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Executives

Jim Robison – CEO

Bill Lacey – CFO

Analysts

Mark Arnold – Piper Jaffray

Jeff Johnson – Robert W. Baird

John Kreger – William Blair

Animal Health International, Inc. (AHII) F2Q2011 Earnings Call Transcript February 8, 2011 10:00 AM ET

Operator

Greetings and welcome to the Animal Health International, Inc. Second Quarter 2011 Conference Call and Webcast. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Jim Robison, Chief Executive Officer for Animal Health International, Inc. Thank you, Mr. Robison. You may begin.

Jim Robison

Thank you and good morning to everybody. With me this morning is Bill Lacey. Bill is going to make some comments on the quarter then I will give some commentary and then we will open it up to questions. Bill?

Bill Lacey

Good morning. Before we begin, I’d like to point out that today's conference call is being recorded and will be available for replay on our webpage at ahii.com under Investor Relations. In addition, I’d like to remind everyone that some of the information discussed on this call, particularly our guidance for fiscal year 2011, our competitive position, future business prospects, revenue growth and market opportunities for the coming fiscal year contain forward-looking statements that involve risk and uncertainty. These statements are based on current expectations.

Actual results may differ materially from those set forth in such statements. Additional information concerning risk and other factors that may cause actual results to differ can be found in the company's filings with the SEC. Please note that in addition to reporting financial results in accordance with generally accepted accounting principles or GAAP, AHI reports certain non-GAAP financial results, including EBITDA and adjusted EBITDA.

Investors are encouraged to review the reconciliation of these non-GAAP financial measures, comparable GAAP results, which can be found in the press release. Finally, AHI has provided in its press release and will provide in this conference call forward-looking guidance. We will not provide any further guidance or updates on our performance during the year unless we do so in a public forum. AHI does not assume any obligation to update the forward-looking statements provided to reflect events that occur or circumstances that exist after the date on which they were made.

I will now talk about the second quarter of fiscal year 2011. Net sales compared to last year increased 16.3%. Net sales for the quarter were $198.2 million compared to $170.5 million for the same period last year. The increase in sales was mostly in the beef and vet divisions and approximately half of the increase in vet sales was attributable to former PVP customers. If you will recall, PVP was a competitor which went out of business in, I believe, September.

Gross margin increased $3.1 million, with $4.5 million due to sales volume, offset $0.9 million by an unfavorable shift in product mix and a special one-time promotional rebate received last year of $0.5 million. Margins in the second quarter were 16.4% of net sales compared to 17.3% in the second quarter last year.

SG&A expenses were 12.5% of sales compared to 13.8% in the same quarter last year. SG&A expenses were $24.8 million compared to $23.5 million last year and the increase was primarily volume-driven. Adjusted EBITDA was $8.1 million, which was an increase of $1.9 million or 29.8% from the year-earlier quarter of $6.2 million.

Net income for the second quarter was $1.9 million compared to the second quarter last year net income of $1.2 million. The net income for the quarter included a one-time adjustment for the completion of the fiscal year 2010 Canadian tax provision of $0.4 million. Net income excluding this adjustment would have been $2.3 million and an 87.1% increase over last year.

Fully-diluted income per share was $0.07 versus $0.05 last year. Earnings per share without the one-time tax adjustment would have been $0.09. Earnings per share without the tax adjustment or amortization, which most of us call a cash basis EPS, was $0.13.

Year-to-date results reflect net sales for the first six months increased 12.9% from the same period last year. Net sales were $374.7 million compared to $331.8 million for the same period last year. Increased sales to beef producers and vets were primarily responsible for the increase in the year as well as in the quarter.

Gross margin increased $4.5 million over last year. Volume accounted for $7.2 million, offset $2 million by a shift in mix to lower product – lower-margin products and a special one-time promotion last year – rebate promotion of 500,000. Gross margin for the first half of the year was 16% compared to 16.7% last year.

SG&A expenses declined to 13.2% of sales compared to 14% last year. SG&A was $49.6 million for the year-to-date compared to $46.3 million last year, an increase of $3.3 million, primarily due to the increase in volume. Adjusted EBITDA for the first half increased 16.7% or $1.6 million to $11.2 million compared to $9.6 million last year.

