Kristen Stewart – Deutsche Bank
Mark Guinan – Chief Financial Officer
Hill-Rom Holdings, Inc. (HRC) Deutsche Bank Securities, Inc. 37th Annual Health Care Conference May 8, 2012 8:00 AM ET
Okay. Good morning. Thanks for joining us today to the Deutsche Bank Health Care Conference. It is my pleasure to introduce Hill-Rom. With us today we have Mark Guinan, the Chief Financial Officer. So Mark's going to give us a couple of minutes of overview with a slide presentation where they're going to move it over to Q&A.
As a reminder, you do have instructions for logging onto or you want to submit questions online and if you're on the web cast, you can free to email me as well at email@example.com. So with that, I'm going to turn it over to Mark.
Thank you, Kristen, and good morning to everyone. Welcome to Hill-Rom's presentation at the Deutsche Bank Conference. First off, I want to remind everyone of the usual statements, remind you that we have some forward-looking statements contained in some of my comments today, and that I will refer you to our 10-K and recent 10-Q for a further explanation on some of the missed factors in our company.
For those of you who are a little less familiar with the Hill-Rom story, we are a medical products company that provides global leading products across the care continuum. And by across the care continuum, we’re talking about products from acute to post acute, starting out with our patient support systems, frames and surfaces, to patient lifts, to architectural products, to furniture and health information IT.
We also have two niche businesses. One is in the surgical positioning category, and one is in the respiratory space. We are a company that is very focused; continue to be focused on improving our margins, our EPS, and growing our cash flow. And over the last several years, we have seen quite an improvement in all three of those categories.
We have revenue sources that are primarily in the area of capital sales, but we also generate revenue in the rental space and also service. And as mentioned here, we have a solid international footprint from which to grow, and recently that was enhanced by our key acquisition of the Volker products business in Germany. Our products are very competitively positioned in our major categories.
In fact, if you look here you can see that our major products are either in the number one or number two position in the categories in which we compete in our major markets. You will notice that our patient support systems, which is our largest business, is number one along with therapy rental, architectural products and respiratory care, and you can see some other product categories in which we compete. We are in the number two position. And again this refers to the major markets because we have a global footprint, and could be all around the world.
We have a diversified business model. If you look both by business segment, business model and geography, even see that in North America acute care, which is primarily in the hospital setting, North America, we have over 60% of our business. That consists of the frames and surfaces as I mentioned, patient lifts, architectural products. It also has our surgical positioning business, and our health information IT.
The post acute setting, which accounts for a little over 10% of our business, is made up of three pieces. One is our extended care business, where we compete in long-term care facilities. The second one is our home care business, and then finally our respiratory care business is also captured within this reporting segment. And finally, we have international business, which is for everything outside of North America, and they carry the product lines I just mentioned, which are sold or rented throughout the world.
The second diversification comes across our business model. 70% of our business comes through our capital sales, sale of software, and services and about 30% from rental. And to be clear, rental is not a product that is a lease versus buy decision. It is actually use of our products for episodic events or specialized products, where the care giver makes a business decision to lease that product as opposed to purchasing it.
We also have diversification by geography, and 75% of our business is in North America, about 17% in Europe, and 8% in the rest of the world. And as I mentioned a minute ago, and we will go into a little more detail, the Volker acquisition will enhance our presence internationally, and especially in Europe.
You are all familiar with the challenges faced by the healthcare industry, and certainly we are faced with those as well. Customers are looking for improved outcomes, they are looking for reduced operating costs, and fortunately we are positioned to help them with those challenges. As I like to say, we’re with the grains. So, as opposed to adding to their challenges, our products, the orthopedic frames and services, our lifts, and our connectivity tools, we can impact both.
If you look at our products, they help to contribute to a reduction in patient falls, a reduction in the frequency and severity of skin pressure ulcers, and also a reduction in
Ventilator acquired pneumonia. They also help with the mobility and assist with the mobility of a patient, which helps to reduce injuries to care givers, both nurses and other staff.
So as you can see, both in terms of patient outcomes and reducing operating expenses, our products are positioned very well do help provide solutions to the challenges faced by our customers today.
Moving to our areas of strategic focus, we are very focused on leveraging our channel. As I mentioned, we have a very strong brand equity. If you go into almost any hospital in North America today, and certainly in many hospitals around the world and you will see a Hill-Rom products. If you also watch any television, and any of the medical shows, you will also quite frequently see a Hill-Rom product featured. So we are very well recognized brand, and that is a great opportunity for us to leverage both through adding products and services that enhance our value proposition.
