Patterson Companies Inc

NASDAQ:PDCO

Earnings Call Transcript 2019-Q1

[Operator]

Good morning. My name is Virgil, and I will be your conference operator today. At this time, I would like to welcome everyone to the Patterson Companies' First Quarter Fiscal 2019 Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker’s remarks, there will be a question-and-answer session. [Operator Instructions] Thank you.

John Wright, you may begin your conference.

[John Wright, Vice President, Investor Relations]

Thank you, operator. Good morning, everyone. And thank you for participating in Patterson Companies' fiscal 2019 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 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 30, 2018. 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 both fiscal 2018 and fiscal 2019. The reconciliation table in our press release is provided to adjusted reported GAAP measures, namely operating income, income or loss before taxes, income tax expense or benefit, net income or loss, net income or loss attributable to Patterson Companies, Inc., and diluted earnings or loss per share attributable to Patterson Companies, Inc., for the impact of deal amortization, integration and business restructuring expenses, and legal reserve costs along with the related tax effects of these items, the impact of the 2017 Tax Act and other discrete tax matters.

We will also discuss free cash flow which is a non-GAAP measure and the impact of foreign currency. 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 at noon Central Time for a period of one-week.

Now, I would like to hand the call over to Mark Walchirk.

[Mark Walchirk, President and Chief Executive Officer]

Thank you, John, and welcome everyone to our first quarter conference call. Before I get into the details for the quarter, our outlook, and the progress against our key initiatives, I would like to formally welcome Don Zurbay to his first earnings call as Patterson's Chief Financial Officer.

Don officially joined us at the end of June and has been getting up to speed on the Company by conducting a deep dive into our financials and certainly supporting our key initiatives. We are very fortunate to have someone of Don’s caliber and experience as part of the Patterson leadership team and I know he is looking forward as well to working with all of you.

Our earnings results for the first quarter did not meet our expectations. While our revenue performance was in line with expectations, reflecting some progress in our efforts to stabilize the business, we fell short on our margin expectations due primarily to two factors, competitive pricing pressures at the point-of-sale and an inventory adjustment.

On the top line, our ongoing initiatives to improve the customer experience and enhance sales execution are gaining some traction. Consolidated revenues were up 2.5% in the first quarter, which was in line with our expectations and represented a return to positive revenue growth.

Our Animal Health segment delivered solid revenue growth in both the Companion and Production businesses and our Dental segment generated 5.4% year-over-year growth in equipment sales as well as improving trends in consumables. While the Animal Health business performed in line with expectations both on the topline and in terms of profitability, performance in our Dental business did not meet expectations in the quarter.

We are in the process of stabilizing and rebuilding our Dental business and we recognized that improvement in this segment will not happen overnight. However, we believe strongly in the platform and are taking the long view as we work to return the Dental segment to positive earnings growth. As I mentioned, margins in the first quarter were primarily impacted by pricing pressure at the point-of-sale.

While we have always operated in a very competitive environment, the impact during the first quarter was greater than anticipated. We also made an inventory adjustment during the quarter as a result of the increased visibility generated through our new ERP platform, which also contributed to the pressure on our overall operating margins. Don will provide more detail on this adjustment in his remarks. Together, the point-of-sale pricing pressure and the inventory adjustment caused gross margins to be approximately 60 basis points lower than our expectations.

In the coming quarters, we expect our revenue to remain in line with our current plan. However, we expect that the point-of-sale pricing pressure we experienced during the first quarter will persist throughout the year. As a result, we are updating our fiscal 2019 earnings guidance to reflect our revised expectations for the remainder of the year. We now expect full-year 2019 GAAP earnings guidance to be in the range of $0.84 to $0.94 per diluted share and non-GAAP earnings guidance to be in the range of $1.40 to $1.50 per diluted share.

As we look ahead, you should expect us to carefully analyze our cost structure and make adjustments to our expenses as needed to ensure they are aligned with the needs and opportunities in the business. While we are disappointed that our outlook for the year has changed, we are staying focused on the key initiatives and actions we believe will help drive improved performance.

As a reminder, we are focused on five broad initiatives to stabilize the business. First, improving the customer experience; second, enhancing sales execution; third, stabilizing our margins; fourth, driving improved cash flow; and fifth, continuing to build the overall talent at Patterson.

Now given the pressure on our margins in the quarter, I will start with the actions we are taking in this area before reviewing the progress on our other key initiatives. A central aspect of the margin initiative we have undertaken is to enhance our strategic sourcing capabilities and we are making good progress on this front.

During the quarter, we executed a number of additional RFPs and we started to actively engage with our top 20 suppliers. This work, however, will take some time before we see the benefits. Additionally, we have increased our focus on our higher margin private label products.

As we discussed last quarter, we have established specific private label growth goals across both our businesses and aligned management and the sales team around increasing penetration of our existing private label portfolio, as well as adding new products to our portfolio over time.

We are starting to see the early impact of our focus in this area. And as an example, our Animal Health private label business grew substantially faster than our overall Animal Health sales during the quarter. And in our Dental segment, our private label business performed better than our overall Dental Consumables segment.

So while the pricing pressure we experienced during the quarter was more than we anticipated and while we also anticipate these trends will persist in the coming quarters, we are taking active steps to address this headwind and we are confident that our efforts will result in more stable margins over time.

Now let me come back to our other key initiatives. Starting with our focus on improving the customer experience, I am very pleased with our team's efforts to improve our core business operations over the last six months. We again made measurable progress on this front during the quarter and I am very confident in our ability to meet the day-to-day needs of our customers and to continue providing outstanding service.

