Henry Schein (HSIC) Stanley M. Bergman on Q2 2016 Results - Earnings Call Transcript

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Henry Schein, Inc. (NASDAQ:HSIC) Q2 2016 Earnings Call August 4, 2016 10:00 AM ET


Carolynne Borders - Vice President-Investor Relations

Stanley M. Bergman - Chairman & Chief Executive Officer

Steven Paladino - Chief Financial Officer, Director & Executive VP


Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

John C. Kreger - William Blair & Co. LLC

Jon Block - Stifel, Nicolaus & Co., Inc.

Robert Patrick Jones - Goldman Sachs & Co.

David M. Larsen - Leerink Partners LLC

Elizabeth Anderson - Evercore Group LLC


Good morning, ladies and gentlemen, and welcome to Henry Schein's Second Quarter Conference Call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this call is being recorded.

I would now like to introduce your host for today's call, Carolynne Borders, Henry Schein's Vice President of Investor Relations. Please go ahead, Carolynne.

Carolynne Borders - Vice President-Investor Relations

Thank you, Sylvia, and thanks to each of you for joining us to discuss Henry Schein's results for the second quarter of 2016. With me on the call today are Stanley Bergman, Chairman of the Board and Chief Executive Officer of Henry Schein; and Steven Paladino, Executive Vice President and Chief Financial Officer.

Before we begin, I would like to state that certain comments made during this call will include information that is forward-looking. As you know, risks and uncertainties involved in the company's business may affect the matters referred to in forward-looking statements. As a result, the company's performance may differ from those expressed in or indicated by such forward-looking statements. These forward-looking statements are qualified in their entirety by the cautionary statements contained in Henry Schein's filings with the Securities and Exchange Commission.

In addition, all comments about the markets we serve, including growth rates and market share, are based upon the company's internal analysis and estimates. The content of this conference call contains time-sensitive information that is accurate only as of the date of the live broadcast, August 4, 2016. Henry Schein undertakes no obligation to revise or update any forward-looking statements to reflect events or circumstances after the date of this call.

I ask that during the Q&A portion, you limit yourself to a single question and a follow-up before returning to the queue. This will provide the opportunity for as many listeners as possible to ask a question within the one hour that we have allotted for this call.

With that said, I would like to turn the call over to Stanley Bergman.

Stanley M. Bergman - Chairman & Chief Executive Officer

Thank you, Carolynne, and good morning, everyone, and thank you for joining us. I'll provide further information, further color on our performance during the second quarter, expectations for the rest of the year, after Steven provides the specific information on our performance in the second quarter.

Generally, though, our North American dental sales were a little bit below our expectations in the second quarter. However, sales in our Medical, Animal Health, Technology, Value-Added Services businesses was strong, as well as in aspects of our North American dental business. And we will again provide further color on specifics after you have the details from Steven.

Over the years, our business has been quite predictable and, as an organization, Henry Schein has been able to adapt, seize opportunities and address challenges. We believe that our business model and strategic plan, including our continued investments, will drive our growth over the long term and in fact in the medium term. And we remain extremely well-positioned in each of our vertical markets we serve, not only to gain market share, but of course to manage our investments very carefully. We have a seasoned management team that is very good at these points and particularly at gaining market share and managing our investments in a very strategic way.

On a granular level, looking at plans for the UK to leave the European Union, they're on a very early stage, which is likely to be a two-year process, many say not much starts until early next year. Surely, there will be developments along the way, but let me be clear that Henry Schein's commitment to the UK remains unchanged and so does our commitment to the European Union. We continue to believe that the UK and Europe on the whole represent attractive long-term opportunities in both our Dental and Animal Health businesses and perhaps even in our Medical business in the long term. We expect to continue to execute well in our value-added custom approach, just as we did before the Brexit vote.

In a moment, I'll provide, as I said, an additional commentary on our recent business performance and accomplishments, but first Steven will review the specifics around our financial results.

Steven Paladino - Chief Financial Officer, Director & Executive VP

Okay. Thank you, Stan, and good morning to all. As we begin, I'd like to point out that our 2016 second quarter results include a favorable proposed tax settlement of $4.5 million or approximately $0.05 per diluted share. Q2 2016 results also include restructuring costs of $20.4 million pre-tax or $0.18 per diluted share. Our prior year Q2 2015 results also include restructuring costs of $7.2 million pre-tax or $0.06 per diluted share.

I will be discussing our results as reported on a GAAP basis and also on a non-GAAP basis, which excludes those restructuring costs, as we believe the non-GAAP financial measures provide investors with useful information about the financial performance of our business, enable comparisons of financial results between periods were certain items may vary independent of business performance and allow for greater transparency with respect to the key metrics used by management in operating our business. These non-GAAP financial measures are presented solely for informational and comparative purposes and should not be regarded as a replacement for corresponding GAAP measures. You can see our Exhibit B to this morning's earnings release that provides a reconciliation of GAAP to non-GAAP results.

So turning to our results. Net sales for the quarter ended June 25, 2016 were $2.9 billion, reflecting a 9.3% increase compared with the second quarter of 2015. This consisted of 9.7% growth in local currencies and a 0.4% decline related to foreign currency exchange. In local currencies, our internally generated sales increased 7.6% and acquisition growth contributed an additional 2.1%.

Also, when further normalizing the switches between agency and direct sales, our internal sales growth in local currencies for the company for Q2 was 5.8%. You can see the details of our sales growth that are also contained in today's earnings news release on Exhibit A.

