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Sirona Dental Systems, Inc. (NASDAQ:SIRO)

F3Q12 Earnings Call

August 3, 2012 8:30 AM ET

Executives

Joshua Zable – VP, IR

Jost Fischer – Chairman and CEO

Simone Blank – EVP and CFO

Analysts

Tycho Peterson – JP Morgan

Ross Taylor – CL King

Brandon Couillard – Jefferies

Robert Jones – Goldman Sachs

John Kreger – William Blair

Steve Beuchaw – Morgan Stanley

Glen Santangelo – Credit Suisse

Jeff Johnson – Robert W Baird

Jeffrey Warshauer – Sidoti & Company

Larry Marsh – Barclays

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter 2012 Sirona Dental System Earnings Conference Call. My name is Stefani and I’ll be your coordinator for today. (Operator Instructions) Following the prepared remarks, there will be a question-and-answer session. (Operator Instructions) As a remainder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today, Mr. Joshua Zable, Vice President of Investor Relations of Sirona Dental. Please proceed.

Joshua Zable

Thank you and good morning, everyone. Welcome to our third quarter 2012 conference call. I would like to remind you that an earnings slide desk presentation relating to this call is available on our website at www.sirona.com.

Before we begin, please take a moment to read the forward-looking statement on Slide 2 of our earnings slide presentation. During today’s conference call, we’ll make certain predictive statements that reflect our current views about our future performance and financial results. We base these statements on certain assumptions and expectations of future events that are subject to risks and uncertainties. Our most recent Form 10-K lists some of our most important risk factors that could cause actual results to differ from our predictions.

And with that, I will now turn the program over to Jost Fischer, Chairman and CEO of Sirona Dental Systems.

Jost Fischer

Thanks, Josh. It is my pleasure to welcome all of you to our third quarter 2012 conference call. Joining me today are Jeffery Slovin, President; and Simone Blank, Executive Vice President and CFO.

I am very pleased to report solid results for the third quarter of fiscal 2012. Our 7% constant currency revenue growth was particularly noteworthy compared to our record-setting third quarter of fiscal 2011. Last year’s third quarter grew 24% constant currency, benefiting from the International Dental Show and numerous product launches. We continue to gain market share. Treatment Centers and CAD/CAM were the strongest performers in the quarter with revenues up 13.3% and 9.5%, respectively, constant currency.

On a regional basis, Sirona’s revenue growth was broad-based. The U.S. grew 7.7% and continued to show sequential improvement up from last quarter’s 4.9% growth rate and first quarter’s 2.0%. International markets were up 6.6% constant currency. While Deutschland was down due to a tough IDS comparison and a very successful Imaging launch last year, we are having our second-best year ever in Deutschland. The rest of Europe was stable for us. Momentum continued in our non-European international markets showing strong double-digit growth lead by Asia-Pacific.

We are particularly proud of our strong sales performance given the difficult comp. It is important to note that our investments in sales and service infrastructure in select international markets continue to yield results. These markets are growing materially above the company’s average rate. Overall, our investments in key markets enable us to compete more effectively today and in the years to come.

During the quarter, we’ve expanded our exclusive distribution agreement with Patterson to include all Sirona products for the U.S. market. This enables us to strengthen our go-to-market approach by increasing the focus on the seamless integration of our best-in-class product offerings and digital solutions, including CEREC, our market-leading Orthophos line and (inaudible). I would also like to note that we have a strong relationship with Henry Schein, who is our largest and most important distributor in Europe.

Let me reiterate the two key pillars of our successful strategy: to expand our outstanding portfolio of high-tech dental products through continuous innovation. We have invested over $250 million in the past six years, which has created new and enhanced products and solutions. To continue building our world-class global sales and service infrastructure, we are active in over 135 countries around the globe. We continue to execute on our strategy, giving Sirona a clear competitive advantage and enabling us to deliver consistent, strong organic growth.

I will now turn the call over to Simone, who will review our third quarter financials.

Simone Blank

Thank you, Jost. In the third quarter, our revenues decreased $2.7 million to $242 million, down 1.1% but up 7% on a constant currency basis. We had a very difficult comp due to the last year’s International Dental Show, and despite foreign exchange headwinds, we were pleased to see revenues grow sequentially. Our revenue growth was driven globally with both for U.S. and international markets growing above market rates. Sirona’s operating income plus amortization decreased 4.4% to $57.8 million due to our planned investment in sales and service infrastructure.

