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Executives

John Greisch – President and CEO

Mark Guinan – CFO

Analysts

Lennox Ketner – BofA Merrill Lynch

Hill-Rom Holdings, Inc. (HRC) Bank of America Merrill Lynch 2012 Health Care Conference May 16, 2012 1:40 PM ET

Operator

Lennox Ketner – Bank of America, Merrill Lynch

Next up we have Hill-Rom. Presenting for the company we have the CEO John Greisch, and with him we also have the CFO, Mark Guinan, and the head of Investor Relations, Andy Reith. John is going to go ahead and speak for 10 minutes or so, give a basic overview of the company, and then we’ll dive into Q&A. Thanks.

John Greisch

Thanks, good morning everybody. Let me just make a few comments before we jump into Q&A here, to start with the normal caveat on any forward-looking information that we may be discussing today. I’d like to refer everybody back to our SEC filings.

Just a quick overview for those of you not that familiar with the Hill-Rom story. We’re about a billion six, billion seven revenue medical device company, serving the full range of the care continuum, from home care, extended care and acute care hospitals. Our core business is in the area of patient handling, patient mobility, so beds, surfaces, patient lifts, and environmental systems, what we refer to there are architectural products and other products to go into the either acute care setting or extended care setting, really to deal with patient handling, patient mobility. We’ve also got a respiratory care franchise and a surgical care franchise. Those, together with our core franchise, is really focused on enhancing outcomes, improving costs for our customers and helping them address their needs, which I’ll touch on here in a few minutes. I think many of you have heard us talk about also the increasing demand for connectivity, getting information off of our products into EMR systems or nurse call systems, which is obviously also a key focus for us.

The real strengths of the company, in addition to very, very strong market share here in the U.S. and in Europe, the Hill-Rom brand is a very strong brand, particularly in the acute care setting here, and one which we intend to leverage going forward as we expand the company.

Most of our businesses are either strong number one or number two positions in the global segments in which we operate. Our largest business segment, patient support systems, is primarily bed frames and surfaces, therapeutic mattresses, if you will, we also have a large rental business of specialized products that both acute care, extended care and home care segments rent products from us, as well as purchase capital sales. And again, our respiratory care business, one of our smaller franchises, but one of our faster-growing, and certainly one of our higher-margin franchises, all of which are number one in their market positions. And as you see on the right hand side of the slide here, our surgical business, furniture, patient lifts, a strong number two in global markets in which we operate.

Just to give you a cut of our business, we enjoy a nice diverse portfolio, whether it’s in terms of how we run our business, as you can see on the left side of this slide. Our North American acute care segment is our largest business. It represents just over 60% of the total revenues of the company. Post-acute business, which is extended care, home care and respiratory care, about 13% of the company. Then international is roughly a quarter of the company. This is 2011 data here. Following the Volker acquisition that we made here in 2012, our international revenues are closer to 30% for us. Again, capital and rental split, good diversity here, and geographically, as I mentioned, roughly 70-30, if you include the Volker acquisition. So, a nice, diverse portfolio to give us opportunity to really manage through some of the cycles that we see.

I don’t need to tell anybody in this room about the challenges that our customers are facing. Clearly, governments and providers here in the United States are all pressured to provide better value at lower cost to patients around the world. We think we’re in a good position to respond to those needs. A lot of our outcome-enhancing products, caregiver productivity-enhancing products, addressing some of the core needs that our customers are facing. Clearly, rising acuities across the care continuum are driving demand for some of our products. Healthcare movement out of the acute care space and into other environments, home care as well as additional post-acute facilities, is clearly a trend that we’re going to continue to see going forward. Internationally, more governments are providing enhanced care to more patients around the world, all of which is leading towards demand for products that we provide, and a lot of these demand drivers are going to enable us to grow and support our customers’ needs with the products that we have and products that we’ll be looking to add to the portfolio going forward.

In terms of where we’ve been focusing our time, I got here a couple years ago, Mark joined a little over a year ago, and we’re really identifying on this slide the six key focus areas for strategically going forward. As I mentioned, the Hill-Rom brand, the Hill-Rom market position here in the United States, and particularly in Europe, significant assets for the company that we hope to leverage by adding additional products, additional services, again really to provide our customers the opportunity to not only improve outcomes but reduce their operating costs, clearly objectives that they’re all following.

