Sirona Dental Systems, Inc. F3Q08 (Qtr End 06/30/08) Earnings Call Transcript

Sirona Dental Systems, Inc. (SIRO) F3Q08 Earnings Call August 6, 2008 9:00 AM ET

Executives

Jost Fischer – Chief Executive Officer
Simone Blank – Chief Financial Officer, Executive Vice President, Director
Jeffrey T. Slovin – Chief Operating Officer - U.S. Operations

Analysts

Analyst for John Kreger – William Blair
Jon Wood – Banc of America Securities
Tycho Peterson – JPMorgan
John Putnam – Dawson James Securities
Jeff Johnson – Robert W. Baird
Glen Santangelo – Credit Suisse
[Unidentified Analyst]

Operator

Welcome to the third quarter 2008 Sirona Dental Systems earnings conference call. (Operator Instructions) I would now like to turn the presentation over to your host of today’s conference, John Sweeney, VP of Investor Relations.

John Sweeney

Before I turn the call over to Jost Fischer, Chairman, President, and CEO of Sirona Dental Systems, I need to inform you that information in this conference call contains forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995.

Forward-looking statements are information of a nonhistorical nature and are subject to risks and uncertainties that are beyond the company’s ability to control. The matters discussed in this conference are subject to various factors which could cause actual events and results to differ materially from such statements. Such factors include uncertainties as to future sales volumes of the company's products; the possibility of changing economic, market, and competitive conditions; dependence on products; dependence on key personnel; technological developments; intense competition; market uncertainties; dependence on distributors; ability to manage growth; dependence on key suppliers; and other risks and uncertainties including those detailed in the company's filings with the Securities and Exchange Commission.

The company undertakes no obligation and does not intend to update these forward-looking statements to reflect events or circumstances occurring after this conference call. You are cautioned not to place undue reliance on these forward-looking statements which speaks only as of the date of this conference call.

Please note that in today’s conference call you’ll be presented with additional financial information including non-GAAP financial measures under Section 101 of Reg G of the 1934 Exchange Act. In addition, during today's conference call, management will comment on guidance for fiscal year 2008. Please note that all statements made in connection with the guidance are based on current expectations, and actual results could differ materially from such forward-looking statements.

Now, I would like to turn the call over to Jost Fischer, Chairman, President, and CEO of Sirona Dental Systems.

Jost Fischer

It is my pleasure to welcome all of you to our fiscal 2008 third quarter conference call. Joining me today are Simone Blank, Executive Vice President and Chief Financial Officer; and Jeffrey Slovin, Executive Vice President and COO of US Operations.

I’m pleased to report another strong quarter. Our growth was broad based across all major regions and all business segments. Revenues reached $186.9 million, up 19%. Our earnings per share showed positive progression, with our third quarter GAAP EPS of $0.12, up from $0.04 in the prior year period. Excluding certain items that Simone will identify later, non-GAAP earnings per share was $0.43, up 80%.

In the US, we achieved 9% revenue growth led by solid performance in our imaging business. International revenues increased 24%. Our non-US, non-European business continued its excellent growth trajectory led by strong sales in Japan and Russia. These markets continue to show an encouraging growth trend as they benefit from our strategy to increase our local sales and service infrastructure. All this has resulted in increased SG&A expense. These investments continue to show positive results.

Europe has double-digit revenue growth with weaker performance in Germany due to the absence of IDS-related sales this year. The third quarter demonstrates how Sirona continues to benefit from its geographic diversification. As you know, non-US markets account for more than two-thirds of our overall business.

In the past few weeks, we announced two significant new product launches demonstrating Sirona’s continued focus on innovation. The latest product launch in our treatment center segment is TENEO, a premium treatment center that combines industry leading technology with a timeless design. The TENEO treatment center is the true centerpiece of the digital dental practice combining patient communication, optimized workflow, and implant and endodontic systems integrated directly into the unit. TENEO provides both the patient and the dentist with the ultimate in convenience and comfort. It features an easy touch display that allows the dentist to focus on the dental procedure at hand resulting in a more efficient workflow. The TENEO line will be at European dental shows starting this fall.

