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Executives

Greg Serrao – Chairman, President and CEO

Breht Feigh – EVP, CFO and Treasurer

Analysts

Brooks O'Neil – Dougherty & Company

Graeme Rein – Bares Capital

Mitra Ramgopal – Sidoti

Alex Silverman – Special Situations Fund

Jeff Johnson – Robert W. Baird

Tyras Bookman – Park West

American Dental Partners, Inc. (ADPI) Q2 2010 Earnings Call Transcript July 27, 2010 9:00 AM ET

Operator

Good morning. Welcome to American Dental Partners reports second quarter and first half 2010 financial results conference call. All participants will be able to listen only until the question-and-answer session. (Operator instructions) I would now like to turn the call over to Mr. Greg Serrao. Sir, you may begin.

Greg Serrao

Thank you, Kathy. Good morning and thanks for joining us. I'm joined by Breht Feigh, the company's Chief Financial Officer, and Mark Vargo, the company's Chief Accounting Officer. I'd like to begin this conference call by reading a brief but important disclaimer. During the course of this conference call, we may make forward-looking statements regarding the future financial performance or business trends of American Dental Partners or other future events affecting the company within the meaning of the Private Securities Litigation Reform Act of 1995.

The words believe, expect, anticipate, project, intend and similar expressions among others identify forward-looking statements. We caution you that such statements are only predictions and that actual results might differ materially from those projected in the forward-looking statements.

Certain factors that might cause such a difference include among others the company's risks associated with overall and regional economic conditions, dependence up on affiliated practices, contracts the affiliated practices have with third-party payers, dependence upon service agreements, the impact of any termination or potential termination of such agreements, government regulation of the dental industry, and the company's acquisition and affiliation strategy.

For a detailed discussion of the factors that could cause such a difference and other risk factors and uncertainties that could materially affect the company's business and financial results, please refer to our annual report on Form 10-K and the quarterly reports on Form 10-Q filed with the Securities and Exchange Commission.

In our call today, we will discuss certain financial measures that are not in accordance with generally accepted accounting principles. Please see our press release, which is available on our website www.amdpi.com, for a presentation of the most comparable GAAP measures and a reconciliation of these non-GAAP measures.

Breht and I will discuss financial and operational highlights and then take questions from participants after our prepared remarks. Before turning the call over to Breht for the financial review, I would like to mention a few highlights as it was very (inaudible) quarter.

We refinanced our senior indebtedness on very favorable terms relative to our prior credit facility, as Breht will describe in greater detail later in his prepared remarks. We affiliated with Cincinnati Dental Services on June 1st, which expanded our presence in Cincinnati and Northern Kentucky.

The continued high level of unemployment continues to present revenue challenges to our affiliated dental groups. But despite a decline in same market revenue growth, we managed to grow earnings during the quarter. Excluding the one-time expenses associated with refinancing our indebtedness and the affiliation with Cincinnati Dental Services, earnings from operations increased 9.5% and net earnings increased 19.7% over the second quarter of 2009. And finally, we continued to expand Texas Tooth Doctor for Kids, completing two additional de novos during the quarter.

I will now turn the call over to Breht to discuss our financial results for the quarter.

Breht Feigh

Thanks, Greg. This morning we will be reviewing our second quarter results. I'd like to begin, as I always do, by referring to the table in the press release entitled Patient Revenue and Same Market Patient Revenue Growth. Patient Revenue with affiliated practices increased 4.5% from $111.9 million in the second quarter from $107.0 million in the same period last year, driven largely by the Christie Dental and Cincinnati Dental platform affiliations.

Same market patient revenue growth by contrast decreased 2.1% year-over-year. In calculating same market patient revenue growth, we exclude the contribution of new platform affiliations completed in either period of comparison. As a result, we are comparing like-for-like platform affiliates.

The components of same market growth for the quarter were 2.3% fewer provider hours, 1.9% improvement in productivity per hour, offset by 1.8% deterioration due to reimbursement rates. This was another quarter in which productivity per hour increased less than the blended full fee increase of our affiliated dental groups, thus indicating a drop in real productivity per hour. Greg will provide comments on continuing revenue softness during his prepared remarks.

Beginning last quarter, we are now providing an additional table entitled Components of Same Market Patient Revenue Growth, which breaks down same market growth into existing practices, de novo or newly constructed practices, expanded or relocated practices, and acquired practices. We have added this information given the increasing number of de novo facilities we are developing. The last three categories of the table require capital investment while the existing practices require no capital investment beyond maintenance capital expenditures.

Excluding the contribution of end market practice acquisitions to our platform affiliates, same market patient revenue declined 2.4% year-over-year in the second quarter. Excluding the facilities that received capital investment during the quarter, existing practices experienced a negative growth of 3.2%, which is a slight improvement from the first quarter of this year.

On our prior earnings call, we also began sharing revenue mix with the affiliated practices rather than disclosing this information in our Form 10-Q and 10-K. During the quarter, fee-for-service and indemnity plans represented 16% of patient revenue; PPO and dental referral plans represented 73%; managed care plans, including patient co-pays, represented 6%; and Medicaid plans represented 5%.