We continue to meet or exceed our key customer experience goals, including fill rates, order quality, and customer satisfaction, focusing on the customer and delivering an outstanding customer experience remains a top priority for us going forward. But from my perspective, major issues we faced with the customer experience have been addressed and are largely behind us.

In terms of our goal of improving sales execution, we have made good progress in continuing to hire new sales representatives and rolling out several of the productivity tools we've been investing in. Both our Animal Health and Dental segments recently conducted their National Sales Meetings and I was very encouraged to find a sales force that is energized, engaged in the business, and committed to helping Patterson deliver to our customers.

I heard directly from our sales force at these meetings that the new productivity tools we’ve rolled out are already helping them manage their territories more effectively. I am pleased that we are seeing early positive signs of these investments as we met our quarterly sales targets for the first time in several quarters.

On the working capital and cash flow front, we generated more than $205 million in cash flow during the first quarter as we continue to put strong focus on accounts receivable, accounts payable, and our inventory. In addition, we also implemented a new dental trade accounts receivable facility, which had a significant impact on our cash flows during the first quarter as well. Don will provide more color on this facility in his remarks.

With respect to our final key initiative, continuing to build the overall talent at Patterson, we've already mentioned our excitement about having Don on Board and we expect to benefit greatly from his expertise and fresh perspective. We are also in the process of conducting a search for a new President in our Dental segment and we look forward to bringing someone on Board with the right skills and expertise to lead this crucial segment of Patterson's business. Our leadership team is focused and operating with a sense of urgency to execute on these key initiatives.

Moving now to our specific segments, Animal Health delivered strong performance with revenue growth in both the companion and production animal businesses. Margins were also inline with our expectations. While the Animal Health segment is also very competitive and we experienced some pricing pressure that we expect to persist, we continue to take actions to help mitigate this margin pressure.

One example is the success of our private label products, which as I mentioned grew significantly faster than our overall Animal Health sales during the quarter. Private label has been a key area of focus for us and we are pleased that our initiatives on this front are showing strong results in our Animal Health segment. Importantly, we continue to build upon our value proposition in this segment.

During the quarter, we announced a joint venture with Cure Partners, and the launch of new cloud-based veterinary practice management software, NaVetor. This unique intuitive software is designed to streamline and simplify workflows for veterinary practices and demonstrates Patterson’s commitment to providing innovative solutions to our customers.

NaVetor is just one example of the comprehensive value proposition we offer to our Animal Health customers, which includes a broad range of products, services, technology, and support. I want to thank and congratulate the Animal Health team for their strong performance in the first quarter.

Turning now to our Dental segment. As I mentioned earlier, revenues were in line with our expectations. In consumables, we saw positive trends in our growth rates and our private label product outperformed the overall consumables business.

Equipment and software sales saw solid growth across all categories, which is particularly impressive given our large installed base. However, as noted earlier, the Dental segment is where we are experiencing much of the point-of-sale pricing pressure in the inventory adjustment we've already mentioned. As a result, operating margins for the segment were not in line with our expectations.

Also as I mentioned earlier, we do not expect the improvement in the Dental segment to take place overnight. However, I do want to highlight that we are making progress and are particularly pleased with the growth we generated in the digital and CAD-CAM categories.

While we continue to manage through the transition related to our prior exclusivity with Sirona and are still seeing the implications of this play out in the market, we are pleased with how our field team is responding to a broader portfolio of products. And we are working closely with the manufacturers of these products, executing marketing and sales promotions and as a result, we saw solid revenue growth across all equipment and software categories during the quarter.

While our Dental business overall did not meet our expectations, we are continuing to take the long view and we are taking a very thoughtful and planned approach to restoring our Dental segment back to profitable growth.

First, we've been heavily focused over the past six months on executing against our day-to-day service goals and improving the customer experience. As I mentioned, we are achieving our core service metrics and I am proud with how our team across Patterson has rallied around improving our service performance. We have made great strides in this area and again believe this issue is largely behind us.

Second, we’ve been reinvesting in our sales organization by adding new territory reps and investing in productivity and territory management tools to help our field teams to be more productive. As a result, in our consumables category, we are seeing improving trends.

Next in the equipment category, we have been working through the transition to a much broader portfolio of products. And while this transition is certainly continuing to play out in the marketplace, we generated solid growth in this category and notably across all of our key equipment categories.

However, as we have made progress in our revenue performance, gross margin both in our consumables and equipment categories has come under greater than anticipated pressure, which we saw in our margin results in the quarter.

We compete in a competitive marketplace and expect continued pressure on our point-of-sale pricing in both consumables and equipment. As a result, we have also been focused on improving the buy side of our business in terms of our cost position and improving our product mix. More specifically around product mix, we are seeing some early positive signs in our private label category, which perform better than our overall consumables business in the quarter.

We are also focused on filling the right mix of our branded consumables products and working closely with our manufacturer partners to ensure we have the right cost position and that we are focusing our sales teams on those branded consumables that meet our customer’s need and also generate appropriate margins.

We have much work to do in terms of stabilizing our margins, but I am pleased with the improved results from a revenue standpoint and the improved morale and focus of our field sales teams. So while we clearly did not meet expectations in our Dental segment in the quarter and our guidance reflects what we expect to be continued challenges in the segment, I want to be clear that we have a thoughtful and methodical plan to improve the performance of our Dental segment and we are executing against that plan.

As we've discussed, we are making a number of investments in the future of the business, but we recognized these investments will take time to see results. I am very excited about the focus and engagement amongst our field sales teams as I saw at our recent National Sales meetings and it's clear the team believes we’re focused on the right initiatives.

In addition to the investments we’re making to drive the topline, our focus and energy going forward will be centered on stabilizing our margins. As we've indicated, we believe fiscal 2019 is a transition year for our Dental segment. We are operating with urgency and feel we are taking the right steps to get back on a growth trajectory and reposition the segment for the long-term.

