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

F2Q08 Earnings Call

May 14, 2008 08:00 am ET

Executives

Peter H. Soderberg – Chief Executive Officer and President

Gregory N. Miller – Senior Vice President and Chief Financial Officer

Blair A. (Andy) Rieth, Jr. – Vice President, Investor Relations

Analysts

Ian Zaffino – Oppenheimer

Alex Schmelzer – Scoggin Capital

Greg Halter – Great Lakes Review

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 a question-and-answer session and instructions will be given at that time. As a reminder, this conference call is being recorded. The call will be available for replay through May 21st, 2008 domestically at 1-888-203-1112 and internationally at 719-457-0820. For the replay, callers will need to use confirmation code 2411564. If you are unable to listen to the live webcast or the replay, the call will be archived at www.hill-rom.com through May 13th, 2009. 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. If you require assistance during today’s call, please press 0 then * and an operator will assist you offline.

On the call today, will be Peter Soderberg, CEO and President of Hill-Rom, Greg Miller, Hill-Rom’s Senior Vice President and Chief Financial Officer, and Andy Rieth, Vice President, Investor Relations, Communications & Global Brand Development. Before we begin, I would like to provide Hill-Rom’s usual caution that this morning’s call may contain forward-looking statements such as forecast of business performance and company results and expectations about the company’s plans and future initiative. Actual results may differ materially from those projected; for an in-depth discussion or of risk factors that could cause actual results to differ from those contained in the forward-looking statements made on today’s call, please see today’s press release. Also you may reference the discussions under the heading “Risk Factors” in the Company’s Annual Report on Form 10-K for the period ended September 30th, 2007, filed in December. If you have not received today’s release, it’s available on Hill-Rom’s website www.hill-rom.com. Now, I would like to turn the call over to Mr. Andy Rieth.

Blair A. (Andy) Rieth, Jr.

Thank you Clara, and good morning everyone. I would like to personally welcome you all to our first official call as the new Hill-Rom since becoming an independent medical technology enterprise. We have lots to discuss today, so let’s jump right in. First, some quick ground rules to make the call more efficient. We have scheduled an hour for the call. Our prepared remarks will take about 30 minutes and then we will move to Q&A. Please limit your inquires to one question plus a follow-up per person. If you have additional questions, you may rejoin the queue. Along with our remarks, we are also displaying slides real-time that amplify our disclosure. We are having a little bit of technical difficulty with those this morning, so we hope those make it through to you, if not they will all be archived for a later date to use. I would encourage you to follow along at this time and we will see if we can get those up and running. The slides will be part of an archive. The telephonic audio replay of this call will be available until May 21st and the webcast and the accompanying slides will be archived on our website for approximately one year at www.hill-rom.com. Also, I want to note that our 10-Q for the second quarter will be filed later this week and will serve as a good compliment to today’s material. And finally, over the next few weeks, we will be participating in several healthcare conferences and investor meetings including Bank of America this week and the Citigroup Healthcare Conference next week. In the month of June, we will participate in conferences sponsored by Goldman Sachs, Jefferies, and FTN Midwest. With that, I will turn the call over to Peter.

Peter H. Soderberg

Thank you Andy, and good morning to everybody. As Andy indicated, our call today marks a milestone in the transformation we embarked on shortly after my arrival in 2006. Because this is the first earnings call for Hill-Rom as a newly independent enterprise and pure-play medical technology company. While we formally began trading the new Hill-Rom equity the regular way on April 1, only six weeks ago, we have been pursuing the strategic imperatives necessary for our transformation since early in our 2007 fiscal year. So while we are coming to you this morning for the first time as the new Hill-Rom, we have been executing our strategy for the past five quarters and are beginning to see the results of our efforts and investments.

Before I begin, let me say that Greg, Andy, and I, have had distinct pleasure meeting with many of you during our road show prior to the separation, and in the recent weeks that have followed. We have been encouraged by the enthusiasm you have shown for our vision, our strategy, and our early results. Andy would also like to acknowledge the over 6000 new shareholders who joined us on April 1, the associates of Hill-Rom around the world. As some of you may know, the management team voluntarily forfeited 2008 merit increases in order to be able to fund a pool of equity that we call founder shares [inaudible] two years granted to all Hill-Rom associates. We welcome all our new owner-operators and look forward to your contributions as we now share the responsibility of increasing the value of Hill-Rom for all shareholders.