If you look at the operating margin on a GAAP basis for the second quarter of 2016, it was 6.3% and contracted 67 basis points compared with the second quarter of 2015. The increase in restructuring costs in the second quarter of 2016 versus the same period last year negatively impacted the contraction by 43 basis points. Acquisitions completed in the past 12 months and related expenses as well as the switches from agency to direct sales also combined to negatively impact our contraction by 9 basis points. The remaining contraction was primarily driven by lower than expected sales growth in our North American Dental business relative to our other businesses. As a result of this, we have extended our restructuring period to the end of 2016 in order to continue to reduce our cost structure.

Our reported effective tax rate for the quarter was 27.6%. On a non-GAAP basis, excluding restructuring costs, our effective tax rate was 27.4%. This compares with an adjusted effective tax rate of 29.8% for the second quarter of 2015 when also excluding restructuring costs.

As I mentioned earlier, our tax rate this quarter reflects approximately $0.05 per diluted share related to a favorable proposed tax element. We also expect the settlement to reduce our ongoing effective tax rate going forward. More specifically, we anticipate that our effective tax rate on both a GAAP and non-GAAP basis to be in the 29% range for the remainder of the year. And previously we had guided that effective tax rate to be somewhere in the 30% range.

If we look at net income attributable to Henry Schein on a GAAP basis, it was $120.1 million or $1.46 per diluted share, representing increases of 1.8% and 4.3%, respectively, compared with the prior year. On a non-GAAP basis, excluding restructuring costs in both periods, our adjusted net income attributable to Henry Schein was $135.4 million or $1.64 per diluted share and that represents increases of 9.9% and 12.3%, respectively, compared with the prior year.

Foreign exchange impact on diluted EPS for the quarter was not material. I'd also like to note that at current exchange rates, we expect the foreign exchange translation of our outside of the U.S. earnings to negatively impact our diluted EPS in the second half of the year by at least $0.02 per diluted share, and that's related to the recent strengthening of the U.S. dollar versus the British pound sterling.

Let me now provide some detail on sales results for the quarter. Dental sales for the second quarter of 2016 increased 4% to $1.4 billion. This consisted of 4.1% growth in constant currencies and a small 0.1% decline related to foreign currency exchange. In local currencies, internally generated sales increased 2.8% and acquisition growth contributed an additional 1.3%. Our North American internal growth in constant currencies was 2%, and it included 1.8% growth in sales of dental consumable merchandise and 2.7% growth in dental equipment sales and service revenue.

As we noted in our press release, our Q2 Dental sales in North America reflect softness that began in early June. Our performance was also impacted by a decision to stop selling certain precious metals products. These products have a very low gross margin and are relatively immaterial to our profitability. Precious metals sales negatively impacted our North American dental merchandise sales growth in Q2 by approximately 50 basis points. So, again, our growth would be 50 basis points higher without the decision to stop selling precious metals. This will continue to impact our merchandise sales growth until it annualizes, so it will continue for the next three quarters.

As Stanley mentioned, we are extremely well-positioned among our dental customers and we will continue to invest in opportunities that we believe will drive our growth over the long term. Looking at international internal growth in local currencies, our Dental group was 4.2% growth and included 4.5% growth in sales of dental consumable merchandise and 3.1% growth in dental equipment sales and service revenues. That growth internationally was driven specifically by Italy, France and Spain, to a large extent.

Animal Health sales were $853.6 million in the second quarter, that was an increase of 14%. This included growth of 15.2% in local currencies and a decline of 1.2% related to foreign currency exchange.

Our internal sales in local currencies grew 11.8% and acquisitions contributed an additional 3.4% to our growth. Looking at the North American Animal Health sales, internal sales growth in constant currencies was 18.8%. And when normalized in the results to account for the impact of certain products switching between agency and direct sales, our growth was 11.4% in North America.

We believe this normalized growth rate is a more meaningful reduction – sorry, I mean, more meaningful reflection of the ongoing performance of our North American Animal Health business, and also reflects the strength of a broader animal health market. Our international Animal Health sales growth internally in constant currencies was 4.9%.

Looking at our Medical group, our Medical sales were $538.8 million in the second quarter and that was an increase of 14.4%. Foreign exchange had virtually no impact on our sales growth. That 14.5% growth included 14.9% growth in North America and 2.4% growth in local currencies internationally. Again, when normalizing for the impact of agency sales in the prior year, North American internal growth was 10.4%. And this is the sixth consecutive quarter of double-digit sales gains for our North American Medical business. So indeed, we have been outperforming the medical market by a fairly significant margin for the past six quarters, and we have effectively capitalized on the growing market trend towards larger group practices, including IDNs, or Integrated Delivery Networks.

Our Technology and Value-Added Services sales were $107 million for the quarter, representing a 19.6% growth. This included 20.4% growth in constant currencies and a 0.8% decline related to foreign currency exchange. In local currencies, the internally generated growth was 8.1% and acquisitions contributed an additional 12.3%. The 8.1% internal growth in local currencies included 8.5% growth in North America and 6.4% growth internationally.

I'd like to highlight that our North American sales growth included more than 20% growth in our Financial Services business. Our Financial Services business includes equipment and practice financing, credit card processing, practice brokerage, and patient collections as well as other services.

Our core software products and upgrades of Technology and Value-Added Services businesses also aims to provide customers with solutions that are efficient and patient friendly, allowing them to generate more business, manage content among multiple sites and improve the overall practice management.