We have increased our R&D spending over the last couple years. We’re committed to grow R&D faster than our revenue growth, whatever that revenue environment offers us, we’ve launched several new products over the past couple years, including here in 2012. We’re going to continue to focus on that, again to maintain the differentiation that Hill-Rom has enjoyed historically in all of our markets.

International expansion and acquisitions, I’ll touch here in a minute on our capital deployment strategy. Volker was a good example of the kinds of opportunities we’re looking for, both from an acquisition perspective, and how do we enhance our international presence, even in a challenged market like Europe, which we’re obviously dealing with, as is everybody in the industry.

Financial excellence goes without saying. We’ve been driving improvement in sustainable cash flow, operating margin, SG&A leverage, all the areas that you’ve heard me speak about the last couple years, and we’re very proud of the improvement that we’ve achieved, even in a challenging environment as we’re dealing with today.

Mark has spoken to our capital allocation focus that we’re really driving towards over the long-term. This chart here just gives you an idea of how over time we plan to deploy our operating cash flow, again with the objective of continuing to enhance shareholder value. About a quarter to 35% of our operating cash flow, which this year is again expected to be about $290 million, about a quarter of that we will be deploying into internal investments, capital spending, to support our existing businesses. Roughly 15 to 20% dedicated towards return to shareholders in the form of dividend or share repurchases, with the rest being available for inorganic investment. This isn’t going to be a perfect percentage every quarter or every year. Last year, for those of you that were involved with the stock, we deployed over $100 million in share repurchases in the absence of inorganic growth opportunities. We will continue to deploy our operating cash and free cash flow more towards return of shareholders, but as I mentioned earlier, acquisitions will be an important element of our growth story going forward.

Volker, just a quick update, this was a company we bought in February. It’s roughly a $100 million revenue company in Germany. It really solidified our position in the German market, and across Europe, and gave us both a long-term care, or post-acute care, as well as acute care portfolio additions to what we were offering in Europe as well as in other markets around the world. So, I’m very excited about what Volker has brought to us. No surprises. We’re about two months into the acquisition, and everything is on-track as we expected going forward.

So just to summarize, before I get into Q&A, obviously we’re dealing in a set of challenging markets here in the states as well as internationally. We’re committed and we’re confident in our ability, despite those challenges, to continue to improve our earnings, improve our margins, and deliver sustainable cash flow, as we’re continuing to demonstrate here in 2012. We’ve seen significant improvement over the past couple years in our operating margin and in our cash flow generation, and we’re certainly confident in our ability to continue to do that.

Again, I think the company represents a good, diverse portfolio upon which we can build great brand equity, great channel strength in the markets in which we operate. I think we bring a set of products that do enhance patient outcomes and address the specific needs of our customers, here in the States as well as elsewhere, in terms of their needs to improve outcomes for their patients and reduce their costs.

Internationally, we’ve spent a lot of time talking about the margin improvement. We do have substandard margins in our international operations. We’ve made some progress over the past couple of years. I think you’ll see significant improvement here as we go through 2012 in our international profitability, and it continues to be a key focus for us going forward. So, as we look ahead, I think we’ve got a great group of franchises to build upon, an improving financial profile of the company, and certainly commitments from the management team to deploy our capital in value-trading ways as we go forward. With that, let me wrap up and I’d be happy to take any questions.

Question-and-Answer Session

Lennox Ketner – Bank of America, Merrill Lynch

Thank you so much. I’ll start it off here. I guess first, if you could just comment a little bit more on what you’re seeing in terms of market environment. You know, hospital beds is a market that saw explosive growth in 2011, at least in the U.S., and your competitors saw 20%+ growth, and it’s obviously slowed here the past couple quarters. The message on your last conference call seemed to be that things had slowed but they felt like they were starting to stabilize somewhat. Your closest competitor, Striker, also saw some weakness last quarter, and at the time they said it was internal, but this morning they actually said that they feel like the market has slowed more than they thought. So if you could maybe just comment a little bit on what you’re seeing in particular in the U.S. market and if it still feels like that has stabilized?