I am pleased with the results for the most recent quarter and excited about the opportunity to continue to successfully execute our plans under the spotlight now upon us. All of us here at the new Hill-Rom appreciate the need to demonstrate sustainable performance in order to enhance shareholder value. Our second quarter fiscal year 2008 is consistent with our flight path to deliver on the expectations that we have set. Our focus today will be exclusively on Hill-Rom’s results. Although, we have reported quarterly and year-to-date results of our former funeral services business as a discontinued operation in our financial results, our remarks today will be about the new Hill-Rom. So with that, let’s proceed.

I will provide an overview of Hill-Rom’s second quarter performance and some commentary on three of our strategic initiatives. Then I will turn the call over to Greg for the financial review, and after some brief concluding comments, we will take your questions.

Starting with revenue, I am particularly pleased to report the solid and balanced growth of our capital and rental revenues in the quarter, both up 12% year-over-year. Even when adjusting for the impact of foreign exchange, consolidated revenue grew 9%, which reflects constant currency growth of 8.4% for capital sales and 10.3% for rental revenues. If we look at revenue by our reporting segments, you will know sales momentum continued to build within all three segments. North American Acute Care was up 5.2%, North American Post-Acute Care was up 11.9%, and International and Surgical grew 32.5% or 22.1% on a constant currency basis. This growth was all organic as no acquisitions affected our period-over-period comparisons. While we still have improvements to make particularly to further accelerate growth of North America Acute care and the full fruits of our investments to realize, directionally I am pleased with our progress. Year-to-date revenues of $716 million were up 9.2% or 6.5% on a constant currency basis; result very much consistent with our promise to organically grow revenues at a 6% to 8% compounded rate.

Turning to other financial metrics – consolidated net income from continuing operations was 15 cents per fully diluted share. This number includes a number of one-time items related to our separation. Adjusting for those items, adjusted earnings for the quarter were 26 cents per fully diluted share, which was the same amount, reported in the prior year for continuing operations. Our adjusted EPS performance suggests that our results are approaching the inflection point we indicated in our last earnings call, and our guidance will confirm that we expect to see quite favorable financial comparisons versus last year during our second half. Cash flow from operations was strong, both with and without the inclusion of our discontinued operations. The improvement was driven by increased working capital efficiencies at Hill-Rom along with cash collected on seller financing related to the sale of our former pre-need funeral insurance business. Greg will spend a bit more time on cash flow during his remarks. As you know, Hill-Rom is putting much more emphasis on cash generation and working capital efficiency and our improved receivables is evidence of this. However, we still have some work to do on inventories.

Now let me discuss our progress in advancing our fix and grow strategic initiatives and delivering on our 3-year compounded 6% to 8% organic sales and 12% to 15% earnings growth goals. You are looking at the slide we have been using in one form or another since our October 2006 strategy presentation in New York. This version, updated for the road show, reflects an extension of our metrics out to 2010. Our second quarter performance of 12% organic sales growth presents an early indication that sales acceleration is indeed happening. But certainly every quarter will not be this strong; we do believe that our performance in quarter 2 is indicative of where this strategy can lead us if we execute properly. In the interest of brevity, I would like to pick up on three of our strategic initiatives to update you on at this time. The first – to develop and successfully launch differentiated new products; the second – to turn around our rental business; and the third – to continue double-digit growth and expansion of our international business. Let me elaborate on each of these.

Innovation and product development is a key component of all five of our strategic imperatives. A year ago, we began to ramp our investment in product development and the pipeline we had built is now beginning to come to market. These products represent the unique internal ability that only Hill-Rom has to combine frame technology, surface technology, connectivity and application software development, and clinical consulting services to help customers enhance both clinical and economic outcomes and generate attractive returns on their investments. Products released during 2007 that are helping to create the kind of results we saw this quarter includes products on the left-hand side of this slide – TotalCare Bariatric Plus, the Envision E700 Wound Surface, and the Vest Model 2005 for hospitals. Each contributed to this quarter’s growth. In 2008, our releases are accelerating, TotalCare Connect and TotalCare Connect Bariatric patient support platforms began shipping in March. TotalCare has long been the standard for hospital ICUs and offers a wealth of differentiated features to improve care for the critically ill patients. However, a number of these features were not easy to master; they were not fully utilized. Now we bring these features alive with our new graphical user interface. TotalCare Connect also offers real and differentiated connectivity with the hospital IT infrastructure. Delivery of digital information to the electronic medical record allows hospitals to monitor patients in real-time and document their care to support continuous improvement efforts. New caregiver training tools and our Clear Lungs and Safe Skin functionality allow hospitals to lower the cost and improve the care of their ICU patients. For Hill-Rom, these investments also contribute to enhanced gross margins based on an improved value proposition.

