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Edited Transcript of PDCO earnings conference call or presentation 29-Aug-19 2:00pm GMT

Q1 2020 Patterson Companies Inc Earnings Call

ST. PAUL Oct 1, 2019 (Thomson StreetEvents) -- Edited Transcript of Patterson Companies Inc earnings conference call or presentation Thursday, August 29, 2019 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Donald J. Zurbay

Patterson Companies, Inc. - CFO & Treasurer

* John M. Wright

Patterson Companies, Inc. - VP of IR

* Mark S. Walchirk

Patterson Companies, Inc. - CEO, President & Director

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Conference Call Participants

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* Brandon Couillard

Jefferies LLC, Research Division - Equity Analyst

* Elizabeth Hammell Anderson

Evercore ISI Institutional Equities, Research Division - Associate

* Erin Elizabeth Wilson Wright

Crédit Suisse AG, Research Division - Director & Senior Equity Research Analyst

* Glen Joseph Santangelo

Guggenheim Securities, LLC, Research Division - Analyst

* Jeffrey D. Johnson

Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst

* Jonathan David Block

Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst

* Kevin Caliendo

UBS Investment Bank, Research Division - Equity Research Analyst of Healthcare IT and Distribution

* Kevin Kim Ellich

Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst

* Nathan Allen Rich

Goldman Sachs Group Inc., Research Division - Research Analyst

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Presentation

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Operator [1]

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Good morning. My name is Christina, and I will be your conference operator today. At this time, I would like to welcome everyone to the Patterson Companies Q1 Earnings Release Conference Call. (Operator Instructions)

John Wright, VP of Investor Relations, you may begin your conference.

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John M. Wright, Patterson Companies, Inc. - VP of IR [2]

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Thank you, operator. Good morning, everyone, and thank you for participating in Patterson Companies Fiscal 2020 First Quarter Earnings Conference Call.

Joining me today are Patterson President and Chief Executive Officer, Mark Walchirk; and Chief Financial Officer, Don Zurbay. After a review of the fiscal 2020 first quarter by management, we will open up the call to your questions.

Before we begin, let me remind you that certain comments made during this conference call are forward-looking in nature and subject to certain risks and uncertainties. These factors, which could cause actual results to materially differ from those indicated in such forward-looking statements, are discussed in detail in our Form 10-K and our other filings with the Securities and Exchange Commission. We encourage you to review this material. In addition, comments about the markets we serve, including growth rates and market shares, 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 29, 2019. Patterson undertakes no obligation to revise or update any forward-looking statements to reflect events or circumstances after the date of this call. Also a financial slide presentation can be found in the Investor Relations section of our website at pattersoncompanies.com.

Please note that in this morning's conference call, we will reference our adjusted results for the first quarter of fiscal 2020. The reconciliation table in our press release is provided to adjust reported GAAP measures, namely operating income, income before taxes, income tax expense or benefit, net income, net income attributable to Patterson Companies, Inc. and diluted earnings per share attributed to Patterson Companies, Inc. for the impact of deal amortization, integration and business restructuring expenses, legal reserve costs and investment gain, along with the related tax effects of these items.

We will also discuss adjusted free cash flow, defined in our earnings release, which is a non-GAAP measure, and the impact of foreign currency. In particular, we will use the term internal sales to represent net sales adjusted to exclude foreign currency impact and changes in product selling relationships.

The reconciliation of our reported and adjusted results can be found in this morning's press release. This call is being recorded and will be available for replay starting today at noon Central Time for a period of 1 week.

Now I'd like to turn the call over to Mark Walchirk.

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [3]

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Thank you, John, and welcome, everyone, to Patterson's first quarter conference call. Our results in the first quarter reflect the impact of our focus over the past year to drive improved profitability and performance. The continued stabilization of our core business and execution of our key initiatives has enabled our team to effectively manage through an evolving end market environment.

Now before we get into the details of the quarter, I would like to summarize a few key points. First, we grew adjusted earnings per share nearly 4% in the quarter and delivered the second consecutive quarter of year-over-year adjusted EPS growth. Second, we enhanced profitability in both our Animal Health and Dental segments and expanded our overall adjusted operating margins by more than 20 basis points year-over-year.

Next, we generated $51.6 million in adjusted free cash flow for the quarter and increased adjusted free cash flow by 30% year-over-year. We continued to return cash to shareholders and paid $25.5 million in cash dividends during the quarter. And finally, we reaffirmed our adjusted annual earnings guidance range of $1.33 to $1.43 per share.

While we still have work to do, I'm very pleased with our progress and the focus of our team, and we are right on track to deliver on our expectations for the year. Despite lower revenue growth, one of the highlights of our first quarter was our ability to drive enhanced profitability through our focus on 3 key areas: operational improvements, mix management and expense discipline.

Now before we dive into the specific results in each of our business segments, I'd like to take a minute to discuss how these initiatives helped shape our quarter and position us well for the balance of the year. One example of operational improvement is the focus we have made in the tools that enhance the productivity of our technical service team. These tools have enabled us to more profitably deliver valuable expertise to customers who rely on Patterson's local on-site support infrastructure and national support center. Through our team's focus on analytics and operational excellence, the increased productivity of our technical service team resulted in double-digit growth in our value-added services business within our Dental segment.

Two examples of our initiatives to improve our mix include our growth in software and e-services as well as our continued focus on private label. Importantly, these improvements came across both our Dental and Animal Health segments. With respect specifically to software and e-services, we succeeded in leveraging our strong installed base and relationships with third-party software vendors to provide these higher-margin services to our customers, which help them more effectively manage their practice with data and important insights. In addition to providing value to our customers, these services are also highly accretive to our margin profile.

