Hillenbrand Industries (HB) Q3 2007 Earnings Call November 15, 2007 8:00 AM ET
Peter H. Soderberg – President & CEO
Gregory N. Miller – Senior VP & CFO
Kenneth A. Camp – CEO Batesville Casket Company
Blair A. (Andy) Rieth – VP Investor Relations,Communications & Global Brand Development
Patrick De Maynadier - Counsel
Greg Halter - Great Lakes Review
Adam Cahn - CitadelInvestment Group
Good morning and welcome to the Hillenbrand Industriesconference call. [OperatorInstructions] Later we will conduct aquestion and answer session and instructions will be given at that time. As a reminder the conference call is beingrecorded. [Operator Instructions]
On the call today will be Peter Soderberg, CEO and Presidentof Hillenbrand and Hill-Rom, Greg Miller, Hillenbrand Senior Vice President andCFO, Ken Camp, CEO Batesville Casket Company, and Andy Rieth, VP InvestorRelations, Communications & Global Brand Development.
Before we begin I would like to provide Hillenbrand’s usualcaution that this morning’s call may contain forward looking statements such asforecast of business performance and company results and expectations about thecompany’s plans and future initiatives. Actual results may differ materially from those projected from an indepth discussion of risk factors that could cause actual results to differ fromthose contained in forward looking statements made on today’s call. Please see today’s press release. Also, you may reference the discussion underthe heading risk factors in the company’s annual report on form 10-K for theperiod ending September 30, 2007, to be filed this month. If you have not received today’s release itis available on Hillenbrand’s website www.hillenbrand.com. Now I would like to turn the call over toyour host Mr. Andy Rieth, please go ahead sir.
Thank you Darryl and good morning everyone. I would like to personally welcome you tothis call; we’ve got lots to discuss today so we will jump right in. I’d like to establish a few ground rules forour call in order to optimize the amount of time available for yourquestions. We’ve scheduled about an hourfor the call and our prepared remarks will take about 30-40 minutes. We will them move on to Q&A. Please limit your inquiries to one questionplus a follow up per person and then if you have additional questions feel freeto rejoin the queue. As noted in ourpress release, the telephonic audio replay of this call is available untilNovember 22. And further, this webcastand the accompanying slides that you will see today will be archived on ourwebsite for about a year. Also I want tonote that our 10-K for fiscal year 07’will be filed before the end of November and will serve as a good compliment totoday’s material. As we announced onNovember 5, Hillenbrand Industries filed an information statement on form 10with the Securities and Exchange Commission on behalf of Batesville Holdingsrelated to the previously announced separation of its two operatingcompanies. This form 10 registrationstatement is posted on the SEC’s website at www.sec.govand also can be viewed on the Hillenbrand website at www.hillenbrand.com. Finally, I’d like to remind you that anarchive of the slides and audio from this call as well as our October investorconference are available on our website. With that I will turn the call over to Peter.
Thank you Andy. Goodmorning to everybody. We’ve got a lot ofground to cover this morning as the face of change is accelerating at HillenbrandIndustries. I plan first to brieflyreview Hillenbrand’s consolidated results then I’ll dive deeper into Hill-Rom’sresults and outlook before turning the discussion over to Greg and Ken. Later I’ll conclude with a brief update onthe status of our separation then we’ll take your questions.
We closed out our fiscal year with a quarter that reflectscontinued progress in executing our operating strategy. The quarter also demonstrated some areaswhere our corrective actions have not yet taken hold as measured by ourfinancial results. On a consolidatedbasis Hillenbrand’s worldwide sales of $530 million collected growth of 1.9% versus 2006. For the full year the sales were $2 billion24 million, growth of 3.1% versus 2006. Hill-Rom’s capital sales showed another strong growth reaching 7.2% and9.1% for the year. Hill-Rom’s rentalrevenue for the quarter decreased by 3.8% a bit more than we anticipated. For the year, rental revenues declined 2.3%. Batesville Casket sales of $158 million forthe quarter were down 3.1% driven by what appears to be a 3.5-4% decline offunerals from the prior year.
Turning to earnings, consolidated net income from continuingoperations was $.77 a share. On an asadjusted basis, earnings for the quarter were $.82 a share a decline of 26.8% versusthe prior year. The year GAAP earningswere $3.07 per share versus $3.60 for the prior year. On an as adjusted basis, earnings were $3.17per share versus $3.55 per share in 2006 a decline of 10.7%. Our EPS performance while down year over yearreflects our commitment to execute the strategies for both companies weannounced last October and is actually at the mid point of the guidance weprovided you at that time.
Let me remind you once again that we’ve just completed thefirst full year of a three year strategic and operational journey designed tofix and grow Hill-Rom and lay a more solid foundation at Batesville Casket to withstanda period of low deaths and increasing death care industry consolidation. 2007 was a critical year of investment in ourbusinesses; we will continue to invest into 2008 before we see a strong upturnin earnings planned during the second half of the year.
In line with these programs with prudent targeted investmentfourth quarter saw operating expenses increase by over $25 million up 19%. Hill-Rom we aggressively ramped up marketingspending which increased 35% and R&D spending which increased 32% versuslast years third quarter. Hill-Romoperating expenses were also impacted by separation related expenses ofapproximately $6 million. Ken willdiscuss Batesville Casket investment programs during his remarks. As a result of these investments we have madeand will make we expect to see 2008 earnings per share as adjusted in the rangeof $3.20-$3.48.
Now I would like to turn specifically to Hill-Rom in orderto recap our fourth quarter and full year accomplishments how much further onhow we have set the stage for profitable growth in 2008 and beyond. A quick review of our original Hill-Rom financialguidance first presented last October shows that we hit our numbers for capitalsales primarily due to the tremendous strength of our international businessand for operating income as adjusted. Wewere softer than anticipated in rental sales and gross margins due to factors thatGreg will explain. Operating expensesramped a little slower than we expected but did accelerate in fourthquarter. Greg will introduce our fullguidance for 2008 shortly but as a result of our investment program Hill-Rom’ssales guidance for 2008 reflects anticipated organic increase of 5.2% to 8.8%and increases in operating income before litigation one time separationexpenses of 1.7% to 16.7%.
