'll turn it over to Ann.

I want to be very clear that we talked about underlying growth rates of 2%, not our internal plan.

I would say when we look at the full year of their performance, we are pleased in their ability to deliver under tougher economic conditions.

And that's one of the legacy parts of that business.

So I'll turn it over to Ann for -- maybe Nathan repeat the question for Ann and exactly what you want to get out of the numbers.

Yes.

Sure.

Just how the AHI business grew organically, and then just an update on synergies, where you are exiting FY16 and what you're assuming for FY17.

Okay.

Great.

Thanks for repeating that.

So organic growth for the current quarter was about 2 percentage points of growth on a pro forma basis.

And I would say that's pretty consistent with their year-to-date performance.

We mentioned -- and in line with market growth.

We have been looking at market share very closely, and we believe we are maintaining our market share.

As we look forward, as we mentioned in our prepared remarks, we're looking at underlying market growth at 2%, and we would expect to do a point or two better than that next year in the production animal business.

So we would expect to take some share there.

As it relates to synergies, you'll have the annualization of the current year synergies.

So we built up to about a $9 million to $10 million run rate at the end of the current fiscal year.

That will continue to annualize into next year's numbers, as well as you'll add on building throughout the year another $10 million, so that as you get to the end of next year, you'll be at an annual run rate of $20 million.

Okay.

Great.

Thanks for the questions.

Thanks, Nathan.

Ross Muken, Evercore ISI.

Hi.

This is Elizabeth Anderson in for Ross.

I had a question on your dental consumable trend.

I was wondering if you could dig into a little bit more detail and talk a little bit more about whether you're seeing that come through from any particular market segment, or just generalized growth?

Additional comments on that would be really helpful.

Sure.

Thanks, Elizabeth, for the question.

I would say we saw very consistent growth geographically and across customer segments.

There was a bit of a step down in the growth curve from the last quarter, and I would attribute that more to the fact that the winter months in the industry were up against a pretty easy comparable in how tough the winter months a year ago.

So I would say there's really no underlying change in terms of utilization that we see.

But continued, really stable, consistent growth throughout our customer base, both in our largest customers as well as our mid-sized and smaller customers.

Okay.

Great, that's really helpful.

And then as a follow up, one of your competitors was pointing to the potential growth that they're seeing in the scanner-only market.

And I just wanted to get your thoughts on how you see selling scatters versus a full chair-side solution, and that would be helpful.

Thank you.

Sure.

Yes.

As many of you know if you know the Patterson story, we've been a real pioneer and leader with our relationship with Sirona and others, in building digital platforms.

And as we look to the future, we absolutely believe that the chair-side CAD/CAM component will be a very important part of dentistry in the future.

But there will also be a component that will be attached to digital scanning, and our current partners will absolutely be a part of that.

If you look at just pure volume and penetration right now, there is no doubt that the CEREC system is the true market leader, but this will be a market that evolves, and companies with great research and development and commitment to the future will be the winners long term.

I think what we really like about our position at Patterson is, and I talked about it in my comments, is we've built an infrastructure to partner with technology.

The fact that we're taking -- have over 1 million customer interactions a year on the digital side, that we have a technical infrastructure of technicians that can visit practices that numbers over 1,000, we will be a partner of choice for many years to come to help dentists integrate these technologies.

So it's exciting to see how the space is evolving.

Yes.

Definitely.

Thank you.

John Kreger, William Blair.

Hi.

Thanks very much.

Scott, in your press release you talked about Dental having -- seeing changing needs of the market and customers.

Can you just expand a bit on what you're seeing and what was behind that comment?

Sure.

Thanks, John.

We absolutely see and experience and do business with customers that are moving into different market models.

From very, very large dental service organizations to practices that are evolving into one, two, three, four, five practices within a geographic location.

So when we look at how do we use the power of Patterson and the relationships we have with our manufacturers to serve those customers, we know that it is not a one-size-fits-all strategy.

So we're building and continue to build ways that we can serve dentistry and the Animal Health segment, because there are a lot of synergies in terms of business models, how we can serve those different business models incredibly effectively and really ensure customer success regardless of practice size.