In addition, we announced the launch of the Galileos Compact 3D imaging system developed specifically to meet the needs of the general practitioner. The Galileos Compact has excellent image quality, integrated implant planning tools, and the largest field of view in its class. It provides an excellent value for dentists who will require 3D diagnostic capabilities, and the system can be upgraded to the equipped Galileos Comfort. The compact unit has significantly lower radiation dosage requirements than other 3D systems. Deliveries of Galileos Compact will start later this month. Both TENEO and Galileos Compact showcase Sirona’s industry leading commitment to advancing dentistry through innovation.

I’ll now briefly outline the highlights for each of our business segments. Instrument revenues increased 26%, with particular strength in Europe. Instrument segment gross profit margin was 44.5%, up 3.3 points from the prior year quarter, primarily resulting from a favorable product mix. Treatment center revenues increased 26% with solid performance in Europe, the Middle East, and Southeast Asia. Treatment center segment gross profit margin was 36.8%, relatively in line with the prior year quarter.

Revenues in our CAD/CAM segment increased 17% with particularly strong growth in some of our European markets. Our third quarter CAD/CAM revenues included the first shipment of MCXL unit for the follow-on trade-in program initiated by Patterson in the US. CAD/CAM segment gross profit margin improved 317 basis points to 68.4%, up from 64.7% in the third quarter of 2007. A favorable product mix and improved margin performance for MCXL milling unit drove the CAD/CAM margin expansion.

Imaging segment revenue has increased 14% with double-digit growth in both the US and our non-US and non-European markets. Imaging system growth continues to be driven by the adoption of digital radiography and 3-D imaging. Segment gross profit margin was 58.7%, up slightly due to a favorable product mix, partially upset by pricing pressure in panoramic product line.

Moving on to outlook, we are pleased with our business performance. The year is progressing as expected, maybe a bit ahead of where we thought it would be at this time. As we have previously discussed, comparisons get more challenging for fourth quarter. Let me remind you that in the fourth quarter of 2007, revenues increased 31%, and our CAD/CAM segment revenues increased 68% driven by our new product launches and the MCXL trade-in program in the US. Sirona’s financial performance year to date and our full year guidance demonstrate that the company with its strong portfolio of leading high-tech products, well-balanced geographic profile, quality sales and service infrastructure, and excellent relationships with dealers including our largest partner, Patterson and Henry Schein, is well positioned for future growth.

I will now turn the call over to Simone who will give you more details on our financial results.

Simone Blank

Third quarter revenue was $186.9 million, an increase of $29.9 million, or up 19% on a reported basis. On a constant currency basis, third quarter revenues increased 7.5%, with instruments up 10%, treatment Centers up 9%, CAD/CAM systems up 8%, and imaging systems up 5%. United States revenue increased to 9%, while international revenues increased 24%, up 7% in constant currency. International growth was led by Sirona’s expanded presence in Japan and Italy as well as strong sales in Russia.

Cost of sales was $103.5 million for the quarter, an increase of $13.6 million or 15.1%. Cost of sales included deal-related amortization and depreciation expense of $21.9 million compared with $19.1 million for the same period last year. Excluding deal-related amortization and depreciation expense, gross profit margin increased 140 basis points to 56.4%. The gross profit margin improvement was driven by margin expansion in the CAD/CAM and instrument segment.

Now, I will review some of the performance of our operating expenses in the third quarter. SG&A expense was $63.8 million, an increase of $14.1 million. As a percentage of sales, SG&A expense increased to 34.1% from 31.6% in the prior year quarter, driven by the weak US Dollar as most SG&A expenses are Euro denominated, expenses associated with growth and revenue, and Sirona’s expanded presence in various markets as well as product launch expenses for TENEO.

