Owens & Minor's CEO Discusses Q3 Results - Earnings Call Transcript

| About: Owens & (OMI)

Owens & Minor, Inc. (NYSE:OMI)

Q3 2012 Earnings Call

October 30, 2012 8:30 am ET

Executives

Craig Smith - President & Chief Executive Officer

Trudi Allcott - Director, Investor & Media Relations

Jim Bierman - Executive Vice President & Chief Operating Officer

Drew Edwards - Vice President, Controller, Chief Accounting Officer & Interim Chief Financial Officer

Brian Shotto - Senior Vice President, Specialty Services

Analysts

Joel Ray - Davenport

Evan Stover - Robert W. Baird

Stephan Stewart - Goldman Sachs

Operator

Good morning ladies and gentlemen and welcome to Owens & Minor Third Quarter 2012 Earnings Conference Call. My name is Huie, and I will be your operator today. At this time, all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference call. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's call, Mr. Craig Smith, President and Chief Executive Officer of Owens & Minor. Please proceed, sir.

Craig Smith

Thank you, Huie, and good morning, everyone, and welcome to the Owens & Minor third quarter 2012 conference call. We do realize a lot of you are currently coping with Hurricane Sandy, so we appreciate your participation on the call today.

In events of a storm as we always do, we made every effort to ensure that our customers were care of and that our hospitals receive their emergency orders ahead of a storm. We believe that our customers and our teammates are in good shape to weather this hurricane and we hope that you are taking every precaution as well.

Now, we'll review our results and take your questions in a moment, but first let me introduce my colleagues on the call today. Jim Bierman, our Chief Operating Officer, Drew Edwards, our Interim Chief Financial Officer, Grace den Hartog, our General Counsel and Brian Shotto, Vice President of Specialty Services, who is available to answer your questions.

Now before we begin, Trudi Allcott, from our Investor Relations team will read a Safe Harbor statement. Trudi?

Trudi Allcott

Thank you, Craig. Our comments today will be focused on financial results for the third quarter of 2012, which are included in our press release. In our discussion today, we will reference certain non-GAAP financial measures. Information about these measures and reconciliation to GAAP financial measures included in our press release and in the supplemental slides, which are posted on our website, where we will also archive the webcast of today's call.

In the course of our discussion today, we may make forward-looking statements. These statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Please see our press release and our SEC filings for a full discussion of these risk factors.

Finally upcoming investor events are provided in our press release, but as a reminder we will have or Annual Investor Day in New York, on Thursday November 29th. You can find the registration link on our website, and we do hope you will join us. Thank you. Craig?

Craig Smith

Thank you, Trudi, and I would like to call Andrew Edwards, our Interim Chief Financial Officer to brief us on the numbers and then Jim will provide us an operational overview. Let's start with Drew.

Drew Edwards

Thank you, Craig, and good morning, everyone. With the acquisition of Movianto, our third quarter financial results require more explanation than in past quarters. We will now report consolidated results along with two reporting segments. International and domestic.

Our new international business segment is comprised of Movianto, while our domestic segment is comprised of existing operations. I'll start with consolidated results and then move to a discussion of each segment. In addition, my discussion of adjusted consolidated results will exclude the after-tax acquisition related cost of $0.10 per share for the third quarter and $0.11 per share year to-date.

By definition, our segment operating earnings or losses exclude these acquisition related costs. Adjusted EPS declined to $0.49 in the third quarter of 2012 from $0.53 in the third quarter of last year due to a 7.3% or $4.3 million decrease in consolidated adjusted operating earnings. This decrease resulted primarily from lower domestic gross margin of $8.2 million and an operating loss of $626,000, for the international segment partially offset by lower domestic segment SG&A of $6.6 million. In addition, for comparison sake, the third quarter 2011 included income of $2.2 million related to the settlement of a lawsuit.

Moving onto results for the international segment, which includes only one month for Movianto since it was acquired on August 31st. The Movianto operating loss of $626,000 was comprised of revenue of $49.7 million, gross margin of $19.6 million, SG&A expenses of approximately $19 million and depreciation and amortization of $1.3 million. September is traditionally a high volume month in preparation for the flu season.

