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Sirona Dental Systems, Inc. (NASDAQ:SIRO)

F1Q10 (Qtr End 12/31/09) Earnings Call Transcript

February 8, 2009 8:30 am ET

Executives

John Sweeney – VP, IR

Jost Fischer – Chairman, President and CEO

Simone Blank – EVP and CFO

Jeff Slovin – EVP and COO, U.S. Operations

Analysts

Natalie Nadler [ph] – William Blair

Larry Marsh – Barclays Capital

Jeff Johnson – Robert Baird

Greg Brash – Sidoti & Co.

Abigail Darby – JP Morgan

Jonathan Block – SunTrust Robinson Humphrey

Peter Bye – Jefferies & Co.

Ross Taylor – CL King

Scott Green [ph] – Bank of America/Merrill Lynch

Derek Leckow – Barrington Research

Operator

Good day, ladies and gentlemen, and welcome to the first quarter 2010 Sirona Dental Systems earnings conference call. At this time all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator instructions) As a reminder this conference is being recorded for replay purposes.

I would now like to turn the call over to Mr. John Sweeney, Vice President of Investor Relations. Please proceed, sir.

John Sweeney

Good morning, everyone. I would like to remind you that the earnings slide deck presentation relating to this conference call is available on our Web site at www.sirona.com.

Before I turn the call over to Jost Fischer, Chairman, President, and CEO, Sirona Dental Systems, I need to inform you that the information in this conference call contains forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995.

Forward-looking statements are information of a non-historical nature and are subject to risks and uncertainties that are beyond the Company’s ability to control. These matters discussed in the conference call are subject to various factors which could cause actual events and results to differ materially from such statements.

Such factors include uncertainties as to future sales volumes of the Company’s products, the possibility of changing economic market and competitive conditions, dependence on products, dependence on key personnel, technological developments, intense competition, market uncertainties, dependence on distributors ability to manage growth, dependence on key suppliers, and other risks and uncertainties including those detailed in the Company’s filings with the Securities and Exchange Commission.

The Company undertakes no obligation and does not intend to update these forward-looking statements to reflect events or circumstances occurring after this conference call. You are cautioned not to place undue reliance on these forward-looking statements that speak only as of the date of this call.

Please note on today’s call we will be presenting additional financial information including non-GAAP financial measures under Section 101 of Regulation G of the 1934 Exchange Act.

In addition, during today’s call management will comment on guidance for fiscal year 2010. Please note that all statements made in connection with the guidance are based on the current expectations and actual results could differ materially from such forward-looking statements.

Now, I would like to turn the call over to Jost Fischer, Chairman, President and CEO of Sirona Dental Systems.

Jost Fischer

Thanks, John. It is my pleasure to welcome all of you to our First Quarter 2010 Conference Call. Joining today are Simone Blank, Executive Vice President and CFO and Jeffrey Slovin, Executive Vice President and COO of U.S. Operations.

We are pleased with our exceptionally strong performance in the first quarter. We achieved strong revenue growth of 19.5% or 10.9% on a constant currency basis, driven by our recent innovative product launches and our technologically advanced product portfolio. The bottom-line benefited from robust sales growth, margin expansion, expense management initiatives and deleveraging.

Looking at our performance by segment in the first quarter, we had record revenues of $73.8 million in our CAD/CAM segment, up 29.3% constant currency. Our Instrument business also had a record quarter with revenues of $26.1 million, up 6.7% constant currency. Our Imaging segment also had record sales of $71 million, up 3.7% constant currency.

Finally, our Treatment Center revenues increased 0.5% constant currency to $43.9 million with a notable contribution from our TENEO Treatment Center.

In addition to our exceptional revenue performance, operating income plus amortization increased 51.5% to $59.6 million. Our strong cash flow translated directly into a reduction in our net debt, which now stands at $254 million, down $40 million as compared to September 30th.

We continued to capitalize on our 2009 product launches with a substantial contribution from our CEREC AC Galileos 3D imaging systems, TENEO and the CDR Elite Sensor.

I would also like to highlight the impact of one of our more recent innovations, the Galileo CEREC integration. This technology combines the diagnostic capabilities of Galileos with the high-quality esthetic restorations offered by our CEREC system. This enables dental practitioners to plan and create customized sample implant solutions more easily with a substantially lower level of risk.

Importantly, we are the only company with a product portfolio to integrate these two technologies and therefore are well-positioned to capitalize on this opportunity. We are seeing that dentists interested in 3D are now looking for CAD/CAM integration capabilities and vice versa. And this capability is increasingly influencing their decisions.

Later this year, we are going to celebrate our CEREC 25th year anniversary. For the past quarter century, Sirona has advanced the field of CAD/CAM in dentistry, constantly upgrading its systems.

I will now turn the call over to Simone for a review of our first quarter financials.

Simone Blank

Thank you, Jost. In the first quarter, our revenues increased $35.1 million to $214.8 million. In the U.S. we had record revenues of $68.7 million, up 12.1%, with strong CAD/CAM and imaging sales. Outside the U.S. international revenues increased 10.4% constant currency with particular strength in CAD/CAM and positive growth in all segments.

