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Executives

James C. Robison - Chairman of the Board, President and Chief Executive Officer

William F. Lacey - Chief Financial Officer, Senior Vice President

Analysts

Stand in for Lisa Gill - J.P. Morgan

John Kreger - William Blair & Company, L.L.C.

Jeff Johnson - Robert W. Baird & Co., Inc.

Mark Arnold - Piper Jaffray

Animal Health International Inc. (AHII) Q3 2009 Earnings Call May 7, 2009 10:00 AM ET

Operator

Good morning. I would like to welcome everyone to the Animal Health International Third Quarter 2009 Conference Call and Webcast. (Operator Instructions) As a reminder this conference is being recorded. It is not my pleasure to introduce your host Mr. James Robison, Chief Executive Officer for Animal Health International. Thank you. Mr. Robison, you may begin.

Jim Robison

Good morning and thanks for joining us for the call. With me this morning is Bill Lacey our Senior Vice President and Chief Financial Officer. Bill will discuss our financial results for the quarter as outlined in the earnings release and then I will give highlights on our performance. We will then open the call up to questions-and-answers. Bill?

Bill Lacey

Thanks Jim, good morning, and thanks for joining us today. Before we begin I want to point out that today’s conference call is being recorded and will be available for replay on our web page at www.ahii.com under Investor Relations.

In addition, I would like to remind everyone that some of the information discussed on this call, particularly our guidance for fiscal year 2009, our competitive position, future business prospects, revenue growth and market opportunities for the coming fiscal year contain forward-looking statements that involve risk and uncertainty. These statements are based on current expectations. Actual results may vary materially from those set forth in such statements. Additional information concerning risk and other factors that may cause actual results to differ can be found in the Company’s filings with the SEC.

Please note that in addition to reporting financial results in accordance with generally accepted accounting principles or GAAP, AHI reports certain non-GAAP financial results including EBITDA. Investors are encouraged to review the reconciliation of these non-GAAP financial measures to be comparable with GAAP results which can be found in the press release.

Finally, AHI has provided in its earnings release and will provide in this conference call forward-looking guidance. We will not provide any further guidance or updates to our performance during the year unless we do so in a public forum. AHI does not assume any obligation to update the forward-looking statements provided to reflect events that occur or circumstances that exist after the date on which they are made.

I will now give you the results for our third quarter of fiscal year 2009.

Net sales decreased 11.6% or $19.7 million to $151 million for the three months ended March 31, 2009. This was down from $170.6 million for the same quarter last year. Lower spending by production animal customers and the profits having been constrained by commodity prices are primarily to blame. Gross margin declined $7.5 million with $3.3 million due to lower sales volume and $1.5 million due to lower rebates from vendors.

Margins in our Canadian subsidiary, Kane Veterinary Supplies, as we refer to it Kane, declined $900,000.00 due to the exchange rate and a heavier mix of low margin product.

Consolidated gross margin as a percent of sales was 16.8% compared to 19.2% for the same period last year.

SG&A expenses declined $3.2 million from last year as a result of lower variable selling expense and cost reductions.

EBITDA for the quarter was $3.7 million which was a decrease of $4.2 million from the year earlier quarter of $7.9 million.

Net loss for the third quarter was $324,000.00 down from the third quarter last year net income of $1.9 million.

GAAP diluted loss was $0.01 per share for the quarter.

The non-cash amortization of intangibles was $1.1 million for the quarter for those of you who add it back in your models. Earnings per share without non-cash amortization was $0.03.

Let’s talk a little bit about the year-to-date results now. Net sales declined $33.8 million or 6.3% to $504.4 million for the nine months ended March 31, 2009.

Gross margins declined $13.5 million for the nine months and were 17.4% of sales compared to 18.8% for the same period last year. Domestic gross margin was down $14.7 million with a decline driven equally by reductions in volume and rebates.