Finally, I want to provide a general update on the long-term strategy process as we've been doing on a quarterly basis. We continue to believe that we are in strong stable end markets and that the Patterson brand is strong in these markets. Importantly, we believe we are building the right team and are providing a comprehensive value proposition to support our customers. It will take time for the work we are doing to take hold, but we believe we are on the right track and making progress.

As you would expect, we are closely evaluating all the markets, trends, competitive environment and product lines in which we operate to identify opportunities for improvement. Across both segments of our business, we recognized the value-added services are a key factor for our customers of all sizes and types and we are constantly guided by the principle of investing in and reinforcing our compelling value proposition for our customers.

Our customers value the products and technologies we offer as well as our ability to tailor a set of solutions most relevant to their needs. But most importantly, we provide the experience and responsiveness to help our customers competently manage and grow their business.

Whether we are working with small private practices or large organizations with national scale, our outstanding dedicated sales support and service teams are focused on enabling our customers’ success. By serving as a trusted business partner, we are able to deepen our relationships and build on the strength of our strong brand, leading products and technology, outstanding service and outstanding people. We look forward to sharing more updates related to our long-term strategy process in the coming quarters.

Now before I turn it over to Don, I would like to provide a brief update regarding the Dental Supplies Litigation. While we continue to believe such claims are without merit and we in no way admit to any liability and while there has been no finding of any violation of law, we recently entered into settlement discussions with the plaintiffs. As a direct result of these discussions, we anticipate entering into a definitive settlement agreement.

We did this solely based upon our desire to avoid the time, expense, distraction and inherent uncertainty of litigation and to refocus our efforts on our business. Based upon these settlement discussions, although we have not yet entered into a definitive agreement and any such agreement would be subject to preliminary and final court approval, we currently estimate that the pretax cost of resolving this litigation will be $28.3 million. We reflected this estimate in our consolidated financial statements for the quarterly period ended July 28, 2018.

And with that, I'll turn it over to Don.

[Donald Zurbay, Chief Financial Officer]

Thank you, Mark, and good morning, everyone. Let me begin with a few introductory comments, then I will walk through the financials for the quarter. And finally, I will explain our guidance revision and outline the assumptions that you might find helpful as you update your models.

First of all, I am excited to be here at Patterson and be part of a great team of individuals. I've been very impressed with the level of talent, passion, and commitment that I've seen from the employees of this Company. We are in growing markets with a strong reputation for serving customers and helping them drive success in their business. I come into this role with eyes wide open to the challenges we have in front of us and look forward to supporting our key initiatives and positioning the business for long-term success.

Now let me walk through the financials for the first quarter of fiscal 2019. Consolidated reported sales for the fiscal 2019 first quarter are $1.3 billion, an increase of 2.5% versus a year-ago. Internal sales which adjust for the effects of currency translation and changes in product selling relationships increased 2.3%. Topline growth has improved compared to Q4 of fiscal 2018 and has also improved on a year-over-year basis compared to the first quarter of fiscal 2018.

Our first quarter consolidated gross margin was 21.2%, a decline of 170 basis points from the same period one-year ago. As expected, segment and product mix and a decrease in customer equipment financing negatively impacted our gross margin by 110 basis points. In addition to these factors, our year-over-year gross margin declined an additional 60 basis points due to larger than anticipated point-of-sale pricing pressure within our Dental business and unplanned inventory charges related to the transition to our new ERP platform and inventory process. This 60 basis point decline impacted our earnings per share by approximately $0.06.

Operating expenses were 70 basis points higher than the same period a year-ago and reflect the continued investments we are making in our Dental business to rebuild our sales force, strengthen our value proposition and drive margin improvement initiatives, principally strategic sourcing and expanding our private label business.

These factors translated to a consolidated operating margin of 3.2% versus an operating margin a year-ago of 5.6%. Our adjusted effective tax rate was 27.0% for the quarter, down from a rate of 34.9% in the first quarter of fiscal 2018, reflecting the impact of the new tax legislation. On the bottom line, the GAAP net loss attributable to Patterson Companies Inc., for the first quarter was $4.5 million or $0.05 per diluted share, compared to net income of $30.8 million or $0.33 per diluted share a year-ago.

Adjusted net income attributable to Patterson Companies Inc., which excludes deal amortization costs and a reserve for the anticipated settlement of certain litigation, totaled $24.0 million for the first quarter of fiscal 2019, down from $41.4 million in the same quarter last year. Adjusted earnings per diluted share was $0.26 in the first quarter of 2019 compared to $0.44 in the first quarter of last year

Now let's turn to our segments. Internal sales for our Animal Health business increased 6.0% compared to the same period a year-ago and our Production Animal business, internal sales in the first quarter grew 6.7% compared to the same period a year-ago. Our overall performance in the Production Animal segment continues to reflect solid topline results across all species with particular strength in the swine and beef cattle categories of our business.

For our Companion Animal business, internal sales for the first quarter increased 5.5% over last year and reflect continued solid sales execution and delivering the full Patterson value proposition to our veterinarian customers. Operating margins in Animal Health were 3.4% in the first quarter compared to 3.7% in the same period last year.

Operating expenses in Animal Health were essentially flat and reflect continued disciplined expense management on the part of our Animal Health team. The entire 30 basis point operating margin decline within the Animal Health business was attributable to unplanned inventory adjustments.

In our Dental business, internal sales declined 2.7% versus the prior year quarter. On that same basis, Patterson sales of consumable dental supplies decreased 5.2% during the 2019 first quarter, and total equipment sales increased 5.4%. This included year-over-year sales increases in all equipment categories.