Seasonality impacts both, revenue mix and margins. Accordingly September results cannot be simply extrapolated to obtain annual amounts. For example, we explained last quarter that annual revenues for Movianto in 2011 were approximately €300 million.

I would like to point out that our consolidated income tax provision is now based on separate domestic and international computations. Determining the effective tax rate on international earnings or losses is complex as accounting rules limit the recognition of income tax benefits on lawsuits that are only realizable in the future.

For example, in September, we recognized an income tax charge of $100,000 for international segment despite a $626,000 operating loss. On a long-term basis with all European entities generating income, we would expect the effective tax rate for the international segment to be below the U.S rate of 35% due to lower local tax rates and structure factors, we will provide more information on the outlook for the international segment at Investor Day.

Turning now to the balance sheet. The international segment had $161 million of net assets at September 30th, comprised of $410 million of operating assets and $249 million of operating liabilities. Total assets include preliminary goodwill of $36 million and intangibles of $24 million.

Another impact of the international segment were consolidated balance sheet relates to other current assets and other current liabilities. These line items include international segment financing receivables of $125 million and related financing payables of $118 million associated with in-voicing and collection services provided to our manufacturing customers. Fees for these services are recognized on revenue. For clarity sake, product sales and cost related to this inventory are not included in the income statement.

Moving onto the domestic segment. For the third quarter, domestic operating earnings were $55.1 million, down $3.7 million versus last year. This decline resulted primarily from lower domestic segment gross margin of $8.2 million, partially offset by SG&A that was lower by $6.6 million.

This quarter, the $8.2 million decline in domestic segment gross margin was predominantly due to the decline in revenue of $46.5 million, including declines of $29.5 million from existing customers, $13.7 million from net loss customers and $3.3 million from lower fee-for-service revenue.

The domestic segment gross margin percentage was 9.79% in the third quarter of 2012, a decline of 16 basis points versus last year due mainly to lower fee-for-service revenue including OM HealthCare Logistics, which had higher fees last year from higher cost incurred to convert a large new customer.

We continue to be pleased with our ability to manage our Domestic segment SG&A. For the third quarter, Domestic SG&A was 6.86% of revenue versus 7.02% last year. On a dollar basis, Domestic segment SG&A for the quarter was lower by $6.6 million. This improvement resulted from lower fee-for-service SG&A of $4.5 million and lower SG&A unrelated to fee-for-service operations of $2.1 million, which declined due to lower incentive compensation and benefit cost and our organizational realignment in the fourth quarter of last year.

The net impact of changes in domestic segment depreciation and amortization and consolidated net interest expense was insignificant for the quarter compared with last year. Substantially all of their interest cost relates to domestic debt outstanding.

The effective tax rate excluding the international segment and the impact of acquisition related cost was 38.7% for the third quarter compared with 39.4% last year. The decline relates to the recognition of tax benefits in the third quarter of this year for the exploration of the statute of limitation for the 2008 U.S. Federal income tax return.

Our domestic effective tax rate excluding special items is expected to stay in the range of 39% to 39.5%. Domestic segment working capital ratios included DSO of 20.7, inventory turns of 10.2 and days payable outstanding of 27.1, all within the ranges that we've seen over the past four quarters.

Thank you. Now, I will turn it over to Jim for his remarks.

Jim Bierman

Thank you, Drew, and good morning everyone. With that, first look at our results I would like to provide further insight into our financial performance.

Revenue growth in the domestic segments so far this year has been hampered by the combined effect of ongoing weakness in utilization and little to no product price inflation. As we told you last quarter, we targeted that for the second half of this year, revenue growth would be flat. That is exactly what we saw this quarter with our large IDN customers.

The factors contributing to the quarter's results were weaker healthcare utilization trends, little to no product price inflation, a reduced level of purchasing activity from the federal government and ongoing rationalization of the company's supplier base. We would reiterate that we expect to see similar conditions with similar results in the fourth quarter of this year.