We had good performance in Germany, Australia, Canada and Japan during the quarter. Operating income plus amortization increased 51.5% to $59.6 million.

Moving on to a review of our business segment performance. Revenues in our CAD/CAM segment increased 37.5% to $73.8 million or up 29.3% on a constant currency basis. This performance was the result of continuous robust global demand for CEREC AC, promotions, the trade-in program in the U.S. and relatively easy comps.

CAD/CAM segment gross profit margin was 69%, down 90 basis points compared to prior year. Imaging segment revenues increased 9.2% to $71 million or up 3.7% on a constant currently basis. This represented a return to positive constant currency revenue growth after three quarters of decline. Strong sales in our Galileos 3D imaging system mainly drove the increase in imaging sales.

Imaging segment gross profit margin was 61%, up 120 basis points compared to the prior year period. Our Imaging segment margin expansion was driven by a significant contribution from Galileos and sensor sales.

Treatment Center segment revenues were $43.9 million, up 12.2% or up 0.5% constant currency. Segment margin expanded 370 basis points to 41.4%. The margin expansion in the Treatment Center segment was the result of regional and product mix with robust sales of our higher-end consult treatment centers led by TENEO.

Instrument revenues increased 19% to $26.1 million or up 6.7% constant currency with solid performance for our hand pieces and high-tech innovations, including SIROPure and DAC Hygiene Systems. Instrument segments gross profit margin was 47.2%, up 160 basis points compared to prior year due to product and regional mix.

And now I’ll review some of the P&L details. Cost of sales was $102.5 million for the quarter, an increase of $9.8 million or up 10.5%. Gross profit margin was 52.3%, up from 48.4% in the prior year. Cost of sales included deal related amortization and depreciation expense of $14.9 million versus $16.2 million for the same period last year. Gross profit margin expansion also benefited from higher CAD/CAM sales and favorable regional and product mix.

SG&A expense was $59.9 million, an increase of $2.4 million. As a percentage of sales, SG&A expense was 27.9%, down from 32% in the prior year. SG&A as a percentage of sales was lower, mainly due to the higher sales level and cost savings. R&D was $11.5 million, an increase of $0.4 million.

In fiscal 2009, we incurred restructuring expenses which we expect to save approximately $10 million per year from fiscal year 2010 onward. These projects and their related cost savings are progressing as planned. As mentioned in our Q4 earnings call, we expect to invest a part of these savings into expanding our sales and service infrastructure and R&D efforts as we move through the year.

Operating income plus amortization expense was $59.6 million, up 51.5% compared to prior year. Foreign currency gain amounted to $0.6 million in the quarter and included a $1.4 million non-cash loss on the revaluation of the Patterson exclusivity payment and a $1.3 million loss on the revaluation of short-term and troubled loans.

Net interest expense was $5.2 million compared to $6.1 million, with the reduction due to lower overall debt levels and lower interest rates. The income tax provision for the first quarter of fiscal 2010 was $7.9 million. The fiscal 2010 effective tax rate is estimated to be 20%.

The Company's net income was $31.2 million, an increase of $25.6 million compared to the prior year. First quarter 2010 GAAP EPS was $0.55 compared to $0.10 in the prior year quarter. First quarter 2010 GAAP EPS included a $0.22 expense for deal related amortization and depreciation, a loss of $0.02 related to the revaluation of the Patterson exclusivity fee and a loss of $0.02 related to the revaluation of intra-group loans.

In the prior year quarter, GAAP EPS included $0.22 of deal related amortization and depreciation, a $0.03 loss related to the Patterson revaluation, a $0.02 loss on the revaluation of intra-group loans and the $0.01 gain on the sale of an asset.

Excluding these items in both periods, first quarter 2010 fully diluted earnings per share was $0.81, up 125% compared to $0.36 per share in the first quarter of 2009. Our first quarter 2010 results included a $0.05 benefit from interest rate swaps compared to a $0.11 loss in the prior-year quarter.

Moving on to cash flow. We had strong operating cash flow of $40.6 million and capital expenditure of $4.2 million in the quarter. At December 31st 2009, the Company had cash and cash equivalents of $215.9 million and total debt of $470.1 million resulting in net debt of $254.2 million. This compares to net debt of $293.8 million at September 30, 2009.

Moving on to guidance. We are pleased that the year is progressing towards the upper end of the guidance expectations that we communicated to you in December. As a result, we expect to achieve revenue growth towards the upper end of our guidance range of 4% to 6% on a constant currently basis.

Factors that influence our quarterly revenue progression include the timing of the bi-annual International Dental Show, the timing of our CEREC AC product launch in January 2009 and the AC upgrade program in the U.S. which largely benefited the second half of fiscal 2009. As we have said, all of these factors are expected to drive higher revenue growth in the first half of the year.

Our first quarter benefited from a favorable product and regional mix, with strong sales of our higher margin CAD/CAM business. We do not anticipate this very favorable mix to continue for the rest of the year.

