American Dental CEO Discusses Q3 2010 Results - Earnings Call Transcript

| About: American Dental (ADPI)

American Dental Partners, Inc. (ADPI) Q3 2010 Earnings Call Transcript October 26, 2010 9:00 AM ET

Executives

Greg Serrao – Chairman, President and CEO

Breht Feigh – EVP, CFO and Treasurer

Analysts

Jeff Johnson – Robert W. Baird

Mitra Ramgopal – Sidoti

Brooks O’Neil – Dougherty & Company

Robert Grote – Bares Capital Management

Travis Devitt – Teton Capital

Operator

Welcome to the American Dental Report third quarter 2010 financial results conference call. My name is Sandra and I will be your operator for today’s call. At this time, all participants are in a listen-only mode. Later, we will conduct the question-and-answer session. I will now turn the call over to Mr. Greg Serrao. Mr. Serrao, you may begin.

Greg Serrao

Thank you. 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.

Before we begin this morning, during today’s call for the first time, we will be using PowerPoint slides for our discussion. The slides can be obtained now from the Investors section of our website at www.amdpi.com. Please note that the slides are investor controlled. A replay of the slide webcast will be available on the website approximately two hours after the call through 6 p.m. Eastern Standard Daylight Time, Tuesday, November 2, 2010.

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 or regional economic conditions, dependence upon affiliated practices, contracts the affiliated practices have with third-party payors, 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 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.

Right now, 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’d like to mention a few highlights contained on slide three this quarter.

Net revenue increased 5% for the quarter, earnings from operations increased to 8% and net earnings increased 35%. The economy continues to challenge our affiliated dental groups as I will discuss more later. We completed two end-market acquisitions during the quarter, one for Forward Dental and the other for Western New York Dental Group.

We continue to expand Texas’ Tooth Doctor for Kids, completing one additional to noble during the quarter. And finally, we initiated share repurchases during the quarter which were authorized by our Board of Directors in June.

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

Breht Feigh

Thank you, Greg. This morning, we will be reviewing our third quarter financial results. I’d like to begin by referring to the slide entitled patient revenue of affiliated practices. Patient revenue increased 7.8% to $111.3 million in the quarter driven largely by the Christie Dental and Cincinnati Dental platform affiliations.

Same market patient revenue by contrast declined 1.6% over prior 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.

Excluding end-market practice acquisitions, same market growth declined 2.1% and excluding facilities that required capital investment, including both the de novo and expanded facilities, same practice growth declined 3.2%. If you look to the right, there is a graph for the trialing five quarters of performance for similar results through the current quarter.

The components of same market growth for the quarter were 2.1% fewer provider hours, a 2.5% improvement in productivity per hour offset by a 2% decline in effectivity. The directional trend of these components has been the same for the past five quarters. And this was another quarter in which productivity per hour increased less than the blended full increase of our affiliated dental practices, thus indicating a drop in real productivity per hour.

Revenue with affiliate practices during the quarter was 14% fee for service and indemnity plans, 75% PPO and dental referral plans, 6% managed care plans including patient co-pays and 5% Medicaid and CHIPS programs.

I would now like to discuss a year-over-year comparison of our third quarter financial results on slide five. I will focus our discussion on the non-GAAP columns. Net revenue increased 5% to $71.1 million. The increase is primarily the result of the revenue contribution from Christie Dental and Cincinnati Dental.

Salaries and benefits decreased 0.5% from the prior year’s quarter to $29.2 million. As a percentage of net revenue, this expense decreased 210 basis points. This decrease resulted apart from the fact that Christi Dental and Cincinnati Dental operate in states in which the dental assistants and dental hygienists must employed by the affiliated practices rather than American Dental Partners. The decrease also resulted in part from our ongoing efforts to manage staffing levels and compensation expense including a reduction of incentive accruals in the most recent quarter.

Lab fees and dental supplies increased 12.9% from the prior year’s quarter to $10.8 million. As a percentage of net revenue, this expense increased 112 basis points. 60 basis points is due to an unfavorable comparison with the third quarter of 2009 when we benefited from distributor rebates and the remainder due to the affiliations with Christie Dental and Cincinnati Dental.

Office occupancy expenses increased 11.1% to $9.6 million. As a percentage of net revenue, this expense increased to 80 basis points, of which 38 basis points were attributable to the affiliations with Christie Dental and Cincinnati Dental. The remaining increase is associated with the de novo practice development at Texas’ Tooth Doctor for Kids and a temporary increase in telecommunication expenses.

