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Animal Health International (NASDAQ:AHII)

F2Q08 Earnings Call

February 7, 2008 10:00 am ET

Executives

Jim Robison - Chairman, President, and Chief Executive Officer

William Lacey, Senior Vice President and Chief Financial Officer

Analysts

Analyst for Lisa Gill – JP Morgan

John Kreger - William Blair

Michael Cox - Piper Jaffray

Jeff Johnson - Robert W. Baird

Operator

Good day everyone and welcome to this Animal Health International second quarter 2008 conference call. Today’s call is being recorded. At this time for opening remarks and introductions, I’d like to turn the call over to Jim Robison. Please go ahead, sir.

Jim Robison

Good morning. I’m Jim Robison, CEO of Animal Health International. Thanks for joining us today. With me today is Bill Lacey, our Senior Vice President and Chief Financial Officer. Bill will be discussing our financial results for the first and second quarter of the year, and then I will be discussing performance highlights, then we’ll open it up for Q&A.

William Lacey

Thanks, Jim. Good morning and thanks for joining us for today’s earnings release. Before we begin, I’d like to point out that today’s conference call is being recorded and will be available for replay on our web page at AHII.com under investor relations.

In addition, I’d like to remind everyone that some of the information discussed on this call, particularly our guidance for fiscal year ‘08, our competitive position, future business prospects, revenue growth, market opportunities for the coming year contain forward-looking statements that involve risks and uncertainties. These statements are based on current expectations. Actual results may differ materially from those set forth in such statements. Additional information concerning risk and other factors that may cause actual results to differ can be found in the company’s filings with the SEC.

Please note that in addition to reporting financial results in accordance with GAAP, AHI reports certain non-GAAP financial results including EBITDA. Investors are encouraged to review the reconciliation of these non-GAAP financial measures to the comparable GAAP results, which can be found in the press release.

AHI has provided in its earnings release and will provide in this conference call forward-looking guidance. We will not provide any further guidance or updates on our performance during the year unless we do so in a public forum. AHI does not assume any obligation to update forward-looking statements provided to reflect different events that occur or circumstances that exist after the date on which they were made.

In addition as previously disclosed, the company is no longer in compliance with Rule 4350(d) of NASDAQ’s listing requirements requiring an audit committee to be comprised of three independent directors due to the unexpected death of Mr. Robert Oelkers on January 7, 2008. The company’s audit committee of the board of directors is currently comprised of two independent directors due to this one vacancy.

The company is relying on the exception set forth in Rule 4350(d) it provides that if an issuer fails to comply with the requirement that an audit committee be comprised of three independent directors due to one vacancy, the issuer shall regain compliance by the earlier of its next annual meeting of shareholders or one year from the occurrence of the event that caused the failure to comply with the requirement. We intend to fill this vacancy on the board of directors and appoint one additional independent director to the audit committee as promptly as possible.

I am now pleased to provide you with the financial results for our second quarter of 2008. Net sales increased 19.4% or $32.9 million to $203.2 million for the three months ended December 31, 2007, up from $170.3 million for the same quarter last year. Acquisitions accounted for $13.8 million or 42% of the increase in sales. Organic sales increased 11.2% from the same period last year.

Gross profit as a percent of sales was 19.6% compared to 21.9% in the same period last year. This reduction in gross margin percent resulted from the previously disclosed and anticipated reduction in vendor rebates. EBITDA for the quarter, excluding a one-time non-recurring severance charge of $1 million, was $14.9 million, which was an increase of $0.1 million from the year earlier quarter of $14.8 million.

The change in EBITDA was due to the increase in volume offset by the anticipated reduction in vendor rebates and $1.2 million for stock option and public company expenses which were not incurred last year as a private company.

EBITDA, adjusted for the non-recurring severance charge of $1 million and $1.2 million for stock options and public company expense, would have been $16 million or an increase of 8.6% over last year.

Net income for the second quarter was $5.5 million, up 26% from the second quarter last year net income of $4.4 million. This increase in net income was due to the increase in sales volume and lower interest expense offset by lower rebates, the previously discussed severance charge, stock option and public company expenses and a higher tax rate. GAAP diluted income was $0.23 per share. The non-cash amortization of intangibles was $1 million for the quarter for those of you who add it back in your models, or $0.04 a share.

