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Executives

John Greisch - President and CEO

Mark Guinan - CFO

Andy Rieth - VP, IR

Analyst

David Roman - Goldman Sachs

Hill-Rom Holdings, Inc. (HRC) Goldman Sachs 33rd Annual Global Healthcare Conference June 6, 2012 2:20 PM ET

David Roman - Goldman Sachs

Good morning everyone. We go ahead and get started with the next presentation. I’m very pleased to welcome management team from Hill-Rom. We have John Greisch and Mark Guinan; CEO and CFO, respectively, here this morning and as always like to keep it as interactive as possible. Andy Rieth is hiding in the audience. So, any of you guys who want to tap him for a question he is sitting right over here in front.

But John maybe we can sort of start off by giving us an update on how the business has progressed and if you put out the LRP just over a year May of 2011 you presented a long range plan and since that, I think business dynamics have not exactly played out. I think as most might have expected. Just frame pretty impressed. What’s changed in the macro environment over the past year and what have been through the surprises to the upside and the downside relative to what you laid out last May?

John Greisch

Yes, I think the rigorous change since then is probably Europe which I think is [two-fold]. Everybody in the med device world the uncertainty in the impact of austerity measures and spending on healthcare in Europe is certainly different than I think what we had anticipated going back 18 months when we began pulling the LRP together. I think as we came into this year, our expectations for Europe included decline in revenues in the low single-digit range which is what we have experienced and that certainly wasn’t part of our long range planning for Europe. So, in that timeframe I think Europe certainly would be at the top in the list of what’s changed.

Over the past several quarters, I think the North American acute care market for bed frames and surfaces that the rate of growth has slowed relative to what we experienced in 2010, 2011, so that’s probably decelerated faster than what most of us in the industry had anticipated going back 1.5, 2 years ago.

I think on the positive side, I think our ability to generate strong sustainable cash flow in a challenging top line environment has certainly matched or exceeded our expectations and I think the strength of what I call the cash flow machine that Hill-Rom represents has been solidified over that timeframe. So, that’s where are encouraged, we got a very strong balance sheet and consistently improving operating cash flows. At the same time, I think when I first got here couple of years ago; we laid out a goal to get our SG&A rate down below 30%. We are just about there right now. So, I think looking back we probably gotten there little sooner than I thought even in an environment where revenues were more challenged than what we had anticipated. So, a bit of a mixed bag, but a lot of positives at the same time, we are dealing with some of the headwinds that were not as visible two years ago as they are today.

David Roman - Goldman Sachs

Is there a quarter for debt cycle, because if you look at the past, I know you expected that five years where unique economic operating environment, but you did this for credit driven meltdown in 2008 and ‘09 you had this massive resurgence in 2010 and ‘11 and now things appear to be sort of softening, but not nearly to a degree to where thought ‘08 and ‘09 and that we are coming off what was very heavy growth to little bit more moderate.

John Greisch

Yes, I think if you look overtime the replacement cycle has been in the 12 to 14 year timeframe. I think it was on the short end of that back in the ‘07 timeframe when credit was cheap and available to everybody. It got to the high end if not above that in ‘08, ‘09 credit crunch timeframe and I think the last couple of years I don’t think the cycle has changed but now it was two more years under our belt and visibility. I think it's clear the pent-up demand that was not being spent in the ‘08, ‘09 timeframe came back in ‘10 and ‘11. And as we come into this year as you all know, I think we have all seen probably a more rapid slowdown in that rate of growth of spending and probably more now in the more normalized replacement rate that would be the expected historical turn.

So, it has ebbs and flow I use the term, this is the lumpy business many times and not just in the United States but oversees as well. And I think if you look back over the last six years this cycle has been more pronounced and probably it had been part of that period.

David Roman - Goldman Sachs

And you think of credit right now is cheap and available as well it seems like the dollars and optimal CapEx are relatively flattish an issue of shifting priorities at the hospital level. Sometimes it's HVAC, sometimes its pumps or beds or who knows MR, CT that sort of the dynamics that you guys are seeing?