For fiscal 2010, we expect SG&A as a percentage of sales to be down slightly versus 2009 and R&D to be in the range of 6% to 7% of sales. Based on all of these factors we now expect operating income plus amortization to be in the range of $170 million to $176 million compared to our previous guidance range of $166 million to $176 million.

Given how our business is trending we are becoming increasingly comfortable that we will be able to reach the upper end of our guidance expectation. Assuming constant interest rates, we expect to see interest expense in Q2 at a similar rate to our Q1 results. Our interest rate swaps roll up in March 2010, so, we anticipate a reduction in hedging costs as we move into the back half of the year.

As always, I suggest our investors evaluate our business on an annual basis as our quarterly progression can vary significantly.

I’ll now turn the call back to Jost.

Jost Fischer

Thank you, Simone. As discussed, we had exceptionally strong performance in the first quarter of fiscal 2010. Our CAD/CAM segment made an extraordinary contribution to this result.

I would now like to take a moment to update you on this important segment. The dental CAD/CAM market has four main components – Chairside, Laboratory, Centralized Milling Centers and Restorative Materials.

Chairside. CEREC is the largest part of the CAD/CAM market with about 5.5 million CEREC restorations created each year and this represents the highest potential going forward. CEREC allows dentists to create long-lasting biocompatible single visit restorations in their dental offices.

CEREC has defined and dominated the category for almost 25 years and we now have an installed base of over 27,000 systems around the world, with the majority of them placed outside the United States.

The adoption of CAD/CAM in dental laboratories is well underway as labs are looking for a way to automate their manufacturing. Labs have a choice between outsourcing their production, using a scanner or purchasing a full system with manufacturing capabilities. They generally want to retain their means of production and keep their position in the value chain.

As a result, we believe we will see continued solid growth for inLab Systems. Sirona is the market leader in this category, with over 4400 systems placed in the lab. We estimate that there are about 5 million CAD/CAM restorations manufactured in laboratories each year and Sirona inLab Systems create about 2 million of those restorations.

Centralized milling facilities represent a smaller segment of the dental CAD/CAM market. Our infiniDent Service supports lab owners with a full range of material and restorative options. We believe that this will be a lower growth area serving the specialty end of the dental CAD/CAM market.

We find that lab owners do not want to fully remove themselves from the manufacturing value chain, but will turn to centralized manufacturers for highly specialized procedures. We estimate that less than 2 million CAD/CAM restorations are created in the centralized milling facilities each year.

The next component of the CAD/CAM market is materials. In conjunction with our partners we offer a broad range of CAD/CAM materials and we are also participating in the growth of this market with our own CEREC branded product. So in total we estimate that Sirona Systems manufacture about 7.5 million of the 12 million CAD/CAM restorations created each year.

As the dental CAD/CAM market develops, we expect to see an increase in the digital connection between dentists and their laboratories. With our CEREC Connect System, dentists can easily connect to the laboratory of their choice. While CEREC dentists can create most of their restorations chairside they now have the ability to utilize CEREC Connect for more complicated restoration such as large span bridge work.

Compared to taking physical impressions, CEREC Connect enhances the entire process and results in higher quality restorations, improved turnaround time and increased patients comfort.

Moving on, I am excited to tell you about three of our new product launches. In January, Sirona launched inEos Blue, latest technology in 3D dental scanning. inEos Blue allows dental technicians to quickly, precisely and easily scan dental models. The inEos Blue is built on Sirona's innovative Bluecam technology, which utilizes short wavelength visible blue light to facilitate flexible recording options resulting in substantially faster scanning and precise 3D digital models.

inEos Blue gives more control to the dental technicians to determine what they want to record, allowing them to process 3-D digital models with unprecedented precision and speed. The scanner can be utilized as a standalone unit or in combination with the in-lab milling unit for complete in-house production.

In addition, inEos Blue can export scans in STL file format, giving labs the flexibility to work with the files in third-party design software.

Also, in January, we launched our own line of titanium connectors that allow in-lab owners to create customized abutments. Our new software allows the technician to design a restoration and an abutment in a single step. This new method for creating custom zirconium oxide abutments is compatible with the leading implant brand.

Next, our SIROLaser Advance sub-tissue laser combines state-of-the-art laser technology with outstanding portability, ergonomics and user friendliness. The color touchscreen, clearly structured menus, and self-explanatory interface provides ideal basis for easy operation. The SIROLaser Advance enables clinicians to perform a multitude of sub tissue applications and it is an ideal compliment for dentists who own a CEREC system.

Sirona’s innovative products enable dental professionals to perform high-quality treatments and to increase the profitability of their practices. It is clear from our strong results that our innovative capabilities positively impacted our December quarter.

In addition to our unrelenting commitment to innovation, our first quarter results were also driven by several significant factors. Our strong global sales and service infrastructure, Sirona’s geographic diversification in over 130 countries, our best-in-class distribution network led by Patterson and Henry Schein, a strong financial foundation, and lastly, an outstanding effort from our employees.