R&D was $11.8 million, flat as compared to last year. Operating income plus amortization expense increased 34% to $33.8 million. The noncash gain on derivative instruments amounted to $6.1 million, compared to a gain of $2.6 million in the prior year period. Third quarter 2008 gain included a $7.4 million unrealized noncash gain, or $0.09 per share on interest rate derivatives resulting from strengthening LIBOR and EURIBOR rates.

Net interest expense was $6.6 million compared to $5.8 million. The increase was driven by a weaker US Dollar compared to the Euro. The income tax provision for the third quarter of fiscal 2008 was $3 million compared to $1.1 million for the prior year period. The effective tax rate for the quarter and for the full year 2008 is estimated at 30%. This compares to an effective tax rate of 35% for fiscal 2007. This improvement was caused by a reduction in the German tax rate and tax planning initiatives.

The company’s net income was $6.7 million, an increase of $4.7 million compared to the prior year. On a GAAP basis, third quarter earnings per diluted share were $0.12 compared to $0.04 in the prior year quarter. Third quarter GAAP EPS included $0.30 expense for deal-related amortization and depreciation and more currency-related loss resulting from the revaluation of the Patterson exclusivity fee. In the prior year quarter, GAAP EPS included $0.23 of deal-related amortization and depreciation and $0.03 gain from the reevaluation of the Patterson exclusivity fee and short-term intra-group loan. Excluding these items in both periods, third quarter diluted earnings per share were$0.43, an increase of 80% compared to $0.24 per share in the third quarter of 2007.

Moving on to cash flow. Operating cash flow during the quarter was $21.4 million. Investing cash flow was $10.5 million. At June 30, 2008, the company had cash and cash equivalents of $122.8 million and total debt of $590.7 million, resulting in net debt of $467.9 million. This compares to net debt of $463.3 million at September 30, 2007. The increase in net debt was attributable to a weaker US dollar relative to the Euro as the majority of Sirona’s debt is Euro denominated.

Now I will make a few comments on the revised guidance that we put out this morning. As a result of the solid performance of the business year to date and the strength of the Euro relative to the U.S. dollar, the company is increasing its fiscal year 2008 revenue guidance. Assuming that the Euro-dollar exchange rates remain at current levels, Sirona now expects fiscal 2008 revenue to be in the range of $750 to $760 million, up from $725 to $745 million. Due to our solid business performance year to date, we are increasing the bottom end of our operating income plus amortization guidance range. Our new guidance range is $150 to $155 million, up from $145 to $155 million. Please note that higher revenue resulting from a more stable Euro-Dollar exchange rate is anticipated to be offset by increased cost as more than three-quarters of our expenses are Euro denominated. That concludes my review of the third quarter and guidance. I will now turn the call back to Jost.

Jost Fischer

Thank you, Simone. I am sure you will agree we had another strong quarter. The year is progressing as expected, maybe a bit ahead of what we thought it would be at this time. Our international revenue base continues to show solid progress, and our results highlight the benefit we’ve received from our geographic diversification. In the US, our business has shown reasonable performance in the quarter and year to date. Fiscal 2008 will be another solid year for Sirona even with the challenging fourth quarter comparison. I am optimistic about our prospects, and we are taking the right steps to ensure that we will continue to succeed in the expanding global dental equipment market.

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

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Analyst for John Kreger with William Blair.

Analyst for John Kreger – William Blair

My first question was just around the revenue guidance. The guidance implies the fourth quarter revenues will decline from the third quarter. Is this just a function of seasonal pattern for you of a summer slowdown or is there anything else behind that expectation?

Jost Fischer

Talking about the fourth quarter, I just want to highlight that we had a very good result year to date, a bit ahead of what we thought we would be at this time of the year. Our guidance implies that revenues will be roughly flat compared to prior year, but down on a constant currency basis. Last year, we were growing 31%, especially CAD/CAM was up 68%, a performance that we cannot do again. We had that strong growth in the US that was even higher than 68%, due to the well-received Patterson upgrade program. Our international markets year to date have very good performance. We expect that to continue. The CAD/CAM I was touching in the US and therefore I think the fourth quarter will be something that is not indicative of our future opportunities.

