DENTSPLY International, Inc. Q4 2007 Earnings Call Transcript

Feb. 6.08 | About: DENTSPLY International (XRAY)

DENTSPLY International Inc. (NASDAQ:XRAY)

Q4 FY07 Earnings Call

February 06, 2008, 8:30 AM ET

Executives

Bret W. Wise - Chairman, CEO and President

Christopher T. Clark - EVP and COO

William R. Jellison - CFO and Sr. VP

Analysts

Steven Postal - Lehman Brothers

Jeff Johnson - Robert W. Baird

Anthony Ostrea - JMP Securities

Jon Wood - Banc of America Securities

Greg Halter - Great Lakes Review

Operator

Good day, everyone, and welcome to the DENTSPLY International’s 2007 Fourth Quarter Earnings Conference Call. Today's conference is being recorded.

At this time, I'd like to turn the conference over to Mr. Bret Wise, the Chairman, President and Chief Financial Officer. Please go ahead, sir.

Bret W. Wise - Chairman, Chief Executive Officer and President

Hi. Good morning, and thank you everyone for joining us on our fourth quarter and full-year earnings call. This is Bret Wise, Chairman and CEO, and also with us today are Chris Clark, our Executive Vice President and Chief Operating Officer; and Bill Jellison, our Senior Vice President and Chief Financial Officer.

I'd like to begin the call today with a few overview comments on our results and a few strategic items. Chris Clark will then provide some insight on certain operational items that are of focus, and Bill Jellison will then provide some detailed insights on our financial results, both for the quarter and the year. And then of course, following our remarks we will be glad to answer any questions that you may have.

Before we get started, its important to note that this conference call may include forward-looking statements involving risks and uncertainties, and these should be considered in conjunction with the risk factors and the uncertainties described in the company's most recent Annual Report on Form 10-K, our periodic reports on Form 10-Q, our press releases, and our conference call transcripts, all of which have been filed with the SEC. And this conference call in its entirety will be part of an 8-K filing latter this week, which will be available on our website.

So last night, we were very pleased to report record sales and earnings for both the fourth quarter and the full-year 2007. Our reported sales for the quarter were $541.5 million, which is an increase of 14.9% compared to the 2006 quarter. Excluding precious metal content, sales were $489.2 million, which is a 16.1% increase for the quarter, and that represents the fastest quarterly expansion we’ve experienced since the third quarter of 2002. Growth in the quarter, again ex-precious metals, was driven by 7.1% internal growth, 3.3% acquisition growth, to arrive at a constant currency growth of about 10.4% in total. And then on top of that, we added approximately a 5.8% pickup in currency.

On a geographic basis, internal growth accelerated in the US to 5.5% and total constant currency growth in the US was 11.6%, obviously aided by the acquisitions that we completed in the second half in 2007. Internal growth in Europe was 6.1%, and that's a continuing a very strong trend we have seen all year, and internal growth for the rest to world was a phenomenal 12.2% led by Canada, Middle East, Africa, and Latin America, all of which grew double digits, and Japan, which grew high single digits. So we believe in each of those regions we are certainly growing well in excess of the market.

I think a few observations I’d make on the growth for the fourth quarter, first thing that I think the results show that the investments that we have been making throughout the year have paid off with accelerated growth. As we enter 2007, you may recall we had committed to additional investments in sales and marketing including expanding our sales force in certain key regions and product categories, investments in improved data systems for selling in our direct marketing efforts, investments in structuring key businesses and distribution channels differently to accelerate growth, and also investments… expanded investments in clinical education and [inaudible] support for many of our businesses. So these investments certainly helped deliver accelerated growth in 2007, and we believe they served to improve our key growth platforms as we move into 2008. So obviously we are very pleased with those returns.

The second point I’d make is that DENTSPLY has a very strong international platform of businesses. Our sales outside the US comprise 60% of our mix, and we are really depended on any one economy or even region for our growth and performance. So 2007 was a good example of this where we are making investments to accelerate growth in the future, particularly in the US, and we had [inaudible] growth in the US. We were able to outperform several of our other regions to deliver what we believe are very good results overall during the period… this period we are making the investments in the US. So I think that’s the testament to a strong balance we have in our business and position us well for the future, even with uncertain economic prospects at this point.

Earnings in fourth quarter were $0.45 per share on a GAAP basis and on a non-GAAP basis, which excludes restructuring charges and tax adjustments, diluted earnings were $0.44 a share in 2006 versus $0.37 on that same basis in the... excuse me, $0.44 a share in 2007 versus $0.37 on that same basis in the 2006 quarter. So that's an increase of 18.9% year-over-year. Fourth quarter earnings were obviously driven by strong sales growth, but also a four percentage points or 100 basis points improvement in our operating margins in the quarter excluding restructuring charges.

So just a few comments on the full year results for 2007. During 2007, in total we saw our growth accelerate to 11% and we crossed the $2 billion mark in sales for the first time, which is an important milestone, and it occurred just six years after we first achieved the $1 billion sales in 2001. Excluding precious metal content, sales growth for the year was 12.1%. That's making it our strongest growth since 2002. And you might recall, in 2002 we benefited from four very sizable acquisitions that were completed in the last half of 2001. Full-year growth ex-precious metal was driven by internal growth of 6.4% for the year. Acquisition growth added 1.6% for the full year and currency added 4.1%.

The regional internal growth for the full year was 4.2% in the US, 7.3% in Europe, and 9.4% for the rest of the world. So certainly, growth recorded in Europe and rest of world categories for the full year were well above market. In the US as you know, growth was muted somewhat by the implementation of our strategic partnership with our dealers. In the fourth quarter, we began to see faster growth in the US, which is rewarding, ad that initiative with our dealers has now anniversaried and is not a drag on our internal growth in the region.

