Patterson Companies, Inc. (NASDAQ:PDCO) Q2 2023 Earnings Call Transcript December 1, 2022
Patterson Companies, Inc. beats earnings expectations. Reported EPS is $0.63, expectations were $0.57.
Operator: Good morning. My name is Rock and I will be your conference operator today. At this time, I would like to welcome everyone to the Patterson Companies Second Quarter Fiscal Year 2023 Earnings Conference Call. Thank you. John Wright, Investor Relations, Vice President, you may begin your conference.
John Wright: Thank you, operator. Good morning, everyone, and thank you for participating in Patterson Companies fiscal 2023 second quarter conference call. Joining me today are President and Chief Executive Officer, Don Zurbay; and Interim Chief Financial Officer, Kevin Barry. After a review of the fiscal 2023 second quarter results and outlook by management, we will open 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, December 1, 2022. 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 Web site at pattersoncompanies.com. Please note that, in this morning’s conference call, we will reference our adjusted results for the second quarter of fiscal ’23.
The reconciliation table in our press release is provided to adjust reported GAAP measures, namely operating income, other income and expense, net income before taxes, income tax expense, net income, net income attributable to Patterson Companies, Inc., and diluted earnings per share attributable to Patterson Companies, Inc., for the impact of deal amortization, integration and business restructuring expenses, legal reserves inventory donation charges, and gains on investments, along with the related tax effects of these items. We will also discuss free cash flow as defined in our earnings release, which is a non-GAAP measure and use the term internal sales to represent net sales adjusted to exclude the impact of foreign currency and the extra week of selling results in the first quarter of fiscal 2022.
These non-GAAP measures are not intended to be a substitute for our GAAP results. This call is being recorded and will be available for replay starting today at 11:00 a.m. Central Time for a period of one week. Now, I’d like to hand the call over to Don Zurbay.
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Don Zurbay: Thanks, John, and good morning, everyone. I’m excited to be speaking with you for the first time as Patterson’s CEO. I’m honored to be leading the outstanding Patterson team, whose commitment to our strategy, customer, vision and values has enabled a track record of strong financial performance. I’m pleased with our performance during our fiscal ’23 second quarter. As we navigated ongoing macroeconomic challenges during the quarter, we remain focused on driving sales execution and profitability. Overall, for the quarter, we achieved $1.6 billion in consolidated revenue representing year over internal sales growth of nearly 1%. Year-over-year operating margin expansion in both our Dental and Animal Health segments, and adjusted earnings per diluted share of $0.63, an increase of 9% year-over-year.
Given our results through the first half and our forecast for the remainder of the year, we are reaffirming our full year EPS guidance range and remain committed to delivering internal sales growth and operating margin expansion for fiscal ’23. Now, before walking through the details of our quarter, I want to take this opportunity to share my perspective on the key elements of Paterson success; our culture, strategy and our people. Patterson’s purpose, vision and values is foundational to our success. And like our employees across Patterson, I am committed to ensuring that they are followed. We are passionate and people first. Doing the right thing and being good to each other are my own beliefs that I will use to continue to guide Patterson moving forward.
In my previous role of Patterson Company CFO, I worked closely with the rest of our executive leadership team to develop the strategy that has enabled us to accelerate business performance and drive long-term value for our customers as well as our shareholders. Looking ahead, we will continue to execute that strategy, which is focused on three foundational pillars. First, continuously deepening the value proposition we offer our customers in both the Dental and Animal Health segments. Patterson is so much more than a distributor. We are an indispensable partner to our customers and play a critical role in their success. We believe that expanding our capabilities for customers will continue to drive sales growth and strengthen these relationships.
Second, enhancing our margin performance to fully capture the value we create in the market with a focus on operational excellence, improved mix and thoughtful coordination with our strategic manufacturing partners. And third, managing the organization with a keen focus on cost discipline. As you would imagine developing a rigorous process for cost discipline and return on our investments has been a key focus for me throughout my tenure with Patterson, and will continue to be in my new role. Patterson’s balanced capital allocation approach supports our strategy with three priorities. First is investing with discipline in the core areas of our business, including our people and the support organizations to drive ongoing improvements in our field sales and service execution.