We have an infrastructure that supports our sales and service of over 150 service centers in North America. So it is another opportunity that provides leverage. We are committed to innovation both organic and inorganic. I mentioned a minute ago, the Volker acquisition, but we are also committed to organic innovation. And we’re going to continue to grow R&D at a rate faster than our sales growth. We have been doing that for several years, and we have expressed an continued commitment to do so.
International expansion is a great opportunity; both top line growth, as well as improved profitability. Volker is one example, but we have also talked about recently some strong success in the Middle East and some of the emerging markets. And we also had a strong quarter in Latin America as well. So we see great opportunity in our international markets.
Portfolio acquisitions also additions like Volker, but also occasionally reshaping the portfolio to deemphasize areas that are not as attractive, not as profitable. It will be something -- that will be an area of focus. Financial excellence, as I mentioned a minute ago, continued focus on growing margins, growing EPS and our cash flow. We have an performance incentive system that focuses all of management on revenues, on EPS, and on cash. So we’re making sure that we really focus the organization around the key metrics that we are looking to deliver.
And then finally, people excellence. Of course, we see people as our greatest asset, and so it is definitely an area of focus. Let me spend a minute talking a little bit about our capital allocation strategy. This is something we rolled out about a year ago at our investor conference, and something we continue to focus on. If you start at the bottom of the chart here, we’re going to continue to need a certain level of capital expenditures to support our business, in the 25% to 35% range.
This is primarily to fund our fleet, our rental fleet. We do need some capital for continued operations in our manufacturing facilities et cetera, but this is primarily to fund our rental fleet, which is a source of revenue. Our 15% to 20% commitment to shareholders in the short term is continuing our historical range. And then finally the 45% to 60% you see here for funding strategic inorganic investments is a target. And all of these are guidelines. Certainly with any short period of time, you are going to see some variations.
As you look in 2011, we were more focused on returning to shareholders, and less so on the inorganic investments, and then recently as you saw the Volker, more emphasis on the top. So this is a long-term target as opposed to being something you would expect to see within a given short period of time.
Volker, which we closed recently in the last quarter in February, is a well recognized, high-quality brand in Europe, leading supplier of equipment and services again across the care continuum, especially focused in the post acute area. Had annual revenue of about $100 million. They bring with them direct sales channels in most of the EU markets, and distributor relationships in 30 countries worldwide. We get two manufacturing plants in Germany, one of them in Vitton [ph] and one of them in Hynicken [ph]. And most importantly, the strategic rationale for us is to continue to leverage our strong brand in Europe, and then to acquire both their commercial capability, as well as their innovative technology and their brand equity.
The details of the transaction as we shared in our recent earnings call was $77 million, funded via cash. And for 2012, we communicated that we don’t expect any impact on our unadjusted EPS. However, we do expect it to be accretive hereafter. So in closing, key takeaways for Hill-Rom, despite the challenging environment in which we are all operating, we remain confident in our ability to deliver improved earnings, margins and cash flow.
In fact, if you look at our recent quarter, you will see that we delivered on these and our guidance for the year suggest our commitment as well. We have diversified portfolio across business segment, across business model and geography that will help us sustain our growth. We have clinical expertise in patient safety focus that actually provides solutions and helps with our customers’ challenges as opposed to adding to those challenges.
We have great opportunity internationally, both for growth on the top line, and improving margin and profit. As I mentioned in our capital allocation strategy, we’re going to remain very disciplined and deploy our free cash flow in value creating ways, and finally, we have a management team that bring significant global healthcare experience with a proven track record of success.
And with that, we will now take questions.
Any questions from the audience? Mark, maybe if you could just kind of just kind of talk a little bit about the big picture of hospital capital spending, both in the US and Europe and those kind of both markets probably remain challenging, but what are your expectations as we look ahead for the US and Europe, and just kind of your thought process there?
Sure, Kristen. As we communicated at a recent earnings call, we have seen a significant slowdown in hospital capital spending in North America. We expect this to slow down, certainly not to continue at the growth rates that we have seen in the previous 18 months or so. But it slowed down at a little faster rate than we expected. And that has caused us to bring our revenue guidance down, from where we saw it at the beginning of the year.
With that said, you know, it is still a healthy market, which is not growing at the rates, but we have seen previously, or rates we had hoped coming into the year in North America, well, it certainly is not something that is falling on and off catastrophically. So if you look at Europe, it continues to be a challenge. Again, as we talked about, some single digit declines, really hasn’t deviated from our expectations.