I would now like to discuss the year-over-year comparison of our second quarter GAAP financial results. Net revenue for the quarter was $72.4 million as compared to $70.4 million, a 2.8% increase from the prior year. The increase was primarily the result of the revenue contribution from Christie Dental and Cincinnati Dental.

Salaries and benefits decreased 3.6% from the prior year's quarter to $28.7 million. As a percentage of net revenue, this expense decreased 270 basis points to 39.7%, largely due to tow factors. First, our ongoing efforts to manage staffing levels and compensation; and second, the affiliation with Christie Dental, in which the affiliated practice rather than American Dental Partners employs the dental assistants and on dental hygienist.

Lab fees and dental supply costs increased 3.4% from the prior year's quarter to $10.7 million or 14.7% of net revenue, which is consistent with the prior year’s quarter as a percentage of net revenue. Office occupancy expenses increased 6.9% to $9.1 million. As a percentage of net revenue, this expense increased 50 basis points to 12.6%, of which 30 basis points were attributable to the affiliation with Christie Dental and the remainder is associated with the de novo practice development at Texas’ Tooth Doctor for Kids.

Other operating expenses increased 18.9% to $6.9 million. As a percentage of net revenue, this expense increased 130 basis points to 9.5%, of which 60 basis points were attributable to the affiliation with Christie Dental. The remainder was increased marketing cost with several affiliated dental groups and one-time professional fees.

General corporate expense increased 10.1% to $3.7 million or 5.1% of net revenue, a 30 basis point increase from the same period last year. The 30 basis point increase was primarily the result of professional fees associated with the Cincinnati Dental Services affiliation of $204,000.

Depreciation expense increased 6% to $2.9 million or 4% of net revenue, a 10 basis point increase from the same period last year. The 10 basis point increase was the result of the Christie Dental affiliation. Amortization expense increased 1.7% to $2.5 million or 3.4% of net revenue, which is consistent with prior year’s quarter as a percent of net revenue.

As a result of the preceding items, earnings before interests, taxes, depreciation and amortization increased 5.6% year-over-year to $13.3 million, and earnings from operations increased 6.8% to $8 million. It is important to note that we had a very tough profitability comparison this year, as last year’s second quarter EBITDA and EFO increased 19% and 33% respectively.

Interest expense increased 25% to $2.7 million. Included in this was a one-time write-off of $615,000 of previously capitalized bank fees associated with our prior credit agreement. Excluding the write-off of these deferred financing fees, interest expense decreased 3% for the quarter. For informational purposes, in future quarters, amortization of capitalized bank fees will amount to $375,000 per quarter.

Our effective income tax rate increased to 39.8% of earnings before income taxes from 39.7%, an increase sequentially from 39.1%. We are currently expecting our effective tax rate for the full year to be approximately 39.5%.

Non-controlling interest, which represents the minority ownership in Arizona’s Tooth Doctor for Kids, decreased 76% to $39,000. This decrease was due to three factors. A reduction in Arizona’s Medicaid reimbursement rates last October; a changing case mix, which is impacting revenue and profitability, as Greg will discuss in a bit more detail later in the call; and we increased our ownership in Arizona’s Tooth Doctor from 85% to 94% at the beginning of the quarter.

Net earnings increased 3%. Excluding the $615,000 write-off of deferred financing fees and $204,000 of professional fees related to the Cincinnati Dental affiliation, net earnings improved by 20%. Diluted earnings per share were $0.19 for the quarter. And excluding the write-off of deferred financing fees and professional fees related to Cincinnati Dental affiliation were $0.22 compared to $0.23 during the same quarter of last year. Diluted cash earnings per share, adding back the after-tax impact of service agreement amortization expense, were $0.29, and again, excluding the write-off of deferred financing fees and professional fees, were $0.32 compared to $0.33 during the same period last year.

I would now like to review cash flow activities for the quarter. Cash flow from operations was $10.0 million for the quarter as compared to $14.3 million for the same period last year. Last year’s cash flow benefited from accounts receivable management by $3.1 million as compared to $923,000 this year. Days sales outstanding of affiliated practices decreased from 35 days to 30 days during last year’s second quarter, which is a tough comparison for this year. Days sales outstanding stood at 26 days at quarter-end this year, which was flat with the end of last quarter.

Cash taxes paid also negatively affected the comparison, as we had a $3 million increase in tax payments relative to the same quarter last year. Last year’s 2009 tax payments benefited from a tax overpayment in 2008, which was applied in 2009.

Capital expenditures were $2.1 million for the quarter. Maintenance capital expenditures were $800,000. This includes not only our ongoing maintenance investments, but also the implementation of Improvis’s electronic dental record at four dental facilities during the quarter. Non-recurring or growth capital expenditures were $1.3 million. During the quarter, we completed two de novo facilities for Texas Tooth Doctor for Kids.

I would now like to make a few comments on our capital structure. Our debt-to-total-capitalization was 36% at the end of the second quarter, which is down from 43% at the end of last year’s second quarter, but slightly up from this year’s first quarter as a result of the Cincinnati Dental affiliation. We have been able to remain comfortably below our 40% long-term target for several quarters while continuing to invest in both affiliations and capital expenditures. Our debt-to-EBITDA for bank covenant compliance purposes was 2.1 times at the end of the second quarter.

