Patterson Companies Inc (PDCO) 2017 Q3 法說會逐字稿

Good day, everyone, and welcome to the Patterson Company's third quarter FY17 earnings conference call.

Today's call is being recorded.

At this time, I'd like to turn the conference to your host, Mr. John Wright.

Please go ahead, sir.

Thank you, Augusta.

And good morning, everyone, and thank you for participating in Patterson Company's FY17 third 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 review of the quarter 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 content of this conference call contains time-sensitive information that is accurate only as of the date of the live broadcast, February 23, 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 FY16 and 2017 third quarters.

Which exclude the impact of deal amortization expenses, non-cash impairment charges, integration and business restructuring expenses, transaction-related costs and the tax impact of cash repatriation.

We will also discuss free cash flow, which is a non-GAAP measure and the impact of foreign currency.

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

As a reminder, 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 distribution business and our production animal distribution businesses are reported as our Patterson Animal Health segment.

This call is being recorded and will be available for a 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.

Today, I want to begin outlining how Patterson continues to evolve, both in relation to the needs of our customers and in our ability to strengthen our operating model.

This is not only important to understanding key aspects of our third-quarter performance, but also establishing the context for where we're heading and our approach to get there.

Patterson has a long history of leading change in our chosen markets, and this is at the center of our current strategy.

Our markets today face a combination of shifting customer needs, opportunities and challenges that demand we continually evolve and further enhance our ability to execute.

I'll break this down starting with our dental segment.

As I discussed last quarter, we've had extensive conversations with customers over the past year representing all clinical environments about how their needs are evolving.

We're speaking to you today from the Chicago Dental Society's midwinter meeting, where we continue to collect these observations and use them to inform our product and service strategy.

These conversations helped solidify our decisions to help make some strategic changes in our dental business over the past couple of quarters.

These changes have the potential to disrupt our business in the near term, but are designed to enhance our long-term competitiveness and move Patterson even closer to being the partner of choice for the widest range of customers.

We began with our salesforce realignment last June.

We undertook this initiative not just to enhance productivity, but to nurture those sales professionals who are better able to accommodate our dental customers' needs, whose needs are becoming more sophisticated.

These changes continue with our decision to alter the nature of our relationship with our long-time and valued partner Sirona.

As you know, we announced last quarter that Patterson has chosen not to extend the exclusive portion of its relationship with Sirona beyond its expiration in September of this year.

We made these moves, fully understanding their potential to impact our sales performance in the near term.

However, we believe Patterson knows how to re-engineer for growth, and we have a history of making well calculated yet disruptive changes in our business to create new opportunities.

For example, just over two years ago we announced our intent to broaden the range of products we sell on the core equipment side of our dental business.

This meant expanding beyond our relationship with our long-time strategic partner ADEC.

While this move certainly created near-term disruption in the channel, we've since added several other manufacturer relationships and product lines to this offering, while further deepening our relationship with our highly-valued Partner ADEC.

Our performance in the core equipment category during the third quarter was a bright spot.

In fact, it was the strongest quarter we've had in this product category since calendar 2009.

We believe our success with navigating these kinds of business model adjustments provides a preview for what we intend to accomplish on the technology side of the dental business.

That decision two years ago to broaden our offering in core equipment led to our desire to expand into other categories, while simultaneously enhancing our relationship with [dent] supply Sirona.

When we announced our decision last quarter to transition to a new working relationship with them, we understood this had the potential to disrupt our technology portfolio in the near term.

We made significant progress in the last 90 days to secure our key assets and focus our sales team, but the possibility for disruption still exists.

However, we remain committed to the CEREC platform for those practice environments where chairside restoration can be an important differentiator.

We were pleased to achieve modest CEREC growth in the quarter.

In line with our expectations for CEREC sales during the period, our performance supports our commitment to this important technology.

Looking at our dental equipment category more broadly, there were two aspects which were disappointing during the quarter.

The first was our performance in the digital X-ray category.

As we've stated before, our efforts over the years have led to a substantial market share penetration for Patterson in this category.

At a certain point, incremental growth in this area becomes even harder to achieve.

The second relates to the effects of section 179 which is now a permanent tax benefit for purchases of capital equipment for buy practitioners.

While we typically see spikes in equipment purchases in late December, this did not materialize during the quarter as it has in previous years.

We believe, however, that the permanence of this tax benefit will create a better capital climbing structure for our customers and lead to an evening out of sales over the course of the year rather than concentrating them at calendar year end.

Lastly, a word about dental consumable sales in the quarter.

The consumable sales environment was mixed during the quarter, and our sales in this category continue to reflect tempered but stable conditions compared to last year.

We also believe that there remains certain softness in our performance that's unique to Patterson as a result of the disruption from our sales realignment initiative.

That said, we remain optimistic that this period of transition for our dental business is a positive and necessary one to make us even more relevant and valuable partner to all our customers, from the small dental practitioner up to the dental service organizations.

The new customer relationships we're creating through expanded equipment offerings we believe will lead to new consumable relationships.

Regarding dental service organizations, we are pleased with the progress we have made with our new customer Heartland Dental.

We devoted the month of January to implementation, and are now getting close to being fully operational with all of their offices.

Based on the feedback from Heartland, this relationship is off to an outstanding start and we're excited about the potential it holds.

