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Hill-Rom Holdings Inc. (NYSE:HRC)

F3Q08 (06/30/08) Earnings Call

August 7, 2008 8:00 am ET

Executives

Andy Rieth - VP, IR, Communications & Global Brand Development

Peter Soderberg - CEO and President

Greg Miller - SVP and CFO

Analysts

Ian Zaffino - Oppenheimer & Company

Steve O'Neil - Hillard Lyons

Alex Schmelzer - Scoggin Capital

Greg Halter - Great Lakes Review

David Hart - Apelles Investment Management

Operator

Good morning and welcome to the Hill-Rom Conference Call. (Operator Instructions). As a reminder this conference call is being recorded. The call will be available for replay through August 14th, 2008 domestically at 888-203-1112 and internationally at 719-457-0820. For the replay, callers will need to use confirmation code 2714692. If you are unable to listen to the live Webcast or the replay, the call will be archived at www.hill-rom.com through August 6h, 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, (Operator Instructions).

Before we begin, I would like to provide Hill-Rom's usual caution. This morning's call may contain forward-looking statements such as forecasts of business performance, and company results and 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 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 ending September 30, 2007, filed in December. If you have not received today's release, it's available on Hill-Rom's website, www.hill-rom.com.

With us on the call today will be Peter Soderberg, CEO and President of Hill-Rom, Mr. Greg Miller, Hill-Rom's Senior Vice President and Chief Financial Officer, and Andy Rieth, Vice President, Investor Relations, Communications & Global Brand Development.

Now I would like to turn the call over to Mr. Andy Rieth.

Andy Rieth

Thanks a lot, Jim, and good morning everyone. I would like to personally welcome all of you to our conference call and webcast for the third quarter of FY 2008. We've got lots to discuss today so let's jump right in.

First I would like to provide a few quick ground rules to make the call a little bit more efficient. We've scheduled an hour for this call and plan to have plenty of time left over for Q&A. During Q&A, please limit your inquiries to one question plus a follow-up per person, and then, 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, and I would encourage you to follow along with us. The slides are posted right now on the Investor Relations portion of our website and the slides will also be a part of the archive of this call. The telephonic audio replay of this call will be available for approximately another week until August 15. The webcast and the accompanying slides will be archived on the website for approximately one year.

Also, I would like to note that our 10-Q for Q3 fiscal year '08 will be filed later today and will serve as a good complement to today's material.

And finally, I would like to invite all of you to save the day for an important Investor and Analyst Day meeting that we will host on October 7, in New York. It will be the first comprehensive Investor and Analyst Day since our spin and we are in planning for an informative half day session that will allow plenty of exposure to management including several business segment leaders. We'll be sending out more formal communications in the future but for now I wanted to allow you to place this on your calendar right away.

With that I'll turn the call over to Peter.

Peter Soderberg

Thank you, Andy, and good morning to everyone. I am very pleased to welcome you to this call as we report on our first quarter of operations, following our successful separation of the Batesville Casket unit. Four months ago we emerged as a pure play Medtech entity. Yet for six quarters now we've been executing the strategy that we first set out in the fall of 2006. We have since reaffirmed several times that we believe we have put in place an exciting and value creating strategy for Hill-Rom shareholders and our third quarter results indicate to us that we are on the right track. We hope you agree.

Now let's take a quick look at our agenda for today's call. I'll provide an overview of Hill-Rom's third quarter performance, focusing on our business segments and a few highlights. I want to also address a couple of the key questions that we've been hearing from investors about our macroeconomic environment. Then I'll turn the call over to Greg for a more thorough financial review and discussion. After some brief concluding comments, we'll take your questions.

Let me start with revenue. We are seeing good balanced growth coming for both capital sales and rental revenue. Capital sales were up 10.9% to $250 million. While rental revenues were up 13.4% to $117 million. Even when adjusting for the impact of foreign exchange, consolidated revenue grew 9.3% to $367 million, with constant currency growth of 8.3% for capital sales and 11.4% for rental revenues.

On a year-to-date basis, our consolidated revenue reached nearly $1.1 billion, which represents total organic growth of 10.0%. Constant currency growth was 7.5%. This performance supports the conclusion that our goal of 6% to 8% organic growth is achievable and this quarter represents the fifth out of the past six quarters, where revenue growth fell in our targeted range.

I would like to now discuss our three reporting segments, starting with North America Acute Care, which showed revenue growth of 5.6%, to $220 million. This segment was paced by growth of over 20% in the rental of our proprietary therapy surfaces and frame surfaces led by the TotalCare Bariatric Plus ICU bed and the envision E-700 Wound Surface. Because these products are so highly differentiated and respond to heretofore unmet needs, we believe they are actually growing the entire therapy category.

This quarter's growth also reflects virtually no tail wind from seasonal influenza, which you'll recall contributed to similar levels of growth in our second quarter. We reported growth of 3.5% in capital sales. Within that number, capital sales of our hospital beds and proprietary therapy surfaces increased by high single digits. This performance was led by our TotalCare Connect advanced ICU system launched in late March and the initial traction on the VersaCare line extension launched during this quarter.

As we said in our last call, we believe our strong therapy rental and approved patient support systems performance can be traced to both our sales additions and the introduction of compelling new products stemming from our increased investment and R&D. Our architectural products and healthcare IT lines showed softness during the quarter. Both have major new product launches coming over the next several quarters designed to turn these trends around.

Finally we appear to be stabilizing the rate of decline of our movable medical equipment rentals, but MME still represents a drag on our growth and profit improvement targets. Earl DeCarli an experienced Medtech Executive whom I've worked with in the past joined us early in the quarter as senior VP Care Continuum Services. The assessment of our strategies and the impact of our investments in MME is one of Earl's key priorities.

Turning now to our North American Post-Acute Care segment, revenues grew to over $50 million, an increase of 10.7%. Like last quarter, both capital sales and rental revenues grew at double-digit rates. While we are still in early innings here, we feel we will continue to be rewarded by our decision to pursue growth outside of our core hospital segment.