We shared during the last quarter’s call that the pro rate bank markets had improved markedly and we have launched a refinancing of our senior indebtedness. We were pleased to announce in early May a successful refinancing of our existing credit facility. We were able to extend the maturity and upsized the capacity of the facilities to four years and $180 million from three years and $130 million.

We achieved a number of additional improvements, including an elimination of the 2% LIBOR floor in the prior facility as well as tighter spreads over LIBOR and increased leverage covenants. So, as an example, at current leverage and LIBOR, we will borrow on the unhedged portion of our borrowings at less than 3.75% as compared to 8.0% with the prior facility.

We also announced during the quarter a $10 million share repurchase program and evaluating our investment requirements and opportunities over the next few years and the expected returns on these investment opportunities. The returns achieved on opportunistically repurchasing our common stock at current share prices would prove attractive. I should stress though that this in no way should be interpreted that we will reducing the reinvestment in our business.

We will continue to invest in de novo practices, end market practice acquisitions, and platform affiliations. We also intend to continue our reinvestment in existing operations, particularly with the digital imaging and electronic dental record initiatives, which we have discussed previously. Based on our internal projection, we can make these investments and repurchase shares, yet maintain the prudent leverage levels and borrowing covenants.

I'll now turn the call back to Greg to conclude today's prepared remarks.

Greg Serrao

Thank you, Breht. I would like to cover a number of topics before opening the call to questions this morning. During the quarter, we announced the Western New York Dental Group achieved accreditation from the Accreditation Association for Ambulatory Health Care. This is the third time that Western New York Dental Group has achieved accreditation status with the AAAHC. We are proud that Western New York Dental Group remains committed to a submission of improving the oral health of the Buffalo and Rochester, New York communities and that the AAAHC once again recognized this commitment.

Effective June 1st, we affiliated with Cincinnati Dental Services. Cincinnati Dental is a six-location dental group in the metropolitan Cincinnati in North Kentucky marketplace and generates about $19 million of patient revenue annually. Our relationship with Cincinnati Dental dates back to 1997 and that was 13 years in the making. We are on at the Cincinnati Dental choice of affiliate with American Dental Partners, and we look forward to working with the doctor group to grow the practice.

The integration of American Dental Partners and Christie Dental continues to proceed well. On the IT front, we implemented Improvis's core scheduling and billing systems and the electronic dental record on May 1st at all 25 Christie Dental facilities. We also implemented our orthodontic practice management system at those Christie Dental practices that provide orthodontic care.

During last quarter’s call, we also commented on developments in Arizona’s Medicaid programs and the potential impact on Arizona’s Tooth Doctor for Kids. There have been a number of positive developments since the last earnings call. Voters approve the referendum to increased Arizona sales tax, thus negating a proposed 10% rate reduction built into the state’s fiscal budget for later this year. And the state has also reinstated its Child Health Insurance Plan program.

There is still the 5% rate reduction pending for this October that we have to contain with. Our team has been meeting with the managed care organizations that manage access, and we are having productive discussions. We believe we have been able to demonstrate the strength of Arizona’s Tooth Doctor and the benefits they provide to the community and to access. So far, two of the major payers representing 24% of Arizona’s Tooth Doctor’s revenue have agreed not to pass on any further rate reductions for two years.

I’d also like to briefly comment on patient trends the group is observing. Arizona’s Tooth Doctor has experienced nearly a 4% increase in daily patient visits this year. However, we have seen a marked change in the dental needs of these patients and that the acuity of care provided has declined since last year.

We speculate these divergent trends between visits and maturity are being driven by a newly eligible Medicaid patient population that is in a better state of oral health and immigration trends in Arizona, which are resulting in decreasing visits by patients with greater dental needs. We estimate acuity mix has negatively affected patient revenue by approximately $650,000 during the first half of 2010 relative to 2009.

We continue to make progress growing Texas’ Tooth Doctor for Kids, a pediatric Medicaid business in Texas. Comparing the second quarter of 2010 to the first quarter of 2010 and looking at the three factors that were operating during both periods, EBITDA was a negative $52,000 in Q2 versus negative $194,000 in Q1, a marked improvement. In fact, one of the practices is now EBITDA positive and two practices have positive earnings from operations in June.

During the quarter, we completed two additional de novos in the Houston area. We anticipate opening two de novos in the third quarter and two de novos in the fourth quarter. This would bring the total to seven de novos completed in 2010 and nine total practice locations in Texas. We are currently projecting patient revenue for 2010 of approximately $4 million, an EBITDA loss of $1.2 million, and an earnings from operation loss of $1.7 million.

It is evident that the current economic crisis and more specific with the high level of unemployment are adversely impacting the industry. The loss of jobs resulted in loss in benefits and income, both of which adversely impact revenue in dentistry. Realistically until the level of unemployment begins to improve and consumers begin to spend, we will be challenged to achieve the same market revenue growth rates we have historically achieved.

On the bright side, affiliates representing 42.2% of our AGR had positive year-over-year same market revenue growth in Q2 versus 36.2% in Q1. In addition, in the 48 metropolitan statistical areas that we track with respect to employment data, the aggregate unemployment rate improved from 9.8% in March to 9.0% in May, the last month this data is available.