Operating margin in Dental were 7.3% in the quarter compared to 11.5% in the same quarter last year and reflect the impact of several factors, including planned investments to rebuild our sales force in the anticipated impact of product mix as well as greater than anticipated competitive pricing pressure at the point-of-sale and unplanned inventory adjustments.

Now let's look at several cash flow and balance sheet items. During the first quarter of fiscal 2019, we generated $205 million of cash from operating activities compared to a use of $46 million during the same period a year-ago, yielding a net improvement of $251 million over last year.

There are two components to our operating cash flow improvement. First is the trade AR facility we established earlier this month. This was an opportunity to efficiently access working capital and we used the proceeds to paydown higher interest debt. The other significant component of the improvement in cash from operating activities came from the continued focus and effort and decreasing our networking capital. After subtracting capital expenditures, our free cash flow for the first quarter in fiscal 2019 was $195 million, an improvement of $248 million from the same period a year-ago.

Turning to capital allocation, we continue to execute on our strategy to return cash to our shareholders. In the first quarter of fiscal 2019, we returned approximately $25 million to our shareholders in dividends.

Let me conclude with some comments on our fiscal 2019 outlook and guidance. My perspective on guidance is that we want to establish realistic achievable earnings per share guidance is based on a balanced, credible forecast of the business. Since arriving at Patterson, I've been working with the team to refine our forecasting process with the objective of continuing to improve our discipline and accuracy.

For fiscal 2019, we now expect GAAP earnings to be in the range of $0.84 to $0.94 per diluted share and we now expect non-GAAP adjusted earnings to be in the range of $1.40 to $1.50 per diluted share.

Our adjusted earnings guidance excludes the after-tax impact of deal amortization expenses and the legal settlement reserve, which together totaled $51.8 million or $0.56 per diluted share.

For modeling purposes, let me give you some of the assumption we used in establishing our guidance for the remainder of the year. We have assumed modest improvement from our first quarter year-over-year revenue growth rate each quarter as we move through the remainder of the year.

For gross margin, we are using the first quarter gross margin percentage as the baseline for the year and still intend to execute on the margin contribution from strategic sourcing and private label that we have been diligently working on.

With regard to operating expenses, we have made certain adjustments for original plan as we prepared our most recent forecast. We are currently modeling operating expenses as a percent of sales to moderate slightly for the remainder of the year from our first quarter level.

While we plan to make the necessary investments to drive improved performance and still have conviction those investments are correct and showing some early progress. We know we need to balance these necessary investments with the cost structure that aligns with the profit contribution of the business.

As Mark outlined, we should expect us to carefully analyze our cost structure and make further adjustments to our expenses as needed to ensure they are aligned with needs and opportunities of the business. Because this analysis is ongoing, any further adjustments we make in our expenses are not reflected in our EPS guidance.

For our tax rate, we still expect our adjusted effective tax rate for 2019 to be in the range of 25% to 27%. Our share count is forecasted to be in the range of 93 million to 94 million shares.

Let me conclude by saying that why I certainly understand there is a lot’s of work to do in a dynamic and changing business. I am excited to be here at Patterson with the new leadership team and looking forward to the opportunity to work closely with Mark and the entire team to improve our performance.

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

[Mark Walchirk, President and Chief Executive Officer]

Thanks, Don. Now before we wrap up, I want to reiterate some of the specific examples that help support our confidence in the opportunity to improve the long-term performance of our Company. First, revenue is in line with our expectations and grew year-over-year for the first time in several quarters. Second, we are encouraged by the performance of our private label products across both segments and the opportunity that this represents to help stabilize our margins.

We continue to generate strong cash flow performance. And finally, our team is engaged and motivated and remain focused on our customers and delivering on our key initiatives as we move forward.

Now that being said, our leadership team is squarely focused on taking the necessary steps to stabilize our margins. We will continue to execute against all of our key strategic initiatives and focus on returning Patterson to profit growth. This is a transition year for our business and we recognized that our transformation will take time. We look forward to realizing the long-term benefits of our efforts in building a stronger Patterson.

And with that, we will open the line. So Don and I can take your questions. Operator?

[Operator]

Thank you. [Operator Instructions] Your first question comes from John Kreger from William Blair. Please go ahead.

[Jonathan Kaufman, William Blair & Company]

Hi, good morning. This is Jon Kaufman on for John Kreger. Can you guys go into more detail around the point-of-sale competitive pricing pressures that you're seeing in Dental? How much of that margin decline was related to discounting CEREC equipment versus promotional pricing on other equipment versus competition from the online channel or price competition among the traditional distributors?

[Mark Walchirk, President and Chief Executive Officer]

Yes. Jon, this is Mark. Thanks for your question. I think there is certainly a number of factors that are driving some of this competitive pricing pressure. And I think you've listed a number of those. I think first, just competitive – we operate in a competitive market in general.

I think from a consumables standpoint certainly we see greater price transparency in the marketplace around our equipment products. As we obviously have a broader portfolio in our products, certainly there's high levels of competition in that area. Obviously, the evolving growth in the market around the DSOs, I think also has contributed. So I think there are a number of factors that are having some impact and creating some of this point-of-sale pricing pressure.

[Jonathan Kaufman, William Blair & Company]

Okay, great. And then if we just do some kind of back-of-the-envelope math regarding the revised guidance, if we keep non-GAAP corporate expenses relatively steady, maybe a modest improvement in Animal Health margins, we’re coming out with an implied Dental segment non-GAAP margin of, call it 8.5% to 9% for the remainder of the fiscal year. I guess number one is that accurate? And two, can you talk about what level of revenue growth will be required to achieve that margin?

