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Hill-Rom Holdings, Inc. (NYSE:HRC)

F3Q2012 Results Earnings Call

July 26, 2012 8:00 AM ET

Executives

Andy Rieth – Vice President, Investor Relations

John Greisch – President and CEO

Mark Guinan – Vice President and CFO

Analysts

Jon Demchick – Morgan Stanley

Lennox Ketner – Bank of America

Constantine – Raymond James

Topher Orr – Goldman Sachs

Matt Miksic – Piper Jaffray

Steve O’Neil – Hilliard Lyons

Gary Lieberman – Wells Fargo Securities

Operator

Good morning. And welcome to the Hill-Rom Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct the question-and-answer session, and instructions will be given at that time.

As a reminder, this conference call is being recorded and will be available for telephonic replay through August 2, 2012, see Hill-Rom’s website for access information. The webcast will also be archived in the Investor Relations section of Hill-Rom’s website, www.hill-rom.com.

If you choose to ask a question today, it will be included in any future use of this recording. Also note that any recording, transcript or other transmission of the text or audio is not permitted without the written consent of Hill-Rom. (Operator Instructions)

Now, I’d like to turn the call over to Mr. Andy Rieth, Vice President, Investor Relations.

Andy Rieth

Thank you, Shannon. Good morning. And thanks for joining us for our Third Quarter Fiscal Year 2012 Earnings Call.

Before we begin, I’d like to provide our usual caution that this morning’s call may contain forward-looking statements such as forecasts of business performance and company results, as well as expectations about the company’s plans and future initiatives. Actual results may differ materially from those projected.

For an in-depth discussion of risk factors that could cause actual results to differ from those contained in forward-looking statements made on today’s call, please see the risk factors in our annual report on Form 10-K and subsequent quarterly reports on Form 10-Q. We plan to file our 10-Q for the third quarter later this week.

Joining me on the call today will be John Greisch, President and CEO of Hill-Rom; and Mark Guinan, Hill-Rom’s Senior Vice President and Chief Financial Officer. The usual ground rules will apply to make the call more efficient. We scheduled an hour in order to accommodate our prepared remarks and leave plenty of time for your Q&A.

During Q&A, please limit your inquiries to one question plus a follow-up per person. If you have additional questions, you may rejoin the queue. As you listen to our remarks, we are also displaying slides that amplify our disclosure. I would encourage you to follow along with us. The slides were posted last night on our website and will also be a part of this archive.

With that, I’ll turn the call over to John.

John Greisch

Thanks Andy. Good morning, everybody, and thanks for joining us today. We’ve a lot to cover this morning. As you saw in our press release, we revised our overall revenue and earnings outlook downward due to the weaker orders in our North American capital business the past several months and weaker order expectations for the remainder of the year. At the same time, we delivered earnings in line with our guidance for the third quarter and last night announced an exciting acquisition for our company.

Let me start with the few comments on the quarter. Our third quarter adjusted earnings per share were up 19%, in line with our guidance but on lower revenue than we anticipated.

Our guidance for constant currency revenue growth in the third quarter was 11% to 13%, compared to the 9% we achieved. By far, the biggest factor in the revenue shortfall was capital sales in North American Acute Care, our largest business unit where revenue declined 5%.

For the first half of the year, we saw capital growth of over 3%. Well, our U.S. Patient Support Systems business declined 11% for the quarter. We believe this to be better than industry performance.

As we discussed on our last earning calls, we had a slight sequential increase in North American Acute Care capital orders during the second quarter and we expected to see continued order growth in the second half of the year in line with our historical patterns.

Second half order improvement has not materialized as we expected. For the third quarter, we experience a declined in order sequentially and year-over-year and we ended the quarter with the backlog down 20% from the prior year.

We also experienced delays of several large orders that were expected to ship in the third quarter, but are now expected to ship in Q4. And unfortunately, this has become a more common trend as we have seen more order and delivery delays over the past several months than we had in the last two years.

It is clear that the capital spending environment in North America has become more challenging throughout 2012 and we have adjusted our fourth quarter guidance accordingly.

With tightened capital budgets and in many cases, delays in decision making around capital appropriation, we are not expecting the environment in North America to improve for the foreseeable future.

I’m disappointed with our third quarter revenue shortfall and with reducing our outlook for the fourth quarter. We have discussed how lumpy this business is and in today’s environment, it has become even more challenging to estimate the timing of our customer’s capital decisions.

We will continue to monitor customer spending patterns as best we can. However, just as we saw upside volatility when the North American Acute Care capital business was increasing over 18% in 2011, the volatility in this business will be a challenge in a down capital market as well.

We expect the fourth quarter to be particularly challenging since the comparable period last year was unusually strong. And while it is premature to provide guidance for next year, it is difficult to foresee a substantial improvement in the macro economic and healthcare environments currently influencing our customer’s capital spending.

To help counteract these revenue challenges, we will continue to aggressively manage our cost structure as we have in the past. Despite the weak revenue environment, our third quarter adjusted SG&A rate was below 30% of sales, reflecting the discipline we will maintain around controlling our cost.

So we have to do more than simply manage costs. We need to diversify our revenue sources as we have with the Aspen Surgical acquisition. We’ve previously discussed the strong reasons to diversify our portfolio with strategically relevant acquisitions in order to reduce our exposure to the volatility of the capital business.

We’ve also discussed how we would prudently deploy our cash to expand Hill-Rom’s global portfolio beyond our patient support franchise. With our acquisition of Aspen Surgical, we now have an established profitable surgical consumables business to complement our existing capital base surgical business, Allen Medical.

Aspen has a portfolio of well-established consumable surgical products and leading brands such as the Bard-Parker line of blades and scalpels, a logical addition for us as they’re focused on improving safety for patients and health care professionals.