Other operating expenses increased 11.2% to $6.9 million. As a percentage of net revenue, this expense increased 58 basis points, which was primarily attributable to the affiliations with Christie Dental and Cincinnati Dental. General corporate expense decreased 13.9% to $3 million, a 99-basis point decrease from the same period last year, primarily due reduction in incentive and compensation accruals as a result of year-to-date financial performance, somewhat offset by an increase in travel expense.

Depreciation and amortization were largely affected by the Christie Dental and Cincinnati Dental affiliations in our ongoing investment in de novo facilities. As a result of preceding items, non-GAAP earnings from operations increased 8% to $6.1 million and EFO margin improved 20 – 27 basis points to 8.6%.

Excluding the write-off of our banking fees associated with our credit facility renegotiation last year, interest expense decreased 12% to $1.7 million due to reduced debt levels and lower interest rates as a result of the refinancing.

Our effective – excuse me – our effective income tax rate decreased from 39.7% to 36.8%. We are currently expecting our effective tax rate for the full year to be approximately 39% to 39.5%. Net earnings increased 35% and diluted earnings per share increased 23%, reflecting the additional share issued last year in a public stock offering.

If we can turn to slide six, I like to spend a few minutes on our earnings per share. As a result of our business model, we record intangible assets related to our service agreements on our balance sheet and amortized these amounts over 25 years. As a result, we have a significant non-cash amortization expense.

The blue bar represents our reported EPS while the grey bar represents the after tax non-cash impact of this amortization. If we didn’t amortize these amounts, our diluted EPS will be 51% greater for the nine months ended September 2010. If I can also draw your attention to the numbers circled in the upper right hand corner, our reported trailing 12 months diluted EPS is $0.69, while if we didn’t amortize the service agreement intangibles, our diluted EPS would be $1.06 or 54% higher.

The impact on our price-to-earnings multiple is dramatic instead of 17 times earnings, the PE multiple would be 11 times based on diluted cash earnings per share. This treatment of amortization also helps to explain the disparity with our enterprise, the EBITDA value multiple and our operating cash flow to market value returns, which I’ll discuss in a few minutes.

I’d now like to discuss a review of cash flow results for the quarter on slide seven. Cash flow from operating activities was $9.6 million for the quarter as compared to $11.5 million for the last year’s same quarter. Last year’s result benefited from a three-day improvement in day sales outstanding of our affiliate practices accounts receivable as compared to a one-day improvement this year.

As a result, accounts receivable contributed 3 million left to operating cash flow this year as compared to last year. We are pleased though that the DSO continues to improve instead a 25 days at quarter end.

Maintenance capital expenditures increased to $582,000 this year from $268,000 last year. During the quarter, in addition to our ongoing maintenance capital expenditure program, we also implemented Improvis’ electronic dental record at 10 additional dental facilities.

Growth capital expenditures increased to nearly $1.7 million from $984,000. During the quarter, we completed one de novo facilities for pediatric Medicaid business in Texas. Finally, acquisition and affiliation investments were $775,000 for the quarter.

We completed two market – in market acquisitions which generated $149,000 of patient revenue during the quarter in which we will anticipate will generate 1.3 million on an annualized basis. Affiliations in acquisitions completed year-to-date in 2010 generate approximately $20 million of annualized patient revenue.

Turning attention to our capitalization on slide eight. We had $106 million of debt outstanding at quarter end and debt to total capitalization stood at 35% which is below of our 40% long-term target. Based on bank compliance calculations debt to EBITDA stood at 2.1 times at the end of the quarter and we have $49 million available for borrowing.

During the quarter, we repurchased 222,000 shares of our common stock at an average of $11.12 per share. I will spend a few minutes on our capital structure framework on slide nine in returns, because we are getting many questions from potential investors.

Long-term, we target our capital structure to be 40% debt funded and 60% equity funded, with our pre-tax cost to debt estimated at 8%. We target a 25% pre-tax return on equity. So, on a weighted average basis, we estimate pre-tax cost to capital at 18%. It is this framework that drives our investment decisions.

We invest in projects that will yield at least an 18% return on capital at the operating level. Our current book returns on capital are being affected by four items. Our 2007 acquisition of Metro Dentalcare at 10 times EBITDA. This acquisition was a strategic move at the time in the midst of ongoing litigation.

The 2008 settlement of litigation with PDG in which we transferred 25 dental facilities to PDG. The ongoing economic downtrend, which we first began to notice in late 2007 and finally our ambitious expansion of our Pediatric Medicaid business in Texas. I would now like to review our returns on capital contained on slide 10.