Moving onto a review of our business segments. Revenues in our CAD/CAM segment increased 2.7% to $85.4 million, or up 9.5% on a constant currency basis. CAD/CAM revenues particularly benefited from strong growth in the non-European market and a solid performance in the U.S. Our CAD/CAM segment margin was 69.7%, up 230 basis points compared to the prior-year period. The increase in the quarter was mainly due to foreign currency benefit. Imaging segment revenues decreased 3.4% to $82.1 million but were up 2.8% on a constant currency basis. Growth was mainly driven by the U.S. and the non-European international markets.

Imaging hah the most difficult comp as a result of the IDS and the launch of the XG-3D last year. As a reminder, last year’s Q3 Imaging grew about 30% constant currency. Year-to-date Imaging growth is 10.7% constant currency and Imaging grew sequentially. We continued to see robust interest in our Orthophos 2D and 3D product lines. Imaging segment gross profit margin was 58.3%, similar to the prior-year period. Margins improved sequentially and continued to be influenced by product mix.

Treatment Center segment revenues were $48.8 million, up 1.3% and up 13.3% constant currency. Growth in the quarter was driven by our comfort and standard product lines. We continued to be excited about the market strong reception of SINIUS, our mid-to-high range product. We continue to take market share. Treatment Center gross profit margins increased 190 basis points to 40.9%. The quarterly development was driven by product mix.

Instrument revenue was of $25.2 million were down 10% but up 0.6% on a constant currency basis. Despite foreign currency headwinds, Instrument revenues still grew sequentially. Instrument segment gross profit margin was 41.1%, down 620 basis points over last year. The quarterly development was driven by a very unfavorable product mix. Year-to-date, Instrument margins are at 46%, above our targeted 45% level. Please note that product mix can create significant variations in margin from quarter-to-quarter.

Moving onto a review of the P&L. Gross profit margin was 53.1%, up 130 basis points compared to 51.8% in the prior year. Gross profit margin mainly benefited from lower amortization. Cost of sales included deal-related amortization and depreciation expense of $10.9 million versus $12.9 million in the prior year.

SG&A expense was $72.4 million, up $3.9 million. This increase was due to the continued planned investment in sales and service infrastructure to capitalize on opportunities to gain share around the world.

R&D was $13.1 million, $1.3 million below prior year. R&D was lower due to timing of projects. Between March 31, 2012, and June 30, 2012, we experienced a weakening of euro relative to the dollar from 1.33 to 1.26. Foreign currency loss amounted to $2.7 million in the third quarter. When you strip out the $3.1 million loss on the revaluation of the Patterson exclusivity payment and the $4.9 million loss on the revaluation of short-term intragroup loans, we are left with a gain due to the currency revaluation of short-term assets of $5.3 million. Partially offsetting that gain was a $2.7 million loss on currency derivatives due to the weakening of the euro versus the dollar in the quarter. The net impact of these foreign currency fluctuations from adjusted EPS amounts to a gain of $0.04.

Net interest expense was $0.9 million compared to $1 million last year. The slight decrease resulted from lower overall debt levels. The income tax provision for the third quarter of fiscal 2012 was $9.2 million. The estimated effective tax rate for the quarter was 23%.

Net income was $30.3 million, down from $36.3 million in the prior-year period. Third quarter 2012 diluted GAAP EPS was $0.53 compared to $0.63 in the prior year. On a non-GAAP basis, that is excluding deal-related amortization and depreciation and the currency revaluation of the Patterson exclusivity fee and short-term intragroup loans, non-GAAP earnings per share was $0.80, up from $0.78 in the prior year. In the quarter, operating cash flow was $58.9 million, up 16% compared to $50.8 million in the prior year.

Capital expenditure was $11.5 million, down compared to $13.5 million in the prior year. In August of 2011, we initiated our three-year $100 million share repurchase authorization. By June 30, we have already spent $52 million under our current plan. At June 30, 2012, the company had cash and cash equivalents of $104.6 million and total debt of $79 million, resulting in net cash of $25.6 million. This compares to net debt of $22.5 million at September 30, 2011.

Now moving onto guidance. For fiscal 2012, we are raising our constant currency revenue growth guidance to a range of 8% to 10%, up from our previous guidance, which was the upper end of the 6% to 8% range. We expect our strong momentum to continue into the fourth quarter.

For the full year, we anticipate segment gross profit margins to be similar to prior year’s level. Reported gross profit margin is expected to be higher than the prior year due to the step-down in amortization expense. SG&A as a percentage of sales is anticipated to be about 30% for fiscal 2012. R&D is anticipated to be slightly below 6% of sales. We estimate our effective tax rate for fiscal 2012 to be 23%.

Based on all of these factors, we are updating our range for operating income excluding amortization to $228 million to $232 million. This range reflects our commitment to invest in sales and service infrastructure.

As always, I suggest our investors evaluate our business on an annual basis, as our quarterly progression can vary significantly.

