Good morning and welcome to the Hill-Rom Conference Call. (Operator Instructions) As a reminder, this conference call is being recorded and will be available for telephone replay through May 03, 2011. See Hill-Rom's website for access information. The webcast will also be archived in the Investor Relations section of Hill-Rom's website, www.hill-rom.com.
If you choose to ask a question today, it will be included in any future use of this recording. Also note that any recording, transcript or other transmission of the text or audio is not permitted without the written consent of Hill-Rom. (Operator Instructions)
Now, I would turn the conference call over to Mr. Andy Rieth, Vice President, Investor Relations.
Good morning and thanks for joining us for our second quarter fiscal year 2012 earnings call.
Before we begin, I'd like to provide our usual caution that this morning's call may contain forward-looking statements such as forecasts of business performance and company results as well as expectations about the company's plans and future initiatives. Actual results may differ materially from those projected. For an in-depth discussion of risk factors that could cause actual results to differ from those contained in forward-looking statements made on today's call, please see the risk factors in our Annual Report on Form 10-K and subsequent quarterly reports on Form 10-Q. We plan to file our 10-Q for the second quarter later this week.
Joining me on the call today will be Mr. John Greisch, President and CEO of Hill-Rom; and Mr. Mark Guinan, Hill-Rom's Senior Vice President and Chief Financial Officer. The usual ground rules will apply to make the call today more efficient. We scheduled an hour in order to accommodate our prepared remarks and leave plenty of time for Q&A.
During Q&A, please limit your inquiries to one question plus a follow-up per person. If you have additional questions, you may rejoin the queue. As you listen to our remarks, we're also displaying slides that amplify our disclosure. I would encourage you to follow along with us. The slides were posted last night on our website and will also be a part of this archive.
With that, I’ll turn the call over to John.
Thanks, Andy. Good morning, everybody, and thanks for joining us today. We're pleased to report second quarter results that were in line with our revenue expectations as well as better than anticipated adjusted earnings per share. We continue to have topline challenges in several areas, but we remain focused on meeting our commitments to improve earnings and cash flow, and I'm pleased that we have delivered 9% adjusted earnings growth this quarter.
It is clear that Europe will remain difficult for the foreseeable future as will some of our other markets. And as evidenced by our recent restructuring actions, we plan to take cost out of the business where it makes sense in order to respond to these conditions. At the same time, we remain committed to invest to grow our business both inorganically as evidenced by our recent Volker acquisition and organically through investment in R&D and our international sales and marketing resources.
Let me continue with some comments our performance this quarter, starting with our largest business North America acute care. Consistent with the guidance that we provided last quarter, we experienced a low single-digit revenue decline compared to last year when we had a record quarter in Canada. While revenue declined year-over-year, we're encouraged that orders grew sequentially from the first quarter. Our orders increased sequentially compared to the first quarter. As expected, orders were down from last year when we recorded two of the largest single orders in the history of the company.
Our patient support systems category, the largest component of our North America acute care capital business, was flat in the United States. However, a decline in our patient support systems sales in Canada where we had a record quarter last year resulted in an 8% overall decline in our patient support systems category.
As you all know, patient support systems in North America has been our strongest performing business over the past couple of years, achieving over 25% growth in 2011. As we previously discussed, we expected the rate of growth to decline for 2012, which we've seen across the industry. Despite the challenges our customers continue to face and the uncertainty in the overall healthcare environment, we expect to see relatively stable order rates in this business for the rest of the year compared to the first six months of fiscal 2012.
Overall, our international segment performed well this quarter, slightly ahead of our revenue guidance. While European revenue declined, we experienced strong double-digit growth in several other regions, particularly the Middle East. Orders in Europe declined slightly year-over-year, but have remained relatively stable over the past several quarters.
We've seen good momentum in regions outside of Europe and we're encouraged by the results we have achieved in countries where we have been investing in sales and marketing resources over the past two years. Although this business tends to be driven by one-off tenders, I'm encouraged by the progress we are making around the world. Revenue will remain lumpy on quarter-to-quarter basis, but we are building a sustainable presence in many of these markets.