In closing, I am confident that we are well-positioned to compete effectively in the markets we serve. We will continue to focus on making best-in-class innovative dental products that take dentistry to new heights. With that Simone and Jeffrey and I will now address your questions.

Question-and-Answer Session

Operator

(Operator instructions). Our first question comes from the line of John Kreger with William Blair. Please proceed.

Natalie Nadler – William Blair

Hi, guys, it’s Natalie Nadler [ph] in for John today. Just had a question on the macro environment level. Can you talk about the differences that you’re seeing between the U.S. and non-U.S. markets currently?

Jost Fischer

Absolutely, Natalie. We have seen when we look at the U.S. a slight improvement out there backed up by the recent shows from New York and from Boston. And we expect that also to continue into the Chicago mid winter time out there. Outside of the U.S. we have a different set-up. We still have challenges out in those countries that have been affected most by the economic downturn, such as Spain, Russia, South Korea, and they remain to be a challenge.

On the other hand, we see good performance in countries like Australia. Australia has been especially good, Germany, Japan. But please take into effect economy is only one factor for Sirona. We think that innovation can beat the cycle. With our product launches like the CEREC AC, et cetera, and the new launches that we just did we think dentists are looking at high-tech products that provide a return on investment for them and are much easier to convince to invest in those kind of products these days.

Natalie Nadler – William Blair

Okay, great. And then I was just hoping you could talk a little bit more about the market dynamics that you’re seeing on the imaging side. I think last quarter you guys talked about a challenging environment and I am just curious if you are seeing any improvement there.

Jost Fischer

Let me just say we are very happy about returning to positive growth in a record quarter for Sirona, but, maybe Jeffrey can give you a little bit of a color on where it happens and how things are looking.

Jeff Slovin

Absolutely. I think that, Natalie, we’re still in a challenging environment. We still see pricing pressure continue, which makes me so pleased that we were able to increase our gross profit margin by 120 basis points and I think that reflects our proposition and more dentists choosing to go 3D, as well as we saw some improvement in our sensor business, after being down for three quarters to have such a great up quarter was significant for us. And I would also add that the U.S. was a record quarter, so we felt good about that. I hope that gives you a little indication of what we’re seeing out there.

Natalie Nadler – William Blair

Yes, that’s great. Thanks very much.

Jost Fischer

Okay. Thank you, Natalie.

Operator

And our next question from the line of Larry Marsh with Barclays Capital. Please proceed.

Larry Marsh – Barclays Capital

Thanks, and good morning, everyone. And another very good result here. I guess I had three questions if I could to follow-up. First, given the strength of first quarter I understand it’s usually your best, but just in my model if you sort of update numbers I’m having a hard time getting, staying down at that sort of 170, 175 EBITDA level. So just maybe remind us.

I know, Simone, you talked a little bit about factors in the rest of the year, but what’s more specifically should we anticipate to cause a big drop in numbers relative to the first quarter? Is it going to be sort of on the gross margin line? Is it unusually large? You talked a little bit about SG&A so (inaudible) that’s going to really bump up a lot. So maybe just a little bit of elaboration just to frame your guidance given the strength of first quarter?

Simone Blank

Yes, good morning, Larry. If you look at our guidance and first of all, first quarter was exceptionally strong with 19.5% revenue growth and 51% NOI plus amortization and we announced today that we’re now guiding towards the upper end of our guidance range on the revenue side, the 4% to 6% on a constant currency basis. We guided you towards the upper end of that. And for OI plus amortization, we narrowed the range from 166 to 176 to now being 170 to 176. Having said that we’re still very early in the year. We’re still cautious about the economy and we still have like eight months to go, but clearly we are very happy with how the business is tracking to-date.

Please remember, we told you about the fiscal year 2010 quarterly progression. We expect financial year 2010 to show a different quarterly progression than last year with the first half will have higher growth and the second half will have lower growth. We face a relatively easy comp in the second quarter due to the impact of the IDS which was at the end of March 2009.

And as we move into the third quarter and fourth quarter we would see lower growth due to various factors. One of them being the timing of the IDS, the trade-up programs in the U.S. we had in place at the second half of last year and the AC launch are basically also impacting that quarterly progression.

And you asked about as SG&A. SG&A we expect as a percentage of sales in the fiscal year 2010 to be slightly lower than last year. We did very well in the first quarter, but remember this was an exceptionally strong revenue quarter so the ratios are obviously positively impacted by that. And our SG&A expenses relatively fixed. And as we move through the year we are going to invest in our infrastructure that’s in front of us.

Jost Fischer

And Larry, we are very early in the year. So still eight months to go.

Larry Marsh – Barclays Capital

Right. Okay. Great start. So, second question then just to elaborate I think in the imaging market. In your slides you talked about margin expansion obviously by mix so increased demand for the Galileos, but then you also talked about continued pricing pressure. So, could you elaborate on that and the magnitude of pricing pressure and where you’re seeing it? Because obviously it’s not reflected in your margin expansion.