Rental revenue strength again was driven by a respiratory care franchise, the best high velocity chest wall oscillation therapy, and by our home care therapy rental and capital products. Going forward, we expect our respiratory care revenues to further benefit from a channel relationship we recently announced with Tri-anim, the nation's largest provider of respiratory specialty sale and distribution solutions. Tri-anim will make the Vest one of its few focused products.

Our home care team continues to make real progress in building our franchise, to improve channel management and launches of new products. Extended care suffered from a slower capital and rental revenues. However, we have made a leadership change here and have several new products coming in 2009, which should help us turn this situation around.

Turning to our international and surgical business, we have recorded yet again another strong and balanced performance. Total revenues of $98 million were up 27.9% or 19% on a constant currency basis. Most of our sales growth came from Europe, the Middle East, Asia and from our surgical business.

In Europe, our expanded focus on medicalized long-term care, which showed almost doubling of sales year-over-year and the strength of our AvantGuard 800 product line, our value point med search offering have been driving much of the growth in capital sales. This growth however has come at lower margins.

Our surgical unit Allen Medical continues to record consistent mid-teens growth, good uptick of its new products and expansion of its OEM relationships.

Let me now comment on our bottom line performance. Consolidated net income from continuing operations was $0.34 per fully diluted share, compared to $0.18 per share in the prior year. Our results include the effects of some discrete tax items that favorably impacted the quarter by $0.12 due to the timing of their resolution.

Even so, this improvement is consistent with our prior guidance that fiscal year 2008 would represent an inflection point, or during the second half we will begin to see the benefits of the investments made during 2007 and the first half of this fiscal year.

Finally, before turning the call over to Greg, I would like to address the two questions that we have been receiving most often recently when we speak with investors about our Hill-Rom investment proposition. They relate to the North American hospital purchasing environment and commodity cost inflation.

Regarding the former, we continue to see a good climate in our core North American Acute Care business, both capital and rental spending. While we do have a handful of examples of customers putting capital expenditures on hold, our quotation and order rates at the moment appear to be stable or growing across most categories.

More over independent services we subscribe to have recently forecasted that new hospital construction starts will actually increase slightly in 2009 versus 2008.

Finally, many of the macro trends we have previously discussed such as patient demographics, CMS no pay reimbursement for hospital acquired conditions beginning October 1, rising acuities across the care continuum, and the need for hospitals to address caregiver shortages have driven strong customer interest in our offerings.

Having said this, if a slowdown in capital products or expenditures does materialize in the future, we believe we have enough levers to pull to stay on track with our bottom line commitments. I'll speak about some of these levers in a moment.

The second question we frequently get is related to today's inflationary environment from materials and fuels. Like most manufacturers, we have seen unexpectedly strong commodity price inflation during the past several months. In response we have intensified our efforts to reduce product and operational cost in a variety of ways, six of which I will share with you at this time.

First; acceleration of cost reduction and continuous improvement activities throughout our business, including the deployment of more engineering resources to cost out projects. Second; the potential adjustments of rental service levels based on analysis of product and customer profitability in light of higher transportation costs. Fuel increases during the quarter adversely impacted our rental gross margins by 40 basis points.

Third; consideration of alternative capital product distribution strategies. During the quarter, we saw inflationary fuel cost reduce capital margins by 80 basis points, versus approximately a 50 basis point impact we saw on capital margins from material inflation.

Fourth; acceleration of in sourcing of external purchases into our Monterrey, Mexico facility to fully leverage its increasing cost advantage versus other low cost regions. Fifth; utilization of contractual provisions bodied many of our capital contracts to take inflationary price increases on contract anniversaries. And finally, the streamlining of the organization in response to our post spin mandate to be a faster leaner organization, driving profit expansion. If approved by the Board, such an action would impact about 3% of our salary worldwide workforce or about 150 people and would result in a fourth quarter charge.

In closing, our current view is, these external issues should not cause us to alter our strategy or materially change our sales and profit growth targets. We now have three quarters of the year in the bank and anticipate a very strong quarter, with 10% to 16% top line growth and nearly a 50% to 75% operating income growth as adjusted.

Accordingly, we are comfortable with updating financial guidance from our May call to reflect increased sales and gross profit expectations. We expect operating income as adjusted to remain consistent with prior guidance, in spite of the negative impact of inflation and currency movements.

Furthermore, we have adjusted earnings per share guidance upward, primarily to reflect the benefits from discrete tax items realized in the quarter. We believe more than ever that the foundation that we are laying is the right one to build shareholder value.

Now I would like to turn the call over to Greg Miller.

Greg Miller

Thank you, Peter. To begin with, as we separated in the middle of the fiscal year on April 1, it is important to note that all amounts presented in the slide and I will be discussing, are presented on the basis of our continuing operations and, therefore, exclude all impact associated with the former funeral services business and most costs associated with the separation. There are no separation-related costs included in our continuing operations in the current quarter. As a reminder, there are $10.6 million of separation-related costs in continuing operations on a year-to-date basis. All other separation-related costs are included within discontinued operations and are discussed in more detail in our SEC 10-Q.

Now let's get started with the financial review. We had another strong quarter in terms of revenue growth. Revenues continued to increase in accelerating rate on a constant currency basis, with strength in both capital and rental revenues and across all reporting segments. This growth results from our investments in new products and our sales channels and a receptive business market.

As noted on the slide, we have seen double-digit total revenue growth year-over-year for the past two quarters, with constant currency growth greater than 9% both quarters. Our currently 12 month growth rate is now 8.5% or 6.2% on a constant currency basis.

Looking at capital sales third quarter revenues increased 10.9% year-over-year, with international surgical leading the way. Our trailing 12 month growth rate for capital sales was 9.7% or 7.1% on a constant currency basis. Rental revenues continued to accelerate, even in the non-influenza period, with 13.4% growth over the prior year or 11.4% on a constant currency basis.