As we think about revenue, we must also think about its impact on operating margin and its components. In analyzing the domestic gross margin results, we would note that we reported a sequential increase in gross margin percentage, which is certainly positive. Also, we would note that the decline in third quarter gross margin dollars when compared to a year ago, resulted largely from the decline in revenues rather than customer mix.

As we've been discussing for some time, customer mix does play a role in our gross margin results. As we look at our core distribution business, the impact of large IDNs, as well as hospital consolidation trends have affected our gross margin percentages. One element impacting our acute care relationships are the GPOs.

Let me provide an update on this year's renewals. Regarding the new Novation contract, we are pleased that we have effectively finished the sign up phase. To a large degree, the new pricing took effect on September 1st. The term of the new contract is five years with two one-year renewals options.

As for the sign-up phase, we ended up essentially where we anticipated and look forward to serving our hospital customers under the new contract. We are satisfied that we retain the Novation customers that were of significance to us under terms that were mutually acceptable. We are now engaged in a somewhat similar process with Premier. We would expect to comment on the prospective effect of these contracts when we discuss our outlook for 2013 at our Annual Investor Day in November.

As we look at our position in the market, we recognize that we are uniquely positioned to drive efficiencies in the healthcare supply chain benefitting hospital and healthcare manufactures. In recent years, we've focused on attracting the business of a number of large and influential IDNs. We believe these will be the winners in a consolidating market and they are a natural fit for our supply chain solutions. Due to their sheer size and purchasing power, these customers have leverage in the marketplace. In order to serve them efficiently, we are adjusting our service model to their evolving needs.

For example, we are working with our acute care customers to provide supply chain solutions for their physician practices. During the third quarter, we converted three additional geographic areas of a large IDNs physician business to our platform. Additional conversions for this IDN are slated to continue into the New Year. For this IDN alone, we are now serving approximately 1,000 physicians. They order through our traditional platform, but access a specific contract-compliant formulary and we have just begun converting another group of physicians of another large regional IDN. This conversion entails over 300 physicians who will be served by Owens & Minor. This group will use our proprietary ordering platform.

We continue to work with our IDNs to develop ways to serve their physicians and we believe we have the right solution for this growing supply chain challenge. In addition to our hospital focus, we are intently working on developing services to support the suppliers and manufacturers who serve healthcare. Our efforts include taking steps to optimize our supplier relationships. We want to work with the most efficient suppliers and those that are interested in partnering with us to deliver their products to the market in the most cost effective manner possible.

We provide a wide range of valuable services to our suppliers including assuming credit risk, carrying inventory, managing orders in returns and efficiently delivering next day orders of their products with exceptional accuracy.

As I said, these services are valuable and we deserve to be compensated in terms that are commensurate with the value of our service. We are well aware that there may be suppliers who do not fit our model and who, therefore, will choose not to work with us. For example, this summer we parted ways with a supplier that maintained it should be receiving our logistic services for free. As common sense would tell you, this was intentable.

Turning now to our successful effort to manage our expenses, we have been and we'll remain keenly attuned to reduce spending in every area. Our teams constantly look for ways to lower operating expenses. As we demonstrated last quarter, our quarterly expense reduction efforts in the domestic segment were commendable as we reduced SG&A dollars and SG&A as percentage of revenues when compared to last year.

The factors that led to these solid results included reduced operating expenses in OM HealthCare Logistics, lower expenses for compensation and benefits and ongoing benefits resulting from an organizational realignment undertaken in the fourth quarter of 2011. We are all pleased that domestic operating earnings margins improved on a sequential basis this quarter. This was no small accomplishment in year with some many challenges.

Consequently, as we reflect on the third quarter 2012 results, we are targeting the fourth quarter, 2012 adjusted operating result to be similar to those reported this quarter. As our outlook further evolves, we will provide additional details at our Annual Investor Day.

Thank you, and I'll turn it over to Craig for his remarks.

Craig Smith

Thank you, Jim, and now that we provided a very in-depth look at our results and operations, I'd like to take a step back and give you a look at the bigger picture.

This has been a very challenging year in healthcare with many healthcare companies facing greater softness in utilization than anticipated. Consequently, many companies, healthcare companies are focusing on improving efficiencies while looking for new opportunities just as we are.