Moving on to our animal health segment.

We're at roughly the halfway mark of our three-year integration timeframe in our animal health business.

In only a relative short amount of time we've accomplished a tremendous amount.

We've unified two cultures, consolidated the animal health business headquarters in Greeley, Colorado, integrated numerous locations, and we accomplished all of this while piloting and preparing to roll out a new enterprise resource planning system.

However, along with these many critical successes, we have some challenges and new learnings on how we can better execute.

Last quarter, I mentioned that we were experiencing a softer pricing environment which was leading to margin compression in the animal health segment.

Indeed, we've had more manufacturer contract changes during this period of integration than we've previously ever experienced and this clearly was one factor affecting the margins.

However, we're fully committed to thoroughly examining all factors and approaches to restore the margin profile of this business.

During the third quarter, we looked very closely at a wide range of potential factors and gained clarity and deeper understanding of areas of execution that we need to target for improvement.

While some of manufacturer pricing pressures remain, we have identified several ways, all within our control, to improve margins.

These include partnering more closely with our manufacturers, adjusting and aligning our marketing approaches, and better managing our product mix.

We began to implement some of these initiatives late in the third quarter.

And while we have more work to do on this front, we're already starting to see improvement.

It's certainly encouraging to see our team respond swiftly to these execution challenges.

We have a long history of collaborating with our manufacturer partners to best serve our customers in a mutually productive way.

I'll remind you that Patterson Animal Health is the distributor of choice in the animal health industry, and as consolidations take place at the manufacture level we believe our scale will become increasingly critical to the supply chain.

Looking at our performance in the segment during the quarter.

In production animal, we continued to see general overall recovery in end markets, with particular strength in swine where we've continued to gain market share.

In beef cattle, which our largest production animal market, we did see some sales softening in the quarter due to lower utilization among independent producers.

We also experienced solid growth in the companion animal category during the period.

A reminder that the fiscal third quarter is the seasonably lowest period in this segment.

Before I turn it over to Ann, it's worth reiterating that both of our businesses are tied to compelling long-term end market trends.

In dental, that includes a generally stable employment market, an aging population that will drive demand for dental care, and practice environments that are becoming increasingly sophisticated.

And therefore, evermore reliant on us to support this dimension of change.

In animal health, it means the central role the US agriculture industry will play in satisfying the protein demands of a growing global middle class.

It also means the persistent rise in both companion animal ownership and spending per pet.

These are opportunities we're engineering for.

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

Thank you, Scott.

Thank you all for joining us today.

As Scott touched on, we experienced the combination of some challenging conditions and self-imposed headwinds during the FY17 third quarter and our performance reflected these factors.

We're focusing on the factors we can control, while adapting our approaches in both of our segments to improve growth and operating performance.

As I've done in the past, I'll discuss sales and adjusted results from continuing operations.

While there are some minor final tax adjustments related to the sale of Patterson Medical reflected in our GAAP results, the results from these discontinued operations have essentially cycled.

Looking at our top-line performance.

Consolidated sales for the FY17 third quarter were virtually flat at $1.4 billion on a reported basis.

When adjusting for foreign currency translation, sales grew 1.4%.

On to margins.

Our third-quarter consolidated adjusted operating margin was 6.7%.

This is down 100 basis points versus the prior-year quarter.

The decline primarily stemmed from reduced gross margins across the business, and the planned incremental costs from our ERP implementation.

On the bottom line, GAAP net income from continuing operations was $27.8 million or $0.29 per diluted share compared to $57.2 million or $0.60 per diluted share a year ago.

As we outlined last quarter, we elected not to extend sales exclusivity for the full portfolio in Sirona products beyond September 2017.

This move we recorded a non-cash impairment charge in the current quarter of approximately $36 million pre-tax or $0.24 per diluted share and our GAAP results reflect the impact.

This non-cash charge related to the distribution fee associated with the [spirits] product component of this arrangement.

It will not affect Patterson's liquidity, cash flows, or compliance with debt covenants.

Adjusted net income from continuing operations, which excludes certain non-recurring and deal amortization costs, declined 14.9% to $55.4 million in the FY17 third quarter.

It's important to point out that on a pre-tax basis, the step up in ERP expenses represents approximately $11 million of the increase in adjusted net income for the quarter as anticipated.

Adjusted EPS from continuing operations decreased 14.7% to $0.58 per diluted share compared to the year-ago quarter.

Now a look at our segments.

In dental, we saw market conditions in the quarter that were similar to the first half of the fiscal year.

On a GAAP basis, sales were down 1.8% and that decrease was essentially the same on a constant currency basis.

Patterson sales of consumable dental supplies decreased 2.8% in constant currency during the third quarter.

The decline here reflects the combination of end-market softness, as well as disruption from our salesforce realignment that we implemented in the first quarter of this fiscal year.

We expect this effect to moderate over time.

While not a significant contributor, consumable sale sin the third quarter, the kick-off to our relationship with Heartland Dental, was another highlight.

In January, we completed the roll-out of our ordering system to Heartland Dental locations on schedule.

This included getting Heartland's 750 office locations trained on the new web portal.

This is an important accomplishment, and Heartland is very pleased with their sell rates thus far.

We look forward to further growing our partnership with Heartland.

On to dental equipment.