Finally, while we remain focused on making investments in areas that benefit the customer and allow us to drive growth and profitability, we have continued to carefully analyze our cost structure and make appropriate adjustments to ensure our expenses are in line with the needs of the business. As a specific example of these cost discipline initiatives, we reduced approximately 100 existing and planned positions during the first quarter. Importantly, these changes were primarily focused on administrative roles across the company and not customer-facing positions. I'm pleased with our team's focus on these 3 key areas, which helped drive our performance in the quarter.

Now I'll turn to each of our business segments, starting with Animal Health. Our Animal Health segment achieved its operating profit goals during the first quarter despite overall top line softness. Animal Health internal sales increased 0.5% in the quarter, driven primarily by nearly 4% internal sales growth in our U.S. companion animal business. Adjusted operating margins for the Animal Health segment increased by 10 basis points on a year-over-year basis for the quarter. And importantly, we saw gross margin and operating margin expansion in both the companion animal and production animal businesses.

As I mentioned previously, our improved profitability is the result of our focus on driving operational improvements and effective mix management. Let me give 2 specific examples within our Animal Health segment of our efforts to increase profitability by focusing on margin accretive initiatives that also provide value to the customer.

First, our ongoing commitment to expand our private label business generated double-digit growth in sales of our companion animal private label products during the quarter. We also launched a new private label brand called PIVETAL and continued to add SKUs to our broader private label portfolio. Our private label brands allow Patterson to serve our customers with exceptional product at an affordable price and at a more attractive margin profile for Patterson.

Secondly is our progress to provide a comprehensive technology solution that meets the evolving demands of our veterinary customers. Our NaVetor practice management software is gaining additional traction in the market as veterinarians seek innovative technology solutions that are easy to implement and help them manage their practices.

In addition, we continue to benefit from our strategic relationship with Vetsource. For more than a decade, Vetsource has provided a powerful suite of tools designed to improve compliance, enhance client relationships and increase revenue to thousands of veterinary practices across the country. Importantly, the Vetsource ScriptRight platform has now been installed in over 21,000 veterinary clinics and hospitals across the country, which continues to position us well to offer an integrated e-commerce and delivery solution. Through this strategic relationship, Patterson is able to effectively compete in both traditional distribution and home delivery, and tailor a solution that best fits the needs of specific veterinarians and their customers.

On the production animal side, our top line performance was primarily impacted by challenging end market dynamics in the beef and dairy markets. On a more macro level, the production market was also affected by uncertainty related to tariffs and trade policy. That said, our production animal team successfully managed through a difficult end market environment in the quarter and was still able to meet their bottom line goals.

Looking ahead, we expect the swine market to stay positive for the rest of the calendar year; however, the beef and dairy markets are projected to remain challenging during this time frame. Despite these anticipated headwinds, our continued focus on meeting the product and service needs of our customers and the continued great sales execution of our production animal team leave us confident we will continue to grow at or slightly above the market during this fiscal year.

Turning now to our Dental segment. We continue to be confident as the overall end market demand is stable and growing slightly. Despite a modest decline of 0.8% in Dental sales in the first quarter, our adjusted operating margin grew 10 basis points on a year-over-year basis through operational improvements and effective mix management. We are pleased that our Dental team was able to achieve its operating profit goals for the quarter.

On the consumable side, we continued to see our trend of sequential improvement. And while we still have work to do to achieve positive year-over-year growth, our consumables sales trend gives us confidence that our strategy to return the consumables category to positive growth is working. We expect our ongoing actions to improve field execution and invest in productivity tools for our sales organization will continue to drive our improving trend in this category.

As I've said before, the equipment market can vary from quarter-to-quarter. Equipment sales growth slowed in the first quarter, except in the CAD/CAM category, which grew 3%. As a reminder, this slower equipment growth was anticipated following our strong 13% increase in the fourth quarter of fiscal 2019 and the lower levels of manufacturer promotional activity compared to the prior year period. Similar to last year, we expect to see our equipment sales build in the second half of the year when new technologies continue to gain additional traction in the market.

Slower growth in equipment was partially offset by strong revenues from our higher-margin value-added services business, including equipment services, which was up 10% in the quarter. This strong performance reflects the value our customers see in Patterson's ability to provide responsive local service and comprehensive national support as well as the return on our investment in an enhanced digital equipment offering and the recurring revenue those additional product sales generate. Our highly experienced technology support staff at the Patterson Technology Center and our team of local service technicians stand ready to seamlessly support our customers and service their equipment throughout its life cycle and that's clearly reflected in our results.

Equipment and dental technology is a key area where Patterson continues to maintain an advantage. We are excited to sell current and future innovation into the marketplace as we are uniquely positioned to provide customers with exceptional support and service long after their purchase is complete. As we continue to drive effective mix management across our Dental business, equipment services as well as software and e-services are important margin accretive focus areas.

Looking across both of our segments, I'm proud of our team's ability to operate in the evolving environment. We are confident in the strength of our value proposition and our capabilities, and we fundamentally believe that continuing to invest in our business for the benefit of our customers is critical to our ongoing and long-term success.

As I personally meet with our customers, it's clear they are looking for a trusted partner to help them run efficient practices and business operations and to help advance their goals. Patterson is evolving along with the needs of our customers to provide a comprehensive portfolio of products, services and technology solutions. Our commitment to being a trusted business partner for our customers will enable us to continue to operate effectively in the evolving environment and deliver enhanced value for our customers and shareholders.