Analyst for John Kreger – William Blair

And then, what are your thoughts about how the second half of the calendar year might play out around the traditional heavy season for equipment buying? Do you think it is likely to be a pretty typical season, or could it be better because of the tax incentive we are expecting in the fourth quarter calendar?

Jost Fischer

Well, we’re looking at section 129. We haven’t seen a real impact at this point in time. We expect that to be more at the back end of the year, which will then be our new fiscal year. Usually doctors tend to make their decision as late as possible after reviewing that with their tax advisors, so we expect positive impact from the tax breaks, but we will see the majority of that in the November-December timeframe.

Analyst for John Kreger – William Blair

And then, just wondering about your thoughts on if you’ve seen any impact in the CAD/CAM or imaging space from your competitor?

Jost Fischer

First of all, I would like to underscore that CAD/CAM is the future of dentistry that not only we see. We are pleased that two thirds of dental reps now are talking positive about CAD/CAM, so we believe this will have a positive effect on the overall market. Let me remind you that we have about a 20-year head-start on this one, and we have lots of clinical reference that we can show, and this is what our competitors still have to work through. I think overall this is going to be positive for CEREC as well.

Operator

Your next question comes from Jon Wood with Banc of America Securities.

Jon Wood - Banc of America Securities

Jost, the new Patterson CEREC trade-in program, any view what proportion of the base will take advantage of that program?

Jost Fischer

First of all, when we look at our first trade-in program, it was clearly a very big success. We do not expect the second trade-in program to go into these numbers. We feel that after a year of not having any opportunity to sign off, doctors will feel intrigued by this opportunity. This program is still running. I think it started out a little slower than we thought in the beginning, but it picked up recently, so we expect that to be a success.

Jon Wood - Banc of America Securities

The changes Patterson made in the commercial strategy especially in the digital side of things, has that started to benefit the numbers yet?

Jeffrey T. Slovin

Hi Jon, it’s Jeff. I think that, as you stated, these are pretty significant strategic initiatives that they’ve undertaken to better align themselves with their goals and certainly plays into our goals. We think that it’s the right thing that they’re doing, and I would tell you that it’s a little too early to see the benefit of that yet. Certainly giving away the EagleSoft directly relates to us. The commission changes and the realignment having the equipment specialists focused on our product line, we think, makes a lot of sense, but I would say it’s early and it’s going to take some time, so we’re not seeing the full benefits of it yet.

Jon Wood - Banc of America Securities

Jeff, you talked about digital imaging rebounding in the US, I think. You said it was double digit in the US in the quarter. Is that right?

Jeffrey T. Slovin

Yes, that’s right.

Jon Wood - Banc of America Securities

How’s the intraoral there? Has it stabilized? I know Patterson has had some problems there.

Jeffrey T. Slovin

I wouldn’t use the word stabilized yet, because I think the initiative that they announced on June 9^th have a lot to do with not only stabilizing but getting us back to where we should be growing, so I think that will continue to take some time for us to work through.

Jon Wood - Banc of America Securities

Jost, you are building cash here. I know that there’s some debit maturities coming. Is there any potential you can put a stock buyback program in place?

Jost Fischer

Jon, certainly we are looking at all options, and that’s why we keep the cash on our balance sheets. Certainly, this is one of the options.

Jon Wood - Banc of America Securities

Okay, one last one for Simone. The SG&A level, I understand your prepared remarks there, but can you give us some sense of where that expense item tracks over the next couple of quarters? Does it continue to rise on an absolute dollar basis, or should we see some tempering in the increases there?

Simone Blank

As we said before, Jon, now we expect it to be around 32% on a full-year basis. That’s still a good estimate for that expense item, and the absolute level is always determined also by the US Dollar-Euro exchange rates to a large extent, and so long as that is relatively stable, then we will not see major changes. And to remind you, as we said earlier, there are some new large expenses in the SG&A which will not repeat every quarter going forward.

Operator

Your next question comes from Tycho Peterson with JPMorgan.