Now, let’s discuss results for the year to date. Net sales increased $51.6 million or 16.3% to $367.6 million for the six months ended December. Acquisitions accounted for $24.6 million or 48% of the increase, organic growth was 8.5%. EBITDA for the year-to-date, excluding a one-time non-recurring severance charge, was $20.9 million, which was a decrease of $0.9 million from the same period last year of $21.8 million.

The change in EBITDA was due to the increase in volume offset by the reduction in vendor rebates discussed earlier and $1.9 million for stock option and public company expenses, which were not incurred last year as a private company. EBITDA adjusted for the non-recurring severance charge of $1 million and $1.9 million for the stock option and public company expense, would have been $22.8 million or an increase of 4.4% over last year.

Net income for the year-to-date was $6.6 million, up 24% from last year’s net income of $5.3 million. The non-cash amortization of intangibles was $1.9 million for the six months for those of you who add it back in your models or $0.08 per share. Earnings per share, year-to-date unadjusted was $0.27.

Talk a minute about asset management. At the end of December there were 40 days of working capital. Our average for the last 12 months was 41 days. Debt increased during the three-month period by $20.4 million, driven by the acquisition of Kane Vet Supplies. The acquisition cost us $23.9 million. Capital expenditures were $1 million and availability in our asset-based loan at the end of December was $32.9 million.

The company affirms its EBITDA to be in the range of $38 million to $40 million and expects its net income for the fiscal year ending June 30, 2008 to be in the range of $13 million to $14 million. Net sales are expected to be in the $700 million to $730 million range. This guidance excludes any effect of future acquisitions.

Now I’ll turn it back over to Jim.

Jim Robison

Thanks, Bill. Our performance in the second quarter of fiscal year 2008 brought us back in line with the consensus analyst expectations for the first half of the year. As you can note, sales were strong; however, gross margin as we had anticipated was unfavorable to prior year due to a reduction in vendor rebates. Our expenses were in line with budget.

We are close to the completion and signing of our annual agreements with our largest vendors. We anticipate that this calendar year’s agreements will be more transactional in nature versus rebate-driven. The anticipated effect of this is a smoothing of profitability among the quarters, reduced discounting, and reduced risk factors associated with a shortfall of sales to goal.

We continue to actively pursue targeted acquisitions and the pipeline is good. As you know during the quarter we acquired Kane Vet, a leading distributor of animal health products in Canada, and quite frankly a premier company in our industry. We were also successful in consolidating our Walco Canadian operations into Kane Vet during the quarter.

We are excited to have the folks from Kane Vet join our organization. During the quarter, we also began to serve our companion animal and mixed practice veterinarian customers out of our new facility in Central California. We also hired ten salespeople since last reporting to you last quarter, covering the companion animal and mixed practice markets. These additions were associated with our expansion into this market.

With that I’ll open it up to questions.

Question-and-Answer Session

Operator

Our first question today is from Lisa Gill – JP Morgan.

Analyst for Lisa Gill – JP Morgan

The organic revenue growth was very impressive in the quarter and I just wanted to drill down on the key drivers there. Obviously field lab placements were up nicely in the fourth quarter, and one of your competitors cited customer buy-ins ahead of price increase on the production side, so any commentary there would be helpful.

Secondly, you had provided some commentary about the negotiations with suppliers in your prepared remarks. I was just wondering if you can give us any incremental update as to the status of the negotiation with the one vendor where you’ve had the rebate issues in the past?

Jim Robison

Yes, I’d be happy to do that. First regarding sales, the drivers for the quarter were -- let me first say that we’re in line with our forecast regarding organic growth. When you net out things that could have driven the unusually high sales performance, which I’ll comment on in a moment, we’re in line with our organic growth forecast.

One thing that drove the sales were, as noted by another competitor, price increases by two rather large vendors January 1. A second thing was that our dairy customers were unusually healthy financially so there is a little bit of forward buying there.