Net income was $1.3 million or $0.05 per fully-diluted share compared to last year's net income of $0.5 million or $0.02 per fully-diluted share. The net income for the year-to-date excluded – excuse me – included a one-time adjustment for the completion of the fiscal year 2010 Canadian tax provision of $0.4 million and net income excluding this adjustment would have been $1.8 million.

Earnings per share would have been $0.07 without the one-time tax provision. Earnings per share without the tax adjustment or amortization or as we know, cash EPS, was $0.16. At the end of December, we had 44.2 days of net working capital compared to our average for the last 12 months of 45 days. Capital expenditures were $1.3 million year-to-date, the fixed charge ratio was 3.4 times on a trailing months' basis and the company is in compliance with all of its bank covenants. At December 2010, the company's availability under its revolver totaled $30.1 million.

We continue to believe our EBITDA for the fiscal year ending June 2011 will be in the range previously stated of $25 million to $27 million. And with that, I will turn it back over to Jim for his final comments.

Jim Robison

Thanks, Bill. I would like to make some commentary on the quarter and what we see on a forward basis. We are certainly pleased with the top-line results for the company for the quarter. As Bill mentioned, the top line was driven by improved production in animal economics, mostly in the beef business and a pickup of sales from PVP's demise as well as our continued growth in our mixed animal vet business.

While we are not pleased with the gross profit margin percentage for the quarter, we believe that the gross profit margin – our gross profit margins have bottomed out and that we’ll see an improvement on our forward basis driven by two factors, an improved opportunity to sell profitable products, improving our mix, if you will and also, marginally favorable terms from vendors for the calendar year.

We are pleased with our expenses for the quarter, holding down our fixed expenses benefited us. We also had year-to-date about $750,000 associated with a transition in our sales compensation program as well as expenses associated with hiring 23 salespeople.

We serviced our customers very well during the quarter. In December, we were awarded an annual contract of approximately $10 million by one major customer. And it is interesting to note that the customer commented that we were awarded the business while we were not the low-cost provider, given our level of service and our ability to integrate with the customer's operations. We found that to be very encouraging.

Our management team managed our balance sheet well. As you know, we've had a rather protracted challenging time, particularly in the production animal business and our receivables risk has been managed well. And we've been able to maintain our investment in inventory that has been used to drive very high fill rates.

I'm also pleased to announce that we will be opening our Lancaster, Pennsylvania facility this quarter. This new facility will extend our reach into the companion animal and production animal markets in the northeast. It will also allow us to meaningfully improve our service levels and save a meaningful amount of money on freight in responding to the needs of our customers in that area.

Finally, I would like to give a brief commentary on our markets. While we are seeing a slow recovery in our companion animal business, mostly a reflection of our general economy, our production animal business is seemingly setting up for a very strong recovery and favorable trend. The recovery is being driven by a return of domestic demand but more importantly, very strong exports and supply limitations, not only domestically but globally.

These favorable trends are being mitigated by unusually high grain prices but we believe that given the demands caused by exports for protein, that prices will more than offset the impact of grain – protein prices will more than offset the impact of grain prices. Given global demand for protein, some of the supply shortages around the world and our nation's production capabilities, we believe that the indications, at least for the near-term, are very favorable for the production animal markets.

In summary, there are many more positive indicators in our business and our industry than negative. We believe that the trends are favorable on the sales, gross profit and expense lines. And then we believe that our company will continue to gain momentum over the coming quarters and throughout the year.

I will now open it up for questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Thank you. Our first question is from Mark Arnold with Piper Jaffray. Please proceed with your question.

Mark Arnold – Piper Jaffray

Good morning, guys. Great quarter. I guess just to start, Jim, maybe, you talked a bit about the demand for exports and domestic demand particularly for beef. But can you talk a little bit about the dairy side of the business? I think milk prices have jumped pretty substantially here since the beginning of the year. Has that started to positively impact your business yet and what is kind of your outlook for dairy for the rest of the year?