We also had a modest contribution from the Volker acquisition which closed mid-February. We're very excited to add the well recognized premium Volker brand and high-quality product portfolio to Hill-Rom. Volker's annual revenue of approximately $100 million significantly enhances our international presence and provides us with a leading portfolio to leverage across the world.
Our North America post-acute business had another challenging quarter with revenue declining slightly worse than we expected. Growth in our respiratory care business was more than offset by declines in our home care and extended care businesses, but we continue to see cost and reimbursement pressures.
Mark will cover our margin performance in his comments, but I'm pleased that we improved our adjusted operating margin and delivered a solid increase in adjusted earnings per share. Despite the margin improvement we saw for the quarter, as we announced at the end of March, we undertook a restructuring to further improve our cost structure and streamline operations.
As we mentioned on previous calls, we intend to take a disciplined approach towards addressing opportunities to improve our cost structure. That isn't one major action that will get us to where we want to be, but includes SG&A rates below 30%. But this action represents the next step in our plan toward that goal. We are eliminating over 200 positions or 3% of our workforce from across the company to better position our operations to support our future growth.
While we are eliminating cost in certain areas, we continue to invest in growth opportunities internationally and in North America as well as increasing spending in R&D at a faster rate than revenue growth. Mark will cover the details of the restructuring in his comments. But before I pass the call to Mark, let me comment on the FDA warning letter that was the subject of an 8-K disclosure we made in March.
After a routine inspection of our Batesville facilities last fall, we received a warning letter identifying a number of improvement opportunities. Since the date of the inspection, we believe we have already corrected a number of the observations made by the agency. We've responded fully to the warning letter and will be working closely with the FDA to remedy all of its observations as expeditiously as possible.
Importantly, the warning letter does not restrict our ability to manufacture or sell products, nor does it require the withdrawal of any products. Further, this is not expected to affect regulatory clearance of any products in our pipeline. And we do not believe these matters will have a material impact on the company's financial results.
We do take this matter very seriously. Over the past 18 months, we have appointed new leaders of our manufacturing, R&D and QA/RA organizations, each of whom has extensive medical device experience. We will work closely with the agency to remediate the issues raised.
With that, let me turn the call over to Mark before I wrap up and take Q&A.
Thank you, John, and good morning to everyone on the call. Before we get started, I want to highlight that many of the figures we will discuss today are adjusted for non-GAAP measures. Reconciliations to our reported U.S. GAAP numbers are included in the appendix to our slide deck.
Now let's get started with revenue. On a consolidated basis, reported second quarter revenue increased 3.2% to $415 million or 4.1% on a constant currency basis. Our capital sales increased 7.8% to $301 million. This was driven by 33.7% improvement in our international segment due primarily to growth in the Middle East and Eastern Europe and the impact of the Volker acquisition.
This strength was partially offset by a 3.4% decline in North America acute care, driven primarily by lower sales in Canada compared to the particularly strong quarter in patient support systems sales in the prior year. As we look ahead, we're excited about the opportunities available to us through our recent Volker acquisition and encouraged by the strong backlog of our international segment. Consolidated rental revenue decreased 7.1% to $115 million with lower revenues across all segments, on lower volumes and unfavorable pricing in select areas.
Domestic revenue decreased 2% to $262 million, while revenues outside the United States increased 13% to $153 million due to strong results in the international segment, including Volker. On a constant currency basis, revenues outside the United States increased 16%.
Looking at revenue by segment, North America acute care revenues decreased 4.4% to $240 million, led by the declines in Canada already mentioned and overall lower rental revenues. Capital sales were down 3.4%, driven by a decline in patient support systems sales of 8.1%.
North America acute rental revenue declined 7% with lower revenues in both the therapy and movable medical equipment product lines. We continue to experience pressure on rental volumes due to shorter lengths of stay and lower flu incidents.