Additionally, Aspen has a variety of other operating room disposables such as Colby fluid collection products as well as wound care dressings. Importantly, Aspen provides Hill-Rom with a recurring consumable revenue stream to help mitigate the cyclicality of our capital businesses.

Operating margins for Aspen are accretive to our existing operating margins with margins in the mid 20s. However, after purchase accounting, Aspen’s margins are expected to be more in line with our current margins.

The $400 million purchase price represents an EBITDA multiple of approximately 10.5 times 2012 EBITDA. Aspen also has a management team with extensive experience that we will retain.

Greg Pritchard, formerly CEO of Aspen, who has over 25 years experience with Cardinal Health and some of it predecessor companies, has joined our executive leadership team as Senior Vice President and President, surgical and respiratory care reporting to me.

In this role, Greg will manage Aspen as well as our existing surgical and respiratory care businesses. We will continue to seek to expand these profitable franchises under Greg’s leadership.

Needless to say acquisitions that are both strategically relevant and immediately accretive to earnings are tough to find. So we are very excited about this acquisition and the prospects for this business. This transaction is aligned with our previously communicated strategy, deals adjacent to our existing businesses in the range of several $100 million.

Before I turn the call over to Mark, I want to comment on a few other aspects of the quarter. Clearly, we are in a challenging top line revenue environment with the majority of our businesses. Despite those challenges, I’m pleased that we delivered 19% increase in adjusted earnings per share and expanded our operating -- our adjusted operating margin by over 100 basis points compared to last year.

While gross margins were down due to geographic mix and other issues that Mark will discuss, we continue to aggressively manage our cost base to drive earnings improvements where possible. As I mentioned previously, we are now planning for an even more challenging hospital CapEx environment for our products particularly in North America.

We’ve taken cost out of our business and streamlined our management structure to position us well for the changes occurring in the market and to best position us for success during the challenging time ahead.

I’m confident that we have the right products and the right people in place to continue to gain share. While our North America business struggled this quarter relative to expectations, our International segment had solid revenue growth in line with expectations, with constant currency revenue growth of 28% excluding Volker.

This is driven by strong performance in the Middle East and Eastern Europe where we won several large tenders during 2012. We also had a strong quarter in Asia where revenue grew 19% over 2011.

We have made significant investments in our International operations over the past two years and the growth that we are achieving this year were not necessarily sustainable on a consistent linear basis has been strong.

Our Post-Acute business has had a tough year in 2012 as reimbursement pressures have impacted our home care and respiratory care businesses. We are evaluating additional changes needed in our Post-Acute business to improve our competitiveness and profitability going forward.

With that, let me turn the call over to Mark. Mark?

Mark Guinan

Thank you, John and good morning to everyone on the call. Before we get started, I want to highlight the many of the figures we will discuss today are adjusted or non-GAAP measures. Reconciliations to our reported U.S. GAAP numbers are included in the appendix to our slide deck.

Now, let’s get started with revenue. On a consolidated basis, reported third quarter revenue increased 5.6% to $406 million or 8.5% on a constant currency basis.

Our capital sales increased 12.5% to $301 million. This was driven by 52.1% increase in our International segment due primarily to growth in the Middle East and Eastern Europe on recent tender wins in those regions as well as the impact of the Volker acquisition completed earlier this year. This expected strength in International was partially offset by a 4.6% decline in North America Acute Care driven primarily by decline in our patient support system sales.

Consolidated rental revenue also continued to come under pressure, decreasing 9.9% to $106 million. Rental revenue declined across all segments on lower volumes and unfavorable pricing in select areas.

Domestic revenue decreased 6% to $258 million while revenue outside the United States increased 34% to $148 million, led by the strength of the Middle East and Eastern Europe and the addition of Volker as I mentioned earlier. On a constant currency basis, revenue outside the United States increased 44%.

Looking at revenue by segment, North America Acute Care revenue decreased 5.3% to $227 million as both capital and rental revenue declined in the quarter. Capital sales were down 4.6% driven by a decline in North America patient support system sales of 12.3%.

Capital orders for the quarter were down mid-single digits. And we expect relatively flat orders sequentially for the fourth quarter, consistent with what we’re seeing in the industry.

Flat orders would be a significant deviation from our previous expectations. Expectations which were based on our historical order pattern of the fourth quarter being our strongest quarter of the year for both revenues and orders.

North American Acute Care rental revenue declined 7.2% with lower revenue in both the therapy and movable medical equipment product lines. This decline was the result of the continued pressure we see on rental volumes due to the ongoing initiatives by hospitals to control costs and other competitive pressures.

Moving to our North American Post-Acute Care business, revenue declined 10.9% to $46 million, as both capital sales and rental revenue were lower in the quarter. Extended care, home care and respiratory care all experienced revenue declines.

Volume and pricing continued to be under pressure in all businesses with this segment and we expect this to be the case for the balance of the year in home care and extended care, with some improvement in our respiratory business.

International revenue increased 42.4% to $134 million or 53.6% in constant currency. Excluding the impact of the Volker acquisition, International revenue increased 28% on a constant currency basis, led by the strength of the rest of the world regions we mentioned earlier.

Despite continued concerns over the economic environment in Europe, sales and orders have been relatively stable in 2012. Constant currency revenue for Europe excluding Volker was up mid single digits for the quarter. As we look to the full year, we expect orders to be relatively unchanged year-over-year.

Note that the strong revenue growth we’ve experienced in certain rest of the world regions has been driven by several large projects and successful tenders. While, we expect continued growth in these regions, the results are likely to be irregular quarter-to-quarter and perhaps even year-over-year.

Moving to margins, we posted lower adjusted gross margin performance for the quarter at 46%, representing a 260 basis point decline over the prior year. Both capital and rental adjusted margins were down, with capital margins experiencing the larger decline.

Our adjusted capital margins were down year-over-year by 290 basis points. The biggest driver of this change is the mix impact we anticipated from adding the Volker business, which has lower gross margins than our enterprise average.