With that, I'll now turn the call over to Don for a deeper dive into our financial results and then I will make a few closing remarks before we take your questions.

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Donald J. Zurbay, Patterson Companies, Inc. - CFO & Treasurer [4]

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Thank you, Mark, and good morning, everyone. My initial comments will highlight our performance in the first quarter of fiscal 2020 as I walk through the financial highlights for the entire company and each of our 2 business segments. And then I'll cover a few of the balance sheet and cash flow items.

Consolidated reported sales for Patterson Companies in fiscal 2020 first quarter were $1.3 billion, a slight decrease of 0.6% versus the first quarter a year ago. Internal sales, which are adjusted for the effects of currency translation and changes in product selling relationships, increased 0.4%. This represents our fifth consecutive quarter of positive year-over-year internal sales growth. We believe this trend reflects the continued positive impact of our initiatives to stabilize and grow the business.

Our first quarter consolidated gross margin was 21.8%, an improvement of 60 basis points from what we achieved in Q1 of fiscal 2019. Adjusted operating expenses as a percentage of net sales for the first quarter were up 40 basis points on a year-over-year basis, primarily related to timing of certain expenses.

As Mark mentioned, during the quarter, we completed a modest headcount adjustment as part of our cost discipline to properly align our cost structure with the business and to invest in higher growth and customer-facing initiatives. We continue to carefully manage our operating expenses within our business segments and at the corporate level, while also balancing the need for investments to sustain and grow the business for the long term.

In the first quarter, our consolidated adjusted operating margin was 3.4%, which represented a 23 basis point improvement over the prior year. It's important to note here that while the top line grew only modestly, we effectively managed the P&L to deliver on our plan for the bottom line. We are pleased with how the operational discipline and practices established in fiscal 2019 have gained momentum and have contributed to our fiscal 2020 results in tangible ways.

On the bottom line, GAAP net income attributable to Patterson Companies, Inc. for the first quarter was $30.0 million or $0.32 per diluted share. This included an investment gain on equity investment of $0.28 per diluted share and a charge related to a legal settlement of $0.14 per diluted share that were both recorded in the first quarter.

Adjusted net income attributable to Patterson Companies, Inc., which excludes deal amortization costs, integration and business restructuring expenses, legal reserve costs and investment gains, totaled $25.4 million for the first quarter of fiscal 2020, a 5.8% increase in adjusted net income over Q1 of fiscal 2019.

Adjusted earnings per diluted share was $0.27 in the quarter, a 3.8% increase over the prior year period.

Now let's turn to our business segments. Internal sales for our Animal Health business increased 0.5% compared to the same period a year ago. This performance was driven by a nearly 4% sales increase in our U.S. companion animal business and partially offset by slowing market growth and reduced producer profitability in our production animal business, primarily related to the beef cattle category of the market. In both our companion animal and production animal businesses, we believe we are growing at or ahead of the overall market.

Adjusted operating margins in our Animal Health segment were 3.5% in Q1, an approximately 10 basis point improvement over Q1 of the prior year. This operating margin expansion took place in both the companion animal and production animal categories of our business. While the top line in our Animal Health segment was impacted by some market softness in production animal, our team delivered on their profit commitment for the quarter.

Now let's move on to the Dental business. In our Dental business, internal sales decreased 0.8% compared to the first quarter of fiscal 2019. On that same basis, Patterson sales of consumable dental supplies decreased 0.4% during the first quarter compared to a year ago. Consumable sales, however, continue to improve sequentially as the experience and productivity of our most recent sales team hire steadily improves.

Internal sales of equipment in the quarter decreased 6.6% versus the same period a year ago. As we have often stated, the equipment market can fluctuate from quarter-to-quarter. And in Q1, that dynamic was accentuated by the strong finish to our fiscal 2019 fourth quarter when we grew the equipment category by 13%. It's also worth noting that less manufacturer and promotional activity in Q1 compared to the prior year also negatively impacted our equipment sales this quarter.

Adjusted operating margins in Dental were 7.4% in the quarter and reflected an approximately 10 basis point improvement compared to the prior year. This operating margin improvement was the result of continued sales execution, improved mix from increased private label sales and value-added services and disciplined expense management.

Now let's look at several cash flow and balance sheet items. During Q1 of fiscal 2020, we used $43.2 million (sic - see press release, "$45.2 million") in cash operating activities. We also collected deferred purchase price receivables of $105.7 million in the quarter, which is included in the investing activity section of the cash flow statement. To fully appreciate our improved cash flow, the combined total of these 2 line items from our cash flow statement totaled $62.5 million for the quarter. This amount is $12.5 million greater than Q1 of fiscal 2019 when excluding the onetime benefit of initiating the trade AR facility we established last year.

When calculating adjusted free cash flow, which we've defined in our press release, cash improved by $11.8 million compared to the prior year. We continue to make progress in the area of managing our accounts receivable, inventory and accounts payable. During the first quarter, these items are favorable by $8 million. And compared to 1 year ago, these same categories in the balance sheet are favorable by $91 million. We believe there is more potential for improvement here, and we will remain diligent in our focus and efforts to extend this improvement and free up additional cash to put to work in the business or return to shareholders.

Turning to capital allocation. We continue to execute on our strategy to return cash to our shareholders. In the first quarter of fiscal 2020, we returned $25.5 million to our shareholders in the form of dividends. Our Board continues to view our dividend as an important component of returning value to our shareholders, and the current dividend yield provides a nice baseline return to shareholders as we continue focusing on our plans to drive improved performance in the business.