Internal growth for the full year was led by our specialty businesses, which grew double digits on a worldwide basis in aggregate. And on a single franchise basis implants grew 20% for the full year on an internal growth basis and close to 30% including acquisitions and currency. Earnings for the full year were $1.68 on a GAAP reported basis, and again excluding tax adjustments and restructuring charges, which is non-GAAP, it was $1.66 per share, a 16.9% improvement over all of 2006. I think it' s important to note that complementing this performance was really extraordinary operating cash flow generation, which on a preliminary basis grew to approximately $390 million this year, which is 40% improvement over the prior year. And that was aided by improvements in inventory and receivables days, particularly in the fourth quarter, and also lower tax payment this year.

So overall, we are very encouraged by our accelerated internal growth, the operating margin improvement that we generated in the fourth quarter, which actually allowed us to show an improvement on operating margins for the full year, and again our record cash flow for the full-year 2007.

Looking forward to 2008, we are very cognizant of the uncertain economic situation we have, particularly in the US. As we said in the past, dentistry is not immune to a slowing or contracting economic environment, but it's much more resistant than most industries. In addition, I would say that unlike some industries, a slowing environment in one region of the world is not really likely to impact the other regions in a meaningful way. We believe we're uniquely positioned to continue to perform well even in a slowing US economy. We have a product mix that is very focused on dental consumables, a balanced geographic mix, and a very effective global sales force. So at this time, we believe the slower economy should only have a limited impact on the performance in 2008. And I think we get comfort from the results we had in 2007, where we had slower growth in US, but it was much… was more than concentrated by strong growth in Europe and the rest of world.

So accordingly, we look to have a another strong performance in 2008. Overall for the year, we believe that internal growth will be in the 5.5% to 6.5% range and assuming current exchange rates hold for the year and adding our acquisition growth for transactions we have already completed in 2007, we would expect total growth for the year to be at or close to double-digits. On a diluted earnings per share basis, we would expect full-year 2008 earnings to be in the range of $1.83 to $1.88, and again that would exclude restructuring charges or one-time tax adjustments.

So that concludes my prepared remarks. I would now like to turn the call over to Chris Clark, our Chief Operating Officer, who is going to discuss our performance in a couple of key product areas. Chris?

Christopher T. Clark - Executive Vice President and Chief Operating Officer

Thank you, Bret, and good morning everyone. Thank you for joining us on our call this morning. I would like to take a few moments and comment on a few of our operations that have been the focus of some key growth investments during the year. In particular, I'm going to comment on the global implant business as well as some of our country specific selling organizations.

Starting with implants, we continue to be very pleased with our global implant performance. Total worldwide growth during 2007 was almost 30%, driven by organic growth of 20%, which was above the underlying segment growth for dental implants. Our growth was strong in virtually all regions of the world. Our ANKYLOS product line with its platform shift design continues to be very well received in the market and it's really helping to drive our strong implant growth. We were particularly excited about the results of two key implant growth initiatives that we executed during 2007.

First, as you know, last January we merged our North American endodontic and implant businesses together, significantly expanding our sales and marketing resources to address the North American implant market. This market has been an area where we... this is an area where we’ve historically been underrepresented from a market share perspective. This is a large undertaking, had a significant amount of ongoing training for the sales force throughout the year. Looking back on the initiatives now one year later, we are pleased as we’ve proven our capability to grow the North American implant business in excess of underlying market growth, and we have certainly gained market share in the process.

Second, during 2007 we launched the unique tissue care positioning of our ANKYLOS product line in Europe. This emphasizes the clinical and esthetic benefits of our platforms shift product design. We conducted five dental symposiums in Europe in late Q3 and also in Q4, and these had very positive customer reactions and very strong resultant orders. We have filed for FDA approval for the key tissue care claims in the US and we hope to expand the tissue care positioning to include the US later in 2008.

In total, we are very pleased with the performance of our implant businesses and the progress we are making in North America with a combination of our endodontic and implant sales forces.

I would also like to comment briefly on the performance of the few key countries and regions that have also represented growth platforms and key investment opportunities for us. In Japan, we’ve clearly gained market share in 2007 with organic growth in the mid-single digits. This is well in excess of the growth rates of the underlying Japanese dental market. In China and in India, we are also seeing strong growth in the 30% to 40% range, in excess of what we believe the underlying market to be growing, as we further expand our sales representation in those countries. These are key strategic regions for us. They have increasingly large middle-class segments that are both interested in and can afford dental care that provide both improved function and esthetics. We are also particularly pleased with our growth in Russia, other CIS countries, and in the Middle East, as we believe our sales force expansion in these regions is also fueling growth that's above the underlying market rate. We are continuing to invest in these businesses as well, and we will continue to add sales reps throughout the region.

We are encouraged by the result of these businesses and the impact of our targeted growth investments. We are going to continue to focus investments spending on higher growth markets and segments, including the areas I have described this morning. As we noted, our rest of the world region including the areas I just mentioned, grew organically 12.2% in the fourth quarter and close to 10% for the year. As these region now comprise 20% of our mix, they are growing in important to us and reducing somewhat our dependence on the growth in any one market in the developed regions such as the US.

I’d now like to turn the call over to Bill Jellison, our Chief Financial Officer, to review the financial results for the quarter and the year in more detail. Bill?

William R. Jellison - Chief Financial Officer and Senior Vice President

Thanks, Chris. Good morning, everyone. As Bret mentioned, net sales for the fourth quarter of 2007 increased by 14.9% and sales excluding precious metals increased 16.1% in the quarter, with 7.1% coming for… from internal growth in the period. Net sales for the full year were $2.01 billion, an increase of 11% over last year, while sales ex-precious metals were $1.82 billion, an increase of 12.1% for the year.

The 2007 geographic mix of sales ex-precious metals was as follows. The US represented 41% of sales. Europe, CIS was 39% this year, and the rest of the world is 20% of sales. Orthodontics and endodontics had internal growth rate of over 10% for the year and our implant sales grew over 20% for the full year.