Kane gross margins increased $1.2 million. Volume contributed $2.2 million to the Kane increase, while margins declined $1 million due to unfavorable exchange rates and a heavier mix of low margin product.

SG&A expenses declined $2.5 million from last year. Kane, acquired in October 2007, contributed $1.4 million to an increase in SG&A this year, while domestic spending on SG&A declined $3.9 million as a result of lower variable selling expense and cost reductions.\

EBITDA for the year-to-date was $17.3 million, a decrease of $11.1 million when compared to the same period last year.

Net income for the year-to-date was $2.2 million, down from last year’s net income of $8.4 million.

GAAP diluted income was $0.09 per share for the year. The non-cash amortization of intangibles was $3.5 million for the nine months. Earnings per share without the amortization would be $0.23.

At the end of March there were 49 days of working capital compared to the same period last year we had about 54 days of working capital on hand. Our average for the last 12 months was 47 days.

Debt decreased during the three-month period by $11.6 million. Debts decreased by $23 million in the last 12 months in spite of $2.9 million of earn outs paid to selling shareholders of prior acquisitions. Capital expenditures were about $400,000.00 and $2.1 million for the quarter and year-to-date respectively.

Fixed charge ratio, which is one of our only two covenants with our bank, increased to 2.2x on a trailing 12 month basis, up from 2x last year. In spite of our decline in EBITDA we had a very large tax payment that was made last year in March compared to a very small tax payment this year which gave us a bump in the fixed charge ratio.

Due to these third quarter results and current market dynamics we are going to revise our guidance. Net sales for fiscal year 2009 are expected to be in the range of $645 to $660 million. EBITDA is estimated to be in the range of $22 to $25 million and its net income for the fiscal year to be in the range of $2.1 to $3.7 million.

At March 31 the Company’s availability under our revolver totaled $24.9 million. The Company is in compliance with all of its financial covenants.

Another thing that we also did during this quarter was to extend our ABL credit facility, our first lien credit facility. It was set to expire in June of 2010. We have extended it to June of 2012, or the lesser of whenever the Term Note expires, which it is set now to expire in May of 2011. In other words, if we can get that term note either paid off or extended then we have a two-year extension, otherwise we just have a one-year extension on it.

Pricing went from we will start at LIBOR +350, it was LIBOR +200 and we have some small changes here and there in the terms of the deal, a few extensions on some AR ineligible calculations and things like that.

Jim, I will now turn it back over to you.

Jim Robison

Thanks, Bill. I have some comments on the quarter and year-to-date. It has to be the most challenging quarter I have seen in my 12 years with the Company. There were two primary drivers, one is that our predominant customer base, protein producers, have experienced losses for most of the last 12 months and they accelerated precipitously during the quarter. It is estimated that last year cattle feeders lost an estimated $5 billion and that losses during the quarter for dairyman averaged $30 to $150 per head. These losses significantly affected the consumption of animal health products and other support supplies.

Also, our largest supplier substantially cut our margins during the quarter. We didn’t anticipate this and we have taken corrective actions with that. That has set us back significantly. We have adjusted by cutting our expenses by just under $8 million. We have been actively managing our receivable risk and we have been highly focuses on the sale of more profitable products and areas of growth for our business.

Indications are that we bottomed out in the quarter and that we will see relatively gradual recovery over the next several quarters. Still, there remains a great deal of uncertainty and risk in the marketplace.

Our company’s people have remained very positive and are making great progress on key initiatives that will lay a foundation for recovery as markets begin to normalize. Also, we have had very good results in our areas of focus. Unfortunately we have not been able to stem the tides, if you will, caused by the financial challenges our customers have faced and the unanticipated reduction in margins from one key supplier.

Select manufacturers during the quarter grew very nicely given our collaboration of selling efforts. Quarter-over-quarter our companion animal business is growing revenue and is profitable. This quarter we are installing business intelligence software that we have been working on for the last 18 months. This software will help us to better manage key elements of our business.