Let me conclude with some comments on our fiscal 2020 guidance. For our fiscal year '20 adjusted EPS, we are reaffirming our adjusted earnings guidance range for fiscal 2020 of $1.33 to $1.43 per diluted share. For modeling purposes, as you think about our second quarter, I would remind you that our adjusted earnings per share for the second quarter of fiscal 2019 included a gain of $0.04 related to equity accounting.

And now, I will turn the call back over to Mark.

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [5]

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Thank you, Don. Now before we wrap up and take your questions, I would like to, again, recap some of the highlights from the quarter. We grew adjusted EPS nearly 4%. We enhanced profitability in both our Animal Health and Dental segments. We generated over $50 million in adjusted free cash flow. We continued to return cash to our shareholders in the form of our attractive dividend. And finally, we reaffirmed our adjusted earnings guidance for the year.

I want to reiterate that our improved profitability in the first quarter underscores the traction we're gaining from the actions to drive performance improvement that began in fiscal 2019, the first full year of our 3-year plan. We continue to make great progress against the 3 strategic priorities we're focusing on in fiscal 2020 to leverage this momentum and grow our business on the top and bottom line. And that will enable us to invest for the future and deliver enhanced value for our customers and shareholders.

First, we are continuing to enhance our value proposition through the ongoing investments in our field sales and service organizations. This involves improving sales execution, measuring and upgrading the customer experience, investing in our digital capabilities and broadening our value proposition to our customers through our value-added services offerings.

Second, we are continuing to focus on strategic margin and mix management through ongoing improvements in sourcing, the expansion of our private label portfolio, disciplined cost management and our focus on improving our product and service mix.

And finally, we are generating stronger cash flow by driving operational excellence and disciplined working capital management. These foundational disciplines are gaining traction and positively impacting our performance. Our team is energized and focused on driving stronger performance across our businesses, while also investing in and growing our value proposition, which continues to differentiate us in the market and positively impact our results.

Finally, we are squarely focused on continuing to improve our performance and driving greater return for our shareholders.

And with that, we'll open up the line, so Don and I can take your questions. Operator?

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Questions and Answers

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Operator [1]

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(Operator Instructions) Our first question comes from Erin Wright from Crédit Suisse.

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Erin Elizabeth Wilson Wright, Crédit Suisse AG, Research Division - Director & Senior Equity Research Analyst [2]

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I had a couple of Animal Health questions for you. How would you characterize kind of underlying demand trends across both the production and companion animal markets? Were there any meaningful shifts in veterinary office visits or core dynamics across each of the species groups? And if you can parse out a little bit more how much of the recent performance in companion animal was market share gains versus underlying demand trends?

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [3]

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Yes, Erin, this is Mark. Thanks for the question. So I think certainly as you think about the Animal Health segment, in general, you got 2 kind of obviously key segments and then certainly within each of those segments, you have some different markets. So maybe we'll talk a bit about companion first. We certainly are really pleased with our results during the first quarter, growing our U.S. companion business nearly 4% from the top line standpoint. We think that the higher end of the kind of 2% to 4% market growth that we believe is taking place in the companion segment.

Certainly, you continue to see some evolution in that segment, and we're certainly serving via the partnerships that we have, via relationships that we have both from an e-commerce and online platform standpoint. So we're pleased there. And certainly, we believe our value proposition for our companion animal customers is very comprehensive and that we're getting the benefit of that.

If you look to the production business, really kind of 3 distinct markets there. We certainly look at the swine market is continuing to be positive, you know, obviously under some pressure just given kind of trade and tariff macro environment there. But certainly as that perhaps resolves, that could lean further positive.

Certainly, I think the key issue in the quarter for us is the tougher beef market. And I think as we indicated earlier, we do expect that to continue. Dairy obviously has been a challenge for some time, and we expect that to continue to be somewhat challenging as well. And if you look at some of the top line in the quarter, certainly our production animal business was affected by some of these end market issues, but certainly we're really pleased with the fact that they continued to expand their margins and met their bottom line goals.

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Erin Elizabeth Wilson Wright, Crédit Suisse AG, Research Division - Director & Senior Equity Research Analyst [4]

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Okay. Great. And then just a follow-up to that. You specifically highlighted Vetsource. How do you think about the potential impact of the recent developments in the alternative channel with some of the large animal health pharmaceutical manufacturers now opening -- or I guess working directly with alternatives online pharmacies but establishing price floors for prescription products? How does that even the playing field for you? Or how is that source position in light of some of those dynamics that have happened recently?

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [5]

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Yes, thanks. So we certainly believe that Vetsource is positioned well. I mentioned some of that obviously during the discussion. I think in general, look, as we talked about, our markets continue to evolve. We're certainly not going to comment on specific pricing strategies of the manufacturers, although we're certainly working closely with them and really pleased with the continued relationships that we have with the manufacturers across the channel. And our team continues to talk about the value that we provide as a channel partner and how we can continue to work together for the common goals of ourselves and the manufacturers ultimately serving our customers.

And so we think that Vetsource is a great platform as that market continues to evolve. As I mentioned, we also have relationships with retailers. Certainly, our core focus is on the veterinary practice and really the comprehensive product and service offering that we have to support those customers. And I would also say certainly, we're excited about some of the non-pharmaceutical oriented parts of our business as well. In the Animal Health space, equipment, value-added services, technology, both were up double digits in the quarter. So we believe that that comprehensive value prop really is important for us and all help contribute to our growth in the U.S. companion segment.