Our results here were also mixed.

The 1% constant currency decline in dental equipment sales reflected a combination of factors.

Lower contributions from the digital X-ray category, modest growth in CEREC, and a double-digit increase in core equipment.

As Scott mentioned earlier, from a volume perspective, this was our strongest performance in core equipment in the better part of the last decade.

Looking at our dental segment margins.

Adjusted operating margin was down 80 basis points year over year.

However, when you back out the step up in ERP expense in the third quarter allocuted to the segment, operating margins grew 20 basis points.

Reflecting good execution on our expense control efforts.

Now turning to our animal health segment.

As in dental, results in this segment were mixed.

Overall, we saw increased sales across our animal health business in the 2017 third quarter.

On a reported basis, consolidated animal health sales grew 1.7% year over year.

After adjusting for the impact of currency, animal health segment sales rose 4.9%.

Our animal health business continued to face a more challenging environment related to branded pharmaceutical trends.

In response, we began adapting our go-to-market approaches to increase profitability and are pleased with the early progress.

It's worth noting, excluding the expense step up related to the enterprise [you first] planning system implementation allocated to the animal health business, operating profits for the segment was up slightly year over year.

We also maintained our focus on integration synergy capture which remains on track.

Taking a look at our companion animal business, our third-quarter reported companion animal sales rose 1.9%.

Adjusting for currency, companion animal sales increased 8.5% over last year.

Looking at our US companion animal sales, reported growth is up 12.8% and 6.2% when adjusted for agency by itself.

As a reminder, our fiscal third quarter is the seasonally lowest sale volume quarter for the companion animal segment.

Growth in production animal sales in the 2017 third quarter improved 1.3% in constant currency versus the year-ago period.

Overall performance in the production animal segment reflects strong sales in the swine market, offset by lower sales in beef and dairy.

A word about beef category sales.

We continue to see some recovery in beef end markets during the quarter.

However, sales were impacted during the period by lower utilization (inaudible).

Our ongoing animal health integration initiative and progress for our planned synergies remain on track.

This fiscal year, we're focused on more effectively leveraging logistics across both of our businesses and further consolidating back-office functions.

We still expect to deliver between $18 million and $20 million in run-rate savings by the end of this fiscal year, which will enable us to beat the $20 million to $30 million run rate in synergies in [year three] that we announced at the time of the acquisition.

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

Our net cash generated from continuing operations improved in the quarter to $45.9 million compared to a use of $33.6 million in the prior-year quarter.

We believe that cash flow will continue to improve for the balance of the year, as we continue to work on reducing our (inaudible) inventory.

I'll remind you that we're receiving higher inventory in our animal health business and to maintain service levels through our ERP implementation.

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

Over the next five years, we expect to generate more than $1.3 billion of free cash flow.

CapEx totaled $8.1 million in the FY17 third quarter.

As you are aware, the implementation of our new enterprise resource planning initiative has been an area of intense focus for our team for the past three years.

This system will ultimately help drive new efficiencies across our enterprise, and provide the foundation for a more ambitious and effective eCommerce platform.

These efforts are now moving much further in to the roll-out phase, and we want to share some perspective on our progress.

For many companies, the past enhanced efficiencies and new capabilities these systems can provide is rarely straight or smooth.

However, as we've moved through the piloting and roll-out stages of this initiative, we've gone to great lengths to ensure that the learnings we need at every step have been quickly leveraged and rolled forward into subsequent stages.

Our production animal colleagues who had recently completed such an implementation have been a tremendous asset in our recent progress.

We continued to make progress rolling out this system, and scaled up our employment in our third quarter.

During the period, we brought another 17 locations on to the new platform, and crossed the threshold in to broad implementation of the new system.

It's impressive to see how the system is already starting to transform our business, especially in the speed of order picking.

As previously disclosed, we expect a $25 million pre-tax step up in the expense for the full year related to this system.

In the third quarter, we began depreciating our investment with the new system, which along with training, contributed to the rise in related expense.

As we noted below, these expense step-ups are largely loaded into the back half of the year as we scale up deployment and we expect this to continue for 2018.

Turning to our capital allocation strategy.

We continued to execute on our strategy by returning cash to our shareholders.

We returned approximately $60 million to our shareholders in dividends and share repurchases during the quarter, and nearly $160 million year to date.

We remain fully committed to our dividends, and we have increased it every year since it was instituted.

We have approximately 14.5 million shares remaining under our current Board authorization.

Our strong balance sheet along with our (inaudible) expanded debt capacity gives us the flexibility to repurchase shares opportunistically.

During the quarter, we extended and increased the Company's revolving credit line from $500 million to $750 million and also amended Patterson's term loans.

These new [banks] really do give us greater financial flexibility at more favorable terms, and enhance our ability to execute on all components of our capital allocation strategy.

Looking at tax rate.

Our adjusted effective tax rate for the quarter was 33.4%.

Our third-quarter tax rate is historically lower due to true-ups of estimated taxes as actual returns are being filed.

By comparison, our tax rate for the quarter was in line for the same period last year.

We still expect an adjusted annual tax rate in the range of 34.5% to 35.5%.

Now I will review updated FY17 guidance.

We have narrowed our adjusted earnings from continuing operations to the range of $2.27 to $2.33 per diluted share.