Jeff Slovin

Right. I think that it is global, but more regions are more significant. One of the things that we have going on, Larry, is that we’re seeing that certain dentists are choosing to go 3D as opposed to 2D and we have a better gross profit margin there. And as we saw our sensors sales become more part of our mix that also improved the gross profit margin. We still see both on the 2D and the 3D in the U.S. and in Europe, and certainly in Asia, pressure on panoramic and on the 3D. Order of magnitude is around the same. We have seen it hasn’t accelerated but the pressure continues to be out there.

Larry Marsh – Barclays Capital

Okay. And then just are you in a position, Jost or Jeff, to talk about how much of your Galileo sales are being driven in conjunction with that integrated model with the CEREC given some of the capabilities, especially now in the implant market? And has the introduction of the software expansion in December help that or is that really not that big of an impact on your product sales, the GALAXIS software introduction?

Jost Fischer

Larry, our strategy to combine two of our best products, our CAD/CAM offering with CEREC and our 3D offerings with Galileos really helps. It’s understood in the market. Dentists are buying the arguments and certainly it drives our business to those general practitioners that want to do or do implant themselves. And we help them with our diagnostic capabilities of 3D with our best-in-class software for that and with our aesthetic solutions that our CAD/CAM systems provide. We help them to give more security and better planning onsite, do these things better and faster. So, I think that is a very significant factor.

And by the way, we just enlarged that with our titanium customized abutments that we offer. This is part of a larger program that we will put out there during the next years in order to enhance those offerings even further. And, yes, it has an impact on CEREC as well and as on 3D sales.

Jeff Slovin

If I could just add a little bit, I would say absolutely we see a benefit. We’ve seen that at a few of the 3D events that we’ve had. And Larry, when you think about our 27,000 installed base of CEREC that adds an added benefit to someone who has CEREC to go 3D. So, no question about it. The fact that we’re also the only company that has this out there makes our proposition unique.

Larry Marsh – Barclays Capital

Great. And then the final question just to – I think I asked this last quarter, I think you alluded to extending the relationship with Patterson on the intra-oral sensors last quarter. But are you confirming that? Is there any length associated with that or not commenting?

Jeff Slovin

We will be getting that done. We’re just finalizing some details. As you know, they’ve had some management transition and so it’s just taking a little bit longer but that contract will get completed.

Larry Marsh – Barclays Capital

Very good. Okay, let me stop here. Thanks.

Jost Fischer

Thank you, Larry.

Operator

Our next question comes from the line of Jeff Johnson with Robert Baird. Please proceed.

Jeff Johnson – Robert Baird

Thank you, guys. Good morning.

Jost Fischer

Good morning, Jeff.

Jeff Johnson – Robert Baird

Wondering first if we can focus on CAD/CAM here for a second. I know you don’t like to give too many details on AC upgrades in that, but can you talk maybe qualitatively about how much of this quarter’s performance was on the upgrade side versus just new system sales and growing demand for new systems?

Jost Fischer

Yes, the upgrade cycle is over. The lion share we did in Q3 and Q4 of last year. There was only just some few, very few items left in the October months where we finalized the upgrades.

Jeff Johnson – Robert Baird

Great. That’s helpful. Jost, and then you gave a number of 27,000 installed CEREC systems at this point. As recently as just the last quarter or two I think I heard a 25,000 number out of you. So is it fair to think of the installed base growing at kind of that upper single digit rate and can that continue going forward?

Jost Fischer

Jeff, we just updated our numbers in January to reflect the more recent number. But certainly 2,000 additional CERECs have been placed out there in the last area. That’s true. So we think we will grow forwards as we speak absolutely.

Jeff Johnson – Robert Baird

Good. So as we get that kind of volume growth on the new system sales, any reason to think pricing would change? I know there has obviously been a lot of promotional activity in the U.S., but even outside the U.S. I don’t think there has been as much. Is pricing going up at all or should we think of this as a pure volume growth going forward?

Jost Fischer

In some markets we have put up the prices as we do every January for that point we do not see pricing pressure similar to what we see in the imaging segment, no.

Jeff Johnson – Robert Baird

So blended basis, Jost, we should think of ASPs for CEREC on a blended worldwide basis up a bit this year?

Jost Fischer

Yes, that’s a little up, with roughly about $129,000 in the United States. And off of that usually you have a little bit of a promotion. The current promotion that is being offered is a $5,000 rebate by Patterson together with a three-month financing.

Jeff Johnson – Robert Baird

Right, right. Okay, great. Thanks. And then, Simone, just a couple of questions on the P&L. SG&A lower, your guidance or you’ve stated throughout the call you expect SG&A to be lower this year versus last. Just remind me that’s on an absolute dollar basis or on a percentage of sales basis?

Simone Blank

No, I said as a percentage of sales we expect it to be slightly lower than last year.

Jeff Johnson – Robert Baird

Got it. And then R&D this quarter obviously just a little lighter than maybe your longer-term guidance of that 6% to 7%. What maybe drove that?