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Donald J. Zurbay, Patterson Companies, Inc. - CFO & Treasurer [6]

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Yes. And Erin, this is Don. I mean, I think one of the things that we value here is just the optionality, I think, that we have as we see how things evolve in that segment of the business.

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Operator [7]

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Our next question is from Kevin Ellich from Craig-Hallum.

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Kevin Kim Ellich, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [8]

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I guess, I wanted to go back to, Mark, your comments about the higher margins coming from software and e-services. Is that going to be a focal point for you guys going forward? And how much higher are those margins versus your traditional margins in Dental and Animal Health?

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [9]

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Kevin, thanks for the question. Well, first of all, I think the software and e-services has been a focus for us and absolutely will continue to be a focus. And we have a tremendous installed base within our Dental franchise. We're building our installed base within our Animal Health franchise. And obviously, this is a really important part of our value proposition as it really brings value to our customers to have a complete technology solution. We continue to invest in building out our capabilities in this area. We continue to develop relationships with third-party software vendors that provide some wraparound analytic services to our customers. And so, yes, this is -- absolutely will continue to be a focus for us.

I'm not going to get into the exact margin obviously, but it certainly is very accretive to our overall margin profile and definitely an area we will be continuing to focus on going forward.

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Kevin Kim Ellich, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [10]

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Got it. That's helpful. And then kind of just piggybacking off of Erin's previous question. With the manufacturers planning to go direct or talking about it, is there anything that you're doing to prepare or anything that you plan to change in your strategy to combat that? And what impact do you think that might have on your business?

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [11]

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Well, I would say that this is not necessarily something that's a change. I think there has been some evolution with the manufacturers. And are you specifically talking about the Animal Health segment or Dental or both?

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Kevin Kim Ellich, Craig-Hallum Capital Group LLC, Research Division - Senior Research Analyst [12]

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Animal Health, Animal Health.

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [13]

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Okay. Yes. I mean, I think this has been something that we've been working closely with the manufacturers on for some time and there have been some modest changes in the sales relationships. I think we've highlighted those over the last number of quarters. We believe we provide tremendous value in the channel, both to the end customer and certainly to the manufacturers as well. I think our companion animal growth began at nearly 4% is a good testament to that and the value that we provide.

And certainly, we're continuing to have discussions with the manufacturers about the -- what we can do to support their business, what we can do together to support our end customers. And again, we -- certainly, the market continues to evolve, but we believe that we provide tremendous value across the channel, and we believe that will help continue to drive success for us going forward.

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Operator [14]

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Our next question is from Jeff Johnson from Baird.

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Jeffrey D. Johnson, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [15]

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Mark, I wanted to maybe switch over and look at your Dental business for a second. On the CAD/CAM, the 3% growth you talked about in the quarter, I would assume that includes DI systems, but if you could confirm that, then maybe tell us what you're seeing in demand trends for full systems versus DI? And even that 3% number may be a little bit below what we were expecting in the quarter with some of the new scanners that have launched here recently. So maybe what are you seeing demand trends for some of those newer scanners as kind of a category any way would be helpful?

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [16]

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Yes, Jeff, thanks for the question. And yes, to the first part of your question, the 3% growth in the quarter does include DI products. Certainly, as we've said in the past, we don't get into specifics around all the different subsegments of the dental technology. I think the overall quarter in terms of our revenues in that area, I think, as we mentioned a couple of key factors; I mean, we had a very strong Q4. In fact, I believe our CAD/CAM revenues were up greater than our overall equipment -- 13% equipment increase in Q4, which is a great testimony to the sales productivity, and our reps obviously driving demand and sales in our fiscal Q4. So I think, we anticipated some softness in Q1. As we mentioned also, there was less promotional activity this quarter.

So I think, from a demand standpoint, we kind of view this as 1 quarter. If you look out over the past 5 quarters, I believe our overall equipment growth is in the 3% to 4%, which we believe is very strong. And we certainly anticipate, as we mentioned earlier, ramp up over the coming quarters as we continue to work with our manufacturer partners, we continue to get traction on new products that are being introduced, we continue to see promotional activity in the marketplace. And we expect the demand trends, again, looking out over a longer period of time to continue at the rate that we've seen.

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Jeffrey D. Johnson, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [17]

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All right. And Don, maybe 2 just modeling questions or finance questions for you. One, receivables now are down about 45% to 50% or so off their 2017 peak. So how much lower do you think -- excluding the equipment financings that you've obviously done on receivables for a number of years -- how much further can those receivables come down?

And then the corporate revenue line almost doubled year-over-year. I don't think I heard you talk about that. Just what flows into that? And how does that flow through to EBIT from that corporate line item?

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Donald J. Zurbay, Patterson Companies, Inc. - CFO & Treasurer [18]

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Yes. The corporate revenue line is really largely driven by the equipment financing. And we did have an uplift there in the quarter relative to the forward yield curve and how that plays into that dynamic. However, if you remember, we are hedging those instruments. And so there is a hedging loss as well that comes in down below on the P&L. So there's a bit of P&L geography there that you have to keep in mind that mitigates that fairly substantially when it relates to the yield curve.

And sorry, what was your first question? Oh, AR, yes.

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Jeffrey D. Johnson, Robert W. Baird & Co. Incorporated, Research Division - Senior Research Analyst [19]

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Just receivables. Yes, receivables, yes.