Some additional drivers of the margin decline include the effects of a higher mix of International revenue, increasing commodity pricing and unfavorable product mix from primarily lower sales of critical care beds.

The adjusted margin decline of 20 basis points in our rental business relates primarily to the lower revenue discussed earlier and a resulting reduction in the leverage of our product fleet and field service infrastructure. In line with our comments last quarter, rental margins have stabilized over last few quarters and expected to be relatively consistent in the near-term.

Our R&D investments for the quarter decreased 6.9% year-over-year, as we continue to tightly manage our operating expenses in line of our revenue softness. Despite that reduction, we expect to maintain R&D at 4% of sales for the year.

Adjusted SG&A expenses for the quarter decreased by approximately 5% year-over-year to $118.6 million. This is down 320 basis points as a percentage of revenue to 29.2% and down 80 basis points compared to last quarter.

The SG&A decrease primarily as a result of lower legal fees and personnel costs, and benefits of our recent restructuring action, which more than offset the incremental SG&A associated with our recent acquisitions.

Adjusted operating profit for the quarter was $52 million, representing a 12.9% operating margin, up 120 basis points versus last year’s comparable period. This improvement was driven by the lower operating expenses outlined earlier.

The adjusted tax rate for the quarter was 32.2%, compared to 31.5% in the prior year. The lower rate in the prior year was due primarily to the benefit of earnings and lower rate jurisdictions, and the now expired R&D tax credit.

So, summarizing our key adjusted income statement metrics, operating income of $52 million was up 16% from the prior year with operating margin higher by 120 basis points, driven by the lower SG&A expense. Earnings per diluted share were $0.56 in the quarter, representing a 19% increase, compared to $0.47 in the prior year.

One final comment on operating results before I move onto cash flow and guidance. During the quarter, we had several items netting to $17.9 million pre-tax charges in our GAAP earnings that are not reflected in our adjusted results.

A few of these items carryover from earlier quarters, well, one is new to the quarter. The first of the carryover items is a continuation of a matter dating back to last year, which resulted in a $1.7 million benefit reflected in rental gross margin. This gain relates to an ongoing vendor product recall action that is expected to continue through the fourth quarter.

The second of the carryover items relates to $1.9 million of acquisition and integration costs included in SG&A, associated with our recently completed acquisitions. Additional integration costs are likely to be incurred in the coming quarters in relation to these transactions, which we will highlight as they occur.

The third carryover item is $1.7 million of costs, associated with the restructuring actions announced in the second quarter. Additional costs of up to $4 million are expected to be incurred in relation to these actions in the fourth quarter.

In addition, during the quarter we initiated a field corrective action on one of our med-surg product lines, related to an intermittent circuit board connection issue for which we recognized a pre-tax charge of $16 million in the quarter. This is a voluntary action by the company and does not limit the manufacture, sale or ongoing use of these beds.

The remediation was identified as part of our enhance quality efforts, as we have strengthen the QA/RA function over the past 18 months. We have substantially revamped the quality organization, with the addition of experienced medical device QA/RA leadership throughout the organization during this time.

Moving now to cash flow, our year-to-date operating cash flow was $187 million, compared to $189 million the prior year. Operating cash flow benefitted in the current year through improved working capital, most notably in accounts receivable collections.

We continue to be pleased with the strong cash generation capabilities of our businesses. That aside, we expect operating cash flow this year will be negatively impacted versus our previous guidance by a combination of reduced earnings and cost-related to our restructuring and field corrective action.

Now, let’s turn to guidance. I would like to remind you our guidance includes the impacts from the recently completed acquisitions of Volker and Aspen Surgical. At this time, we are providing guidance for the upcoming quarter and full fiscal year of 2012. We will provide guidance on fiscal 2013 when we release our fourth quarter and full year results.

For our fourth quarter, we expect to report revenue of $413 million to $421 million. This reflects organic constant currency revenue decline of 10% to 12%, adverse impact from foreign currency of approximately 3% and revenue from 2012 acquisitions of approximately $45 million.

The organic decline is primarily driven by lower than expected North American capital revenues. In addition to the weaker recent order trends, the fourth quarter last year was unusually strong even for our historically strong final quarter of the year.

For the quarter, we now expect constant currency revenue for North American Acute Care to decline in the mid teens, a low double-digit decline in North American Post-Acute Care and a double-digit increase of International including Volker. We expect adjusted diluted earnings per share of $0.53 to $0.55 for the quarter.

Moving to the full year, we are anticipating reported revenue of approximately $1.6 billion and adjusted earnings between $2.21 and $2.23 per diluted share. This reflects organic constant currency decline of approximately 2%, adverse impact from foreign currency of approximately 2%, and revenue from 2012 acquisitions of approximately $80 million.

Our anticipated full-year 2012 financial outlook reflects the following, a mid-single digit decline in North American Acute Care, a high single-digit decline in North American Post-Acute Care, and double-digit constant currency revenue growth in our international segment aided largely by the addition of our Volker business and large tender wins in Middle East and Eastern Europe.

Gross margin of approximately 47%, R&D spending at approximately 4% of revenue, continued operating leverage of our SG&A infrastructure, operating margins down for the full year approximately 70 basis points due to lower revenue and gross margin, a tax rate of approximately 31%, shares outstanding for the year in the range of $62 million to $63 million, operating cash flow of approximately $260 million to $270 million and finally $75 million to $80 million of CapEx investment during the year.

This has been an extremely difficult year given the continued economic conditions in Europe and a weak U.S. hospital CapEx spending environment for our products, which has slowed at a greater pace than we first saw. Though, we continue to instill disciplined expense management and maintain the R&D investment necessary for the sustainability of our business, the speed and severity of the U.S. Acute Care capital downturn unfortunately does not allow us to fully offset the operating income impact of the resulting lower revenue.