Gross margins for the fourth quarter were 55.8%, that’s ex-precious metals, or lower by 1.4 percentage points compared to the fourth quarter of 2006. This drop resulted from the impact of reason acquisitions, foreign exchange transactions, and our push to reduce inventories in the quarter, which resulted in lower overhead absorption in the period. Full-year gross margins were 57.2% ex-precious metals, flat compare to last year. Recent acquisition and foreign exchange impacts offset improvement made in the year. In 2008, we are expecting that operational improvements and product line mix will slightly more than offset those negative impacts.

SG&A expenses were $173.5 million or 35.5%, sales ex-precious metals, in the fourth quarter of 2007 versus 37.9% in the fourth quarter of 2006. Total-year SG&A was $675.4 million or 37.1% of sales, ex-precious metals, in 2007 versus 37.4% in 2006 as we leveraged some of the recent investments we made at the end of 2006 and the first part of 2007.

Operating margins were 18%, including restructuring expense, in the fourth quarter of 2007. Operating margins were 20% on sales ex-precious metals in the fourth quarter of 2007 and 18.9% in the same period last year including restructuring and impartment charges. Operating margins ex-precious metals on a non-GAAP basis, excluding impartment and restructuring charges in both periods, were 20.3% for the fourth quarter of 2007 compared to 19.3% in the fourth quarter last year, a 100 basis points improvement. Full-year operating margins were 19.5% on sales ex-precious metals in 2007 and 19.4% in 2006. Operating margins on sales ex-precious metals on a non-GAAP basis, excluding impairment and restructuring charges in both periods, were 20.1% in 2007 compared to 19.9% last year, an increase of 20 basis points in 2007. This improvement included the negative mix impact of our recent acquisitions. Our targeted level of improvement in operating margins on average over the next few years is 30 basis points to 50 basis points per year. This improvement is expected to come from new products, improved product mix, operating efficiencies, and leveraging of overhead costs.

Net interest and other expense in the fourth quarter was $0.4 million, or $0.2 million lower than last year's fourth quarter. Interest expense was $0.7 million higher in the quarter than last year, while foreign exchange transaction and other expenses were $0.3 million lower in the quarter than last year.

Net interest and other income for the full year was $3.2 million, which was an improvement of $3.2 million compared to 2006. Net interest income was $2.6 million in 2007 compared to interest income of $1.6 million in 2006. The impact of foreign exchange transactions and other items was income of $0.6 million in 2007 versus a 1$.7 million expense last year. We expect net interest expense will run approximately $0.1 per share per quarter higher in 2008 as interest expense... or interest income is negatively impacted by lower rates and current European interest rates are now higher than those in the US negatively impacting our investment hedges.

The tax rate for the fourth quarter was 28% compared to 17.9% in the fourth quarter of 2006. However, the operational tax rates in these periods were 30.7% in the fourth quarter of 2007 and 29.2% in the fourth quarter of 2006. The full-year tax rate in 2007 was 27.5% compared to 28.9% in 2006, and the 2007 tax rate of 27.5% included an operational rate of 30.4% compared to 30.6% in 2006. The company benefited from various tax adjustments of $9.9 million in 2007 compared to $4.8 million of favorable adjustments in 2006. The favorable tax-related adjustments in 2007 resulted primarily from the deferred tax impact of a German tax rate change, which became effective January 1, 2008. This change reduces Germany's overall corporate tax rate to roughly 30% effective January 1, 2008 from approximately 39% in 2007 and prior. We are expecting a future operating tax benefit, beginning in 2008, from both this change and a global business project currently underway. The operational rate for 2008, which is currently… expected to be at least 100 basis points to 150 basis points lower than the operational rate in 2007.

To better understand and follow some of the following comments, you can look at the tables included in our recent press release. Net income for the fourth quarter of 2007 was $70 million or $0.45 per diluted share compared to $64.9 million or $0.42 per diluted share in the fourth quarter of 2006. Net income in the fourth quarter of 2007 includes the net of tax impact of structuring and other related items of $1 million, which is $0.01 per diluted share. The fourth quarter of 2007 also includes a net reduction to income tax expense of $2.5 million or $0.02 per diluted share from tax-related adjustments, while the fourth quarter of 2006 included a net of tax impact of $1 million or $0.01 per diluted share for restructuring and other related items and a net reduction of income tax expense of $8.8 million or $0.06 per diluted share related to those tax adjustments.

On an adjusted basis, earnings excluding restructuring and other related items and tax adjustments in both periods, which constitute a non-GAAP measure were $68.5 million or $0.44 per diluted share in the fourth quarter of 2007 compared to $57.1 million or $0.37 per diluted share in the fourth quarter of 2006, an 18.9% increase in diluted earnings per share.

Net income for 2007 was $259.7 million or $1.68 per diluted share. The 2007 earnings included the following items; restructuring and other related items of $10.5 million, which is $6.7 million after-tax or $0.04 per diluted share; net reduction of income tax expense of $9.9 million or $0.06 per diluted share related to tax related adjustments. Net income for 2006 was $223.7 million or $1.41 per diluted share, and the 2007 earnings included the following items; restructuring and other related items of $7.8 million, which is $5 million after-tax or $0.03 per diluted share; and net reduction of income tax expense of $4.8 million, which is $0.03 per diluted related to tax-related adjustments.

Net income for comparability analysis excluding the other items noted upon for the years ending 2007 and 2006, which constitute the non-GAAP measure were $256.4 million and $224 million respectively. This represents earnings of $1.66 per diluted share for 2007 compared to $1.42 in 2006, an increase of 17.1%.

Now, let's look into cash flow and a few balance sheet items. Operating cash flow ended strong with $133 million generated in the fourth quarter of 2007. Operating cash flows for the year were approximately $390 million compared to $272 million in 2006, or an increase of 43%. The first quarter of 2006 however included $23 million of cash outflow for the tax payment associated with the repatriation of foreign earnings, which was made in the fourth quarter of 2005. Adjusting for this in cash flow in 2006, operating cash flow would've increased by 32% during 2007. We expect strong cash flow again in 2008. However, we expect to have higher tax outflows this year than in 2007.