Now I’d like to discuss progress related to our strategicinitiatives. As we shared before inpresentations and in the many meetings we’ve had with investors, we arecommitted to fix and grow Hill-Rom as summarized in this slide. It is my strong belief that successfulexecution of this strategy must begin with the people and culture ofaccountability in performance. Whilecultureship never happens as rapidly as one would like, we have madesubstantial progress, 42 of the 80 positions that report to me or to my directreports have seen changes in leadership over the past year or so. This includes a mix of external highlyexperienced talent that we have brought in blended with strong leaders alreadyhere. Then of structures, communicationsand transparency have all improved focused and align these teams. Our planned separation of Hill-Rom into asignificant pure play medical technology company will aid us materially inthriving further a culture that will fuel more rapid innovation and profitablegrowth.
Our core as we referred to it is our cornerstone NorthAmerica hospital capital sales business which recorded revenues of $197 millionfor the quarter up a meager 0.3% and $655 million for the year up 3%. During the quarter North Americacapital sales increased 5.6% excluding the decline in our total care ICUproducts. As we suggested last quarterwe believe there is a temporary slow down of ICU purchasing decisions whilecustomers evaluate a new competitive IC product as well as our own enhancedproduct now in its early launch base. These results are clearly unacceptable as they collectively representsome share loss in a category we believe is growing at mid to high singledigits. This is why we are focused onexecuting the following two major initiatives.
First, new product development, we continue to increasespending in this area and a significant portion of this has been targetingNorth America Acute Care patient support, patient environment and ITsolutions. Most recently we are bringinga broad array of new and or improved products into their launch stages includinga long overdue set of enhancements to our total care ICU bed and the serviceswe offer with it. Multiple new productsfor patient rooms to enhanced patient and caregiver satisfaction. A new range of Temper-Pedic services, [Bedcon]activity interoperability solutions couple our beds with hospital ITinfrastructure and a portfolio of patient safety solutions programs powered bythe NaviCare Patient Safety Software Suite. Our patient safety solutions programs bring together Hill-Rom clinicalresources, proven processes, tightly integrated technology. Our Safe Skin, No Falls and Clear Lungsprograms facilitated by our NaviCare software provide comprehensive solutionsthat are highly differentiated.
Recently updated CMS in patient reimbursement rules couldaccelerate the focus and adoption of patient safety solutions. As incremental reimbursement for severaltypes of adverse events that often occur in hospitals will be eliminatedeffective October 2008. Patient fallsand nosocomial acquired pressure wounds are two of the clinical conditionstargeted by the skin is changing. Wewill work with our customers to help them identify ways in which Hill-Rompeople processes and technologies will help reduce the incidents of theseadverse clinical events.
Our second area sales force focus upgrade andexpansion. During the quarter weconcluded that we did not have adequate representation in the field both to accommodatethe numerous new products we were launching and to service our installedbase. Accordingly we are in the finalstages of building a new market specialist sales organization. Very successfully tried out this concept in2007 we will have in place a total of 30 new reps fully trained during thisquarter.
Turning to our North American Acute Care Rental business thequarter was a tale of two cities. Rentalrevenue from our proprietary therapy products accounting for a majority of ourrental revenue stabilized and grew slightly thanks in part to some strongperformances by our new TotalCare Bariatric Plus platform. We are looking forward to renewed growth inour rental therapy products after securing a five year full source contractfrom [Broadlane] a large group purchasing organization covering Hill-Romtherapy services and certain services, rental and purchases. This is the first time in 11 years that over900 hospitals were [Broadlane] members have access to Hill-Rom products oncontract. On the other hand, furtherweakness in our Movable Medical Equipment (MME) products area. We are convinced that much of our problemhere is that we ask 100+ clinical services sales force to represent MME alongwith their many other responsibilities. Given the need of sales force to increasingly focus on our numerous newproducts coming down the line and on patient safety solutions offering, we havedecided to create our Midway in creating and recruiting and training adedicated sales force of 34 professionals. We believe it will take until the second half of 2008 to see a turnaround in MME.
Turning towards our strategies to improve gross margin,while we made progress for the year, we were disappointed in our gross margindecline in Q4. Greg will explain this further,however, let me confirm that our key low cost region manufacturing initiativeis proceeding very well. Our Monterrey, Mexico plant is nowstaffed by great team coming online. Going forward our guidance reflects returns of positive gross margintrends in 2008. As we increase oursourcing from low cost regions, improve our sales mix from ICU hospital bed andsurface sales and ramp up production in Monterrey.
Next let’s move down to our North America Post Acutebusiness. As we have describedpreviously to you we believe post acute care offers us an addressablemarketplace approximately $2 billion per year. Growing at high single to low double digit rates. Our penetration of this space is only about10%. We enthusiastically look for latein the quarter the introduction of our Hill-Rom 100 Low Bed pictured in theslide, which fills a large gap in our offerings. As we heretofore did not offer home basedpatients a frame on which to put our preventative and treatment surfaces. We believe we offer our customers a superior valueproposition considering design, secures and functionality.
We will also be seeing on the highway the new branding thatwe have developed for our nearly 900 USdelivery vehicles used to transport our rental products to and from hospitals,clinicare facilities and homes. As weincreasingly focus on the post acute business we want to communicate topatients and their caregivers get the same great products in these settings asthey are used to getting in the hospital. As such, our branding features Iconography presenting the full continuumof care. This fresh new look also featuresa No Falls, Space Spin, Clear Lungs, patient safety solutions methods.
Additional progress is also made during the year in fixingour post acute rental billing systems for the cash processes other ITinfrastructure challenges we previously faced.
Finally, we saw from a 33% increase reported in the currentquarter our post acute care capital sales started offset decline in theirrental side of post acute care as customers choose to capitalize their rental.
Now let’s turn to perhaps the biggest bright spot of our2007 performance, our international business. By beefing up new product flow enhancing our channel presence,collectively pursuing acquisitions in alliance, we are growing our business atsuperior rates. We believe we aregaining significant share in Europe largely due to theintroduction of the AVG 800 Bed and associated line of furniture. This platform will be iterated to other competitiveproducts offerings. Introduction of anew derivative of this AVG frame launched late in the quarter will allowHill-Rom to have compelling product available for customers medicalized longterm care. Other care settings where wehave had limited offering. This productand our renewed efforts international markets have enabled us to secure solesource multi year contracts in Francefor acute care, medicalized long term care, ICU and labor and delivery.