During the quarter, we continued to repurchase our common stock in the open market. More specifically, we purchased 337,000 shares during the quarter at an average price of $169.41 and that represented about $57 million. The impact on the current quarter of that purchase was immaterial to our EPS. I think it's important to note that, at the close of the quarter we had approximately $243 million authorized for future repurchases of common stock, and we continue to believe that our capital allocation strategy, which deploys a large portion of our annual free cash flow to share repurchases and M&A activity will continue to drive increased shareholder value.

If we look at some brief highlights of our balance sheet and cash flow, we had very strong operating cash flow for the quarter, $274 million compared to $207 million in the prior year, and we believe we'll continue to have strong operating cash flow for the year.

Accounts receivable days outstanding was 40.8 days this quarter, compares to 39.3 days last year. Inventory turns for the quarter were 5.6 turns and that compares to 5.8 turns last year.

Let me conclude my remarks by discussing our 2016 financial guidance. We are revising our guidance due to the impact of a number of factors. These factors include the ongoing business and economic uncertainty related to the Brexit vote, which would have a potential impact on the UK as well as the rest of Europe.

As noted earlier, given the recent strengthening of the U.S. dollar versus the pound sterling at current exchange rates, we expect foreign exchange translation to negatively impact our diluted EPS in the second half by at least $0.02, and this new guidance also includes a cautious view of the North American dental market.

So for 2016, we now expect adjusted diluted EPS attributable to Henry Schein to be $6.55 to $6.60, which represents growth of 10% to 11% compared with the 2015 adjusted diluted EPS of $5.96. All of these adjusted diluted EPS numbers exclude restructuring costs, and this compares to our previous guidance, which was $6.55 to $6.65.

Our guidance is presented on a non-GAAP basis only, given that the company cannot reasonably project a restructuring cost that we expect to incur in the second half of 2016. For the same reason, the company is unable to address the probable significance of that information.

Our guidance for 2016, adjusted diluted EPS attributable to Henry Schein is as always for continuing operations, as well as completed or previously announced acquisitions, but does not include the impact of potential future acquisitions, as well as restructuring costs.

We now anticipate that the restructuring initiatives will continue into the second half of the year, as we continue to reduce our operating costs in light of some of these market conditions. At this time, again we're not able to provide estimates for this impact in our 2016 financial results.

Specifically, for Q3, we expect our growth in adjusted diluted EPS, again excluding restructuring cost, to be in the mid-single digits, so mid-single digit growth for Q3, but we obviously expect the growth to accelerate in Q4.

This guidance also assumes foreign exchange rates are generally consistent with current levels as of now. However, we do believe that there's a possibility that the U.S. dollar may continue to strengthen; and remember that 35% of our worldwide sales are in currencies other than the U.S. dollar.

Also, I'd like to conclude by mentioning that our fourth quarter results, since we're on a 52-week, 53-week basis, ending on the last Saturday of December, include an extra week. So 2016 consists of 53 weeks. The extra week is in Q4 of 2006 (sic) [2016] (20:03) and it's the last week of our fiscal year, which is the holiday week at the end of the year. So, sales are typically lower during that week, and we typically don't have the same level of profitability because of fixed costs remaining relatively constant.

So with that, I'd like to now turn the call back to Stanley.

Stanley M. Bergman - Chairman & Chief Executive Officer

Thank you, Steven. Let me begin my review of our four business groups with Dental. As Steve noted, North America Dental sales were impacted by softness in the U.S. that began in early June. We believe the strength of our relationship with our customers and our commitment to delivering value to their practices will continue to be key to our long-term success. And as in the past, it'll enable us to continue to gain market share not only in the United States, but globally in the dental markets.

Although the sales growth was lower than expected in the second quarter, we believe we have a proven and successful model of delivering value-added solutions to our customers and we have increased our focus on delivering better sales results in the short term.

As evidence of this commitment, during our second quarter, we announced an investment in Custom Automated Prosthetics, known as CAP. CAP is a U.S. digital laboratory supply company with 2015 sales of approximately $30 million. They offer CAD/CAM equipment as well as a full line of zirconia materials, the integration of CAP with Zahn, which is our dental laboratory business, and our Custom Milling Center furthers our commitment to providing dental laboratory customers with a greater selection of digital equipment, materials and services. We believe these products will help them, our laboratory customers, to navigate through the important digital transition that is occurring in the dental technology space today, and I might add, at a rapid pace.

Further supporting our commitment to advanced technology and to help prepare the next generation of dental professionals for advances in digital dentistry, in May we announced the opening of the Henry Schein Digital Dentistry program at Temple University's Kornberg School of Dentistry.

Technology advancements are affecting almost every aspect of the practice of dentistry, and we are committed not only to bringing those advancements to our customers, but also to making sure our current and future customers are well versed in all aspects of running an efficient and profitable practice, while allowing for high-quality patient care. Dental students and faculty at Temple University now have access to the latest 3D imaging equipment, intraoral scanners and milling machines made available as a result of this partnership.

Regarding our digital dentistry efforts, we continue to see strong growth in sales of digital impression solutions with our 3M, 3shape and PlanScan scanner offerings. The breadth of our product offering is reflective of our belief that customers want choice and open architecture for their restorative dentistry needs. This also creates an opportunity for follow-on software and mill sales, when these dental practices are ready to move to a full scale in our systems. With Zahn Dental and CAP, we continue to be well positioned to provide innovative solutions to the lab market for restorations that are outsourced from the practice.