Even in a challenging environment, we are pleased that our teams have turned in a steady performance and made solid headways on many fronts. Under Jim's leadership, our operation's teams have made significant progress in adapting to changes in our market. The realignments we undertook nearly a year ago have helped lower our expenses in 2012.

Our customers increasingly seek our help with emerging supply chain challenges and of course we are excited about the opportunities presented by the Movianto acquisition to expand our global reach in our third-party logistics services.

Now even with these pressures in today's economy and in the healthcare industry, we are providing supply chain solutions that can deliver a tangible difference for our hospital and our supplier customers. One of the ways we serve suppliers is through our third-party logistics offering and during the quarter we completed the Movianto transaction, our first overseas acquisition.

Movianto is one of only two pan-European healthcare 3PLs, and it gives us an experienced team and well-run logistics facilities throughout Europe.

After we close the transaction, our teams quickly began to transition Movianto from the parent company to Owens & Minor. The transitioned team is focused on ramping up services previously provided by the parent company such as certain corporate support functions, marketing efforts and information technology systems.

As we said last quarter, this is a strategic platform acquisition of a leading 3PL company that we believe will create a widening path of opportunity for us. Before divesting Movianto, the parent company had made strategic capital investments in the network so there is plenty of capacity for growth.

Our near-term focus is building our client base and putting more volume through this network. We believe that our 3PL services both, domestic and international offer manufacturers a streamlined cost effective solution. We also believe that our legacy relationships with 4,000 hospitals and 1,200 manufacturers in the U.S. give us a competitive advantage that general 3PL providers do not enjoy.

We also know that 74% of the global healthcare spend occurs in North America and Europe. With our new platform, we are now well positioned to leverage this concentration of healthcare spending. Since completing the acquisition, we have had an increasing number of calls from suppliers who want to talk to us about third-party logistics. We are very encouraged by the heighten level of interest in working with them. For example, we signed an agreement with an existing legacy supplier to provide 3PL services in Europe through Movianto, and we have signed a Letter of Intent with another U.S. supplier to become a Movianto client.

In recent days, we have also signed a new customer for OM Healthcare logistics, our domestic 3PL service and exchanged a Letter of Intent with the second manufacturer.

The OM HCL customer is a medical device manufacturer that is working with us to bring its new spinal implant devices to market. This physician preference item is a type of product that typically does not go through traditional distribution, but is a perfect fit for our 3PL services.

At the end of the day, we aim to create long-term shareholder value, which is key to our mission, vision and values. Accordingly, our board just declared a fourth quarter dividend at $0.22 per share. Our 3% dividend yield is among the strongest in our sector and dividends remain a priority for our board.

During the first nine months of this year, we returned more than $53 million to our shareholders, almost $42 million in dividends and another $11 million from the board approved share repurchase program.

By allocating cash through strategic acquisitions and investment in our infrastructure while also paying for dividends and repurchasing shares, we believe we are using a balanced approach to strengthen our foundation for future growth.

Before we take your questions, I would just like to say a final word about our results this quarter. We saw a sequential improvement in Domestic operating margins, gross margin and SG&A. We completed the Movianto acquisition, we signed new customers for our Domestic and International 3PL services and we implemented a physician service model with few large IDN customers. Looking ahead, we will continue to maintain our focus on our operating as efficiently as possible while positioning ourselves for future growth.

Thank you and we would be happy to take your questions. Operator, you can open the line for questions.

Question-and-Answer Session

Operator

Yes, sir. (Operator Instructions). All right, it looks like our first question in the phone queue comes from the line of Joel Ray with Davenport. Please go ahead. Your line is open.

Joel Ray - Davenport

Folks, could you possibly elaborate a little bit on the revenues that were generated in the quarter. They seem to be fair a bit light and you'd mentioned not only volume but pricing. I was wondering if you could give us a little bit more detail on that. How much was do you think was related to each component, where was this coming from and so on and if anything has changed on the outlook on that effort?

Jim Bierman

I'd be happy to. This is Jim Bierman. So, as we commented there were several factors that played this quarter, as we looked at revenue for the third quarter 2012 compared to the revenue for the third quarter of 2011.