As Peter has mentioned in North America Acute, this has been driven by investments into our innovative bariatric frame and wound care surface rental fleet as well as the refocus of our account clinical directors after adding the MME sales channels and the conversion of recently won GPO therapy rental contract. Our other two business segments have also seen double-digit growth in rental revenues. Our trailing 12 months growth was 5.8%, or 4.2% on a constant currency basis. That said, it should be noted that rental revenues have increased at a double-digit rate in the past two quarters.

As Peter has already discussed other parts of our revenues for our reporting segments, I'll move straight into discussion of gross profit and margins.

During the third quarter, Hill-Rom's gross profit increased on a year-over-year basis 10.4% as both capital and rental gross profit showed growth. This is the highest growth rate in consolidated gross profit in six quarters. Gross margin, measured as the percent of revenues, declined 50 basis points, compared to the prior year, with the decline related entirely to capital sales, as rental margins continue to be strong. In fact, despite inflationary pressures that I will discuss next, we experienced gross margin improvements in our North America Acute and our Post-Acute segment. Unfortunately, we continue to see gross margin declines in our international segment.

We continue to face higher than expected inflationary pressures in key commodity markets, primarily from fuel and commodities, including steel and plastics. Overall gross profit and margins were negatively impacted on a year-over-year basis by higher inflation by $2.6 million or 100 basis points in the third quarter. While we have been able to mitigate some of these cost pressures through contracts with our suppliers, cost improvement activities and trade contract and route optimization programs, we were not able to keep pace. As supply for these materials and commodities remained constrained, we expect commodity inflation pressures to continue in the fourth quarter and into fiscal 2009.

In addition to the incremental activities that Peter has covered in offsetting these inflationary pressures, we will continue to execute our strategic initiatives towards improving gross margins which includes low cost region manufacturing sourcing, continuous improvement initiatives in our long-standing manufacturing facilities, continued centralization of our global supply chain, introductions of innovative, higher new margin products and platform product design which is the increased use of common sub-assemblies and modules across multiple surfaces and frame product platforms.

Moving to capital margins, Hill-Rom capital gross profit increased 6.8% with all three segments reporting higher gross profits, led by our International Surgical and North America Acute segments. Despite margin improvements in North America Acute and Post-Acute, overall third quarter capital margins as a percent of sales declined a 150 basis points year-over-year from 41.3% to 39.8%, primarily due to the following. First, 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.

Second, overall international margins declined on a year-over-year basis by 220 basis points. While we had hoped that the lower international margins we experienced in the second quarter would show improvement in the last half of the year, we are disappointed that we've not been able to change this unfavorable trend.

In addition to the inflationary pressures I've already discussed our international gross margins continue to be pressured in part by an unfavorable product mix with significant increase in sales of long-term care bed platforms in Europe and negative foreign currency impact of the strengthening euro on products sourced from France and sold in countries with a different functional currency.

Cost increases and lower than expected margins on a number of recently introduced products and to a lesser degree, the continued inventory adjustment associated with excess and obsolete inventory. We have a number of actions underway to improve international margin levels and expect a rebound in fiscal 2009, including the actions Peter and I have already mentioned, plus cost improvements on new products and exiting of older, lower margin products.

As I mentioned, despite these negative pressures, capital sales gross margins in our North America Acute segment increased 50 basis points due primarily to higher prices and favorable sales mix driven primarily by the launch of our new TotalCare Connect ICU platform in March. In addition, gross margins within our Post-Acute segment were up 220 basis points, principally due to higher margins on new product introductions, improving sales within our respiratory and home care businesses and the benefits of profit improvement initiatives for specific customers and product lines. I will discuss the impacts of inflation on our guidance for capital margins near the end of my remarks.

Hill-Rom rental gross profit increased 16.8%. Despite fuel inflation, third quarter gross margin improved to 160 basis points year-over-year to 52.4%. This improvement results from the increased rental volumes, combined with continued positive leverage of our field service organization, various profitability improvement activities and the higher product margins we are experiencing on new product introductions.

Looking forward, we continue to be positive with respect to our rental operations and see additional opportunities that levers and improve field service organization cost, despite the margin pressure associated with higher fuel costs necessary to operate our field service network.

Now I would like to move on to operating expenses. For the quarter, we saw an overall increase of approximately 10% to $137.3 million. As we have predicted in previous calls, we are beginning to see the improvement in operating expenses as a percent of revenues from 37.9% to 37.4% on a year-over-year basis.

Looking at the various components of our operating expenses, selling expense increased 11.9%, generally in line with the increase in revenues. Variable compensation drove 25% of this increase while the headcount additions to the sales channels at the beginning of fiscal 2008 generally contributed the rest of the increase over the prior year. Marketing expenses also increased year-over-year, up 24%, primarily related to the significant rollout of new product launches.

G&A expenses increased just under 5%. As mentioned previously, we are in the process of revisiting and analyzing our investments and our G&A structure with the intent to shift some of these investments, if necessary, streamline the organization and to leverage operating expenses moving forward.

R&D spending have remained consistent during the current fiscal year which results in strong increases year-over-year in accordance with our plan. We currently are spending in a range of 4% of revenues and over the long-term hope to increase this percentage to an excess of 5%. R&D spending for the quarter was up nearly $2 million over the prior year comparable period or 16%.

Although our investments in new and enhanced products have been a key component of our revenue growth, during the quarter we did appoint a new leader of our R&D efforts who is focused on improving the yield of these investments which includes the startup of our Singapore innovation center.

On an as adjusted basis, excluding the affects of prior year separation costs, operating profit increased to $23.3 million, up 11.5% from the prior year. We are beginning to see the benefits of the past year's strategic investments with our first year-over-year improvement in operating profit since the adoption of our current strategy. We are excited about reaching this inflection point in our journey and look forward to continuing improvement in operating results as we move forward.