Jim Robison

The prices really didn't start to move upward nicely until January in the dairy market. We think the situation there is still a bit tentative. Exports are growing. There is some concern around global supply and yet domestic supply last year was up about 2.5%. So although we've seen prices spike into the mid to high 16 range, I think that although dairymen are generally more optimistic than they've been historically, they are still a bit tentative.

Mark Arnold – Piper Jaffray

Okay. And then just adding to your comments about gross margin, how should we think about gross margins over the rest of the year, given your changing product mix with both the addition of the PVP business as well as kind of the shift in, I guess, percentage of your business that is dairy versus beef. I mean, it seems like beef is becoming a bigger component of your total sales than what it has been – if we go back three or four years ago. So how should we think about that and that continued changing mix impacting margins going forward?

Jim Robison

I think – well, the largest factor impacting margins has been the shift in policy from a major supplier. There are products coming to the market now that are meaningful and we think that throughout the year there will be increased competition around key products as well as our launch of proprietary products. There also is a settling of competition around PVP's closing.

When that happened, there was a bit of a jump-ball phenomenon and people were scrambling for business and we think that will settle as well. So it is our belief that sequentially, at least, margins will improve on a forward basis.

Mark Arnold – Piper Jaffray

One last question for me and I let somebody else jump in but Bill, can you remind me what the prepayment penalties are on your new refinanced debt?

Bill Lacey

It is three, two, one, 3% in the first year, 2% in the second, 1% in the third year and I think it has a 1% change in control. It's only 1% if there is some change of control in the company.

Mark Arnold – Piper Jaffray

Great. Thank you, guys. Great quarter again.

Operator

Our next question comes from Jeff Johnson with Robert W. Baird. Please proceed with your question.

Jeff Johnson – Robert W. Baird

Thanks. Good morning, guys. Let me follow up, I guess, just first on some of Mark's questions there on the dairy versus the beef business. Last quarter, you know, obviously, dairy markets still under pressure, still seeing those revenues grew a little bit. Any insight into what dairy revenues did this quarter and could those revenues stay positive in the second half of the year with the improving dynamics we are seeing here?

Bill Lacey

Yeah. Jeff, our dairy business was up about 10% in this quarter. But a lot of that was the calf ranches associated with what we consider our dairy business. So I don't think there was a lot of growth in this quarter in our dairy business. It was mostly the calf ranches associated with the beef business.

However, there was a lot of uncertainty in the last quarter, in that October to December quarter around pricing. This is when – during that period, the corn went from $3.50 to over $6. And we didn't see much movement in milk prices during the quarter, so – and don't hold me to it, but I think we probably ended that quarter with milk prices around $13.00, $13.50, which was not a healthy combination of $6 corn and $13 milk price. And as Jim alluded to, since then, we've seen corn prices edge up slightly. They are in the upper $16 range right now, but you're also looking at beef – excuse me – milk prices in the $18 and $19 range.

So the milk prices have recovered substantially, and I think we will see growth in that area in the future.

Jeff Johnson – Robert W. Baird

Right. And then two follow-ups there, I guess. Bill, one, last quarter, you provided some sort of revenue range as far as your expectations for the year at 700 to 730. Any updates there? And Jim, maybe what you're seeing as current breakevens in the dairy market at this point.

Bill Lacey

I'll take the first part of that. I think the range of sales is still a solid range for us. I think we will see – if we surprise, it will probably be on the top line, modest – very modest growth in margin and continue to leverage the SG&A cost.

Jim Robison

I think that it is changing continually, given the dynamics around grain prices. But if you – just looking back 30 days, breakeven is in the $15, $16 range. The real strong operators might be in the mid 14 to 15. But dairymen are still, on a cash basis, struggling a bit and probably only slightly over their breakeven.

Jeff Johnson – Robert W. Baird

Okay. Got it. And the last couple questions here. Bill, as I break out your guidance for the rest of the year on the EBITDA side anyway and try to take that to an operating margin, it does look like you are guiding to maybe 100 basis points or so operating margin over – expansion over the back half of the year. Is that a fair look here? I know you just made some comments here about not getting a whole lot of margin leverage but it does look like we could get, in the back half of the year, up maybe close to 100 basis points.