Our proprietary or push products that we focus on highly with rare exception have been growing and are increasingly profitable. Finally, our cash flows were good and with the extension of our credit facility we feel like we have demonstrated the strength of our business even in these difficult times.

So, short term we face challenges and some uncertainty in the marketplaces. There are indications that dairyman are getting close to break even. If you look at the futures contracts for milk, it those prices hold milk prices will trend up and as break evens come down, as dairymen work out of their long position on feed, we should see dairymen approaching break even. The good operators are cash flow neutral right now, so we are seeing light in that market and we’re seeing similar indications in the beef market. The numbers are very, very tight. I think that should our economy start to recover and demand picks up we will see good recovery in the beef markets as well.

Short term there is continuing challenges. There are some indications of an improved situation, but again we are still very optimistic about the long-term prospects for the Company.

With those comments I will now open up the call for questions-and-answers.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Lisa Gill with J.P. Morgan

Stand in for Lisa Morgan - J.P. Morgan

Hi, thanks [audio gap] for Lisa.

I have a question on the production animal segment. Bill, you mentioned things are bottoming out there, so do you envision that returning to profitability next quarter? Then going back on those comments about boding well, it looks like your guidance for next quarter it seems something like $140 to $155 million in the revenues, so the low end of that is a little bit below what you came up with this quarter. So, do you believe things could get a little bit worse before they get better?

Bill Lacey

There were a lot of questions there. I think our fourth quarter is going to be a very tough quarter very similar to our third quarter, although there will be more drop through to the bottom line. The third quarter is our business is one of the least profitable quarters during the fiscal year.

If you look at milk prices right now they are in the $10.00 range. Break even for these guys, some of the better operators, is around $12.00 to $12.50 and for the majority of them it is probably in the $13.00 to $14.00 range. As Jim pointed out they are working out through some long-term grain contracts. So, if you look at the futures markets these guys will be back in the black, depending on where their break even is, sometime this summer. As you know we are at June year-end so we don’t think that we’re going to get a lot of relief on this in the fourth quarter here, but we do think that things will start to improve in the first quarter of next year.

Stand in for Lisa Morgan - J.P. Morgan

Okay, that would be on the dairy markets, what about the beef markets?

Bill Lacey

The beef markets I will comment, Jim you jump in and help me out here, but the beef markets is a price issue where carcass is being basically priced for its hamburger value, because that is where the demand is. There is not a lot of great demand for prime cuts of beef, so based on where the demand is carcasses are getting priced for hamburger. This is more of a general economy deal than it is a specific, because once that improves than the restaurants will start picking up the high ends and that will drive the carcass values up and get these guys making more money.

Is that fair to say, Jim?

Jim Robison

Yes, no, with corn prices the challenge that our customers have is that generally they are long in their feed. When prices last summer were approaching $8.00 a bushel for corn, which has historically been in the $2.50 to $3.50 range, a lot of our customers went long. Some of them are just now working out of those positions. So, break evens are coming down and prices are trending up slightly.

The value of the carcass, to Bills point, has been low given the restaurant demand and other factors, but the losses, which for the quarter averaged $200.00 to $300.00, are decreasing. I think people believe that given the very tight numbers on the supply side any improvement in demand will straighten out the market pretty quickly.

Stand in for Lisa Morgan - J.P. Morgan

Okay, that is helpful. Finally, on the rebates you said gross profit this quarter was negatively impacted by what $1.5 million in lower rebates. Could you perhaps break out what portion of that was due to the change of your largest supplier versus just kind of volume driven lower rebates?

Bill Lacey

I probably don’t want to isolate vendor rebates by vendors, so let’s just say that it was overall driven by the decline in volume.

Stand in for Lisa Morgan - J.P. Morgan

Okay, all right, that is good. Thank you.

Operator

Your next question comes from John Kreger with William Blair.