Moving to tax rate, the effective income tax rate for the company's continued operations for the third quarter was 2.3% compared to 35.4% in the prior comparable period. The lower rate in the current year is due primarily to favorable discrete period tax benefits of $7.8 million, recognized in the quarter. These tax benefits related primarily to the net release of valuation allowances on our foreign tax credit carry-forwards and the recognition of certain previously unrecognized tax benefits associated with the completion of the federal audit of the company's fiscal years ended 2004 to 2006. This compares to an immaterial amount of favorable discrete period tax benefits recorded last year.

Looking forward, we believe that our full year effective tax rate should be approximately 29.9% on a continuing operations basis, reflecting discrete items recognized to date, but excluding the impact of future discrete items. With the schedule conclusion of several tax audits and the expiration of various state statutes in the fourth quarter, we generally expected any additional discrete items to be favorable to our tax rate.

Adjusted earnings per share were $0.34 per fully diluted share in the third quarter of fiscal 2008, compared to $0.18 per share in the prior period. The increased earnings per share results related to improved operating results discussed above, as well as to the very favorable tax rate for the quarter. A reconciliation of these amounts to GAAP earnings per share is provided in the appendix of the earnings release slide deck and the earnings release itself.

Now I would like to take a quick look at free cash flow, which we define as cash flow from operations less capital expenditures. As noted on the slide, we continue to show improved quarterly year-over-year free cash flow. As we outlined in our last call, we expected third quarter cash flow to come under pressure as we had significant payables outstanding at the end of the second quarter related to our international business and for non-recurring separation costs.

The decline in international payables totaled $11.5 million for the quarter and payments of separation costs totaled $17.3 million for the quarter. Despite that, increased net income continued improvement in accounts receivable and inventory returns over year-over-year, and slightly lower capital expenditures in the current year resulted in slightly improved free cash flow. On a year-to-date basis, free cash flows have improved to $97.4 million, an increase of $92 million from the prior year.

Now a few comments on liquidity and capital resources. Overall, we continue to have solid liquidity, and to maintain strong balance sheet from which we can carry out our strategic plan. In light of the continuing liquidity issues associated with auction rate securities, we reclassified such securities in the current quarter from short-term investment to long-term. As of June 30th we continue to hold $46.2 million of AAA rated student loan auction rate securities. These securities are stated net of a $1.5 million unrealized loss, related to an assessment of the fair value of such securities, consistent with the prior quarter.

We continue to be optimistic regarding our ability to fully recover our investments in these securities and we have the ability and intent to hold them until market conditions improve. During this past quarter, we collected approximately $2.4 million of these securities and additional $1.3 million in July.

Now let's move to an update of our 2008 guidance. Based on the strengths of revenues in the third 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 raising the guidance for healthcare sales with an updated guidance of $1.040 billion to 1.051 billion which represents a year-over-year growth of 10.5% to 11.7%.

After increasing guidance last quarter end, we will reaffirm our previous guidance for healthcare rental revenues of $455 million to $464 million. As such, total revenues will increase to $1.495 billion to $1.515 billion a growth rate of 10.2% to 11.7% over the prior year.

As previously covered due to the year-to-date results, segment mix pressures, international near term margins and our expectations of continued inflationary pressures, on commodities and fuel cost, we are adjusting our healthcare sales gross margins downward to 40.5% to 41.5% from the previous 41.9% to 43.2%.

Although we continue to expect inflationary pressure in fuel costs, due to year-to-date results and our expectations to execute on additional opportunity to leverage and improve our field service organization costs, we are raising our previous guidance for rental gross margins to 52% to 53%, from the previous guidance of 50.8% to 52.5%.

Also, our effective tax rate excluding the benefits of discrete tax items, will improve to 35.3% for the year. If the favorable impact of discrete tax items recognized on a year-to-date basis were considered, the effective rate excluding in future discrete items would approximate 30%. This rate does not include any benefit which will occur if the Congress reenacts R&D tax credit which right now appears unlikely for our fiscal year which ends on 9/30.

Overall, our guidance for adjusted earnings per share increases to $1.33 to $1.43 from the previous $1.18 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, 2008 is an inflection year and the exact timing of the benefits of our strategic investments may vary. That said, despite expected inflationary pressures and lower international margin during the third quarter we have turned the corner with our accelerated sales growth translating to higher year-over-year profitability. As our guidance implies we expect to continue to see increased returns from our strategic investments during the fourth quarter and we look forward to sharing those results with you.

With that I'll turn the call back over to Peter. Peter?

Peter Soderberg

Thank you, Greg. Let me wrap up the prepared portion of our remarks with a few observations. As some of you know, I am quite a baseball fan. If you'll indulge me I'll use a baseball metaphor to characterize where I think we are in our journey to create and sustain the new Hill-Rom as an engine to deliver shareholder value. We're now beginning the middle innings of our ballgame. We've been successfully executing the strategy we first laid out in the fall of 2006 and began to implement in our events during fiscal year 2007. We're following our game plan and tweaking it as required. We're hitting singles and doubles and on occasional home run, such as with successful separation of our two operating companies.

The game plan is a straight-forward Medtech strategy, identify solid growth markets that leverage our brand and capabilities, invest in innovation and product and service differentiation, build and maintain world class sales and distribution channels with the like customers and drive operating efficiencies across the P&L. We are steadily improving our stewardship of the balance sheet and we'll use it strategically to generate value for shareholders.

After assembling a new lineup early on, drafting some great additions along the way, developing talent already on our bench, we like our team. We now have a solid management group reflecting extensive Medtech experience. The next phase is to infect the entire organization with a passion to perform and continue to increase team speed. Just as great baseball teams usually find ways to win the tough games, we at Hill-Rom have a variety of levers we can pull in order to ensure that we meet our sales and profit growth goals, and we're not hesitant to pull them.