I’d first ask you to focus your attention initially on the 1997 and 2006 columns. 1997 was our first full-year of operations and 2006 was the year prior to the economic downturn, acquisition of Metro Dentalcare, fallout of the litigation of PDG and the growth of our Pediatric Medicaid business.

As you will see, during that decade period, we grew revenue 17% and equaled 32% per annum, while we increased committed capital 16% per annum. The result was an increase in return on capital from 4.5% to 14.5% and the return on incremental capital was 18% during this period.

We’ve also included in this table, cash returns on capital by adding back the amortization of service agreement intangible assets to EFO and the accumulative service agreement amortization to our committed capital.

Now, if I can turn your attention to the nine months ended September 2010 column, we have made adjustments for two of the four items presently affecting our book returns. On the income statement announced, you’ll see we have added $11.3 million. The settlement of litigation with PDG we estimate resulted in EPO reduction of $15 million on a full-year basis or 11.3 million for nine months.

On the invested capital announced, we eliminated the net asset pick up of $4.6 million from the litigation settlement and reduced the acquisition price of Metro Dentalcare from 10 times of EBITDA to 6.5 times EBITDA or $33.3 million.

The total adjustment to 6.5 times as well our typical evaluation range of five to six times. Metro Dentalcare offered a number of factors sort of merited a premium to our normal evaluation approach including size, demonstrated growth track records, state-of-art technology, invaded in its dental facilities at the time of acquisition and opportunity for revenue and margin improvement.

With these adjustments, you will see our return to increase from 9% on our book basis to nearly 16% on an adjusted basis. These return differences associated with these two items as permanent and already reflected in our stock price. The book return on capital issue is similar to what we faced in 1997. And going forward, we intend to invest capital in our business based on our capital structure framework, just as we did from 1997 to 2006.

In other words, we will invest in those projects that we believe will provide at least an 18% pre-tax operating return on capital, which should lead overtime to incrementally improving book returns.

If we can now look at slide 11, we have calculated our equity returns based on current share price. As you’ll see a $12 per share, cash flow return on equity market capitalization is 18.3% and free cash flow return on equity market capitalization is 16.2%. These returns explain why we are opportunistically repurchasing our shares.

As mentioned on our previous slide, we had purchased approximately $2.5 million of our shares at quarter end with remaining approximately $7.5 million on a $10 million authorized program.

I’ll now turn the call back to Greg to make concluding remarks.

Greg Serrao

Thank you, Breht. I’d like to make a few observations before opening this morning’s call to questions. It is clear that the current economic crisis is adversely affecting healthcare utilization in the United States, as patients are postponing or forgoing care given the high unemployment rates and declining consumer confidence.

Across the spectrum, healthcare is experiencing a down trend in utilization. Hospital admissions are down nearly 1% in 2010 as compared to 2009. Physician office business were down over 4% in the second quarter of 2010 and were down nearly 8% in July 2010 as compared to the same period a year ago.

Even pharmaceutical prescriptions are experiencing a down trend, growing less than 1% year-over-year, rates unheard prior to the economic crisis.

Specifically pertaining to American Dental Partners, we continue to experience unpredictability as it relates to revenue. The measure we most closely watch related to revenue productivity per hour, demonstrates this unpredictability.

In the first quarter of 2010 productivity per hour for the doctors was $499. In the second quarter 2010 productivity per hour for the doctors was $513. For the third quarter of 2010 productivity per hour for the doctors declined to $482, a 6% decrease from the sequential quarter. While we typically experienced a decrease from quarter two to quarter three this was a larger decrease than we have experienced. For instance the decrease last year was 4.9% and that was the largest decrease we had experienced from Q2 to Q3 until this year.

To provide further detail in to the unpredictable nature of our business today, productivity per hour for the third quarter was as follows. July was $505 per hour, August $489 and then September $454. As is evident from the data just provided September was a particularly challenging month. This was a common theme among all of our affiliates across the country with nearly every geographic region experiencing the same trend.

We are fortunate that we’ve been able to continue to offset the revenue weakness with strong cost containment measures and thereby experienced growth in operating income. In fact, we have reported year-over-year increases in earnings in every quarter since the economic crisis began in 2007.

We’re also pleased with the progress we continue to make in the pediatric Medicaid business. We have opened seven pediatric Medicaid offices in Texas, five of which were opened this year. While these offices are negatively contributing to earnings today, the total losses are declining as the earlier bills are returning to EBITDA profitability.

So patient demand in this area is great and the long-term demographic trends in United States suggest there will be no abatement in these trends. We intend to open an additional pediatric Medicaid office in the fourth quarter and then accelerate the openings of new pediatric Medicaid practices in 2011 with the intention to open 10 to 12 new practices.