These functions enable Paterson to deliver the high-level of service that our customers reward us for as they navigate markets in good times and more challenging ones. Prioritizing investment ensures we don’t take our foot off the gas. Second, our dividend remains an effective means of returning cash to our shareholders. As a reminder, in fiscal ’22, we returned approximately $100 million to shareholders through our dividend. Third, we regularly evaluate opportunities to leverage our strong balance sheet and make strategic investments. As we’ve said before, we will be thoughtful and selective on opportunities that will further enhance our strategies, meet our financial criteria and drive improved returns for our shareholders. For example, in the second quarter, Patterson announced acquisitions of Dairy Tech, and RSVP and ACT.
These are examples of our business units identifying areas where they want to focus and using M&A to help them execute. Our strong financial position and balance sheet provide us with flexibility to continue to pursue these opportunities to accelerate future growth and profitability. Taken together, we have a great foundation to build from through the continued execution of our proven strategy I am confident in our future. Ultimately, is our people who execute on that strategy. Our people are a key differentiator for Patterson and I’m so proud of the way our team supports each other and the dedication they have to serving our customers. Across our organization we are fortunate to have a talented and driven team that is resilient and knows the power of working together to support each other.
Over the past several years, Patterson has cultivated a deep bench of highly capable executive leaders who have all been instrumental in developing and implementing Patterson’s strategy. We expect continued benefit from the expertise, teamwork and continuity of our existing leadership team. I’m also pleased to keep working closely with Kevin Barry in his new capacity. As our former Vice President of Finance and Corporate Controller, Kevin has been an integral member of the executive leadership team in the finance organization. Internal promotions and succession demonstrate the depth of Patterson’s talent, and Kevin is certainly a part of that. I have complete confidence in his ability to take on this important responsibility. You’ll have an opportunity to hear from Kevin in his remarks to walk through the details of our second quarter performance shortly.
I believe our executive leadership team and strategy will enable us to maintain our strong performance. Patterson has all the elements to create value for our customers and shareholders alike, a strong position and too attractive and healthy end markets, entrenched relationships with customers that view Patterson as an indispensable partner, a clear and focused strategy to drive profitable growth and the financial foundation to ensure we can invest to position this company for long-term success. With that overview, I’ll turn to a discussion of our segments financial performance starting with Dental. Our Dental segment grew internal sales nearly 2% year-over-year, primarily driven by strong performance in our equipment and value added service categories.
Outstanding execution by our teams enabled our Dental segment to reach double-digit operating margins and year-over-year operating margin expansion, as we continue to deliver a strong mix favoring the higher margin areas of our business. We remain focused on advancing and strengthening key margin enhancement initiatives by mitigating the impact of an inflationary environment, strengthening our mutually beneficial vendor relationships and focusing on operational efficiencies including mix management, and logistics productivity. For consumables, our internal sales in the first quarter declined mid-single-digits year-over-year, primarily due to the persistent deflationary impact of certain infection control products. We continue to provide a broad range of infection control products because they are foundational to the practice of dentistry.
And while the demand for these offerings is lower than the peak levels of the pandemic, we remain strong in comparison to pre-COVID levels, as dentists have adapted to meet a higher standard of care. As we have previously discussed, improvements in the supply chain for infection control products have resulted in considerable pricing declines from the pandemic highs for certain products in this category. We expect this deflationary pressure in the infection control category to persist at least through the remainder of the fiscal year. Notably, Patterson achieved year-over-year internal sales growth in our non-infection control portfolio in the fiscal second quarter. We continue to leverage our broad consumables offering including private label products to deepen our relationships with customers across the spectrum from independent private practices to regional and national DSOs. We expect the overall consumables market to normalize to a low-single-digit percentage growth rate over the long-term.
Dental financial performance in the equipment category reflects what makes Patterson Patterson. Our customers recognize Patterson’s expertise in supporting the full purchase, training and maintenance cycle of the latest technology and equipment. They feel confident investing in their practices with Patterson as their partner, knowing they have access to hands on support from the Patterson Technology Center and the deep knowledge and service our local branch teams provide. Internal sales in Dental equipment in the second quarter were up double digits year-over-year, benefiting from improved demand for digital equipment portfolio and continued momentum in the core equipment category. As we previously discussed, equipment sales can fluctuate quarter-to-quarter.