Thanks for your interest. We now have time to take plenty of your questions.

Question-and-Answer Session

Operator

(Operator Instructions). And we'll hear first from (inaudible) at Oz Capital.

Unidentified Analyst

Hey, guys.

Greg Miller

Good morning, Jim. How are you?

Unidentified Analyst

Good. How are you?

Greg Miller

Good.

Unidentified Analyst

Good. I had a quick question on the guidance for 2008, right. So it seems to me that if you look at it and you kind of back into the fourth quarter guidance, you're getting a pretty material uptick in EPS over last year, and I think it's something in the mid-50s in terms of cents per share. I guess you're also assuming that gross margins expand 240 basis points, kind of over 2007, and 150 basis points sequentially. If you're continuing to talk about the strong growth from international, which is great but coming at a lower margin and the raw materials and increased R&D spend, I am just kind of curious, like how are you getting that kind of leverage? Where is all the leverage coming from for the fourth quarter?

Greg Miller

This is Greg. I mean a couple things. First of all, in the last quarter of last year, we did have some receivable write-offs that were over $7 million, so part of is that just not having to write-off receivables again this current year.

Unidentified Analyst

Okay.

Greg Miller

In addition, during the current quarter, the fourth quarter we generally have a much larger sales time, so that allows for the lever down the income statement, and so you're seeing some pick-up from that, and then when take a look at margins, we are seeing mix-up in our products. We just introduced a number of new products including our TotalCare ICU product which do carry on average higher margins than our overall margins. So, as we look at the fourth quarter and look at what we knew, and with our new products and some of the leverage that we can gain off the increased sales, that's where the numbers came out.

Unidentified Analyst

Okay. And then, I guess one other question, just on the international division. So, obviously you guys are growing very well there, both this quarter and last quarter, and I am just curious if this level of growth is sustainable, clearly, it's great from a top line perspective, but it's obviously like you talked about having a bit of a negative impact on the margin. So, I just want to get a sense of how much longer, or how strong you think this can grow into the future once you start comping these 20%, 30% type numbers.

Peter Soderberg

Jim, its Peter. Obviously, to keep this kind of tour pace, we're seeing in international, particularly in Europe is not sustainable. We've had a great expansion into medicalized long-term care and you're seeing the early efforts against very low basis to penetrate that category, which frankly is bigger than hospital beds in Europe. So we think that rate of growth will obviously slow. I think the performance of the AvantGuard 800 has obviously been very excellent, but is unlikely to continue as it matures as a product. So we'll be taking actions to update and replace that product.

So, Europe, I would think is going to slow fairly significantly. Having said that, we have huge opportunities in other parts of the world and we're putting a lot of time in the Middle East, lot of time in Asia. We made a couple of management changes in Asia and Australia and pretty excited about what's possible there. Our alliance with Paramount, Japan still early days. We continue to work that. But, I think our forward plans are a much more reasonable level of growth in Europe and starting to see strong momentum from other parts of the world.

Unidentified Analyst

Right, okay. and I just had one last one. In every presentation that you guys have given I think since you introduced the sort of restructuring plan you've included the slides that have a lot of the long-term goals on it, which included the gross margin expansion plan of I think 400 basis points by 2010. I notice that it wasn't in this presentation, and I am not sure whether I should be reading anything into this. You spent a lot of time talking about the pressures that you're seeing on the margins and also some of the opportunities that you see on the margins, but you never said we're reaffirming that guidance for the 2007 to 2010 400 basis points of gross margin improvement.

Greg Miller

Well, remember I talked about the levers we pull to deliver on profit.

Unidentified Analyst

Right, but on gross margin.

Greg Miller

If you walk down the indices, the five indices we've provided in our road show, we talk about sales growth, I think check that one off. We talk about that gross profit growth, we check that one off. We talk about operating income and EPS expansion.

The gross margin percent is the one that temporarily is suffering, number one, from mix. I think mix is the overwhelming impact, the mix from international and the mix down in international and number two from inflation.

You can see some bumps along the road and obviously if we are going to back-off gross margin percent and tweak gross profit up because of our high growth, and when we see you in October we'll update our thinking. But again, we're not concerned with the overall picture that we've painted for you.

Unidentified Analyst

Okay. Well, great, guys. I appreciate the time.

Peter Soderberg

Thanks for the question, Jim.

Operator

Next question comes from Ian Zaffino with Oppenheimer & Company.

Ian Zaffino - Oppenheimer & Company

Hi, guys. Thank you very much.

Peter Soderberg

Good morning.

Ian Zaffino - Oppenheimer & Company

Good morning. When you talk about the strong environment, are you talking about specifically what you're seeing from hospital spending or is that more attributable to any type of stemming really the market share loss in some of your products or is it more of like a share change or is it more of just the overall environment being robust as you described?

Peter Soderberg

Well, Ian, thanks for calling. I think it's a little bit of both. I do think that with the increased pressure on hospitals to focus on hospital induced events, I think we're seeing a tremendous realization that the technology in place, which averages 10 to 15 years old, doesn't begin to meet the needs that today's technology does. So, I think what we do, patient support systems is kind of moving up the food chain in terms of priority.

So on October 1, as you know, the CMS no pay policy goes into effect on some of the hospital's business. So clearly, we've seen an awful lot of interest in how to mitigate the impact of that rule change. So, we clearly look at our quotation pipeline, our order pipeline, our shipments as lead indicators and we don't really see a material change in rate there. In terms of our performance, I think we're getting better. We're not where we want to be, but the trends are positive and we're putting a lot of investment into making sure that those trends continue.

Andy Rieth

Ian, this is Andy. One other thing I'll add to that is, many of you probably have seen the new CMS proposed Reg come out for October 1, 2009 and that continues this path that CMS and Medicare are taking clearly toward trying to incent hospitals through reimbursement to avoid avoidable kinds of adverse events and injuries and things like that. So, we think this march toward trying to tackle avoidable events will continue.