John Kreger - William Blair & Company, L.L.C.

Can you help us quantify in any way the hit from that largest vendor that you took in the quarter, either rebates or just traditional gross margin? Can you help us understand how big that was and should that hit get larger as we go through this calendar year, or have we sent the worst and it starts to improve from here?

Bill Lacey

I am not going to give you the percent that we make on that vendor, but it is down about 300 basis points from where we were a year ago.

John Kreger - William Blair & Company, L.L.C.

Okay and do you expect that difference to get larger as we go through the year, Bill?

Bill Lacey

No, I do not. I think it will be steady. We are contracted with these vendors on calendar years, so we know where we are, I think, for this fiscal year.

Jim Robison

I think product sales mix will decrease the effect of the impact.

John Kreger - William Blair & Company, L.L.C.

Great, thank you. As you think about the next several quarters, I have a couple of general questions. One, what are your thoughts about the consolidation that we are seeing right now in pharma. Are there any particular deals that concern you? Also, if you are willing, can you give us your thoughts on fiscal 2010? How comfortable are you that we’ve bottomed and that you’ll see growth and when do you think you’ll give us some more formal guidance for that year?

Bill Lacey

Regarding consolidation of suppliers, we don’t have any information or knowledge at this time. All we have is hearsay. The regulatory authorities have been extraordinarily active and what we are hearing is that the obvious and in some cases the not so obvious components of the businesses that are being looked at in this case, namely Fort Dodge Animal Health and Pfizer Animal Health, are not going to be put together. During the quarter the CEO of Lily made the statement in the Journal that they were in an inquisitive mode and that they had a specific focus on animal health. We have also seen others express interest informally regarding acquisition potential products, or companies that come to the market. S

We don’t have knowledge, again, right now, but the tell is that there is a pretty good likelihood that there will be more than sufficient competition for customers to get a fair deal on a forward basis given what we are hearing today.

John Kreger - William Blair & Company, L.L.C.

Great, thanks. Then do you have any early comments on your outlook for fiscal 2010?

Bill Lacey

It is a little bit early, we prefer not to speak to that just yet, but we do feel we bottomed out. There are a lot of really good things going on with the Company, so we are optimistic.

John Kreger - William Blair & Company, L.L.C.

That is great. Can you give us an update on your bad debt assumptions? Did you see any up tick in write offs and have you changed your allowance assumptions at all?

Bill Lacey

No, we have not at all. Actually our day sales outstanding have improved from a year ago. We are at 38.2 days and a year ago we were at 38.8 days. Our agings’ have not deteriorated at all and we have not made any changes to our overall bad debt provisions. It is something we are watching like never before. I can assure you of that, because of the money being lost especially in the diary and cow calf operations. But, we just haven’t seen it yet. There are isolate pieces of slow pay, but that happens in the best of times. So, we are very alert to the problems, but we haven’t seen them yet.

John Kreger - William Blair & Company, L.L.C.

Great, thanks very much.

Operator

Your next question comes from Jeff Johnson with Robert W. Baird.

Jeff Johnson - Robert W. Baird & Co., Inc.

I was wondering, Jim, if we could start with you. I would like some qualitative comments. Last quarter you gave us some thoughts on the beef and dairy market, your specific businesses there, beef being down you thought maybe 6% or so for the year; dairy being down, I think you said, for the first time in your career, or in at least a number of years on that side of the business. Could you update those this quarter? Is beef going to be down more than that you think now given this quarter’s performance and diary any thoughts there?

Jim Robison

Yes, we thought the quarter would be better than it was obviously. One of the subcomponents, Jeff, of the diary business is the Holstein calf ranch business. It fell off 35% or so during the quarter and it almost stopped. Not to go too deep into it, but a bull calf is purchased at birth and put in a hutch and grown out for beef. With the excess number of cows coming to slaughter in the dairy market and the weak prices on the beef market for traditional cattle, people just weren’t investing in that market. That market dropped precipitously, but it also recovered. So, yes numbers were worse than anticipated on the dairy side and they will probably be so in a year-to-date that is just moving into the quarter.