Simone Blank

The R&D, first of all is driven by the timing of projects and we are ramping up some of our efforts. And bear in mind that we had a very high sales number so they’re relative, so the ratio doesn’t give you the full picture. But, Jost, you might want to add something to R&D?

Jost Fischer

Yes, certainly innovation is the hallmark of Sirona. And when you look at that we have over 200 scientists and engineers doing nothing, but trying to make a better product or a good product better or a new product. We’re adding people to our research and development departments and we’re working on new products. So as we ramp up those we will ramp up the costs. That is the usual pattern that we go through. Nothing unusual.

Jeff Johnson – Robert Baird

All right. Fair enough. And then just last question; we talked about this last quarter, but I just want to confirm again this quarter. The interest rate hedges, Simone, at this point you would expect those to expire in March when they do and just let all of the debt float back to floating rate or variable rate or how should we think about that?

Simone Blank

Yes, as we said last quarter, the second quarter we expect to be similar to the first quarter. After that our swaps roll off and then that could be a benefit of $2 million per quarter assuming that the interest rates remain where they currently are.

Jeff Johnson – Robert Baird

Okay. So that $2 million per quarter starting in fiscal Q3 that is assuming you flowed everything back down, I think, if my math is correct?

Simone Blank

Yes, correct.

Jeff Johnson – Robert Baird

Okay, great. Thanks, guys, that’s all I have.

Jost Fischer

All right. Thank you, Jeff.

Operator

And our next question comes from the line of Greg Brash with Sidoti & Co. Please proceed.

Greg Brash – Sidoti & Co.

Good morning, Jost and Simone. Thank you for taking my call.

Simone Blank

Good morning.

Jost Fischer

Good morning, Greg.

Greg Brash – Sidoti & Co.

On the gross margin side you did mention there was a regional mix added in the quarter. Doesn’t sound like that’s something or it may not be sustainable. How much do you think that added to the quarter, 100, 200 basis points?

Simone Blank

Yes, if you look at our margins you always have to think about it in a product and regional mix and that can vary and that can influence and has influenced the margins in every quarter we’ve reported. Our first quarter had very favorable both product and regional mix. And you heard us talk about the regions and you saw the U.S., you heard talk about Germany and other regions. And we do not expect this very favorable mix to continue, but for the full year, we anticipate some margin expansion, but not at the level of this first quarter.

Greg Brash – Sidoti & Co.

Okay. Fair enough. I know the upgrade cycle is over for the CEREC AC so when I think about gross margins on the CEREC is this sort of the levels, 69% a good way to look at it going forward or is there room for further improvement there?

Jost Fischer

Greg, when you look at that sequentially our margin is up as the upgrade cycle expires so 69% is a fair rate to look at.

Greg Brash – Sidoti & Co.

Okay. In this current promotion with Patterson, is there a time when that promotion ends?

Jeff Slovin

The promotion, the upgrade is over.

Greg Brash – Sidoti & Co.

No, I think you mentioned a –

Jost Fischer

$1,000 promotion –

Jeff Slovin

Yes, yes, through April (inaudible).

Greg Brash – Sidoti & Co.

Through April?

Jost Fischer

Yes.

Greg Brash – Sidoti & Co.

Okay. And then just one last for me, instruments were very strong in this quarter. Do think that’s a sign at all that basic equipment sales are improving that there is maybe some pent-up demand that came through this quarter?

Jost Fischer

No pent-up demand. We think we gained market share out there and we’re not looking for a real snap back on basic equipment, at least it’s not built in our forecast. We believe that dentists will continue to invest in high-tech dental equipment where they have a positive ROI. And we are not dependent on a real snap back in basic equipment here.

Greg Brash – Sidoti & Co.

Okay. Thank you.

Jost Fischer

Thank you, Greg.

Operator

And our next question comes from the line of Tycho Peterson with JP Morgan. Please proceed.

Abigail Darby – JP Morgan

Hi, this is actually Abigail Darby sitting in for Tycho today. Most of my questions have already been answered, but just wanted to follow-up on one point. So in your prepared remarks you mentioned reinvesting part of the restructuring savings into the sales and R&D infrastructure. Are there any specific initiatives you can point to or highlight that we should be aware of in the coming year?

Jost Fischer

No, I think very normal. We are continuing what we did in the last years, building our sales and service infrastructure in select markets and there is no change in our strategy and policy about that. We’re just going to continue to do that. And on the R&D side I mentioned we hired additional R&D engineers and scientists in order to better serve markets in that way. So I think that is nothing significant that changes in our strategy.

Abigail Darby – JP Morgan

Okay, great. Thanks very much.

Jost Fischer

Thank you.

Operator

And our next question comes from the line of Jonathan Block with SunTrust Robinson Humphrey. Please proceed.

Jonathan Block – SunTrust Robinson Humphrey

Thank you. Good morning.

Jost Fischer

Good morning, Jon.