[Donald Zurbay, Chief Financial Officer]

Yes. I mean that's probably in the ballpark, but – this is Don. I don't think we're going to get into – I think I gave the guidance in terms of the overall revenue profile. I don't think we want to get into the specifics related to Animal Health and Dental in terms of our guidance assumptions.

[Jonathan Kaufman, William Blair & Company]

Okay. Fair enough. Thank you.

[Mark Walchirk, President and Chief Executive Officer]

Thanks Jon.

[Operator]

Your next question comes from Jeff Johnson from Baird. Please go ahead.

[Jeffrey Johnson, Robert W. Baird & Co.]

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

[Mark Walchirk, President and Chief Executive Officer]

Yes. Good morning, Jeff.

[Jeffrey Johnson, Robert W. Baird & Co.]

Great. Good morning, Mark and Don and John. Don, I guess starting with you, just – you gave some color on what the Animal Health gross margins did in the quarter. I only see operating margins in Dental down to 420 basis points. Can you parse that between OpEx and gross margin changes for us? And then I’ll -- have one other question on the point-of-sale commentary.

[Donald Zurbay, Chief Financial Officer]

Yes. I think the 30-basis point decline in our operating income as a percent of sales was all at the gross profit line. And so operating expenses as a percent of sales in the Animal Health business were flat, and if you really look at that, it's a 30-basis point decline, it relates to the – it all relates to the inventory adjustments in the quarter.

[Jeffrey Johnson, Robert W. Baird & Co.]

Yes. Thanks. And I was hoping you could do the same in Dental. Sorry, maybe I was unclear there. Just could you give us some color on the Dental gross margin change in the quarter?

[Donald Zurbay, Chief Financial Officer]

Yes. I tried to lay out the impact, I think on the gross profit which was down 180 basis points, there’s about 100 basis points of point-of-sale margin pressure, 30 basis points of mix, and roughly 30 to 50 or 30 to 40 basis points of inventory charges.

[Jeffrey Johnson, Robert W. Baird & Co.]

All right. That's helpful. Thank you. And Mark on the point-of-sale answers you just gave on the first question there. I guess I'm trying to figure out, historically if we think about Patterson, you guys always kind of sold to a premium Dental set of customers, if you will, and you've now – maybe that is changing some. You've also lost some sales reps over the last two years. I would assume you have to figure out ways to get back into some accounts or open new accounts maybe using price a little bit there.

So I'm trying to figure out how much is pricing at the end user level changing across the industry and coming down across the industry versus maybe you're finally having to effect some change here, if you will, by taking out the Patterson premium that's often been there and maybe even using price a little bit to win back some business over time?

[Mark Walchirk, President and Chief Executive Officer]

Yes. Jeff thanks. I mean it’s a good question. I mean I would say that as the industry and the markets evolve, and we too need to evolve, and we're certainly – we lead with our value proposition and we believe we have a very strong and compelling value proposition, and we don't lead with price, but we also recognize that we need to be competitive on price.

And so I think you're seeing more transparency in the market. Obviously, we have an opportunity to partner with the DSOs that generated a nice growth opportunity. We're working and finding ones that fit with our value prop and really value the things that we bring to the table. But certainly that's part of the market that we need to continue to focus on and we need to think about how our cost structure is aligned to service that customer base that obviously has purchases a larger volume of products and obviously commands an improved price position.

I think also as I mentioned, we've got a much broader equipment portfolio now. Our customers have a lot of choices about which equipment products they purchase. Again, our focus is on helping them find the right one that fits with how they want to practice their craft. But again, it's I think generally competitive. So I wouldn't suggest that our strategy has changed. I think we certainly continue to stay very focused on the private practice positions and bringing real value private practice doctors bringing real value there, but certainly competing in the DSO space as appropriate and again generally I think there's – I wouldn’t say there's one factor in particular. I think there's a number of factors that are contributing to some of the pricing pressure that we're seeing. But again, I wouldn't want to give the impression that we're walking in and competing on price and taking our prices down, that’s not the case at all. We're leading with our value proposition, but we recognize that we need to have a competitive price point as well.

[Jeffrey Johnson, Robert W. Baird & Co.]

Understood. Thank you.

[Operator]

Your next question comes from Erin Wright from Credit Suisse. Please go ahead.

[Erin Wright, Credit Suisse Securities]

Great, thanks. I understand it’s early days of your tenure Don, but can you give us a sense of I guess where some of the near-term opportunities that you see are? And I understand you are part of the receivable securitization, for instance, I guess what other near-term opportunities you see? And then also what are some of those internal metrics or benchmarks that you're focused on relative to what prior management focused on and contributed to the fiscal 2019 guidance? Thanks.

[Donald Zurbay, Chief Financial Officer]

I think the biggest near-term opportunity that I would talk through is just, well, there's two. I think that we mentioned that Mark and I recognize the need to analyze our cost structure to really dig into this and figure out where it makes sense to continue to make the investments we're making, but also be responsible for and understand the margin profile we're dealing with, and so that's an opportunity.

And then I think just on guidance and clarity, hopefully you'll find that the prepared comments today gave some additional clarity on our thinking around how we put together the guidance and kind of the philosophy. I’d like to be transparent in terms of what we're doing to the extent we can.

But I think that bringing some credibility here in terms of how we set the guidance, a process – I have a process it's fairly well warm that I think works and give ourselves – put ourselves in a position to give you reasonable conservative guidance that as we move through the year, we can hopefully move in the right direction.

[Erin Wright, Credit Suisse Securities]

Okay, great. I’m curious what your view is on capital deployment and commitment to the dividend at this point and any other strategies that you could speak to that are on our off the table for instance that may not Animal Health? Thanks.