We are also pleased that despite economic crisis and its direct adverse impact on our revenue, we continue to invest in our people and in technology. In 2011, an additional 85 individuals will join the American Dental Partners Leadership Institute, our proprietary leadership development program.

As mentioned on previous calls, 2010 marked our first steps toward the conversion to totally electronic dental offices meaning electronic dental record and digital radiography. We now have 50 dental offices that operate with an electronic dental record and digital radiography. We intend to convert over 50 additional practices to the electric dental record and digital radiography in 2011 and to convert all of our existing practices by 2014.

These are indeed trying times like unseen in the industry before. However, as we begin to look to 2011 we see three areas that should provide significant growth opportunities. First is obviously our pediatric Medicaid business and as I have already mentioned, we have plenty to build 10 to 12 de novo facilities in 2011.

Second, we are seeing very positive results for our newly created Director of Specialty Care. Many of our dental groups provide specialty dental services, but we think there’s tremendous opportunity to grow revenue and improve margins in this area.

We believe that total potential annual revenue opportunities for specialty care across all of our affiliate in dental groups is $80 million. We are currently focusing our efforts at four of our affiliate dental groups. These four groups represent approximately 40% of the total specialty care revenue opportunity. Given that specialty care has better margins than our existing business, we expect our operating margins to increase.

Third, we continue to have a very busy corporate development pipeline. In sum, we expect 2011 to be a year with many investment opportunities, offer and returns add or in excess of our target to returns on capital.

With that, we’ve concluded our prepared remarks and would like to open the call up to questions for the participants.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) The first question is from Jeff Johnson from Robert W. Baird. Please go ahead.

Jeff Johnson – Robert W. Baird

Hey. Thanks, guys. Good morning.

Breht Feigh

Good morning, Jeff.

Jeff Johnson – Robert W. Baird

Greg, Breht I wonder, I guess, Breht, I’ll start with you just on last quarter you gave number of offices that’s maybe improving trend versus percentage of your offices worsening of trends. Could you update us on that number this quartered off?

Breht Feigh

Yes. It’s a number – we’ve quoted the number of affiliates rather than actual dental facilities.

Jeff Johnson – Robert W. Baird

Yeah.

Breht Feigh

Last – first quarter this year is seven or positive, second quarter seven or positive and this quarter there were 10.

Jeff Johnson – Robert W. Baird

Okay. And – for some reason, I thought, I’ll remember the percentage of last quarter? I have to go back to my notes. But is that different than how you quoted it in the past?

Breht Feigh

No. I don’t believe so. I’ve had to look back at...

Jeff Johnson – Robert W. Baird

Okay. Yeah, maybe I could follow-up offline after I review my notes in no better.

Breht Feigh

Okay.

Jeff Johnson – Robert W. Baird

Also then just on Texas, any update on Medicaid reimbursement rates going into the end of this year into 2011?

Greg Serrao

Nothing definitive Jeff here, obviously all the states are experiencing challenges with their budgets, we understand the State of Texas is considering a shift to manage care program for the Medicaid – for their Medicaid program, but we don’t know that definitively, we’ve just heard out through the payer community.

Jeff Johnson – Robert W. Baird

What would that impact be on you guys, I know that would be a good thing or bad thing if a shift to manage care, just lock me through kind of how to think about that?

Greg Serrao

I would anticipate that if there is a shift, there’d be a drop in reimbursement of some sort.

Jeff Johnson – Robert W. Baird

Yeah. By any quantifiable amount or...

Greg Serrao

I don’t know.

Jeff Johnson – Robert W. Baird

Yeah. Okay. Fair enough. And then, so, along those lines Greg, can you just an update maybe on, you said some of those earlier stage offices in Texas are working towards profitability, are some of those early offices profitable and is the hang up maybe on some of those earlier offices still finding dentist, dentist some sort to staff those offices or how are you on the employees side there?

Greg Serrao

Finding dentist is not a challenge, so what as I mentioned, I think on previous calls, I think going into Texas we stumbled a little bit. I think now that we’re five build-in, I think we’ve worked out most of our thing [ph] so to speak.

So first we got to hire the doctors, of course, we have to prudential the doctors and then we have to get them privileged to do the sedation part of dentistry and as we’re prevailing more doctors to do the sedation, the productivity per hour is increasing and as that happens to practices returning the profitability. And so, we’re seeing the practices in Houston actually ramping up much quicker than we saw with the practices even in San Antonio, but we do have practices turning to EBITDA profitability.

Jeff Johnson – Robert W. Baird

Okay. Great. And remind me again there is five offices you have opened now, is that correct?