Bill Lacey

At the operating margin, I think you could see 100 basis points but it's not going to come all through gross margin.

Jeff Johnson – Robert W. Baird

No, understood there. And then last question just on cash flow, I guess. Any figures for the quarter, Bill, that you could provide and then I'm assuming you are going to be building inventory throughout the year with the PVP and some of these new products and that. So is it fair to assume cash flow doesn't provide you much for the year to pay down debt but as we get into fiscal '12, maybe start thinking about some debt paydown at that point?

Bill Lacey

Yes. That is a great question and I think you are spot on. We don't anticipate any positive cash flow for this year due to the increased needs of working capital as the company grows again. In the quarter, we paid down the revolver just slightly, about $1.5 million but year-to-date, we have a negative $14 million cash flow.

And I measure cash flow as change in revolver, not in the GAAP sense of change in cash. So the revolver has been up about $14 million and about $19 million of that is change in working capital. So again, we put in a lot of inventory and receivables in growing this business in that first quarter and that's leveled out in the second quarter.

Jeff Johnson – Robert W. Baird

All right. That's all I've got. Thanks, guys.

Bill Lacey

Thanks Jeff

Operator

(Operator Instructions) Our next question is from John Kreger with William Blair. Please proceed with your question.

John Kreger – William Blair

Hi. Thanks very much. Bill, could you talk a bit about your bad debt reserves? Were you able to reverse any of those in the quarter?

Bill Lacey

No, we've seen probably about $400,000 of bad debt provision over last year in this quarter and it was a result of – I think there were four dairies that went out of business during the quarter. And they seemed to be – I mean, we know the dairies were a little stressed but these seem to be isolated. It is not an epidemic.

John Kreger – William Blair

Okay. So you wrote down 400,000.

Bill Lacey

We wrote off – or we set up a provision for $400,000. Our bad debt reserve is relatively flat year-over-year.

John Kreger – William Blair

Got it. Okay. And Jim, I think you mentioned earlier that it sounds like you're feeling like you could have at least a modest improvement in margins as the manufacturer contracts for calendar '11 are all put in place. Any more clarity on that? Do you have those contracts at this point?

Jim Robison

We have not signed all of our contracts. We generally have terms for all of them and they were slightly favorable. Given our current sales activity, probably measured in the low-single-digit millions of gross profit margin. We've also seen the return of the modified live vaccines from two suppliers at superior margins to what we're currently selling. So that is going to provide us some upside as well.

John Kreger – William Blair

Great. Great. And perhaps maybe just expand on – as you look across your portfolio of products, what do you think about as particularly low-margin versus high-margin? What are the key things that we should be watching to see if your mix is likely to get better or worse in the coming year or two?

Jim Robison

I think there is essentially two factors. One is our ability to drive share with vendors that we have either a preferred or focused relationship with. And we are very excited about the opportunities for the year across all markets, companion and production animal. And then secondly, our launch of proprietary products.

And as I mentioned in my shareholder letter, we've targeted five initiatives this year. They may not have a material impact to our sales or earnings this year. But four or five of those projects are progressing very nicely and we are very excited about them. So we've spent a lot of time, effort and resources around proprietary initiatives and we think on a forward basis, they are going to pay off very nicely.

John Kreger – William Blair

Great. And then next one, to come back to your comments about dairies and breakeven level, with feed costs going up, are you seeing those breakeven levels also go up?

Jim Robison

They go up, certainly do, yeah.

John Kreger – William Blair

So the 15 to 16 is – reflects current feed prices or does that reflect hedging levels with lower costs?

Jim Robison

I think that is probably a current number. Dairymen are very creative. A lot of them are vertically aligned. They grow a lot of their own feeds. So they find a way to manage ration costs down as grains that they do have to purchase go up. I think it is fairly safe to assume that most dairymen are operating at a slight profitability or breakeven.

John Kreger – William Blair

Great. Great. Thanks. And then finally, just to clarify your comments about rebates, did we hear you right that the rebate swing was negative $0.5 million this – versus a year ago?

Bill Lacey

Correct. That's right.

John Kreger – William Blair

Okay. Thanks.