[Donald Zurbay, Chief Financial Officer]

Yes. So first of all, we're very committed to a dividend. I think we feel like this has been – we have a longstanding history of a dividend. We like this as a recurring return to our shareholders. Obviously, we're going to be disciplined about how we allocate our capital. But maybe as we move forward, Mark and I would like to be a little bit aggressive. I think that that involves looking at anything that's out there that makes sense. M&A, the attractiveness of purchasing our own stock and early days on that, and Mark and I need to get fully aligned. But I think as a regards to the dividend, we're definitely committed there. Sorry, what was the second part of your question, Erin?

[Erin Wright, Credit Suisse Securities]

I guess any other strategic initiatives that are on or off the table for instance that may not Animal Health?

[Donald Zurbay, Chief Financial Officer]

Okay. I think that obviously comments on M&A and comments on any other kinds of strategic moves like that probably we wouldn't comment on the call. So look, in the situation we're in, we're just – we’re evaluating anything that makes sense, but definitely wouldn't comment about that on the call here.

[Erin Wright, Credit Suisse Securities]

Okay, thank you.

[Operator]

Your next question comes from Kevin Ellich from Craig-Hallum. Please go ahead.

[Kevin Ellich, Craig-Hallum Capital Group LLC]

Good morning, guys. Thanks for taking the question, Don, great to have you on the call. I just want to clarify of the 60 basis point impact on margins or $0.06 of EPS as you call it on your prepared remarks, was half of that attributable to the pricing pressure point of sale or – and then how much was due to the inventory adjustments?

[Donald Zurbay, Chief Financial Officer]

So of the 60 basis points roughly 20 basis points was related to the inventory adjustments and 40 basis points related to the point-of-sale pressure on the dental margins.

[Kevin Ellich, Craig-Hallum Capital Group LLC]

Got it. Okay. That’s helpful. And then last quarter, I think there was an inventory adjustment as well, do you think we're beyond that? Or do you think this is possible this could be recurring theme?

[Donald Zurbay, Chief Financial Officer]

No, I think the system gives us improved visibility into our inventory. So I think as we move forward, we will significantly improve our ability to manage inventory levels going forward and really look at the composition of the inventory and be able to analyze it more effectively.

In the month, since we've implemented, I think as you know the systems uncovered some things, some operational efficiencies that we couldn't see through our prior system, which now – which involve manual reconciliation. So we're really moving to a much more modern system, a system that's going to give us more efficiency and ultimately going to be more accurate. And so I don't expect this to recur on a regular basis. I think it's really going to be – we think we have this behind us and that we're going to now use this to our advantage.

[Mark Walchirk, President and Chief Executive Officer]

Yes, just to add. Kevin, this is Mark. I think as we have greater visibility that from a common platform, obviously there are areas where we need to put improved operational processes into place and certainly inventory would be one example. Certainly over the last several months, we've got a team of folks that are working on improving our process management as relates to inventory reconciliation, so that we can minimize these issues going forward. There is always going to have some inventory reconciliation, but certainly we don't expect to the levels that we've seen over the last two quarters.

[Kevin Ellich, Craig-Hallum Capital Group LLC]

Great. That's helpful. And then going to the strong cash flow this quarter, I’m wondering if you could parse out how much of the improvement in – do the operating cash flow came from the trade AR facility versus the effort to just decrease working capital?

[Donald Zurbay, Chief Financial Officer]

Yes. The trade AR facility gave us about $160 million.

[Kevin Ellich, Craig-Hallum Capital Group LLC]

Okay. That's helpful. And then does that change or affect your operating cash flow and CapEx guidance for the year? I noticed you didn't mention that.

[Donald Zurbay, Chief Financial Officer]

Yes. I didn't mention it for a reason. I’m honestly not planning on giving that as guidance. I just think that – that's an area that I think has too many moving parts. There's too much variability and too many different types of things can impact that. So I'm not as comfortable. I know that's been the history here, but I'd like to get us to a point where we're not giving that as guidance.

[Kevin Ellich, Craig-Hallum Capital Group LLC]

Sounds good. Thanks a lot guys.

[Mark Walchirk, President and Chief Executive Officer]

You bet.

[Operator]

Your next question comes from Jon Block from Stifel. Please go ahead.

[Jonathan Block, Stifel, Nicolaus & Co., Inc.]

Great, guys. Good morning. Hopefully you can hear me okay. Mark, one for you and then Don, I think I’ll circle back with you just on the second question. But Mark within Dental, you're talking about investing appropriately for growth and stabilizing margins. And with the magnitude of pricing pressure that you seem to be experiencing with Dental, can you successfully do that in the coming quarters? In other words, invest in the business while supporting margins at the same time? And then Don, I just got a quick follow-up.

[Mark Walchirk, President and Chief Executive Officer]

Yes. Thanks Jon. I mean I think it's crucial that we balance that right, so I think we've made some investments in the business over the past number of quarters primarily and rebuilding our sales organization. And importantly as well investing in some tools to help improve their productivity and their ability to kind of manage their territories, so I think that that's a really critical element and we certainly have to gauge and balance the investments with obviously the need to stabilize the margins.

So a) we're going to continue to make investments that we believe are appropriate, again kind of taking the long view. But certainly as I think and I would say those investments primarily on the sell side, but we're also investing kind of time and effort and energy against the buy side of our business and really looking at how we can improve our sourcing capabilities, obviously improve our mix that we believe will have an important element on really stabilizing the gross margin.

And I think in terms of the operating margins, as we decide that we need to make investments in our field, sales organization that may require us to consider what we do or don't invest in other areas. And as I think, both Don and I mentioned, obviously with the margin profile needing to take a real fresh view of our overall cost structure as well.