I will now turn the call back to Jost.

Jost Fischer

Thank you, Simone. As we have said many times, 2012 is an investment year for Sirona. I am very pleased that our investments over the last few years have been without question a great success. We expect them to continue benefiting Sirona for the future.

Our top line growth was broad-based, but the substantial contribution came from those countries that we continue to invest in. Our strategy is be the first mover, provide innovative products to the market, leverage our infrastructure to support our customers and drive short- and long-term growth.

Moreover, Sirona’s top line has never been more diversified. The diversification is two-fold. One, we have numerous product lines that contribute to our results; and two, we have contributions from more geographies than ever before as we’ve extended our reach and market share across the globe. Sirona has an outstanding technology platform that has consistently delivered best-in-class dental products over the course of decades. As markets develop, Sirona has the resources to deliver those products around the world.

Let me remind you, the penetration rates for most of our groundbreaking products are still relatively low. Sirona’s technology enables dentists to be more efficient, productive and do better dentistry. It is the combination of our innovation, reach and support for the customer that drives our growth.

With this in mind, I’d like to highlight again that our strong revenue growth this year is being driven by international markets, specifically Asia-Pacific. In the past, we have talked about our success in Japan as an example for our strategy to invest in sales and service infrastructure. Japan now is our third-largest country in terms of revenue behind the U.S. and Deutschland. It is also the second largest dental market in the world. Our investments in Japan have positioned us well to compete effectively and grow our business. Today, I’m proud to talk about another example of our successful strategy in action. Sirona began in China with just a representative office years ago.

Recognizing a significant opportunity, we invested in our sales and service infrastructure. By creating an early presence, Sirona was able to help drive and take advantage of this rapidly-developing dental market. This important market continues to grow, fueled by an increasing amount of private dental clinics. Today, we have around 200 professionals selling and servicing our equipment. Sirona has a strong local presence with 15 locations throughout this large country, covering not only the major hubs, but also the regional centers. We have seen strong double-digit growth in China over the last years and we expect this country to be one of the strong contributors to our revenue going forward.

Finally, in addition to committing significant resources to build out our sales and service infrastructure, Sirona remains committed to developing new technologies that benefit dentists around the world. Our R&D pipeline continues to be robust and it is the strongest it has ever been.

So in closing, I’m very pleased with how our team is executing. We have built this company for balanced and sustainable growth, and we are accomplishing that goal. I would like to thank our outstanding employees and distribution partners who we believe are unparalleled in the industry.

I’m happy to remind everyone that Sirona will be hosting CEREC 27 & a half, the largest digital dental event of the year in Las Vegas on August 16 through 18. We’re not only celebrating 27.5 years of CEREC, but of also 20 years of Schick, 10 years of inLab and the 5th anniversary of GALILEOS. We expect more than 3,500 dental professionals to attend this spectacular event.

Simone, Jeffery and I will now address your questions. Operator?

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, we are ready to open the line for your questions. (Operator Instructions) Your first question comes from the line of Tycho Peterson with JPMorgan. Please proceed.

Tycho Peterson – JP Morgan

Hey, good morning. First question, I wanted to ask about the CAD/CAM trends. Obviously nice, strong growth here against a difficult comp. Can you just talk about some of the underline dynamics in the market? Was that all CAD/CAM 4.0? And maybe just talk about whether we’re really seeing kind of an inflection point here in demand.

Jost Fischer

Hi. Good morning, Tycho. This is Jost. Oh, yeah, we are pretty happy with our growth rate here in this quarter, and we are happy with the trends. The quarterly growth was driven by both the U.S. and the international markets. We continue to benefit from our investments in sales and service infrastructure, very clear. And we’re going to have a lot of positive reviews on our CEREC 4.0 drives new users in because if it reduces the learning curve, that’s certainly something. And our existing users are loving it because it’s faster. It – we can do multiple restorations at the same time. We can do a lot of it. And of course, it helps us to faster implement new software features and other stuff. So from that point of view, that has helped the growth from a situation of 11% CAGR over the last five years. We’re up over 15% last year, so I think we’re in a healthy position right here. And from that point of view, we’re pretty happy with what’s going on right now and in the future for CEREC.

Tycho Peterson – JP Morgan

Okay. And then with regards to the expanded Patterson agreement, is that a pretty smooth transition from your standpoint? In other words, what’s the risk of inventory kind of being worked down from Shine in the channel here in the U.S.?

Jost Fischer

I think we’re pretty pleased, very smooth takeover. There wasn’t a lot of inventory out there. I think we’ve managed that quite well. And from that point of view, I see no situation here that is in anyway any negative.

Tycho Peterson – JP Morgan

Okay. And then for Simone, can you talk about the effect of currency on margins this quarter?