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Donald J. Zurbay, Patterson Companies, Inc. - CFO & Treasurer [20]

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Yes, receivable. I think we're really pleased with where we're at with the receivables at this point. Obviously, we'll continue to work it. We're doing a lot of different things to try to bring that down. But I think for us, the opportunity continues to -- the bigger opportunity on working capital really continues to be an inventory where we're making great progress, but we're not satisfied with where we're at yet. And we think we have more opportunity there.

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Operator [21]

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Our next question is from Glen Santangelo from Guggenheim.

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Glen Joseph Santangelo, Guggenheim Securities, LLC, Research Division - Analyst [22]

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Mark, I just wanted to follow up on the revenue questions. You gave some color around Animal Health and you suggested that maybe more of the weakness was on the beef and dairy side. I was wondering if you could give us a little bit more color about specifically what the issues are and when they may ultimately abate?

And then secondly, on the Dental side, I think, you sort of commented that the company continues to make progress on the consumable side. And hopefully with the path back into positive territory, do you feel like that could be a 2019 event? What's your sense with what's going on in overall market growth? Because a couple of your publicly traded peers on their 2Q call sort of reported that they maybe saw a modest contraction in the market in the second quarter. So anything to help us better set the top line trends would be helpful.

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [23]

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Yes, Glen, thanks for the question. Maybe I'll cover the first part of the Animal Health. Where we did specifically see the softness was in our production category, and we talked a little bit about those 3 markets -- 3 core markets. Swine, I think being slightly positive. I think the real change in the quarter was the beef market where there are a number of kind of end market dynamics affecting the demand -- end market demand there in terms of the relationship with the producer, et cetera, the timing of when the product goes to the producer, et cetera.

So I think there's a number of factors there. And certainly, I would say dairy has been more consistently soft. Just in terms of general demand for dairy products, I think there's been certainly a lot discussed in the marketplace about that. So again probably kind of 3 different markets there. I think the one that was more challenging for us in the quarter that we expect to continue is in the beef area.

Turning to the Dental area from a consumable standpoint, we certainly, as I mentioned earlier, believe that the market is stable and slightly positive overall. We are pleased with the continued positive sequential trends we're seeing in our consumables business. Obviously, we -- it's important for us to move that into the plus category. One of the things that does give us some confidence as we continue throughout the year is our unit volume is actually up on a year-over-year basis. And so from -- as we think about mix and a focus on private label, things that affect obviously the consumables market, we feel good about the continued trend there.

I'm not going to comment specifically on and be precise about the exact quarter where we expect it to turn positive, but we certainly believe that the trend that we've seen will continue. So hopefully that helps answer your questions.

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Glen Joseph Santangelo, Guggenheim Securities, LLC, Research Division - Analyst [24]

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No, it does. Maybe if I can just follow-up with one question for Don with respect to the cash flow. If you look at the cash flows in the quarter, obviously, they were negative from an operating perspective. And when you take into consideration, the sale of the receivables, it was positive. But I think what the market is really trying to assess is that how much more can you go on in terms of factoring these receivables? And at the current growth level, do you feel sort of comfortable that if you look at your cash flows on the sort of pro forma or adjusted basis, do you feel comfortable that you can continue to meet the dividend at this level and continue to invest in the company's growth initiative? So any sort of color around that dynamic.

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Donald J. Zurbay, Patterson Companies, Inc. - CFO & Treasurer [25]

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Yes. Well, yes. So as you mentioned, we had a really nice cash flow quarter. Obviously, you have to take the negative operating activity and add in the deferred purchase price receivables. When you do that and look at it in that context, we had about 21% growth in our -- really our cash flow. And that's not a sustainable number. I think that what you're going to see is as we improve our net income growth, I expect the cash flow -- there's some ability to generate cash flow above the net income growth; but over time, you'll see that moderate. We're not doing anymore factoring of receivables.

But I do think on an ongoing basis, yes, we're comfortable that we can fund our dividend. We think that's a really nice sustainable piece of our cash allocation back to shareholders, and our Board is extremely supportive of that as an ongoing initiative to continue to return cash to shareholders.

So -- but and then balancing that with M&A, I mean, I think, as we continue to improve the cash flow and continue to improve the income growth for the company, I think that we feel confident that we need to look for the right opportunities and we need to be prudent in terms of how we do that, but we think that there is opportunity there to invest in the business as well.

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Operator [26]

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Our next question is from Elizabeth Anderson from Evercore ISI.

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Elizabeth Hammell Anderson, Evercore ISI Institutional Equities, Research Division - Associate [27]

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One of the things I just had a question on was the corporate profitability line. Obviously, there was a pretty big step change in that sequentially and an improvement year-over-year. And so could you just comment on that and sort of how you see perhaps maybe the pace of the rest of the year turning out or if there are any like one-time factors that would impact?

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Donald J. Zurbay, Patterson Companies, Inc. - CFO & Treasurer [28]

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Yes. This is Don. Thanks for the question. I assume you're looking at the table on the press release, which is prepared on a GAAP basis. And so that showed about $14 million improvement in the corporate line, but $11 million of that was really driven by legal settlements. We had a legal settlement in both Q1 of last year and Q1 of this year: one for $28 million last year, and one this year for $17 million. And so there's an $11 million delta that's impacting that number.

I think if you get into what our real adjusted earnings numbers, our -- actually, our corporate expenses were up slightly in the quarter due to some timing issues. And then the remaining impact was some favorability on the equipment financing, which I already discussed as primarily related to valuing the equipment receivables and how that -- how the yield curve fits into that. So really in terms of sustainability, I mean, expenses were up slightly. We like what we're doing there, but from a adjusted earnings per share standpoint, it's very sustainable.