John Greisch

It's hard to generalize across the hospitals within the United States and point to anyone single thing that’s impacting the industry broad way. I think every hospital has its own set of dynamics that is dealing with, but I think as you said capital spending broadly appears to be relatively flat. I think our case as best as we can tell, with the pent-up demand accounting for a portion at least of the 2010, 2011 growth that we saw. I think our frame and surface business was up 25% last year over 2010 clearly that wasn’t sustainable. And I think other capital priorities had probably jumped ahead of beds as we are now in 2012, but again hospital to hospital it's a different story, but I think broadly the priorities will focus more towards beds in ‘10 and ‘11 to catch up with some of the demand that had been delayed. And now what we are seeing that growth rates for now.

David Roman - Goldman Sachs

Maybe we can switch to more the technology side of your business, you have done I think very well from a share perspective in the past couple of years and I think one Hill-Rom was spun out there is a pretty big refocus on the sales and marketing effort you can sort of see in your competitors growth rate, how they sort of slowed in a period of time during which I think your growth was accelerating. Can you just talk about the key competitive advantage on the product side and where you think things are going particularly well?

John Greisch

Yes, I think a couple of things have occurred over the past couple of years which I think had helped us get our market share back on-track and as you said we have gained some over the past couple of years. One is some introductions of products that fill some portfolio gaps that we had both on the frame side and on the therapeutic surfaces side of our portfolio. And secondly, I think bringing in some new leadership into the sale and marketing organization and getting more focused on the value proposition that we bring across our portfolio from frames to surfaces to patient lifting equipment to device connectivity as well as our extensive service infrastructure I think has enabled the sales force to be even more effective than we have been historically. And this is a sales force because you all know that’s been incredibly successful over the years.

I think we lost a bit of momentum over the last five to eight years when we were losing share but I think we have right at the ship if you will and are now taking advantage of broader portfolio as well as some of the technology enhancements that we have made around software as well as electronics improvements in particularly our higher end beds in addition to really introducing some device connectivity capabilities.

David Roman - Goldman Sachs

And maybe on the therapeutic surface side continues since that is also a scenario where you guys have unique advantage which are the product categories there leading the charge and anything new comes from the pipeline perspective that we should be watching for?

John Greisch

Yes, we introduced last year a higher end powered mattress product, air power surface product and we have got a broad portfolio from pulmonary to bariatric, to air fluidized management for burns and ulcer patients. So, I think the breadth of our portfolio is unmatched in the market today. That together with service network that we have really puts us in a strong of a competitive position as anybody out there.

David Roman - Goldman Sachs

I want to get back to international and both Europe and emerging markets. And maybe we should do a side bar on the P&L prospect and just looking at the margin picture of the business; obviously it's a little bit of tougher year on gross margins on a year-over-year basis. Can you maybe just remind people of the factor that are influencing the decline in the gross margin ratio?

Mark Guinan

Thank you, David. The largest driver in the year-over-year decline recently in the second quarter was really Volker acquisition. So, we acquired a lower gross margin business and it was really mixed. Some of the drivers beyond that in these not just been in the most recent quarter but we have had some of these over a couple of quarters are the mix between our rental business and our capital business while rental business is several 100 basis points higher. So, as we saw the capital business growing and growing significantly as John referenced and we saw rental business actually declining that was hurting our overall enterprise gross margin.

Within the rental space, the rental margins themselves were also declining we have talked about that on many of the quarterly calls, the biggest driver being, really, the average in use time. So, we were seeing fewer days of revenue generation for an asset on any given placement. We have also seen some commodity inflation, first is the first half of ‘11 we saw fewer spike we saw certainly other raw materials including steel go up. That towards the back half of ‘12 we talked about the comps getting easier because of that factor in the back half of ‘11 we talked about it getting easier in the back half of ‘12 but we are also seeing fuel inflation continue actually this year littler more than expected and that drives rental margins because we have got a fleet of 700 trucks in North America that are going in and out possible as everyday whether it's taking service calls or it's making deliveries of our rental products. So, that those have been factors.