Greg Serrao

Five offices this year, we will open an additional one in Houston in the fourth quarter and then 10 to 12 next year all in the state of Texas.

Jeff Johnson – Robert W. Baird

Okay. Okay. That’s helpful. Thank you. And then Breht just last question for me. Tax rate you said for the year would imply maybe a tax rate over 40% in Q4 ‘10 or in the fourth quarter, I’m sorry. Am I off on my calculation there?

Breht Feigh

Should be close to that.

Jeff Johnson – Robert W. Baird

So right around 40%.

Breht Feigh

Yeah.

Jeff Johnson – Robert W. Baird

But not necessarily above.

Breht Feigh

No.

Jeff Johnson – Robert W. Baird

Okay. That’s all I have. Thank you, guys.

Breht Feigh

Yeah.

Operator

Thank you. The next question is from Mitra Ramgopal from Sidoti. Please go ahead.

Mitra Ramgopal – Sidoti

Yes. Hi. Good morning, guys. Just a few questions. Greg, as we look at sort of relatively staff revenue from Tooth Doctor, thus that sort of make you a little more cautious in terms of the expansion plans as it relates to Texas and elsewhere?

Greg Serrao

It does and Mitra we’ve had a lot of discussions internally on this – on the Medicaid business itself. I think the demographic trends in America aren’t going to obey. One at a three kids are born into this population and it is going to be a huge market opportunity.

Now there are some dental practice management companies that are bigger players in this market area and their returns on capital are tremendous and have been for some time. And so we anticipate that reimbursement will be cyclical and there will be times on the states, more well capitalized than they are today and we will see rates go up. We will see rates go down. But with this being such a huge market opportunity we’re going to continue to invest and believe the returns on capital to be very strong.

Mitra Ramgopal – Sidoti

Okay. And again one of you guys have mentioned was – assuming for examples things that meaningfully pick up as it relates unemployment levels invest on certain, et cetera. How much you have and those are your ability to be able to manage or cut cost more than you’ve already done?

Greg Serrao

Well, I think, that we probably would say there are limited opportunities to continue to cut cost. There are always opportunities to improve. Practices that aren’t performing as well as they could be performing and to see, see that kind of opportunity. But there is not a lot more cost cutting then that’s available in the business.

Mitra Ramgopal – Sidoti

Okay. And I know mention the last quarter was very choppy from month-to-month. Can you give us sense of what you are seeing so far in October?

Greg Serrao

Just continued weakness.

Mitra Ramgopal – Sidoti

Okay. And Breht just quickly on the tax rate, could you give us a rough estimate as to where we should be modeling for 2011?

Breht Feigh

I don’t have that yet, but we can get in new course.

Mitra Ramgopal – Sidoti

Okay. Thanks again guys.

Operator

Thank you. The next question is from Brooks O’Neil from Dougherty & Company. Please go ahead.

Brooks O’Neil – Dougherty & Company

Yeah. First I’d like to say thank you very much for including this slide. There is a tremendous amount of information there and I found it very, very helpful, so thanks for doing that.

Secondly, I’m just curious obviously, Greg, you provided the sequential productivity per hour from July through September and as I was thinking about, I was curious if the decline in September in anyway related to recruiting efforts, I know frequently you may add some new dentals – dental recruits towards the end of the summer. But if not that, is there anything beyond the obvious continued weakness in the economy to which you might attribute the softening as you went into September?

Greg Serrao

Brooks, I would say it’s totally related to the economic situation in the country. I mean, it was across the board. We had a number of meetings here, over the cost, of course September where we had doctors from around the country here and everybody was lamenting on, how like the schedules where the cancelation rates, the patients opting not to – opting for either lower cost or just postponing care and it was just a common theme everywhere.

Brooks O’Neil – Dougherty & Company

And did you continue to see a reasonably robust hygiene traffic or you see net softening as well?

Greg Serrao

Actually, the traffic is still good. I mean, patient appointment levels are still good. But it – the productivity per hour even for hygiene in September declined pretty significantly.

Brooks O’Neil – Dougherty & Company

It’s probably not to a good trend, I guess?

Greg Serrao

No. I mean, the hygiene, one of the big drivers for hygiene productivity per hour will be the periodontal therapy programs.

Brooks O’Neil – Dougherty & Company

Yeah.

Greg Serrao

And so if there hygiene productivity per hour is dropping, that would mean patients are postponing periodontal therapy. That would be the biggest reason why you would see the drop in productivity per hour.

