Patterson Companies Inc (PDCO) 2018 Q2 法說會逐字稿

Good morning.

My name is Adam, and I'll be your conference operator today.

At this time, I'd like to welcome everyone to the Patterson Companies' Second Quarter Fiscal 2018 Earnings Conference Call.

(Operator Instructions)

James -- John Wright, VP, Investor Relations, you may begin your conference.

Thank you, operator.

Good morning, everyone, and thank you for participating in Patterson Companies' Fiscal 2018 Second Quarter Earnings Conference Call.

Joining me today are Jim Wiltz, who recently served as our Interim President and Chief Executive Officer; Mark Walchirk, our new President and Chief Executive Officer; and Ann Gugino, our Executive Vice President and Chief Financial Officer.

After a review of the second quarter by management, we will open up the call to your questions.

Before we begin, let me remind you that certain comments made during 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 upon 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, November 21, 2017.

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 fiscal 2017 and fiscal 2018 second quarters, the reconciliation table in our press release, adjusted reported GAAP measures, namely earnings, net income and earnings per diluted share or the impact of transaction-related costs, deal amortization expenses and integration and business restructuring expenses.

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

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

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 Jim Wiltz.

Thank you, John.

Welcome to today's conference call, everyone.

We have several goals for our call with you today.

First, we want to give you an update on our progress on several initiatives to position Patterson for improved growth.

Second, we will review the financials and update our outlook as we head into the second half of FY 2018.

And lastly, we will discuss our leadership transition.

We are delighted to be joined today by our new President and CEO of Patterson, Mark Walchirk.

I will conclude my remarks with a short introduction of Mark.

Following that, Ann will review the financials.

Mark will make a few comments before we take your questions.

As we discussed last quarter, Patterson is in the middle of several initiatives that are creating near-term challenges as we move toward improved growth opportunities.

In our Dental segment, we are midstream in adjusting our talent, implementing new systems and adding marketing capabilities to better serve our customers now and in the future with technologically innovative products across a full range of clinical environments.

In Animal Health, we are concentrating on sales execution and improving margins and we remain committed to realizing the strength and scale of our Animal Health platform.

I'll start with Dental.

While we had initially factored in some disruptions that our initiatives and this new territory for this industry would create, the pace of navigating the product and distribution changes in our technology equipment category had been more difficult to predict than we anticipated.

As you may recall, Patterson's decision to move beyond selling exclusively chairside technology was a customer-focused strategy that allows us to serve a much wider range of customers and their respective needs.

We remain confident in our decision to expand our technology portfolio and expect these sales to ramp as the market adjust for the influx of new products.

As a reminder, Patterson is pursuing the digitization of dentistry with the backbone of the industry's most experienced and advanced service and support structure.

These capabilities are second to none and we believe they have been selling points of differentiation for both our customers and manufacturing partners.

In other product categories, while we have made progress strengthening our sales force and marketing initiatives, overall consumable growth reflects the factors I have described as well as stable end market conditions and the negative impact of recent hurricanes.

Sales of basic equipment posted solid gains in quarter 2 and we are seeing customer receptivity in our broad range of product offerings.

A final world on Dental.

We are pleased that the rollout of our ERP implementation is now complete.

This is a significant achievement.

However, the system is creating short-term challenges as we move from initial rollout to now working on enhancements to the new workflow in the business.

As we refine our new ERP system, we are encouraged that the heavy lifting is behind us and that this dynamic will stabilize going forward.

Turning to Animal Health.

Our focus has been to successfully complete our integration and accelerate performance in this segment.

I am pleased to report that we continued our momentum from the first quarter and made additional progress in quarter 2. During the second quarter of FY 2018, we continued to experience positive end market fundamentals in this segment.

In terms of pharmacoeconomics, animal feed input prices continued to be favorable and farmers are benefiting from higher product pricing.

Beef cattle herd numbers continue to grow and feed steer prices remain elevated.

Finally, export [port pass] are up for both meat and dairy products.

We must execute well to capitalize on these dynamics and I am pleased with the sales level this quarter in both production and companion animal.

We believe we outperformed the market as we achieved growth in all species, particularly in our swine business.

We anticipated important share gains and margin expansion during the quarter.

These have been important goals and the optimization of our sales mix and marketing initiatives have contributed greatly to our success in this area.

Patterson Companies have made important progress against many of our current initiatives and, clearly, our organization also has challenges and more work to do, challenges that we believe will lead to growth opportunities under new leadership.

After Ann reviews the financials, we will ask Mark to introduce himself and share some of his early observations as he steps into his new role as President and CEO of Patterson Companies.

Mark joins Patterson after nearly 30 years of experience in health care services and distribution, including 16 successful years at McKesson Corporation where he most recently served as President of the U.S. Pharmaceutical business.