We will continue to aggressively manage our cost base and drive operational improvements, while continuing to address our portfolio to drive longer term value.

With that, I’ll turn the call back to John for concluding comments. John?

John Greisch

Thanks, Mark. This is a challenging time for companies like Hill-Rom that are heavily dependent on hospital capital spending cycles. Following the strength, we experienced in our North American capital business in 2010 and 2011. The downturn, we’re now experiencing has been greater than what we had anticipated several months ago.

Between reimbursement and payor mix pressures, uncertainty around the macro economy and the future impact of the healthcare reform, capital spending in our key markets has tightened more quickly than we expected as we moved through 2012.

As we navigate the challenges of our core bed business, we are excited about the opportunity that Aspen brings to enhance our surgical franchise and provide us with a consumable revenue stream for the future.

As I said earlier, I’m pleased to make an acquisition of this size that is immediately accretive to earnings and that gives us an opportunity to build a strategically meaningful franchise for the future.

We are committed to continuing to drive improvement in our existing portfolio and to addressing underperforming businesses within that portfolio. At the same time, we will deploy capital as we did with Aspen to enhance shareholder value with strategically relevant acquisitions that enhance our growth opportunities in attractive markets.

With that, Operator, please open the call to questions?

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Matthew Miksic with Piper Jaffray. You may begin.

John Greisch

Hey, Matt. Are you there?

Operator

Mr. Miksic, please check your mute line.

John Greisch

Why don’t you move on? Operator, we’ll get Matt back in the queue.

Operator

Our next question comes from David Lewis with Morgan Stanley. You may begin.

Jon Demchick – Morgan Stanley

Hello, this is actually Jon Demchick in for David.

John Greisch

Hi, John.

Jon Demchick – Morgan Stanley

Hi. Wanted to ask a quick question on the overall bed market, competitors suggested that the market may have bottomed in this quarter, but your guidance revisions suggest further deterioration into the end of the year. So, was wondering if you can give any additional color into that overall selling environment and if you feel any of your visions reflect any sort of change in the competitive landscape or if it’s mostly just the industry?

John Greisch

Well, Jon, I think if you look at not just this past quarter but the several -- several of the past quarters, I think our performance has outpaced what we’ve seen the industry performance to be at this quarter being no exception even with the decline in our business.

I think it was little lower of a decline than what you’ve seen with certainly one of our competitor. So from a industry competitive perspective, I feel very good about Hill-Rom holding its own and maintaining and growing share a little bit.

Relative to our outlook, I don’t see, as I said in my prepared comments any fundamental changes in the macro dynamics that are impacting our customers’ spending patterns. As much as I would like to believe, CapEx is going to turnaround.

I think based on the order trends that we’ve seen, which obviously have been lower than what we had expected three, four months ago. I have hard time sitting here saying that it is troughing at this point in time.

So, until we see some more indicators of improvement in order rates, we are taking a prudent view that we’re in a tough cycle and as I mentioned, whether its reimbursement pressures, payor pressures, operating margin pressures that our customers are under, I think capital is getting squeezed, particularly relative to our product lines.

I was out last week with two of our larger customers and their comments are consistent with what I hear from every CEO of every large hospital system and hence the view that we’ve taken that we’re in for at the tough time going forward. And I’m certainly not in a position where I can say that we’re expecting any rebound any time quickly.

Jon Demchick – Morgan Stanley

Thank you. Very helpful. And just a quick follow-up on Aspen.

John Greisch

Yeah.

Jon Demchick – Morgan Stanley

Was wondering if you could give a little color on the profitability breakdown on -- of course, in operating lines and also its current growth rate. And we were kind of curious whether this purchase was mainly about diversity or if synergies were a major factor in it.

John Greisch

Sure. As I mentioned in my prepared remarks, the operating margins are in the mid-20s, which obviously better than Hill-Rom’s current average margins, gross margins are pretty much in line with our margins overall.

The growth that we expect going forward, we’ll comment more during our October call with respect to our 2013 guidance. But both on the top line and bottom line, we’re excited about the growth profile that this brings to our existing portfolio.

The acquisition itself, strategically again, in line with my comments earlier, we’ve been looking at this for a while. And it’s a great addition to our existing surgical business, selling into the OR with a disposable stream of products.

I wouldn’t say there’s a huge amount of synergy from a cost perspective, but the channel into the OR together with our capital base product line, we’re obviously going into the same call point to some degree with this product line relative to ours and I look at it as a platform to strengthen our existing surgical business and give us a larger platform to build upon going forward.

:

Okay. Thank you. Very helpful. I’ll jump back in the queue.

John Greisch

Okay. Thanks, Jon.

Operator

Thank you. Our next question is from Lennox Ketner with Bank of America. You may begin.

Lennox Ketner – Bank of America

Hi, guys. Thanks for taking the questions.

John Greisch

Hi, Lennox.

Mark Guinan

How are you?

Lennox Ketner – Bank of America

I guess first one, obviously is very difficult environment and, the topline is somewhat out of your control. But I guess I was just surprised by the guidance change just by the magnitude of the earnings guidance reduction, given that the topline guidance is only coming down by 2% to 3% and you’re reducing earnings by 10%.

I’m wondering if you can, obviously there can be high incremental margins with any capital equipment business. But I’m wondering if you can maybe give people some way to think about, going forward if you do see continued meaningful declines in 2013, continued topline declines, how should people think about how much of that will fall through the bottom line versus how much of it you can offset and how people should think about the potential for additional restructurings?

John Greisch

Sure. This is John, Lennox. Let me just make a quick comment and I’ll have Mark address the specific guidance change comment. If you look at the third quarter, we’ve got our SG&A rate below 30% for the first time. So we’re obviously making some headway on our cost base even in a, fair to describe it, a depressed revenue environment.