Brooks O’Neil – Dougherty & Company

And then I am curious in those months where you see somewhat better revenue result, are you seeing pretty good operating leverage and would it be possible in any way to help us understand sort of magnitude of operating leverage, if there is any?

Greg Serrao

It’s huge. Just like a practice level like in the months of June which is a strong revenue month and I am just going at the practice level, so I am not talking about the overall company, but practice level margins go over 19%. Then you get a month like September and there are like 14%. So it is a huge difference in a month like June, where the productivity per hours – going to be like 515, 516 then in a month like September where you are at 454 or whatever, I should remember the number I just gave it you.

Brooks O’Neil – Dougherty & Company

454 is what you said September.

Greg Serrao

Yeah, 454. So the margin swing is dramatic. This is one of the things that we have talked about here internally is that once we start to see a pick-up in same market revenue growth and I am not talking like 3 to 5%. I am talking about just even 1%.

Brooks O’Neil – Dougherty & Company

Yeah.

Greg Serrao

We will see a very significant margin improvement because the cost like many American or I shouldn’t maybe say just America, but many company in this crisis. Some of the cost moves that we made such as moving hygiene compensation from a per hour basis to a production based compensation, those things aren’t going to change.

Brooks O’Neil – Dougherty & Company

Yeah.

Greg Serrao

And actually a lot of the cost moves we made are pretty much now permanent, so even a small increase in revenue is going to have a significant impact, positive impact on operating margins. Brooke, I wanted – just to go to one other thing as – think it about as maybe this is really towards Mich’s comment, but in – there are number of privately held companies that are focused on this pediatric Medicaid business.

So we were the first person to see this opportunity and they’ve been added a longer time and of course they are dealing with the same issues that we will deal within – our dealing with such as there in Arizona which is a drop in reimbursement, but even with the reimbursement drops the margins are still relatively attractive.

Brooks O’Neil – Dougherty & Company

Yeah.

Greg Serrao

And, so – the board, our board has elected next year to support our decision to want to accelerate the investment in the pediatric Medicaid business. And I think, we’ve been hurt in 2000 – this year we’re going to carry almost about $200 million and losses for that investment. Next year, it will be a similar number or if not more, with 10 to 12 practices opening. But as you get into 2012 and ‘13, I think you start seeing some significant improvement in operating margins in that business which obviously impacts our overall operating margins. So there’s still opportunity for good margin improvement in the company.

Brooks O’Neil – Dougherty & Company

Absolutely. And then maybe you could just talk about the impact you’d see from acquisitions obviously part of the revenue growth was that. Do you see operating leverage coming through the platform or tuck-in acquisitions and any elaboration on sort of your outlook for those in the coming year would be helpful?

Greg Serrao

Well, the pipeline is very, very strong.

Brooks O’Neil – Dougherty & Company

Yeah.

Greg Serrao

As I mentioned in my calls where the rolling acquisitions, there is a tremendous number of those that are in the pipeline and those are always very beneficial to our existing affiliated dental groups. And then the platforms, there are a number of platforms that were in – I would say, late stage discussions, but we are going to, the pricing discipline we are going to continue to maintain because, we again were seeing from the end market de novos and anticipate from the Medicaid business that the returns on capital there will be greater than they are from the acquisition side.

Brooks O’Neil – Dougherty & Company

Yeah, which makes total sense. So, that’s where you are focused and then just lastly and I appreciate all the comments. Do you see anything you can do beyond what we have been talking about sort of in the core business to drive productivity and I am thinking just generally like advertising, or any other things that you have sort of on the plate as you think about 2011, that you either think or hope can strengthen the trends?

Breht Feigh

Brooks, my reaction is like, the comment on advertising, 90% of the patients that come into the dental practices of our groups have dental insurance.

Brooks O’Neil – Dougherty & Company

Yeah.

Breht Feigh

So, to advertise heavily I guess, you are going to, I don’t know if it has any impact on those that already have insurance.

Brooks O’Neil – Dougherty & Company

Sure.

Breht Feigh

Might have impact on those that don’t come to the dental center regular basis. But our groups haven’t positioned themselves historically to serve that population that doesn’t come to a dental center regular basis and probably they wouldn’t come anyway.

Brooks O’Neil – Dougherty & Company

Sure.

Greg Serrao

And the practices that we observed that are more retail oriented that kind of lead with price and lead with, well lawfully they are like a $19.99 x-ray and exam. The way that works is that when you get there as a patient they are treating you up.

Brooks O’Neil – Dougherty & Company

Yeah.

Greg Serrao

Yeah. And that’s not part of what American Dental Partners is about.

Brooks O’Neil – Dougherty & Company

Right.