Let me just add that in North America, CAD/CAM sales were strong in the second quarter, driven by digital scanner sales, while our traditional equipment sales was soft; and I might add partially due to timing.

Lastly, I'd like to comment on a recent change in our Global Dental Surgical Group. As of June, BioHorizons has become the exclusive distributor of CAMLOG branded products in the United States and Canada. This creates a unified sales force in the U.S. for compete dental offerings to specialists and general practitioners. By combining the two sales forces for these high quality complementary brands we're creating a more efficient go-to-market strategy, giving our customers access to a greater selection of products and services from high-quality branded to high-quality economy implants with a wide variety of clinical base products.

It also will afford more robust North American coverage in strengthening our position to effectively compete and grow our market share in, as I said, the premium and value-added segments of the dental implant market. We look forward to continued success in this important segment. These businesses are and actually have been doing quite well for a while.

Now let me turn and, of course, happy to answer more questions on the Dental side during the rest of the call. On the Animal Health side, as Steven mentioned, when normalizing for Animal Health results, our internal sales growth in local currencies was 11.4% in North America, reflective of a healthy market, but also reflective of market share gains. We have been gaining market share in North America in the animal health arena for a while now.

International currency sales during the second quarter were up 12%, with organic growth complemented by acquisition growth. We are making good progress with our diagnostic product portfolio, targeting practices that are nearing the end of the instrument lease agreements as well as growing clinics with a need for multiple systems for high volume testing. Indeed, sales of diagnostic products in North America grew in the low-double digits in the second quarter compared to the prior quarter. We believe this is ahead of the market growth in this sector.

Axis-Q continues to be an attractive element of our sales proposals as customers see strong benefits in efficiently linking their practice management software with their diagnostic instruments. This is a holistic approach. It's not selling devices nor is it selling software; it's the interoperability of devices and software connected to the practice management system, the clinical workstation. As a reminder, Henry Schein's practice management software is today used by more than 50% of the U.S. veterinary practices. Again, strategy here in the animal health space is doing very well, well thought out and being well executed, of course, not only in the U.S., but throughout the world in the animal health arena where Henry Schein is in fact active.

Let me now turn to Medical. The reported growth in our Medical group of 14.5% was impacted by agency sales in the prior year. When normalizing for this impact, the core internal growth for North America Medical was 10.4%, as Steven mentioned. And let me stress, this is the sixth consecutive quarter of double-digit sales gain. We continued to see solid growth from large group practices, including IDNs, the integrated delivery networks, as we onboard new customer wins from the past year. These are internal growth wins that we've been working on for a while and that are bearing fruit.

In addition, the expansion of large health systems with which we have built strong relationships over the past several years is contributing to our growth. Our focus on the ambulatory surgery center segment of the market is yielding solid results as well, as we are seeing strong sales in the sector. And our teams are making inroads with our smaller market segments, including universities and sports medicine, where we have a growing base of customers who rely on our broad value-added service model.

Now, let me talk about the Technology and Value-Added Services group. We are pleased, again, with the second quarter performance of this business group. North American Technology and Value-Added Services internal sales growth was 8.5% in local currencies, matched the highest growth rate in more than three years. Strategic acquisitions that bolstered our market share in this business as sales in local currencies increased by more than 21% in North America during second quarter and by nearly 15% internationally. Of course, we are very pleased with these results as reported to the P&Ls of these businesses. But let me remind our investors that, in fact, it's the stickiness, the value-added services, that our Practice Solutions group brings to bear in our customer base that has the real strategic value.

Enhancing digital platforms across the businesses we serve is an important priority for Henry Schein, in fact, one of our largest and perhaps most important priority. We provide a means for our customers to better connect with their patients and improve overall efficiencies, thereby reinforcing our value to their practices and, in fact, allowing our customers to show their value to their patients. And we continue to develop innovative solutions to drive interoperability with devices and, of course, the cloud to manage workflows.

We are very, very pleased with the progress we've made specifically on our cloud-based dental product and the connection between our practice management software and the devices in the dental space, whether it is in the imaging area or in the prosthetics area, likewise, as I reported earlier on, in the animal health space with our diagnostic and imaging product offerings that are connected so well to our practice management software, which will only get better over time.

So as you may know, 2015 was a special year for Henry Schein as we marked 20 years as a public traded company. In May, we had the opportunity to celebrate this milestone as we opened trading at the NASDAQ Stock Market. 20 years ago we had a vision for what Henry Schein could become. Since then, more and more people have joined us in sharing that vision, in building our company and expanding our presence in the global markets we serve. And all the while we have demonstrated we can successfully serve shareholders while also serving society and, of course, our suppliers and our customers and the team.

We are pleased to have accomplished so much as a result of the hard work of the team Schein members across the globe over the past 20 years since we've been public. We continue to be most optimistic about our strategies. We're unwavering in executing our strategic plan, which revolves around the notion of helping practitioners operate a more efficient practice while providing better clinical care. We feel that we have the right strategies and the tactics in place, and we'll of course make sure that we manage our expenses in a way that delivers on our commitments to our shareholders.

Lastly, we are pleased to announce that in June Henry Schein moved up the number 268 in the ranking the Fortune 500, celebrating our 13th year as one of the America's largest corporations. This is testament to more than 19,000 team Schein members throughout the world who are dedicated to helping our customers build better practices so that can provide better quality care. We, of course, have been on the list of the Fortune's Most Admired Companies for the entire period.

So, with that commentary and an overview of our quarterly results from both the financial and operating performance point of view, we thank you for your attention and we're of close ready to answer any questions that shareholders may have.