Turning to the acquisition and affiliation front, our balance sheet is well positioned to take advantage of opportunities as they arise or as we uncover them. We have historically completed one to two platform affiliations annually. With Christie Dental completed in December and Cincinnati Dental completed in June, we are back on that pace. We continue to see robust activity in our corporate development pipeline, particularly as it relates to roll-in acquisitions.

Before opening the call for questions, I’d like to conclude by thanking our team members and affiliated dentists for their commitment and professionalism through very challenging times. We should all be proud of the financial results that we continue to achieve.

With that, Kathy, we would like to now open the call up to questions from the participants.

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Our first question comes from Brooks O'Neil from Dougherty & Company.

Brooks O'Neil – Dougherty & Company

Congratulations on a strong quarter. I have a couple questions. I guess the first is, in recent quarters, you’ve been willing to give us some detail on how the quarter unfolded on a month-by-month basis, and I would love to get any color you could offer like that, including perhaps what you might be seeing so far in July.

Greg Serrao

I would say, Brooks, consistent with what we’ve talked about in, I think, the last couple of quarters, the market seems very, very choppy. So we had a particularly weak May and a particularly strong June. June, in fact, with all of the focus over the last – or I guess since the economic crisis in particular started focus on managing the costs. The strong revenue in June actually contributed significantly to contribution margin, which is great. So you see the leverage when the revenue returns to hopefully when they return to the level that we’ve seen historically. So, still very choppy or lumpy. From month-to-month, it’s hard to predict. July looked for us like every July won’t ever be like June due to the significant vacation time that occurs both with the patient population and with the doctor population. But we are anticipating that we will have over the third and fourth quarter as many if not more doctor hours as we had in the same quarters of the prior year. And if that happens, obviously that’s a positive thing for revenue.

Brooks O'Neil – Dougherty & Company

Are you seeing at this point any signs? Obviously, if I understand it correctly, so far this year hygiene activity is strong, but some of your more higher end services provided by the doctors have been a little soft. Have you seen any change in that? It sounds like obviously in some of your markets you are seeing a little bit of encouraging trend.

Greg Serrao

I would say, not really a change, still the patient decisions to try to find the least costly treatment option or to forego treatment if they can still.

Brooks O'Neil – Dougherty & Company

All right. And then the last question I’d ask – and by the way, I appreciate all the incremental detail in the tables as well as in your commentary. That was very helpful. I’m just curious how you are thinking about the Tooth Doctor business. You provided that detail on your expectation for the impact in 2010. Do you think you will continue to make that level of investment and have that kind of impact on profitability in 2011, or do you think there might be some incremental improvement next year?

Greg Serrao

So Tooth Doctor, you are talking about outside of Arizona?

Brooks O'Neil – Dougherty & Company

Yes. Obviously, if I understood it correctly, you are talking about $4 million of revenue and $1.2 million negative EBITDA impact for the year.

Greg Serrao

Yes.

Brooks O'Neil – Dougherty & Company

And I was just curious how you might – obviously it’s early in those latter moving parts, but just how you’re thinking about it for next year.

Greg Serrao

I guess how I would answer this Brooks is that I’m very bullish on this business. And I’m thinking about from the macro trends, with one out of three children born in this country, either into a Medicaid eligible or SCHIP eligible family. And that number not changing. In fact, if anything, it will be one out of 2.7 or one out of 2.8. There is going to be a very large population. It’s already 34 million, I believe, eligible children in this country, and that’s going to continue to grow. The demand for care and the need for care will be there. We have witnessed that in Texas. Every practice we’ve opened has shown a significant ramp-up in revenue.

And when I see the trends that we’re seeing now with the practices that we opened originally meaning the San Antonio practices now turning the corner to profitability in a relatively quick timeframe and the practices in Houston showing a strong revenue ramp, maybe even stronger than San Antonio, I want to accelerate the openings, to be quite honest. And I think we’ve also learned, I mean, which is always the case, every time we do – the first and fabulous [ph] conversion we did was never as good as the last one, as we’ve learned along the way. And I think the same thing going into Houston, or I should say, Texas. We are learning along the way and with the success of practice opening, I think we’re more successful more quickly. So I would say 2011, at least the same as 2010, if not more. And there is tremendous interest at the board level for us to accelerate the growth of this business.

Brooks O'Neil – Dougherty & Company

That’s great. I guess I just have one last question. I apologize for keeping on. But does anything about what you’ve seen in Arizona, either from the legislator perspective or from the case mix perspective you mentioned, give you any pause about further development of the Medicaid business? Or is it just part of the learning process and part of what you need to adapt to grow the business over time?

Greg Serrao

I think one of the things that we are learning, we’ve been since that last quarter’s call, I think, we’ve worked very diligently with the managed care players in Arizona to understand our business. And probably should have done this earlier, candidly. I don’t think they were able to differentiate Arizona’s Tooth Doctor for Kids from other people that do what we do. I’d just give you for example one managed care player. We estimate that we save them over $2 million by treating the patients that we treat with IV sedation in our practices versus sending them to the hospital. That’s our estimate. Their dental director’s estimate was – probably that was on the conservative side. So I think we are able to show them that we are bringing tremendous value not only to the patients but to them, managing the program, which is why I think we are seeing at least so far the two agree not to further rate reductions. And I think we also have to educate the state on the programs that we are doing, which we are doing now in Arizona.