That's helpful.

Thank you.

And I think this was the first quarter where you were dealing with the newly combined Dentsply Sirona.

Any comments there?

Was there any change in underlying strategy given the new entity?

No.

I would say we performed very well across the whole portfolio outside of some softness on the digital products; but we've been a great partner of the entire team over there at Dentsply Sirona as they're going through their integration.

So we see nothing but very interesting opportunities going forward.

Great.

Thanks.

And then one last quick one, Scott, you mentioned digital X-ray is getting up to I think you said 70% to 80% penetration.

Should we start to think about that category more as a stable replacement cycle type of business, or do you think that can continue to be a strong grower over time?

I think there's a lot of growth opportunities, but you have to accept the reality that the market is maturing.

And we have a history of building markets and greenfielding markets and then watching them mature.

And then they become fantastic replacements and innovation markets.

So there's no doubt that the digital X-ray sensor, and that's the -- I want to be very clear, that's the one product that is getting to a higher level of penetration.

I would say there still is a segment of our customer base that uses film and probably will use film until they retire.

But I don't want to have anyone think that there is not growth opportunity here because you'll see manufacturers innovate, you'll see processes get better, and the digital workflow will be a huge part of the modern practice.

Great.

Thank you.

Steven Valiquette, Bank of America.

Thanks.

Good morning, Scott and Ann, thanks for taking the questions.

Maybe start off with one on the Animal Health side.

There's been a few other production animal health companies that talked about some slower sales of MSAs in the US.

Maybe ahead of some upcoming regulatory changes for reduction or elimination of anti-bacterials in protein production.

Can you just remind us whether or not Patterson has any material exposure to that situation?

I'd say that's an issue that we've spent a lot of time as we learn the market and through due diligence, and we feel comfortable that as treatments of all new products will be established that will replace older legacy products, we look at some markets in Europe that have gone through this transition and I get back to when you look at our business I think you really have to focus on we're the partner that helps the producer keep animals healthy.

And there will be innovation that creates products that do that for the producers, so we don't feel there's a material exposure, but there could be a transition from one product to a new type of product.

Okay.

Got it.

Okay.

And then one other quick one here.

Not sure if this is still easy for you guys to quantify or not, but within the new FY17 EPS guidance, the $2.60 to $2.70, do you have a sense for the approximate amount of incremental EPS accretion year-over-year from AHI that is baked into that assumption?

Sure.

So it's obviously an estimate because as you alluded to we're integrating rapidly, right?

But my estimate would be about $0.08 to $0.10 for next year.

Okay.

That's helpful.

One other quick clarification, you did highlight in the press release the lower digital equipment sales were a culprit in the decline year over year for dental equipment.

I know there have been a few questions on dental equipment, but just to clarify is that primarily digital X-ray equipment that you are alluding to when you make that statement, or is it a much wider portfolio of products that you're referencing when you talk about the lower digital equipment sales?

It's really digital, but I also think it's very important to clarify we were up against a very significant comparable from a year ago.

In fact our cone beam business a year ago was up nearly 50%.

So in no way do we want to signal that there is a slowdown in the digital business.

One of the interesting components, and it will be a net positive, is on the extra-oral we introduced new products this year with our partner Sirona, the ORTHOPHOS SL line, and I think what we're seeing bottom line is the products are getting better but price points are coming down.

But this brings tremendous value to the practitioner.

So we could not be more excited about the ongoing opportunity, but we did run into a bit of a headwind here in the quarter.

Otherwise I would say the fundamentals of the dental business were very sound, but we also leave and enter the new fiscal year with a lot of urgency internally because we feel there's so much opportunity out there.

Okay.

Got it.

Okay.

Thanks.

Jon Block, Stifel.

Thanks.

Good morning.

Maybe two questions, first one is for you, Scott.

You mentioned the early traction with Zirconia for CEREC, and now that maybe you're a couple months into the launch, how would you characterize Zirconia's ability to meaningfully accelerate new system sales?