Mark is an exceptional leader and on behalf of the Board of Directors, I would like to express our support for Mark as he steps into his new leadership role to move our organization forward.

Now, I will ask Ann to review the financials.

Thank you, Jim, and thank you all for joining us today.

Our performance in the second quarter of fiscal 2018 reflected many of the factors Jim has described.

Consolidated sales for the fiscal 2018 second quarter were $1.4 billion on a reported basis, down 2.3% versus a year ago.

When adjusted for currency translation, sales declined 2.8%, including an estimated negative impact for recent hurricanes of 60 basis points.

Turning to our margins.

Our second quarter consolidated operating margin was 6%, a 47 basis point decline versus the prior year quarter.

While we demonstrated another year-over-year operating margin improvement in our Animal Health segment for the quarter, this gain was more than offset by a decline in our Dental segment and by the planned incremental costs from our ERP implementation, which accounted for 30 basis points of the consolidated operating margin decline.

On the bottom line, GAAP net income was $40.2 million or $0.43 per diluted share compared to $45.8 million or $0.48 per diluted share a year ago.

Adjusted net income, which excludes certain nonrecurring and deal amortization costs, totaled $47.6 million for the second quarter of fiscal 2018, down $5.9 million from the same quarter last year.

It is important to point out that on a pretax basis, the incremental step-up in ERP expenses represented approximately $4 million.

Adjusted earnings per diluted share from continuing operations was $0.51 in the second quarter of 2018 compared to $0.56 in the second quarter of last year, a decline of 8.9% from a year ago.

Now, let's turn to our segments.

In Dental, the 2018 second quarter sales reflected the impact of our strategic initiatives.

While we factored in a level of sales interruption related to our current business initiatives, sales were lower than anticipated in the 2018 second quarter in both dental consumables and the technology equipment.

On a reported basis, Dental sales were down 8% and, in constant currency, sales decreased 8.4% versus the prior year quarter.

This also includes an estimated negative impact from recent hurricanes of 90 basis points.

On that same basis, Patterson sales of consumable dental supplies decreased 4.4% during the 2018 second quarter.

Moving on to dental equipment sales.

On a constant currency basis, equipment sales declined 17.7% in the 2018 second quarter.

The decline in equipment sales is primarily due to the decrease in sales of CEREC products and other digital technology equipment.

We are confident in our decision to expand our technology portfolio to sell exciting new products to more customer types.

However, the transition will take longer than a quarter or 2 from the September date when the transition officially began.

Given the performance of this category through the first half, we now anticipate that the effect of the transition in our technology equipment business will persist through fiscal 2018.

Turning to our Animal Health segment.

We are encouraged by the sales performance and market share gains across our Animal Health business in the 2018 second quarter.

On a reported basis, consolidated Animal Health sales grew 2% year-over-year.

In constant currency, Animal Health sales rose 1.4% year-over-year.

After normalizing for a change in product selling arrangements, total Animal Health segment sales rose 3.7%, including an estimated negative impact from recent hurricanes of 30 basis points for the segment.

Looking at our companion animal business.

For the second quarter, global companion animal sales declined 1.4% in constant currency.

When normalizing for a change in product selling arrangements, global companion animal sales grew approximately 3.2%.

This includes an estimated negative impact from the recent hurricanes of 60 basis points.

On that same basis, our companion animal business in the U.S. increased 3.9% with an estimated 90 basis point hurricane impact.

Production animal sales in the second quarter of fiscal 2018 grew 4.2% in constant currency versus the year ago period.

Our overall performance in the production animal segment reflects strong top line sales and share gains across all species.

End markets in the production animal space continued to be favorable, which drives additional profitability for our producer customers and motivates them to invest more in the health of their animals.

Gross margins are up in our Animal Health business and we continue to make progress on improvement at the operating margin level.

This quarter, we achieved another sequential and year-over-year operating margin improvement in Animal Health.

Operating margins in the quarter were 24 basis points over the prior year period.

Our margin challenges in Animal Health are largely a function of our integration efforts where operational priorities led to underinvestment in marketing support and less focus on product mix.

We are driving operating margin improvement in Animal Health in 3 primary ways: First, through better marketing and focus on product sales mix; second, by more effectively partnering with our vendors; and lastly, continued focus on cost controls and capturing the remaining integration synergies which will surely leverage the strength of our combined Animal Health platform.

We believe these actions are within our control to manage and correct.

We are working our plan and seeing the results on the bottom line and we are determined to continue improving our operating margin within our Animal Health segment.

As we near the end of the 3-year integration time frame, we are pleased that our synergy capture is on pace to deliver the targeted range we committed to when we announced the acquisition of Animal Health International.

Regarding the enterprise resource planning system rollout.

The deployment of our ERP system rollout for the U.S. Dental and veterinary business is now complete.