Capital expenditures were $64 million for the year, yielding free cash flow, operating cash flow less capital expenditures and dividends, of about $301 million for the year. Depreciation and amortization for the year was $50.3 million. And capital expenditures in 2008 are projected to be in the $70 million to $80 million range, with depreciation and amortization of approximately $55 million to $60 million.

Inventory days ended the year at 95 days for 2007 year-end, or a one-day improvement from 2006, but 11 days lower than at the end of the third quarter of 2007. Receivable days ended 2007 at 51 days compared to 60 days at the end of the third quarter of 2007 and 56 days at the end of last year. So we've made some excellent improvements in a number of working capital categories this year. We are very proud of our progress, and we've… made in reducing our working capital and also of the strong cash flow results for 2007.

The balance sheet remains very healthy at the end of 2007. The year ended with $316 million in cash and short-term investments compared to $65 million at the end of 2006. Total debt was $483 million at the end of 2007 compared to $370 million at the end of 2006, reflecting our acquisitions and stock repurchases during 2007.

DENTSPLY repurchased 3.4 million shares for $125.4 million at an average price of $37 per share in 2007. Based on the company's authorization to maintain up to 14 million shares of treasury stock, we still have approximately 1.9 million shares available for repurchase.

And as Bret stated, we are comfortable with internal growth expectations for 2008 of 5.5% to 6.5%, with total sales growth approaching or exceeding 10% for the full year. We anticipate earnings for 2008 to be in the range of $1.83 to $1.88 per diluted share.

And that concludes our prepared remarks, and we'll be glad to answer any questions that you may have at this time.

Question and Answer

Operator

Thank you. [Operator instructions]. and will go first to, [inaudible]

Steven Postal - Lehman Brothers

Thanks a lot. Good morning, and congratulation on a great year.

Bret W. Wise - Chairman, Chief Executive Officer and President

Good morning, Steve.

William R. Jellison - Chief Financial Officer and Senior Vice President

Thank you, Steven.

Steven Postal - Lehman Brothers

Can we just start with the economy since that seems to be a focus of a lot of people? Could you maybe discuss how economic conditions impact the business in the US and how you think that compares to Europe, and then drilling down there, what you’re seeing in both those regions and if you’re seeing any particular business in the US that's having an… that’s seeing an impact on the changes in the economy?

Bret W. Wise - Chairman, Chief Executive Officer and President

Okay, Steven. This is Bret. I'll take a stab at that. I think as we said before, just as the general premise, dentistry is more resistant to economic downturns than most industries. In the… it differs in different regions because the reimbursement comes from different places. But in the US for instance our reimbursement comes from our job… our insurance comes from our job. So if we have job loss in the US, there could be a slight downturn in the ability to pay for dental procedures and that could have an impact.

I’d say, as you look at the portfolio, our portfolio, it's a very balanced portfolio between lab products, general consumables, and than the specialty items. Certainly, I would expect that the specialty items excluding endo are the most vulnerable, and that’s because implants and orthodontics are more discretionary than for instance an endo procedure where there is pain relief involved or even general dental procedures where you need a restoration of some sort. Certainly, what we have seen in the marketplace is that the implant market has slowed. We know that because the vast majority of the market is represented by public companies and they disclose their growth rates. So as we look at the US market, we know that it has probably slowed from the upper teens to the lower teens or maybe... we still think it's growing double digit. Our growth is faster than that, but as we've said before, we think that's because of the amount of resources being applied to a business with very small market share.

In orthodontics, because it’s discretionary, it can be deferred that’s also… and it’s expensive. That's also an area where you could see a slowing of case starts for instance if we hit tough economic times. So those are the two that I would expect to be most impacted.

In Europe on the other hand, reimbursement most often comes from the government or there is no reimbursement at all, for instance in Italy. And our experience has been that rather than economic changes it's government reimbursement changes that drive the dental markets in those parts of the world.

So at this point, as we look at our portfolio… and we have gone back and looked at the last several recessions to see what happened in those recessions, we would expect there to be some modest impact on growth, perhaps more on the specialties than in the general dental areas, from economic recessions, but we wouldn't expected it to be dramatic and past history has demonstrated that as well.

Steven Postal - Lehman Brothers

Bret, that was very helpful. Can you guys just go into, to the extent you can or want to, your exposure in specialty implants and then specifically in US implants?

Bret W. Wise - Chairman, Chief Executive Officer and President

Sure. Our exposure in specialty and… specialty is about 40% of our business. Certainly, the biggest part of that… of the three segments within specialty, which are implants, orthodontics, and endodontics, endodontics is the largest segment for us. Implants and orthodontics represent between 10% and 15% of our mix and endodontics is slightly larger. So we are vulnerable to economic changes I think in those two areas. With respect to implants however, our market share is very low. So the percentage of our mix in the US in particular that's represented by implants is less than 5% of our US sales. So I think that although a slowdown in implants would have an impact on us in the US, I don't think we are highly vulnerable to that, at least at this time, and particularly in a period where we are putting a lot of resources towards that business and I believe taking market share. So we may be able to mitigate any impact from the economy just through pure muscle at this point.

Steven Postal - Lehman Brothers

Okay. And then just a question on cash flow, how should we think about working capital trends in 2008? You went into great detail about what you've done with inventory and DSO in 2007. Could that possibly ever moderate a bit in '08?

William R. Jellison - Chief Financial Officer and Senior Vice President

Yes. This is Bill, Steven. I think that from a cash flow perspective, we feel very, very good about how we ended the year in both inventory days and also receivable days. Looking into 2008, I would say that we'd be comfortable in that kind of 50 to 55 day range, which I think is very good performance in general. We actually ended at 51 days in the year. So I don't believe that we will see day improvements necessarily in 2008, although we've got a lot of additional focus within those areas, especially in the international markets.

From an inventory perspective, we made good improvement in the fourth quarter, but for the year last year we really only reduced it by about one day. I think we have some good expectations of some continued improvements in inventory over the next few years, and I'd probably say in the maybe two to three day per year kind of range.