Then on the beef business, the challenges that we’re facing is the trough, if you will, in prices and profitability has been deeper and broader then has historically been experienced. Markets are tougher than we had anticipated and we don’t see them improving quickly over the next couple of quarters.

Jeff Johnson - Robert W. Baird & Co., Inc.

Okay, that is helpful, thanks. Jim, as I look at the futures contracts on diary the September/October contracts have been hanging out kind of above $16.00. They seem like they have fallen just in the last couple weeks down closer to the $14.00 range and spot write downs in the $9.00, $9.50 range I think at this point. The offset to that is you have some retirement programs in place here and you should be at least reducing the supply, I guess. Where do you think the inflection point comes when diary prices can actually stay up above those break evens and what is it going to take to get there?

Jim Robison

Jeff, I am not an expert on that. I can only anecdotally repeat to you what customers tell me. Our customers are seeing the break evens fall into the mid to low teens from the mid to high teens, mostly driven by grain prices. They also continue to actively cull marginally productive animals. One of the troubling factors is the heifers that are in the channel to supply or to replace marginally producing cows are fairly high; so the rate of production in total herd size is not really what it needs to be. The buy out programs should accelerate that. There is a little bit of uncertainty about when and how that is going to occur, but it should happen in the next couple of months.

Intuitively we think that probably in the later part of the calendar year, third quarter, we will start to see some improvement, but as you know we saw some improvement three or four weeks ago and it’s kind of backed up a little bit. The next two or three quarters may be fairly challenging and gradually improving.

Also keep in mind that the credit markets, we think, are going to slow the recovery of the production market somewhat, because people are going to be less able to lever and it is going to create some fairly unique challenges.

Jeff Johnson - Robert W. Baird & Co., Inc.

Great, and then your best guess if we get above break evens on the diary side, do diary farmers just immediately turn on their purchasing of products from you? Or, do they need that to hang out above break even and maybe made whole for a few months, a couple of quarters, something like that before they start believing and coming back and actually spending on the animal health product side?

Jim Robison

That one is a little bit too big of a guess for me to take a shot at. We have never experienced a market downturn like this before, so we don’t have any historical experience that we can reference to give you a swag around how it might recover. This downturn is extremely unique, never experienced before, and we are just not very certain about what the next couple of quarters are going to look like.

I will tell you, though, that long-term markets are going to normalize and customers will become profitable. Our export markets are way off on the beef and the dairy side. We believe long term the dollar is going to weaken, exports will pick up again, our U.S. economy will come back and things will be relatively good to what it was the last year or so. But, we just can’t predict how fast and when just yet.

Jeff Johnson - Robert W. Baird & Co., Inc.

Yes, I understand. Thanks Jeff. Bill, I have a couple of modeling questions for you. What was the top line foreign currency impact in the quarter? Then on your debt covenants, I think the denominator as we calculated is interest payments and principle payments. I am just not sure what the principle payments, maybe it has been on a trailing 12-month basis or how should we think about them going forward as we try to correct the covenant issue?

Bill Lacey

Let me go backwards on those questions. The interest and principle payments you would be looking at over the next 12 months would be approaching about $11 million.

Jeff Johnson - Robert W. Baird & Co., Inc.

Okay and over the trailing 12 as we just look at your covenants?

Bill Lacey

The trailing 12 is like $8.9 million.

Jeff Johnson - Robert W. Baird & Co., Inc.

Thank you, and then on the FX top line impact?

Bill Lacey

I didn’t really look at it on the top line, Jeff, but I do have FE for the quarter the foreign exchange cost us about $1 million, about $970,000.00 with about $654,000.00 of it being at the margin level. Keep in mind that Kane purchases about 30% of its product in the United States and you’ve got a fairly unfavorable exchange rate there between us and the Canadian dollar.