Tycho Peterson – JPMorgan

Maybe I’ll just start out with a question on the new Galileos. I know obviously you’re not shipping yet, you said August, so I assume later this month, but can you just give us a sense as to how you expect demand to play out here, maybe over the next couple of quarters and just how you’re positioning it with sales force?

Jeffrey T. Slovin

Sure, absolutely. I think first of all, it’s been very well received around the around by our distributors, and going from our comfort to the compact gives us an excellent opportunity to segment the market and to go after the general practitioner, who will find that the campact serves all of their needs especially for implant. From a pricing perspective, we’ll be very competitive depending on the market that we’re in. We feel good about that. The field of view is the largest, and it continues to have our outstanding software and the intuitive implant, and as you know, the big thing for us at Sirona is dosage, and again we have the lowest in class in radiation.

Tycho Peterson – JPMorgan

Jeff, maybe could you elaborate on how often dosage comes up in your sales discussions with customers in terms of priority?

Jeffrey T. Slovin

I think that it’s one of those situations, Tycho, that at the end of the day they feel good about. I can’t say that it’s the driver of their decision, but once they buy it, all of their patients know about that. Now, just talking about the demand, I think that having the two products is going to absolutely stimulate the overall demand for our 3-D category, so I would expect our unit sales to increase as we go forward significantly.

Jost Fischer

Tycho, let me add to this on these low dosage requirements. I think in Europe, this plays a bigger role from that point of view. In Central Europe especially, we get a lot of questions about how is your dosage and how does that compare to your competitors.

Jeffrey T. Slovin

That’s absolutely right. In other countries, they almost mandate the level.

Tycho Peterson – JPMorgan

Okay, that’s helpful. Jost, the comments you made on pricing pressure on panoramic, is that coming from a few vendors, or is it just pretty much widespread across the landscape?

Jost Fischer

I think that’s certainly widespread when you talk about a higher volume market. I think from our point of view, we will be playing on that field. I think certainly there are some competitors mainly with a US dollar-based cost structure who are trying to take advantage of that, but from our point of view, that’s okay.

Jeffrey T. Slovin

I would just add one other thing, Tycho. When you take a look at our panoramic and the features that we offer from our XG-3 all the way to the XG-Plus, it’s pretty well differentiated over the competition, and for the competition itself, the only way to compete is to get in the pricing game, and so we’ve have had to deal with that as well.

Tycho Peterson – JPMorgan

Finally, you called out the expanded presence in Italy and Japan, and Russia, I guess, as well in terms of strong sales. Can you give us a sense geographically beyond your core markets where you’re placing your efforts these days?

Jost Fischer

That’s pretty much determined by the size of the market and potential size of the market, and certainly our core besides North America is Europe, but we also see that Japan being the second largest market for dental in this world is compelling addition to CERONA’s product line, and then you have those emerging markets that we talked about. They comprise of China, Korea, and Russia, and the Middle East where we will have a bright future. As you know, the oil price is up. There are some challenges with some of the western industries, but there are also some positives for people who receive oil money and where that goes. There are also some big plans to improve dental care.

Tycho Peterson – JPMorgan

Okay, and then finally your comment on the German market was really a function of not having IDS this year, not some underlying dynamic?

Jost Fischer

Yes. In the third quarter, we came right out of IDS with all the orders that we then fulfilled, and I think the absence of that for this year will have an effect. As you know, traditionally, in a non-IDS year, the summer quarters are the weaker quarters, but that’s not true after a product launch or IDS side of it, and I think that’s a function of that, Tycho.

Operator

Your next question comes from John Putnam with Dawson James Securities.

John Putnam – Dawson James Securities

I was just wondering if you might give us a little bit of guidance on gross margin in the fourth quarter.

Jost Fischer

I’ll pass that to Simone from that point of view. I think basically it’s a function of our mix that we’ll see, but Simone, please.

Simone Blank

Our gross profit margin in the quarter as Jost said is always a function of product mix, and we have a difficult comp. As Jost said earlier, in last year’s quarter, we had 68% increase in CAD/COM sales, and that clearly will not repeat in the fourth quarter this year, and as you know it is the segment with the highest margin for us, and so that’s one of the main reasons.