Carolynne Borders - Vice President-Investor Relations

Sylvia, can you open the Q&A, please?

Question-and-Answer Session


Your first question comes from Jeff Johnson from Robert Baird.

Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

Thank you. Good morning, guys. Can you hear me okay?

Steven Paladino - Chief Financial Officer, Director & Executive VP

Yes, very well.

Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

Great. Steve, I guess or Stanley, I guess it's a question for either of you. But I'm having a little trouble reconciling I guess a couple of things. And one is that, you're having some very solid performance in the Vet and the Medical side, probably better than we expected or better than you expected, but better than we expected. Dental's soft, but if I back out that little bit of precious metals, consumables still growing north of 2%. So, no big disaster there.

But, Steve, when I look at your guidance, you're taking it down a nickel at the top, another nickel if I adjust for the tax rate, updates you provided today, it just seems like it's a pretty sizable take down in guidance of $0.05 to $0.10, I'm sorry, at the top-line, when there's strength elsewhere in the business. And I just can't understand, maybe, how sizable that change was on the Dental side in the last month or two in what you've been seeing?

Steven Paladino - Chief Financial Officer, Director & Executive VP

Well, there's a couple of things. Remember, we do want to be cautious on the conservative side in our guidance. As we've said, in the U.S. Dental, we saw a slowness of sales that began in June, and while we're not convinced that this is a long-term permanent impact, we do want to make sure that if it continues for a little while that our guidance is sustainable. We do have foreign exchange headwinds. We do expect, although we haven't seen much impact right now in the UK, we do expect that the UK market will soften, and as you probably know, about 8% of our revenues are in the UK market between Dental and Animal Health.

We also because, I know you know this also, but when you look at profitability, our U.S. Dental on a distribution business is our most profitable business, so we have a mix issue on profitability where the most profitable business is growing the slowest; and while Medical and Animal Health are nicely profitable, they're just not as profitable. So, there's a lot of things going on, Jeff, and we just feel that right now, given that we were not expecting this June sales slowdown, is the time to be a little bit cautious in the market. So, hopefully, that helps you a little bit.

Jeff D. Johnson - Robert W. Baird & Co., Inc. (Broker)

That does. And maybe just one follow up then is, it sounds like July really hasn't bounced back, right, assume it hasn't if you're taking the guidance down the way you are. And then I know you don't give segment specific operating margin details, but just qualitatively within Medical, are those margins holding steady? Is Dental margin itself coming down or is the 9 basis points, 10 basis points of operating margin contraction we saw this quarter, once we adjust for all the moving parts you talked about, is that 10 basis point contraction, just mix driven more than anything? Thank you.

Steven Paladino - Chief Financial Officer, Director & Executive VP

Okay. Yeah, it is primarily mix driven. We did not see a significant rebound in U.S. Dental sales in July, consumable sales. It's really right now continuing at similar rates to Q2. On the other hand, equipment, we did see an increase in equipment demand, our backlog is very strong and increasing on equipment. We do expect an uptick, a modest uptick, in consumable sales in the U.S., but again, we're trying to be cautious. And I'd like to point out, when you look at our margin, look at the components of our margin, for the quarter, excluding restructuring costs, our operating expenses are down 35 basis points versus the prior year. And if you exclude the acquisitions in the last 12 months, operating expenses are actually down 55 basis points.

So, our restructuring activities are making us more efficient, but on the gross margin level, Dental consumable sales for distribution are our highest gross margin business. So, again, we're trying to be cautious in the market, and a little bit conservative. And so we need more data points in the future in order to be able to talk about what we're seeing for a longer term in the market.

Stanley M. Bergman - Chairman & Chief Executive Officer

Thank you, Steven. Just, let me just add a little bit more flavor. First of all, there is no IMS data, as we've said, over the past in dentistry, but it's our view that essentially from a unit's point of view, the market is flat. It's not going down, it's not going up, talking about the U.S. consumable market. And we think that the market is growing at about 2%, which is essentially price increases. We've now – there is an independent market data product out there, it's not accurate, but it does show a modest sequential downturn, and it is more or less accurate directionally. But two months is not a statistically valid view of that market from our point of view.

We've also spoken to several key manufacturers who support this view that the consumable business in the U.S. is essentially flat, with a couple of hundred basis points of inflation. So, we're talking about 100 basis points, 80 basis points margin of error; it's very, very small. And in that context, we believe we are still gaining market share and have gained market share consistently for a while. We hear this from most of the major if not all the major manufacturers.

So, we wanted to take a cautious view. I'd be quick to say that our demand for equipment is good. One of our key manufacturers was delayed a little bit in the second quarter with providing equipment, a new system which we had taken a lot of orders for. We believe that that equipment will be delivered in time for the third quarter. So we're looking at a much better second quarter, but within these hundreds of basis points this way, that way we want to be on the cautious side.

I also mentioned earlier on, that we're doing quite well with CAD/CAM sales, particularly with scanners. So we have to be careful not to be too negative, but also want to be cautious here. And, yes, our Medical, our Animal Health, our Oral Surgery, our Dental specialty businesses in general remain solid. In fact, our Corporate Accounts business, our Special Markets business in dentistry is actually doing quite well and so is the mid-market.

The area where we just can't put our finger on right now is what's happening to the smaller Main Street dentists in the U.S. And again, overall, we do see that we're gaining market share in this country and abroad and in all of our businesses. We don't see any area on the strategic side that we want to moderate or change; perhaps we want to advance the Solutions business, leading with software a little bit faster. But overall, I think, Steven is right to be on the cautious side, and we want to reduce the top end a bit of our guidance.