And so our learning is, get in early in Texas to make sure enough. In Texas, the state doesn’t, at least to date, use managed care companies to manage their Medicaid programs. So frankly, our educational process will be even easier, as we just have to educate the state and the state dental director. We do anticipate in the next quarter that our Texas’ Tooth Doctor for Kids in Texas. I guess that was redundant. Sorry. But that will be accredited. Yes. And we are finding that the accreditation is much more meaningful when you are dealing with state agencies than it is when you are dealing with commercial insurers. They put a much higher value on the accreditation, and of course, the accreditation is the hallmark of American Dental Partners. But in Arizona, we are the only accredited dental group practice, both on our traditional business but on the Medicaid side, which is an important differentiator.

Brooks O'Neil – Dougherty & Company

Well, that’s great. All right. Thanks a lot for all that information.

Greg Serrao

You’re welcome.

Operator

Our next question comes from Graeme Rein, Bares Capital.

Graeme Rein – Bares Capital

Good morning. Greg, I was hoping you could talk a little bit more about the Cincinnati Dental deal, what you saw there, sort of how profitable they are, how they stack up sort of to the rest of your affiliations in terms of profitability, and how quickly you can sort of get them to where you like them to be from that perspective.

Greg Serrao

Okay. From a metropolitan statistical area, if you go back to the family of American Dental Partners, one of the cornerstones is for us to identify metropolitan statistical areas that we find attractive that we’d like to operate in. And Cincinnati, and frankly there is a number of MSAs in Ohio, but Cincinnati in particular ranked very high on our geographic list. The Cincinnati marketplace is a very strong economic environment. You have a couple of large colleges like the University of Cincinnati. There is every university. Of course, you have a very large corporate presence there, the biggest being Procter & Gamble. So it’s got a vibrant economic aspect to the community. We’ve identified a number of dental groups in Cincinnati. None met the quality standards of Cincinnati Dental.

So we pursued them for a number of years. We’ve watched them over the last 13 years grow from – I believe, it was two practices when we first met them to the six that they currently have. So they have demonstrated as a team their ability to open on a de novo basis new practices and grow those practices, focused on group practice much the same way we are. We believe we have some tremendous opportunities to bring value there in terms of the hygiene programs and specialty services. We think there is a lot of growth opportunity in the Northern Kentucky market in particular. So – and the people are terrific. I mean, for 13 years, we’ve built the relationship and got to know how we sink up in terms of values and the way we look at the dental business.

Graeme Rein – Bares Capital

Okay. And in terms of profitability, how do they stack up relative to your other affiliations?

Greg Serrao

I think their average profitability could be better, hopefully will be better. But they have done a very nice job on their own running a profitable business.

Graeme Rein – Bares Capital

Okay. And sort of how many of these do you have in the pipeline? And it sounds like you’ve had this relationship for a while. Can you just give us a sense for – absent any sort of capital constraints, how many of these are sort of sitting in front of you at this point?

Greg Serrao

Well, we look at the pipeline – and really two pipelines, the roll-in and the platforms like Cincinnati. We are – I think you could just look at Christie being done in December and now Cincinnati in June to show that the platform affiliation activity is picking up. I won’t say the number, but there are a number of other platform opportunities where we are reviewing data, which is a long way from actually consummating a transaction. But there are platforms in the pipeline. And then the roll-in activity is just incredibly strong at the moment. And on top of it we’ll close a number of roll-in transactions between here and the end of the year.

Graeme Rein – Bares Capital

Okay, great. And then, have you guys repurchased any shares since the quarter-end?

Greg Serrao

Since the quarter-end, no.

Breht Feigh

No.

Graeme Rein – Bares Capital

Okay. Thanks a lot.

Operator

Our next question comes from Mitra Ramgopal from Sidoti.

Mitra Ramgopal – Sidoti

Hi, good morning, guys. First, just starting off, we saw nice improvement in margins. And I was wondering if you can maybe give us a sense of some of the things that you might be doing a little differently that resulted in the improvement.

Greg Serrao

Well, I think it’s the same thing, the same trends that we’re seeing, Mitra. So one thing to consider in margin improvement at least over the last – certainly beginning in – well, I shouldn’t say beginning, but really accelerating in ’09 and into ’10 is that Metro Dentalcare. So we have significantly improved their operating margins since they affiliated with us, with a lot of that margin improvement beginning in the third and fourth quarter of 2009 and continuing into 2010. So that would be, I would say, an affiliate-specific improvement on margins. I’ll tell you, across the board, managing in this economic environment, trying to manage the schedules more tightly and which might lead to less provider hours, meaning less doctor hours and then less bedtime [ph], which managing the costs when you then have a month like we had in June where revenue was very strong, is a significant flow-through to the contribution margin line.