So can you do both? I mean I think it's important that we continue to invest. We want to take a long-term view. But we’ll have to balance those investments obviously with the need to stabilize our margins.

[Jonathan Block, Stifel, Nicolaus & Co., Inc.]

Okay, very helpful. And Don, maybe a small handful of quick ones for you. I just want to verify, the litigation all shows up sort of in that other consolidated line, the litigation charge in the quarter. Is there still the opportunity to bring down inventories throughout the year seem up from year-end, but that might be seasonality?

And then quickly just with all the uncertainties that seem to be swirling around Dental, is that $0.10 range on the guidance the right approach? I know that’s sort of been the historic way for Patterson. But is that the approach you want to take with what seems like a little less visibility specific to the industry? Thanks for your time guys.

[Donald Zurbay, Chief Financial Officer]

Yes. So with regard to your first question, I do think there's opportunity in our inventory to continue to make progress there and help our working capital. Yes, the $0.10 range is a great question. I’ll be frank with you, we are in a period of a little bit of uncertainty. I think that we debated broadening the range. We're in a situation where $0.01 is worth about one – slightly over $1 million. So we consider that, I think that we're comfortable obviously in putting this out there today. But I think maybe as you fast forward to initial guidance next year, it's a great question and maybe you start the year with a broader range. So appreciate the commentary.

[Jonathan Block, Stifel, Nicolaus & Co., Inc.]

Thanks guys.

[Operator]

Your next question comes from Robert Jones from Goldman Sachs. Please go ahead.

[Nathan Rich, Goldman Sachs & Co.]

Hi. This is Nathan Rich on for Bob this morning. Mark maybe to start, I just wanted to make sure that I understand the commentary on pricing. Would you say that the pressure was I guess mainly a response to other competitors getting more aggressive in the market and you kind of had to match that? Or should we think about this more as you kind of being more proactive in trying to go out and win market share kind of given the new reps that that you've brought on over the past couple of years?

[Mark Walchirk, President and Chief Executive Officer]

Yes. Nathan, thank you. I wouldn't say it necessarily in response to others necessarily in the market. I think the market is generally – it's a competitive market and not – I hate to just reiterate some of the things I’ve said, but I think those are really the key factors. Yes, there is price transparency in the market. I think that put some pressure on the point-of-sale pricing.

You've got a broader set of players in the market now carrying a broader portfolio of equipment products. I think that just generally adds to the general nature of the competitive market. And certainly as we're seeing the growth of the DSOs both at the national and regional level and their expectations and ensuring that we want to compete with the right partnerships there.

Again, I think there is kind of multiple factors, so I wouldn't point to one thing in particular. And I would again point to we're certainly not leading on price. We're leading with our value proposition, but we recognized that the need that we need to be competitive, we don’t expect to be the lowest price. But we certainly recognized the need to be competitive in the market.

[Nathan Rich, Goldman Sachs & Co.]

Make sense. And then just a quick question on the dental equipment. Obviously, very nice performance in the quarter, and I think as we get into September, we’re lapping the distribution change with relation to the Sirona portfolio. It sounds like you're working more closely with manufacturers on ways to drive sales. So as we think about the growth outlook for equipment over the balance of the year, do you think we should expect to continue to see or remain positive given some of those dynamics and the fact that you are facing kind of easier comps over the final three quarters of the year?

[Donald Zurbay, Chief Financial Officer]

Yes. I think first of all, certainly the equipment market is far more difficult to forecast then kind of the core sundries market. So our expectations assume that we meet our goals for the year around equipment. We are pleased with the results in the quarter, but again, difficult to – it’s a little bit more of a choppier business obviously than the consumables are. We're working closely with the manufacturers, really pleased with the meetings that I have personally had with a number of our manufacturers recently. Joint sales and marketing efforts that we're putting together to help create demand.

And so we’re – as I said, we had a good quarter across really all of our categories. But it would be difficult to give you a forecast obviously and certainly in general, those products are more difficult to forecast. But we're pleased with the results in Q1 and frankly pleased with the work and the collaboration with our manufacturer partners.

[Nathan Rich, Goldman Sachs & Co.]

Appreciate that. Thanks for the question.

[Mark Walchirk, President and Chief Executive Officer]

Thank you.

[Operator]

Your next question comes from Ross Muken from Evercore. Please go ahead.

[Ross Muken, Evercore ISI]

Good morning, guys. So maybe just on the litigation settlement, can you just – given the commentary you gave on pricing overall, give us a sense is if you feel while I realize no admission that there is any sort of change in the customer conversation around pricing related to sort of that settlement particularly in some of the areas, where the GPOs and others kind of made noise. And then if it has any bearing on sort of where you are with your process with the FTC around the Section 5 complaint?

[Mark Walchirk, President and Chief Executive Officer]

Yes, Ross, thanks. I mean obviously I’m not kind of go into any more depth with regard to the settlement that we discussed and I covered kind of in the prepared remarks. So just point you to that in terms of anything specific. And as it relates to the FTC case, we're we continue to work through that. I believe we’re planning for the trial that take place in October. Just as a reminder, there is no money damages sought in the FTC administrative complaint. And we're obviously fighting that vigorously. So not sure I completely answered your question, but probably the best I can do on the legal front.

[Ross Muken, Evercore ISI]

Thanks Mark. And maybe just quickly on the debt side. Don, you kind of talked about obviously want to sustain the dividend and also maybe thinking about repurchases and M&A and the like, and obviously the receivables agreement gave you some flexibility. I guess this relative to that, what sort of level gross debt-to-EBITDA or net debt-to-EBITDA, or do you think this business in the public markets and sort of – how do you think about it and on that basis or debt-to-cap given the cash flow profile?