John Greisch

Yes, I’ll comment on what happened in the first half of the year. I’d rather not get into what we’re seeing mid-quarter here for Q3, but just to repeat what we saw for the first half of the year. As we came into fiscal 2012, we expected the rate of growth to slow down, and it clearly has. As we went through Q1 and Q2, our comments around stability here in the U.S. market were really driven by the fact that our orders have been relatively stable for Q1 and Q2. We were coming off some pretty strong comps in the first half of last year, relative to our order rates where we received two of the largest orders the company’s ever received in North America in fiscal 2011. So, those two orders aside, the rate of growth has certainly slowed, as expected, as we went through the first half of this year. However, relative stability in our order rates. But the market is clearly tougher this year than it was last year, no doubt about it.

Lennox Ketner – Bank of America, Merrill Lynch

And is it possible to give a sense of what’s driven the slow-down? It’s a somewhat unique market in that, at least over the past two years, it hasn’t really correlated with the rest of the capital equipment market. You obviously saw much higher growth last year when the rest of the capital equipment was relatively flat, and then this quarter we actually saw acceleration in some other capital equipment areas. So maybe just, your thoughts on the drivers of the market?

John Greisch

Yes, I think if I look back on 2011, and you have to go back even a little further to put 2011 in perspective, there clearly was some pent-up demand in hospital bed spending. We saw what we call our “patient support systems” portfolio, which again is our beds and therapeutic mattress product category, we saw about 25% growth in that category in fiscal 2011 over 2010, which was a fairly healthy growth over ’09 also. So, you go back to late 2008, 2009, when the capital crunch was most acute, and capital spending didn’t come to a screeching halt, but it certainly declined significantly. Some of that replacement spending that got deferred from those years into 2010, 2011 certainly accounted for some of the growth that we saw last year. That aside, I think what occurred was a return to a more normalized spending level for hospitals. The replacement rate for hospital beds has historically been in the six, 7% range, went down to five or so in 2008, 2009. And I think we’ve come back up more to the normal historical rate. So I think, again the percentage growth we saw in 2011 we knew was not sustainable. The absolute spending level has come back to a more stable level. I think it’s clear, however, just a couple comments further. I think everybody knows the bed population is not growing, so there’s not going to be volume growth. Our challenge is providing differentiated products, higher-value products, to our customers to drive some revenue growth into the market. And as we do that, I think we’ll be able to maintain the share that we’ve seen improving over the past couple years.

Lennox Ketner – Bank of America, Merrill Lynch

Okay, great. And just on the margin front, a lot of your margin improvement over the next couple years is expected to come from the international business, and you mentioned in that last slide that you do feel like you can see some improvement in your international margins as we move on?

John Greisch

Yeah. I think there’s a number of sources of margin improvement for us. One of them is certainly international. The growth rate we’re seeing this year internationally is largely ex-Europe, our European business, like [inaudible], the NetTech World. You know, it’s challenged from a revenue perspective.

So from a pure mix perspective, as we see some growth internationally outside of Europe as the higher operating margin markets for us, we’ll continue to see some uplift with our international business overall.

Within Europe, we’re continuing to focus the team on profitability, which wasn’t necessarily historically a key focus there. The restructuring we announced in March were we took out about 200 positions across the company, roughly 20% of that was in Europe, so we’re addressing the cost structure in Europe, it is certainly a means to enhance our margins going forward.

I think a couple of other opportunities just in terms of the enterprise margin expansion opportunities over time, I think I mentioned on the last call, we still have some pieces of portfolio that are preforming at virtual breakeven levels. There’s about $100 million of our revenue that, you know, we’re not satisfied with the profitability of today. We will either improve those margins to pass that revenue or something else with those businesses that are driving that substandard performance.

And then thirdly, you know, our supply chain operation, we do have opportunities globally to address some of the fixed structure within our supply chain. We took out some costs here in March in our service infrastructure, both here in the states and in Europe and we’ll continue to address cost opportunities to offset both inflationary pressures as well as other cost structures that we will have going forward. Mark, do you have anything you’d like to add?

Mark Guinan

The only thing I would add is that in addition to what he talked about in Europe, we’ll soon be looking at trying to create services around some of the back office operations directly [inaudible] distributed within the country in which we operate. So we created a headquarters in Amsterdam and we’re migrating activities there, which we also plan to help us with the margin in Europe.

Lennox Ketner – BofA Merrill Lynch

Just one follow up on the margin question for Mark. I know part of the headwind on the first half of the year was from commodity costs, the rising cost of fuel. That was anniversaried in the back half, but I know you mentioned on the last call that the price of steel and other commodity costs are higher. So how’s your people think about the impact of commodity costs overall in the back half of the year? Is that still a headwind for you or how should we clarify that?