Moving to our North America post-acute care business, revenue declined 6.3% to $49 million, as both capital sales and rental revenues were lower in the quarter. Extended care and home care revenue declined, while respiratory care revenue increased slightly. Volume and pricing continue to be under pressure in all businesses within this segment, and we expect this to be the case for the balance of the year.
International revenue increased 27.7% to $126 million due to the growth in several regions outside of the Europe and the impact of the Volker acquisitioned mentioned earlier. Excluding Volker, international revenue increased 16% on a constant currency basis as mid single-digit declines in Europe are more than offset by strength in the rest of the world regions.
Despite continued concerns over the environment in Europe, order patterns in Europe appear stable, and strong rest of world orders enabled us to achieve the highest international order level in our history. Note that the strong revenue growth in certain rest of the world regions was driven by several large projects and successful tenders. While we expect additional growth in the near term, these results may be irregular quarter-to-quarter.
Moving to margins, we posted lower adjusted gross margin performance for the quarter at 47.2%, representing a 200 basis point decline over the prior year. Both capital and rental adjusted margins were down with capital margins experiencing the larger decline. Our adjusted capital margins were down year-over-year by 180 basis points due to a number of factors, including the effects of a higher mix of international revenue, increasing commodity and fuel pricing, unfavorable product mix and generally lower margins associated with Volker products.
The cost pressures noted in the quarter are consistent with the commentary we provided in October. We expected inflationary pressures to negatively impact our year-over-year margins, particularly in the first half, but less so in the second half of the year. And that is what we have seen through our first two fiscal quarters.
The adjusted margin decline in our rental business of 130 basis points relates primarily to the lower revenues discussed earlier and the resulting reduction in the leverage of our product fleet and field service infrastructure along with the effects of higher fuel cost.
This is true in all segments of the business and compounded by some pricing pressure in North America post-acute and international. With that said, we expect our rental margins to be relatively constant over the balance of the year.
Regarding operating expenses, our R&D investments in the quarter increased 3.7% year-over-year. As we have previously discussed, we expect to continue to increase investments in R&D over the long term at a rate faster than revenue growth.
Adjusted SG&A expenses for the quarter decreased by approximately 4% year-over-year to $124.7 million. This is down 250 basis points as a percentage of revenue to 30% and down 120 basis points compared to last quarter. The SG&A decrease was primarily the result of lower personnel cost, legal fees and community donations, which more than offset the incremental SG&A associated with our recent acquisitions.
Adjusted operating profit for the quarter was $54 million, representing a 13.1% operating margin, up 40 basis points versus last year's comparable period. This improvement was driven by our aggressive management of operating expenses, which more than offset the previously discussed lower revenue and gross margins for the quarter.
The adjusted tax rate for the quarter was 30.7% compared to 31.2% in the prior year. The lower rate in the current year was primarily the result of higher current tax benefits partially offset by a higher tax rate on certain international earnings which were not subject to tax in the prior year.
In addition, recall that the expiration of the research and development tax credit at the end of calendar 2011 will negatively impact our full year fiscal 2012 rate by approximately 1 percentage point compared to last year unless the credit is reinstated.
So summarizing our key adjusted income statement metrics, operating income of $54 million was up 6% from the prior year with operating margin higher by 40 basis points on lower SG&A expenses despite lower gross margins. Our effective tax rate was down slightly. Adjusted earnings per diluted share was $0.59 in the quarter, representing a 9% increase compared to $0.54 in the prior year.
One final comment on operating results before I move on to cash flow and guidance. During the quarter, we had several items: net interest 16.9% of pre-tax charges, inter-GAAP earnings that are not reflected in our adjusted results. A couple of these items carry over from the first quarter, while several others are new to the quarter, reflecting current period strategic initiatives.
The first of the carryover items is the continuation of a matter dating back to last year, which resulted in $1 million benefit reflected in rental gross margin. This gain relates to an ongoing vendor product recall action that is expected to continue for the balance of the year.