We have previously spoken about the new Hill-Rom 100 Low Bed. Extended care and care and home care are very enthusiastic about our efforts to bring important patient and caregiver safety features from a hospital environment into the post-acute environment. And the Hill-Rom 100 Low Bed offers a breakthrough in style and patient and family friendliness that has been very well received.

And finally, I want to highlight the launch this month, of the latest VersaCare line extension, which is designed to refresh, extend, and further differentiate our most widely sold patient support platform for medium acuity patients. We have incorporated some of the advances introduced on the TotalCare Connect line and have leveraged common features, technologies, and components across multiple products. Last week, we also launched two new and sophisticated therapy surfaces which supports our Safe Skin value proposition. These new surfaces also introduced the new Nano AG Antimicrobial Surface Technology for the first time, a product of our exclusive partnership with NanoHorizons.

The second set of initiatives I would like to highlight deals with the significant improvement we have experienced in our North American rental area. As many of you know, our rental business has been a challenging one for us in the past several years. This quarter, our rental business showed great improvement, driven by growth of over 25% in our therapy rental business. These results were attributable to a number of factors. The strength of national accounts team, leading to our gaining more GPL business; the strong uptick of TotalCare Bariatric and Envision E700 products; the focusing and redeployment of over 100 clinical directors; no longer having to support our moveable medical equipment or MME services following our addition of 34% sales force dedicated to MME; improving customer satisfaction scores through fixing our IT systems and increased emphasis on service levels; a virulent influenza epidemic after several mild years, and stabilizing results of our MME business which still showed declines period-over-period although much more modest ones than in past quarters.

To wrap up our highlighted initiatives, let me turn to the success that we have had outside in North America. As you know, expanding our international business as a percent of worldwide sales has been a strategic imperative from the outset. Historically, our international business had been slow growing and unprofitable. Our turnaround began in 2005 with the restructuring of our plant in France. In late 2005, management changeovers were affected by the interim CEO, my predecessor and our current Chairman, Rolf Classon. And now under the able leadership of Greg Tucholski, President of International and Surgical, we made further changes over the past two years that are really starting to have a sustained impact.

Year-to-date revenues, on a constant currency basis, have grown over 15% and grew 22% this quarter. Sales growth continued to be driven by the AvantGuard 800 and 1200 hospital bed products, by sales of our new Meltis furniture line in both the acute care and medicalized long-term care businesses. As we speak, we are launching the AvantGuard 1600 for higher acuity hospital settings. The combination of a more relevant product portfolio, itself the result of additional product development investment specific to overseas markets, better success in securing European tenders, and successful initial efforts to penetrate the medicalized long-term care category, have all resulted in accelerated growth. We do pay a price at the gross margin line because international revenues generally secured a lower margin. However, we have and will address this issue aggressively via supply chain efficiencies and sourcing strategies, better aligned segmentation, and innovation.

In conclusion, we are more confident than ever that our strategies are sound and our fix and grow initiatives are on track. With an encouraging first half of the fiscal year ’08 behind us, we are in a position to adjust our full year guidance. In considering our year-to-date performance and our future prospects and in spite of much higher inflationary pressures than anticipated, we are comfortable with increasing the sales guidance range and expect that adjusted EPS results will finish in a somewhat more positive range than originally forecast. Greg will describe the updated guidance in more detail in his remarks, and I will be a bit more specific on our second half outlook at the end. Now, I would like to turn the call over to Greg Miller.

Gregory N. Miller

Thank you Peter and good morning. To begin with, I would also like to welcome you to the first earnings call for the newly separated Hill-Rom especially all our associates as new owner-operators. I also echo Peter’s comments regarding the high level of interest shown in our meetings with many of our current and potential investors on the road show; we appreciate it. Before we move forward, it is important to note that all amounts presented within the slides are presented on a basis of our continuing operations, and, therefore, exclude impacts associated with our former funeral services business and most costs associated with the separation. There are $10.5 million of separation-related costs, which remain as a component of continuing operations based on accounting requirements. I will highlight those as I move through the presentation. Now, let’s get started.