This is a significant milestone as we can now receive and ship orders using one system across the business instead of 2. Our continued experience with the system will provide the foundation for a more ambitious and customer-centric e-commerce platform.

Ultimately, the foundational data and the analytics from this new platform will help us run our entire business with greater speed and agility and with less working capital to free up cash for other strategic uses.

However, the journey is not over and we do recognize the inconvenience and disruption we have caused with customers, suppliers and field offices through the implementation phase.

We have shifted our focus and we are ramping resources to improve the systems experience for our customers as they do business with Patterson.

Now, I will conclude with a look at several key balance sheet and cash flow items.

During the quarter, operating cash flow improved significantly as we generated $123 million of cash from operations compared to $17 million in the second quarter of last year.

So at the halfway point of fiscal 2018, we have generated $132 million of additional cash compared to the first 6 months of last year.

This increase in cash flow is a result of our focus on improving working capital.

Through the first 6 months, our working capital is down $144 million versus the same period last year.

We achieved this improvement even though working capital has been impacted by ERP deployment.

And now that these deployments are complete, we expect to stabilize and enhance our processes to further reduce our investments in working capital over time.

Our adjusted tax rate in the second quarter was 34.6% and slightly lower than last year because of a geographical shift in earnings.

The small benefit here was offset by increased interest expense in the quarter.

For the 2018 fiscal year, we still expect our adjusted tax rate to be between 34.5% and 35.5%.

Turning to our capital allocation strategy.

We continue to execute on our strategy to return cash to shareholders.

In the second quarter of fiscal 2018, we returned nearly $62 million to our shareholders in dividends and share repurchases.

That brings the total for the first half of fiscal 2018 to $124 million.

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

Our strong balance sheet, along with our newly expanded debt capacity, also gives us the flexibility to repurchase shares opportunistically and we have approximately 12 million shares remaining under our current repurchase authorization.

Given our performance through the first half, we have revised our outlook for the remainder of fiscal 2018.

We now expect GAAP earnings to be in the range of $1.67 to $1.77 per diluted share.

Non-GAAP adjusted earnings are now expected to be in the range of $2 to $2.10 per diluted share.

Our adjusted earnings guidance excludes the after-tax impact of deal amortization expenses of $25.3 million or $0.27 per diluted share as well as integration and business restructuring expenses of approximately $5.3 million or $0.06 per diluted share.

Before turning the call over to Mark, I would like to conclude my remarks with a word of thanks to Jim Wiltz.

On behalf of the executive leadership team and all employees here at Patterson, we want to personally thank Jim for serving as our Interim President and Chief Executive Officer.

Jim has served as a steady hand and a leader familiar with our customers, industry relationships, employees and shareholders during the past 6 months as the board searched for the right next leader for Patterson.

We are grateful, but we will continue to benefit from Jim's valuable experience as an ongoing member of the board.

And now, I will turn the call over to Mark Walchirk, our new President and Chief Executive Officer.

Thank you, Ann.

I appreciate the warm welcome to Patterson and certainly Jim's introduction as well.

And I'd also like to add my personal word of thanks to Jim Wiltz for his commitment to Patterson as he stepped in to serve as the Interim President and CEO for the past 6 months and, more importantly, for his over 40 plus years of service to Patterson Companies.

I'm also grateful for the foundation built by Jim and other senior leaders who have shaped the culture and capabilities of Patterson into the company it is today.

Now, as I considered accepting this great opportunity, there are a number of aspects that really attracted me to join Patterson.

First, Patterson has a great tradition and legacy of success.

The company also has leading positions in strong markets and certainly a strong commitment to serving our customers in a customer-first approach.

All these create a solid platform for growth and long-term success and these are just a few of the key reasons I'm excited to be onboard.

It's certainly a privilege to be joining Patterson at this important inflection point for the company and I truly believe the company has the right people and commitment to create a great platform, again, for growth and long-term success.

However, I certainly understand the challenges we are facing and the need to revise our outlook for the rest of fiscal 2018.

I've worked with our leadership team and established a formal and comprehensive 90-day transition plan and, over the next 90 days, I will get to work on doing a deep dive into the business to develop a thorough understanding of our customers and our business model to gain clarity and alignment for the action plan that will accelerate our path to improve growth.

To accomplish this, I plan to engage with employees across the organization, our customers, our key manufacturers and business partners to gain and develop a deeper understanding of our business from the ground up and to complete a strategic assessment that includes the clear action steps needed to drive improvement.

At a high level, as part of this 90-day plan, I will be focusing on 3 key areas that I believe will set the foundation for long-term success: Operational excellence, growth and our people.

First off, I'm a big believer in operational excellence.

In a business like ours, doing the day-to-day and the basics exceptionally well and delivering operational excellence across all parts of the company will be a critical foundation for success.

Second, we obviously need to be focused on growth.