Integration of Medicraft acquisition in Australiais succeeding successfully contributes strong performance in 2008. Further, our partnership with Paramountin Japan shouldalso begin to show its roots second quarter 2008. They have just commenced distribution of ourhigh end patient support platforms in Japan. The second largest medical device market inthe world.
Finally, let’s consider our three entrepreneurialunits. Hill-Rom IT solutions, Hill-RomRespiratory Care and Allen Medical. We’ve seen early successes with these units each under new leadership,collectively grew revenue over 9% in 2007 and margins by 26%. At Hill-Rom IT Solutions group introduced avariety of new software releases, including the Navicare Patient SafetySoftware Suite already mentioned. OurRespiratory Care Group has had remarkable success with the Vest. Our high frequency chest wall isolationtherapy platform. The new Vest Airway ClearanceSystem is designed specifically for hospital use and promises to continue todrive strong growth for respiratory care. Allen Medical our surgical patient positioning business continued torelease sophisticated apparatus for use in specialized spine, orthopedic andlothodomy procedures.
In conclusion, fiscal year 2008 financial guidance willconfirm that the initiatives I have described will begin to bear fruit in2008. We are more confident than everthat our strategies are sound that our investments are prudent. While these investments will continue toprovide us with headwind in the first half of 2008 they are consistent with astrategy we communicated previously. Webelieve they are essential to reverse historical underinvestment to positionthe company for accelerated growth at or above industry rates. I am pleased with early indications verypleased with the fine team we have assembled and have sufficient evidence toconfirm this is an appropriate path.
Now I would like to turn the call over to Greg Miller.
Thank you Peter. Thismorning I will discuss our fourth quarter and our fiscal 2007 performance, Iwill also include insights into our fiscal 2008 guidance. To begin with though I would like tohighlight two items. First, as Petermentioned the fourth quarter and full years lower earnings partial results fromthe plan and guided accelerated investment spending were in the key strategicinitiative. As we ramped up theseinvestments in 2007 especially in the last half, lower earnings on a year overyear basis fault and are expected to carry into the first half of 2008.
Second, it is important to note that the fourth quarterresults reflect a total of approximately $23.5 million of significant costsitems including costs associated with our pending separation of the businessunit to two independent companies increased Hill-Rom reserves for each rentaland receivables, increased Batesville Casket customer rebate allowances awarranty item and costs associated with the termination of Batesville effortsto acquire Yorktown Casket. I willfurther discuss each of these later.
Let’s get started with consolidated revenue. Overall, consolidated revenue for the quarterincreased $9.7 million or 1.9% on a year over year basis for a strong fourthquarter of fiscal 2006. The next fewslides I will discuss revenues across our business more specifically.
First, fourth quarter consolidated revenue growth cameentirely from Hill-Rom’s capital sales with an increase of $18.6 million or7.2%. Leading the increase capital salesin the fourth quarter was our International Surgical business which increasedsales $16.1 million or 29.2% which is an increase of $12.4 million or 22.5% ona constant currency basis. This resultsfrom strategic investments into new products, expansion of our sales channel, afirst quarter acquisition of Medicraft.
Year to date International Surgical revenues are up 25.7% orup 20% on a constant currency basis. In2008 we anticipate a continued double digit international revenue growth drivenby growth from new products, increased expansion into the medicalized long termcare market in select European countries and continued expansion of sales andmarketing efforts and to under penetrated geographic regions.
Further, as illustrated by our 2007 acquisition of Medicraftand our recently announced distribution relationship with Paramount Bed in Japanwe will continue to selectively evaluate acquisitions and alliance opportunitiesthat provide us product extension, augment our capabilities or enable us toenter into a new geographic segment.
Capital sales in North America Acute Care were essentiallyflat in the four quarter and up 3% for the full year. We continue to see accelerated volume ingrowth areas where we have invested in new or improved products, however, thisgrowth was offset by lower revenues within our mid to high acute hospital bedplatforms in the ICU segment. As Peterdiscussed, excluding the year over year decline of sales, which in the ICUsegment due to delayed purchases, North America Acute capital sales would haveincreased 5.6% in fourth quarter and 6.3% on a full year basis. In order to maintain our strong leadershipposition in the North America Acute Care patient support system business wewill continue to focus on the investments, launch a number of new products andextension of important core products, increase our sales channel capacity withan additional 30 market specialists and work with our customers to enhancepatient safety, reduce the number of adverse events.
For 2008, based on our strategic investments, the last half offiscal 2007 and the first half of 2008 we expect revenue for North AmericaAcute Care capital to increase at the market growth rate of mid to high singledigits. Although less than 5% of totalcapital sales are post acute capital sales for the quarter and for the yearcontinue to grow at a rate in excess of 30% the result of enhanced saleschannel focus and proved bed frame sales.
We believe there are substantial opportunities for Hill-Romto increase our low participation level in the post acute care marketplace forboth capital and rental items. During2007 our strategic investment capabilities have proved our business processesand extended our portfolio of products. In early 2008, we will be launching several new products including a newglobal patient support platform as well as patient room furniture andaccessories. We believe we are wellpositioned to maintain mid teens revenue growth in this critical and expandingmarketplace. Overall for 2008, Hill-Romcapital sales are expected to grow 5-9%.
Moving to Healthcare rental revenues. Fourth quarter revenues were down $3.8million or 3.8% from prior year. Thisdecline includes a charge for aged receivable reserves of $7.6 million up $2.6million from a similar item in prior years fourth quarter in our acute and postacute rentals. During the fourth quarterwe completed and extensive collection program of our aged rental receivablesinvolving both sales and credit personnel. Following occurred higher allowances we believe we have now collectedand or cleaned up the aged receivables related to prior year’s systemimplementation billing issues.
We also experienced continued declines in our North AmericaAcute rental business due to cannibalization from capital purchase of pulmonaryitems and our Post Acute rental business due to lower Medicare reimbursement ofGroup II surface rentals. Both segmentshave also been unfavorably impacted by the year over year loss of business backto movable medical equipment products from GPO contract realignment.
That said, we have been able to offset some of thesedeclines and have realized significant growth in areas we have invested in thepast year including new products for bariatric rental which were up 22% year todate and fleet investments into the wound segment up 8% year to date.