So, it's really cautionary, indicative of these numerous areas that may be slightly questionable, including the economy, in this country and in Europe. We're actually quite comfortable that we will deliver good results in the end in Europe, but the economy in Europe is out of our control. So that's why we'd like to be a little bit more cautious and also control our expenses a little bit more carefully.


Your next question comes from John Kreger from William Blair.

John C. Kreger - William Blair & Co. LLC

Hi. Thanks very much. Stan, maybe just a follow-up on that same theme. How did some of your specialty products do across dentistry versus more of your typical preventive and restorative? So, for example, how does your implants do in the U.S. and Europe?

Stanley M. Bergman - Chairman & Chief Executive Officer

So, our implant business in general, John is doing okay. And again, we want to be careful about not creating expectations that we're going to report monthly sales on an ongoing basis. But because of this particular situation, I must say, it caught us a little bit by surprise heading into our Dental National Sales Meeting in June. It is possible that a little bit of a downtick occurred because our entire sales force was out of the field for a while.

But to answer that question directly, April and May were pretty good in the implant business. June was a challenge, but it would appear that July bounced back. But again, John, we're talking within a hundreds of basis points both sides, not even hundreds, 100 or so basis points both sides. So I'm not sure if this is conclusive on the downside or conclusive on the upside. I will say the U.S. implant market is quite strong; we're comfortable with the European markets for implants.

But on the margin, our implant business has been driven by few countries, not Henry Schein on the ground, but through distribution agents in countries like Russia and Turkey and even Japan. And these are markets that have been very helpful, again driving within 100 basis points here or there growth. But we're a little cautious about these markets. Having said that, let me quickly remind that we are quite comfortable with our two big markets for BioHorizons, the U.S., Canada, and for CAMLOG Germany and the Duc (44:49) region.

John C. Kreger - William Blair & Co. LLC

Great. Thanks. And then one quick follow-up, the trends that you've been talking about over the last few minutes in June in particular, did you see that kind of consistently across your various SKU within consumables? Or were they kind of isolated to certain ones that might suggest this is a volume issue or more of a kind of spending-per-visit issue? Thanks.

Stanley M. Bergman - Chairman & Chief Executive Officer

It's a good question. You can imagine, to quote one of our finance people, we've been torturing numbers, and really we cannot come up with anything 100% conclusive. What we've told you is what we believe. And I think we don't want to create the precedent of having to go into this detail every quarter. But because of this unusual situation that occurred in June, we felt we should provide a little more information. But there are clusters leading one way, but there are clusters going the other way.

And it's really very hard to come up with anything conclusive other than to say that this particular survey, this independent market survey, does show modest sequential downturn, but it's only good from a directional point of view and manufacturers have given us this view. But I have to tell you, there are manufacturers that have shown us that business has been good. And for those – and I would say more or less across the board, Henry Schein has been gaining – continuously gained market share. And again I'm talking about consumables, because I think the equipment business is quite sound, especially in the digital space, whether it's the digital imaging or digital prosthetics.

John C. Kreger - William Blair & Co. LLC

Thanks so much.


Your next question comes from Jon Block from Stifel.

Jon Block - Stifel, Nicolaus & Co., Inc.

Great. Thanks. And good morning. I'll try to ask two. The first one just the delta in growth between North America Animal Health and Dental is significant. You got Animal Health growing about 11% adjusted, Dental consumables 2% to 2.5%. So, Stanley, can you talk to the consumer and why you think we're seeing this divergence in these two industries and is this sustainable? In other words, can you have this, call it, 900 basis point delta in growth between what are essentially two consumer-driven industries? And then I've got a follow-up. Thanks.

Stanley M. Bergman - Chairman & Chief Executive Officer

Jon, that is probably the number-one vexing question we have. The animal health market is doing well, yet we are doing better than the market both here and in Europe. But it is doing well, it's alive and well. We saw similar things, and I don't want to draw any more analogy to what I'm about to say than just the narrow point I'm going to make, don't read any trends into this. But in 2008, 2009 and 2010, Animal Health, in most of those quarters did better than Dental. But I don't want to come to any conclusions because there are a lot of other factors in Dental, insurance. We have to also remember I think we may have gotten a false positive in the first quarter. We saw growth was significant on consumables and that may have been due to weather.

I think the dental market in the United States has been more or less flat for a while and driven a little bit by inflation and also perhaps visits to implant dentists a little bit more. But, again, we're in a few hundred basis points here in Dental and it's hard to gauge what is happening specifically within that range. Having said that, the animal health market is a healthy market around the world, driven by the middle class and, as we've said before many times, the baby boomers. They're buying more pets.

Again, I'm not really speaking on behalf of the agri side of it, the production side, which has its own dynamics related to the milk price, the meat price. But Henry Schein is not a big player in that space, with the exception of a few markets like Ireland or New Zealand, where we are in the dairy field, and in couple of markets, Australia and parts of Europe, where we have some production. But from the pet point of view, it's growing. The demand for pets is growing and people are spending more money. We've seen that with our customers, both the customer that is public and the customers that are not public. It's a hot space, it's a good space. And I would say the medical space in good, too, but it's not driven by consumer issues on the medical side. It's driven by a realignment in the way in which healthcare is provided.