Ian Zaffino - Oppenheimer & Company

Okay. And then, just one other question here. On your increase of the healthcare sales, how much of that is foreign currency, how much is led to the commodity inflation, and how much is actual true I guess of organic growth?

Peter Soderberg

Are you referring to our International Surgical segment and capital?

Ian Zaffino - Oppenheimer & Company

Well, when you increased your healthcare sales, you talked about the growth, what are the components of that between pricing and volume or any type of currency fluctuations?

Peter Soderberg

Well, the third quarter results on capital sales for international were $82.4 million, which was a 27.6% year-over-year change as reported and a 19.7% constant currency growth and that was all organic.

Ian Zaffino - Oppenheimer & Company

Okay. All right. Thank you very much.

Peter Soderberg

Thank you, Ian.

Operator

Next question will come from Steve O'Neil at Hillard Lyons.

Steve O'Neil - Hillard Lyons

Hi, good morning.

Peter Soderberg

Good morning.

Greg Miller

Hello, Steve.

Steve O'Neil - Hillard Lyons

One quick question and Greg touched on this with regard to separation costs. A year ago for the combined company, there were $6.2 million of separation costs and you all probably explained this but can you review where those costs are?

Greg Miller

This is Greg. Just to make sure I understand the question, $6.2 million a year ago, you're asking me to explain what those were?

Steve O'Neil - Hillard Lyons

Well, I mean they're not mentioned in the year ago report. I mean, in your current press release the year ago figures do not refer to any separation costs.

Greg Miller

Okay. Because year ago we were combined company, so any separation costs that we experienced as the combined company is down in disc-ops right now. So that's why you're not seeing that commented on. The $6.2 million from last year is in disc-ops. So, I don't know if that's creating…

Steve O'Neil - Hillard Lyons

So, they are neither in the Hillenbrand report, nor in your records, it is just sort of floating in limbo somewhere, I guess this is what I am asking?

Greg Miller

Well, there are no disc-ops . They are not floating in limbo. They are down in our disc-ops of our income statement. They are not in our continuing ops. So, from continuing ops earnings per share perspective, they wouldn't impact that. I will remind you that year-to-date we have $10.6 million of costs in the current year, which happened primarily in the second quarter.

Steve O'Neil - Hillard Lyons

Okay. And of course you don't show discontinued operations in your press release. I guess will that be in the 10-Q?

Greg Miller

Yeah, it will definitely be in the 10-Q. You'll see the footnote on disc-ops and separation costs.

Steve O'Neil - Hillard Lyons

And then one other question, this is sort of an anecdotal thing. Here in Louisville, our [bed] hospital recently expanded its capacity, building a new 130 bed wing. In a tour of that facility, every single bed in there was a Striker bed. And I realize this is just anecdotal thought but it made me think and I wanted to see if you would just review where you overlap or where you compete with Striker and what some of the key products are?

Peter Soderberg

Yeah, well, I am disappointed about your Louisville experience.

Steve O'Neil - Hillard Lyons

Actually that was anecdotal. I am sure that doesn't apply to everything. I was in there, expecting to see a bunch of Hill-Rom beds, and I didn't.

Peter Soderberg

Well, I think typically, if you looked at the relative installed base, you probably are more likely to see Hill-Rom. However, Striker has done a great job as we've said frequently. I think if you looked at the two companies, where we are the same is certainly in North America, we both provide hospital beds and the surfaces that go on them. Striker has the kind of position in stretchers, they have a leadership position there and we have strong leadership position in the higher end of higher acuity segments in the hospital.

We have a pretty significant therapy, rental business. We've talked about in our calls and I think that's an important way to introduce new technology. Striker has an EMS business that we noted in their recent call is growing the fastest of their medical segment. So, I have kind of reading between the lines, I think we're bringing into better balance, our relative performance. We don't compete in the EMS market. We both have architectural products and furniture and we have a health IT unit that is differentiated. And overseas it's little bit of a more complex picture.

Steve O'Neil - Hillard Lyons

What is your key product I guess that would be versus their standard product? Is it the VersaCare?

Peter Soderberg

Our probably most widely distributed and largest product is VersaCare, which is a higher acuity med-surge. As acuities rise in hospitals and these patients get sicker, they need more technology. Clearly, the TotalCare at ICU is the high performance product and the highest acuity settings and that's done very well. We've really refreshed that product. We've had tremendous acceptance of the refresh product as our comments would indicate.

Steve O'Neil - Hillard Lyons

Thanks for your thought.

Andy Rieth

Sure, hey, Steve, this is Andy. Obviously we can recite numerous wins that we have in the marketplace as well. And as Peter mentioned, global must not have been one of them. But that said, I do think that we have seen the competitive stature of our products improve dramatically, both because of the product introductions themselves as well as this increased sales channel. We certainly do not want to minimize that impact. We were being out shouted by more feet on the street by the other guys and we think we have addressed that to a large extent.

So it is a competitive marketplace out there, and we like our lineup as you heard and we'll continue to get some of those wins. So, if there is anything you can do to help us down there in Louisville, let me know.

Steve O'Neil - Hillard Lyons

I am not trying to cast a negative light on your market share. It made me think about the competitive dynamics and I thought I would take the opportunity to ask.

Andy Rieth

You bet.

Steve O'Neil - Hillard Lyons

Thanks very much.

Peter Soderberg

Appreciate it, Steve. Thank you.

Operator

(Operator Instructions). Alex Schmelzer with Scoggin Capital, your line is open.

Alex Schmelzer - Scoggin Capital

Hi, guys. I have a question on table 10, I was a little confused. You had EPS from continued ops as adjusted $0.34 for the quarter. That includes the tax gain, right?

Greg Miller

That's correct, and we highlight that in our earnings release.

Alex Schmelzer - Scoggin Capital

Okay. So it's $0.22 without that?

Greg Miller

Well, that would be the math.