The second of the carryover items relates to the combined effects of the inventory step-up and acquisition cost of $1.9 million incurred in related to our recently completed acquisitions. Approximately $1 million of this amount is reflected in capital gross margin, while the remaining $0.9 million is reflected in SG&A. Additional integration costs are likely to be incurred in the coming quarters in relation to these transactions which we will highlight as they occur.
Moving on to the new items, as outlined in the press release, during the quarter the company announced a restructuring action that included the elimination of approximately 200 positions. This action is anticipated to yield annualized savings of approximately $18 million after full implementation.
In addition, as a result of various strategic actions initiated during the quarter, the company also recognized various non-cash tangible and intangible asset impairments, the largest of which was the impairment of a previously acquired trade name based on anticipated changes in how the asset would be utilized on a go-forward basis.
The company anticipates incurring pre-tax charges in connection with the restructuring and other asset impairments totaling approximately $19 million to $22 million during 2012, of which $16 million or $0.17 per diluted share was recorded in the second quarter. Of the estimated $19 million to $22 million in charges, approximately half are non-cash.
Moving now to cash flow, our year-to-date operating cash flow was $124 million compared to $108 million in the prior year. The increased operating cash flow is driven by improved working capital, partially offset by higher current year estimated tax payments.
Now let's turn to guidance. I would like to remind you our guidance includes the impacts from the recently completed acquisition of the Volker Group. As with the change we initiated last quarter, we intend to provide you with guidance on the upcoming quarter for revenue and earnings per share. We continue to believe this will provide you with some additional insight into how we view the business and our near-term expectations.
For our third quarter, we expect constant currency revenue to be up 11% to 13% compared to last year with adjusted diluted earnings per share of $0.56 to $0.58. Organic constant currency revenue growth, excluding Volker, will be approximately 4% to 5%.
This guidance reflects relatively flat revenues in our North America acute care segment. I would like to remind you that while North America acute care orders were down year-over-year, orders were up slightly sequentially and flat with last year if you exclude the two large orders John mentioned previously.
We project a low single-digit decline in our post acute care segment and we expect our international business to continue to be strong with growth of approximately 25% excluding Volker. The forecasted growth in international is based on expected stability in Europe and strong performance from our rest of world regions due to recent order patterns. The 25% growth for the third quarter in our international business is a result of very strong orders over the last six months. We don't expect this rate of growth to be sustainable.
Moving to the full year, we are anticipating full year constant currency revenue growth of 5% to 6% and adjusted earnings between $2.45 and $2.50 per diluted share. Excluding Volker, our organic revenue growth is projected to be up slightly for the full year compared to our previous guidance of 3% to 4%. The reduction is due primarily to lower than previously anticipated second half revenue in North America acute care.
The foreign exchange rates remain near current levels, but company expects reported revenue growth to approximately 2 percentage points lower for the third quarter and approximately 1 percentage point lower for the full year.
This full year 2012 financial outlook reflects the following. We expect relatively flat revenues in North America acute care, slightly lower revenue in North America post-acute care and double-digit constant currency revenue growth in our international segment. Gross margin is anticipated to be approximately 47.5% versus our prior guidance of roughly 49% due primarily to the lower margin Volker business.
We plan to continue to grow R&D spending by mid-single digits as we continue to invest in new and innovative products. We expect to see continued operating leverage of our SG&A infrastructure. Operating margin improvement should be up 40 basis points on the year. Our tax rate of approximately 31% assumes the R&D tax credit will not be renewed this year. The number of shares outstanding for the year is expected to be in the range of $62 million to $63 million. 2012 operating cash flow is anticipated to be in the range of approximately $290 million to $300 million. And finally, we estimate $75 million to $85 million of CapEx investment during the year.
This has been a challenging year given the continued economic conditions in Europe and our U.S. hospital CapEx spending environment which slowed at a greater pace than anticipated. Notwithstanding the impact this has had on our revenue, through disciplined expense management, we are on track to deliver our EPS and cash flow commitments.
With that, I'll turn the back to John for concluding comments.