[Donald Zurbay, Chief Financial Officer]

Well, I think our debt-to-EBITDA at least kind of the way we measure it, we ended the quarter at 2.6 times. I’d like to model ourselves in the – I think that's a decent level and I think that I can look at levels at three maybe slightly higher than that that could make sense and obviously for the right M&A opportunity. I think there's more capacity in that that you might think about given that depending on the profile of the acquired company. So that's really – at that point and obviously two months into the job, but that's – those are numbers I'm thinking about.

[Ross Muken, Evercore ISI]

Okay. Thank you

[Operator]

Your next question comes from Michael Cherny from Bank of America. Please go ahead.

[Michael Cherny, Bank of America Merrill Lynch]

Good morning and thanks for taking the question. Jumping back, I know we’ve had a lot of discussion on the pricing dynamic. Is there an area as you go into the reinvigoration of sales force and having the sales people out and in their commission levels where you're going to start to change your methodology or change your strategy in the event of pricing remains and fairly competitive in terms of whether it's their commission levels or the type of business they go after, but any changing dynamics in terms of the level of profitability pricing dependent that you're willing to underwrite business on.

I know you said you’re not going to be a low price competitor, but will it cause you to start to walk from business or you’re still not at that point relative to the sales force and what you've understood on the new ERP?

[Mark Walchirk, President and Chief Executive Officer]

Well, thank you, Mike, for the question. I mean the main thing I would say is mix matters. And it's important that we have an aligned organization all the way from our relationship with our manufacturers all the way through to what we are the tools and how we incent our sales force. And I think as we continue to kind of evolve our approach both are certainly both across – both of our businesses, certainly Dental as well as Animal Health.

I think this idea of mix being really critical is something we'll continue to focus on. And I think over time, you'll see us again ensure that from the buy side through the sell side, we are incenting around the fact that mix matters and creating great opportunities for our sales organizations to continue to grow their incomes.

And by selling the right mix of products, obviously those that meet our customer’s requirements and making sure that the incentive structure for our field teams are aligned with that. So that's work that we're doing. And certainly part of our broader strategic sourcing initiative is a key element of the overall strategy around driving improved mix across our businesses.

[Michael Cherny, Bank of America Merrill Lynch]

Perfect. That’s all for me. Thanks.

[Operator]

Our last question comes from Steve Beuchaw from Morgan Stanley. Please go ahead.

[Steve Beuchaw, Morgan Stanley]

Hi, good morning, and thanks for squeezing me in here. First thing I'd like to talk about is private label. You called it out in a number of ways in the prepared remarks. It would be really helpful just to level set on a few things as we think about what it means for the model. I wonder if you could size it for us and how big are those businesses for you in Animal Health and Dental? Who are the customer categories, are there really driving the growth? And what is it doing for you at the margin line relative to the rest of the business?

[Mark Walchirk, President and Chief Executive Officer]

Steve, good questions. I hope you can appreciate that we're probably not going to get into the level of detail that you might like us to and hopefully you can respect that. I mean I think there's a few ways to think about private label. I think first of all, we have a private label business today across both of our segments. So it's not like we're starting from ground zero. But there is certainly an opportunity for us to do a couple of things.

Number one, to improve the penetration of our existing private label portfolio across really our Dental and Animal Health segments; secondly, we're also working aggressively to introduce source and introduce new private label products, so we can expand the portfolio. So what we want to do is we want to increase the penetration with our existing portfolio and then obviously make the pie bigger by expanding our portfolio. And the margin profile for those products is better obviously than the non-private label products.

And I would just also say, we absolutely are committed and focused on the branded consumables products as well and we recognized that those have a crucial – are crucial part of our portfolio. We expect to continue to carry a broad product line. And as I indicated, our sourcing efforts focused on working with our top 20 manufacturers or so is to ensure that we have the right cost position there.

So I think there are multiple things that we're focused on to help to stabilize margins. Private label is certainly one of them and we see that as a good opportunity. And as I indicated, we're seeing some early signs, some early results across both of our businesses there.

[Steve Beuchaw, Morgan Stanley]

Thanks Mark. The second thing I'd love to touch on in the little time we have left here is actually the DSO space. We're approaching the two-year anniversary of the Heartland win, and there have been comments, since then confirming that you guys want a stepped up approach, trying to go after the DSO space.

I wonder if you could just talk to us about how that progress has evolved over the last year or so. Where you've seen DSO contract wins and how you think you might modify the approach to try to go after that very important segment of the market? Thank you.

[Mark Walchirk, President and Chief Executive Officer]

Yes. Thank you. And then we’ll just need to wrap after this. But – I think it's important, we're not just going after all the DSOs. I think we want to be strategic about the DSOs that we work with. We're very pleased with the relationships that we have and we believe that both parties are bringing good value to each other there.

We obviously see that that's an evolving growing part of the market and we need to have a position there, but we want to do it with those entities that see some value in the overall value proposition from Patterson.

We're investing in that area. We're building the teams to support that space. And we're also making sure that we have kind of an appropriate operating model to support that space to ensure that we can generate a reasonable return. So certainly as we think about continuing to grow the topline and to be part of the overall growth in the segment. That is one of the numbers of things that we are focused on. So thank you for the questions Steve.

End of Q&A

[Mark Walchirk, President and Chief Executive Officer]

And just really – as we wrap up here, thank you all again for joining us today. We appreciate it. Sorry for those of you that we didn’t get chance to answer your questions. We look forward to providing another update during our next quarterly earnings call at the end of November. Thanks very much.

[Operator]

This concludes today’s call. And you may now disconnect.