Simone Blank

Yeah. Sure, Tycho. The main effect, as we’ve mentioned, was on the CAD/CAM margin. We’ve said that the growth in that margin was mainly driven by FX, but even if you back that out, the gross profit grew for CAD/CAM, and that’s the main area where we’ve seen it. The others are not so much impacted.

Tycho Peterson – JP Morgan

Okay. And then just one last one for you. I mean if we think about your comments on Europe, are you still pretty confident that things are going to hold up in the back half of the calendar year here?

Jost Fischer

Oh yeah, oh yeah. I mean this quarter was a very, very tough comp. And Deutschland was (inaudible), as I mentioned in the third quarter after following the IDS and the other stuff. That was clearly true. But the German economy continues to hold up. We heard that also from our distributors. We have the lowest unemployment rate since the reunification days over there and we will have our second-best year ever in Deutschland. So pretty happy.

When we talk about total Europe ex-Germany, that was stable; was stable during Q3. Of course, Europe is a little bit of a mixed bag as we talk to you. Central Europe is good, like Austria, Benelux, Scandinavia or Switzerland. France is quite fine. Situation in Italy is we will be growing this year, so a little more challenging, but in this environment, we’re taking market share, so that’s difficult. But we will be growing. And from that point, I want to draw your attention though, we have increased our revenue guidance because our non-European, non-American market grow a very, very double-digit. So we’re pretty happy there. This is the momentum that we see that is going to continue on the basis of an also strengthened U.S. market for Sirona.

Tycho Peterson – JP Morgan

Okay. Thank you very much.

Jost Fischer

Thank you.

Operator

Your next question comes from the line of Ross Taylor with C.L. King. Please proceed.

Ross Taylor – CL King

Yeah, hi. Just a couple questions. I guess if you could describe any factors that are driving the sequential improvement and growth in the U.S., just to start with.

Jost Fischer

Yeah, sure. Certainly we’re feeling better about the U.S. We were up three quarters in a row with our growth rate. We’re also benefiting from our successful trade-up program in the U.S., as we told you. But this market has not yet returned to its full potential. But we feel good about how we’re positioned in the U.S. We’ve expanded our exclusivity payment with Patterson, which will enable us to strengthen our go-to-market approach by increasing like, Ross, the focus on the seamless integration of our best-in-class products, which is a big seller like CEREC meets GALILEOS, the Orthophos line, Schick, and that will help us grow in the U.S.

Ross Taylor – CL King

Okay. Good. And just two other quick questions. Revenues have been a little bit stronger than your guidance and I just wondered if that’s kind of prompted you to want to spend more, anymore additional dollars on SG&A on some of the international infrastructure build-out. And then related to that, you talked about China a little bit. I just wondered how that number – your number of employees there of about 200 compares to what you have in Japan. And what kind of increases we might see in your infrastructure in China over the next few years?

Jost Fischer

Yeah, going with the last question first, Ross. Yeah, about 200 professionals in the sales and service infrastructure. Let me remind you we also have a plant, a manufacturing plant there, which has about 300 people. So all-in-all, it’s over 500 people in China, which compares to roughly a little less than 200 professionals we have in Japan for sales and service infrastructure. So that’s the side of it. We believe we have been growing these numbers big time because China is already one of the top dental markets in the world. I think we believe its top-10. It becomes increasingly important. Yes, we’re the biggest player in the equipment market out there and the market has been rewarding us for what we have been doing. We still though see a lot, a lot of opportunities going forward.

Simone Blank

Yeah. And then maybe on your other question, Ross. Good morning. Obviously, we’re very pleased with the progression of the sales, right. It’s clear we’ve progressed better than we’ve expected. You heard us raise the top line guidance this morning. We are, as Jost mentioned, we are particularly benefiting from strong double-digit growth in the non-European international markets and those are the markets that (audio gap) that we have in the past and we continue to invest in.

And I think it’s very obvious that our strategic investments are yielding strong results on the top line. We told you that this was an investment year and we’ve intended to use the money for building out our sales and service infrastructure to maximize our opportunity here, and this is what we’re currently doing. We clearly expect to get leverage. I would say we will get leverage over time. We said that many times. And we clearly expect that we’re benefiting this year; it’s visible on the top line. We expect to benefit next year and in the years to come.

Jost Fischer

Maybe I can add to this a bit a, Ross. I mean we’re addressing most of the markets, as Simone has said already. On the other hand, when we invest in markets, we typically – we rent offices; we set up show rooms and hire sales and service people, as we’ve talked about. We do this the Sirona way. We train our employees and we educate them about our high-tech equipment, and you know these markets want it. They have the money. They want the best, but you have to be able to service and sell these kind of products, and so you need trained employees. And this takes about like 18 month, as we said, to get them full out there in that. So the leverage takes a bit of time. Every country is different; some have been faster. But I think we’re well on the way and we’re addressing most of the markets strongly that we want to be in, in the future.