Thanks, Mark. Despite the obvious challenges, we are pleased with how we have delivered on our commitments for the quarter and with the outlook for a solid third quarter due to strong international performance. Even without the contribution of Volker, the overall third quarter revenue growth is expected to be in the mid single-digit range, stronger than we have seen for the first half of the year.
One of the challenges we mentioned earlier is the uneven level of business driven by tender cycles in many of the regions around the world. Although we are pleased with the anticipated 25% growth in our international business in the third quarter, we do not expect to sustain this rate of growth on a consistent basis.
In addition, based on our strong fourth quarter last year together with the weaker North American acute care orders this year as compared to last year, we are not expecting a strong growth rate in the fourth quarter as our third quarter might suggest. We will continue to manage the business in light of these challenges, and we are confident that we will deliver on our commitments.
We will also continue to aggressively pursue opportunities to further leverage our cost structure and redeploy investments into higher growth and value creating areas. I'm pleased to have completed the Liko Distributors and Volker acquisitions, and I'm optimistic that we will continue to deploy our strong cash flow to create value for our customers, employees and shareholders.
With that, operator, please open the call to questions.
(Operator Instructions) Our first question comes from Matt Miksic of Piper Jaffray.
Matt Miksic - Piper Jaffray
I wanted to go through some of your comments regarding I guess you added a little bit more color here on trends for the next quarter. I appreciate the quarterly guidance. If we look at acute care in North America for Q3 as being relatively flat, as you mentioned, is it a fourth quarter tough comp that sort of requires then that things may be slow down at the back of the year? Are you seeing anything that would suggest that things would slow down later in the year, or are we talking about something that's two quarters away and given the comps you're setting the guidance such that you've set? Just some color on your thinking for the rest of the year and your full year guidance would be helpful.
Specific to North American acute care, Matt, traditionally the third quarter is our weakest quarter of the year with a reasonable decline from the first half of the year. Last year we saw that in Q3. This year, as you mentioned, we actually expect Q3 to be relatively flat to what we saw here in Q2 and Q1 for that matter.
The fourth quarter, there is a couple of things in play. You mentioned one of them. It is a tough comp. One of the two larger orders that I mentioned in my comments shipped in full in the fourth quarter of last year. And that was about a $25 million. So fairly sizeable single order in the fourth quarter last year makes that comp a bit tougher than normal.
And then as I mentioned in my comments, the order rates in North American acute care have been down for the first half of the year. Our outlook for the rest of this year in terms of orders, which obviously translate into sales ultimately, is relatively stable. So we're expecting stability in the North American acute care market for the rest of the year relative to the first half of the year. But given that we've started the first half with weaker order rates than we had last year coupled with the large shipment that we had in the fourth quarter will result in a decline in revenues for us in North American acute care in Q4.
Matt Miksic - Piper Jaffray
And then just one follow-up, if I could, on what you're seeing with Volker, off to a strong start, it seems. Is this in line with your expectations? Are things going a little better than you expected there? And with the vis-à-vis egress technology, I noticed this may be looking out a littler further into the pipeline, but what kind of opportunity do you see for leveraging that differentiated technology?
Volker is pretty much as expected. As Mark mentioned in his comments, the financial impact of it was $15 million in revenue here in the quarter. When we announced the acquisition, we indicated it was going to be neutral to this year's earnings and that it was lower than our overall margins which you've seen here in the quarter. And Mark mentioned certainly the outlook for the rest of the year.
Six weeks into it now, it's completely as expected. We're very excited about the opportunities to leverage the portfolio. You mentioned one of their technologies. They've got a very good portfolio across the acute care and post-acute spectrum. And our ability to take their products into other markets outside of Europe is one thing that we're very excited about, including opportunities here in North America in our post-acute business.
So no surprises. Because eight weeks having it under our ownership, same level of excitement and opportunity to improve the business and take their technologies in the markets around the world.
Our next question comes from Larry Keusch from Raymond James.
Larry Keusch - Raymond James
I know, John, this is the smallest of your three business units. But the North America post-acute care really hasn't posted much growth in the last three years. So could you remind us again of sort of what your strategic plans are around that business? I recognize the environment is tough. But what can you do to kind of move things along?