As Drew mentioned in his remarks, one of the factors in play was that there was one less sales day between the two periods. That being said, there were other factors that came into play. One was the fact that we have continued to see and we mentioned this during last quarter's call, we continued to see softness in healthcare utilization in the United State.

When you take the softness and utilization and you couple it with the lack of really any product price inflation, we are seeing results that are flatter than we were thinking a year ago when we talk in terms of our outlook for 2012.

Other factors in play were that last year in the third and also the fourth quarter, the Department of Defense, which is one of our top customers had significant activity, and so the comparable between the third quarter of this year, fourth quarter of this year and last year as it relates to that particular customer are high.

Then the final point is as is normal and customary and you might expect, we are constantly looking and working with our suppliers and brining on suppliers that haven’t traditionally used distribution services or whose line up product may not have gone through distribution services and add them to the mix, but also quite candidly, looking at opportunities where economically, it doesn’t make sense for us to continue to handle product where we are not receiving fair financial consideration for the efforts we are putting forth. And again, in this quarter there was an impact with a decision that we made there that I mentioned.

So, those factors combined explain the variance that we saw in the third quarter and as I said I think we'll see those factors in a similar fashion coming to play in fourth quarter of this year.

Joel Ray - Davenport

I presume that the calling of one or more suppliers is probably one of the key drivers to the improvement in gross margins?

Jim Bierman

It certainly would be a factor improving gross margin particularly in instances where that supplier was virtually receiving those service for free, so no question about that. Yes.

Joel Ray - Davenport

Okay. And, you would mention that you are in process with the premier renewal. Could you update us as far as what you think the timing is getting all of that pulled together?

Jim Bierman

Yes. I would think that by the time the year ends, or even really by the time we meet with the investor community at our Investor Day at the end of November that we have a pretty good outlook as to what the sign up impact may be as it relates to 2013.

Joel Ray - Davenport

Okay. And finally, with the addition of the 3PL capability in Europe, are we starting to see some cross-selling opportunity, bringing some of those products to the U.S. also in addition to the domestic organizations you are talking to, possibly shipping over there?

Jim Bierman

Let me hand it up to my colleague, Brian Shotto to answer that.

Brian Shotto

Sure. The short answer to that is yes. It was certainly one of the things that we put some immediate resources on to see if we can leverage work has been done both here in the U.S. and Europe, and look for a commonality amongst customer basis and we have had some successes coming right out of the gate. Nothing that we are ready to announce today, but certainly some successes and we anticipate that to continue going forward.

Joel Ray - Davenport

Very good. Thank you very much.

Jim Bierman

Thank you.

Jim Bierman

Thank you.

Operator

Thank you, Mr. Ray. Our next questioner in queue comes from the line of Evan Stover with Robert W. Baird. Please go ahead your line is open.

Evan Stover - Robert W. Baird

Hi. This Evan in for Eric. How you guys are doing today?

Craig Smith

Good, Evan.

Evan Stover - Robert W. Baird

I just had a quick question on little point of clarification on the guidance. You had spoken to similar performance in the fourth quarter. I just wanted to clarify is that on an absolute basis sequentially or should we be thinking about similar year-over-year growth rates versus the prior year? Just want to clarify that.

Craig Smith

Yes, and, not to parse technical terminology, but really the comment had to do with our outlook for fourth quarter operating results that would say that the results should be similar to what we reported this quarter.

I think if one was to take my other comments relative to revenue in the context, there I think it is a more of a relative rather than absolute thought, and in large part because there is an additional sales day in the fourth quarter when compared to the third quarter of this year. Yes.

Evan Stover - Robert W. Baird

Okay. That's helpful. As we think about Movianto, we have one month now of the business incorporated into results. Obviously, understand the comment that we cannot take that business and run rate it given the September month was I guess a higher run rate month, but as we step back and think about €300 million at the time of acquisition, call it $400 million, does that estimate still hold, or are you seeing anything in the first month that gives you a little more confidence as it kind of contribute at a higher level?