The economics in the production animal business were not necessarily favorable in any way. As a matter of fact, given high wheat prices, there was a lack of grazing in the cow/calf stocker market that usually occurs. A lot of animals went straight to the feed yard so we didn’t see any unusual occurrences relating to placements during the quarter.

Analyst for Lisa Gill – JP Morgan

With respect to the negotiations with the supplier?

Jim Robison

We’ve got all of our agreements negotiated with the exception of one and it relates to that particular supplier mentioned. We have made progress in moving more of the margin to transactional and less to rebate. We will see an improvement, we believe, this year in transactional margin from that vendor. We’re still working with them on an appropriate margin, as we’ve done historically, for what we call high-value initiatives and compensation for growth. We are hoping to reach as we have in the past, favorable conclusions on those matters.

Analyst for Lisa Gill – JP Morgan

With respect to the ‘08 guidance, does that assume that that negotiation gets completed or is that built in the current range?

William Lacey

It’s built in. The negotiations, where we are right now on those negotiations, Mike, is built into the forecast.

Operator

Your next question comes from John Kreger - William Blair.

John Kreger - William Blair

Can you talk a bit more about the severance charge that you had? What was behind that? Was that a typical acquisition/integration or something else?

William Lacey

It’s two pieces. It’s about $700,000 for the agreement we reached with Mr. Greg Eveland, our former Chief Operating Officer and there was about $260,000, call it $200,000 to $300,000 of severance associated with the consolidation of our Canadian operations into Kane Vet, which we acquired in October.

John Kreger - William Blair

Pulling forward of revenue due to the timing of price increases, can you speculate about how much that helped your top line?

William Lacey

It’s very hard to isolate it. A couple of million, several million. It’s not a big number and it’s hard to say. It was our two largest vendors contributed most of the change in the price increase, one of them we saw very little difference between this January and last January. So, we assume that there is not probably a whole lot in the other one either. But, we are assuming there is probably a couple of million dollars brought forward.

John Kreger - William Blair

One last question around rebates, that was clearly a headwind for you guys in calendar 2007. As you think about calendar 2008 based upon what you know now, should we view that issue as a headwind again or neutral or perhaps a positive driver for your earnings?

William Lacey

That’s a great question. We believe that the economics in the go-forward calendar year ’08 -- and this is unsigned right now, it’s in negotiation -- will probably be very similar to the economics around those rebates in calendar year ‘07. So, I think we fought the headwind. We are where we are right now. We think we will continue to improve margins as we go forward, but it won’t be because we’ll hit it back in those rebates.

Operator

Your next question comes from Michael Cox - Piper Jaffray.

Michael Cox - Piper Jaffray

It sounds like you are expecting rebate dollars to be roughly flat in calendar ‘08 but you have an assumption of improving the gross margin. I am curious as to what the drivers of that will be here in calendar 2008?

William Lacey

Well, we believe that the acquisition of Kane Vet carries a little bit heavier margins than we do historically.

Jim Robison

Also, Mike, we’ve got four initiatives underway. As we discussed with many of you in the past, one is to place emphasis on nationally branded vendors that provide us higher margin opportunities. I can tell you that the vendor that we’re having a problem with is clearly an outlier to the norm, and as we’ve discussed, those pressures will stay in place until they are not an outlier. Their share of our business reduced last year and we anticipate that their share will be reduced this year; not because we do anything other than emphasize other people’s products where we can make more money.

Secondly, we are going to be emphasizing exciting new products that we’ve brought to the market and there is a handful of those, none of them onto themselves are material, but there is some exciting opportunities there.

Third, we have an initiative underway to work to be less arbitrary in how we discount. If you do analysis around our 240 some odd salespeople manage their pricing in their territories through pricing intelligence systems, there is an opportunity, we believe, to improve our margin while remaining competitive on the visible lines.

Third, we believe that given the structure of the agreements for ‘08, we’ll see reduced discounting caused by a reduction in the back half of the year in pursuing the volumes associated with the goals to get the rebates.

Michael Cox - Piper Jaffray

In terms of the acquisition environment, I was hoping you would comment on what you are seeing there in terms of multiples, availability?