The most attractive part of the post-acute business is clearly a respiratory care segment, which represents about a third of that business. The growth there has slowed somewhat over the past several quarters, mostly driven by some reimbursement pressures. But that specific franchise, we have pretty ambitious strategic intent to grow organically and inorganically.
The other two segments of post-acute, extended care, as we have talked on previous calls, that's a tough business with some of the reimbursement pressure that the extended care facilities are having. Our intent there is to continue to refine our product portfolio where we can and take cost out of the business as effectively as we can, as we did here in part of the restructuring.
The hardest of three segments for the impact of post-acute care is the home care business, and we've taken some actions here in the most recent quarter to exit some lower performing parts of that business, and we are continuing to look at that business long term to either improve the profitability or strategically do something different with it. Right now, it's not a terribly attractive part of the portfolio. We still have within the portfolio overall revenue in the $100 million range that is not contributing much to the bottomline. And we're either going to fix it or do something else with it.
Larry Keusch - Raymond James
This may be a little early to ask the question, but any color would be appreciated. I guess if I look at the restructuring savings, those should easily, if my math is right, offset the impact of the excise tax of the three quarters that you'd have in fiscal 2013 assuming it goes through at the contemplated rates. So if I look at your business and look at the offsets there and you get a little bit of benefit from the restructuring over the excise tax, your continued push on operating efficiencies, is it reasonable to think about earnings growth for the business in the double digits at this point?
I'd really not comment on '13 or beyond at this point, Larry. We're committed as we did here in this quarter to continue to drive operating margin improvements, and that's going to be a function of continuing to drive our cost down, as I mentioned, getting SG&A below 30% and we're just about there, but there is more to come. As I mentioned, we've still got portfolio realignment opportunities that are not in significance and continuing to redeploy our cash flow into value creating and obviously accretive opportunities going forward.
So we're committed to continue to drive operating margin improvements and it's going to come from a number of sources. But specific to '13 and beyond, I'd rather wait till the end of this year to comment on specifically.
Our next question comes from David Lewis with Morgan Stanley.
Jon Demchick - Morgan Stanley
This is actually Jon Demchick in for David. Had a question on Volker and how it's impacting the business. Clearly, as you guys mentioned, it is lower margin. But I was wondering just where the rest of your international business that was in the upper single digit, maybe mid single digit level, and just wondering if you could discuss the growth part.
I think when we announced the acquisition, Jon, we indicated that the operating margin profile of Volker was consistent with our international operations and that for this year was going to be a neutral contributor to earnings and going forward expected to be accretive. So we're in the same position with respect to Volker as we were when we looked at it and closed the deal and excited about the opportunity going forward.
Jon Demchick - Morgan Stanley
Do you see the same sort of cost savings associated with Volker that maybe you see in the rest of your international business?
Probably a little less relative to Volker. I think where the opportunity is, Jon, we're adding $100 million to our $400 million base and the opportunity to consolidate cost across the combined operations whether they specifically come out of Volker or parts of our existing operations we'll deal with going forward. But the real opportunity is to leverage the combined costs going forward. And that likely will result in some cost adjustments in the future.
Jon Demchick - Morgan Stanley
And then just one quick one on a comment you mentioned with stable order rates for the rest of the year. And I was just wondering what maybe gave you confidence in that given the recent fluctuations?
We saw growth here in Q2 over Q1. I think your question probably is specific to our North American acute care business. So recent trends, Q1 to Q2, we saw a slight increase in orders. And based on the order book we have in front of us, we're reasonably confident that we're going to see stability there. Obviously internationally, as Mark mentioned in his prepared comments, we saw a significant increase in orders here in the second quarter. But North America stability is really based on what we're seeing here in the last six months and the order rank that we've got in front of us.
Our next question comes from Lennox Ketner of Bank of America-Merrill Lynch.