Bill Lacey

Not all rebate. That was just one particular rebate we got last year for a special circumstance and we didn't get that this year.

John Kreger – William Blair

So in aggregate, would you say the change was about $0.5 million or a different number?

Bill Lacey

I would say that is a fair number.

John Kreger – William Blair

Okay. Thanks.

Bill Lacey

We didn't see a lot of change in rebate rates over the quarter.

Operator

Our next question is a follow-up from Mark Arnold with Piper Jaffray. Please proceed with your question.

Mark Arnold – Piper Jaffray

Two quick ones. Jim, for a lot of us, I know me included, the last three or four years – or the last three years, given how it has been such a struggle, I've forgotten what normal is. So can you give us a sense for how we should think about the rest of the calendar year from just a seasonality perspective, given how your business in more normal times would kind of flow through the year, so we can think about the next few quarters, really out through the end of the calendar year?

Jim Robison

You know, that is kind of a tough call. I think you are asking to make a subjective comment around a question that is kind of difficult to nail down. But let me just tell you this, we are still not back to normal. Ethanol legislation got extended for the year. It got thrown into the extender package of 10 days before the holidays, after 15 senators sent Harry Reid a letter telling him, telling Harry that it didn't make any sense to support ethanol legislation.

About 40% of the corn that is grown today in the U.S. is used to create ethanol on a whole host of arguments that doesn't make sense. That has been a negative factor for our business, as you know, affecting volatility of grain prices and risk in the production market. The general downturn in the economy would have been something that we handled much more effectively had it not been for the increased volatility in the production market.

And then the second – the third factor is that of manufacturers' policies. And after a very protracted, successful relationship with a key manufacturer, they cut our margins by 60%, that’s not normal. So we've sustained in a very difficult environment. I think the ag markets generally are setting up for a very favorable trend. I do not believe that corn will be used to make ethanol for the long-term because there are alternative production processes that are much more efficient.

And so I – but we can't count on that affecting us really certainly in this fiscal year or even in this calendar year. But the reality is that we have a – we sell to a customer – about 80% of our business goes into the production market. We sell to a customer that is world-class in making proteins and we are blessed with tremendous natural resources in this country. Given the growth in developing countries and their propensity to consume proteins, I think that the ag business is setting up very nicely for a protracted run.

And for us, that means growth rates in the mid-to-high single-digit levels. I think our normalized gross profit margins – if you took out what has happened to us in the last three years, our transactional gross profit margins would actually be up slightly. And I believe that as we see a return to growth in the marketplace, given by macro trends – given to macro trends of demand and supply and we see new products enter the marketplace, we're going to see more competition for share.

And I think we will see a return of the use of rebates to drive sales growth and we will see margins trend favorably. And I think our business will recover pretty nicely over time. I wish I could give you more of a quarter-to-quarter analysis, but other than to say that as our companion animal business grows and it was up nicely – it is up nicely year-to-date, we see the offset to the production animal business. The production animal business is more of a fall business. The companion animal business is more of a spring business. So I think we will see less swings in our quarter-to-quarter results. But again, I think the long-term macro trends are very favorable.

Mark Arnold – Piper Jaffray

Okay. And then just the last question was you mentioned the Lancaster facility opening in the quarter. Give us a little bit more color of when that may happen and then you also said that that should allow you guys to save on freight. I assume you picked up a decent amount of PVP business in that region. Does that – so I assume that those higher freight costs were a drag on your margins here in the last quarter. So we should think about that as maybe being something, as we think to the June quarter, at least, that will be a positive contributor to gross margin.

Jim Robison

We are currently servicing that market out of Memphis and I think the freight impact is between $500,000 and $600,000 favorable for opening that facility. There is a pretty nice net savings associated with it and given that we have a fairly strong position with rep coverage, we are excited about that opportunity. And it should kick in – date-wise, I think it will start to impact us in the fourth quarter and certainly mostly in fiscal year 2012.

Mark Arnold – Piper Jaffray

Great. Thank you, guys.

Operator

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

Jim Robison

Thanks for joining us this morning and we appreciate your participation in our company. Thank you. Have a good day.

Operator

Ladies and gentlemen, that conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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