So I’m very pleased with the progress we’re making on our cost structure, the topline obviously is the challenge and Mark can address the guide tunes guidance comparisons from where we were a few months ago. But I think we are making great progress on keeping our cost base in line with our revenue expectations.

Mark Guinan

Yeah. Lennox, I appreciate the question. As I’m sure you can appreciate in the short-term, any sort of revenue changes on the margin are pretty difficult to offset. We took some pretty significant steps early in the year to offset some anticipated revenue softness.

There are other moving parts of the businesses I’m sure you can appreciate a greater decline in rental which has higher gross margin as we talked about some of the other mix impact of International growing in North America which is our most profitable business declining.

So with all of those moving parts, you November, at this stage when get a 2% to 3% topline change in net and most of it coming in North American capital. On the margin, it’s just a lot of operating income that falls through and very difficult in very short period of time to us that.

So I think that’s the acclamation which we could do more in the short term, but certainly as John pointed out, we pretty aggressively manage our cost, don’t want to choke off R&D because it’s obviously necessarily for our long-term sustainability. We want to be careful about that, but we’ve taken the steps we could to try to mitigate what is a pretty severe swing in a short period of time.

John Greisch

Just one other point Lennox, your math is absolutely right, but 2% to 3% is closer to 3% in terms of top line revenue expectation changes is about $50 million. And that’s obviously between Q3 and Q4 and at a high 40s gross margin rate, that’s going to drop close to $0.25 off the bottom line. So it sounds like a relatively small top line impact.

We’ve taken a lot of cost out. We obviously had anticipated the benefit of cost we had taken out. And with orders in short for the last 26 weeks of the year by upwards in a couple million bucks a week that the flow-through and drop-through to the bottom line of that revenue shortfall is obviously insignificant. And we are doing everything we can to mitigate that with cost reductions, but in the near term that’s the impact on the outlook for the year.

Lennox Ketner – Bank of America

Okay. So from a longer-term perspective, just given your expectation that the top line isn’t likely to get better in the next few quarters, is it fair to assume that you could potentially contemplate just more restructuring?

John Greisch

Well, we are never going to give up on continuing to reduce our cost base, so I don’t want to sit here and say when we may have another restructuring. We obviously came in to this quarter with the restructuring that we took in March. I’ve mentioned previously, and again I mentioned at this morning, we still have some underperforming parts of the portfolio that we are addressing at a pace as quickly as we can manage.

So one way or another improving the underperforming pieces of the portfolio, while at the same time stripping cost out and looking for additions to the portfolio is really the game plan going forward which is unchanged from I think what we’ve been talking about over the last year or so.

Lennox Ketner – Bank of America

Okay. And then just last one if I can is just on capital deployment strategy going forward, the Aspen deal obviously should help you guys in terms of diversifying, but it was a little bigger than we were expecting and is requiring sounds like to take on a little bit of debt. So how should we think about going forward, it sounds like you’re still planning to do additional acquisitions despite the size of that one or if you could just stick to whether M&A still your main priority for cost use?

John Greisch

Sure. I think we’ve been fairly consistent with our longer-term capital deployment outlook which Mark can comment specifically. But I think as I said in my comments, this deal size-wise and adjacency-wise I think is very much in line with what I have been saying over the last several quarter in terms of expect a legal size or a several $100 million deal.

This is at that the higher end maybe of what you had expected based on your comments, but I think the fit with the portfolio we have and the attractiveness of the margins as I commented on in my comments was a great opportunity for us to diversify and expand our surgical platform, but our capital deployment strategy is certainly unchanged.

Mark Guinan

And Lennox, as I am sure you are aware, given the cash flow generation of this business over last couple of years even despite some smaller add to net cash position going into this. And so the amount of debt we are taking on at this point well certainly is increasing relative to where we were, it accounts to less than a year of operating cash flow and not even wanted to have times annual free cash flow. So we don’t feel we are overleveraging ourselves in terms of bringing on what we see is a very, very attractive asset at this point.

Lennox Ketner – Bank of America

Okay. But fair to say going forward then the main priority for cash use is still M&A?

John Greisch

I think it’s going to continue to be a combination Lennox of cash return to shareholders along the percentages that Mark has articulated as well as M&A. Obviously, this has been a fairly heavy M&A year with between Volker and Aspen, $500 million of capital deployed towards acquisitions.

The prior year it was all about share repurchases and dividends. So again we are not trying to manage this quarter-to-quarter, but over time I think the split between return to shareholders, which was 15% to 20% internal CapEx and M&A, you should expect this to stay with exactly the same profile that we’ve articulated.

Lennox Ketner – Bank of America

Okay. Thanks very much.

John Greisch

Okay. Thanks, Lennox.

Operator

Thank you. Our next question comes from Lawrence Keusch with Raymond James. You may begin.

Constantine – Raymond James

Hi, guys. This is actually [Constantine] for the Larry. So I guess I just wanted to get your thoughts in terms of Aspen deal, just kind of if you can talk more about really this vision for this business and the platform. I mean, I totally guess that if talks you diversify away from capital, but can you talk about more I guess about the division, the platform and in that context also as we think about additional M&A. So we basically think of that’s kind of M&A now that you have this platform and you can build upon or is it really kind of adding more adjacency. So any color would be appreciated?

John Greisch

Sure, [Constantine], this is John. A couple of comments. Our channel strength is clearly in the acute care hospital. Aspen’s business fits right into that channel in the OR more than in the hospital room where Hill-Rom’s brand is arguably strongest, but it complements one of our strong and one of our more profitable franchises with our existing Allen Medical surgical business.

So together we’ve now got nearly a $200 million surgical products franchise, one more capital sensitive, one more disposal sensitive. I think the opportunity to continue to build upon a surgical products business largely through additional bolt-on acquisitions as well as, Allen has demonstrated over the years, good internal organic driven growth through product development division for this business going forward.