Then the last one has really been this year the mix between international and North America. So, we have somewhat higher gross margins in North America since North American business slow and you see our growth coming internationally, you will see a little gross margin erosion again on the enterprise basis. So, as you look apples and apples, really the rental business we have seen a decline, but if you look at the North American gross margin themselves on a given product we have not seen erosion actually we have seen cost out improvement, if you look at the international margins themselves apples and apples actually improvements. So, it's really been largely a mix factors and then the acquisition and then some commodity inflation that has really been the impact on the enterprise.

David Roman - Goldman Sachs

And then I will be just sort of keep stepping of the P&L R&D you have it to grow what you have done. SG&A, I think the restructuring programs are well publicized. And Johnny started with the goal of getting below 30% awfully close to that right now. As we think forward I looked at it what are the headwinds and tailwinds that influenced the operating margin profile as we go into 2013 and I’m not seeing specific numbers, I know you are not going to give guidance but what are the moving parts up in the model. I think about it and maybe you sort of help me fill in the gap which is the tailwinds are and the year-over-year basis Volker in the numbers that sort of annualizes the rental business, the comparison get a little easier and maybe as utilization improves you might see the rental revenue trajectory also get a little bit better. And the SG&A side, I think it's an amortization that starts to roll off next year so that helps a little bit than with the ongoing restructuring program those are all the positives I could think of. On the other side it seems like international might still be a bigger growth driver that sort of modest headwind and many of the medical device tax, if you want to characterize?

John Greisch

There is a couple of other items that are worth noting once specifically and I think I have commented on this couple of times over the last several months relative to operating margins. You are right; the restructuring benefit will continue to improve our operating margins as we go into 2013. If I look 2013 and even beyond I think I mentioned on the last call, we still have a couple of pieces of the portfolio that are generating virtually no operating margin in excess of $100 million of revenue. We need to either fix that or get rid of it to be perfectly [want]. So, those changes either getting those margins up or doing something around some portfolio realignment activity will enhance our operating margins going forward. Internationally, as you all know and as Mark touched on, our European margins have been subpar for quite a while; those are moving in the right direction even in the environment that we are in today. So, I think while international mix has heard us a little bit as Mark said in the first half of the year, as we go forward and continue to migrate our international margins up that will have positive impact on our operating margins. Again I don’t to focus just on 2013 but certainly in the years ahead.

David Roman - Goldman Sachs

And just to make sure I understood, John, that you said the couple $100 million.

John Greisch

It's about $100 million.

David Roman - Goldman Sachs

Of zero operating margin revenue?

John Greisch

Yes.

David Roman - Goldman Sachs

And which segment is that in?

John Greisch

I’d rather not comment on to say really where it is, I think we talked a little bit about home care, one of the margin pressures that Mark mentioned give mixed impact. If you think of price mix and cost, it's the three big drivers in gross margin. Price has impacted a couple pieces of our business in terms of reimbursement pressures, home care being one of them. And that the business that we are taking hard looking at in terms of how do we improve it or reduce the dependency on it.

David Roman - Goldman Sachs

And then maybe you can talk little about international, because that is maybe today Europe has headwinds build overtime, international will be a growth driver for your business. And I think you were very well familiar with the operating dynamics in Europe, or maybe you could have touched on other OU.S. sort of happening in the emerging markets. I was recently in Brazil visiting a couple of larger hospitals, and there were a lot of Hill-Rom beds there. So maybe just help us think about that opportunity and what you are doing sort of capitalize on it.

John Greisch

Yes, if you think of our international business now with Volker on an annualized basis it's roughly just under $500 million business for us about 75% of that is in Europe. And the rest of our business this year very good growth coming out of the Middle East and Eastern European markets at attractive margins for us. Asia has been growing for us nicely this year and Latin America which is largely Brazil is also an attractive for us. What we have done over the past couple of years is we have invested a lot in SG&A in those markets at the same time reducing cost particularly in Europe, but pretty in place the management structure and some sales resources on the ground in the Middle East, Latin America and Asia. And we are going to see top line growth accelerate in those regions. We don’t have today any local manufacturing, Brazil is clearly a target market for us, China we have spoken about being an attractive market for us, but first to really accelerate the growth in those markets above and beyond where it is today. I think we have to have some local production presence there we were evaluating that as we go forward and obviously we haven’t made any commitments at this point in time and we will only do so if the return on investment is attractive.