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Elizabeth Hammell Anderson, Evercore ISI Institutional Equities, Research Division - Associate [29]

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Okay. Perfect. That's super helpful. And do you have any change in expectations about your share count for the year?

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Donald J. Zurbay, Patterson Companies, Inc. - CFO & Treasurer [30]

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No. I think, left alone without share repurchases, generally, the share count will increase slightly, but I would really model it about where we're at right now as you go through the rest of the year.

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Operator [31]

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Our next question is from Brandon Couillard from Jefferies.

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Brandon Couillard, Jefferies LLC, Research Division - Equity Analyst [32]

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Mark, you spoke to the private label business on the Animal Health side. Could you give us some color on just where you stand in terms of traction, in terms of SKU builds or relative growth rates for that side in the Dental business?

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [33]

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Yes, absolutely. Brandon, thanks for the question. I think as we've indicated previously, the trend of our private label business within Dental in terms of growing faster than our overall consumables business, that actually continued in the quarter. We continue to focus strongly on that area. We continue to look at opportunities to introduce new products. We continue to incent our field sales organization. We continue to work closely with the manufacturers to drive great value there from a supply chain standpoint.

And again, our private label business in Dental continues to grow faster on a year-over-year basis than our overall consumables segment. And that's certainly something that we expect to continue and certainly help contribute to some of the improved mix and margin profile from our Dental business that we referenced earlier.

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Brandon Couillard, Jefferies LLC, Research Division - Equity Analyst [34]

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And then a two-part question for Don. You mentioned some headcount reductions in the quarter mainly around back office. Is there more room to go in terms of the types of moves over the balance of the year? And then on the gross margin line, would you still expect gross margins to be down year-over-year for the full year despite sort of the better first quarter start?

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Donald J. Zurbay, Patterson Companies, Inc. - CFO & Treasurer [35]

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Is there more room? Yes. I mean, we're really continually looking at our expense structure. I think we'll continue to manage that. We'll continue to find areas that we think there's some potential opportunity. So I think, you probably -- you may not see anything of this -- of that magnitude. But I think, as we go through the year, there is just -- that continued kind of cadence of trying to find and realize more expense reduction.

In terms of the margin with a good start, I think -- I'd probably -- the gross profit, I think I'd probably really point you to potential flat to slightly up on the gross margin as you look at the full year fiscal '19 over the full year fiscal '20.

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Operator [36]

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Our next question is from Kevin Caliendo from UBS.

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Kevin Caliendo, UBS Investment Bank, Research Division - Equity Research Analyst of Healthcare IT and Distribution [37]

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Dentsply made some comments on their call around changing some of the marketing, especially around end of quarter, talking and marketing more directly to dentists. Some of the survey data that we've compiled recently also suggests more manufacturers are going directly to dentists and DSOs. Are you seeing anything like that? Can you talk a little bit about that both in the consumables and equipment market on the Dental side?

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [38]

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Well, certainly, in terms of the relationships that we have with our DSO customers, we're obviously very pleased with that. That's been an area that we've focused on, we've invested in and we're seeing some good results from that part of our Dental business overall.

I think, in terms of similar answer to the question within the Animal Health space, we bring great value to our customers across a wide range of products, services and technology in the Dental space, and frankly, great value to our manufacturer partners as well. And we provide a wide range of services to both our customers and manufacturers that bring a lot of efficiency to the supply chain. Certainly, DSO customers have options and I believe they certainly see the value in their partnerships with full service providers like Patterson.

And certainly, in terms of your question around kind of the general kind of marketing of some of the technology and equipment products, we're working very closely with our manufacturer partners to help market those products and new innovation and technology in the market; jointly focused on creating demand in the market, jointly focused on bringing strong promotional activity to the market.

And as I mentioned earlier, certainly, we believe that is a big advantage for Patterson, and the history of our understanding of these high-technology products, our expanded portfolio of products, the technical service that we provide before and after the sale. So we're excited to see the manufacturers continue to do things that will generate demand and we think we certainly benefit from that.

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Kevin Caliendo, UBS Investment Bank, Research Division - Equity Research Analyst of Healthcare IT and Distribution [39]

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Great. One follow-up on DSO space. Are you seeing increased RFP activity? I know you guys have picked up some share and signed up some new DSOs. Are you seeing an increase in the RFP activity? Is there more opportunity? How would you sort of lay of the land in terms of DSO opportunity moving forward?

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [40]

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Yes. I would say, the lay of the land is consistent. I don't think there's necessarily any more RFP activity. I think, certainly with the large national DSOs and the multiyear contracts that have, there's, obviously, contracts that come up on every several years. So nothing real change there. I think in the RDSO, the regional DSO space, obviously, that's a growing area. As I mentioned earlier, we're investing in our field sales and support infrastructure to support that area. And -- but I wouldn't say that there's any more activity than there was 3, 6, 12 months ago.

Certainly, we look forward to continuing to work closely with both our national and regional DSO customers and pursue the opportunities that make good sense for Patterson, and that really create those partnerships where there is real value in the broad products and services and technology solutions that we can provide.

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Operator [41]

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Our next question is from Jon Block from Stifel.

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Jonathan David Block, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst [42]

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Just a couple from me. Don, I think, first one just high level. I believe most of us had about 2.5%, give or take, internal growth dialed in this year with more difficult comps. So it really implied a nice step-up in sort of that 2-year stacked. Should that line of thinking maybe be closer to, call it, 1% due to the production animal dynamics that you called out or maybe the softer dental equipment leases for the quarter? But, hey, that you're able to sort of offset that lower revs with some of the initiatives that you called out around OpEx? Just trying to get sort of the moving parts around the fiscal '20 guide. And then I got a quicker follow-up.