There are a variety of ways to drive growth across the company, whether it's organic growth, the development of new products and services, new markets as well as M&A and business development opportunities.

And I certainly expect to consider all of these alternatives as we build out our longer-term strategic focus and approach.

And finally, I will focus on our people and our culture.

I believe strongly in a focused and engaged team.

And certainly, in a relationship-driven, customer-focused business like ours, our people play a crucial role in our success.

I'm looking forward to getting to know our team and continuing to build on the engagement and culture that has been established at Patterson.

I'm very excited for this opportunity and certainly ready to dive in headfirst with the team in the weeks and months ahead.

And now, Jim, Ann and I will take any questions you may have.

Operator?

(Operator Instructions) And your first question comes from the line of Robert Jones from Goldman Sachs.

Welcome to Mark.

I guess, just looking at the results in the quarter from an EPS perspective, they actually weren't that far off from where the street was modeling, yet, clearly, Ann, as you discussed, the back half guidance is being reduced quite a bit.

If I'm hearing you right, is the biggest delta from where you are today, looking out the back half versus the previous guidance, just a reduction in your expectations around the high-tech equipment?

Is that where things have maybe changed the most?

And if that's the case, maybe specifically could you talk a little bit about what hasn't gone necessarily according to plan?

Sure.

So you hit it.

I mean, I think there's 2 factors that are really playing into the reduction in guidance and it's really based on the performance we're seeing in the current quarter.

One is around the high-tech equipment piece, but I would also note that the consumables were below our expectations in the quarter.

So as you noted, we did expect the first half of the year to be challenging and then we are expecting earnings growth to anticipate -- or to accelerate at the back half of the year as we work through some of these transitions.

And what I would say is while we continue to make great progress on the strategic initiatives, the speed and pace has been difficult to predict and the process is taking just a bit longer than we expected.

So as it relates to the high-tech equipment, customers are continuing to take time to evaluate and recalibrate, both evaluating new product offerings as well as multiple distribution arrangements.

And then, there continues to be some sales rep productivity challenges relating to ramping on the new products and adjusting to the new competitive environment.

So we just felt like based on the current performance in the current quarter and our revised outlook, it was prudent to take down guidance.

It makes sense.

One of the other big initiatives you guys have talked has obviously been penetrating deeper into the DSO space.

Your largest competitor in this most recent quarter discussed repricing a number of their DSO clients.

I was wondering if you guys could just talk a little bit about what you're seeing on the pricing front within the DSO segment.

And more importantly, how much of an opportunity is there still to win share in that space?

Sure.

So I would start by saying that we are aware of all the bids and we are bidding and participating in the bids in the segment.

And so as you alluded to, we know that some DSO business is won purely -- won or lost purely on price, while other business can be more about supply chain partnerships.

And so we're going to compete heavily in the space.

We want to win business where relationships can be a win-win.

And where we lose, we know whoever wins -- win without fight and that's different that it was a couple of years ago.

So I think I would conclude by saying we absolutely believe that there is opportunity to gain share in the space.

Yes.

I would just add.

I think, certainly, as you think about these dental service organizations, we obviously see that as a continued growth opportunity for us.

And certainly, these large customers have a different set of expectations oftentimes in terms of what their business models are or how they need to be supported by their business partners.

So I think we need to continue to think about our value proposition and how we can best serve these -- this part of the marketplace, and that will certainly be a focus for us going forward.

Your next question comes from Kevin Ellich from Craig-Hallum.

Mark, I want to welcome you and I look forward to hearing more about your strategic vision as that 90-day plan comes together.

I guess, just continuing on with Dental, and in the press release you talked about expanding the sales force headcount.

Just wondering what we should expect and how much is baked into the guidance, if you could help quantify that for us?

Yes.

So we won't discreetly quantify exactly how much is baked into the guidance.

What I would say is it's definitely included in the guidance range that we provided.

So we have factored that in.

And at the end of last quarter, we stated our intention to make targeted supplemental investments in the sales force.

We made solid progress this quarter.

We've actually added 90 new reps in the last 90 days, but clearly there's more work to do around here in terms of adding additional headcount and then getting those new reps productive.

And, I guess, before I move on to the Animal Health question I have, how long does, I think, we take -- can you remind us how long it takes for them to become productive?

What the ramp is?

About 6 to 9 months.

Okay.

That's helpful.

And then, on the Animal Health side, great to see the stable growth in all of the end markets.

One that kind of surprised me was you guys called out swine with the veterinary feed directive this year.

It seems like swine has kind of been more of a problematic area for some people.

Wondering what you're doing differently and what's your expectation for swine going forward?

So as it relates to the veterinarian feed directive, what that does, at the end of the day, producers have to keep their animals healthy.

So what the veterinary feed directive really does is it caused producers to switch from one product to another, so be it a move from a preventative to a more therapeutic product.