Ross Taylor – CL King

All right. That’s very helpful. Thank you.

Simone Blank

Jost.

Operator

Your next question comes from the line of Brandon Couillard with Jefferies. Please proceed.

Brandon Couillard – Jefferies

Hi, good morning.

Jost Fischer

Good morning.

Brandon Couillard – Jefferies

If I look at the revised organic revenue growth outlook, it appears to imply about an 8% experience in the fourth quarter, even though the comparison gets about 12% easier on a sequential basis year-over-year. So is that simply conservatism on your part? Or perhaps some caution around near-term developments in Europe?

Simone Blank

No. I mean, you know, we’ve grow our revenues year-to-date 9.3%. We’ve with just raised our guidance, as mentioned, to 8% to 10%. That’s how we currently see it. This reflects our expectations. And remember, look at us on an annual basis; quarterly progression of this, it can vary significantly.

Brandon Couillard – Jefferies

All right. And then Simone, it looks like somewhat tepid activity on the share repurchase front. Cash continues to build on the balance sheet. Any sense that you feel more comfortable being more aggressive on that front given where the valuation is and where the cash position is? And then to what degree at all are you constrained by perhaps cash held overseas?

Simone Blank

First of all, I would like to say that we had an authorization for $100 million for three years, and that was last August. It was put in place last August. We’ve already spent $52 million by the end of June and we doubled our buyback activity from this quarter compared to the last quarter.

Jost Fischer

Doubled.

Simone Blank

So we are active on this, no question. We are a global company, so obviously, we have cash outside of the U.S. I think that’s part of our business model and part of the structure.

Brandon Couillard – Jefferies

All right. And then lastly, it looked like pretty good, solid progress on the working capital front, particularly on the inventory side. Should we look at this as a trough level as you come into IDS next year and perhaps maybe an uptick over the next few quarters?

Simone Blank

No. I think we’re always working on our working capital. Obviously that’s something we’re doing consistently. We’re pleased with the development of that. We’ll continue to work on that. But even over the last years, if you look at the inventory turns, they have been in a certain range and relatively stable. So they move with the business obviously, but we’ll continue to work on that. And we’re obviously pleased with that contribution to the cash flow in the quarter.

Jost Fischer

Great cash flow.

Brandon Couillard – Jefferies

Alrighty. Thank you.

Operator

Your next question comes from the line of Robert Jones with Goldman Sachs. Please proceed.

Robert Jones – Goldman Sachs

Yeah. Thanks for the questions. I wanted to just start with the Imaging margins. I was under the impression that the strength in Orthophos 2D, 3D sales was what was actually weighing on Imaging margins, particularly the last two quarters. Nice bounce-back this quarter. I was wondering if you could just talk a little bit about the mix within Imaging and how sustainable the margins we saw this quarter are.

Simone Blank

The quarter, the margin was flat year-over-year, sequentially up obviously. I mean when we talk about margins here, we told you that in general, we’re looking at levels of 60% this year. We are a little bit below that because of the mix of the 2D, 3D. The quarter wasn’t untypical in terms of mix. It was a good performance of the 2D, 3D and the both product lines, also the sensors. It’s nothing spectacular. These are movements that we can see in the margins.

Robert Jones – Goldman Sachs

Great. And if I could just ask one on CAD/CAM. We heard yesterday that E4D also saw some strength in the quarter. So coupled with your CEREC results, it does appear that the CAD/CAM market, at least domestically, seems to be growing. Jost, I was wondering if maybe you could just give us an update on your perspective of what’s going on in the marketplace. Doesn’t necessarily seem like share shifts; maybe anything worth calling out as far as an uptick in uptake of the product.

Jost Fischer

As always, we’re happy if people talk about CAD/CAM out there in the market. As you know, we by far are the dominant player in this market. And actually, we see an uptick in the U.S. as well. So from that point, if you – that’s fine, but from a competitive landscape, we don’t see any changes in the marketplace noteworthy. I, as always, say Henry Schein has some loyal customers that will buy, but from our point of view, that is not a factor. We’re happy with what we have seen for Sirona.

Robert Jones – Goldman Sachs

Great. Thanks for the questions.

Jost Fischer

Thank you.

Operator

Thank you. Your next question comes from the line of John Kreger with William Blair. Please proceed.

John Kreger – William Blair

Hi. Thanks very much. Just a follow-up question on CEREC. Jost, could you remind us of the CEREC installed base, how many of those are the older Redcam platforms?