Jeff Johnson - Robert W. Baird & Co., Inc.

I understand and I’m sorry, did I hear you say the $900,000.00 or so was the top line impact from Kane in the quarter from the Canadian dollar strength?

Bill Lacey

No, no, no, that is the EBITDA effect.

Jeff Johnson - Robert W. Baird & Co., Inc.

EBITDA, I’m sorry. All right, thanks guys.

Operator

Your final question comes from Mark Arnold with Piper Jaffray.

Mark Arnold - Piper Jaffray

I have a question on the cost side. I know you guys said you have taken out about $8 million in costs. Are there any other things you have implemented or are considering, particularly on the way you distribute, whether you might look at the overnight mail delivery or closing and consolidating any additional DCs?

Bill Lacey

We are constantly looking at consolidating distribution centers, or banding them for that matter. I will speak historically. The third quarter we had projected to save about $2.4 million from our cost cutting measures and we ended up with about $3.6 million. So, we are about $1.2 million ahead of what we hoped we would be. If you recall, I think we said we would hit around $7 million hopefully in this fiscal year and next year will be a bigger number unless we are in good enough shape to pay bonuses. Which I hope is the case.

What was the other part of your question Mark?

Jim Robison

He asked about changes in distribution methodology to go to overnight delivery or mail order.

On the production side, specifically in the beef and the dairy markets we are very, very close to our customers and we can literally get the most customers within a couple of hours. A cost effective model, we have tested on a lot of fronts. Some customers may feel fine with a UPS model, but they really don’t work too well given the location of our production customers and the nature of some of their products. On the dairy side we delivered a lot of very, very heavy products that are delivered in long tail trucks or flatbed trucks, so you can’t ship that stuff UPS, coordinators, sanitizers, milk, and those kinds of things. So, we are not considering any kind of change in our distribution policies or procedures to drive dairy costs down.

Mark Arnold - Piper Jaffray

Okay and then I hate even asking this question, but as it relates to demand, you have seen pork demand drop considerably here in pricing in the last few weeks. Do you think, or has it had any impact on beef demand? It doesn’t appear to have had much impact on pricing, but on beef demand here in the second quarter?

Jim Robison

We don’t think there is going to be any material affect by this concern about swine flu to protein consumption or activities.

Mark Arnold - Piper Jaffray

Okay and not inside the mix of business there either between what types of proteins?

Jim Robison

Not that would be material to the performance of the Company.

Mark Arnold - Piper Jaffray

Okay. My last question kind of goes to the coverage ratio issues, but it looks like you guys have changed your definition of EBITDA this quarter and are now adding back stock comp expense. Is that something that has always been allowed under your credit facility? Can you just explain that a little bit?

Bill Lacey

Yes, it has been allowed under our credit facility. We had discussions recently that it was becoming more acceptable to use it in your calculation of EBITDA. We were counseled early on after we became public that we could not add that back. It seems to be more acceptable now, so we are adding it back. It runs about $1 million a year.

Mark Arnold - Piper Jaffray

Okay and then I think the last person asked a question about that coverage ratio, but can you just repeat those numbers, Bill, on the interest and principle payments that you gave out here a minute ago?

Bill Lacey

Yes. Interest and principle on a go forward basis would be about $11 million. Right now we are sitting at about $8.9 million on a trailing 12 months.

Mark Arnold - Piper Jaffray

Okay, great. Thank you.

Operator

Thank you. There are no further questions at this time. I would like to turn the floor back over to management for closing comments.

Bill Lacey

We appreciate you joining us for the call and we appreciate your interest in our company. Thank you and have a good day.

Operator

This concludes today’s teleconference. (Operator Instructions) Thank you for your participation.

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Source: Animal Health International Inc., Q3 2009 Earnings Call Transcript
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