Specifically, are you seeing some doors open that were previously closed?

And then, Ann, just one for you down the same road, I think last quarter you called out some high levels of inventory specific to CEREC but you had a good quarter, so where do you stand with the inventory levels specific to CEREC at year end?

Thanks, Jon.

I'll talk to the early feedback on Zirconia.

I think this is a story that's going to play out over the long term, and we take a long-term perspective on this relationship having been doing it for well over a decade.

The initial feedback is the Zirconia really opened up doors once again for a large segment of the dental population to look at CEREC again.

And we always get excited when the innovation curve allows us to do that because many times the impression of CEREC may be a dentist who looked at the product, two, three, four, five years ago.

So we have a lot of activity, very pleased, and I would say if there was risk going into the fourth quarter, when you have a new product launch you have to train everyone up and you have to get the supply chain right and get the products in the right spot to serve the demand, there's a lot of risk in that.

So I could not be more pleased with our Dental team and how they, particularly our folks in the field and in the branches, on how they met that demand for the customers.

While generally historically summer can be a quieter period of time, I think we'll have a lot of interaction with customers over the summer about Zirconia.

And I'll turn it over to Ann to talk about inventories.

Okay.

Sure.

So you might recall, we were caring higher levels of inventory but also higher levels in our long-term receivables for a number of reasons.

You mentioned CEREC being one, which was certainly the case because of the delay in Section 179.

But we also had more caring inventory levels higher than normal because of the consolidation and integration activities within the Animal Health business and the SAP implementation.

So certainly we saw good reductions in our investments in working capital, both in inventory and long-term receivables.

Certainly CEREC was a portion of that, and they'll see inventory in total came down nicely about $90 million.

I think there's still room to improve in terms of working capital in total.

As we move into FY17, I think there's room to improve upon that, and as I mentioned in my remarks, we expect to get back to that 85% to 100% of net income to free cash flow conversion next year.

Okay, great, very helpful.

And just one more, a long one for me.

Scott, you're now about a year and a half after IDEXX's announcement to go direct, and obviously you've got a real solid partner with Abaxis, but they seem to come out of the gate real strong and maybe a little bit more modest as of late.

So how do you view how that relationship has progressed over the quarters?

And then, Ann, just going forward will we just get -- you're normalized I take it, in other words going forward that in all Animal Health numbers now that diagnostics has been with you for a year plus?

Thanks.

Yes.

Thanks, Jon.

As I've said, we were for years a great partner of IDEXX and have a ton of respect for their company, but at the same time I think we've established a great partnership with Abaxis and continue to incrementally grow that business internally, and it remains a really high focus item.

With that being said, I think one of the really exciting things that is coming out of the transformation of our Animal Health business is a real sense of excitement inside our companion business about what we can do to help our customers.

So we think it's a great market with really strong underlying dynamics, and we think the Patterson position is going to be a position that's going to grab market share over the coming year.

So continue to be very excited about that, and within the construct of our go-to market, Abaxis continues to be a very important partner to us.

Sure.

And then, Jon, just in terms of the sales results, you're right.

The diagnostics change actually annualized into our results last quarter.

But I think, as you know within that Animal Health segment, the terms and selling arrangements with the manufacturers do change from time to time, so what you saw this quarter with one manufacturer, their sales moved from an agency relationship with us to a more traditional distributor role, which we refer to as buy/sell.

And so that change that happened this quarter did add about 2 to 3 percentage points of revenue growth to that total Animal Health segment, and that change will continue to affect us for the next four -- the next three quarters.

Got it.

Thank you.

Jeff Johnson, Robert Baird.

I'm sorry.

Scott, can you hear me okay now?

Yes.

Hi, Jeff.

Great.

Good morning.

So just a few questions here, if I could.

First on Zirconia, obviously the CEREC number was a good number, especially against that tough comp.

Wondering if you could just update us on maybe capacity constraints there?

I know Sirona has had some issues getting some of that out the door initially, so where are you with inventory or ability to get your hands on that product?