John Putnam – Dawson James Securities

So, on a sequential basis, Simone, do you think it will be flattish, or…?

Simone Blank

Probably more down than flattish.

Operator

[Operator Instructions]. Your next question comes from Jeff Johnson with Robert W. Baird.

Jeff Johnson – Robert W. Baird

Simone, one followup question for you. Was there any benefit from acquisitions in the quarter?

Simone Blank

No, nothing.

Jeff Johnson – Robert W. Baird

Fair enough. Jost, a couple of followups. One, on your point on potential buyback, remind me, you are covenant restricted at this point until debt to EDITDA levels come down just a touch. Is that correct?

Jost Fischer

We have some restrictions from when refinanced in November 2005. I think those were the heydays of loose credit giving, so we feel comfortable that we can manage a buyback with the current levels of debt and cash that we have.

Jeff Johnson – Robert W. Baird

Okay, so you could put a plan in place as soon as today?

Jost Fischer

Yes, we could.

Jeff Johnson – Robert W. Baird

Last question, I’m not looking for ’09 guidance here, but just your thoughts, I guess, on the dental market given macroeconomic issues we’re seeing, just general dental equipment market comments maybe over the next 6 to 12 months taking out comp issues and things like that. Just where do you see US and European dental equipment market maybe playing out over the next 12 months?

Jost Fischer

Jeff, first of all, I think our distributors are closer to the market than we are, but when listening to yesterday’s call from Henry Schein, they do not see a large impact although they don’t think they’re totally immune, and I would underscore that statement. As of today, we’ll see our European markets holding up very well, and as I said earlier today, the emerging markets are showing very positive trends, and we have not seen a slowdown in those markets as of today.

Operator

[Operator Instructions]. Your next question comes from Glen Santangelo with Credit Suisse.

Glen Santangelo – Credit Suisse

I just had a quick question regarding the split between your US sales and your international sales. It seems like you’re seeing some modest deceleration internationally, and it seems like you’re seeing some acceleration in the US, when I look at international on a constant currency basis. Is that the right way to think about it? Are you seeing some momentum in the US and some deceleration internationally, or is that not right?

Jost Fischer

I think on a sequential basis for the quarter over quarter, that’s a right statement. I do not see this as a trend. I think from an international point of view, two-thirds of our sales are international. We have a variety of different countries with different performance sizes, and as I said earlier, Germany had a weaker quarter just because of the function of a non-IDS year that held down our growth rates internationally in the aggregate. In the US, I think 9% is a good rate at this point in time. On the other hand, we do not see a meaningful change in those markets from that point of view.

Glen Santangelo – Credit Suisse

Jose, maybe if I can just follow up, you sort of suggested in the press release that the United States was CAD/CAM and imaging segments, and so when I kind of look at it, you posted a single-digit constant currency growth rate in both imaging and CAD/CAM overall. Is it fair to say that the US market experienced better trends in both of those product segments than what I see in total here?

Simone Blank

No, I don’t think we can confirm that. We said that we are seeing good performance of the imaging business in the US, double digit growth-wise, Jeff said that before, and we continue to see good performance in our international markets. When we talk about all of this, I think we have to take into account the quarterly progression for the full year 2008 also, and Jost mentioned some of the aspects like the IDS which impacts the quarterly progression in a given quarter, so I think we need to take all of that into account also.

Glen Santangelo – Credit Suisse

Simone, when you talk about double-digit growth in imaging systems, are you talking about total dollars or constant dollars?

Simone Blank

For the US, that’s not a question that’s…

Jost Fischer

It’s total dollars. Constant and total is the same for this market.

Operator

I’d now like to turn the call over to Jost for closing remarks.

Jost Fischer

Thank you. I am optimistic about our prospects, and we’re taking the right steps to ensure that we will continue to compete and win in the expanding dental equipment market. Thank you for joining us today. I look forward to updating you on our next quarterly conference call.