Total revenues continued to accelerate during the second quarter with an increase of 12% over the second quarter of last year, which is an increase of 9% on a constant currency basis. This is the highest year-over-year quarterly growth we have experienced in over 3 years. Our quarterly and year-to-date revenues have increased in all segments for both capital sales and rental revenues. Our trailing 12-month growth rate is now 7.6% or 5.5% on a constant currency basis. As I discuss capital rental revenues for each segment, in addition to favorable foreign exchange rates, you will hear a common theme. We are seeing positive impacts in the areas that we have invested in the new products, expanded and focused our sales channels, and improved our marketing for these new products.

Moving to the next slide, Hill-Rom’s capital sales in the second quarter increased 12%, which is an increase of 8.4% on a constant currency basis. Breaking it down by segment, capital sales in North America Acute Care increased 1.6% as higher volumes on recent product introductions offset lower volumes in our mid-acuity product line. More specifically, new product launched in 2007 and the expansion of sales specialist early this year continued to drive double-digit growth of our Affinity Four Birthing Bed, our new stretcher line, and furniture. We also experienced higher revenues from the sale of therapy products generally deployed from our rental fleet, which is up over $3 million from last year. Again, improved internal focus, new product offerings, and the increased number of sales specialist are starting to positively impact this area. Favorable price realization and product mix are also contributing to some of the favorability during this quarter. Finally, we experienced some positive signs in the ICU area. In March, as Peter mentioned, we launched our updated TotalCare Connect platform, the latest update to our highly successful ICU product line. After two consecutive quarters of decline, we experienced strong demand for the product and reported revenues in line with last year and up from the 10% decline reported last quarter. In spite of recent competitive product launches, we expect strong acceptance for the product in the future period. Partially offsetting these increases, we experienced some weakness in our mid-acuity bed platforms – VersaCare and CareAssist. We experienced some product shortages related to temporary supplier issues, which are now resolved, and our order movement associated with pending new product launches in the third quarter, as Peter has already mentioned.

Capital sales in our International and Surgical businesses increased $22 million or about 36% overall. On a constant currency basis, this represents growth of 22% and is driven by the initiatives Peter has already mentioned. Although still a small portion of our capital business, North America Post Acute capital sales posted an increase in excess of 46% as a result of enhanced sales channel focus and improved support surface, bed frame and furniture sale to our home and extended care customers. The second quarter introduction of the Hill-Rom 100 Low Bed and sales of the Vest respiratory care product have also shown nice increases during the period.

Moving to healthcare rental revenues, second quarter rental revenues increased 12% led by North America Acute Care. Following declines during fiscal 2006 and 2007 our North America Acute Care rental revenues increased over 15% versus the second quarter of last year. The continued launch of new innovative rental products, the renewed focus of our account clinical directors within the sales channel, and the new CMS rulings regarding nonpayment for certain adverse events occurring in the hospital which goes into affect on October 1st, 2008, gives us reason for continued optimism in this part of our business as we look ahead. Partially offsetting the significant increase in therapy rentals, the movable medical equipment rental line suffered a decline in the quarter due to continued carryover impact of contract losses over the past year and a half. As we have discussed, although we continue to be disappointed with the results of our movable medical equipment product line, we did see the initial signs of stabilization as revenues increased 20% from the first quarter of this year. Now part of this increase was from higher incident of flu and pneumonia during the quarter when compared to the prior year; however, we are also seeing positive signs attributed to the recent addition of 34 dedicated MME sales representatives. Further, during the past quarter, we brought in a new leader to drive enhanced performance and growth in this product line. Our increased and focused sales team coupled with the continued investments into new equipments specific to this business should position us to stabilize and then profitably grow our MME product line as we move forward.

North America Post-Acute rental revenues increased 6.5% or $2.4 million as continued softness within our extended care rental lines was more than offset by continued strong revenue growth within our respiratory care product rentals, lower rental reserves requirements compared to prior year, and strong quarter-over-quarter revenues in our homecare business. International rental revenues increased 13%, which included $1.3 million of foreign exchange benefit along with slight improvement in volume.