And how do we think about the opportunity potentially to do a dry mill upgrade over the next few quarters?

Or is this going to be about -- in the first year, is it going to be about supplying new users the mill to begin with?

Yes.

I would say we feel good about the supply chain.

There were some short-term issues on the speed fire oven, but most of those have been rectified.

And I would say just as we looked at the Omnicam strategy two, three years ago, the strategy will be around new users here in the short to medium term, but absolutely believe there is a growing opportunity longer term as people still have the opportunity to not only move into Omnicam, but also move into the dry mill and the speed fire with Zirconia.

So, exciting time in the CEREC community.

All right, great.

And then, Ann, a question for you just on the ERP expenses, the $25 million.

I think there's been some discussion over the last few months about some of that could potentially be non-GAAP or looked at as kind of non-recurring expenses.

And you chose not to do that, which I actually applaud you for, and then just absorbing it into the model.

But I guess my question is as we think about FY18, of those $25 million, are those new infrastructure expenses that stay in place?

Are some of those one timers in nature that could start coming out as we go to 2018?

Just how to kind of think about what that part of that $25 million this year?

Sure.

I think I might start by giving you a breakdown of the $25 million in some rough ranges.

So what I would tell you is about 20% to 25% of the step up is depreciation.

Keep in mind that's a partial year depreciation because we're implementing it for about half a year, but about 20% to 25% of the $25 million step up is depreciation.

About 25% is rollout and implementation costs, so that's the piece that you can think about that would go away, right, in the back half of 2018 as we complete the rollout, and then the balance is what's required to support the system.

I think when you think about 2018 and how much comes out, we expect to see some benefits in the back half of 2018 because the training and implementation is done, you're fully up and running, and so now you can turn off the legacy systems and you can also now truly harness the benefits of the new system.

But I'm not ready to really publicly quantify dollar amounts at this time.

We're still working on those estimates, refining them.

No, the breakout is helpful there.

And then just my last question on the production market, I think you talking about 2% market growth and slightly higher for the AHI business itself this year.

Scott, I think you made the comment, I was in and out of the call so forgive me if it was Ann, if it was you instead, but I think you made the comment about expecting maybe approaching rebound in protein prices to help support that 2% market growth this year.

As I look at the future, it looks like beef and dairy futures have both taken a bit of a step down even in the last month, month and a half.

So how much of that 2% market growth is subject to we need to see a rebound in protein prices, or can that be tied more back to just if we bounce along at these levels?

Just wondering conceptually how you're thinking about that 2% market number?

Yes.

As we spend a lot of time with the management team at AHI, and this is a team that has really deep 10- , 20- , 30-year experience in the industry, and we put our plan together, really what they are beginning to see is a move in an expansion of the herd size as profitability gets better for the producer you've got some people holding back calves this year.

So we feel that is what they've talked about, the tailwind beginning to build throughout the fiscal year.

So we feel really good about the market and our opportunity to really execute in that type of market.

The other place I would point you, Jeff, is the swine area, which is a significant piece of our portfolio.

And that's one where we're already starting to see some tailwinds in that area and would expect that to continue to improve.

All right.

Great.

Thanks.

Kevin Kedra, Gabelli & Company.

Thanks for taking the question.

First just wanted to ask about CEREC.

You said you had a good quarter.

Just wondering if you have reached the necessary requirements for that first year of extension, of your exclusive agreement with Sirona, I guess now Dentsply.

Can you just give a little bit more detail about what that agreement looks like and where you are on some of those extenders?

Yes.

I would say, Kevin, we've never spoken publicly about the details of the contract.

We continue to perform and have performed well over a decade as a partnership, but we don't discuss the contract specifics publicly.

Okay.

When thinking about the equipment business, I know in the past you have been talking about opportunities there for double-digit or at least high single-digit growth.

I haven't quite seen that in the last year or two.

Just how should we really be thinking about that business over the next two to three years, especially as we talk about X-ray being -- digital X-ray being a bit of a maturing business?

Yes.

I would say we would anticipate in the coming fiscal year mid-single digits growth.