And so where it's not impacting us as much and where we tend to be more resilient is we have that broad breadth of product line.

So I think that's why you're seeing it not impact our results as much.

And then, as it relates to our strong performance in swine, we have some unique competitive advantage in this area around biosecurity.

We have a deep expertise with the sales force.

And so we've done a nice job, the team has done a nice job of winning new business.

And we think that, that will continue.

Excellent.

Well, I guess, that's coming at the expense of one of the other big swine distributors.

Your next question comes from John Kreger from William Blair.

This is Jon Kaufman on for John Kreger.

And, Mark, congratulations on your new role.

So first -- actually, first, Mark, a question for you.

So you mentioned 3 areas of focus in the first 90 days.

I guess, how do you define success in these areas?

And then, thinking longer term, how do you view your long-term mandate?

I guess, what are your medium- to long-term goals for this business?

Yes, Jon.

I mean, I think, certainly for me, coming into this business, I have a lot to learn.

Obviously, I don't have a lot of background specifically in the Dental and Animal Health markets that we serve here at Patterson, although certainly a broad range of experience in health care services and distribution.

So really, for me, a lot of the next 90 days is about really diving in and learning the business and really focusing on kind of 3 key areas.

I think, first, just doing a complete operational assessment of the business, really understanding the business kind of from the ground up.

I'd like to say start with a customer and work back.

So I'll be spending a lot of time in the field, meeting with our customers, our team on the ground, in the branches, in the operational centers, our technology center, et cetera, and really getting their impressions around the business and what's working and what we need to focus and work on.

Obviously, working closely and meeting with our key business partners across the channel from a manufacturer standpoint, et cetera.

There's some key relationships there around business partnerships that we have and so it will be important for me to engage with that team.

So really, the first challenge is, again, just to focus on the core business and really dive in and learn the business, again, kind of from the customer back.

I think the second area is, as part of that, to really complete more a broader kind of strategic assessment of kind of where we are, what's going on in the marketplace, key trends, competitive assessment, our business model, again, what's -- what we're doing well, what do we need to focus on, looking at some of the external and internal trends certainly.

And then, I think, ultimately, while I wouldn't expect to have all the answers after the first 90 days certainly, I'll certainly start to have a point of view and really think and be very clear about where we plan to play and, frankly, how we plan to win.

And so that will be the kind of the second piece is really to conduct kind of a strategic assessment.

And finally, this is a very people-focused, a very relationship-oriented business and I want to spend a lot of time engaging with our team, building relationships with our team and really continuing to build on the outstanding culture at Patterson and hopefully bring a little bit of my perspective and approach to that as well.

So those will be kind of 3 key areas in the short term.

And then, I think the second part of your question, I guess, is kind of the long-term mandate.

And I would tell you, as part of my near-term transition plan, I'll have hopefully more -- or we'll have more to say on that certainly in the months ahead, but I would say, at a high level, Jon, the long-term mandate, frankly, is for us to improve our performance and drive results.

And that's really what I, along with our team across the entire organization, that's going to be our core focus is to improve our performance and drive results.

Okay.

That's great.

Kind of switching gears here.

I would like to dive a little bit into dental consumables.

And I think you mentioned consumables in the current quarter is a little weaker than expected.

So, I guess, how should we think about what the end market looks like versus loss of consumable sales perhaps related to CEREC versus additional contributions from new salespeople?

Sure.

So we clearly have a number of factors negatively impacting this category in the quarter.

You've got the hurricane, which certainly we didn't anticipate.

You have the added risk, as you noted, to the block business given open distribution.

We just completed the largest wave of deployment with respect to our ERP implementation.

We actually bought 50% of the company up in the last 120 days.

And then, as we talked about earlier, we continue to add headcount back into the system.

So we're not going to get specific in terms of quantifying those various drivers discreetly, but I would say probably the largest impact continues to be around headcount.

And so when we're softer than we expected, it's just progress on adding headcount and then just some of these interruptions I was referring to.

So we continue to make solid progress this quarter and, as I mentioned, we added 90 new reps, but there's more work to do here.

As it relates to the broader market, it's hard to give you a precise answer.

There's not great data available on consumables and then, of course, we just have a lot of noise in our numbers, but the impression from our team is that the market is stable and we'd say flattish.

And your next question comes from Jeff Johnson from Baird.

Ann, I guess, a couple questions in there I'd like to follow-up on.

I know you say you don't want to break out the specifics on the CEREC Block business, but maybe just talk about we're 2.5 months into the transition with the open relationship, just stability of your client base, your customer base, either on the consumables side or on just the block business side of the CEREC business, stability you're seeing there over the first 2.5 months of this change?

I would say, as you noted, we're not going to discreetly talk about it, but I would describe it as stable.