Additionally our respiratory care business, the Vest, postedstrong mid teen quarterly and year to date revenue growth. Year to date rental revenues are much thesame story, down $9.9 million or 2.3% compared to the prior year. The decline was expected given theunfavorable impact of prior year GPO realignment activity, which at the beginningof the year we guided as potentially unfavorable impact of $25 million and fromthe carry over affect the past billing and processing issues service andproduct efficiency.
During the past year in line with our revitalizationstrategy, we have stabilized and improved the efficiency of our rental billingsystems and processes. In addition, ourrevitalization efforts also included innovating and investing in fresh ofrental fleets with new clinically superior products and to regain ourcompetitiveness and better share of our customers.
We invested approximately $65 million of the original fullyear estimate of $60 million into our rental fleet in fiscal 2007. Carrying this momentum into 2008 in additionto continued investment in the higher value added clinical therapy new technologywe intend to create a focus sale function of 34 specialists aimed at profitablygrowing our Movable Medical Equipment product line. Aligned with the opportunitytin post acute previously mentioned we expect 2008 rental revenues to increase4.5-9%.
Moving to funeral service revenues, Batesville Casketcompany revenues of $158.2 million were down $5.1 million or 3.1% compared toprior year fourth quarter. Fiscal 2007revenues declined $7.4 million or 1.1% from fiscal 2006. Revenues in the quarter consistent with therest of the year were negatively affected as a result of lower burial volumesand a downward shift in product mix which was partially offset by positive netprice realization. The trend in lowerburial casket volume and an unfavorable product mix from metal to wood and tolower price point caskets all continued. After I complete my comments, Ken will address the efforts in place andthe opportunities that should yield 2008 revenue growth of 1.5-4%.
Now I’ll cover some key points on gross profit. Fourth quarter consolidated gross profit wasdown $7.9 million or 3.4% year over year. Consolidated gross margin rate was also down from prior year by 230basis points. Contributing to the lowermargins in the fourth quarter was a number of significant cost items that Iwill cover in a minute. Year to dateconsolidated gross profit increased $31.3 or 3.7% which continues to be at ahigher rate of increase in consolidated revenue in 3.1%. More specifically, in starting with HealthCare capital sales, fourth quarter gross profit improved slightly from theprior year despite the higher volumes in favorable net price realization. As we outlined in our last call, we hadexpected margin pressure in the last half of the year reflected by the declineof 280 basis points to 41.4%. The loweroverall margin rate in the fourth quarter is primarily the result of businesssegment sales mix. More specifically,during the fourth quarter our largest capital business unit, North AmericaAcute grew slightly and recorded a margin improvement of 80 basis points ourother major capital business unit International Surgical experiencedsignificant growth at 29% and also recorded a margin improvement of 70 basispoints, however, when viewed in total, fourth quarter capital margin ratesdeclined as the heavier mix of international revenues have margins that aresignificantly less than North America Acute margin. All that said, overall, we are improvinggross profit dollars and margins in each of our major businesses.
In addition to the overall segment mix overall gross marginswere negatively impacted in the fourth quarter by $1.2 million of start upcosts associated with our new Monterrey, Mexicomanufacturing facility and a $4.5 million charge it was an increase of nearly$2 million versus prior year. On a yearto date basis capital sales gross profit increased in line with the growth incapital sales with gross margin rates holding steady at 41.9%. This increase in gross profit was drivenprimarily by volume, various costs savings initiatives in our sourcing andmanufacturing areas and favorable price realization. These improvements were offset in margin bysimilar factors as we mentioned in the fourth quarter including startup costsassociated with our new Mexico manufacturing facility now totaling $3.4 millionfiscal 2007.
In 2008, we expect to expand capital sales margins 90-240basis points to a range of 42.8-44.3%. Margin improvement actions in 2008 include a continued focus on improvedprice realization, select price increases and improved pricing discipline. Continuous improvement activities in ourcurrent manufacturing facilities, the introduction of higher margins, newproducts and the increased utilization of low cost region manufacturing inMexico and sourcing from China.
Moving to health care rental business, fourth quarter grossprofit decreased $.9 million or 2% when compared to the prior year on lowerrevenues of 3.8%. The fourth quartermargin decrease is directly related to the 7.6 million in rental reserveadjustments as outlined earlier this charge directly impacts gross margin aswell. If the additional rental reserveswere to be excluded we would have achieved our fourth consecutive quarter withmargin rates in excess of 50%. Asmentioned before we believe we have now collected and are cleaned up all theaged rental receivables related to previous year’s rental system implementationbilling issues. Full year 2007 rentalgross profit remained relatively flat despite a decrease of rental revenues of$9.9 million. As gross margins improved120 basis points, 49-50.2%, improvements in gross margin rates experienced infiscal 2007 is primarily related to lower field service costs which were down$4 million for the quarter and almost $13 million for the year. These lower field service costs are directlyrelated to the affect of restructuring and other cost improvement actions takenat the end of fiscal 2006 and completed in 2007. Margins have also been favorably impacted byenhanced pricing discipline, product and customer profit improvement activitiesand investments into higher margin products.
In 2008, we expect to continue improved health care rentalgross margin to 50.8-52.5% by increasing our leverage in economizing scale fromour field service network to increased rental revenue. Continuous process and product improvement effortsand continued investments in higher margin rental products.
Batesville Casket business fourth quarter gross profit wasdown $7.6 million or 10.8% versus the prior year and down 340 basis points as apercent of revenue. While the prior yearincluded a gain on a sale of a facility of $.8 million, a majority of themargin declined related directly to the affect of higher discounted rebates,overall lower volume, unfavorable product mix and higher commodity price of redmetals. The higher rebates and discountsin the fourth quarter of $3.5 million related to year end true up of primarilyindependent customer sales programs and allowance accounts.
Fiscal 2007 gross profit has declined only $1.2 milliondespite a revenue decline of $7.4 million as gross margin rates increased 30basis points to 41.8%. Our ability toslightly improve margins for the year despite some of the margin pressuresdiscussed above is driven by favorable net price realization cost savings ofapproximately $2.7 million associated with our prior year wood plantconsolidation and productivity improvements achieved in manufacturing,distribution and endless supply chain. As Ken will mention later, we believer there are still opportunities forimprovement here.