But Patterson has delivered year-over-year equipment sales growth averaging nearly 14% for the last eight quarters. We continue to see that dentists are making equipment investments to keep their practices running well and maintaining their planned upgrade or replacement schedules. During the second quarter, our value added services category delivered solid high-single-digit growth driven by our field technical service offering. We’re proud that our customers turn to and trust Patterson to ensure their equipment is delivering for their practice. This category also benefited from growth in the sales of our practice management software products, which our customers see as the foundation of their practice operations. The Dental business is supported by resilient long-term trends including an ageing population, practice modernization and a growing appreciation for oral health as a key link to overall health.
We are confident in our ability to continue to effectively manage through the current macroeconomic environment to achieve our goals in fiscal ’23 and beyond. Let’s now turn to the Animal Health segment. During the second quarter of our fiscal ’23, we leveraged the depth of our offering and breadth of our channel presence to deliver solid performance in the face of more challenging external market conditions. Patterson has an omni-channel presence that spans a wide range of animal species and offers a comprehensive solution for diverse customers, ranging from large producer operations with onsite veterinarians to independent vet clinics to individuals shopping at their local veterinary supply retailer. Our Animal Health segment achieved internal sales growth of nearly 1% year-over-year, driven by mid-single-digit growth in companion animal and a low-single-digit decline in production animal.
Despite some softness on the top line, which we attributed primarily to external factors, including staffing shortages and veterinary clinics, weather conditions impacting producers and the impact of a widely used product in the production animal market that has recently gone off patent, Patterson was still able to expand its operating margins in the Animal Health segment. Our success expanding margins was the result of our team’s laser focus on mix, including the growth of our accretive private label and e-services offerings and continuing to enhance our relationships with strategic manufacturing partners who reward us for our performance. In our companion business, I’m particularly proud of our growth this quarter when you put our performance in context.
First, the broader market growth has continued to moderate in line with our expectations. Second, our results are compared to the extraordinary 21% sales growth Patterson achieved in the prior year period. We attribute this sustained outperformance of the market to our ability to serve more and more veterinary practices as they recognize the value we offer in a dynamic market environment as well as the deep relationships Paterson has with our preferred manufacturing partners, and the growth of our private label portfolio. We’re continuing to invest in the companion animal business in ways that deepen our value proposition and address critical customer needs. Last month, we announced an agreement to acquire RSVP and ACT, which stands for Relief Services for Veterinary Practitioners and Animal Care Technologies, respectively.
These are entities that provide innovative solutions to veterinary practices through data extraction and conversion, staffing and video-based training services. We believe this proposed acquisition will expand our companion animal capabilities in three key areas. First, ACT provides an in-house platform for data extraction and conversion capabilities, which will enhance our software offerings and provide better insights both for our business and our vet customers. Second, as RSVP is a staffing business that connects short staffed clinics to the resources they need, this acquisition will help resolve a critical pain point for clinics and address a growing trend in part time vet and technician work. This is particularly compelling given the staffing challenges our customers are facing today.
Finally, ACT will help Patterson expand its educational offerings, including the addition of a state recognized certification program for vet assistants. As we’ve previously discussed, our established education platform, Patterson Veterinary University, is a key component of our value proposition for companion animal customers. Working alongside customers to help them establish and enhance their practices lays the foundation for a meaningful long-term partnership. Importantly, we remain confident in the long-term growth opportunity of the companion animal market. Data shows that today’s pet parents are increasingly dedicated to the health and well-being of their pets and willing to invest in the care that veterinarians provide. We believe that over the long-term people who own pets will continue to invest in their care throughout the pets lifetime and own more pets during their life.
On the production animal side, our internal sales performance was challenged by the impact of pricing pressures on a broadly used product Draxxin that now faces generic competition. While this pricing pressure was not unexpected in the market, it still had an effect on our internal sales. Excluding the deflationary impact of this product, our production animal sales were up about 1%, reflecting positive fundamental growth over the extraordinarily strong 11% growth in the prior year comparative period. We attribute our positive financial performance in the production business to Patterson service model in a market where we believe customers generally prefer to develop a long-term relationship with a single supply partner. We provide producers with a customized combination of hands on service and delivery options, and a comprehensive product and service portfolio which they increasingly demand.