Lennox Ketner - Bank of America-Merrill Lynch
First one, Mark, on the Q3 guidance. You gave a lot of detail on what's driving the revenue growth which is surely helpful. But I'm just trying to understand the Q3 EPS guidance and why that will be down sequentially. It seems like your guidance is implying revenue should be up slightly sequentially and that gross margins are relatively stable and then you have the restructuring kicking in. So I'm just trying to understand why EPS will be down sequentially. Is that just conservatism on your part or is there something specific that's driving that?
It's not down significantly sequentially, as you know, just a little bit of wiggle in any item on the P&L can make a difference. So if you look down the P&L there is nothing significant that would concern anyone in terms of changes in the business.
So at this point, I'd say it's a little bit here and there that the tax rate for instance, as we mentioned in current period, a good guide in the second quarter. And just a little changes in gross margin, SG&A, et cetera, but nothing of significance. We're then a couple of pennies on the bottom-end and there was a penny on the top-end as you know. So it's not a big difference.
Lennox Ketner - Bank of America-Merrill Lynch
So the restructuring, I think you said in the press release that that would be $18 million annualized. So is it fair to assume that we would kind of $4 million to $5 million impact on next quarter or that's not going to kick-in until Q4?
It's going to be a little more of a ramp, Lennox, as you know from my prepared remarks. We haven't completed everything. We still have some cost and therefore some actions. They are going to take place in the third quarter. So it's not a straight line and certainly that's an over estimation of the benefit we'll be seeing in the third quarter.
Lennox Ketner - Bank of America-Merrill Lynch
And then just last question on the gross margin. Is it possible that you say what the impact of Volker was in the gross margin this quarter to stand back from having that at perhaps the quarter?
If you look at the 200 basis point decline, Lennox, year-over-year, a little more than half is attributable to Volker. The balance is really a combination of product mix and geographical mix as I referenced and also few in material inflation contributed to that as well. So Volker was drove over half of the year-over-year decline.
Just a couple of follow-ups to what, Mark, just said. Remember for the third quarter also most of the revenue increase relative to Q2 is coming from a full quarter of Volker, which again as we indicated is going to be neutral to earnings. And then on the margin fronts maybe a small victory. But our gross margins excluding Volker from Q1 to Q2 actually showed a slight uptick.
So even if it's down year-over-year, I think we've stabilized the margin performance here, excluding the impact of Volker. And obviously are doing everything we can to keep the cost structure in line with revenue expectations.
And I'll just add to that, Lennox. As we spoke, the second half of last year, we had a couple of key drivers that eroded our gross margin in the back half of last year. One of them was the decline in the rental business, which eroded those margins. The mix between rental and capital, where capital was growing significantly, rental was declining. And there is a differential in the gross margin there and then the inflation that we incurred in the back half of last year.
So if you look from the back half of last year to the second quarter of '12, adjusted margins have been fairly stable. And as, John, mentioned they actually improved slightly from Q1 to Q2.
(Operator Instructions) Our next question comes from Chris Cooley of Stephens, Inc.
Chris Cooley - Stephens, Inc.
I just want to go back and maybe see if I can get some color in regards to your prepared remarks, as it pertain to gross margin on the capital side. You mentioned the pressure there, obviously I think you cited international component. I understand Volker having a lower margin, but with the growth in the Middle East historically, which has been a higher-end product sale.
Could you maybe just talk to us a little bit about the mix of what you're seeing in terms of your international business? And similarly how that looks in terms of the order flow going forward for the remainder of the year, so I can get a better understanding of the gross margin as we think about capital? And I have a quick follow-up.
On the gross margin front, you're correct. I'd say gross margins, which were representative of the enterprise and not lower gross margins. Some of the other growth was in some of the emerging markets was at a slightly lower gross margin. However, the important thing to note is that we go through distributors in those markets.
So while the gross margin is lower, the operating margin is actually comparable to what we would get in some of the direct markets. So it's a little different mix in the P&L.
Now, in terms of the balance of the year, which is the second part of your question. As we mentioned, at this point we anticipate very strong growth in the third quarter. But at this point we don't expect that you can do the math by backing the guidance for the year. We don't expect that to be sustainable through the fourth quarter.