Greg Serrao

The Dental groups are about. And so we’re not going to – we’re not going to be able to change the stripes on the leopard so to speaking or the spots in and of our practices to try to do business that way.

Brooks O’Neil – Dougherty & Company

Sure. No, I understand – I actually was just touching on advertising as one fairly common approach. But as I think about it may be some type of enhanced referral program among patients or I was just curious if you guys had any things you are going to try to implement 2011…

Breht Feigh

From a specialty care initiative, Brooks, I mean this is – this is something that really doesn’t require any incremental capital.

Brooks O’Neil – Dougherty & Company

Yeah.

Greg Serrao

But it is a revenue opportunity.

Brooks O’Neil – Dougherty & Company

Superior [ph] dental program.

Breht Feigh

No, no…

Brooks O’Neil – Dougherty & Company

Specialty.

Breht Feigh

Specialty, so making sure that we maximize the specialty referrals within the groups themselves. So we’ve disclosed in prior conference calls that we’ve created a new position earlier this year the director of specialty care. So we took actually the leader of our group out of Texas. Whom you might know and he is now working with all the groups on a national basis on their specialty opportunity. And as we just said in the call in the prepared remarks, he is focusing on four groups where we think there is over a $30 million opportunity.

The first thing that he did is, he visited every group to understand what their processes are in the group for capturing and monitoring specialty referrals. And once you’ve got that then you can figure out what’s the opportunity for adding specialists in specialty services. That lead to actually earlier this year – basically a complete redesign of the referral tracking process in Improvis.

The nice thing about having our own programmers in North Carolina – in a period of probably four months, they completely redesigned the referral tracking. So now it’s kind of like in amazon.com or you have one click buy, now in three clicks, a practice can create a referral and replete that new functionality in one affiliate and the increase in the referrals over the manual tracking method, was up like 80% or something like that.

Brooks O’Neil – Dougherty & Company

Well.

Breht Feigh

So now we have good data. So now we start working with the group – okay, you’ve got tremendous Endo, Oral whatever these specialty referrals are and they are going out of the practice.

Brooks O’Neil – Dougherty & Company

Sure.

Breht Feigh

So let’s get the specials on board and keep these referrals into the practice.

Brooks O’Neil – Dougherty & Company

It seems like a no brainier and it’s great. It sounds like a great program.

Breht Feigh

And I think that aligns well with the ownership in our dental groups. I am going out to visit a dental group next Thursday night to meet with all the leadership to talk to this exact issue which is how do we grow despite the economy.

Brooks O’Neil – Dougherty & Company

Yeah.

Breht Feigh

And the specialty area is definitely an area that doesn’t require a lot of capital, but it does require a lot of management expertise.

Brooks O’Neil – Dougherty & Company

Yeah.

Breht Feigh

And let’s get going.

Brooks O’Neil – Dougherty & Company

Yeah, that’s great. I appreciate that elaboration. That’s really helpful.

Breht Feigh

The other time, Brooks, when you are asking about margins, I just looking back, if I look at back at the last one, two, three four quarters, where we’ve been saying to investors it seems like we’ve been having maybe one bad quarter out of three.

Brooks O’Neil – Dougherty & Company

Yeah. One bad month you mean?

Breht Feigh

I mean one bad month out of three.

Brooks O’Neil – Dougherty & Company

Yeah.

Breht Feigh

And when I look back over the last four quarters, we’ve had, every quarter we had a month for contribution margin with solidly over 20%. And contribution margins did practice level profitability.

Brooks O’Neil – Dougherty & Company

Yeah.

Breht Feigh

In the third quarter of this year, we didn’t quite get over 20% in the best month of the quarter. But having said that when you look at the contribution margin on a daily basis when we see a margin over 20%...

Brooks O’Neil – Dougherty & Company

Yeah.

Breht Feigh

That profitability jumps up over 30% over the year-to-date average. So when you have a good month, I mean it really does flow down relative to kind of the overall average and what we need to do, is get to back to one or two or even three months of good months in the same quarter. Part of the recession – if we have two or three bad months in a year that was kind of routine, has been kind of one every quarter. And we just – we will continue to managing – wait for the turn and do what we can, where we can with like specialty initiatives and growing the Tooth Doctor and doing in market acquisition and so forth.

Brooks O’Neil – Dougherty & Company

All of that sounds good to me. Thank you very much.

Breht Feigh

Thank you, Brooks.

Operator

(Operator Instructions) The next question is from Robert Grote from Bares Capital Management. Please go ahead.

Robert Grote – Bares Capital Management

Hi, guys.

Greg Serrao

Good Morning.