As such, in 2008 we expect gross margins to expand as muchas 120 basis points or within a range of 41.5-43%. Fourth quarter 2007 consolidated operatingexpenses increased $25.2 million or 19% versus the prior year. Fiscal 2007 consolidated operating expensesfor the year increased $75 million or 14.2%. As mentioned in previous quarters, fourth quarter spending represents ayear over year acceleration from the beginning of fiscal 2007 as we ramped upstrategic investment spending in the last half of the year.
As detailed in the corresponding next slide the maincomponents of the fourth quarter and the year to date increases include thefollowing. First, the increasedstrategic investments in operating expenses of $12.8 million during the fourthquarter and $33.7 million for the year as outlined as part of our 2006-2009strategic plan to accelerate revenue growth in future years. As Peter mentioned this increased spendingincluded research and development, marketing, merchandising and sales channeldevelopment.
As part of this, Hill-Rom R&D increased a total of $8.6million the full year and the percent of revenues from 3% in 2006 toapproximately 3.5% in 2007. Further, weexpect to continue to grow R&D as a percent of revenue to be more in linewith that of our peer group of companies which spend 5-5.5%.
Also contributing to higher expenses were first costsincurred with respect to the pending separation of the two operating units of Hillenbrandof $6.2 million in the fourth quarter and now $12.4 million for fiscal2007. Secondly, write off other costsassociated with the discontinuance of Yorktown supplyagreement of an additional $1.5 million in the fourth quarter and totaling $8.7million for 2007. This matter is nowfully behind us. Third, acquired companyoperating expenses are $1.6 million for the quarter and $6.1 million for theyear associated with our acquisitions of Medicraft and a small distributor inthe funeral industry. Fourth, foreignexchange impacted $1 million for the quarter and year to date of $3.5 millionand then general and salary benefits and other spending inflation.
As Peter mentioned fiscal 2007 was a critical year ofinvestment in our business and we will continue to invest in 2008. As such, considering the ramp up investmentsduring 2007 we expect year over year increases in operating expenses tocontinue in the first half of 2008 with the benefits of earnings in the secondhalf of fiscal 2008 and accelerating through 2009. Overall on a consolidated basis for 2008 weexpect operating expenses to increase 5.7-12% when the range of $615-652million excluding anti-trust litigation and separation transaction costs. This also excludes incremental costs that wouldbe required for Batesville Casket to be operated as stand alone company uponseparation.
Please refer to our details in the guidance release for abreakdown of Hill-Rom corporate and Batesville Casket Company operatingexpenses.
A reconciliation of GAAP to adjust diluted earnings pershare has been provided in the slide for your reference. And also is a schedule of to our earningsrelease. In the fourth quarter as aresult of the increased strategic investment and numerous large costs items ouradjusted earnings for fully diluted shares declined $.30 on a full year basisadjusted earnings for fully diluted shares declined $.38 to $3.17 which is inline with our guidance and consistent with the investment gross strategyoutlined last October.
As far as liquidity and balance sheet position I just pointout that we continue to have solid financial position from which to execute ourstrategic initiative.
Moving to primary work in capital. Primary work in capital increased $9.3million in Q4 year over year primarily due to increased inventory levels associatedwith the current year acquisition, new or scheduled product introductions andthe ramp up of our Mexicofacility. We have seen an improvement inoverall sales outstanding and accounts receivable and as mentioned before webelieve we have collected or reserved for the aged rental receivables resultingfrom previous year system implementation billion issues. This has resulted in slight reduction inaccounts receivables despite increased four quarter revenues andacquisitions.
Our detailed fiscal 2008 guidance is included within ourearnings release today and our related conference call slide. As I have already discussed many aspects ofour guidance I will summarize it now.
For fiscal 2008 we expect Hillenbrand consolidated revenueof $2 billion $104 million to $2 billion $170 million, where Hill-Rom total revenuesare expected to increase 5-9%, Batesville Casket revenues are expected toincrease 1.5-4%. We expect GAAP earningsper share in the range of 299-327 and adjusted earnings per share in the rangeof 320-348. Adjusted earnings per sharerange reflect gross of approximately 1-10%.
As final comments, we generally have performed consistentwith our expectations in relation to our investment and gross strategy forfiscal 2007 we remain confident we are on the right track and as such we willcontinue to make necessary and prude investments and continue to fix andaccelerate our rate of growth in our Hill-Rom business and protect and grow BatesvilleCasket business in 2008. With that Iwould like to now turn the call over to Ken.
Thanks Greg. Goodmorning everyone. It is a pleasure toaddress you this morning with a few prepared remarks and to be available forquestions at the end of our combined presentation.
My purpose this morning is to provide an additional level oftransparency about our operation more consistent with reporting requirements ofa separate public company instead of a wholly owned division. As many of you know from your experience withBatesville and from the recent releases of the other publicly traded companies,the past two years are in the base volume challenge. Although these volume challenges represent acontinuation of flat to declining deaths and increasing cremation the recentpast second straight year without a significant combine to reduce the number ofcaskets and in so doing, provide a challenge to revenue growth. As we haveanalyzed these drivers and search for weaknesses in our own performance and forcorresponding opportunities, we find that the diminished volume is presentacross all geographic areas -- rural and urban, U.S.and Canada --and all customer types, large and small, public companies and independent.
That said, I'll provide a high level summary of Batesville'sresults and some commentary on our actions and counter measures. As Gregmentioned, our fourth quarter revenue of $158 million was down 3% from thefourth quarter of 2006 and the total 2007 revenue was $667 million, down 1% fromthe prior year.
Our disappointing performance in this period was mostheavily affected by the aforementioned reduced demand for caskets which isconsistent with industry trends, as we noted in our press release. The casketbusiness is one where the consumer's purchase is not discretionary and the saleis driven by adequate floor representation, shelf space if you will, and aneffective and timely funeral director reorder process. While there is noindustry reporting system for market share and we do not comment on ourestimated share numbers, it is our belief that our customer base is intact andthe representation of Batesville Caskets in these selection rooms isundiminished.
Another factor which reflects revenue is the mix of productssold. Our mix has been somewhat negatively affected by the long-term industrytrend toward a lesser mix and by our introduction of several new metal productsin those lower price point segments where we have traditionally beenunderrepresented. The results of these introductions have been good, but theynaturally increase the mix effect.