Steven Postal - Lehman Brothers

And Bill, are you… I think you guys made a comment that you are making an effort to push down inventories as I guess you're just alluding to. Was there anything special there in the fourth quarter or this is more of that long-term initiatives to just become more efficient there?

William R. Jellison - Chief Financial Officer and Senior Vice President

I think it was a couple of different things. As you saw, probably through last year inventory kind of crept up on us for a couple of different reasons, some planned, some unplanned, up through the third quarter, and we specifically had some very detailed attention on it at a number of different levels during that quarter to bring that down knowing we were going to still have a very good kind of year-end performance. And I would say that as we move forward this year, while we would expect maybe some creep in the first three months to six months, which we typically do, I would hope that the expectation is to mitigate that in that first six-month period, so that we can have that 2 to 3-day improvement for the entire year.

Steven Postal - Lehman Brothers

Okay. Thanks a lot.

Bret W. Wise - Chairman, Chief Executive Officer and President

You bet.

Operator

We’ll go next to Jeff Johnson with Robert W. Baird.

Jeff Johnson - Robert W. Baird

Good morning, guys. Thanks for taking the questions.

Bret W. Wise - Chairman, Chief Executive Officer and President

Good morning.

Jeff Johnson - Robert W. Baird

Couple of things here. Bret, just going to your point on the implants and the orthodontics business here in the US, are you seeing any early signs in the orthodontics business? I know your implant business has been up. I didn't hear... I don't think any Q4 specific comments on orthodontics, if you could just maybe talk about that?

Bret W. Wise - Chairman, Chief Executive Officer and President

Sure. Our orthodontics business is mostly US. We have a growing representation outside the US, but I would say is still heavily weighted towards the US and it performed very well last year, double-digit growth throughout the year. In certain businesses, for instance in orthodontics, we get occasionally case starts for the industry and we don't have it yet for the second half of the year, but we have it for earlier points in the year, and it looked to us like case starts were slowing slightly as we moved through 2007. Now, in our own business that was compensated by... we introduced some new products early in the year or very late last year, and in particular we implemented or introduced this product called Innovation C, which is a highly esthetic bracket that has the efficiencies of a metal bracket, and it comes to the market at a higher price point than our traditional brackets. So we were still seeing strong growth in 2007 as more or less we were upgrading customers or taking share through the introduction of that new product. But I think it is still early to say what will happen to the orthodontics market, and we will probably be monitoring that closely as we move through this year. But at this point the market looks okay.

Jeff Johnson - Robert W. Baird

And Bret, is there enough ramp room on Innovation C, the mix benefits there to power through, like you said on the implant side you're able to kind of power through the softening market there given the sales force changes you made. Can Innovation C on mix do that, even if the market does slow in '08 for you? And secondly, I think you guys were implementing like a centralized manufacturing even on the orthodontics side where you could place brackets on a model and send that out to the dentists. Are those plans still under works and could that help at all?

Bret W. Wise - Chairman, Chief Executive Officer and President

Well, I think there is a number of factors that could help our business in particular in '08, in orthodontics, mainly the things that you have alluded to. I mean certainly, the penetration of Innovation C is still pretty low. So that product has ways to run and whether that's upgrading our own customers to Innovation C or it's taking share from competitors with Innovation C, obviously that has a strong potential to mitigate, in part at least, if the market itself starts to slow in some meaningful way.

And the second issue that you raised was new product introductions or new product/service introductions, which includes what's called indirect bonding, which is where you impregnate a tray with implants and that makes it much more efficient… excuse me, with orthodontic brackets… impregnating a plastic tray with orthodontic brackets and that makes the procedure to place the brackets on the teeth much more efficient for the orthodontist and we are introducing that service later this year. So that could have a positive impact as well.

Jeff Johnson - Robert W. Baird

Great. And then just for Bill a couple detailed questions I guess here from a modeling standpoint. It is a minor point, but I thought CapEx growth kind of in line with organic growth and looks like it's going to be a little higher in '08. Is anything driving that? And then just gating [ph] of operating margin, the 30 to 50 bps for '08, currency hopefully falls off… or not hopefully, but currency might fall off here as we get later into '08, so that should help maybe on the gross margin line as you get through the Sultan anniversary middle of the year that should help the gross margin. So will operating margin in the back half of the year be stronger than first half or… how should that play out?

William R. Jellison - Chief Financial Officer and Senior Vice President

Yes, this is Bill. I think that from our perspective, as you mentioned we've got Sultan that doesn't anniversary until the end of the second quarter and that's absolutely a drag on at least our comparable rate of about 20 basis points to 30 basis points on that. So we would expect from an improvement perspective to probably look better as we move into the second half of the year. But the 30 basis points to 50 basis points that we talked about, that's really a 3 to 5 years kind of average that we kind of target in at, and I'd say that for 2008 we will probably be more at kind of the mid to lower end of that at this point, primarily because of the negative mix drag that's taken place there and also some negative PP variance mix. Keep in mind that purchase price variance mix occurs in the gross profit margin rate. I mean we picked up a benefit on the translation side as we convert those earnings into US dollars.

Jeff Johnson - Robert W. Baird

Right, and then on the CapEx, Bill?

William R. Jellison - Chief Financial Officer and Senior Vice President

And then on the CapEx side, yes, the CapEx side is really being driven from some of the additional growth that we've had. As Bret mentioned, we had double digit growth in all three of the specialty categories right now. We are continuing to add capacity in a couple of those different areas to make sure that we are positioned for future growth.

Jeff Johnson - Robert W. Baird

Great. That's all I've got, guys. Thanks a lot.

Bret W. Wise - Chairman, Chief Executive Officer and President

Thank you.

Operator

We'll go next to Anthony Ostrea with JMP Securities.

Anthony Ostrea - JMP Securities

Hi, guys. Good morning.

Bret W. Wise - Chairman, Chief Executive Officer and President

Good morning.