I would say the outlier to that, the potential upside would be if the Section 179 tailwind really kicks in and we would get back to sort of 2008/2009 levels in terms of the core equipment business, and you would see historical levels of new office construction.

So those would all be upsides to our model.

They're not included, so we would see stable growth in the coming fiscal year.

But would probably, I would say, lean towards optimism that this could be a year where we could begin to see growth trajectory move back up to a more traditional level.

Okay.

Thanks.

Robert Willoughby, Credit Suisse.

Thanks.

Scott, are you expecting any promotional activity on the equipment side this fiscal year?

Or do you think that's been weeded effectively out of the industry?

And then was there any real disparities in the strength of equipment over the quarter where the winter months, the February much stronger on the easy comp, or was it kind of a similar trend across all three months?

Yes.

Our March/April time period is always a bit stronger, so I would say it's pretty traditional.

I would say and also I think it's important to note that there was nothing we did incrementally in terms of promotions in the quarter, particularly around CEREC, so I think it was really good end user demand and strong sales execution.

And I would say going forward we would do nothing that would be out of our past practices in terms of promotional activity.

Without a doubt, the biggest promotion that is out there for small business owners is the benefits from Section 179.

So the fact that those -- that extension was made permanent and it's something we are talking about every day today with customers, I would say is probably the biggest potential tailwind for the industry for the whole.

And the comments on acquisitions, you have interest in doing them.

What's the likelihood, though, of you identifying and closing something this year?

Is it first half, second half you could steer us towards, or is it just hey, we're always interested but nothing in the pipeline?

Well, I would say we're always looking -- we have a lot of activity going on.

As we talked about one of our strategic intents that we laid out was an expanded view of the market, but at the same time we will be very disciplined with the capital and we'll look for good partnerships at the right price.

I wish I was smart enough to perfectly time when an acquisition would happen.

But I would just say we're out there looking.

We think we're a great partner.

I talk a lot about this is the 140th-year anniversary of Patterson and this is a company started by two brothers in a drugstore.

So over those times we've combined with many other great businesses and family-owned businesses and will continue to build those relationships.

I would say from an internal capacity and from a financial capacity, we're in a good position to be able to integrate additional acquisitions at this time.

And can you weigh in, I know it's hard to say but Animal Health versus Dental, is Animal Health still the better area right now?

Or more -- but.

No.

I would say they are equally attractive.

Okay.

Thank you.

Lisa Gill, JPMorgan.

It's actually Mike Minchak in for Lisa.

So first on the dental consumable side, despite the sequential deceleration in constant currency growth rate you saw this quarter versus the strong third quarter, you mentioned in the press release that your growth was ahead of the growth in the end markets that you serve.

What do you estimate the end market is growing at?

Has that decelerated versus historical levels, and if so is that something that you view as more transitory and that you would expect to see improvement going forward or are we kind of at a new normal here?

I would say the underlying markets are probably growing about 200 basis points.

When we look at our sales market share with our major suppliers, the 3M, Dentsplys, KAVO, Kerr, Danahers, we feel confident that we're taking share and growing faster in the underlying market.

I think it's definitely an era of stability right now in the dental market.

And I would say if there is any bias over the next five years, it would be a bias towards an increase in market growth, driven by particularly how strong the underlying demographics are in the North American market.

But currently, you've got an underlying consumable market that we think has grown about 200 basis points.

Got it.

And then maybe just a quick follow up for Ann, can you talk about the exposure to FX and what's incorporated into your 2017 guidance?

Sure.

So our main exposures, just to remind you, are in the UK and Canada.

And we've got about 1% to 2% headwinds baked into the guidance from the top line.

Got it.

Thanks for the comments.

That does conclude our question-and-answer session for today.

I'd now like to turn it back to CEO Scott Anderson for any additional or closing remarks.

Thanks, Leanne, and thanks, everyone, for joining us today.

Again, we're optimistic as we begin FY17, and we look forward to updating you on our results in the next quarter.

And that does conclude today's conference.

Thank you for your participation.

You may now disconnect.