Mark Guinan

Yes, that’s a good question, Lennox. Thank you. As we spoke on the earnings call and actually, as we talked about going into the year, we saw inflation, you know, primarily in raw materials for steel makes up a preponderance of our raw materials and then fuel, which obviously contributes to petroleum-based materials such as plastic, et cetera, but also contributes to our cost in our service business where we have a fleet of over 600 trucks that are in and out of hospitals on a daily basis in the U.S. and then also in Europe. So we’re definitely impacted when fuel prices spike.

In the first half of fiscal 2011, prices were lower, in the back half, they spiked. So from a comp standpoint, you know, we talked about the first half margins comparisons being a lot tougher than the back half. So you know, as we’ve talked about guidance for the balance of the year, we talked about gross margin improvement sequentially and we certainly talked about operating margin improvement as well in the back half of the year versus fiscal 2011.

John Greisch

Yes, so there would be – the year, you know, maybe say a little different than we originally expected in some respect from the margin perspective. I think we articulated as we came into the year exactly what – we said, margin headwinds in the first half of the year, operating margin headwinds, we’re going to be more so than in the second half of the year. We saw that. We saw a slight improvement in our operating margin in Q2. And if you look at the expectations we had after the full year, we’ll see not only sequential improvement in the second half versus the first half, but year over year improvement in operating margin.

Mark Greisch

And the other dynamic was in our enterprise margins that we have about 1/3 of our revenues in our rental business and 2/3s in the capital business. And you know, there’s a 8 to 10-point differential between those, rental being a higher gross margin in 2011 and to progress throughout the year, and the rental business actually declined. And we also had large infractures and so a combination of the rental business margin was declining and the mix between capital and rental was unfavorable for us throughout the year. So from the beginning of the year to the end of the year, that was definitely a headwind. As we look at the results thus far this year, you’ll see with capital fairly flat as opposed to PSS going in at 25%, mobile/rental still has continued to decline so that mix impact is a lot less this year than it was last year.

Lennox Ketner – BofA Merrill Lynch

John, in a lot of my conversations with investors lately, the focus seems to have been – obviously people are still focused on the margin expansion, but less on margin expansion and more on what you guys can do with your cash given that you do generate very good cash flow. You know, you spoke in the presentation about how your main focus is M&A. Could you maybe just give us a little bit of a sense, I guess, one, kind of what the deal pipeline looks like right now, you know, if people should be expecting an uptick in the case of M&A. And two, give people a sense of what kind of deals they’re looking at, whether people should expect more deals like the Volker acquisition that was – or the rollup of more kind of diversification focused?

John Greisch

Sure. Obviously, I don’t want to comment specifically on the deal pipeline in terms of specifics in what we’re looking at. Will there be an uptick in the pace? Yes. I think there will. I think I made it really clear when I got here that M&A wasn’t even on our radar screen for the first year or so. We had some internal financial improvement initiatives to get our arms around. I actually built a team. As they got here, they didn’t want distractions of integrating that position to divert our attention from really those two key focuses.

Now that we’re a couple years into it, the team is now stabilized. We obviously announced a little bit of restructuring of my senior team over the past month, and that’s part of the March restructuring that we changed last week. But the team I’ve got, I’ve got a high degree of confidence in the Volker acquisition. It’s one that we actually worked on for a year and as you well know, you know, you can’t throw the switch on and a few months later get a deal done. So we have been focused more over the last year than we certainly were in the first year.

Going forward, which is really the root of your question, I think you’ll see us do Volker-type size acquisitions. You know, we’re not going to be a debt-ranch management team by any means. I think we have, as I mentioned in my prepared remarks, you know, a great market position, a great brand and very strong channel points here in the U.S. and in Europe to leverage with additional products and additional services, you know, we go after acquisitions as a great example of that.

So we’re looking for deals like that going forward. Our respiratory care and our surgical franchises, both very profitable franchises for us. Both are businesses where we would like to grow going forward and an acquisition focus is certainly going to be there.

I wouldn’t say diversification necessarily, Lennox, but you know, we’ll see what we can do with those smaller franchises. They’re very attractive businesses for us today as well as what else can we put into the bag of the sales guys or else we’re here to leverage the channel strength. Not necessarily carefully focused on more rollups, [inaudible] Volker, which I think is a fair description of what Volker was. I think we’re satisfied with what we have in the bedframe market generally. So you know, these are where we’re going to focus.