Jost Fischer

Yeah, the general installed base is about 33,000 I think it’s the number that we put out. So we think most of the customers have been upgrading, but there’s still a substantial number out that use the Redcam. And when we talk to those kind of customers and they say, hey, we’re happy with what we have, so some people just don’t want to upgrade because they’re happy with what we do.

John Kreger – William Blair

Okay. Thanks. And then if you look at your growth this quarter in CEREC, what sort of trends are you seeing for the full system versus scanner only versus lab? Anything unusual or changing there?

Jost Fischer

Yeah. I mean first of all, the dominance position is Chairside. I think you start out with kind of like, hey, you want to do some scanning and this is the modern way of doing things, and when you talk to in front of the customer, 70% of all customers are upgrading even more because then they say, oh I didn’t know it is that positive for me and now it’s so easy 4.0. All of these factors come in. The dominant sales are with the full system. Doctors get it, doctors buy it and it’s not a question of money.

John Kreger – William Blair

Okay. Great. Thanks. And then lastly, kind of early thoughts on fiscal 2013. How do you think about the tradeoff between continuing to aggressively invest in sales and service infrastructure versus trying to drive a bit more bottom line leverage? How should we thing about the 2013 in terms of being another investment year?

Jost Fischer

Let be – before I’ll turn this over to Simone, say 2012 was labeled as the investment year for us. Simone, please.

Simone Blank

Yeah, actually that’s what I wanted to say too. We’ve said that, and just as a reminder to everyone, we have not discarded these kind of investments. We’ve done them already over the last four to five years and we were able to generate very good growth. You know our numbers, right? We labeled this year as an investment year because we’ve seen so many opportunities and I think our top line and the performance in the non-European markets clearly demonstrates the success of these investments. And we told you we’ve accelerated those, but clearly, we expect to benefit from them. We expect to see leverage as we move into next year and into the years beyond.

John Kreger – William Blair

Great. Thanks very much.

Jost Fischer

Thank you, John.

Operator

Your next question comes from the line of Steve Beuchaw with Morgan Stanley. Please proceed.

Steve Beuchaw – Morgan Stanley

Hi, good morning. Thanks for taking the questions.

Simone Blank

Hi.

Jost Fischer

Good morning.

Steve Beuchaw – Morgan Stanley

Simone, I wanted to ask about the fourth quarter implied operating profit. It looks like the operating profit growth in the fourth quarter is a pretty meaningful improvement from what we’ve seen over the course of this year, at least on an implied basis in the guidance. Can you speak to the drivers there? Is that more of a mix issue with CAD/CAM coming on stronger, more of an emerging markets maturation story, or is there some other dynamic?

Simone Blank

Yeah, I think in general, it’s a quarterly progression dynamic. Obviously, we will also invest in the fourth quarter into sales and service infrastructure, but remember, the fourth quarter last year was a little bit of a weaker quarter, so that also plays into it. But you’re right; our guidance implies top line and bottom line growth in the fourth quarter.

Steve Beuchaw – Morgan Stanley

Okay, thanks. That’s very helpful. And then more of a broader question. There’s been some disagreement in the marketplace over the last couple of weeks on U.S. patient volume flows during the quarter. You guys are in a unique position with a dialog with a wide range of connections to the market and different distributors in the U.S. So I wonder based on the entirety of what you’re hearing from the distribution channel, how would you characterize dental patient flows in the U.S. during the quarter? How are they trending here over the course of the calendar year?

Jost Fischer

Steve, as you know, our distributors are in a better position to comment on U.S. patient flows here. On the other hand, what we see obviously, equipment is trending a little better maybe than the patient flow would suggest, and specifically in the high-tech area. So I would say we have a stable situation on the patient flow side. But we have dentists investing in the higher-tech equipment. But to just put a little water on that, we have not seen this market return to full potential yet, but we feel good about the Sirona position here in this market, and that’s what shows in the growth rate.

Steve Beuchaw – Morgan Stanley

Thanks. That’s very helpful. Have a good morning.

Jost Fischer

Thank you.

Operator

Your next question comes from the line of Glen Santangelo with Credit Suisse. Please proceed.

Glen Santangelo – Credit Suisse

Yeah. Thanks and good morning. Just a couple of quick follow-up questions regarding the investments that you’ve made. It kind of sounds like, Jost, as you classified 2012 being that investment year, China was obviously a big market. What were some of the other big markets where you made investments? And are there any other major markets where you’re not currently where you ultimately would like to be?

Jost Fischer

Certainly. As I said, we addressed most of the markets, almost all of the markets that are important for us already. I think there is no surprise to say that the Asia-Pacific market, the BRIC states, as they were like South Africa, Brazil, Russia, Korea, those are markets that we have been investing in and I think that’s markets that we’ll continue to grow – to play the catch-up game to the U.S. or European markets.