Our adjustments exclude the impact of transaction-related costs, deal amortization, integration and business restructuring expense, non-cash impairment charges and a benefit from cash repatriation, totaling $0.56 per diluted share.

On a GAAP basis, we expect FY17 earnings from continuing operations in the range of $1.71 to $1.77 per diluted share.

Our guidance range assumes North American and international market conditions similar to those experienced in the first nine months of FY17.

I'll also note that it does not include the impact of future share repurchases.

Our guidance assumes we'll continue to have EPS headwinds related to our ERP integration, our Sirona relationship change, and margin pressures in animal health, much of which will extend into the next fiscal year.

We are committed to delivering on key elements within our control in these areas.

Realizing efficiencies as we implement our ERP system, focusing on procurement savings across all areas of our business, improving working capital, particularly in the area of inventory and receivables, and closely managing expenses.

In addition, we will work to capture even more synergies in our animal health segment.

With that, I'll turn it back to Scott for further comments.

Thanks, Ann.

I'll wrap up with just a few additional comments.

We've mentioned this before, but it's worth repeating.

We're guiding Patterson through an important period of change that we believe will lead to an even tighter alignment with our customers and Partners in both segments and improved growth.

As we've gone down this path, we've received positive feedback from many of you regarding our ability and willingness to make the difficult decisions to move Patterson to a new plateau.

With our desire for portfolio expansion efforts in dental, our margin improvement efforts and ongoing integration efforts in animal health and enterprise resource funding initiative, we believe will combine to do just that.

And I'm greatly encouraged by the confidence and enthusiasm of our teams.

Whether it's our efforts to refocus in dental, stepping up our execution in animal health, or pushing through each stage of enterprise resource planning initiative, I believe that our level of engagement and commitment has never been higher.

This will drive our future success.

So will the support of our customers and manufacturing partners.

We're encouraged by this engagement at dental and vet industry events thus far in 2017.

We had substantial traffic at our booth at our North American Veterinary earlier this month.

We are again looking forward to a positive engagement here in Chicago at the midwinter meeting, and we are certainly here to again participate in the International Dental Show in Germany next month.

This is the world's leading dental trade show, and we're looking forward to the introduction of multiple new inventions at this event.

Finally, we are in the process of putting together our tactical business plan for FY18.

We look forward to giving you insights in to this when we report our fourth quarter and full fiscal year earnings in May.

Now I'd like to take any questions you may have.

I'll turn the call back over to Augusta.

(Operator Instructions)

We'll go first to Ross Muken with Evercore ISI.

Good morning.

This is Elizabeth Anderson in for Ross.

How are you thinking about the dental consumables trends coming out of the quarter given the industry trends we've been seeing over the last six months or so?

Thanks, Elizabeth.

With regards to North American consumables, while we're seeing some encouraging signs around the consumable market, we do think it's too early to call any short-term trends permanent.

I think it's safe to say we're taking a prudent approach to the remainder of our fiscal year with regards to consumables, but we're still quite confident in the long-term fundamentals for the market in North America.

And just as a reminder, we look at stable to improving consumer confidence, unemployment levels that are below 5%.

I think a key thing is continued customer interest in investing in equipment and technology, which we believe enhances their clinical outcomes and productivity.

And then the big macro factor that is the favorable demographics that are going to drive demand.

So we still look at a stable market, some encouraging signs, but want to be cautious not to call a break-out just yet.

Got it.

Thanks.

Can you also talk about any early feedback you've received from the salesforce in customers regarding the Sirona transition, and perhaps anything you've heard from the Sirona competitors as well?

I'd say on the Sirona front, when you look at the quarter, I think from an operational perspective, it was very successful as we worked through a number of tactical issues.

I feel very good about the messaging that's been communicated throughout our organization and throughout dental supplies Sirona with regards to the decision being in the best interest of our customers and our partnership.

And also I think the traction we're getting from our prior strategy about expanding the portfolio I think gives our people and our customers great confidence in the future.

I think it's important to state once again as I did last quarter, that dental supply Sirona is and always will be a great and strategic partner.

Currently, we're working very close with them on managing through the next phase of the partnership, and are absolutely committed to each other's mutual long-term success.

I would say the initial noise of the announcement, and I don't want to underestimate that, is mostly behind us and we're focused on sales execution through the balance of our exclusive relationship with Sirona.

Great, thank you.

Our next question comes from John Kreger with William Blair.

Hello, thanks very much.

Scott, can you expand a bit more on your comments around the profitability for animal health?

Some of the contract issues that you talked about last quarter, how has that played out?

Is it just one manufacturer or is it a broader trend?

It seemed like margins had a nice little rebound, at least sequentially.

Can you talk about where you see that going on a normalized basis?

Thanks.

Thanks, John.

I'll have Ann cover the shorter-term tactics that we've tackled, and then let me talk a little bit about the longer-term strategy around margins and the segment.

Sure.

So over the last 90 days, we've done a deep dive on the margin compression and contract terms.

And we have confirmed that our contract term across the big pharma companies did deteriorate relative to prior year, and at a little bit higher clip than the compression that we've seen in the past.

We do believe our contract terms are similar to others in the industry.

With that said, clearly it appears we've experienced more short-term negative impacts than others in the industry.

However, if you look at the current quarter, our actions have resulted in some nice margin improvement.