So building a business again that leverages Hill-Rom strength in the hospital and combining it with a business that are now on a combined basis very strong in the operating room environment, both of which focused on patient safety and caregiver safety on the one hand with the Aspen products and on the other with the Allen products. As a business we think we can continue to grow going forward again both organically and inorganically, but again focused on the surgical products category.

Constantine – Raymond James

Okay. That makes sense. And then I know you kind of not wiling at least at this point to talk about really the end market growth for Aspen, but can you may be share with us what has been the organic growth for that business over the last couple of years?

John Greisch

The business has really been built over the last five or six years through series of acquisitions by the company’s owners. We look at this business as I said with the top line growth rate pretty comparable to what we’ve laid out for desired growth rate going forward in the mid-single-digit range.

Constantine – Raymond James

Got you, okay. And then if I could just ask a question about the North America business. So again what changed this quarter relative to last quarter that kind of really resulted in the image change in guys, I mean is it the environment, I guess is there anything that you can pinpoint to that kind of really resulted in basic continued to deceleration kind of things coming in below your expectations?

John Greisch

Yes. It’s a couple things. It’s a very good question. Let me paraphrase my comment with the repeat of what I said earlier which is from a competitive standpoint we look like we performed better than the competition here in the third quarter even with the 11% decline in our US patient support systems business. So nothing has changed in terms of our competitive position.

What’s changed relative to three or four months ago, I think Mark and I both commented about this scenarios in our prepared comments. We’ve seem a much more significant slowdown and reduction in order rates from the hospital systems particularly here in North America and we had expected as Mark said a rebound particularly in the fourth quarter, which is typically our strongest quarter, but also we expected some improvement in Q3. We just haven’t seen that.

And again I think the pressure is that hospitals are same which is nothing unusual than anybody on this phone call are certainly forcing capital decisions to be scrutinized more and more everyday and the prioritization of capital that is being spent certainly appears to be less directed towards beds that it has been over the last year and half, over the past several months and our expectation is that’s going to continue going forward.

Constantine – Raymond James

Terrific. Thank you.

Mark Guinan

As John also mentioned, just real quickly in total capital not just patient support systems, North America grew despite the challenges in the first half of the year by about 3%. In the third quarter, it declined 5%. And as we said based on orders through this quarter shippable in the fourth quarter and also our projections over the next several weeks, we don’t see that bouncing back.

So that it’s just been a market change and momentum between the first half and the second half even though the first half obviously has slowed dramatically from 2011, it’s got more severe and instead of continuing to grow slightly or even stabilize.

John Greisch

We’ve also seen just to put a little more specificity to it. We’ve seen and Mark – I think Mark mentioned this in his comments. We’ve seen a significant slowdown in our higher priced critical care product lines, which also have to be one of our higher margin products.

So the volume of orders here in Q3 and Q4 for critical care products is as low as it’s been going back to early 2010. And again consistent with squeezing capital and redeploying capital where they can or they being our customers can. And to some degree that appears to be coming out of the higher cost products that we have in the marketplace.

So there’s not one thing I can point to but again, either the pressures on capital spending or having a bigger impact on our product categories than we certainly anticipated three, four months ago.

Constantine – Raymond James

Go you. And so kind of you putting that kind of altogether, so it sounds like second half is more challenged -- for North America is a lot more challenging than the first half. So I know you’re now going to provide 2013 guidance, but would it be basically fair to assume that in 2013 does -- the North America business is also -- is basically going to have a negative growth given this trajectory?

John Greisch

I’ll just repeat what I said in my earlier comments. I don’t want to dodge your question, but I also don’t want to get into the specifics around 2013. But I don’t see anything at the moment that’s going to change the environment that our customers are operating under right now.

Constantine – Raymond James

Terrific. Thank you.

John Greisch

Thank you.

Operator

Thank you. Our next question comes from Topher Orr with Goldman Sachs. You may begin.

Topher Orr – Goldman Sachs

Thanks for taking the questions, guys. I know we set a decent amount of time talking about the U.S. developed market’s business. I was wondering if you could spend a little time on emerging markets, may be any trends that you guys have seen any changes during this past quarter?

John Greisch

Yeah. It’s a great question Topher because North America obviously has been a disappointment for us and focused a lot of attention, but you may have notice in Mark’s comments Europe, despite all of the concern around Europe has been a relatively steady performer for us not just in the third quarter but throughout the year. I think revenues in Europe in Q3 are up in the mid-single-digit range.

Our order rates in Europe -- and when I say Europe, I’m talking about Western Europe, have been very steady throughout the year surprisingly so to some. But I think it’s a focus of some of the investments we’ve made and some of the managerial changes we’ve made over there.

Rest of world, specific to your question, again we’ve made some significant investments in sales and marketing resources in Asia, in Middle East and Eastern Europe. And we have seen significant growth in those regions here in 2012. I think the only cautionary comments that Mark and I have made is that business tends to be even more lumpy than our developed world business because they tend to be -- those regions tend to be driven by larger tenders more than even the rest of our business is.

But our success in those regions has been quite pleasing and quite strong this year and I think it’s a result of the investments that we’ve made coming into 2012. So it’s been a very, very strong year for us with the rest of the world regions outside of Western Europe.

Topher Orr – Goldman Sachs

Okay, thanks. And then just one follow-up if I can. I know you guys had alluded to -- there’s about $100 million of zero operating margin business that you guys have been in the process of assessing whether or not to, I think spin it off. I think one of them specifically was within the Homecare business. Is there any update on that given recent events and obviously the guidance change, or you guys still considering that or is that being moved off the table at this point?

John Greisch

No, as I mentioned a little bit earlier I mean our focus on improving the performance for adjusting the portfolio remains quite high. So I’m not going to panic and do something in the immediate term that doesn’t make sense for us in the long term. But our focus I can assure you on the pieces of the portfolio that are underperforming is quite high. So no updates today, but it’s getting the attention that it needs to.