Jim Robison

We had one fall away, as you might know. Iowa Vet sold to private investors at a very high multiple, we don’t have visibility into that transaction, but through hearsay we do believe that sold at a very high price but there’s still a lot of regionals and nice tuck-unders available, so the industry is still consolidating.

Michael Cox - Piper Jaffray

The net income guidance that you provided, is that on a GAAP basis, so it would include the severance cost?

William Lacey

It is on a GAAP basis.

Michael Cox - Piper Jaffray

You noted the increase in wheat prices and just in general grain prices have moved higher, what type of impact do you foresee that having on the beef market over the next six to 12 months?

Jim Robison

It’s real difficult to forecast. As I mentioned a moment ago, the high prices of wheat cause people not to graze wheat pastures, they actually harvest it out and sell it. It disrupts the normal flow of beef cattle. We’ve seen good commodity prices other than in the beef market where we’ve seen fairly soft fed prices, but we think that later on in the year a lot of these things will come into play.

If you look at the long-term economics of corn, the belief is that we have the capacity, at least theoretically, to produce sufficient corn to supply our ethanol demands and still remain healthy in the production animal markets. But right now, it’s just a stress on the market because the associated cost of finishing these animals with the wheat and corn prices what they are.

Operator

Your next question comes from Jeff Johnson - Robert W. Baird.

Jeff Johnson - Robert W. Baird

Bill, I just want to circle back, you said net income guidance is on a GAAP basis. EBITDA guidance of 38 to 40 though is on an adjusted basis ex the severance charges there of $1 million or is that on a GAAP basis as well?

William Lacey

The EBITDA is on an adjusted basis, if you will, with that added back. The net income is an unadjusted GAAP number.

Jeff Johnson - Robert W. Baird

Is unadjusted GAAP. On the tax rate being up at 41.5% this quarter, what are the thoughts for the back half of the year, and again just remind me the reasons why it was up this quarter?

William Lacey

It has to do with ongoing state tax adjustments. We have a deferred tax position and option expense as well which are non-tax deductible, which keeps us in a higher number, as well as those amortization of intangible assets, which were also non-cash deductible. So, it keeps us at a pretty high level. We have had a high number for the first half. I’ve been modeling around 40%, could go high, could go low from that number.

Jeff Johnson - Robert W. Baird

For the last two quarters then somewhere right around 40% if I’m hearing you right to kind of balance off the first half of the year?

William Lacey

40%, 41%, yes.

Jeff Johnson - Robert W. Baird

I mean with net income guidance coming down $500,000 on both the upper and lower range that is pretty much all just tax rate related, there is nothing else here impacting the net income guidance as far as my model is concerned anyway, would you agree with that?

William Lacey

We’ve got the tax rate issue and we’ve got the unamortized finance charge if you recall from the first quarter was pre-tax 267, so it’s about 160 or so after-tax. It’s a small number, but it has an effect.

Jeff Johnson - Robert W. Baird

Any sales to synergies at all that you are seeing with the consolidation of Walco Canada and Kane? The sales to synergies, I thought at one point we talked last quarter that there was some risk there because of some product overlap and different vendors and what have you, there could be some dissynergies?

Jim Robison

We did talk about that, but it’s not material and so far everything has gone well on that front.

Jeff Johnson - Robert W. Baird

Last question I have just on gross margin and I think we’ve had enough color on it throughout the call, but we are three quarters in here of seeing a 40 basis point decline, a 120 basis point, a 230 basis point as the three quarters have progressed. One more quarter of pressures, but then after that thoughts would be the gross margins can begin to stabilize if I’m hearing your earlier comments correctly?

William Lacey

Over last year. That’s right.

Jeff Johnson - Robert W. Baird

Yes. On a year-over-year basis, we should start seeing gross margin stabilization maybe a quarter or two out from here?

William Lacey

Right. That’s correct.

Operator

I have no further questions at this time. Mr. Robison, I’ll turn the conference back over to you.

Jim Robison

Thanks again everybody for joining us this morning. Have a good day.

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