Now, I will move on to gross profit and margin. During the second quarter, Hill-Rom’s gross profit was up on a year-over-year basis by $15.1 million or 9.9% as both capital and rental gross profit showed growth. And while gross margin as measured as a percent of revenues was down 80 basis points compared to the prior year, rental margins continued to be strong and capital margins improved over the last quarter. Overall, gross profit and margins were impacted by higher inflation on commodities than we had expected, especially steel and fuel costs with an unfavorable impact of 72 basis points in the quarter. Fuel prices alone increased 41% versus the prior year period, while plastics increased 28%, and fuel prices increased 35%. Our cost improvement and supplier engagement programs were able to offset 60% of the material inflation and trade contracts and route optimization programs offset about 5% of the fuel inflation. However, this will continue to drive inflationary pressures in the second half of the year. More specifically, Hill-Rom capital sales gross profits increased 7.5% or $7.3 million with all three segments reporting higher gross profits led by our International and Surgical business. Second quarter capital gross margins as a percent of sales declined to 180 basis points year-over-year from 42.9% to 41.1% primarily due to continued segment sales mix towards international. As we have discussed in the past, our overall gross margin percentage on products sold internationally generally provide relatively lower margins than those in North America.

In addition, overall international margins declined on a year-over-year basis by 580 basis points driven in part by the negative impact of unfavorable inventory adjustments associated with periodic physical inventories taken at various operations in Europe, along with currency movements on products in certain geographic region. In addition, the prior year or the second quarter of 2007, included a one-time gain that favorably impacted last year’s gross margins by 230 basis points related to an adjustment of costs on product sourced from one of our French manufacturing facilities. With the launch of our new ICU product in Europe and the lack of such adjustments repeating in the balance of the year, we expect to see significant improvement in international margins for the rest of fiscal 2008.

Despite the second quarter start-up costs related to our Mexico plant of $2 million or about 80 basis points on capital sales, and higher inflation on our commodities than we had expected, capital sales gross margins in our North America Acute segment remained flat, and our margins increased in our Post-Acute segment due to higher margins on new product introductions and a variety of cost-saving initiatives underway, including low-cost region sourcing and manufacturing cost improvements. Looking forward, we expect commodity and fuel inflation to continue to put more pressure on our margins than we had initially anticipated, and even though we expect continued marginal expansion throughout the rest of the year, it will not be as high as we initially guided. I will discuss guidance for capital sales margins later.

Hill-Rom rental gross profit increased 14.3% or $7.8 million. Second quarter gross margin improved 110 basis points year-over-year to 52%. This improvement results from the increased volumes discussed previously combined with the continued positive leverage of our field service organization, the profitability improvement activities competed during 2007, and new product margins. Looking forward, we continue to see positive momentum in our rental business and leverage of our field service organization, which should assist in offsetting the margin pressure from higher field service fuel costs.

Moving to operating expenses. For the quarter, operating expenses including spin-related costs increased 20.4%. Excluding separation costs of approximately $7 million, operating expenses would have been approximately $140 million or an increase of 15.6% as shown on the slide. Overall, there are a few drivers of increasing operating expenses year-over-year in the second quarter. First, expenses related to separation of the funeral service businesses that are accounted for within continuing operations, which I will discuss in a moment. Second, our continued year-over-year investments into R&D, sales channels, and marketing related to the increased new product launches. And thirdly, we also experienced an unfavorable swing of about $4 million in our self-insurance reserves, primarily related to product liability coverage. While the majority of separation-related costs are reflected as a component of discontinued operations, accounting requirements dictate that certain separation costs totaling $7.3 million in the second quarter remain as a component of the continuing operation. During the quarter, the separation costs included within our operating expenses included $1.5 million of legal and professional fees directly associated with the confirmation of the separation and a non-cash charge of $5.8 million associated with the modification of outstanding equity awards held by employee. This equity modification was done to maintain the intrinsic value of such awards at the date of separation and provided no incremental benefit to the employee. Looking forward, we expect to incur approximately $2 million of additional separation costs for the rest of the year. As we have discussed, after the ramp of strategic investments starting in the last half of 2007 and continuing into the first half of 2008, we believe our strategic investments are on the verge of becoming accretive to earnings on a year-over-year basis. We are at the inflection point for improved earnings.

Moving on, operating profit decreased $9.6 million or 32% this quarter. This decline is mostly due to the separation requirement costs of $7.3 million. Operating profit adjustment for separation costs still decreased due to our increased strategic investment spending partially offset by increasing gross profits driven by revenue growth. As I just mentioned, we continue to believe these investments will drive accretive results versus the prior year in the second half of the year.