Obviously, we've shown very good results on the Medical side for the past six quarters, but obviously it's not sustainable at that high level, although we remain very optimistic in our ability to gain market share. And the foot traffic in to the medical office is not really as important as us gaining bigger accounts.

Jon Block - Stifel, Nicolaus & Co., Inc.

Got it. Perfect. That was very helpful. And, Steven, one for you. Your third quarter commentary around mid-single digit earnings growth implies around $1.90 or low to mid-teen EPS growth for 4Q. So can you just talk to your level of confidence on that reacceleration? Does that assume any snapback from a top-line perspective, or is it just the easy year-ago comp in 4Q and some of the restructuring initiatives taking hold? Thanks, guys.

Steven Paladino - Chief Financial Officer, Director & Executive VP

Yeah. Jon. So for Q3, the first important thing is Q3 was a difficult comp on an EPS level and an easier comp in Q4. And specifically, Q3 of last year had 15.7% EPS growth. So it is a more difficult comp. So that's one thing.

Some of things that we talked about, cautious view of dental market in the U.S., Brexit, foreign exchange, but there's also timing of expenses between Q3 and Q4. There's also further restructuring activities, which will only have a modest impact in Q3 and have a greater impact in Q4. And lastly, a potential for flu vaccine sales timing that could be a little bit negative for us. But the biggest reason, I gave you a laundry list, but the biggest reason is that 15.7% EPS growth last year's third quarter.


Your next question comes from Robert Jones from Goldman Sachs.

Robert Patrick Jones - Goldman Sachs & Co.

Thanks for the questions. And just hate to go back to this, but on the North American dental market, I wanted to hone in a little bit on the merchandise side. Obviously, must have really fallen off in June based on your commentary. I'm curious, is there anything you could elaborate on or share with us relative to the competitive environment? Did you see any changes in behavior from your traditional competitors in the way that they're approaching their go-to-market strategy? Did you see any increased pressure from alternative distribution channels, like online pure play competitors?

Just anything that might help us get our heads around what seemingly was a pretty consistent growth until May and then obviously, based on the numbers you've shared, seems like a fairly dramatic pullback in June, would be helpful.

Stanley M. Bergman - Chairman & Chief Executive Officer

Yeah. So, Bob, let me stress that this is not the first time we've seen this. Even in the last three years, four years, five years, we do periodically have a month or two months with a challenge. What happened here is that we had an extremely good April and May, and we didn't expect it to fall off this much. So that's number one.

Number two is, I don't think there's any major that changed dynamics on the competitive side. It is a competitive market to be sure. There's no shortage of competitors. Everybody is fighting for that last dollar. So it is a competitive market.

Having said that, we do own some brands in the discount area and they did not see any real change in dynamics. Their trending is more or less the same as ours. We have those interests in those businesses just so we can keep an eye on what's going on on that side. By the way, we do this not only in the U.S., but throughout the world. And we don't see any major change in the competitive pressures.

In fact, on the contrary. We see equipment doing quite well and practitioners investing specifically on the digital side. So what we said is what we know and we don't normally go this deep into it, but given this change, we felt we should be more explicit. And I can't nor can Jim Breslawski the President of Henry Schein, the CEO of our Dental business, nor could he point to anything specific on the competitive side.

Steven Paladino - Chief Financial Officer, Director & Executive VP

Yeah. And just to add to that, based on the data that we have, we don't see any share shifts of any magnitude that we can reasonably comment on. So, we don't think that our share really changed dramatically during this period. We think the biggest issue is we just had a soft Q in market.

Robert Patrick Jones - Goldman Sachs & Co.

Got it.

Stanley M. Bergman - Chairman & Chief Executive Officer

On the share gain, directionally, I think we continue to gain share. And this seems to be an issue with the very small practices and, yes the very large ones seem to be growing a little bit and the mid-market ones are growing quite substantially. But the little ones are struggling a bit, at least from a June point of view. I would not take that and extrapolate and say, the smaller practices are having problems, but it seems that in this particular two months' cycle there was a challenge there.

Robert Patrick Jones - Goldman Sachs & Co.

Okay. Got it. And then just one quick follow-up. You guys mentioned that you're spending the restructuring program beyond this year. Can you remind us how much of the current program has reduced the cost base so far? And then how will the extended program compare to the details you shared around the initial program?

Steven Paladino - Chief Financial Officer, Director & Executive VP

Okay. Again, on the previous call, I highlighted some of that. For the current quarter, excluding restructuring portion of the core operating expenses and excluding acquisitions that were done within 12 months, because they just changed the base, we took down operating expenses as a percentage of sales by 55 basis points. So we're looking to do more. Right now, we're still determining exactly what additional restructuring activities should be executed on, and that's why we can't give an estimate for how much the additional restructurings are, because we haven't finalized that. But we do expect to take operating expenses down even further, again to reflect this more cautious view. And there's opportunities there for us. But it's really difficult to pinpoint that at this point.


Your next question comes from David Larsen from Leerink.

David M. Larsen - Leerink Partners LLC

Hi, can you talk a bit about the Medical division. It looks like the growth rate was very in the quarter, but it seems like it did decelerated a little bit sequentially. How's the relationship with Cardinal and how are trends in that space? Thanks.

Stanley M. Bergman - Chairman & Chief Executive Officer

Yeah. So, David, I think we've mentioned in the last couple of calls that the sales in Medical to some extent is to a large extent dependent upon bringing on these larger accounts, and they come onboard in a lumpy way. So we brought a lot of these accounts onboard in the last two years. It's obviously not sustainable at these phenomenal rates, because the market is not growing by these rates. The market probably, and there's no specific data, is growing by a couple of hundred basis points and definitely not because of inflation, because pricing is moving from branded to generics on the pharmaceutical side and on the MedSurg side.