Drew Edwards

Well, I'd like to answer that question, Evan, really from earnings perspective. Our guidance for the impact of Movianto for the year is probably in the neighborhood of $0.15 a share and that includes the acquisition related cost, so a negative impact of $0.15 per year. As you look forward to 2013, consistent with what we said in the second quarter, we expect that to be neutral on earnings and then it to be accretive thereafter beginning in 2014.

Evan Stover - Robert W. Baird

All right. That's helpful and my final one. I think there were some comments to the effect that the U.S. 3PL business last quarter was running at breakeven or just above. Can you verify that business to achieve breakeven this quarter and then any other color on the trajectory there is helpful.

Drew Edwards

Yes. This is Drew again. It has achieved a breakeven level.

Evan Stover - Robert W. Baird

All right. Thank you all. I'll step back in queue.

Operator

Thank you, sir. Our next question comes from the line of Robert Jones with Goldman Sachs. Please go ahead. One moment please. Your line is now open.

Stephan Stewart - Goldman Sachs

Hey, guys. Thanks for the questions. This is Stephan Stewart calling in for Bob. I just wanted to follow-up on the fee-for-service businesses. It's still breakeven or acute breakeven this quarter. How much did that contribute to the sequential improvement in gross margin?

Drew Edwards

This is Drew again Stephan, and the contribution was, it had a negative impact not sequential. I'm talking year-over-year of 14 basis points overall to gross margin.

Stephan Stewart - Goldman Sachs

Okay, and anything un-sequential, I'm assuming given the relative change in revenue sequentially versus the rest of your distribution business that there were some positive impacts?

Drew Edwards

Yes. I don't have that calculation with me Stephan on a sequential basis the impact.

Stephan Stewart - Goldman Sachs

Got it, and just a follow up on SG&A. A couple of quarter's of impressive cost control. How much benefit is there left out of the realignment you announced last fourth quarter you think, and is there further room to improve efficiency in fee-for-services businesses? I guess moving forward as the sort of 6.8% of revenue is a good run rate to think about for the year combined business axe I guess domestic axe Movianto?

Drew Edwards

Yes. It's a great question and probably deserves a more full form answer that we can provide at Investor Day.

Stephan Stewart - Goldman Sachs

Okay.

Drew Edwards

As we think about 2013, but let me answer it directly now with limited time. I think we are at near record levels of performance presently. So, the challenge we have going forward is not lost on us. That being said, we also acknowledge that we have seen gross margin compression that exist, particularly as a result of consolidation that's going on with our customers in the industry, so I think we are vigilantly looking for opportunities to continue to set the SG&A bar at record levels and we think that we have some strategies and some tactics that will accomplished that some of which we'll share when we get together in November, but we think it's a paramount and important that we continue to demonstrate our ability to lead in the area of SG&A.

Stephan Stewart - Goldman Sachs

Great. Thanks, and one last follow-up if I may. The $0.10, $0.15 dilution from Movianto for this year's guidance, I know we got $0.10 in acquisition related cost this quarter. Is there an estimate for acquisition related cost in next quarter?

Drew Edwards

Steven, our estimate is that the overall adverse impact of Movianto for the year is probably going to be closer to $0.15.

Stephan Stewart - Goldman Sachs

Okay.

Drew Edwards

We already have $0.10 associate with acquisition related that was in the third quarter, so the $0.15 would include the acquisition related for the whole year as well as the impact of operating results.

Stephan Stewart - Goldman Sachs

Got it. Thanks for the questions guys.

Operator

Thank you, sir. And at this time, there appears to be no additional questioners, and I would like to turn the program back over to Mr. Smith for his closing remarks.

Craig Smith

All right. Thank you, Huie. I know we are all struggling with Hurricane Sandy here in either personal or professional mode in terms of taking care of our patients and taking care of the hospitals, and I know it's been very challenging in the Northeast, so I appreciate those of you who have phoned in.

I think, we tried to put a lot of the information in our comments, so I would encourage you as you go to the website to review this to look at the comments. I think we went into more detail than we normally do, and we are looking forward to all seeing you at Investor Day at the end of November. Thank you.

Operator

Thank you for your participation in today's conference. This concludes the call. You may now disconnect. Good day.

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