Adjusted earnings per share was 26 cents in both the second quarter of fiscal 2008 and 2007. The effective income tax rates for the second quarter on a continuing operations basis was 44.4% compared to 38.7% for the prior year comparable period. The higher rate in the year is due principally due to discrete period tax expenses of approximately $1.4 million in the current period. The discrete items included additional valuation allowances on foreign tax credit that we can no longer reasonably project using following the separation along with the approved additional tax reserves under FIN-48. With the lower level of income in the current year, the effects of such items on the tax rate are more pronounced. Looking forward, we believe that our full year effective tax rate should approximate 37% on a continuing operations basis excluding the impact of any future discrete items. With the scheduled conclusion of several tax audits in the last half of the year, we generally expect any related discrete items to be favorable to our tax rate. The above tax rate also does not include any benefit which will occur if Congress reenacts the R&D tax credit which expired earlier this fiscal year.

Now, let’s take a quick look at free cash flows, which we define as cash flow from operations less capital expenditure. Despite year-over-year declines in net income related to our strategic investments, free cash flows have grown over the prior year quarter for three consecutive quarters. This continues to reflect improving AR-DSO matrix. In addition, quarter 2 cash flow was benefited from $50 million increase in accounts payable. Of this amount, $18 million of separation costs, which had not been paid, and our international operations account for another $18 million. Substantial portions of these amounts are expected to be paid in the third quarter. We continue to focus on improved working capital matrix, particularly receivables and inventory. Looking at other financial measures, while there have been some changes associated with the separation, we continued to be with very solid liquidity and balance sheet position from which to execute our strategic initiatives. Our cash and short-term investment balances following the distribution to Hillenbrand are still nearly $195 million. Our short-term investments totaling $48.6 million is currently comprised of highly rated AAA Student Loan Auction Rate Securities. As you are aware, the market for auction rate securities has experienced a high rate of failures and we have not been exempt from these developments. As such, our portfolio is currently subject to a high degree of illiquidity. While we believe, there is no market deterioration in the credit quality of the underlying securities in our auction rate portfolio, given the deterioration in liquidity; we recorded an unrealized loss on the balance sheet during the quarter of $1.5 million to reflect the estimated decline in the fair value of these securities. We continue to expect that we will be able to fully monetize these investments at par value within the next 12 months, but this may not occur if the current market conditions do not improve or if these issuers are unable to issue replacement debts. Fortunately, we have the ability to hold these securities until market conditions improve, and we intend to do so.

During the quarter, we put in place a new revolving credit facility with a syndication of banks with a credit capacity of $500 million. This facility replaces our previously existing $400 million facility. Also during the quarter, we completed the repurchase of 224.3 million of our 250 million of outstanding 4.5% senior notes that were due in June of 2009. This leaves us with long-term and short-term debt totaling $138 million. As such, after considering our cash balances we are in a net cash position. With respect to the termination of the $400 million credit facility and the repurchases of our senior notes, we incurred a loss on the extinguishion of debt of approximately $3.2 million, which is recorded under continuing operations as other expenses in our income statement. Finally, we continue to have access to the $750 million remaining under our shelf registration statement, which expires later in the calendar of 2009. We anticipate that we will complete a new shelf registration before the current arrangement expires.

Now moving to 2008 guidance update. Hill-Rom’s previous guidance for total revenue was $1.427 billion to $1.476 billion reflecting a 5.2% to 8.8% growth. Based on the strength of the revenues in the second quarter and year-to-date and our expectations for the remainder of the year, we are updating our guidance for revenues as follows: we are narrowing the guidance for healthcare sales towards the previous high end with an updated guidance of $1.009 billion to $1.022 billion. We are increasing the guidance for our healthcare rental revenues to $455 million to $464 million. As such, total revenues will increase to $1.464 billion to $1.486 billion, a growth rate of 7.9% to 9.5% over the prior year. As previously covered, due to the year-to-date results, segment mix pressures, and our expectations of continued inflationary pressures on commodities and fuel costs, we are adjusting our healthcare sales gross margin downward 90 to 110 basis points to 41.9% to 43.2%. Although we continue to expect inflationary pressures on our field service fuel costs, we are maintaining our previous guidance for rental gross margins of 50.8 to 52.5% as we expect to gain additional cost leverage from the higher projected revenue. Also as previously discussed, our effective tax rate will decrease from 37.7% to 37% excluding the impact of future discrete item. It also does not include any benefits which will occur if Congress reenacts the R&D tax credit, which expired earlier this year.