We will also look at some of the emerging markets if there is an entry strategy that could be accelerated with a smaller acquisition in markets where we don’t have a strong presence today. Those are certainly interesting also.

Lennox Ketner – BofA Merrill Lynch

Okay, thanks. And on the Volker acquisition, I know you guys haven’t – I know you said you expected it to be accretive next year, you haven’t said how accretive. If I had to assume, you know, 10 to 15% cost synergies, I get a $0.05 or $0.07 contribution for 2013. I guess, is there anything structural that [inaudible] that you can’t see those types of cost synergies?

John Greisch

I’d rather not comment on the specifics until we get into 2013, but we knew when we bought the company that the margins were – I think we clearly communicated comparable to our international margins, but below our corporate level margins. And we certainly have ambitions to improve the profitability of Volker.

Lennox Ketner – BofA Merrill Lynch

Okay. Any questions from the audience? I guess, one other question I get a lot with respect to your past deployment strategy is that you know, with respect to the dividends, you guys have increased the dividend, I think twice since you arrived and how has a 1 to 2% dividend [inaudible]. And a lot of investors or potential investors that you could easily have a 4 to 5% dividend yield or higher if you wanted to. You know, is that something that you would ever consider or any increase that would be more incremental?

John Greisch

Yes, we’ve had that question a few times this morning. And not surprisingly. You know, it’s something we’ll continue to evaluate. And you know, we’re incrementally increasing the dividends right now while we, you know, scan the acquisition opportunities for the company going forward and I think the – the one thing investors I think should take confidence with is, you know, where are you going to be disciplined and focus on how we deploy capital. If higher dividends are the best value creating opportunity for us, for [inaudible], the best value enhancing strategy for us, we’ll certainly [inaudible].

Mark Guinan

And one thing I would add, Lennox, is you know, as John walked through, and we’ve talked about previously, we’ve got a capital allocation strategy and what investors should be, you know, at least for the near term, should be thinking about is we’re going to be [inaudible] to that strategy. So the dividend increases are completely along the lines of that strategy as we’ve grown our operating cash flow and as we project the growth this year, we’ve got to increase the dividend to keep in that 15 to 20% return to shareholder guidance that was on the slide.

John Greisch

Yes, we’re not terribly interested in making dilutive acquisitions, certainly not highly dilutive acquisitions but as I mentioned, you know, we are going to increase our focus on what can we add to the portfolio to diversify a little bit away from the capital intensity that we have, strengthen the margins, the margin profile that we have and I want to keep the flexibility, certainly in the near term, to be able to pursue some of those opportunities if they’re out there. If after an extended time of evaluating what can we bring in house profitably, we conclude that the dividend increase of [inaudible] is warranted, then we’ll certainly consider that. But in the near term, I want to maintain the flexibility that our balance sheet provides us to day and again, you know, hopefully investors have seen and will continue to see we’re not going to invest in M&A just for the sake of growth sake. We’re going to do it profitably and with value driving our assets.

Lennox Ketner – BofA Merrill Lynch

Okay. I guess my last question would just be on, you mentioned the one change the management team recently and you now have one person running both the North America Acute and Post-Acute. Was that, you know, a personnel decision where you wanted that person to be running a larger portion of the business, or is there structural reasons to have that in place?

John Greisch

A couple of comments on that. What I did, I combined our Acute Care and our Post-Acute Care businesses under one leader, a guy named Eldon Shrader, who I recruited from Baxter. I’ve worked with Eldon for several years at Baxter. I brought him in to run our Post-Acute Care business about a year ago. He was much larger than our Post-Acute business was in terms of capability. [Inaudible] who was running our Acute Care business, for personal reasons, left the company. He actually left the industry and is taking another job in a company up in Minneapolis where he lived. So you know, this business structure that I had I mind when I got with the company, I wanted to have the right leader in place to put this structure in place. Why is it important? Because as I mentioned I my comments earlier, our customers are increasingly looking at how can they participate up and down the care continuum. So we structure ourselves internally online with where we think our customers are heading and I’ve got a guy in Eldon Shrader for whom I’ve got tremendous confidence in.

Lennox Ketner – BofA Merrill Lynch

Okay, thank you.

John Greisch

Thank you.

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