Our consolidated growth margins in the segment were actually up 10 basis points in the current quarter, and if you compare that to the first half of the year where we saw margin compression, that's a nice improvement.

You asked long term where we think margins could go, I would expect that we can get back to that 5% operating margin rate in the next two years.

Great.

Let me hit a couple of items to give some context to where we're at, and more importantly where we're driving the business.

It is a fact that we had more changes, and I mentioned that in my script, to our vendor contracts with our largest partners than probably any other time in our 15 years in the companion space.

And at the very same time, we were integrating two businesses and combining or incorporating end marketing functions to one location in Greeley.

I'd say the integration timing magnified some of these short-term issues with regards to the contract changes.

That being said, we have identified our issues and really spent the last 90 days implementing our go-forward strategy which includes strengthening our marketing and promotional strategy as well as better management of our product mix.

We've had substantial communication with our top Partners which we really appreciate and are working on driving mutual success, because we see Patterson as a partner that future suppliers are going to want to leverage in terms of sales coverage scale and logistics expertise.

So we feel like we're tackling the issue and making progress.

Thanks, Scott that's helpful.

Maybe to go back to I think the very last thing you said in the prepared remarks about still working on the plan for 2018.

Broadly speaking, should we be able to view 2018 as a return to more normalized earnings growth for Patterson, or should we be thinking about it still as a transitional phase for the Company?

Thanks.

John, I'd say it's still going to be a transitional year.

Clearly if you look at the current year, there's a lot of moving pieces here and some of those factors will take time to work through and carry in to FY8.

So namely working through the profitability challenge that we just talked about in the animal health associated with the branded pharmaceuticals.

We've got the changes within the dental technology products.

In addition to Sirona, we'll plan to add two technology products to the portfolio next year.

We have new customers that we're onboarding, but of course we'll continue to ERP roll-out.

So as you look at the puts and takes heading in to FY18, we do expect our ability to grow EPS will be a bit constrained and below our stated five-year average target of 8% to 10%.

So we're continuing to refine our outlook as we continue to work through the challenges we're facing, and we'll continue to do that over the next 90 days and provide a more definitive outlook on 2018 next quarter.

I'd emphasize though that longer term, past 2018 when it gets through the ERP implementation and some of these transitions, we do believe the underlying business organically will grow in that 8% to 10% range or better and we'll be able to continue generating significant amounts of (inaudible).

Very helpful.

Thanks, Ann.

Our next question will come from Robert Willoughby with Credit Suisse.

Hey, Scott and Ann, can you evaluate the salesforce realignment?

Is it safe to say sales trended below where you thought they'd be net of this effort but what can you say about profitability?

Did that meet your expectations what the remaining salesforce was able to accomplish?

Thanks, Bob.

Good question.

I'll have Ann start with some breakdown and growth by customer segment, then I'd like to come back and revisit the strategy which I think is important.

Sure, so I'll start with the profitability.

So I'd say yes.

If you look at the dental business, while we saw an 80 basis point margin decline, when you back out the impact of the ERP implementation, we were actually up and improved by 20 basis points.

So we're definitely getting the profitability that we expected.

If you look at the top line and you look at the accounts that were not impacted by the salesforce changes, we're definitely growing at market or better in those accounts.

Then if you look at the accounts that were impacted by the changes, I'd characterize it as stable and similar to what we saw in Q2 as it relates to consumables.

But definitely equipment sales are up nicely in these accounts which was part of the strategy.

Just as a reminder before I return it back to Scott, the upside opportunity from these actions is much greater than the current business lost.

There's between $200 million and $300 million of market potential tied up in these underperforming accounts.

Yes, I'm just going back to the strategy, and as many people have followed our story know, we have a history of evaluating our go-to-market strategy.

We took similar action about eight years ago when we really retooled the way we went to market around technology, and that really led to a big acceleration for Eaglesoft and our digital products.

So the move strategically was about putting our best people in front of more opportunity, as well as knowing that we're going to leverage more and more technology to make our salesforce more productive.

So it really does tie in strategically to this foundation we're building through ERP in terms of really being able to drive data and then the digital strategy we're building out.

So I'd say we anticipated there would be some short-term share loss, but are incredibly committed, not only to the strategy, but I think it's very important, committed to the market leading strategy that the Patterson salesforce is the best salesforce in the dental industry.

And we're now just giving our salesforce even more opportunity going forward to interact with customers.

Maybe a followup.

While you're below your 8% to 10% EPS growth guidance for this year, next year, are there no opportunities to accelerate your ERP implementation, and why not step up the share repurchase at this point?

It doesn't make as much sense if you're growing north of 8% to 10% in 2019 and beyond.

I think as it relates to the ERP, I would agree.

It's the common theme amongst the team where we're saying let's pull it forward, let's go faster.

So this was the first quarter where we're really in that broad implementation phase and we brought up 17 sites.

So we need to watch that closely.

But certainly if there's an opportunity to accelerate that and go faster, we're in 100% alignment that we want to make that happen.

As it relates to the share purchases, clearly it's a balance.

We are carrying higher than normal investments in working capital as it relates to the ERP, so we have to balance the share repurchases against the cash needed to operate the business, and then, of course, the debt leverage.