Certainly, we anticipated some level of interruption and we have marketing programs in place to compete for that business just like any other highly competitive category, but in general, I would describe it as stable.

All right.

That's helpful.

And then, as I look at the guidance, takedown rough and tumble numbers, maybe $25 million to $30 million coming out of the operating income assumptions in the second half.

The sales rep adds, I could convince myself are $3 million to $5 million, somewhere in there, of added costs.

And even if I assume Dental is 10 points worse than I was thinking in the second half, that's another $10 million or so of EBIT that comes out of my model.

I'm trying to bridge the rest of that.

It might be another $10 million or so on the takedown.

Just wondering, has anything changed in the ERP gating of expenses?

You talked about ramping resources there.

Wondering if that's the other part of the bridge that I'm missing or if there's some other expenses in there that's outside of just the lower revenue expectations?

No.

I would say we reached a exciting milestone this quarter with the rollout phase of the next-gen system being complete.

So I would -- as we expected, that expense is actually slightly favorable in the quarter and we would still expect that ramp down in the back half of the year, about $3 million to $5 million a quarter.

It really is just confined to the Dental business and our outlook on revenue.

Your next question comes from Kevin Kedra from Gabelli & Company.

Mark, I know you haven't had a great deal of time to really look into Patterson's businesses, but you have a lot of experience in health care distribution.

One of the issues overhanging not just Patterson, but your former employer and many in the space has been competition from online distributors, most notably Amazon.

So maybe curious to get your thoughts on how you see them as a competitor and what a company like Patterson can do to protect your business on the Dental and bedside?

Yes, Kevin.

Look, it's obviously in the news on a daily basis and certainly would not underestimate Amazon and their capabilities and certainly their interest and likelihood of getting into the health care space in some fashion.

It's still a little bit unclear, I think, where their time and focus is going to be, but obviously they're in health care.

I think the key for us at Patterson is really to think about how we focus on driving and bringing the greatest value for our customers.

I think, ultimately, our customers choose their business partners based on a variety of factors and ultimately where they believe they're generating the greatest value or getting the greatest value, and that value can come in many forms.

Certainly, supply chain and economics is one form, but certainly, in the case of our Dental and Animal Health businesses, there's a wide range of programs and services that are offered.

Certainly, the technology, equipment, the technical support, practice management software, just to name a few of kind of the value-add services that are provided by Patterson to our customers, I think, play a huge role in helping our customers run their businesses and ultimately, hopefully, help their business to be successful.

So I think while we're certainly very aware of how others could enter the space and thinking through our -- the moves that we will make, really our focus is going to be and has been and will continue to be on how we can continue to bring value to our customers so that we have the most compelling value proposition, the most compelling customer experience and can win in the marketplace with that approach.

Great.

And if I could just throw one more in to Ann.

Animal Health margins, we saw some pressure there a few quarters ago.

It seems like there's a bouncing back.

I mean, have we gotten all the way back?

And how should we be thinking about the opportunities on those margins going forward?

So we are not all the way back, but as you pointed out, we continue to make measurable progress quarter-by-quarter and it's in a variety of ways.

One is improved product mix, which is what you're seeing this quarter.

It's just continuing to drive product mix to our preferred vendor partners.

There's some new products on the marketplace that are helping out.

We're performing well on rebates.

And then, I think as we think longer term, it's really reframing those relationships with our vendor partners as the single largest Animal Health platform in the space to really leverage that to improve margin profile over time.

So I continue to think and believe that we should get that margin back to 5% the next couple of years.

And your next question comes from Steve Beuchaw from Morgan Stanley.

I had one on CAD/CAM and one on margins.

The first on CAD/CAM.

It's more of a 10,000-foot view question.

If we think about the evolution of that market in the U.S. over the last 2 years, there have been a lot of puts and takes and I think we kind of all understand what those are at high level, but there is this hypothesis, at least I have a hypothesis, that over the last few quarters, there was a market freeze of sorts as there was a lot of confusion in the market.

And then, as we got toward the latter stages of 2017 and into 2018, that freeze would lift as some amount of confusion that the customers had given all the transition going on has lifted.

Can you give us a sense for how you think about that hypothesis within the context of guidance and maybe even beyond this fiscal year?

Yes.

So I think you're exactly right in your hypothesis and I think what we're saying with the revised guidance is it's difficult just to predict the pace and timing when you're going through such a significant change, again, not just with distributors, but with new products coming on the market.

And so it's our belief that all the causes that you just listed are still true.

It's just predicting the curve of how long it will take and so that's why we felt it was prudent to bring down the back half of the year.

And what I would say is we still -- we feel and I'll let Mark comment on this, but deeply convicted that the digital revolution of the dental office will continue and that offering choice as this evolves is important and that we are absolutely making the right decisions for the long term.