Topher Orr – Goldman Sachs

Okay. That’s it. Thanks guys.

John Greisch

All right. Thanks.

Operator

Thank you. Our next question comes from Sachin Kulkarni with Piper Jaffray. You may begin.

Matt Miksic – Piper Jaffray

Hi, it’s Matt Miksic, sorry about before.

John Greisch

Hey Matt

Matt Miksic – Piper Jaffray

I’m not sure I could hear you. I’m not sure why you couldn’t hear me?

John Greisch

No, that’s okay.

Matt Miksic – Piper Jaffray

So thanks for getting me back in queue. The question I had and I appreciate the color on the U.S. market. One thing I’m not sure if I heard you talk all about it, but one of your competitors had mentioned it. It was some of the inner play that you’re seeing potentially here in the market between priority of spending on hospitals -- other hospital priorities like electronic medical record projects, milestones coming due, hospitals need to hit them, maybe at least according to one of the other focus in the bed business. I talked about a more significant focus shifting towards that, those projects and standard resources. Are you seeing any of that? Do you anticipate any of that or is that just not a factor in what you’re seeing?

John Greisch

It’s a factor Matt. I can’t comment on what was said by others. In my visits with our customers, as I mentioned last week, with two of our larger customers, IT has certainly gotten more attention over the past year, several quarters then it had previously for the reasons that you just mentioned. Is that squeezing out bad capital spending today, it’s a hospital system by hospital system story to be honest with you. There’s no doubt that’s happening in some areas.

On the other hand, one of the customers as with last week, one of our larger customers displaced a very large order with us to replace their Med-Surg bed. So it’s hard to generalize but is IT capturing a higher percentage of capital spending within the hospital system? Probably is the short answer. But again I think it’s a different story for each hospital system.

Matt Miksic – Piper Jaffray

Okay.

Mark Guinan

I’m sorry, Matt. I was just going to say relative to our outlook three, four months ago, I don’t think anything fundamentally has changed relative to capital spending prioritization from one product category to another in the last four months. I think what has changed is the breaks are being put on capital spending more quickly and more broadly than we probably anticipated four months ago across the board.

Matt Miksic – Piper Jaffray

Okay. And again I apologize if you hit on this, John. I’ve been hoping back and forth as a lot of folks have here between some calls this morning, but is -- can you put your finger on, is it Accountable Care Act, is it new election, is it Europe? Can you give any sense of what -- why the breaks are on at the moment?

John Greisch

Well, I would say for the north American market, it’s less about Europe and more about looking forward to operating margin getting squeezed for all the reasons you just mentioned. Reimbursement rate changes, the Affordable Care Act and the impact particularly starting in 2014 and some of the reimbursement dynamics that affect hospital, payer mixes are changing.

Every single account I talk to is looking to take operating costs of a significant percentage out of their system and out of their capital. And I think you know -- I sit on the hospital Board. Several of our executives sit on other hospital boards, several of our directors do and the story’s the same, reducing operating costs, improving outcomes and reducing and deploying capital in a cost efficient manner as best as they can.

I think some of the recovery we saw, recovery we saw in capital spending particularly for our products over the last couple of years I think is in a different light today, hence the change in our outlook as we look forward.

Matt Miksic – Piper Jaffray

That’s fair.

Mark Guinan

I really think -- hey, Matt, I really think the rental revenue which we’ve seeing for a more extended period of time being impacted is more directly correlated with cutting back on operating expenses.

Matt Miksic – Piper Jaffray

Absolutely.

Mark Guinan

I think the capital change is more about cash flow and their projections and their interest in making sure they don’t overextend themselves in the near term with some uncertainty and probably some certainty that things are going to get tougher. So I think the capital has lagged a little bit on the rental business for that reason, but we’re getting closer to a period of time where that uncertainty makes them nervous about large outlays, and certainly and at least in our business.

Matt Miksic – Piper Jaffray

Okay, that’s helpful. And then maybe if I could just one follow-up on some of the leverage that you’ve done. I think someone mentioned earlier that you’ve done a very good job, given the pressure on the top line tightening in, the other lines of the P&L to offset the bottom line.

But -- and Mark, I appreciate the color on where you’re going with restructuring and cost cutting and margin improvement. I have a feeling this question’s going to be deferred to your, maybe full year guidance for ‘13.

But I’d love to know what some of the annual -- what should we be looking for going forward over the next several years in terms of the annual EBITDA margin expansions, some of the ways we used to look at the company as a margin expansion story, what can we think about it in terms of -- should we just be giving a haircut by 100 or 200 basis points until we see the top line turn up or John, maybe help us understand how to think about that?

John Greisch

Well, Matt, I guess my response would be we will continue to look for opportunities and our expectation is that we will grow margin. When we spoke previously and I’m assuming you’re referencing back to the investor conference, we had qualified what we put forward saying borrowing any significant economic disruptions.

I guess we can all debate what is an economic disruption and what’s significant, but certainly we’d have some setbacks this year relative to expectations. That doesn’t completely change our strategy and our view of being responsible for five improvements in our operating margin and we certainly feel we can do that.

But the exact pace and the exact you know rate at which we get improvement and where that ends up in the next several years is going to be depended on some or the other factors and certainly revenue will play some key, you know factor in that so. No we’re not abandoning margin improvement it’s just means that it could be a little tougher slide, but you know certainly we expect to see as it come out you know what future projections that that will be a part of our continued strategy.

John Greisch

Yeah. Matt, this is john, and that’s a great question and you’re right and some of it is about 2013, and beyond, but I echo what Mark said. You know the strategy here is unchanged, there’s a $40 million to $50 million top line reduction from what we’re expecting a few months ago, going to put a dent in our operating margin expansion, opportunity in the new term, you bet.