Alex Schmelzer - Scoggin Capital

And then, on the guidance for '08 as you increased the guidance that is also including the tax gain?

Greg Miller

It includes the year-to-date discrete tax gain, correct.

Alex Schmelzer - Scoggin Capital

Okay. So in essence, the earnings per share doesn't really change from the prior quarter, if I eliminate the tax gain?

Greg Miller

We have narrowed the earnings per share around the previous mid-point effectively.

Alex Schmelzer - Scoggin Capital

Okay. Then I just had a question, you have a chart on 21 where you have the operating profit margin. I got a little confused. For Q4 of '07, in other words, as I look to Q4 of '08, I am trying to understand what I am up against. The 9.1% EBIT margin is for 2007 or 2006.

Greg Miller

I am sorry. I am not where you're at.

Alex Schmelzer - Scoggin Capital

I am on table 21 of the chart. It says "Operating Profit * Investment Payoff".

Greg Miller

Okay. What's your question again?

Alex Schmelzer - Scoggin Capital

It says 9.1% EBIT margin in Q4. I can't tell if that's for 2006 or 2007.

Greg Miller

That would be the fourth quarter of 2007.

Alex Schmelzer - Scoggin Capital

Okay. So, I am actually just looking at Ian's model. He has a 10.6% EBIT margin for the fourth quarter of 2007. that's incorrect?

Greg Miller

I will tell you that our number of 9.1% is the EBIT margin for fourth quarter 2007.

Alex Schmelzer - Scoggin Capital

Okay. So, then, again, I think you address an earlier question, to generate the $50 million in EBIT in the fourth quarter I guess the math makes sense, Ian here, probably just as correct, has a 12% margin. So, what I thought was a 150 point increase is actually a 300 basis point increase year-over-year, Q4 coming up versus Q4 of last year and given that the Q3 EBIT margin was flat year-over-year, and the commodity pressures, can you just explain again where you're going to get the 300 basis point improvement?

Greg Miller

Well, I think we've had already answered that question in regards to simply last year we had accounts receivable write-offs, so we are not going to repeat this year. We've had new products introduced, and as we took a look at our mix of products that we are planning to sell in the fourth quarter, that's how we predicted our margin.

Alex Schmelzer - Scoggin Capital

But didn't you have all those new products in this quarter and yet it didn't improve the margin, because I am reading your --.

Greg Miller

We just rolled out a number of new products, the ICU product just rolled out in March, so it's accelerating and I will also remind you that fourth quarter sales do increase the leverage on our income statement, and one other reminder --.

Alex Schmelzer - Scoggin Capital

Well, no, that I understand. But I am just comparing apples-with-apples. So, it also has leverage in Q4 of '07.

Greg Miller

Well let me remind you, in Q4 of '07 we were ramping up our spending increase and you've seen the benefit that we've seen over the last couple of quarters on the top line that we're seeing right now, so all that combined, that's where we're at.

Alex Schmelzer - Scoggin Capital

You're comfortable with the 300 basis point improvement?

Greg Miller

We're comfortable with our guidance.

Alex Schmelzer - Scoggin Capital

Okay. And then just one more question, I know in the original slide you had, your North American Acute Care. You expect it to grow at 4% to 7%, it grew 3.5%., where was the shortfall there?

Peter Soderberg

I think your math is wrong. I think North America Acute Care grew 5.7%.

Alex Schmelzer - Scoggin Capital

I think actually I am talking about sales, not rentals.

Peter Soderberg

Well, our original guidance was 4% to 7% for North American Acute Care on the road show, is that what you're talking about?

Alex Schmelzer - Scoggin Capital

Yeah.

Peter Soderberg

Yeah, that's a blended number.

Alex Schmelzer - Scoggin Capital

That's blended for rental and sales, got it. So, you're in there, got it. Okay, great. Thanks very much.

Greg Miller

Thank you, Alex.

Operator

Greg Halter at Great Lakes Review, your line is open.

Greg Halter - Great Lakes Review

Thank you for taking the question. Relative to your share repurchase, just wondering if you bought any shares in the quarter.

Greg Miller

The answer is no.

Greg Halter - Great Lakes Review

Okay. And I think you still have maybe 3 million shares authorized, is that correct?

Greg Miller

That is correct. Our Board has authorized for us to buy up to 3 million shares.

Greg Halter - Great Lakes Review

Okay. And given the strength of your balance sheet and the cash flow that you have been able to generate, notwithstanding this quarter, just wondering what your thoughts are on buying the stock, given where the price has been over the last three or four or five months.

Greg Miller

I appreciate the question. I mean, as we take a look at where our cash is and a reminder that we're four months into a spin and so this past four months we've spent our time while working our way through separation items including the final payment of our separation cost and our first quarterly dividend. And quite frankly with the volatility of our capital markets, led us to keep our powder dry during these early days, if you will. But, that being said, as we look forward our priorities are consistent with what we've been saying, continue to invest in the business. We have our quarterly dividends. We do expect to have opportunities in M&A to grow our revenues 2% to 4% which we talked about during the 2007 to '10 time period, and share repurchases as well. And so that is definitely on our forward-looking view of how we'll use our cash.

Greg Halter - Great Lakes Review

Okay. And I believe in exchange for the competitive bidding situation, that there is I think a 9.5% reduction in certain items beginning January 1 of '09. Just wondering what kind of impact that may have on your particular business?

Andy Rieth

Thanks, Greg. This is Andy. That is correct. That is the compromise that was struck in order to delay that competitive bidding program. It was not implemented obviously July 1 as it was initially planned. By the way, we have been successful in bidders in all of the areas where we had wanted to experiment with that bidding opportunity. The 9.5% across the board, we believe has gone into effect. It does not really affect us much because we have such small exposure to that business, particularly in the test markets where that's being applied and so forth.