Overall adjusted earnings per share is now $1.18 to $1.32 versus the previous $1.13 to $1.32. Additional details of our updated guidance is provided in our slides and our press release. As we have discussed with many of you, this is an inflection year and the exact timing of the benefits from our strategic investments may vary. As can be seen from the first half, we are definitely seeing the acceleration of revenues and some improvement on gross margin. We expect to continue to see increased returns from our strategic investments during the balance of the year. With that, I will turn the call back over to Peter.

Peter H. Soderberg

Thank you, Greg. In closing, I would like to reflect on the benefits we look forward to deriving from our recently completed separation. I want to thank all investors who supported this important initiative throughout this period. Further, I want to comment on the tremendous excitement and enthusiasm expressed by Hill-Rom associates around the globe for the new Hill-Rom. Together, all 6000 plus owner-operators, are committed to delivering on our promises to investors and to our customers. Among the benefits we expect from the separation are the following: allowing optimal capital structure, and where and when appropriate potentially use our stock as currency; create focus for management and the board to build shareholder value as a pure-play independent medical technology enterprise; energize and advance the culture at Hill-Rom through employee ownership and increased accountability; and finally, create greater awareness among investors, analysts, and other stakeholder communities of our fine company and its contribution to healthcare.

In closing, during the second half of 2008, we anticipate sales growth in the mid-to-high single digits, gross profit growth of 10% to 20%, moderation of operating expense growth of 5% to 12%, and operating income growth, as adjusted, well ahead of gross profit growth. We feel we are indeed at or near the inflection point of our transformation plan. We will now be pleased to take your questions.

Blair A. (Andy) Rieth, Jr.

Clara, you can go ahead and queue up the question line.

Question-and-Answer Session

Operator

Thank you. [Operator instructions]. And our first question will come from Ian Zaffino with Oppenheimer.

Ian Zaffino – Oppenheimer

Hi, good morning. Very good quarter.

Peter H. Soderberg

Thanks Ian, good morning.

Ian Zaffino – Oppenheimer

Just a really quick question. You had mentioned some of the contract losses in your movable medical. Can you give us an idea of how long this will take to work themselves out, what the magnitude of those were, and how you are going to go about achieving that? Thanks.

Peter H. Soderberg

Yeah. We have of course a very aggressive set of competitors out there; the contracts that we have participated in are generally dual or multi-source – we have a couple of exceptions for that. We have been – I think – quite aggressive in putting together a first class national accounts team. We have mentioned that we have added a direct sales force of 34 people to help turn this business around. As Greg indicated, the loss has significantly moderated. No question that it’s been an anchor for us on our rental revenue results, but we see that beginning to turn in the second half of the year. So it’s a hole we don’t dig out of off quickly, but we have also brought in, as Greg said, a very seasoned executive; a former colleague of mine, to oversee this area, and I am very pleased with some of the early results of his efforts.

Ian Zaffino – Oppenheimer

Okay. And can you give us a magnitude of that or is it something you can disclose?

Peter H. Soderberg

Well, we don’t disclose on that level of detail breakdown. We would rather not break down our rental revenues that finely.

Ian Zaffino – Oppenheimer

Okay. Thank you very much. Again, good quarter.

Peter H. Soderberg

Okay thanks Ian. Thanks for your support.

Operator

Alex Schmelzer with Scoggin Capital.

Alex Schmelzer – Scoggin Capital

Hi guys, good quarter. I know that in the road show presentation you had mentioned that the North American Acute Care market grows about 5% to 8% or so it says on the chart. You guys were at 4%, and I know you had mentioned that there was a Scandinavian competitor, I think, trying to enter the market here. Can you just address why there was the below market growth in North America Acute Care?

Peter H. Soderberg

I think we grew at 5.2%, didn’t we?

Alex Schmelzer – Scoggin Capital

I guess ex-currency.

Peter H. Soderberg

Yes. We are still not where we want to be, particularly in the capital side. As we have indicated, we are releasing now a fairly steady stream of new improved products, and that’s going to take time to get trialed and actually penetrated. We also have expanded our sales force – our field sales force – and focused that sales force. So as I mentioned, we have freed up our 100 plus account clinical directors to really focus on both the therapy rental and some of our high-end solutions, but it is clear that we are not where we want to be and we are not growing as quite as rapidly as the market. The competitor you mentioned is a company called [Gettinger].