Not a lot to add really other than, Ann, just to reinforce, I think, this is a key part of our value proposition for our customers and will be something that we spend a lot of time and focus on and obviously that I'll be diving into to learn as well.

Right.

I appreciate that.

But, I mean, given the change to the guidance, it sounds like you probably haven't seen the change to trajectory on CEREC order flow subsequent to September 1. Is that right?

Yes.

I mean, I think the big unknown when we're in the quarter last call was what happens when we're actually able to compete for the product?

What happens at SIROWORLD?

So certainly, as we're looking at and gather additional information post-SIROWORLD and post-open distribution, we thought that those 2 events would help lift some of the confusion and accelerate some of the customer decision-making.

And we're just not seeing that.

Okay.

And then, my question on the financial side relates actually to working capital.

Ann, I wonder, now that you've seen a nice quarter here on free cash flow, if you could just give us an update to your thinking about improvements in working capital over the next year or so as you've gotten a little bit of clarity of what the world looks like as we wrap up ERP?

Yes.

So certainly, to your point, we had some nice cash flow generation this quarter.

We're done with the ERP implementation.

So we're moving into that enhance and refinement.

So we would expect working capital to continue to decline.

The biggest improvement you're seeing this year is in the accounts receivable.

And while we've seen some improvement, I think there's still more opportunity there.

There continues to be an opportunity in inventory.

So I look at the numbers and I think there's still another $100 million that we can get out of working capital over time, but I think that will take us another 12 to 18 months to get fully back to normal.

And your next question comes from Erin Wright of Credit Suisse.

I understand it's early days, Mark, and welcome, but curious how involved, I guess, you were in setting the guidance range for the year?

And more broadly, I guess, as you step into the role, how should we be thinking about your general thoughts and strategy on capital deployment and what your priorities are there?

And Ann, how should we be thinking about share repurchase activity for the balance of the year?

Yes, Erin.

I think, certainly, I was involved in, obviously, reviewing the results through the first half of the year and involved in thinking through the forecast and the guidance.

Obviously, working with the team over the past several weeks as I prepared to come onboard officially starting yesterday, so to answer the first part of your question there.

I think, second, with regard to capital allocation, I'll probably let Ann chime in more specifically.

I think certainly that's something that would be a little premature for me to comment on.

I would say that, in general, we want to make sure we have a very aligned approach with our board obviously and with our team to think about capital allocation and, frankly, use that as a means to help drive some of the strategic initiatives and some of the growth initiatives that, ultimately, we believe are going to be key to our success long term.

Sure.

And then, Erin, specific to your question on share repurchase, our guidance range implies share repurchases of between $100 million and $200 million and we continue to be on pace to do that.

Clearly in the shorter term, given market conditions and where our overall cash and leverage, that we could choose to opportunistically increase the buyback.

We just need to make sure we balance that with the underlying performance of the business and then the working capital needs we have in the near term.

And I think as Mark mentioned, going forward, as he develops his strategic direction for the company, capital allocation will certainly be an important part of that conversation, so more to come on that piece.

Okay.

Great.

Excellent.

And in Animal Health, you typically go through your annual contract renewals around this time and how are you positioning yourself this year with these sort of conversations as you approach a more consolidated vendor base.

And do you anticipate there will be any major shift in either agency versus buy/sell or access to do products next year that would meaningfully move things on the Animal Health side?

It's a little early in the process and a little premature for me to comment and then, obviously for competitive reasons, we're going to keep that a little closer to the vest, but I would say we are, longer term, working to reframe the relationships with manufacturers.

And certainly, this year, part of the contract negotiation would be to take the first step in that direction, so more to come on that.

And your next question comes from Steve Hagan from RBC Capital Markets.

Could we go back to the dental consumables sales?

When we look at those sales, who's currently supplying these products to your customers?

And what will be required from Patterson to win that volume back?

Do you think there will be a need to get prices to win some of that volume back?

So when you're looking at the market share, are you asking where it's leaking?

I think that would be to a variety of competitors.

And then, I think in terms of winning that back, certainly price is one area, right, to get your foot in the door, but I think there are multiple avenues to win that business back.

And we have a very value-added business model approach so I think a piece of it, frankly, is just getting the reps back in the system and darkening the doorway.

As I mentioned, we had about 50% of the company go live on ERP this quarter and that means, in addition to doing their day job, they're also doing a night job, too.

So I think it's -- what are the things that we can do and the tools that we can put in the hands of the sales force to get them back out competing for business as well as adding more headcount into the system, but I don't know Mark if...

No.

It's good.

And then, just on the dental equipment sales, kind of what are your expectations for the growth of those sales once we get through kind of the near-term impacts of both inventory and the new competitors in the market?

It would be our expectation when we get through the transition that just based on the digitization of the dental office and that trend, that this should be a double-digit growing category over time.

And your next question comes from Sarah James of Piper Jaffray.