Our differentiated model has continued to enable us to win new customers and outperform the broader production animal market. And we are focused on continuing to differentiate Paterson with the addition of new critical capabilities. A recently announced agreement to acquire Dairy Tech is expected to expand our value added platform within our production animal business. Dairy Tech provides pasteurizing equipment and single use bags to safely produce, store and feed colostrum, a necessary nutrient for newborn calves. This is a critical capability for our cattle producer customers, and we expect our acquisition of Dairy Tech to efficiently and effectively support the health of the producers herd. We believe this acquisition will align well with several key trends we’re observing in the market, including producers looking for more efficient ways to manage costs and improve profitability, a continued market emphasis on biosecurity and herd health and strong global demand for protein and dairy.
As we look ahead to the rest of fiscal ’23, our Animal Health business will continue to focus on accelerating our momentum of strong sales execution, operational excellence and deepening our value proposition to better serve our customers. And now we will turn the call over to Kevin to discuss our fiscal ’23 second quarter financial performance in more detail.
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Kevin Barry: Thank you, Don, and good morning, everyone. Let me begin with a sincere thank you to Don and our Board for the opportunity to serve in this new role. I’m also grateful for the increasing levels of responsibility and formal mentoring Don has given me over the past several years. And it’s a privilege to be a part of the very talented and committed leadership team here at Patterson. In my prepared remarks this morning, I will cover the financial results for our second quarter of fiscal ’23, which ended October 29, 2022, and then conclude with a few comments on our outlook for the remainder of the fiscal year. So let’s begin by covering the results for our second quarter of fiscal ’23. Consolidated reported sales for Patterson Companies in our fiscal ’23 second quarter were $1.63 billion, a decrease of 1.4% versus the second quarter one year ago.
Internal sales, which are adjusted for the effects of currency translation increased 0.7% compared to the same period last year. Our second quarter fiscal ’23 gross margin was 20.2%, an increase of 40 basis points compared to the prior year. Our gross margin was negatively impacted by 60 basis points this quarter by the mark-to-market accounting adjustment from rising interest rates on our equipment financing portfolio. However, this negative impact was nearly offset by the gain in our corresponding hedging instrument, which is reflected in the interest and other expense line on our P&L. So the net result has a minimal impact on our adjusted earnings per share. This dynamic also occurred in the second fiscal quarter of last year, when the negative impact of the mark-to-market accounting calculation was 20 basis points.
We’re normalizing for the negative impact in both periods for an alternative view of how our business is operating. Our gross margin is up 80 basis points compared to the prior year. This increase in gross margin reflects our continued focus on pricing and cost execution and driving an improved mix with higher gross margin accretive product categories. Adjusted operating expenses as a percentage of net sales for the second quarter of fiscal ’23 were 15.9%, and unfavorable by 60 basis points compared to one year ago. In the fiscal ’23 second quarter, our consolidated adjusted operating margin was 4.3%, a decline of 20 basis points compared to the second quarter of last year. Again normalizing for the negative impact from the mark-to-market valuation of our equipment financing portfolio, our consolidated adjusted operating margins for the fiscal second quarter improved by 30 basis points compared to the prior year.
We remain focused on driving continued operating margin expansion through our efforts to improve gross margin with pricing and cost execution, working more closely with strategic vendors to reward us for our sales performance, driving improved mix as well as exercising expense discipline and leveraging our cost structure as we grow the top line. With these collective efforts, we intend to deliver operating margin expansion in both of our business segments and our total business for fiscal ’23. Our adjusted tax rate for the second quarter of fiscal ’23 was 24.2%, a decrease of 80 basis points compared to the prior year. For the full year, we expect our tax rate to be in line with prior year. Reported net income attributable to Patterson companies.
Inc., for the second quarter of fiscal ’23 was $54.1 million or $0.55 per diluted share. This compares to reported net income in the second quarter of last year of $48.3 million or $0.49 per diluted share. Adjusted net income attributable to Patterson Companies, Inc., in the second quarter of fiscal ’23 was $61.2 million or $0.63 per diluted share. This compares to $57.1 million or $0.58 per diluted share in the second quarter of fiscal ’22. This increase is primarily due to the operating margin expansion in both of our business segments. Now let’s turn to our business segments, starting with our Dental business. In the second quarter of fiscal ’23, internal sales for our Dental business increased 1.6% compared to the second quarter of fiscal ’22.