So we'll take a very disciplined approach, but I do agree there's more opportunity to invest in the future there, Bob.

Thank you.

Our next question comes from Brandon Couillard with Jefferies.

Thanks, good morning.

Scott, back on the core equipment experience in dental.

Can you parse out how much of the improvement is the new portfolio and some of the internal things you're doing versus the market?

And is it fair to look at that growth experience as a positive leading indicator potentially for consumables?

Yes, Brandon, I think you're on to something here.

I think where we're very encouraged is the strength of the sales and traditional equipment is broad across our Partners and leading the way with our largest Partner.

I think there is some benefit, as I mentioned, from section 179 being permanent and dentists being able to plan in their capital spend more strategically.

So with volume numbers like we had here in the quarter, and I'd say we feel very confident as well in our backlog, we're starting to see new office builds and remodel projects begin again and that absolutely is a very positive indicator for the future.

So when I look at what's going on in the marketplace, I am a believer that the consumable market has very strong long-term fundamentals in it.

We're still going through I think a bit of a patchy period in the industry where any green chutes, people are saying that's a trend.

But longer term, I think the market is in a very solid place.

Our customers are small business people with the right tax incentives and economic environment.

Our ability to get back to normal market rates for the whole industry I think is very realistic going forward.

Thanks, and then one for Ann.

On the inventory line, it stepped up quite a bit sequentially.

Can you talk about where you see that level of safety stock plateauing giving the ERP roll-out will continue over the next few quarters?

And the free cash flow for the year, another year back-end loaded.

Is this the new normal in terms of the seasonality for free cash flow generation?

It's definitely always been a bit seasonal, but I'd agree it's been a little bit more volatile over the last couple of years.

I think part of that is the integration with the animal health business, and just learning how their inventories flow.

And then, of course, as you mentioned, we're working through the ERP implementation.

We did have improved cash flow from operations in the quarter.

We actually generated $45.9 million this year versus a year ago.

We used $33.6 million, so we are getting better each quarter.

And we believe the cash flow will continue to improve in the balance of the year.

We estimated about $200 million, and to your point, this will be driven by a strong finish in working capital.

But it's also historically strong just due to the sales volumes and operating profitability that happens just naturally in our business in Q4.

We're probably somewhere between $100 million and $150 million higher than we'd like to be.

A year ago, between Q3 and Q4, we were able to take out about $140 million and we'll probably take out $100 million.

But to your point, the real value is reducing it over the longer term.

That's something we're really working on with the ERP team.

It's a balance, because you want to make sure you hit those spill rates and take care of the customer.

So we're really just refining that.

It's something we talk about every day, but I'd expect us to get to more normal working capital levels next year in 2018.

Super, thank you.

Our next question comes from Jon Block of Stifel.

Hello, this is Ethan on for Jon Block.

A couple questions here.

Maybe if you could just circle back on the North American dental market.

You indicated that consumables conditions in fiscal -- the third quarter were similar to what you experienced in the first half of the year.

To the other larger dental players, specifically called out improved market conditions in January and also December.

I just want to be clear.

Are you not seeing that same level of improvement that the other players alluded to, or is just you're choosing to take a more conservative view at this point?

Good question.

I think we're just taking a more conservative view.

If you look at the raw numbers that people are reporting, they're very similar to the prior quarter on absolute terms.

So we're in no way saying the market is degrading at all, it's stable.

There are signs of improvement.

But I just think as the entire industry struggled for explanation as to the slowness over the last six months, I think you'd have to be careful as well to bullishly call a rebound.

Got it.

Then shifting to animal health, you provided a decent amount of commentary on the beef cattle market.

I was hoping you could discuss how dairy performed in the quarter.

I believe last quarter you called out a more protracted recovery than expected, but prices have seemed to rebound over the past couple of months.

So any thoughts on how dairy performed in 3Q?

Thanks.

Dairy was similar to prior quarter, but I would say we're encouraged by a few things on the dairy front when we think longer term.

Particularly the largest dairy market is California, and obviously the impact that the drought has had on input costs for our producer customers has been a strain.

And obviously, I think everyone knows, it looks like the drought has been broken, and longer term that will benefit our customers and the health of that sector.

So our team, one of the things we really love about our animal health team is the deep experience they have managing through cycles.

And I would say the leader of that business feels good about the longer term prospects around dairy and the strategies we'll implement to gain share there.

Great, thank you.

Jeff Johnson with Robert Baird has our next question.

Good morning.

Scott, I guess one question on the salesforce realignment I want to come back to.

I think at one point last June when you talk about these cuts, you talked about back selling with some of your higher performing reps and all that.

Is it still the plan to back fill with current reps?

Are you hiring new reps for those territories?

And if you're back filling, are you starting to see some -- I don't know, pickup of business I guess would be the word I'm looking for, or something there in those territories or is it going a little slower than you thought?

Great question, Jeff.

It's a mix of putting the right talent.

Sometimes it's a two or three-year rep is really hitting their stride and we're giving them more opportunities, other times it's our more established reps who have more capacity.

I would say some early positive signs, as Ann mentioned, is the equipment sales we had in to that segment.

As we said, there was a lot of white space, almost $200 million to $300 million of what we felt was trapped opportunity.

That being said, when you do something like this, it's never a straight line but we're very committed to it I would say.