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Donald J. Zurbay, Patterson Companies, Inc. - CFO & Treasurer [43]

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No. That's fair. I think that it's probably prudent to look at it that way. I think, if you were to dig into our most recent forecast, you'd see some of those dynamics, particularly in the companion animal space. I think equipment, again, we're trying to look at it here now over longer time frames because of the -- you can run into a lot of different fluctuations on a 3-month basis. But, yes, I think we're looking at this as -- we're taking into consideration the production animal dynamic and also looking at the rest of the P&L and continuing to look at how we're going to manage it to make sure that we hit the guidance and put ourselves in a position to hopefully have some upward mobility there.

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [44]

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Yes. And I would just add. I think, as we shared earlier, our performance this quarter is indicative of the work that the team has done over the past year, focusing on operational improvements, focusing on driving better mix, focusing on continuing to run an efficient, cost-efficient operation, continuing to drive sourcing benefits, private label, investing in our value-added services, all of those things that help contribute to our performance this quarter. And I think work that's been done over the past number of quarters, and I think that gives us confidence as we look through the remainder of the year, even in light of some softness, I would say, certainly particularly in the production animal category. And we're confident as we look forward that the work that we've done in those areas and just running the operation and the business more effectively, more efficiently, more productively will yield good results going forward.

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Donald J. Zurbay, Patterson Companies, Inc. - CFO & Treasurer [45]

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Yes. I mean, I think those are all sustainable. The things that drove the outperformance on the rest of the P&L are really sustainable type things. I would not characterize any of the -- any of what's happening in below the sales line as kind of onetime this quarter only, but most of it's all sustainable for the remainder of the year.

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Jonathan David Block, Stifel, Nicolaus & Company, Incorporated, Research Division - MD & Senior Equity Research Analyst [46]

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Yes. Okay. Great. And then just on the follow-up, Mark, maybe for you. I mean, we sort of look at dental equipment on the TTM basis because of the choppiness that you alluded to earlier. But I think you did call out increasing momentum over the next couple of quarters. I just want to make sure that is specific to the back part of fiscal '20, you feel comfortable dental equipment will strengthen despite what will be more difficult comps?

And then more high level, when we think about dental consumables for you guys, you're obviously specific towards more of the basic consumable relative to the specialty. So just wanted to get my arms around what is market for you guys? I mean, you're scraping at flattish on your dental consumables. Now is market sort of 1% if we isolate that basic number?

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [47]

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Yes. Thank you. Maybe the second part of your question first. I think that's probably reasonable. If you look at the overall market, certainly, we mentioned earlier, we believe it's stable and slightly positive. Obviously, you can slice and dice up the -- slice and dice the customers and the segments and all the different elements of the products that we provide or maybe not -- don't provide, like as you mentioned. But I do think certainly as you would look at how we think about our market, certainly slightly positive. And as I mentioned earlier, we're confident in the continued positive trending of our consumables. And one of the things as I also mentioned is our unit -- units in our consumables are up on a year-over-year basis, and so we believe that that's a good indicator as well.

I think with regard to kind of the equipment area: I think, if you're looking at a dynamic of a Q4 FY '19 and a Q1 FY '20. And I think, we know, to your point, you look at the kind of the trailing 12 months, as we indicated earlier, we believe we've grown overall in that category about 3% to 4% over the past 4 to 5 quarters. And we certainly expect that to continue. And we certainly expect to see continued innovation and the work that we're doing with our manufacturers -- continued promotional activity, new product introductions, all of that -- that we believe gives us some confidence that we can continue to see positive, as you mentioned, kind of trailing 12-month trends in our dental equipment business.

We do have time for 1 question.

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Operator [48]

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Okay. Certainly, our last question is from Nathan Rich from Goldman Sachs.

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Nathan Allen Rich, Goldman Sachs Group Inc., Research Division - Research Analyst [49]

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Mark, you highlighted the progress you guys are making with your software and technology businesses across both segments. I was curious, could you just comment a little bit more on what's driving the acceleration in growth that you're seeing? And how big are those businesses overall for you now, and what type of growth should we kind of expect to see from them going forward?

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Mark S. Walchirk, Patterson Companies, Inc. - CEO, President & Director [50]

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Nathan, thanks for the question. I think really what's driving the growth is focus. These are areas that bring great value to our customers. These are areas that are certainly accretive to us from a margin profile standpoint. We believe, we have opportunity to continue to grow in those areas. I mentioned technical service earlier, great example where just a focus on operational excellence and analytics to help improve productivity. These are the kind of things that we're doing to run the company. And as we continue to find opportunities where we can drive improved productivity, where we can focus on areas of our business that are -- support our customers that are accretive to our margins. I mean that -- focus gets results.

So we're certainly going to continue to invest in those areas. We're certainly going to continue to focus on these areas. I'm not going to go specifically into the size of those compared to the other areas. But I can assure you that these are areas that our teams are very focused on that we expect continue to invest in, and we believe that they can yield continued good results. So thank you, Nathan, for your question.

I think, that's all the time we have today. Thank you, everyone, very much for your time and interest this morning. We certainly look forward to connecting with all of you again on our second quarter of fiscal 2020 call. Thanks very much.

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Operator [51]

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This concludes today's conference call. You may now disconnect.