So while there is as, John, mentioned and I mentioned, (technical difficulty) in terms of creating what we think are sustainable businesses and presence in those market, they will still be a lumpy business where we'll have some headwinds in terms of the strength of the orders.
Chris Cooley - Stephens, Inc.
But help me think a little bit about organic growth because effectively excluding Volker, we've lowered the revenue guidance and the earnings guidance if we adjust back the lower tax rate and little bit lower shares. What can you do to push organic growth across the portfolio, are there just anything that you can kind of point us to, that's in your direct focus of control here in the back half of the year that we kind of think about, so we're starting to think about the top line growth potential longer term?
Chris, the obviously that the biggest component of the portfolio today is our North American acute-care business and that's going to driven by the U.S. CapEx market and specifically hospital spending towards our patient support systems category. Our strategy going forward is to make sure we've got the best and most differentiated product portfolio to take advantage of the opportunity as it exists in the marketplace and a lot of our R&D spending is directed towards doing that across the portfolio, our surfaces, our stretchers as well as our bed frames.
As I mentioned in my comment and in response to Larry's question, the portfolio still has a component that is not terribly attractive towards on the bottomline, so you may see some revenue adjustments to really enhance the operating margin performance of the portfolio going forward while we are investing in areas that do provide some organic growth opportunities either driven by new products or enhanced products as I mentioned in the North American acute-care our with some of our organic investments that we're making in international markets as well as the respiratory care business, I mentioned earlier.
So all of our opportunities are not created equal here across the portfolio but the ones where we think the greatest opportunities exist are ones where we're deploying most of our R&D and sales and marketing resources and we're going to drive growth where we can there.
And at the same time, as you mentioned, I appreciate your comment, ensure that we're adjusting our cost base where appropriate to ensure we're achieving the operating margin growth that we can and deploy our cash flows into other areas that can accelerate the organic growth as we acquire new products or businesses.
I'm very pleased this year despite having to take down our organic revenue growth rate for the year on the back of the weakness we're seeing in the North America that we've been able to take actions to protect the earnings commitment that we made.
And as Mark said, the 245 to 250, we are committed to obviously for the year and making progress on a lot of the key metrics that we laid out over the last couple of years. That the biggest challenge clearly is the one you've asked about in terms of the organic growth rate. And we are trying to direct over SG&A and areas that are going to optimize that profile for us.
(Operator Instructions) Our next question comes from Gary Lieberman of Wells Fargo.
Gary Lieberman - Wells Fargo
Granted you haven't had Volker for too long but can you talk a little bit about the traction that you've had in the U.S. and kind of what are your initial thoughts are there?
The traction so far in the U.S. is not very strong, to be honest with you, we're just beginning to identify what products and what channels can we bring their products into. So to date there has been no contribution of their products into the US market.
The opportunity as we see it as I mentioned is expected to largely be in our extended care business segments. I think I've commented on previous calls the portfolio that we have in that segment is not what I wanted to be. And I think Volker represents a great opportunity for us there and our team is extremely excited about getting that product into the U.S. market which we hope to do here in coming quarters.
Gary Lieberman - Wells Fargo
So then maybe, can you talk a little bit about from what you're doing from a sale cycle in terms of planning to get ramped up with Volker sales in the U.S.?
Yes. We've got the team in place. Obviously, we have a sales force for the extended care market segment for us here. It's really about insuring, we've got the product knowledge, the registrations are all in place and bring it in through the channel that that we have today. So this isn't a year or two's process, as I mentioned, we're eight weeks into it and it's one of our key priority in terms of the integration to accelerate the growth of the product line here in North America.
Thank you. I'm showing no further questions in the queue. I'll hand the call back to speakers for closing remarks.
Okay, nothing further to say at this point everybody. Thanks for being on the call. And we look forward to speaking with you in the future. Take care.
Thank you, ladies and gentlemen. This concludes the conference for today. You may all disconnect. Have a great day.
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