And I think on the hygiene side, not only had we improved productivity per hour over the last couple of years rather significantly, but we have switched the compensation methodology at most of our dental groups. We have more to go from a per-hour basis to a percentage of collections, which has improved the yield in hygiene. So this could be very significant where you can see a drop from – if you look at hygiene compensation, the hygiene AGR on a per-hour basis, maybe that’s 45%. That could drop to as low as 36% to 38% and you get our second highest labor cost in the practices. So that’s a significant improvement.

Mitra Ramgopal – Sidoti

Okay, thanks. And again, you talked about the economy continuing to have an impact on the business. Is there anything on the competitive side that’s also might be pressuring you?

Greg Serrao

No. I don’t see that at all. And then we’re seeing the economy mixing around a bit. So we’re seeing trends a bit. I think I mentioned this in the last call, but places that didn’t really see an economic impact in ’09 are beginning to see it in 2010, there is no doubt related to the job losses in their communities. And we are seeing some – like I said, some improvements in unemployment rates. And hopefully we’re knocking on wood and some markets have seen a bottoming out. So for instance, on the West Coast, we saw actually in June year-over-year revenue improvement. Not much, but at least it went positive from negative.

Mitra Ramgopal – Sidoti

Okay. Thanks. And then finally, just more of a big picture question, again, and it focuses on the expansion into the pediatric Medicaid business. The one thing we hear, are you getting a sense of some of the number of states that they can barely afford to matching dollars in terms of Medicaid programs? Is that something of a concern for you as you look to be more aggressive in this area?

Greg Serrao

Yes, I mean, short-term though. I mean, in other words, we – it's hard not to say it would be a concern when you witness what Arizona did. It’s obvious that the states are having financial difficulties. But they are still going to have to grapple with – particularly after healthcare law was approved, they’re still going to have to grapple with the fact that there are 34 million kids and more that are going to need access to care. And I think we have proven we can provide that care in a cost-effective manner. And our feeling is that there will be bumps along the way and reimbursement, but there will also be improvements. I mean, three years ago, I believe, ’06 or ’07 – '07, Arizona increased Medicaid reimbursement 6%. So that’s kind of 5% last year. So you’re still in that 1% ahead if you look at it that way. So I think there will be ebbs and flows on the reimbursement, but there is going to be tremendous pressure to make sure that these kids get access to care.

Mitra Ramgopal – Sidoti

Okay. Thanks. And finally, again, as you look to add more affiliates or de novos etc., is the cost of maybe doing some of these transactions or opening new facilities, are you able to do it a little cheaper now in light of the environment?

Greg Serrao

No, not on the platform side. On the roll-ins, I think those are where we generally get the best going in multiples. And then on opening on facilities, no, I don’t think that we’re seeing any – maybe we might witness or experience some lower rents than we would have witnessed before, but that’s not really that meaningful.

Mitra Ramgopal – Sidoti

Okay. Thanks again.

Greg Serrao

Next call – next question. Kathy?

Operator

Our next question comes from Jeff Johnson, Robert W. Baird. Please check your mute button. Okay. We’ll go to the next question. Alex Silverman, Special Situations Fund. You may ask your question.

Alex Silverman – Special Situations Fund

Good morning.

Greg Serrao

Good morning.

Alex Silverman – Special Situations Fund

Good morning. Can you give us a sense of what same market census growth or decline has been, sort of as a forward indicator for what business might look like when the unemployment rate comes down?

Greg Serrao

I’m not sure I understand the question.

Alex Silverman – Special Situations Fund

Well, in terms of the growth in patient census, the number of patients you guys are serving, has it stayed the same during all of this? Have you grown it?

Breht Feigh

The way we measure active patients, Alex, as we look at whether the patient has been in the last two years to little bit of a – I don’t know if you call a lag indicator or other thing that we look at our patients appointments per day and appointment bookings per day. That’s been kind of – it's interesting. It’s variable almost day-to-day. We get a daily report of patient visits, and we can go through a stretch of five-day straight of very strong patient visits and also very strong patient bookings. And then we’ll go through couple of weeks of softness. So we don’t look at a statistic like the way you are asking maybe like the hospital might, but it’s variable.

Alex Silverman – Special Situations Fund

Okay. Fair enough. Thank you.

Operator

(Operator instructions) Our next question comes from Jason Bednar from Robert W. Baird.

Jeff Johnson – Robert W. Baird

Hey, guys. Can you hear me okay?

Breht Feigh

There you go.

Greg Serrao

We hear you.

Jeff Johnson – Robert W. Baird

All right. Sorry. And this is Jeff Johnson. I’m on Jason’s phone. I’m having major technical difficulties today, so apologies. So Greg, I guess just want to start with you. You talked about June trends being up, July obviously nobody ever expects July to be strong relative to June. But any sense on where July is maybe on a year-over-year basis? Is that looking weak, strong, just kind of could you qualify that at all?

Greg Serrao

I would say generally positive.

Jeff Johnson – Robert W. Baird

Generally positive, yes. All right.

Greg Serrao

Yes. And I say it hesitating like that because I looked at the data a couple of days ago. I noticed it was mixed, but I was particularly looking at some of the bigger affiliates in there. I think those are positive. So I’d take generally positive.