We continue to add high-level sales talent, but it's not like we're filling back the same number of sales reps as we go forward.

But I think the interesting part to note when you look at the overall strategy and the number of accounts impacted, if you look at it, about 85% of the accounts were actually retaining the majority of the business and growing very nicely at market or better.

There's about 15% of the accounts where we're just struggling a little bit more where maybe the rep was a little bit stickier, and we're starting to see that stabilize but that will take some time.

But it's in a very small group of accounts.

That's helpful.

Thank you.

Then, Ann, my other question would be on the dating of the ERP and I ask this quite a bit.

But I just want to make sure again this quarter.

I think you said $11 million in incremental ERP this quarter, so it feels like we're at now the peak level we should be expecting in the near term.

Is that fair, or are we up here now at $10 million, $11 million a quarter, and we see that for another what three quarters and then maybe we start to see some leverage off that in the back half of 2018?

Or how should we think about the dating of the ERP expenses from here?

No, that's correct.

So it's $25 million for the year, so we had $1 million in Q1, it was about $3 million in Q2, $11 million in Q3.

So we're expecting somewhere in the neighborhood of $10 million in Q4.

That step up in expense will continue to annualize in.

So it's not that it will be increasing beyond the $25 million necessarily, but it will continue to annualize in for the first half of 2018.

Then to your point, we'll start reducing the expenses as we get the roll out completed in the back half of the year.

And any early views on how quickly that maybe $25 million run rate could come down?

Is it a third of that comes out over a year, or just how to conceptually think about that?

So if we go back to the $25 million step up, 20% to 25% is depreciation and doesn't go away.

Then 25% is roughly implementation costs, and that goes away right away.

So as soon as we're done implementing and we're not doing any more, so I would say 25% comes out right away.

Then the remaining 50% is really the infrastructure required to support the ongoing system.

And as Scott alluded to, the next step is to continue to improve our web platform.

So I would say about 25% comes out right away.

Then the real magic is now how do you get the return on investment in terms of efficiencies across the portfolio once you're up and running.

Now you're able to truly shut down legacy systems, so there will be some other expenses that come out now as well that we're working right now on plans to implement.

Fair enough.

Thank you.

Our next question comes from Robert Jones with Goldman Sachs.

Hey, this is Jason Jacoby in for Bob.

Can you talk about your CEREC inventory levels as we get closer to the end of your exclusivity agreement with Sirona?

What are you seeing in terms of sell through in dental equipment?

Thanks.

Thanks, Jason.

This is Scott, I'll take that and actually why don't I have Ann talk about working capital strategy.

She talked a little bit about it previously, but I think that's important.

Then let me get in to the specificity around Sirona.

So we're still carrying, as we talked about, a higher level of investment in working capital.

It's in accounts receivable, but as Scott mentioned, it's inventory as well and it's primarily related to the ERP implementation.

We expect to reduce our investment in working capital by about $100 million over the next 90 days, as I talked about before.

And this is very similar to prior year, so we tend to run inventories down at the end of the year to minimize the impact to LIFO.

And then Q4, and this ties in a bit to your Sirona question, is usually a big equipment quarter which helps working capital utilizations because we don't generally carry receivables on equipment sales.

So there's still an opportunity to improve, and we fully expect to do that through the balance of the year.

I would say with regards to Sirona, obviously as we move from an exclusive to non-exclusive relationship, we are working with them on working our inventory levels down in certain product lines, CEREC in particular.

We've had a 20-year relationship with Sirona, and have worked through many supply chain ebbs and flows with them.

So this is not new to either company.

But we're committed as partners, and I think you saw that already in some public messaging from our great partner Dental Supply Sirona.

So in the quarter, we did make some progress on the CEREC front and on some digital internal products.

I would say we were a little bit heavier on the external X-ray front, particularly because that's an area that traditionally in the late half of December, those are the fastest moving products.

Because a customer can make a late tax-based decision, and in the last two or three years we got into situations where we were actually short on inventory towards the end of the year.

So we always want to be very cognizant of not being able to fill all orders.

Net-net, we ended the calendar year with a little bit more external inventory than we had hoped, but we're starting to make progress on the other side and moving our CEREC and some other inventories down.

And we'll continue to work on that over the next six months.

Got it, thanks.

Then on the DSO segment, thanks for the update on Heartland.

Good to hear that's almost fully operational.

Could you provide us any more detail there?

And then broadly speaking about the DSO segment, how focused are you on this market and its further DSO penetration embedded in your long-term growth outlook?

Thanks, Jason.

Obviously, we're very excited about this new partnership with Heartland.

As I said, we're off to a really good start, and I think both our Management Team and Heartland's are very encouraged by how our teams are working so closely together.

They're pleased with the transition, and when the customer is happy, those are good things.

I'd say it was -- I had the honor to speak to over a thousand of Heartland's dentists at their winter conference in December, and that was an incredibly impressive event.

It was also exciting, I spoke to a lot of customers who were former Patterson customers who were excited about the new relationship.

I'd say we've seen this space as a strategic imperative and one that will drive future growth.

I'd couch it right now as very active and dynamic, and we're excited about the number of conversations we've been brought into and also I think it's a proved point in our ability to serve this space and also be a partner of choice with more customers.

So as we work through our strategic plan and tactical plan for FY18, obviously this will be a part of our growth story we that talk about 90 days from now.