William R. Jellison - Chief Financial Officer and Senior Vice President

Good morning.

Anthony Ostrea - JMP Securities

Few questions here, just first on your US distribution business, can you… at least now that you've anniversaried that event, can you tell us what... how it performed in Q4, and then now it is anniversaried what your expectations are for 2008?

Christopher T. Clark - Executive Vice President and Chief Operating Officer

Sure. Anthony, it's Chris. I mean, as we looked at it we were… we certainly saw a ramp-up in the US consumables business in the year, in the fourth quarter. As you know, we anniversaried the implementation of the strategic partnership program. I guess I would characterize it by saying, if you compare the US growth rate in Q4 to what we had in the first three quarters, most of the improvement in the overall US growth rate in the quarter came from the consumable business. So I think that would be the way that I characterize candidly the impact of that now that we've anniversaried. Obviously as we look forward, we are continuing to really enjoy in our mind the benefits of not only transactional data, but candidly the tighter relationship and the increased collaboration with the distributors, and I would expect that what we saw in terms of improvement in Q4, we'd expect that to continue as we move forward.

Anthony Ostrea - JMP Securities

And then maybe just to ask a little more about those collaborations, are you seeing… or are you able to really monetize those… the data that you are getting from your… the industry leaders and maybe just cite one or two examples?

Christopher T. Clark - Executive Vice President and Chief Operating Officer

Yes. I guess what I would say is the benefits are several-fold. If you look at it, not only does it help us in terms of really targeting… are we calling in and marketing to the right dentists, but also we are using the right message and taking about the right products at that time. So I think that we are seeing improvements, if you will, in terms of the impact of our sales and marketing activities through that as a result of that collaboration, but I think the other piece is we're now working with the distributors candidly in a much tighter manner really focusing on specific customers and specific opportunities that their data and our data together are identifying. So we're excited about that.

Anthony Ostrea - JMP Securities

Again, this maybe on guidance, and I will take a stab at a few line items in your guidance, so topline internal growth of 5.5% to 6.5%, that indicated that... or at least you talked about… a little about specialty, particularly in the US and Europe. Would you say... and I think I have these numbers correctly, but I think you grew 4% in the US, 7% in Europe, 9% plus in rest of the world in '07. Are you expecting the '08 numbers to more or less reflect what you did in '07, i.e. lowest growth in the US right on the 4% range and rest of the world still… and Europe picking up the… well, if you can call it slack, in the US?

William R. Jellison - Chief Financial Officer and Senior Vice President

Well, it is hard to be risk-specific on regions, but let me take a stab at your question. In 2007, we grew 6.4% in total and I think after nine months we are running at about 6.2%. So we've got a little bit of a boost in the fourth quarter. Frankly, we had a little bit of an easy comparison in fourth quarter. When we came out with 5.5% to 6.5% guidance, that's based on a bottom-up analysis by region and obviously it takes into account some weakening coming in the US or at least the US economy, the signs we see in the US economy. So if things don't improve in the economy, we would probably think we are towards the lower end of that range. If things do improve, we think we could be above that. If I had to guess right now I would say that despite the weakness in the US economy, I would expect our US growth to improve a little bit in 2008 for the reasons that Chris just discussed and that you commented on with the distribution change we made retarding '07 growth a little bit in that segment.

And Europe we've been growing really well for a couple of year now 6%, 7% growth, which we think is above market in that region of the world. So if I had to guess, I'd probably think the US would pick up a little bit versus '07 and Europe might come down a little bit versus '07. But in total, we are comfortable on that 5.5% to 6.5% range.

Anthony Ostrea - JMP Securities

And then just maybe, as I move down the income statement, I heard Bill what you said about operating margins, you are saying 30 basis points to 40 basis points roughly in '08. Below the operating margin line, did you say a negative impact of $0.01 per quarter in other income and then also a 100 basis points to 150 basis points improvement or actually lower tax rate in 2008?

William R. Jellison - Chief Financial Officer and Senior Vice President

That's exactly right, Anthony. So you will see a negative impact on the interest and other category, and you will see a positive pickup on the tax front.

Anthony Ostrea - JMP Securities

I haven't really calculated it, but is this... does that wash out on the other income and the tax rate, or is that tax rate benefit actually improving or--?

Bret W. Wise - Chairman, Chief Executive Officer and President

It really depends on what the ultimate tax rate benefit is associated with that, Anthony, but it is probably pretty close, there is probably a slight negative impact between the two.

Anthony Ostrea - JMP Securities

Okay. Great. That's all I have for now.

Bret W. Wise - Chairman, Chief Executive Officer and President

[inaudible] that we gave on the tax side anyway.

Anthony Ostrea - JMP Securities

Okay. I’ll… go ahead.

Bret W. Wise - Chairman, Chief Executive Officer and President

I would like to point out… I think this was clear from Bill’s remarks earlier, but just to make sure, that 100 basis points to 150 basis points improvement comes off the operational rate for this year not the GAAP rate, because the GAAP rate was forced down artificially by the change in the German tax law as we adjust our deferred tax items.

William R. Jellison - Chief Financial Officer and Senior Vice President

That's correct.

Anthony Ostrea - JMP Securities

And just remind me, Bill, is the operational tax rate in '07, was that 30. some...?

William R. Jellison - Chief Financial Officer and Senior Vice President

30.4.

Anthony Ostrea - JMP Securities

30.4. Okay. Great. That's all I had for now. Thank you.

William R. Jellison - Chief Financial Officer and Senior Vice President

Okay.

Operator

We'll go next to Jon Wood with Banc of America.

Jon Wood - Banc of America Securities

Hi, thanks a lot. Has the merger and acquisition pipeline changed at all over the past few months? Are prices getting any more reasonable? And then, would you guys be interested in the... if there was an appropriate equipment asset out there, would you guys look to do an equipment deal or are you going to stick towards the consumables?