So it is soft, but again it is not disastrous at this point. And then the markets outside of the developed world, we are seeing some healthy growth since we talked. That is really where it has been double-digit growth, both in the Middle East and some of the other emerging markets, including Eastern Europe. Recently we had a significant order in Russia, and then some strength in Latin America. So some of the investments that we have made internationally, or we see those starting to pay off as we are driving growth in those markets.
So softness in the developed markets, continuing in Europe, a little softer than we had hoped in North America. But you know, we see all the same projections you see about growth in the business, growth in capital spending, and we’re competing for those dollars along with other priorities.
And I guess what is your view on why you think starting this quarter we are starting to see CapEx flow? What are you hearing from customers?
We are not hearing anything, but given we can point there is no any sort of watershed event. I think the pipeline is as we have mentioned, it looks solid. People still have means to invest in the capital availability. The other thing I can point to other than other businesses capital somewhat cyclical and you are going to see some ups and downs. But there is nothing at this point that I can suggest as a trend breaker or anything like that.
I might add that I think in large measure, what we are seeing here is a bit of a reversion to the norm. We had seen if you kind of map out the peaks and valleys over a longer period of time, you are probably looking historically at a low single digit growth environment. And lastly I think we’re reverting to that after some very aggressive cycles that we have seen.
And maybe if you could just provide some color or an update from the FDA warning letter?
Certainly. We talked about this in John’s prepared comments pretty extensively at our quarterly earnings call. The FDA warning letter came out of a regular inspection last fall in our Batesville facility, which is our primary manufacturing facility in North America. We have responded in a timely fashion to the FDA. We continue to work with them on resolving them. Importantly the warning letter does not prohibit us in any way from shipping products. At this point, we don’t see it as an issue in terms of getting any approvals for any products that we have in our pipeline. And we didn’t have to recall any products from the market.
So, while we take it very seriously, and we certainly are committed to address this in the short term, we don’t see it as being material to our financial and business results.
Maybe, you could talk about gross margins, they were weak this past quarter, and I think you guys reduced your full year gross margin guidance, can you just kind of talk about the factors affecting it, and what you expect going forward, and what kind of improvement can we see in the gross margin line over the next two years?
Certainly. So a couple of questions there. Gross margin was down several hundred basis points year-over-year. A significant part of that was mix. The Volker acquisition has significant impact on the gross margin. So if you look on an organic basis, while it was down year-over-year and I will talk about some of those drivers, it was actually up quarter-to-quarter.
So as we have talked about improving gross margin throughout the year, you know, you saw some positive trend there. What has impacted gross margins really over the last three quarters has been several factors. One of them has been some inflation, commodity inflation. Certainly fuel prices started to jump up around the middle of our fiscal 2011. So the first half of 2011 had the advantage of not having higher fuel prices, makes it a tougher comp.
Also, steel, plastic, et cetera also have gone through the inflationary period in the back half of 2011, and then early in 2012. And that contributes both to our cost of our products in terms of manufacturing, acquiring materials, but also in delivering them. So in our service business, when fuel costs go up, we have got a fleet of over 600 trucks going in and out of hospitals every day. That impacts gross margin of the rental business.
The second key driver is that in 2011, our capital business was growing much more quickly, and our rental business declined somewhat, and that mix impact is significant to the enterprise gross margin because our rental business has about a 1000 point higher gross margin than our capital business. While this differential has slowed in the first half of 2012, we continue to see a decline in rental business, somewhat growing in capital business, and therefore that mix impacts, it is also driving some of the gross margin differential.
And then finally, there is the growth in the international business, which has been stronger than North America, there is gross margin difference. Not all of that has impact on the bottom line because some of those markets are through distributors. We have lower gross margins, but they have lower operating expenses. So the tradeoff between gross margins and operating expenses, you know, that is still looking very profitable.
Those are really the key drivers. As we said, we expect to stem the gross margin decline throughout the balance of the year, and the comps get a little bit easier year-over-year, but importantly sequentially we expect to improve that.
And then maybe on the Volker acquisition, how can you improve the profitability there?
Well, the first part is getting the purchase accounting behind us. But once that is done, certainly there is several opportunities, most importantly is to grow the business. We think there is a lot of opportunity in combining Hill-Rom and Volker’s capability to grow that business. The second one is really to look at some of the synergy opportunities between the groups; we want to be careful about that. One of the most important things when you integrate is to make sure you don’t act too quickly and damage the business.