So I think that where that's hitting us, we have relatively limited exposure based on our Post-Acute business. Remember that competitive bidding program only applies to Medicare supported home patients. Okay. So it does not affect the hospital business and it only affects those patients supported by Medicare in a home environment.

Peter Soderberg

Let me add to what Andy said, maybe provide a little clarification. What we offer to the home are group one, two and three surfaces and just recently we've started to offer bed frames. So what's impacted here are bed frames where our sales have been virtually zero historically, as well as group one and group two surfaces. I think the impact for us will be on our Medicare as Andy said, our national sales of group two principally surfaces. So those sales are likely to see that kind of top-line reduction but in the scheme of things, it's quite a small component of our total sales.

Greg Halter - Great Lakes Review

Okay. That's good to hear. The streamlining of the organization that you talked about in the press release, I don't know if it's too early to indicate, what the amount of that charge may be. I think you had said about 3% of the salaried workforce or 150 folks.

Peter Soderberg

Yeah. It's 3% of the professional and non-exempt force and we'll be reviewing the particulars with our Board and probably communicating to everybody involved, including shareholders, as soon as we've gotten a green light from the Board.

Greg Halter - Great Lakes Review

Okay. And one last one for you. Any thoughts on your capital spending for this year, which there is only two months left and then any early thoughts for fiscal '09?

Greg Miller

We will provide fiscal '09 in October as Andy had talked about, but currently our previous guidance we had I think $115 million of CapEx out there and I will tell you that we will probably not spend that much. We'll probably be $5 million to $10 million less than that.

Greg Halter - Great Lakes Review

Okay. Great, Thank you.

Andy Rieth

Thank you, Greg. Appreciate it. I think given the time, we've got time for two more questioners. Please go ahead, operator.

Operator

We'll hear next from [David Hart] with [Apelles Investment Management].

David Hart - Apelles Investment Management

Hi, thanks for taking my call.

Andy Rieth

Good morning.

David Hart - Apelles Investment Management

Good morning. Two quick questions. Can you just comment, as you look back on, in 2008, in terms of the top line growth, what portion of that growth is attributable to volume and what portion would be attributed to pricing?

Greg Miller

Yeah, this is Greg. I mean, I don't have the specific breakouts in front of me. I will tell you the vast majority of it is volume, although we have been able to get price in North America, and our 10-Q, we do comment on it, but I do not think we break those out either. So, I will tell you that the majority of it is volume, with some price in North America Acute specifically.

David Hart - Apelles Investment Management

Okay.

Peter Soderberg

David, one thing to amplify. When we talk about price, please note that, price often times includes mix changes as opposed to, specific product line item increases. But, volume has been the driver and new products that we've been talking about has been the big driver.

David Hart - Apelles Investment Management

Okay. Great. As we look at Q4, have you given any guidance as to free cash flow?

Greg Miller

We do not typically give guidance on free cash flow.

David Hart - Apelles Investment Management

Okay. Great.

Greg Miller

I just gave the CapEx number, so you could probably calculate it pretty close.

David Hart - Apelles Investment Management

Thanks.

Andy Rieth

Thank you.

Operator

Our final question today is a follow-up coming from the line of Steve O'Neil.

Steve O'Neil - Hillard Lyons

Good morning again.

Peter Soderberg

Hi, Steve, what's up?

Steve O'Neil - Hillard Lyons

Well to use your baseball analogy I am going to hang a curve ball over the plate and ask you about tax rate. The discrete item you mentioned and the $0.12 per share in the quarter, I would ordinarily just exclude those but I am thinking, nowadays companies used to be able to accrue taxes with the thought of what their tax rate might be for the full year. I don't think they're able to do that now, and so I've observed greater volatility in the quarter-to-quarter tax rate due to discrete items, that if you had some idea going into the year that you were going to get these items, you might estimate a lower tax rate in early quarters. And I am just wondering if you could discuss that. Because if you're looking at a tax rate below 30% for the year, might you have accrued differently and maybe the first and the second quarter, meaning maybe those quarters' earnings might be understated. Just like your thoughts on that?

Greg Miller

Without getting into specific details as far as accounting and all that, you're exactly right. You used to be able to smooth the tax rate over the year to where you thought your targeted rate was for the year. FIN 48 accounting pronouncement came out and it basically has created this volatility that you see, not only with us, but with a lot of other companies. So the accruing or non-accruing is specific to whatever period and what you know as of that date, including the events that will happen from time to time with the IRS, which aren't always predictable or consistent.

So what you're seeing and what we're trying to break out for example with that $7.8 million is some of the tax items that have been resolved. For example, the 2004 to 2006, which makes up about 50% of that amount, tax returns, where we basically settled our tax returns with the Federal IRS as far as the audit is concerned, they're complete. So any FIN 48 reserves that we had established for items that could have been debated that came out favorably, that's what you saw come through the income statement, as an example.

So being our footnotes of the 10-Q, you could read that. It talks about the next 12 months and some of the items that might be coming up the next 12 months to allow you to try to interpret that. But to be honest, I think that we try to break them out for your better understanding.

Steve O'Neil - Hillard Lyons

I know you haven't given 2009 guidance. Any thoughts on what kind of a tax rate we might expect from Hill-Rom going forward?

Greg Miller

Well, I will just tell you that our current year without the discrete tax items I think I said was 35.3%.

Steve O'Neil - Hillard Lyons

Thank you.

Andy Rieth

Thanks, Steve. Operator, I think that was our last caller.

Operator

Correct, gentlemen. Do you have any further additional or closing remarks?

Andy Rieth

No. I think that should wrap it up at this point in time. I want to thank everybody for being on the call and again, also remind you to save the date for October 7 in New York, and appreciate all the interest. Thank you very much.

Operator

Ladies and gentlemen, that does conclude Hill-Rom Holdings Q3 earnings conference call. We thank you all for your participation. You may now disconnect your lines and have a great day.

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Source: Hill-Rom Holdings Inc. F3Q08 (06/30/08) Earnings Call Transcript
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