Glen Santangelo – Credit Suisse

And so, Jost, not that you want to give anything on 2013 guidance away today, but clearly we saw a pretty big step-up in SG&A in 2012 to the magnitude in the 10% range. I mean is it fair to say that if 2013 is not going to be an investment year, we should start to see that level start to trend more flat? Or certainly shouldn’t grow at the same pace would be my guess.

Simone Blank

A few comments on that. First of all, we will obviously not give guidance on 2013. But Jost explained a little bit what these kind of investments are like, right. So we hire sales and service people. We rent offices. So what we have is a base then, which we expect to leverage as we move into 2013 and through the next years. So obviously, you should think about it as a reduction in the percentage of sales rather than in the absolute number variation.

Glen Santangelo – Credit Suisse

And okay, I appreciate that, Simone. And then lastly, I’ll just ask one question. I mean clearly in 2013, it’s an IDS year. Are you excited about what you are seeing in your R&D pipeline? Should we expect some new products to hit the market in fiscal 2013?

Jost Fischer

The – no Glen, Glen sorry – Glen, our pipeline is as full as it’s ever been. We have been spending $250 million in the last six years. We continue to do. And of course, I mean we have already a lot of new products out there, but you will see some nice pickup through continuous innovation during the next time.

Glen Santangelo – Credit Suisse

Okay. Thanks for the comments.

Simone Blank

Thank you.

Jost Fischer

Thanks.

Operator

Your next question comes from the line of Jeff Johnson with Robert W. Baird. Please proceed.

Jeff Johnson – Robert W Baird

Thank you. Good morning, all. Jost, I guess it wouldn’t be a Sirona call if don’t ask a couple questions on margins here. Let me just – and they’re clarifying questions I guess more than anything. I think one of the questions was about next quarter’s implied operating margin guidance. When I do some back-of-the-envelope math, I agree it looks like it’s maybe being implied up 200, 300 basis points at the very least. Simone, it looks to me like a lot of that is going to be at the SG&A line with your implied 30% SG&A guidance for the year. Looks to me like SG&A may come down year-over-year over 100 basis points next quarter and sequentially down $4 million or $5 million. One, is my math fairly accurate there? And two, is that a good sign that some of these investments are – the infrastructure investments are starting to maybe top off here?

Simone Blank

Yeah. A few comments on that. First of all, think about it on an annual basis, 30% of total sales. And secondly, you have to take into account the FX development between the quarters. The dollar was very weak last year, so there is some element in this too.

Jeff Johnson – Robert W Baird

Okay.

Simone Blank

But Jost can take you through this if there are more questions on this later.

Jeff Johnson – Robert W Baird

Ex-currency, Simone, I guess would you expect SG&A to be topping out, if not coming down a little bit as a percentage of sales then going forward even ex-currency?

Simone Blank

Total guidance for the full year is 30%.

Jeff Johnson – Robert W Baird

All right. Fair enough. And then on the Imaging margins that I know – I think Rob asked this question, but I want to come back to it. First time in seven quarters we’ve seen Imaging gross margins flat, as opposed to down. So that was encouraging. I think your comment was that FX didn’t have a big impact there. So is some of that’s just operational improvement in that margin trend? And should we think that operational improvement being able to be maintained here?

Simone Blank

I think it’s more, as my comment always is, it’s product mix, and obviously, that can be these variations. We’re very pleased with the development of the gross profit margin here in Imaging. FX didn’t play a major role. That was more on the CAD/CAM side. So product mix is the main driver and this can vary between the quarters.

Jeff Johnson – Robert W Baird

All right. Great. And then just last two clarifying questions. Japan has become your third-largest market. Can you just remind me the margin profile? I would assume the margins are good in Japan, given high price points. That’s how it tends to work. But I just want to make sure I understand that. And then on Patterson, and with the exclusive deal there on all product lines now in North America, are there any margin implications there? Or is that mainly a move that helps de-risk kind of your U.S. revenue growth with those minimum purchase agreements?

Jost Fischer

So talking about Japan, absolutely it’s a high-end market. It’s a very demanding market, so a lot of our competitors cannot follow easily because you have to have a sales and service infrastructure second to none to be successful in the market, specifically on the higher end. So absolutely good margins, but challenging environment from a sales and service infrastructure point of view.

Simone Blank

On the Patterson question, with the agreement, there has been no change in the pricing, so it all remains the same.

Jeff Johnson – Robert W Baird

All right. Thanks, guys.

Simone Blank

Thank you.

Jost Fischer

All right. Thank you, Jeff.