Alex Schmelzer – Scoggin Capital

Right.

Peter H. Soderberg

We see the Argyle Huntley unit of [Gettinger] moving into the U.S. We have not really encountered them in a significant way so far, but we anticipate that they will make a fairly aggressive effort to try to enter this market. We face them in Europe and we do quite well in Europe. So, it’s not a competitor we are not quite familiar dealing with.

Alex Schmelzer – Scoggin Capital

Okay. And just one more question. In terms of – the top line seemed quite strong this quarter, but it didn’t translate into operating leverage. Going forward, can you tell me what type of leverage you have control of and what you don’t? In other words, the impact of raw material costs plus the negative product mix going forward and how that will affect the ability to get operating leverage going forward?

Gregory N. Miller

Yeah. Historically, I think the reason we haven’t seen leverage on the bottom line and the increase in the top line are some of the things we have been seeing since the second half of last year and certainly in the first half of this year, we have definitely seeing increased operating expenses related to our strategic investments and I think we have talked about that a lot. We do see that turning around the second half; we do see our operating expenses and the strategic investments starting to flatten out, and the leverage falling to the bottom line. Certainly, we can’t control commodity inflation; we try to offset it as I mentioned with a number of our initiatives, but that is one of the reasons that we did lower our capital sales gross margins forecasted, and we think we have included that in our forward-looking guidance.

Alex Schmelzer – Scoggin Capital

Okay, great. Good quarter guys.

Peter H. Soderberg

Thanks a lot, Alex.

Operator

[Operator instructions]. Greg Halter with Great Lakes Review.

Greg Halter – Great Lakes Review

Yes, good morning.

Peter H. Soderberg

Good morning, Greg.

Greg Halter – Great Lakes Review

During the prepared remarks, Greg, I think you referred in the capital sales side about some shortages of parts or so forth that have now been resolved. Can you delve into that a little deeper and give us some assurance that that situation has been rectified and maybe go into some more detail on what happened there?

Gregory N. Miller

Well, I am not going to delve too much into it because I don’t want to make it a bigger deal than it really was. It’s just a matter of the timing that we received parts from a supplier did not match, but when we wanted to ship our products especially right there at quarter end, so it was more of a timing thing than anything. And we have worked with our supply chain partner to resolve that, and we don’t see it as an ongoing problem. So I wouldn’t make it any bigger of a deal than it was; it was just – it happened to be near quarter end.

Greg Halter – Great Lakes Review

At the end of March, I presume, you are referring to?

Gregory N. Miller

Correct.

Greg Halter – Great Lakes Review

And any indication on what kind of a sale that may have pushed into the current quarter?

Gregory N. Miller

I don’t have a number that I want to disclose on that.

Greg Halter – Great Lakes Review

Okay. And…

Peter H. Soderberg

It’s a portion of our sales and, you know, it’s not a big number.

Greg Halter – Great Lakes Review

Okay. In the body of the release, there’s a comment about $4.1 million unfavorable swing for self-insured reserves, is that included in the adjusted figure?

Peter H. Soderberg

It is included in our adjusted figure. In other word, it is reflected in that. We did not exclude it from the adjusted figure. And it’s a combination of two things. One, we have some historical product liability claims that we have been working on for sometime that got resolved during the quarter and so the reserve just had to reflect that. It also reflects -- last year for the same quarter reflected some favorability. So year-over-year was about $4 million swing and we did not adjust that out of our adjusted earnings per share.

Greg Halter – Great Lakes Review

Okay. And one last one, on the gross profit side, you are expecting 10% to 20% improvement. I presume that’s on a year-over-year basis for the second half?

Peter H. Soderberg

Yes, that’s correct.

Greg Halter – Great Lakes Review

Okay. Thank you.

Peter H. Soderberg

Thanks Greg.

Operator

And at this time there are no further questions. I will turn it back over to you, Mr. Reith.

Blair A. (Andy) Rieth, Jr.

Thank you, Clara. I appreciate everybody being on the call. Thanks for your interest and we look forward to seeing you at the upcoming conferences. That will conclude the call for the day.

Operator

And that does conclude our conference for today. Thank you for your participation and have a wonderful day. You may now disconnect.

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