David Roman - Goldman Sachs

And what are the market dynamics like? I know Stryker is there as well, but how about local competitors low cost local providers?

John Greisch

They exist certainly in Brazil and in China. And potentially could represent an acceleration of our market entry strategy into those markets. Again if the return on invested capital its attractiveness enough for us to do so. But there is most of the market in Brazil and China if you get below the higher end electric beds are served by local competitors.

Mark Guinan

It's important point to clarify, so there is no low cost that have the same features that we have than delivering for low cost. it's basically not featured on manual bed is what you see in the market.

David Roman - Goldman Sachs

We saw those too, yes. What do you guys see as the private hospital market which is developing as where the opportunities that lies. I think you brought it up the issue local manufacturing being important from a tax perspective and just competitive standpoint. Maybe you sort of alluded to I think it has mentioned M&A but not directly in the answer to that question, Maybe we should talk about of cash used. I mean just like the challenges from a top line perspective or operating margin, you think cash I described it as an ATM sometime to people. (Inaudible) in the more aggressive in returning cash to shareholders either through larger repurchase program or dividend?

John Greisch

Yes, I articulated capital allocation strategy has been fairly consistent in the last couple of years and I think Mark laid it out at the investor conference a year and a half ago. What we are going to overtime deploy roughly 15 to 20% of our operating cash flow to returns to shareholders in the form of dividend or buybacks, 25 to 35% of our operating cash flow to be reinvested in the business, capital spending, rental fleet replacement. And the remainder for strategic investments, M&A joint ventures what have you.

Last year 2011 we did repurchase I think over $100 million of our shares, we did very little M&A activity in fiscal 2011, obviously as we came into 2012, the Volker acquisition consumed about 100 million bucks and we certainly remain committed to that allocation split among those three buckets. At any one point in time as we’re going to perfectly match those guidelines but overtime that’s certainly the policy that we are following.

David Roman - Goldman Sachs

But you are building up cash at pretty healthy rate and I think you don’t have the same jurisdiction issues. I mean you appears to do so. Given what the stock has done and where the valuation is there any reason why you haven’t stepped it up over the immediate terms or competing interest or sort of evaluating the business development landscape in what sort of shoot first and regret it later.

John Greisch

Yes, I think that’s part of it David, we are constantly looking at opportunities and I’d say they are competing interest but evaluating the opportunities that are in front of us near-term certainly has an impact on whether we are going to accelerate a share buyback as I mentioned at a conference recently. We will continue to evaluate our dividend policy as well as our buyback policy in the context of other alternatives as we see them.

David Roman - Goldman Sachs

And I want to open it up to questions to see if there were any.

John Greisch

We have no intention of deviating from that capital allocation philosophy. And we are certainly highly focused on deploying on cash use as productively and value enhancing as possible.

David Roman - Goldman Sachs

Was that an annual? I thought that was over the period of the LRP on average if that it would work out to about that mix.

Mark Guinan

That’s correct, in 2011 if you look at the share repurchases and the dividend we spent over 50% of our operating cash back to shareholders versus a target of 15 to 20, but we spent very little on business development in this year. And obviously had the $100 million of about $7 million broker deal and we can still raise the dividend but we haven’t done significant share repurchases thus far.

John Greisch

I think we are also highly focused on the fact that as Mark said last year we spent more on shareholder return of cash this year to-date less than that profile would indicate, but we are also highly focused on the fact that we got a balance sheet that can be used either for M&A activities as we see them or other uses of returning cash to shareholders.

Question-and-Answer Session

Unidentified Analyst

Got a number of different areas that your business is involved in, do you have a particular focus for M&A? Some of the signs like its serendipitous if something shows up, you'll consider but is there focused on one division in particular?