So, we've had very healthy growth in this area, organic. We are growing on top of that. So I would repeat what we said in previous calls, that we are gaining market share. I think we're gaining very nicely on the market share side organically. Of course, the Cardinal acquisition did help, but organically, I think that's where the impetus is coming from.

So I'm not sure, as I said in my – I think in the prepared remarks, that these double-digit growth numbers are sustainable in Medical, but we will grow at a multiple of the markets. And we will increase our profits in this area as we drive more profitable mix in products in this area. We're very happy with our Medical business.

Now on the Cardinal side, the integration of the Cardinal Health physician office business is substantially complete, and we have received positive feedback from the acquired customer base. There's a lot of change going on in healthcare and we are in the process of modifying our purchase commitment to Cardinal to reflect the rapidly changing environment that makes more business sense from both of our points of view. We're creating greater flexibility in our relationship with Cardinal, specifically around the integrated delivery networks. They are better at servicing aspects of the IDN and we are better at servicing other aspects of the IDN.

So we are modifying the marketing arrangement with Cardinal. And there are certain products that doesn't make sense for us to buy from Cardinal as they have very good procurement pricing as it relates to hospitals. But the demand for choice in the physician market is much greater than in the hospital where formularies can be mandated and not so much mandated in the physician space, and even in large group practices.

So, we're modifying this thinking right now with Cardinal, but I would say, our internal growth is pretty good in this physician space, arguably the best of all the players, the bigger players. And we're very optimistic about this business and actually optimistic about the strategic direction we can take this business in over the next five years.

David M. Larsen - Leerink Partners LLC

Great. Thank you.


Ladies and gentlemen, we have time for one final question. And your final question comes from Ross Muken from Evercore ISI.

Elizabeth Anderson - Evercore Group LLC

Hi. This is Elizabeth Anderson in for Ross. I was wondering if you could give us any updated thoughts on, in terms of the M&A pipeline and in terms of valuation or technologies that you guys are looking at?

Stanley M. Bergman - Chairman & Chief Executive Officer

Yeah. I would say that on the M&A side, we very rarely participate in books that are put out. We have bought some companies where a book has been put out, for example, BioHorizons. But generally, our deals are known well in advance before they're close. It's usually a family company, a private equity firm that understands we're the best buyer. And so really, yeah, I think prices are higher in that segment than they were before, because interest rates are lower. But we don't participate really in the bubble pricing where you are seeing crazy multiples on some deals because private equity has a lot of money on the sideline and because interest rates are low.

Our deals are deals that are carved out for specific strategic reasons, a family wants us to buy 80%, somebody wants to stay a partner once the merger does bring their product to our channels. And I would say, we have no shortage of deals; our pipeline is pretty good. And I think we're still on line with putting to work, I think, what is it, $200 million, $220 million, $250 million...?

Steven Paladino - Chief Financial Officer, Director & Executive VP


Stanley M. Bergman - Chairman & Chief Executive Officer

Sometimes as much as $300 million, but I doubt, less than $200 million a year. These kinds of deals in the end are expensive in the first year from a P&L point of view, because you've got all the deal cuffs (62:18), sometimes you have software amortization that has to be picked up in first year or inventory adjustments, but in the second year or so that become very profitable.

Elizabeth Anderson - Evercore Group LLC

Okay. Great. And I guess as a follow-up, my other question is, have you seen any changes in the large practice dental market in terms of increased competitiveness there, anything like that? I know that some of your competitors have been saying that they're looking more closely at that end of the market. Thanks.

Stanley M. Bergman - Chairman & Chief Executive Officer

Sure. There's always increased competition. There's no shortage of suppliers that would like to take these accounts. And we believe that we have very good value-added services. Of course, we will lose an account from time-to-time. But I think in the end, we've shown that we can gain more accounts than lose them, especially those that are centrally managed, that are formulary driven. I think our knowledge from the Medical space, which was introduced into the Animal Health space and into Dental, stands us in good stead. But, yes, there's obviously increased competition. To my knowledge, there's been increased competition over the past decade almost. And I think we're doing okay and we are building more and more value-added services, that's the nature of the free market.

Stanley M. Bergman - Chairman & Chief Executive Officer

So thank you, everyone, for calling in. We're, of course, very bullish about the future of Henry Schein; nothing has changed there. We have a good strategic plan. We start in January of 2017 working on the strategic plan for 2018, 2019 and 2020. I'm sure that will result in allocation, reallocation of resources, as you would expect. But overall, we're very pleased with the direction, the longer-term results.

Sometimes one business is ahead of another; that's the nature of business. Sometimes you have a challenge here and you've a challenge there and you have a plus here and a plus there. We have a great management team, a team in the organization that is highly motivated and ready for even more competition. And so, we remain very, very excited about where we are and the opportunity for the future.

If anybody has further questions, please contact Carolynne Borders at 631-390-8105. And thank you for your participation, and look forward to speaking with our investor community again in 90 days. I believe Steven, and I'm not sure about myself, but I know Steven will be at investor conferences over the next 90 days, and certainly are ready to speak about any questions that you may have in the form of clarification of information already disclosed. So thank you very much.


Ladies and gentlemen, this does conclude Henry Schein's second quarter conference call. Thank you for participating. You may now disconnect.

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