In order to respond to our substantial core of customers,who are also facing the recent volume challenges, we have expanded ourcapabilities and conducted sales rep training around effectively merchandisingthe selection rooms of more customers in '07. Batesville's proprietarymerchandising system enables a funeral home to present a broad array ofproducts to serve all of their client families and to articulate the value ofthe product at each price point. The system permits us to accurately predictincremental average sales based on the casket assortment offered.
The gains we have experienced here have been veryencouraging. We believe there is still tremendous opportunity for our customersand for us. Perhaps most important, families report higher levels of purchasesatisfaction when provided with more information about the features andbenefits the products offer.
Another driver of revenue is effective price realization.Batesville brand continues to be strongly viewed among most industryprofessionals and to some degree by consumers. This positioning enables us tocommand a premium price for our premium brand. We are especially effectiveamong those customers and client families who recognize the value of addedfeatures, materials and overall quality and are naturally less effective withfuneral directors who are solely price buyers.
One element of our results which clearly deservesexplanation is our fourth quarter gross margin percentage decline of 340 basispoints. Despite the challenging fourth quarter results, our year-over-yeargross margin improved 30 basis points as a result of increased productivity andprice realization.
Fourth quarter's gross margin results were driven by severalfactors:
- The effective lower volume on our manufacturing and distribution fixed cost base;
- Previously mentioned mix trends;
- Inflation on key commodities, which include red metals and steel, total of which increased 18% in average price;
- Increased distribution costs as customers and consumers demand ever more rapid service. This item, while adding to our cost profile, is one of our key competitive advantages.
- We also had a one-time gain on the sale of a distribution facility in 2006 that is comparable during that period.
Another driver of our results was some year-end adjustmentsof nearly $3.5 million, $2.5 million primarily for existing independentcustomer sales programs and fixturing agreements and slightly less than $1million to increase our reserve for estimated customer product returns.
As I mentioned earlier, we are not satisfied with our grossmargin performance this quarter. As we push to grow top line revenues, we arealso are challenging ourselves to ensure that we're achieving the mostefficient and effective cost structure.
We have several key margin improvement projects in placewhich we expect to generate savings in 2008. Our first is a new computerizedwood optimization system which will improve yield throughout our wood manufacturingfacilities by reducing the amount of wood that is lost in the manufacturingprocess.
Second, we have made investments in robotics in our metalplants in 2007 and are seeing the effects of those investments now.
Third, we are realizing the full benefits associated withassembly plant consolidation.
Fourth we will continue improvements as we have done in pastyears to generate year-over-year productivity gains using our kaizen skills.
Despite the challenge we've identified, there are a numberof elements in our business about which we are very pleased. The merchandisingsuccess we have had is good for our customers and for us. We are working toexpand and accelerate that effect in 2008 and beyond.
We are also developing products that match the changingsociety needs, an example of which is our dimensions caskets that serve theneeds of an increasingly obese population.
Another growth opportunity for us is our veneer woodproducts made in Chihuahua, Mexico.This product line continues to show steady growth as funeral directorsrecognize they can provide the uniqueness and beauty of wood at lower cost thansolid wood products.
As part of our continued efforts to drive volume and improvemix, last month we introduced several new bronze and wood caskets, all withinterchangeable life symbol corners and our patented memory safe drawer. Thesecaskets are positioned at price points well above our current average sale.
As the gradual consumer shift from metal to wood purchasescontinues, maximizing efficiencies at our consolidated modern wood plantcontinues to be critical. While we have made good progress here, there havebeen some periods of efficiency variation as we finalize the consolidation oftwo wood plants into one. We believe that there are still further gains torealize as we apply our continuous improvement capabilities to further increasethe level of performance.
As some of you may know, in 2005 we purchased casketstamping and other tooling to enter the business of manufacturing casket partsand finished products. The strategy is to develop relationships withindependent distributors and manufacturers while using our production capacityto provide high quality, private label caskets to them. This product line,which we call North Star, is separate and distinct from the Batesville brandand does not contain the patented Batesville piece. North Star businesscontinued at a nice growth pace in 2007. We have added sales and engineeringcapacity to expand our customer base in '08.
In the last year-and-a-half we completed the acquisition andintegration of two small regional casket distributors. The retention of theircustomer base exceeded our targets and the financial result in both instanceswas several times our weighted average cost of capital. These successfulacquisitions have provided some positive learning, helped us refine ourcapabilities and future opportunities.
Finally, our e-business initiatives continue to bear fruit.We are now the largest creator and host of funeral home websites in theindustry. In fact in 2007, the number of funeral homes that have opted forBatesville's website services doubled over the prior year, providing thefoundation for us to bring a continuing series of new features and products toour customers and their client families in future years. As you can see, we'vehad a number of successes this year and we view them also as opportunities onwhich to build solid results in both the near and long term.
The core principle in Batesville is building upon existingcompetencies, strengthening our ability to meet emerging trends and makinginvestment decisions to provide increased shareholder value over the long term.
With that guiding principle in mind, I would like to commenton the elements of our strategy and the priority Batesville places oninvestments. Our strategic direction is aligned with our core competencies andindustry dynamics. Our first investment priority is protecting and growing thecasket and cremation products business.
In addition to the items that I discussed earlier, ourefforts to grow the casket business involve expansion of our sales presence byadding sales representatives to improve account coverage over the next coupleof quarters. All of these sales representatives will be trained in effectivemerchandising and that will be the cornerstone of our selling process.
As I previously mentioned, we're also expanding salescoverage in our North Star private label business. We continue to deepen ourrelationships with all independent distributors. We believe that this supplyrelationship with those distributors and manufacturers may in some cases leadto future acquisitions.
Our last strategic priority will be to periodically evaluateand consider the relative returns of entering businesses that capitalize on ourcore competencies and are adjacent to the [healthcare] business.
Despite a tough quarter, our ability to produce attractive,industry-leading margins and turn them into operating profit and shareholdervalue and our ability to generate substantial free cash flow remains strong. Wehave counter measures in place for most of the business conditions we face,we're structuring our business for solid performance if death rates do notincrease in 2008. If there is a return to historic influenza patterns, ourresults will be stronger.
In addition to the risk of lower mortality, it should benoted that we face the risk of continued inflation in some commodities,particularly steel, red metals and as we've all experienced recently, fuel.
In conclusion, our entire organization is excited at theprospect of becoming a standalone public company and providing significant andconsistent financial returns to our current and new shareholders. We willdiscuss our plans in more detail in future investor presentations.