So I’m not going to suggest that we have significant impact, the Volker impact, what we are more likely to do, and we announced recently, is we are moving our headquarters in Germany to their location in Vitton [ph], is to synergize between the two groups as opposed to specifically targeting Volker. There is an opportunity to create simplicity and efficiency between the two organizations primarily in Europe.
Could you quantify the cost for dealing with the Batesville warning letter, and are any of those costs sustainable in a going forward basis?
No, we haven’t talked about the cost yet. I guess the only comment I can make is they are not material. So at this point, you know, there is not much more I can say about it. You know, we are not expecting it to change at this point. We think that we can deal with the FDA issues without any material impact.
Secondly, are any of your products impacted by the medical device tax?
Yes. Many of our products. Anything that is a registered device in the United States will be impacted by the tax. So we’re going to have both on our capital sales and our rental products as they are placed into our fleet, we will incur that tax starting next year.
Should I assume all of the North American sales are impacted by it?
No, because not all of our revenue comes from registered products. We have a furniture business that was not impacted, architectural products, head walls [ph] et cetera, et cetera in the hospital space. So, it is not all of the business. And we also, as I said, have a rental business. So you only incur the tax at one time. Then you have a continued revenue stream that will not be subject to the tax, which you paid up front.
And it will just be the US revenues?
Have you guys quantified what the tax will be roughly?
Not externally. We have obviously made a number of internal estimates of that. And there still is some sorting through of the final determination to figure out how they will tax the rental. But we have got some pretty good estimates.
Hi, I was just curious, how much overlap is there between the Volker product line and Hill-Rom, I’m wondering if this deal is really about cost synergies or revenue synergies, and taking the Hill-Rom products and having a better distribution channel in your…
The product lines compete in the same space, previously competed. Now will obviously be sold within the same space. The acute and post acute setting, well, because they are complementary in many ways in that we were relatively underdeveloped in Germany on the Hill-Rom brand, and that is where they are very, very strong. They have excellent brand equity, brand recognition. They have a very distinctive look to them. They have some features such as being washable that we don’t have in our product.
So they are not completely redundant. So I think it really is both things. The products are complementary. They were stronger as I mentioned in the post acute setting. We were stronger in the acute setting. I think we are going to bring their products more into the acute setting. And they are going to help us in the post acute setting. And then there are some slight product feature differences, some of them appearance, and some of them functional like l mentioned the washability.
So, on the Hill-Rom side, will you rebrand them under Volker for the European market, or will you try to push the Hill-Rom brand in Germany?
Well, at this point we are not going to rebrand Volker. Volker has a strong brand recognition.
I meant the other way, I meant the other way, take the Hill-Rom products that are complementary, tweak them a little bit, take them and market them more as Volker products?
No, we are using technologies. So, using some of the Volker technologies, putting them into Hill-Rom products, but continue with the Hill-Rom brand. It is in many ways the branding is tied to the appearance of the products. And so the Hill-Rom products and the Volker products do not look similar.
In your discussion about capital allocation, you mentioned back in 2011, you were more focused on returning to shareholders as opposed to the inorganic investments, was there a change in philosophy or what drove the shift in focus one year to the next?
Yes, it is not a shift in focus. It is more of a situational item, you know in any given point in time. So, we’re always looking for inorganic opportunities, and certainly have the strong enough cash flow to support business development activities. But in a given period of time it may not be an acquisition that makes sense from a value price point view, or strategic point of view.
So while the 15% to 20% that I mentioned returning to shareholders is a long-term target, as I also mentioned previously, if we go through a period of time when we don’t do any of deals, as opposed to just sitting on the cash, we will return more to shareholders in the short term.
Next one more quick one on in the discussion about gross margins, you mentioned that the rental business has actually been declining, is there some discernible trend there as to what would be driving the decline?
I think there is a couple of factors. One of them is the continued pressure on hospitals to reduce cost. We have seen a shortened length of stay. So the average days given an asset is generating revenue has declined. As I have mentioned on previous calls, we think that is starting to bottom out. It is only so efficient they can get, unless they are changing their therapeutic approach if the given patient needs a certain type of service, you know, a burn patient or someone with certain pressure ulcers that makes them eligible for a higher end air-powered surface, you would think that there's a limit to how efficient they can get.
So they are getting better and making sure that the minute the patient is off the surface, we get the call to pick it up and revenue collection ceases. So, and then that has been a big factor, and certainly there is some competition, especially in the home care space. Our rental business crosses both patient therapy, which is in the hospital setting, but also in the home care setting. Primarily it is rental, and certainly competition has been a factor in addition to some price pressures.