Christopher T. Clark - Executive Vice President and Chief Operating Officer

On the pipeline, I would say that we're still very encouraged by the discussions we're having with other parties. We think the pipeline is pretty robust. With respect to pricing of deals, I haven't seen much change frankly. I think deals are being priced about where they were… have been historically for the last 24 months or so. So I don't see a big change there. Now that could change if we start to see some of the other participants in the industry's growth rate change or decrease, then you might get more reasonable valuations. And for some reason I forgot your second… the second part of your question.

Jon Wood - Banc of America Securities

It was just on your enthusiasm for any equipment type of transactions?

Christopher T. Clark - Executive Vice President and Chief Operating Officer

Yes. Well, equipment represents 25% to 30% of the industry, large equipment. Our appetite thus far has been for consumables and small equipment. I don't want to say never on the larger equipment because you just don't know what the future holds. But I think we have to be convinced that it would improve our overall business. It would give us a more stable product mix and more stable growth platform, and perhaps some pull-through of consumables. And so at this point, I think that large equipment is... we were watching that segment closely with Cone Beam, with some of the things that are happening where it gets tied to the implant type of businesses. But at this point, I think we're still more focused on consumables to small equipment.

Jon Wood - Banc of America Securities

Okay.

Bret W. Wise - Chairman, Chief Executive Officer and President

And also, with kind of where the economy is at today and kind of the first earlier stages that if anything that the negative impact on equipment plays, that you’d kind of [inaudible] and see all those were sorting out first.

Jon Wood - Banc of America Securities

Sure. And then, Bill, I might have missed this, but did you put any buybacks in the numbers for '08?

William R. Jellison - Chief Financial Officer and Senior Vice President

We do not have buybacks in the numbers.

Jon Wood - Banc of America Securities

Okay. And then one last one, Europe, do you see anything on the horizon as far as the reimbursement is concerned that might be an impact in 2008?

William R. Jellison - Chief Financial Officer and Senior Vice President

Nothing that’s imminent.

Jon Wood - Banc of America Securities

Okay. Thanks a lot.

William R. Jellison - Chief Financial Officer and Senior Vice President

Jon, just to correct maybe that last statement, as far as buybacks is concerned we don't really have any additional incremental buybacks, but we do include buybacks to offset options in our... in kind of the expectations and numbers.

Jon Wood - Banc of America Securities

Okay. Thanks, Bill.

Operator

[Operator Instructions]. We'll go next to Greg Halter with the Great Lakes Review.

Greg Halter - Great Lakes Review

Good morning, guys.

Bret W. Wise - Chairman, Chief Executive Officer and President

Good morning.

William R. Jellison - Chief Financial Officer and Senior Vice President

Good morning.

Greg Halter - Great Lakes Review

I wonder if you could comment on your R&D spending for the year-end '07, and then your expectations for 2008, and if you could detail the number of new products and some the more significant ones that you see either introduced in '07 or coming for '08?

William R. Jellison - Chief Financial Officer and Senior Vice President

Okay. Let me address the first question. I'm going to let Chris comment on things we introduced in '07, although I think we've covered most of them on previous calls. And we’d like to not forecast a lot of what we are going to do in '08 because we don't want our competitors to know where we are headed. But R&D spend in '07 I think was right in line with historical rates, kind of somewhere between 2.5% and 3% of revenue, and we would expected it to be in that same category, probably towards the higher end of that category… or that range in 2008. And I’d like to remind you that some of our R&D spend on top of that 2.5% to 3% ends up coming to the cost of goods sold line when we work with outside parties to license their technology. So in total, R&D spend is probably closer to 4% of revenue on an ongoing basis when you include the use of an outside technology.

Bret W. Wise - Chairman, Chief Executive Officer and President

Chris, do you want to comment on things we introduced in '07?

Christopher T. Clark - Executive Vice President and Chief Operating Officer

Yes, Greg. As you know, we commented on that in previous calls. We continue to be very active in that front. I think if you look back over the year, certainly our rate of innovation was at least at if not slightly higher than what we have done in previous years. Just to highlight a few, we talked a little bit on Innovation C and obviously the positive impact that had, not only in the orthodontic growth but also the mix, and again the concept of an all-ceramic self-ligating bracket, that combination is extremely powerful.

I’ve commented previously I think on the GT Series X endodontic file, basically that utilizes the M-Wire technology coming through Sportswire acquisition, and again that provides the significant boost to a really important endodontic line of GT Series in that it now provides significant improvements in reduction of cyclical fatigue in the files, and the file breakage is certainly one of the major concerns with endodontics and this certainly helps to address that concern and alleviate and then certainly make sure that they are comfortable with the procedure. So I think that's a huge plus.

We've chatted previously about a couple of larger ones in the restorative area, certainly the B4, which is the pre-additive for impression material that improves accuracy even further, and than also the Lasting Touch polish, which again is really a nice esthetic improvement to an overall restoration. So again, I think just to comment, I think we are pleased overall with the year in terms of innovation. You saw innovation on a number of fronts across our different franchises and businesses, and I think that you’ll… you can expect to see more of the same as we look to 2008.

Bret W. Wise - Chairman, Chief Executive Officer and President

And I think in total, Greg, we introduced 25 to 30 new products this year, kind of in line with what we did in 2006, and the major ones that Chris noted are important, but… because most new products or new brands in dentistry end up being small, $3 million to $5 million in revenue ultimately. I think the continuation of introducing a number of new products, meaning something in that 25 to 30 range, is as important as anyone new product in the mix.

Greg Halter - Great Lakes Review

Okay, that's helpful. And relative to the offshore situation, any update that you can provide us regarding that?

Bret W. Wise - Chairman, Chief Executive Officer and President

Are you talking about the lab business?

Greg Halter - Great Lakes Review

Yes.