I'll now turn the call back to Peter Soderberg for closingcomments.
Thank you, Ken andGreg. In wrapping up our prepared remarks, I would like to briefly update youon the status of our planned separation. As we announced on November 5th, wefiled our Form 10 with the SEC related to the spin-off of Batesville Caskets.Filing the Form 10 is an important milestone in the journey towards separation,which remains on track for completion in February 2008.
While we await clearance of the Form 10 and a ruling on theaccounting treatment of the sharing agreement related to the Batesville Casketantitrust litigation, we are hard at work in preparing for separation byFebruary. I am pleased to say we have also just received from the IRS thefavorable tax ruling we had anticipated.
Our operating executives are focused on executing theirrespective operational strategies while we have our small corporate grouplaying the foundation for this defining event. We will provide you with moreinformation on the progress of the SEC's consideration of our filings andrelated accounting treatment of the JSA as soon as we have more information.
Before we take your questions, I would like to summarize byobserving that we remain committed to the strategies we laid out for you justover a year ago in New York.While we have much to accomplish, we are pleased with the early signs ofprogress in the areas we are heavily invested in. We are starting to seeresults from our fiscal year '07 investments, but are not yet satisfied. Ourguidance reflects continued investment during the first half of fiscal '08,especially in sales channel expansion and new product development, as well asthe beginnings of accelerated growth in sales and profits.
Separation is proceeding and we continue to believe that itwill be a transformational event that will unlock value creation forshareholders and employees of both operating companies.
We will now be pleased to take your questions.
(Operator Instructions) Your first question comes from GregHalter - Great Lakes Review.
Greg Halter - Great LakesReview
I know you filed the form for the spin relative toBatesville, and we certainly appreciate the detailed information there. Tryingto get at the same data on Hill-Rom on a pro forma basis, will there be anysort of information provided in that regard?
In regard to Hill-Rom, typically the process is we file theForm 10 for the “spinnee” and then the “spinnor” will file an 8-K within fourdays of the actual distribution of dividends. That being said, I think that theinformation in the Form 10, you could pretty much use that and the consolidatedresults that you have to model out where Hill-Rom is at. I think it has enoughpieces to be able to figure out Hill-Rom.
Greg Halter - Great LakesReview
I certainly attemptedthat but there's a lot of investment income and things going back and forth.
The second question I had is on the antitrust litigation,who will be responsible for paying those costs going forward?
We have our general counsel, Patrick De Maynadier here.Patrick, I'll let you respond to that.
Patrick De Maynadier
The costs of thelitigation going forward would be paid by Batesville Casket Company.
It will be paid by Hillenbrand as long as we're together andthen after separation, Batesville Casket Company.
We'll take our next question from Adam Cahn - Citadel.
Adam Cahn - Citadel Investment Group
It seems that if we take out the costs that you've justidentified on the operating expense line as relating to the spin of the Yorktowne failedacquisition on integration, we have around 150 point increase as a percent ofrevenue and op expense at the midpoint of the guidance of 2008 versus 2007.Curious what the dynamics are around that? Did we not increase R&D thisyear and what are the expenses that increased op expense in 2008 versus 2007?
Let me take Hill-Rom and I'll let Ken respond to BatesvilleCasket. In Hill-Rom, we showed you a chart in the presentation of R&D andyou'll see the infection point was in the second quarter of this past fiscalyear. So we are maintaining that in fact we will increase year-over-year R&Dspend and that's just because it takes a while to fill the pipeline.
I am very pleased with the projects in the pipeline and thefact that they're going to come to market shortly. As you know, we are severalhundred basis points below the industry average.
The other thing we are doing is we spent some time on thecall describing our channel initiatives, particularly in North American AcuteCare. We cannot adequately sell all of the new products coming to market plusthis change in the market dynamic of safety solutions. We are adding feet onthe street and I think we've also improved the feet that were there. Our focusis really on the things that are going to yield acceleration in top line andmargin which is channel costs, sales and marketing.
One of the elements of the ramp-up in 2007 is the fact thatwe also have the annualization impact of some of the items that we did executeon in 2007 occurring for the full year of 2008 in the categories that Peterdiscussed.
For Batesville Casket, it's actually a negligible result ifyou take out the one-time expense current year for Yorktowne in the guidanceand investment in some of the items I mentioned to you when I spoke, that getsus right back to about the same level we were at prior.
Adam Cahn - Citadel InvestmentGroup
I am sorry. Can you speak up somewhat? We are having troublehearing you here.
I'm sorry. I'm alittle gravelly. I may be leading the charge in the winter cold season here.What I was saying is that the change in our OpEx is negligible. If you take outthe effect of Yorktowne in 2007, we have some expenditures for some of thegrowth items that I mentioned to you, which essentially nets out the Yorktowneeffect. From a dollar point of view, we're essentially flat year over year.
I go back kind of bigpicture here and say that on our fix and grow strategy at Hill-Rom, we promisedThe Street 6% to 8% compounded growth over the three-year period. You can seeadmittedly it is not as large a base in '07 as a straight pencil out on the '06base would indicate; we are getting that kind of growth in '08 and I thinkyou'll be pleased to see the trajectory thereafter.
These expenses support that commitment. We also remaincommitted to delivering the bottom line performance over time at Hill-Rom thatwe've indicated to you. I think none of our fundamental views of the marketopportunity has changed. In fact, the events of the last year, if anything,confirm our vision of where the opportunity is.
Adam Cahn - Citadel InvestmentGroup
So we're still seeing on a 2009 basis, based on thethree-year guidance, what would be a double-digit acceleration in 2009 versus2008 for operating income and earnings per share?
We're well aware of the math and we expect to reap theinvestment. Remember, we're at the front end of the power curve on some ofthese investments with this great new sales source we're fielding and with the Montereystart-up, so I'm pretty encouraged that we're going to get to where we promisedwe're going to get.
Adam Cahn - Citadel InvestmentGroup
Finally, in the other income line for 2008, you put out this$2 million number where we had $22 million in 2006 and then $13 million forthis fiscal year. What's happening in this line item and how does it go to $2million next year after we've had in excess of $10 million for the past coupleof years?