John Greisch

I’d say there is three or four areas that I think you will see us focused on; one is what Volker represented which is opportunities to enhance our presence in specific markets, Volker not only Europe but specifically Germany gave us a much-much stronger position in Europe’s largest healthcare market. So, that’s one. Number two, products or technologies that we can push through our existing channels. And Liko, even though it's three plus years old represent a great example of a product that we can put in the bag if the sales guys around the world and leverage the channel strength that we got with our sales folks around the world. So, products and technologies that we can push through our existing channel. The other two couple of franchises we don’t talk a lot about we got a respiratory care business and surgical products business both of which are between 50 and $100 million in revenues, and both of which are very profitable opportunities for us that we would like to expand through again product or business either bolt-ons or businesses of similar or larger size. So, those are the focus areas, you are not going to see a step outside of the areas that we are in today and get into a completely different business than we are in today anytime soon. And that’s where our efforts are highly focused. So, it's more than just responding to whatever comes across the trend, buts it's those four specific areas for putting lot of effort in.

Mark Guinan

The only thing I’d add John is, is we are also looking at as John referenced it earlier add geographical expansion opportunities. So, as David was asking us about Brazil and then China certainly two areas that we see having a lot of growth opportunities, the question is beyond what we are doing today which is largely operating at the top of the economic pyramid as we anticipate these markets to evolve as the economies grow and the expanding bed for market for our current offerings is there an opportunity to step down a little bit in through an acquisition, some lower-tech beds, and to position ourselves more strongly for the future when we think it's going to migrate. So, we are looking at all that stuff, so it's certainly far from serendipity, we are very focused and strategic, but it's fine being the value creating opportunity at the right time to execute against.

Unidentified Analyst

So to taking out of financial side, tax rate size higher, I understand you are more U.S. weighted company so that has a bearing on what the tax rate looks like. But what are the opportunity to bring that down without any open scenario where you trapped your cash ex-U.S.?

Mark Guinan

That’s a great question. We are no trapping your cash ex-U.S. tax reform I guess. But to bring the tax rate down effectively it's really continued sourcing strategies outside the U.S. and so today we have majority of our income as you referenced in the United States, we have our manufacturing in the United States for a lot of reasons that’s not something we have plans to change because there is advantages to that that would offset any sort of tax advantages or labor advantages from moving that. So, that’s really on our future product well and we are certainly doing it. we got a nice beach ad in Singapore and as we are talking about some of these other potential geographical expansions, it's looking to have a sourcing which we probably included R&D and certainly manufacturing that would be tax advantaged as we grow the business.

John Greisch

I think also as we look at acquisitions, Volker as an example, how we restructured it, how we financed it, where we place the technology that we acquire are all things that Mark and his team are looking at as revaluating things going forward.

David Roman - Goldman Sachs

We have got a minute left if there are any other question. So, maybe just to close it off, John, you could speak more broadly about you came to Hill-Rom couple of years ago sort of you picked the bottom, really you picked the bottom of where things were operationally, how you are feeling about the long-term outlook, the trajectory for the company, the big goals for the next year?

John Greisch

Yes, I feel as enthusiastic as I did two years ago when I came here about this being a company with an incredibly strong group of franchises, brand equity, as you described it as an ATM machine, it's an incredibly powerful cash flow portfolio. And the opportunity to expand internationally, expand the portfolio as I mentioned, leverage the channel strength that we have got and deploy that cash and as the value creating ways as possible whether it's through M&A, international expansion or buyback/dividends I feel as enthusiastic about as I did two years ago. Are there more headwinds in a macro perspective today, yes, but Hill-Rom got a loan in figuring out how to deal with those headwinds. So, I think we continue to be in a great position certainly with some challenges that are different today than they were two years ago, but overtime, I think the portfolio strength, the cash generation strength and our ability to deploy that cash use is an exciting opportunity for us.

David Roman - Goldman Sachs

Okay. With that we will conclude this session. John, Mark we greatly appreciate your being here and taking the time to travel the West Coast.

John Greisch

Thanks David.

Mark Guinan

Thanks David. I appreciate it.

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