Jeff Johnson – Robert W. Baird

Okay. And you talked about some changing trends by geographic region. I’m assuming maybe if West Coast sounds like it may be bouncing back a little bit, but still Southeast is still weak. Just the Christie revenue number seems to be coming in a little light of where we expected. I’d assume that’s one of those areas maybe just being hit the hardest at this point.

Greg Serrao

I would say Christie is – the unemployment rates in that part of Florida are difficult. I would say the aggressive approach that we took to conversion, we have never converted an affiliate to the ADP systems, and I mean not just Improvis, but everything. I mean, most of their lab work now goes to occidental lab. We can go on and on with all of the changes that they have made. We did those rather aggressively. And I think there was some disruption to their ability to schedule patients, street patients when their front office staff is out being trained on Improvis and working through all this integration. So I think some of it is economic and some of it will chalk up to the conversion.

Jeff Johnson – Robert W. Baird

Okay. And so that’s – are we maybe in the latter stages of the company-induced portion and the economy will just have to wait on kind of thing?

Greg Serrao

Yes. The company-induced stuff is done. The major piece of their integration are done, which is a positive thing obviously.

Jeff Johnson – Robert W. Baird

Okay, great. And then just on the Medicaid side, you gave the first half numbers, kind of the changing mix. And I think you quantified at $600,000 to $650,000 impact there. How long have you been seeing that? Has that just been a two-quarter impact or we have few quarters into that?

Greg Serrao

I would say we heard it anecdotally from the team there in late ’09, but did understand what that meant (inaudible) digging in. And I think we are seeing – first of all, more people are eligible for Medicaid in most states now because of the unemployment levels. So people who are Medicaid eligible are now Medicaid eligible. We are seeing that they tend to have had a better oral healthcare. And then this immigration law that’s in Arizona that’s so controversial has definitely impacted – well, not just our business, but you can just Google Star Tribune in Arizona and there is an article. That’s an article from retailers who are complaining that people are leaving the state because – and we are seeing that, no doubt, in the practices as well. So it seems like those with the highest need for care are leaving, and the people entering the system don’t quite have the same level of need.

Jeff Johnson – Robert W. Baird

Yes. No, understood. So if I look just quarter, the Tooth Doctor business was down 10%. We drove 5% reimbursement rate cut in somewhere in the neighborhood of 5%. It was the change in mix on a go-forward basis. Is that how it should be? And then once we get maybe to the October to follow up a little bit from there, do we start anniversarying some of the mix issues, so kind of down 10% is where your expectations are over the next maybe six to 12 months for that business?

Greg Serrao

I don’t know how to predict the acuity piece. I don’t know if these trends are going to continue in terms of who comes into the system and people – these people are leaving the state are leaving the state for good or – I don’t know how that’s – how to predict that, if that’s the question.

Jeff Johnson – Robert W. Baird

Yes. No, that’s fair. That’s fair. So some wiggle room in there I guess. So Breht, last two questions I have, just purely from a modeling standpoint, if I ex out the debt write-off costs, it looks like you are interest expense was lower even than I was looking. What should that be trending on a go-forward basis over the next few quarters?

Breht Feigh

LIBOR plus three in a quarter, whatever debt that you have in your model. $20 million of our debt remains hedged at 5%.

Jeff Johnson – Robert W. Baird

Right, and then –

Breht Feigh

Plus the spread. So that will kind of remain over 8% till February of 2012 I think is the date.

Jeff Johnson – Robert W. Baird

Yes. And then we’ve got just the $300,000 of amortization expense, right?

Breht Feigh

Yes.

Jeff Johnson – Robert W. Baird

Okay, okay. And then just kind of a detailed modeling question, I’m just not sure where – now that some of those Texas practices have been open for more than a year, where do the revenues from those practices start to fall in your disclosure page? Did that go into then just end market growth?

Breht Feigh

Yes.

Jeff Johnson – Robert W. Baird

Okay. And so if it’s open less than a year, it’s in the de novo part of the disclosure, otherwise it’s in the end market?

Breht Feigh

Correct.

Jeff Johnson – Robert W. Baird

Okay. Got it. That’s helpful. Thanks.

Breht Feigh

Thank you.

Operator

The next question comes from Tyras Bookman from Park West.

Tyras Bookman – Park West

Hi.

Greg Serrao

Hi.

Tyras Bookman – Park West

I might have missed it, but what did you guys say the margin was on the business that you bought in Cincinnati?

Greg Serrao

We didn’t. We just said it’s average for margins on relative – if you look at it relative to other businesses we acquire, it’s kind of at the average rate.

Tyras Bookman – Park West

So is that normally better or worse than your company margins?

Greg Serrao

Worse.

Tyras Bookman – Park West

And you paid $18 million for this business?

Greg Serrao

Yes.

Tyras Bookman – Park West

Okay. And so, are the growth prospects better than your current business?

Greg Serrao

Are the growth prospects better than our current business? No, it’s a great geographic area. I think there is great opportunity. I’m not sure if I understand –

Tyras Bookman – Park West

I’m just wondering if you guys expected to grow faster than the rest of your business.