Robert Grote – Bares Capital Management

With regard to your latest platform affiliation with Cincinnati Dental, how far along are you in eliminating duplicative costs and getting in line with other practices in terms of profitability?

Greg Serrao

Pretty far along. The next big thing will be the conversions from their computer systems to empower us, which will pretty much complete our transition. And just one comment on that software system, Cincinnati Dental had its own proprietary system. So, we typically whenever we affiliate with the group we’ve seen the system, before we know how to convert the data and get the conversion done well. And this is an affiliate with its own proprietary system, so it’s going to take a little more effort to get it converted, but the flip side of that I think is the opportunity to use our system for the improvement of the operations of that group. So it’ll take us a little more time, but I think we’ll have tremendous information for that benefit.

Robert Grote – Bares Capital Management

Okay. And then, in terms of your share repurchase program you said you are still authorized to repurchase 7.5 million. But if you wanted to buy more than that, are there any restrictive covenants in debt agreements prevailing larger repurchase?

Greg Serrao

The credit facility allows 10 million, so I don’t recall if we discuss this on the last call. But when we renegotiated or refinanced in May as you can probably well imagine our real focus at the time was getting the LIBOR spread down rather than trying to negotiate a share repurchase basket. But I think 10 million relative to our current level of leverage in our cash flow generation and certainly we can go back to the banks and talk about an amendment to that $10 million basket if we think that’s necessary or prudent.

Robert Grote – Bares Capital Management

Then lastly, could you elaborate a little more on new acquisition pipeline and the likelihood of a large platform affiliation versus small de novos or tuck-in? And how do those valuations compared to ADPI’s current business?

Greg Serrao

Right. I think the – well, the platforms issue, we did one in last December, one in June which was probably the quicker. The quickest we’ve done two back to back in quite some time. We are in late stage discussions with a number of large groups that’s not to say we’ll get transactions done. But we were focused on the dichotomy between what our value is and what they think is fair value for their practice and now we better-off just investing more in our business and unless we can get that into equilibrium, we’re not going to make those acquisitions at this time.

Robert Grote – Bares Capital Management

Thanks a lot.

Greg Serrao

Okay.

Operator

Thank you. The next question is from Travis Devitt from Teton Capital. Please go ahead.

Travis Devitt – Teton Capital

Hi, guys. Question here on Arizona, Tooth Doctor, it looks like sequentially it’s got a little bit worse and has throughout the year, I’m wondering on if you have any comments on what’s going on there and what you expect to happen there here over the next year or so?

Greg Serrao

You want to comment, you want me to comment?

Travis Devitt – Teton Capital

Yeah.

Greg Serrao

I think, what Tooth Doctor in Texas is experiencing is – well, more people are qualifying for Medicaid than ever before.

Travis Devitt – Teton Capital

In Arizona, you said Texas.

Greg Serrao

I’m sorry. In Arizona – Tooth Doctor in Arizona, more people are qualifying for Medicaid so their office visit numbers are actually increasing, but what they’re getting per-visit is decreasing, so the acuity of care mix has changed, if that make sense.

Travis Devitt – Teton Capital

And it seems like then it’s getting a little bit worse this quarter, so do you expect that to continue or at least for the near-term or do you think we can sort of bottom out here in the next quarter or two, I mean any read on trends going forward?

Greg Serrao

Travis, what we’ve heard locally was when they pass that immigration law in Arizona that there was and we’ve seen this confirmed in local news paper articles there was somewhat of an exhibits out of the state, from people who are fearful of what that law could mean to them, so that’s having an impact on the business we believe as well. But again, we are seeing more patient visit such as – it’s from healthier patients. So we are doing less sedation evasive care, which is where the productivity is really strong and I – to be honest, I don’t know how to predict whether that’s bottoming out whether that trend will continue.

Travis Devitt – Teton Capital

Okay. Thanks.

Greg Serrao

Yeah, I think Travis, unprofessionally friendly with the CFO here in the Boston area has a business. So a portion of its business serves that type community and what they saw was decrease in Arizona and then increases in places like Colorado, Washington, Oregon so it seems like people kind of migrated other locals maybe when the winter sets in and maybe they will head back south. But it’s definitely – that immigration was definitely impacting other business as well.

Greg Serrao

Operator, you want to queue for more questions?

Operator

Yes. Thank you. (Operator Instructions) At this time, there are no further questions.

Greg Serrao

Okay. Thank you very much. We look forward to talking to you at the next earnings call.

Operator

Thank you, ladies and gentlemen. This concludes today’s conference. Thank you participating. You may now disconnect.

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