In that line, the major variance is the investments that wehave in private equity limited partnerships. Some of them were historicalcorporate investments, some of them were separated when we sold the [inaudible]business back into corporate and those are very volatile. They're in variousindustries and various types of investments. They're very volatile. If you goback a few years prior to that, you'll see that we had losses as big as gainsthat we're experiencing over the past two years.
So it is not part of our underlying operations and sotherefore, we do not project those in our guidance favorably or unfavorably. Welet those happen as they happen throughout the year and as you can see, we alsoadjust our earnings per share. That would be the line called net realized gainson investment, that's the primary thing going through other expenses.
Adam Cahn - Citadel InvestmentGroup
Should we expect thecost of capital return over time on the investment that you have in thesepartnerships?
Obviously, the intent on these investments was when weoriginally invested in them was to get our cost of capital out of them. Most ofthese are very historic and date back. Quite honestly, we've tried to monetizea few of these from time to time which is not an easy thing for us to do, justthe nature of the limited partnership deals that they are. So yes, right now,the last two years they've been doing very well.
Your next question comes from Greg Halter - Great LakesReview.
Greg Halter - Great LakesReview
I didn't see this anywhere and maybe I missed it, but didyou have what you spent for capital expenditures in '07 as well as yourdepreciation and amortization?
We have in our press release, you can look on one of theschedules that's attached to the press release and for capital expenditures intotal for the year, we spent $118 million at Hill-Rom and $17 million atBatesville Casket. Our depreciation was $89 million at Hill-Rom and $18 millionat Batesville Casket. That's detailed by quarter and for each fiscal year inthe press release.
Greg Halter - Great LakesReview
Regarding the shelf that you have, who is going to maintainthat?
That would bemaintained with the Hillenbrand, if you will, Hill-Rom companies, but as partof the capital structure, obviously we'll be looking at that for the spun-offcompanies with regard to setting up their capital structure as well.
Greg Halter - Great LakesReview
One last one for Ken on the Batesville side, I think there'san operating income growth projection of 3% to 4% for the next couple years andthen there were some costs related to the spin, I think of $4 million to $6million. I'm just wondering if those costs are in that projection figure?
I'm not sure I got the first part of your question.
Greg Halter - Great LakesReview
Within the Form 10 there's an indication that theexpectation for Batesville is to grow their operating income at a 3% to 4% paceover the next couple years. But then there are also some costs of $4 million to $6 million. I'm just wondering if those costs areincluded in that 3% to 4% or if those exclude those costs?
In the Form 10, what we've got is historical financialstatements and a pro forma financial statement for certain periods --historical periods, though. They're not prospective. The $4 million to $6million costs that you're seeing in there would be costs that you would have toadd to those pro formas. It is an estimate of what those costs would be, to theallocated costs that are already in the pro forma for Batesville Casket torepresent a stand-alone company.
I think if you look in the pro forma financial statementfootnotes and the pro formas, you can build a pretty good bridge on thestandalone Batesville Casket going forward. That's why we provided that extranote.
Just one more thing on your CapEx question. When we gave youoriginal guidance, we had not anticipated buying our Monterey, Mexico plant. So lastyear reflects a one-time fairly significant [bonus?] to purchase rather thanlease that plant which we did because of very favorable returns we could get onthat investment.
Greg Halter - Great LakesReview
I found it on these statements now, it looks like yourguidance for '08 on capital spending is about $135 million, which is aboutequal to what it was for fiscal '07. Any comment there?
I'll comment that on the Hill-Rom side we continue toimprove the currency of our rental fleets. We have a pretty strong new productflow. The Total Care bariatric product, as an example, is well exceeding ourexpectation which has led us to make investments in that product. We haveanother very exciting product that is highly differentiated. So we're backingthe high return portions of that fleet, the technology intensive portions withappropriate level of capital.
The final thing I'll say is we have additional capitalrelated to Monterey coming on as acompletely integrated plant. It's going to be one of the most modern,sophisticated plants in the world. Finally, our new product surge has causedsome increase in capital expenditure as well.
Greg Halter - Great LakesReview
Relative to on the last call there was some discussion Ibelieve of a competitor -- and I think it was Stryker -- that was mentionedroiling the market on the ICU side. Iknow you've made some comments about that, but just wonder how you see thatplaying out currently?
I'm not sure we mention competitive names but you'reapproximately right. In the ICU, this is the kind of flux that happens when amajor player in the industry introduces a significantly new product. Theinteresting thing is we thought this was going to happen earlier in the yearbut we're now in a situation of facing the early stages of a new product launchfrom them. Fortunately, in that period of time we've made tremendousenhancements to our products.
We really have a situation where customers contemplating amajor purchase are going to take the time to evaluate both products. What yousee is a stall in this market that will take a quarter or two to work throughand it's exactly what happened when we brought our VersaCare product online in2004.
We'll take our next question with Joe [inaudible] Partners,please go ahead.
Could you comment a little bit on some of the new productinitiatives, particularly Tempur-Pedic, how that's rolling out, what kind ofacceleration you're seeing, et cetera?
Tempur-Pedic is an example of our desire to reach outsidethe four walls of Hill-Rom to people with technology and I'm just thrilled withthe alliance we have with Tempur-Pedic. They have taken their technologies andredesigned very specific products for a variety of our stretchers and hospitalbeds. We began shipping our first products in July. We've had the incrediblywonderful anecdotes you would hope to hear of people not wanting to go homefrom the hospital.
It's early days, but we have a very significant opportunitypipeline right now on Tempur-Pedic. We've talked about the bariatric rentalbed. I showed you pictures of the brand-new extended care and home bed. This istruly a revolutionary platform that will allow us to really reach people wehaven't effectively reached with a sophisticated new offering.
In Europe, the results of the salesyou saw in '07 were driven by a new value point or lower priced point acutecare bed, but a very exciting thing is we've just gotten a French contract formedicalized long-term care. In Europe, the medicalizedlong-term care market is bigger than the hospital bed market. We now have acomplete portfolio of beds and surfaces and furniture, so we're aggressivelyexpanding into medicalized long-term care in Europe.
I think there is timefor one more question. Darryl, if you have anybody else in the queue, then we'llwrap it up.
No, sir. We don'thave anyone else in the queue. I wouldlike to turn it back over to management for any additional or closing remarks.
Thank you, everybody for being on the call. I appreciateyour interest. Lots going on here and we'll be happy to speak with you offlineas you desire. Thanks for your interest and attention.
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