Thanks, guys.

Thanks, Jason.

We'll go next to Kevin Kedra with Gabelli.

Thanks for taking the questions.

First on the dental market, I know it's been tough to pinpoint what's been driving the softness there.

Just any additional intelligence on that, and maybe anything that might be driving the easing of that softness we seem to be seeing.

Secondly, on the UK vet business, the old [MVS].

Any update on how that business is doing in the quarter and any opportunities to maybe improve the cost structure there?

Hello, Kevin.

So the update on the UK business is it was a pretty average quarter growing at market, so they were up at about 4% in local currencies.

They've been trending around that 4% to 5% all year long.

They are having some good customer wins.

We just won a large corporate account over there.

Clearly when you look at leveraging, your fixed and semi variable costs, that definitely helps.

We're always looking at ways to become more efficient and more profitable.

One of the other things that we're working on there is bringing some of our value-added equipment offerings and service offerings to that market, so we've been at that for about 12 months or so.

We're starting to get some traction there.

We do believe we can bring those margins up over time, and I'd say the business is stable and performing well.

Kevin, sorry about that.

Back to the US market.

I think it's just a case of mixed signals in terms of where the market was headed over the summer.

But I think we're in complete agreement with many of our industry partners in the long-term prospects, as well as the stability of the market.

And as I said before, our dental footprint is North America.

And as we look to improving North American economic conditions and also potentially US pro business friendly tax policies, we think that can drive the business to more historical market trends.

So in no way do I want to be pessimistic because I'm not, but I think just given the fact set of the last six months you need to be careful about calling the break-out just yet.

We'll go next to Michael Cherny with UBS.

This is Alan in for Mike.

On animal health, you spoke about the contract changes upstream.

Looking downstream, are there any opportunities to partner with other pharmaceutical purchasers or other things to improve your leverage for procurement?

Yes, that's definitely part of the strategy.

So one piece of it is the big pharma companies and the contract terms there, but then to your point there's always a private-label strategy.

About 60% of the total revenues are pharmaceuticals, but there's another 40% where getting after a private-label strategy, potentially doing some bundling is an opportunity.

I will say on the pharmaceuticals, and this is a point that I think is important, as it relates to the big pharma branded products, the manufacturers actually set the price with the customer.

So that one is a little bit more to manage, or a little bit more difficult to manage.

With the customers, you really have to manage that more back with the manufacturer.

But certainly there are other areas, private label, certainly the value-added services as we continue to build out the equipment platform.

Equipment has margins in the 30 percentile.

So there are a number of things that we can do to improve margins in that segment.

And of course there's cost reductions, how do you become more efficient, the ERP implementation is a piece of that and so are the synergy captures.

So we're looking at where are more creative ways that we can get after the expenses.

Got it, thank you.

Our next question comes from Lisa Gill with JPMorgan.

Thanks for taking the question.

It's actually Mike [Majack] in for Lisa.

Maybe taking a step back on the dental equipment side, you obviously have some near-term headwinds related to the decision around the Sirona portfolio and you've talked about the slowing growth in digital X-ray.

Can you maybe talk about what you see as the longer-term top line growth in the broader dental equipment category on a more normalized basis, and do you think that growth opportunity is slow relative to prior years?

Mike, I would say absolutely not.

I think when we look at the future and you look at the best-in-class infrastructure we've built in terms of technology support and probably the highly trained -- most highly trained salesforce, that we see we will be the most relevant player in the digital transformation of dentistry.

And that I think you'll see a lot of investment in the space going forward.

So I think we're working through just some short-term issue, as I said, very, very encouraged by the volume levels we saw in the traditional chair unit light cabinetry business.

Back to really pre-recession levels which we haven't seen for eight years.

So when I look at growth rates, I see technology and equipment being a big part of the future growth story for the entire industry and it's going to lead to productivity gains and better clinical outcomes which is good for everyone.

Got it.

You talked about increasing capacity on the revolver.

Wondering if you could talk about the longer-term target for leverage, and can you remind us of how you rank your priorities for capital deployment?

So if we look at our leverage, we're currently at 2.5 times EBITDA.

And we can comfortably take that up to 3.5 for a short period of time, but we would target somewhere between 2.5 to 3 times as an optimal leverage scenario.

Our capital allocation priorities really haven't changed.

Our first is to reinvest in the business for strategic growth.

We remain committed to the dividend which is at $0.96 per share, that uses about $100 million annually.

The third lever is the share repurchases.

We tend to allocate between $100 million to $150 million there, but we can get more aggressive if we choose to depending on market conditions and working capital levels et cetera.

Got it.

Thanks for the comment.

We have no other questions at this time.

I'd like to turn it back to our presenters for any additional or closing remarks.

Thanks, Augusta.

I'd like to close by sharing some sad news from the Patterson family.

Yesterday, we learned that our long-time former Chairman and CEO Pete [chef] passed away unexpectedly.

We trace our roots of the Company back to 1877, but as many of you know, Pete was our modern Founder.

He shaped the industry in the 80s and early 90s, and built a company with an amazing customer, person and employee culture.

Please keep Pete's family in your thoughts and prayers, and we thank you all.

That does conclude our conference for today.

Thank you for your participation.

You may now disconnect.