Hence the downward revision to earnings here for the fourth quarter, but the need to continue to take cost out as we did this year, I felt great, about the operating margin expansion that we’ve not only achieved the last couple of years, but even through this year you have 120 basis point here improvement in Q3 in a tough environment. I think reflects the commitment that we remain focus on as a management team.

I’ve been asked several times, you know, is revenue going to matter and that, you know, charged towards expanding operating margins and in the context of a small revenue deviation, your answer has consistently been no, but as we look to the size of revenue shortfall that we’re staring at here in Q4, obviously it’s a bigger impact, but long term absolutely focused on driving toward the same operating margins that we’ve been talking about.

Mark Guinan

I’ll just take you back John’s comments about, the underperforming part of our business. So I’d say in the short term, you know, we have to lose the opportunities and work as john said looking at that very hard you know, so I would encourage you to believe that there’s places we are looking at right now that certainly will offset some of the impact of lower revenues and some of the other headwinds such as the device tax, et cetera that we have coming forward so. You know there’s things on our radar that we’re working on that’s certainly will help to move us on our strategic direction.

Matt Miksic – Piper Jaffray

I certainly understand that slower growth in declining revenues make it tougher to drive that leverage, but may be it just to understand the way where we should look at it in the near term, as sort of you know look for some stabilization in the US, acute care growth perhaps before we start thinking about the bigger steps in margin improvement is that a fair way to look at it?

John Greisch

I think that’s probably fair, yeah.

Matt Miksic – Piper Jaffray

Okay, thanks so much.

Operator

Thank you. (Operator Instructions) Our next question comes from Steve O’Neil with Hilliard Lyons. You may begin.

Steve O’Neil – Hilliard Lyons

Yes. Good morning.

John Greisch

Good morning.

Mark Guinan

Good morning, Steve.

Steve O’Neil – Hilliard Lyons

I may have missed this. Did you site a revenue figure, an annual revenue figure for Aspen?

Mark Guinan

$120 million approximately, this year.

Steve O’Neil – Hilliard Lyons

Okay I understand. And then I think you talked about this a little bit but I want to revisit it. There’s a lot of uncertainty this year about the Patient Protection and Affordable Care Act, and a Supreme Court decision and I just wondered – yet that might have been the cause of some hesitation on the part of hospitals because the act itself appears to be positive for hospitals in the way of storing the number of uninsured patients that’s coming to the hospital, admittedly, at probably lower reimbursement rate so. I know there’s trade off there, but I wondered if that might have caused some hesitation in the order patterns for hospitals?

And now that that’s been decided do you think there is – you know hospitals may be inclined to loosen up their capital spending a little bit?

John Greisch

My own personal view, Steve, is I don’t think the ruling will have an impact of freeing up capital spending that had been held back. I think the dynamics that hospitals are operating under are unchanged from what they were talking about six-twelve months ago and what they’re talking about today.

So all the things are mentioned earlier in terms of, and like Mark put it well, looking forward, the operating margin pressures and the cash flow pressures at hospitals are going to continue to be under regardless of the Supreme Court ruling, I think it’s the bigger impact on in some cases delays and in some cases reductions on capital spending.

So I don’t sense and I’ve been with customers quite a bit over the last year before and after the ruling, I don’t sense, any change in sentiments post Supreme Court ruling.

Steve O’Neil – Hilliard Lyons

All right, thank you.

John Greisch

Okay.

Operator

Thank you and our next question comes from Garry Lieberman with Wells Fargo Securities. You may begin.

Gary Lieberman – Wells Fargo Securities

Thanks for taking the question. At least from the for-profit hospitals, we haven’t really heard too much about changes in guidance for CapEx for the full year. So I guess I’d be interested in your thoughts on is it – is there different dynamic there or do you think also the for-profits, it’s just a matter that you’re seeing a shift away from, you know, spending on your products towards something else or, if there’s a different environment for some of your other customers.

John Greisch

No, I think it’s a combination of shifting priorities and again without commenting on any either specific category of hospitals or individual hospital system, I think it’s fair to say everybody is looking at reducing where possible, their capital spending, but clearly if I look at this year again our and I think the industry performance for our products has seen a shift away from beds relative to what we were experiencing last year.

Mark Guinan

Yeah. The other comment I would make Gary is that, you know, over simplification but in any given year, less than 10% of hospitals are making a significant investments in our products just given the product the life cycle.

So and it’s sometimes hard to tease out at a macro level, you know, it’s hospitals in general, slightly increasing, decreasing or holding steady, what that impact might be and ask us some much smaller sub-segment that actually is looking to spend significantly on beds.

And so if we are disproportionately impacted by the people that are making changes in the less than 10% of hospitals on plan that they – beds that year, then it could be very different than kind of the industry view.

Gary Lieberman – Wells Fargo Securities

Okay and then you said your backlog was down, 20% can you maybe just give a little bit of color on what your visibility is into the back log and maybe what your visibility into those lead-time for orders is?

John Greisch

Well, the lead-time here in North America tends to be in the anywhere from four to eight weeks. And the backlog as we commented previously, generally gives us visibility into half of the quarter as we’re approaching the quarter.

Again what’s happened a little more than what we have seen in the last couple of years, is what’s in the backlog, we’ve seen some more push-outs and we’ve certainly has seen over the past couple of years so. Relatively short term visibility and that’s a little bit exacerbated here recently with a few more delays than we have been anticipating back to the end of 2010-2011 with some specific orders.

Gary Lieberman – Wells Fargo Securities

Okay. Great. Thanks a lot.

John Greisch

All right.

Mark Guinan

Thank you.

Operator

Thank you. I’m showing no further questions at this time, I would now like to turn the call back over to Andy Rieth.

Andy Rieth

Okay. Thanks, everybody. I appreciate your time on the call and we’ll talk to you later.

Operator

Ladies and gentlemen this concludes today’s conference. Thank you for your participation. Have a wonderful day.

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