Jonathan Block – SunTrust Robinson Humphrey

Really just a couple of questions. Maybe the first one is on the imaging segment. You mentioned that the pricing pressure continues, but yet your margins were strong and better sequentially. So maybe just some commentary around the pricing pressure specific to 2D, is that accelerating year-over-year, is it largely just unchanged? And then –

Jeff Slovin

2D and the price pressure has increased, but it hasn’t accelerated into the quarter. That was the point, but what we are really seeing is that we are less sales in the 2D and a shift to the 3D. And the 3D comes with a better gross profit margin and a pick up from our sensor sales. So when you look at the product mix within imaging it’s improved and also the regional mix has done well too with the record quarter we had in the U.S.

Jonathan Block – SunTrust Robinson Humphrey

That’s perfect. And actually that just sort of leads into my next question where I know you guys don’t break out all the detail, but just quantitatively could you maybe point us to where those 3D margins shake out relative to your total imaging, let’s call it, low 60s?

Jost Fischer

Yes, certainly 3D imaging is helping the margin.

Jonathan Block – SunTrust Robinson Humphrey

Okay. Nothing more than that.

Jeff Slovin

Yes, I think that we are pretty pleased with our low cost position in a number of our products and the margins that they bring. But, of course, high-tech product does bring higher margins.

Jonathan Block – SunTrust Robinson Humphrey

Fair enough. And then, Simone, maybe just one quick one on the P&L. You mentioned what happens to interest expense when those swaps roll off. But just maybe to scrub 2011, if you had to maybe refi at current rates do you know what that current rate would carry when we look out to 2011 roughly?

Simone Blank

That’s an interesting question. At the moment we are happy with the financing we have and with the structure we have and that’s continuing.

Jonathan Block – SunTrust Robinson Humphrey

Okay. Great. Thanks a lot, guys

Simone Blank

Thank you.

Jeff Slovin

Thank you, Jon.

.

Operator

And our next question comes from the line of Peter Bye with Jefferies & Co. Please proceed.

Peter Bye – Jefferies & Co.

Hey, thanks, guys. Just a couple quick follow-ups, most things have been asked. Just on the CAD/CAM and maybe what Jeff was trying to get to on the underlying growth rate of demand here, you are seeing anything new from your competitor there. And as you go deeper into penetration and these guys maybe aren’t as sophisticated at the earlier adoption guide (inaudible) do currently on the marketing, service support to get these guys up and running in the system?

Jost Fischer

Peter, just from our point of view we think with a penetration of something like 10% to 11% in the U.S. and a little bit higher in some other markets, but most markets are even lower. We think there is a lot of runway left for penetration from that point of view. And remember, we are a global company and we’ve had and will have competition, but we are the leader and we are very well-positioned for growth in this arena. While we don’t split up our segments by geography, I note that all the regions contributed to the growth. But the majority of our growth this time came from international markets.

Peter Bye – Jefferies & Co.

And then just a thought on as you go into (inaudible) technologically savvy positions, is that something that you might feel like you have to do differently to (inaudible) adoption as you go deeper into the penetration curve? (inaudible) what we have been doing (inaudible) going forward for the near-term?

Jost Fischer

Yes, going forward, innovation certainly helps driving penetration. We see that with our CEREC AC launch. We’ve seen that with our MC XL before and I think there is a number of things that we will focus on. Ease of use, new technology that will help us. I just want to remind you again, it’s only early part of penetration that we get into and we believe every dentist that does restorative work should have a CAD/CAM system in his office.

Peter Bye – Jefferies & Co.

Okay, great. Just one last (inaudible) any update on Japan, where you think you are momentum wise?

Jeff Slovin

I am sorry, Peter, you didn’t come in clear there. Did you ask where we are in terms of January or Japan?

Peter Bye – Jefferies & Co.

Japan, sorry.

Jost Fischer

Yes, okay. Japan is a very good market for Sirona also in the CAD/CAM side of it. A very nice growth rate. We’re still expecting to get the approval for AC unit which will come soon and that will be another growth driver going forward.

Peter Bye – Jefferies & Co.

All right, great. Thanks, guys. Hope to see you out in Chicago later this month.

Jost Fischer

Okay. See you in Chicago.

Operator

And our next question comes from the line of Ross Taylor with CL King. Please proceed.

Ross Taylor – CL King

Sure. Hi. I think most of the topics have been covered, but you did give out some statistics about kind of laboratory restorations. I just wondered how much of your CAD/CAM revenues currently come from the laboratory market or maybe you can quantify how important this segment is for your future growth?

Jost Fischer

Certainly, I think in my prepared remarks I gave you the order of magnitude for CAD/CAM, where we see the majority, the vast majority of those revenues come at our shared site systems. But lab has a significant contribution for us and on top, Ross, it is very important that our CEREC doctors meet the labs with our CEREC Connect at big numbers. So we believe we are the market leader in both segments, but Chairside is the larger piece of the cake.

Ross Taylor – CL King

Okay. And maybe last question related to that, what’s your penetration like in the U.S. lab market versus in some of the international markets?