So you are seeing some of the reimbursement changes, I mean, specifically with the SNIF [ph] reimbursements, but also through competitive bidding, which is just really starting. But you know, there is certainly other price pressures that are hurting the rental business as well.
Unidentified Corporate Participant
And I might add that in some cases we are actually managing those revenues downward as we rationalize those product lines. We try to be pretty disciplined about looking at profitability by product line, and so in some cases we have actually rationalized out of certain revenue streams if they are no longer profitable to us.
Maybe just comment as you are going into the hospitals, to what, I guess to what extent are you at a disadvantage because you don’t have kind of other product lines to stock, Stryker [ph] obviously has a broader portfolio. So, is that a major challenge for you and just how did you think about Hill-Rom going forward, does the company has further diversification high on the priority list.
We don’t believe that it is a major, or even a significant competitive disadvantage. I mean, we don’t make, typically we don’t make decisions on capital expenditures like upgrading your frames and services at the same time when you are making decisions on your disposable purchases, for that matter, even other capital equipment, visualization products, and what have you.
So I have heard from some customers that as I think you have of many industries, they are preferring to reduce the number of suppliers they have. So there is certainly some advantage to companies that have multiple products, and can offer them to the portfolio as possible. But given, when you look at the dynamics of a given competitive RFP for 100 beds in hospitals, I have not heard anything that suggest that you know, because you don’t sell these products, and those products are at a advantage.
They are really making that decision based on our product offering, and its competitiveness. If there is a significant purchase, and you know, I think it is really an independent decision as opposed to being tied to some other purchase.
Unidentified Corporate Participant
And I think you could also make the argument that within our decision making customers, we probably have a broader portfolio than many of our other competitors as well, given the call points and decision makers.
Guess one last question from me, I guess it was maybe nearly a year and a half ago, you guys outlined longer-term goals for the company, can you maybe just talk about how you are feeling about moving the margins up. And what type of growth rate do you think is sustainable on the top line, given the mix of business that you have today, I’m sure you have done a couple of deals?
Well, we have not. Nor are we going to update them, the way of long range plan. But in terms of some of the strategic focus areas, I mean, growing top line it has always become more challenging this year. We had a very strong year in 2011. It has been a little more challenging in 2012. We are guiding to a 8% or so, 8% EPS growth. We are guiding to margin improvement. We are guiding to increasing our cash flow.
So, people should take that away to say, we are continuing to commit to some of those strategic focus areas in terms of improving the business financially. And of course, with the Volker acquisition, we are showing our interest in looking at means [ph] as well, to grow the top line and improve our profitability.
Certainly our commitment to improving profitability, our international business in Europe has not wavered. It is a little more challenging, and the business is going backwards, but it is not impossible to do, because it is not dependent as we talked about previously. It is not just leveraging growth. It is also doing other things to improve the efficiency of their operations. And to focus really on the bottom line, which was a change for management from the previous years, where it was really focused on revenue versus what I mentioned earlier, where we now had management focused on revenue, on earnings, and on cash flow across the organization.
Maybe one last question on the North American post acute care business, that business hasn’t performed as well, can you just kind of talk about your thoughts in general about that business, and how you could kind of reaccelerate growth there?
Sure. As I mentioned, there is really three parts to that business. I will start with the one that is doing well, which is the respiratory care business. It has not grown as quickly this year as it has previously, but it continues to grow, and we see that as a very strong business both in terms of its revenue growth and its contribution to the bottom line.
The second segment is extended care. Certainly a lot of pressure on that category. That business is going backwards slightly. Certainly reimbursement is probably the biggest challenge in that area. We also, as we have mentioned previously, don’t have the optimal portfolio in that space to compete. So we’re looking through both some of our R&D investments, and also externally to enhance that portfolio.
And that will be critical I really think to accelerate results in extended care. Then finally in home care, it is just a very, very tough business. As we have talked about recently, of all the reimbursement pressures, competitive pressures et cetera, similarly challenged to extended care, but I would say more so in terms of not having the optimal portfolio in that space. A lot of what we're renting in that space is similar to what we sell in the hospital environment. And the payer is really looking for things that are less featured, more commoditized, and you know, that is difficult, it is something we are not going to compete with.
We want a differentiated product. So, while we are certainly having some success in the critical -- the key to your question accelerating growth is having more products, but have the differentiation, but the payers are willing to pay for that differentiation.
With that, we are out of time. So thank you very much and have a great day.
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