Operator

Your next question comes from the line of Jeffery Warshauer with Sidoti & Co. Please proceed.

Jeffrey Warshauer – Sidoti & Company

Hi, everyone. Thanks for taking my questions.

Simone Blank

Hi.

Jost Fischer

Hi.

Jeffrey Warshauer – Sidoti & Company

So just maybe to get a little more clarity on the full-year guidance. So you’re raising your constant currency revenue growth estimates but bringing down the top end of your adjusted operating income guidance. Can you just maybe add a little more color there? And if that’s – yeah, if you could just add on that. Thank you.

Simone Blank

Sure. Yeah. As we mentioned, we’re pleased with the development on the top line, which is to a large extent also the result of the investments that we’ve done and that we continue to do in the sales and service infrastructure. And our guidance, again, is a reflection of the fact that we’ve said this is an investment year, so we continued to get maximized so to say the opportunities that Sirona has in these markets. And again, we clearly expect to leverage that. And just as a reminder, we narrowed the guidance on the bottom line too.

Jeffrey Warshauer – Sidoti & Company

Is the increase – is the investment accelerating due to the solid performance in Asia-Pacific?

Simone Blank

Sure. Mathematically, obviously, that’s what you get to that we are maximizing the opportunity and that mainly shows in the SG&A line this year. Obviously, investment year next year we expect to leverage above that.

Jeffrey Warshauer – Sidoti & Company

Okay. Thanks. And just one more. So year-over-year, it looks like operating income, your adjusted number decreased about 4% like you said, but your adjusted earnings metric increased a couple pennies. Could you just provide a little more color of what was going on there?

Simone Blank

In the quarter, yeah, the adjusted EPS was $0.80 over $0.78 last year. The main – we had a $0.04 positive FX impact in the adjusted EPS.

Jeffrey Warshauer – Sidoti & Company

Okay. Thanks.

Simone Blank

Thank you.

Operator

Your final question will come from the line of Larry Marsh with Barclays. Please proceed.

Larry Marsh – Barclays

Oh, thanks, and good morning. Most of my questions have been asked, but just maybe two quick follow-ups, Jost and Simone. First, on the Patterson agreement, I know it was signed end of May, so it’s the first public forum to sort of talk about this. In the agreement itself, you talk about some minimum purchase requirements, as well as some margin obligations I guess that Patterson has. So just I want to understand, it seems to me, if I’m understanding, that some of these purchase minimums are a bit higher than what were incumbent in the other contract. I just want to confirm that there is a change in sort of purchase requirements. And then secondly, then on the margin, at least when you said there’s no change in the pricing, so is it fair to say that the original agreement had the exact same language around margin protection that this one does? Or no?

Simone Blank

No, first of all, obviously, we – this is a very good agreement for us and we’re looking forward on the execution of that agreement. As you mentioned, there are financial goals in the agreement, no question, and they are challenging. We will not comment on what they are relative to what they’ve been before, but they’re challenging. And yes, you’ve identified that there are penalties associated with this agreement in case the goals are not met and there are different ones, some of which you mentioned, and there are also potential consequences in prolongation or shortening of the exclusivity period.

Jost Fischer

In total, this is a good contract I think for Sirona and I think it aligns the U.S. market with Patterson.

Larry Marsh – Barclays

Right. Yeah, and as I see it, Jost, it seems like it does give you a great level of protection over that period of time, so I would agree with that.

I guess the second follow-up and just you may have addressed it earlier, which is just in general, as you sort of think about IDS, I know that Stanley Bergman was asked about this I think yesterday, how does he think about IDS in 2013 given the substantial dynamics of change in the European market. And I guess I’ll ask you the same question, which is as you think about IDS in April of 2013 relative to past years, given all the uncertainties in the marketplace, do you think there’ll be additional focus on value generation, immediate return? Or in your mind, Jost, is it going to be a similar show that we usually – you usually have been experiencing over the last number of years?

Jost Fischer

Yeah. We feel good about our – let’s put it that our plans for IDS. It’s a little early at this point in time. But given what we’ve seen a year and a half ago, or a year and four months ago, we want to repeat that at least. We want to do our part in order to be in a position to have another very successful IDS. I think that is what we are gearing up to.

Larry Marsh – Barclays

Okay. Very good.

Operator

Thank you. Ladies and gentlemen, that concludes the question-and-answer session. I would now like to turn the call over to Mr. Joshua Zable for closing remarks. Please proceed.

Jost Fischer

Yeah, we’ll take over from you, Josh, no problem. For my closing remarks, thank you for joining us today and I look forward to updating you on our next quarterly conference call in November. You all have a good day and thank you for listening.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect and have a great day.

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