Bret W. Wise - Chairman, Chief Executive Officer and President

Oh sure. Just for everyone on the call, what Greg is referring to is that we run a service for our US labs whereby they can outsource to us the production of crown and bridge units, mainly crowns, which are produced outside of Shanghai and then shipped to them. It's about 6 to 7-day turnaround at a very low cost, just because of the differential in labor rates and so forth. And we've been ramping that business up every quarter. The number of technicians continues to grow. I would say the number of companies or customers that seek us out for that service has grown, both in the size of the customers and in the pure number of customers using the service. And I would remind you that we only provide that service to customers who buy our traditional lab products. People can't come and buy stuff… buy those units from us on a one-off basis. So it continues to grow. Access to highly trained technicians is always an issue. We work with universities in China to get the highly trained technicians. We are very pleased with the progress of the business and also the acceptance by the US customer base. And we only sell those products in US, they don't go to any other markets around the world.

Christopher T. Clark - Executive Vice President and Chief Operating Officer

Greg, I guess I'd also add that scenario where we are continuing to invest in terms of additional capacities, to go back to the capital comment. For next year, that certainly is an area where we are putting some money in.

Greg Halter - Great Lakes Review

Okay. And is there any fall-outs still from the… some of these certain discontinued offshore dealers shipping products into the US?

Christopher T. Clark - Executive Vice President and Chief Operating Officer

Yes, from a gray marketing standpoint it is an area, Greg, where we have to remain extremely diligent. There is a lot of creative ways to... the folks seem to try to find ways to get product back into the US and frankly for that matter into Europe and other developed countries.

At this point, if you look back over the last six months or last year, we invest in a couple of different areas. I mean obviously first, we have continued to make some pricing changes, some changes in terms of packaging and labeling in terms of how we mark our product for specific export countries and also for specific export customers. We also then discontinued dealers that… in various areas including Israel, Algeria, Tunisia, Lebanon, Morocco, and it was numerous dealers that we identified as basically selling gray back into developed markets and we discontinue those customers. We're shipping to those customers both in Q3 as well as Q4. We’ve got several as well right now that we are continuing to investigate. So again, I think it's an area where we’ve made a considerable amount of progress, but it's a scenario where we need to remain there very diligent.

Greg Halter - Great Lakes Review

Okay, that's very helpful. And relative to the merger of the US endodontic and implant businesses, in fact the personnel there, is that completed now?

Christopher T. Clark - Executive Vice President and Chief Operating Officer

Yes… you mean the merger of the two businesses?

Greg Halter - Great Lakes Review

Yes.

Christopher T. Clark - Executive Vice President and Chief Operating Officer

Yes. It was a Q1 2007 event, and then of course we had ongoing training because we were... we had to train both sales forces on the alternative products. So we had ongoing training throughout the year as we tried to bring the now combined sales force up to a level of proficiency in both endodontics and implants.

Greg Halter - Great Lakes Review

And you'd consider them now at that level of proficiency where you want them to be?

Christopher T. Clark - Executive Vice President and Chief Operating Officer

I think they are largely there. There is still some work to be done, and frankly I think there's always be work to be done, but we're well along the learning curve now and I would say that the majority of those reps... the vast majority of those reps have a high level of proficiency in both.

Bret W. Wise - Chairman, Chief Executive Officer and President

I think if you look at the North American growth rates for us particularly, as we mentioned in implants, certainly that’s indicative of the fact that they’ve hit their stride and I think are increasingly comfortable, and again we believe we are taking share in that market.

Greg Halter - Great Lakes Review

Okay, and one last one for Bill. What is your… the current… company's current derivatives position?

William R. Jellison - Chief Financial Officer and Senior Vice President

The derivatives I think at the end of December was about 142 million liability.

Greg Halter - Great Lakes Review

Right, thank you very much.

Operator

We're going next… we have a follow-up, Anthony Ostrea, JMP Securities.

Anthony Ostrea - JMP Securities

Hi. Thanks for taking the follow-up. Bret, you had mention earlier about the case starts in US ortho, and I believe you had mentioned that you had the first half data and it looked like there was some softening, but not a lot. Maybe… can you just walk us through maybe in past sessions whether... how much of a slowdown has there been in US case starts? Has it ever turned negative… if you… and maybe if you can quantify maybe the reduction in the growth rates in US case starts [inaudible]?

Bret W. Wise - Chairman, Chief Executive Officer and President

Let me... I'm going to have to avoid part of that question. Frankly, as you go back to the previous recessions we've had, I mean they date back to '01, there was the recession, then you go back to '90, then '82 and '80. So they are pretty dated and frankly on the orthodontic side I don't have the case starts history for those downturns in the industry. What I was commenting on earlier was, case starts in ortho has not grown rapidly for sometime, I don't know, five, six years, but the ortho businesses have been growing because of innovation. And what we saw earlier in the years, the first half of the year for instance we saw case starts were flat to slightly down in the US. It's not a big surprise to us because case starts in ortho haven't really grown a lot for some period of time. So the fact that they are flat would be a continuation of the previous trend, slightly downward would indicate to us that there is some softening in that market occurring. So at this point, I don't think it's a dramatic impact on the ortho market and we are monitoring it closely, but the data we get is pretty dated by the time we get it. And at this point, our own business is a better... probably a better indicator for us than that market data just because of the time lag in getting it.

Anthony Ostrea - JMP Securities

Great. That's all I have. Thank you.

Bret W. Wise - Chairman, Chief Executive Officer and President

Okay.

Operator

Having no further questions, Mr. Wise, I'd like to turn the conference over to you for any additional or closing comments.

Bret W. Wise - Chairman, Chief Executive Officer and President

Okay. Well, I think we're pretty proud of where we finished 2007. We accomplished many of the objectives that we had set forth at the beginning of year including making some key investments to accelerate growth, getting our business development activities ramped up, and redeploying cash flow in a meaningful way. So we are heading into 2008 with a fairly high level of confidence. We are very cognizant of the swapping of the US economy and what impact that will have on us, and you can rest assured that we will be sure to react to that as we see that softening occur, if it occurs. And we look forward to continuing to update you on our progress as we move through 2008.

So thank you for the time this morning, and we look forward to talking further as we move through the year.

Operator

This does conclude today's conference. Thank you for your participation. You may now disconnect.

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