I wanted to talk big picture about dental consumables.

So across the market, we've seen some pressure, but we've also seen a divergence from the historical correlation to the Consumer Confidence Index.

And I'm wondering why do you think that is?

Is it the influence of insurance benefit design?

Or is there some other factor that is going from the divergence from the Consumer Confidence Index?

It's a great question and I think it's one that we as an industry are wrestling with and contemplating.

And there's quite a few theories out there so it's hard to give you a precise answer.

And then, of course, we have the luxury -- we have just a lot of additional noise in our numbers.

One theory is when you look at the correlation with consumer confidence over that same time, you had real wage growth.

And while we've seen unemployment and underemployment come down, we haven't necessarily seen real wage growth.

We're bound at the same level and you have to remember dental care is a discretionary spend.

That is a theory to your point there.

Other theories in terms of millennials and how often they go see the dentist then -- but longer term, with the aging population, we think this is a strong and stable market.

That's helpful.

And can you talk a little bit about pricing discipline?

So as the online sales market for consumables becomes more competitive, how should we think about Patterson prioritizing margin versus volume when looking at the specific product categories that are more commoditized?

Our goal is profitable growth and so I think that is a mix.

And it's hard to make a blanket statement because it depends on the customer segments and the situation.

So as we talked about, if we're going in to win back market share, you might become more competitive on price, but as you work people up the value proposition and people really do stick with us because of the value-added services, whether that's practice management software or technical service, how do you garner enough value to grow your margins over time with the rest of the basket.

So certainly, we'll need to be competitive on price, but we're going to have to manage that with the cost structure and with the other value-added services to drive profitable growth.

And your last question comes from the line of Jon Block from Stifel.

A couple of questions.

First, on consumables, down 4.4%, that's with an incremental contribution from Heartland.

Making that adjustment, I have consumables down around 6% or 7%.

And I know you're adding back sales reps when they get up and fully productive, but can you guys just talk about your long-term positioning in the dental consumable market?

In other words, we've seen from, I believe, multiple players that specialty consumable growth is well outstripping that of basic consumables.

And even when your new reps are up and fully productive, can you guys grow at market?

Or will that be difficult because I do believe you're underrepresented in that specialty subset?

And then, I've got a follow-on.

Sure.

So I'll see if Mark wants to comment on this, but my initial reaction is it's how low you define the market.

So you are correct that we are underweighted in some of these specialty areas and so I think that will be part of the strategic conversation as Mark evaluates avenues for growth because, clearly, those areas are growing faster.

So I think that, that will be something that Mark undertakes as part of his strategic view.

As it relates to the markets that we currently play in today and how fast those are growing, when we get back to hold, do I expect that we will win our share and grow market?

I do.

I'll just add.

Certainly, that will certainly be an area that we will take a look at here in the weeks and months ahead.

And I would just say, in general, long term, we obviously want to be -- have a leading position and be a leading player in the markets and certainly the product categories that are growing and there's an opportunity for growth.

So if there's opportunities for us to enhance our position in certain segments of the market, that's certainly something that we'll consider.

Great, Mark.

That was very helpful.

I appreciate that color.

And then, just a follow-up just from a sort of a modeling perspective, the operating expense experienced deleverage in fiscal 2Q after what I thought was very good expense control in fiscal 1Q.

Was that predominantly driven by these additional 90 dental reps, Ann, that you called out?

Or is there anything else there?

And then, just maybe from a guidance perspective, did that OpEx deleverage sort of persist or last for another 2 to 3 quarters until you lap the rep expense and arguably they get closer to full productivity?

Yes.

So it really is deleveraging on the semi-variable and fixed costs with sales.

So we get leverage and are able to expand margins very nicely when we have 3 to 4 percentage points of sales growth and, unfortunately, it hits us on the backside when we don't.

So what you're seeing in the current quarter is we still have great expense control.

We're still driving favorable mix, but it's really the softer than anticipated sales in Dental that's really causing that 50 basis point contraction along with the step-up in the ERP expense.

So when I look at modeling for the back half of the year, what we would say right now is that we're looking for margins -- operating margins for the year to be down around 50 to 70 basis points.

And so that implies that we'd have a 70 to 80 basis point drop in the back half of the year.

I'd like now to turn the call over to Mark Walchirk for closing remarks.

Yes.

Thank you very much.

Sorry to interrupt.

Well, thanks, everyone, for joining us today.

I know we're at top of the hour so we will conclude here.

As I indicated in the opening, I'm really excited to be onboard and looking forward to hopefully meeting many of you next week out of the Greater New York Dental Meeting.

And certainly in the interim, wishing all of you and your families a fantastic and happy Thanksgiving.

And again, look forward to updating you next quarter.

Thanks very much.

And this concludes today's conference call.

You may now disconnect.