Internal sales of dental consumables declined 4.9% compared to one year ago. As Don mentioned earlier, we continue to experience the deflationary impact of infection control products compared to the prior year. Internal sales of non-infection control products increased 1.0% in the fiscal second quarter compared to the year ago period. We expect the deflationary impact of infection control products to continue for the remainder of fiscal ’23. Internal sales of dental equipment and software increased 11.1% compared to one year ago. In core equipment, our double-digit sales increase in the quarter reflects our continued efforts to manage the supply chain as category to deliver and install the equipment our dental customers have ordered to update their practices or open new dental offices.
Sales of digital equipment products were also up double digits, and sales of CAD/CAM products declined mid single digits in the quarter. Internal sales of value added services in the second quarter of fiscal ’23 increased 7.8% over the prior year period, led by the strong year-over-year performance of our technical service team and double-digit growth of our software business. Value added services represent the entire suite of offerings we provide to our customers that help make us an indispensable partner to their practice, and these valuable offerings are also mix favorable to our P&L. Adjusted operating margins in Dental were 10.2% in the fiscal second quarter and a 90 basis point improvement over the prior year period. This strong performance reflects the efforts of our dental team to improve gross margins and exercise continued expense discipline compared to the prior year period.
Now let’s move on to our Animal Health segment. In the second quarter of fiscal ’23, internal sales for our Animal Health business increased 0.7% compared to the second quarter of fiscal ’22. Internal sales for our companion animal business increased 3.5% with the U.S companion animal business growing by 4.5% in the quarter. Internal sales for our production animal business decreased 2.3% in the quarter compared to the prior year as the production animal market has been affected by the deflationary impact of the key branded product that recently came off patent. And as Don mentioned, it’s now experiencing generic competition. Excluding this deflationary impact, internal sales for our production animal business increased by 0.7%, and industry data would indicate that our sales team and production continues to outperform the overall market during the fiscal second quarter.
Adjusted operating margins in our Animal Health segment were 3.8% in the fiscal second quarter, an increase of 40 basis points from the prior year. Our Animal Health team continues to drive business with strategic manufacturer partners who value our ability to move market share while also exercising expense discipline. Now let me cover cash flow and balance sheet items. During the first 6 months of fiscal ’23, our free cash flow declined by $88.4 million compared to the same period one year ago. This was primarily due to an increased level of working capital in the first 6 months of fiscal ’23, driven by strategic inventory purchases and timing of accounts payable. Now turning to capital allocation. We continue to execute on our strategy to return cash to shareholders.
In the second quarter of fiscal ’23, we declared a quarterly cash dividend of $0.26 per diluted share, which was then paid in the third quarter of fiscal ’23. On a year-to-date basis, Patterson has returned $65.7 million to shareholders through dividends and share repurchases. Also during the second fiscal quarter, as previously disclosed, we successfully amended and extended our credit facility. Even in this challenging credit environment, we achieved favorable terms, while maintaining our existing lending group, demonstrating the confidence our lenders have and the ongoing strength of our business. This new facility provides the capacity and flexibility to continue investing in our core business and to execute on strategic transactions. Let me conclude with some comments on our outlook for fiscal ’23.
Today, we are reaffirming our fiscal ’23 GAAP earnings guidance of $1.96 to $2.06 per diluted share, and our adjusted earnings guidance of $2.25 to $2.35 per diluted share. We intend to deliver internal sales growth and operating margin expansion for fiscal ’23 and remain committed to achieving our guidance for the fiscal year. And now I will turn the call back over to Don for some additional comments.
Don Zurbay: Thanks, Kevin. A few final comments before we open it up for Q&A. First, I want to again thank the entire Patterson team. I’m proud of their work in delivering another strong quarter and their dedicated focus on supporting our customers. Second, despite macroeconomic challenges, the performance of this quarter demonstrates the strength of our strategy, discipline and execution of our talented team and continued momentum within our end markets. With this winning combination, I am confident in Patterson’s ability to succeed in any environment and look forward to what we can accomplish together. That concludes our prepared remarks. Kevin and I will be glad to take questions. Operator, please open the line.
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