Breht Feigh

That’s an interesting question, Tyr [ph]. I mean, I look at Cincinnati like Milwaukee or Buffalo where you think when we first get going in Milwaukee, it was what, a $12 million down group. And now we do between forward ADS and it would be probably to $65 million a year. Buffalo, when we went into Buffalo, that was $2.8 million a year. We’re now $40 million a year. And you look at both of those groups, particularly the group in Buffalo, they virtually had no specialty services or specialty care. So you look at Cincinnati and you say, does it have tremendous growth opportunity? Absolutely. Does that mean though that – I guess if we didn’t do any more platform affiliations and we just ran the business for relative to all the other markets, there is no reason why it can’t grow faster than some of the markets where we already have a very big penetration, if that makes sense.

Greg Serrao

I would say Cincinnati Dental has not been experiencing because of the geographic market, but their same market year-over-year growth rates have been positive, which is largely related to just being in a very good demographic and geographic area.

Tyras Bookman – Park West

Okay. And on those other two markets that you talked about, how much capital did you spend to grow them from $12 million to $65 million and $2.8 million to $40 million?

Breht Feigh

Good question. I don’t have the schedule here with me. But the returns on capital on those two groups have been pretty good.

Tyras Bookman – Park West

Okay. Because one of the things I’m wondering if you guys authorized the share buyback. It’s been a couple months you haven’t done anything. You spent one times revenue to buy a platform that you said doesn’t probably have that much different growth prospects than what you currently have. I don’t understand why you guys haven’t bought stocks.

Breht Feigh

Well, when we announced the program, we basically headed into a quiet period.

Tyras Bookman – Park West

Okay. Should we take that as –?

Breht Feigh

That would be a signal as to why we didn’t do stock as we were approaching a quarter-end and headed into a quiet period.

Greg Serrao

We are following for the corporation the same blackout policy that we have for insider training.

Tyras Bookman – Park West

Okay. Because it just seems to me that you guys are going to buy other businesses at one times revenue. You might want to buy your own stock since there is no risk of integration at one times revenue.

Greg Serrao

One times revenue is not a indicator of – we don’t look at that. I mean, what we’re looking at is the business earns this much money and we acquire some – there is going to be some bump-up pretty quickly because some of the costs that they have are going to get eliminated. And so here is what we think it will now earn and then what we think the earnings are worth. And if that turns out at 60% of revenue or 100% of revenue, part of that depends on how profitable the business is on its own.

Tyras Bookman – Park West

Sure. But I mean, you guys right now sell at one times revenue. And you said you have better margins than what you are buying.

Greg Serrao

American Dental Partners, actually if we look at the SEC, we understand the SEC’s rules, and so we have to record our revenue as the reimbursement of our expenses and the fees we earn from the dental groups. But the way the businesses manage everyday is we manage the business off of patient revenue. And that’s getting close to $450 million. So we don’t trade anywhere near revenue. Obviously for American Dental Partners –

Tyras Bookman – Park West

When you guys talk about $19 million of revenue, are you talking about –?

Greg Serrao

Patient revenue .

Tyras Bookman – Park West

– equivalent to your revenue?

Greg Serrao

That’s patient revenue.

Tyras Bookman – Park West

Okay. So you are paying essentially way more than what your stock cost currently in the market to buy these platforms?

Breht Feigh

Tyr, let’s cut this to the point we pay a multiple of the profit they were going to get. You can focus on multiples of revenue, but it’s not going to get to how we look at our cost of capital and the multiples that we pay. And as we’ve talked about the multiple we paid for Cincinnati Dental, it’s not out of line with what we’ve paid for other platforms historically. And the bigger point is that it’s a long established group in a marketplace. It’s very attractive. We’ve been very successful in markets with populations of 1 million or so. We are in a business of growing ADP, investing capital into groups and getting a return on the capital. I think we’ve done pretty well on these types of markets, and we will do pretty well in Cincinnati.

Tyras Bookman – Park West

Okay. I also think that one shouldn’t let historical inertia to hide the future. And if your stock is cheaper than what you think you can get out there in the market by buying platforms, especially given the risk of buying platforms, you should think long and hard about it. And I’m sure the market will appreciate that and your shareholders will too.

Greg Serrao

We have – because that’s why we announced the share repurchase. But you can look at all the de novo practices we’ve built since the beginning of time. And the return on capital on those de novo practices is north of 25%.

Tyras Bookman – Park West

De novo in my mind is very different than buying a platform.

Breht Feigh

You got to have a platform to start with to build the de novos.

Greg Serrao

Yes. Most of the de novos we’ve built have been built to add to the platforms that we have. So we enter the market with a platform acquisition and then we move on from there. We’d never be able to walk into Cincinnati and build six practices and achieve $18 million or $19 million of revenue for the cost that we just did Cincinnati Dental. It just wouldn’t happen.

Tyras Bookman – Park West

Fair point. Okay. Thanks, guys.

Operator

(Operator instructions) And at this time, I’m showing no further questions.

Greg Serrao

Thank you very much. We look forward to talking to everybody at the next conference call. Enjoy the rest of your summer.

Operator

Thank you. This concludes today’s conference call. You may now disconnect at this time.

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Source: American Dental Partners, Inc. Q2 2010 Earnings Call Transcript
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