Jost Fischer

The U.S. lab market is made up a little different because you have a lot of labs that are very small mom-and-pop shops. When you talk about the bigger labs, they are penetrated to a very large extent. So, we are talking over 50% here.

Ross Taylor – CL King

Okay. All right, that helps. Thanks very much.

Jost Fischer

Thank you.

Operator

And our next question comes from the line of Scott Green [ph] with Bank of America/Merrill Lynch. Please proceed.

Scott Green – Bank of America/Merrill Lynch

Hi, thanks for the question. Given the timing of the 510(k) clearance for Galileos implant late in the quarter in the U.S., how much do you think Galileos implant help sales for Galileos in the quarter? Or given that you have a string of dental symposiums lined up in the first half of 2010 do we see a lot of that initial benefit associated with the implant software here going forward?

Jost Fischer

I think it is a longer-term prospect here when we talk about our CEREC Galileos integration. And I think given the 510(k) is just one factor in that, I think telling the story, showing the product, and showing their abilities that’s something get in by, and by the way, Galileos is doing very well even without the 510(k). Jeff, is that correct?

Jeff Slovin

Absolutely right. I think, Jost, you hit it right on the head. It’s certainly a benefit. It’s early going and we have got a lot of room ahead of us with this integration proposal. And again, I would say that it’s unique because we are the only company that can do it

Scott Green – Bank of America/Merrill Lynch

Okay, great. And for the inEos Blue new product is there any sort of formal upgrade program or will that all just be new sales?

Jost Fischer

We do not have a formal upgrade program as of today, but certainly there will be one. As you know, we have a large installed base, but we rely that this product is the best-in-class out there. And we also think we can gain some market share with opening up with our SDL files to third-party software here.

Scott Green – Bank of America/Merrill Lynch

And how many inEos Blue users or legacy inEos product users do you have worldwide?

Jost Fischer

We have not discussed about that, but it’s a significant number, yes. Do not forget, the ASP is around about $20,000. It’s not anywhere close to our CEREC system when it comes down to revenue opportunity here.

Scott Green – Bank of America/Merrill Lynch

Great. And then one last question on Germany. Some better economic data points coming out of there and Germany dental reimbursement I think we’re up 2% or so for the next year, but I also recall that there was some accelerated pro rata depreciation stimulus at the beginning of the last year. So could you maybe weigh those pluses and minuses and where you think the Germany market shakes out going forward?

Jost Fischer

Yes, I think the accelerated depreciation is over a year now so therefore no additional impact from that point of view. It’s positive, but as Section 179, if you have before a number of time the impact diminishes. But generally, the economic climate in Germany is positive. Dentists are buying across the board and we see Germany being up in all of our categories. So, we are pretty happy with that. And from what we hear from our dealers I think this is going to continue.

Scott Green – Bank of America/Merrill Lynch

Okay, thank you.

Jost Fischer

Thank you

Operator

And our next question comes from the line of Derek Leckow with Barrington Research. Please proceed.

Derek Leckow – Barrington Research

Thank you. Good morning.

Jost Fischer

Good morning, Derek.

Derek Leckow – Barrington Research

Just have one final question here on your balance sheet. You’re obviously developing a nice cash balance. You talked about the improvement in your net debt level. Maybe give us a sense for where the net debt should be by the end of the year. And then as it relates to the possibility for acquisitions, do you guys currently at this point in the cycle see any attractive acquisition candidates out there?

Simone Blank

Certainly, we are pleased with the development of our cash and we have continued to put our priority on deleveraging and pay down our debt. And I think that what shows in the balance sheet. No question. With regards to cash flow for the year we’re targeting at least the level of last year so that we hope to end with a nice balance there. Jost, do you want to say something about acquisitions?

Jost Fischer

Absolutely. We have a four-fold acquisition strategy. As we have explained a number of times, we are very disciplined about that and early stagers and development stagers to help to get good product for Sirona out there is the thing we always do. But then there are consultation opportunities out there like we did with Schick. We certainly be willing to look at something if it presents itself out there. And the outer base, the larger ones are going within dental, but outside of our current product portfolio. We would consider that. But again, we are very disciplined. If there is something we will certainly analyze it.

Derek Leckow – Barrington Research

So just a follow up to that. If you were to make an acquisition that was somewhat dilutive, if it’s a development stage type company, would we then see a corresponding reduction perhaps in your overall R&D expenditure?

Jost Fischer

No dilutive acquisition, Derek.

Derek Leckow – Barrington Research

Okay. All right, thank you.

Jost Fischer

Thank you

Simone Blank

Thank you

Operator

And there are no further questions in queue at this time.

Jost Fischer

So thank you for joining us today for our first quarter call. I look forward to updating you on our next quarterly conference call. Thank you very much and have a nice day.

Operator

Thank you for your participation in today’s conference call. This concludes the presentation. You may now disconnect and everyone have a wonderful day.

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Source: Sirona Dental Systems, Inc. F1Q10 (Qtr End 12/31/09) Earnings Call Transcript
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