Patterson Companies Inc

NASDAQ:PDCO

Earnings Call Transcript 2020-Q2

[Operator]

Ladies and gentlemen, thank you for standing by and welcome to Patterson Companies Second Quarter Fiscal 2020 Conference Call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question-and-answer session. [Operator Instructions]. Please be advised that this conference is being recorded. [Operator Instructions].

I would now like to hand the conference over to your speaker today, John Wright, Vice President of Investor Relations. Thank you. Please go ahead sir.

[John Wright, Vice President, Investor Relations]

Thank you, operator. Good morning, everyone, and thank you for participating in Patterson Companies' fiscal 2020 second quarter earnings conference call. Joining me today are Patterson President and Chief Executive Officer, Mark Walchirk, and Patterson Chief Financial Officer, Don Zurbay.

After a review of the fiscal 2020 second 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, December 5, 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 second 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 expenses, accelerated debt issuance 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 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 one week.

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

[Mark Walchirk, President and Chief Executive Officer]

Thank you, John. And welcome, everyone, to Patterson's fiscal 2020 second quarter conference call. Our second quarter results reflect the focus of our teams and the continued traction we are gaining from our ongoing initiatives to drive performance improvement.

Before we dive into the details, let me summarize a few key highlights from the quarter. First, we grew internal sales approximately 2% in the quarter, notably growing our Dental segment internal sales by 4.2%. We expanded our operating margins by 40 basis points year-over-year, bringing our consolidated adjusted operating margin to 4% for the first time in over a year, reflecting our efforts to drive operational improvements, manage expenses, and focus on improved mix.

In our Dental segment, our performance was driven by strong equipment sales where we delivered 12.3% growth. Our dental consumables trend continued to improve and our US consumables business posted year-over-year growth for the quarter. In addition, we generated strong revenue and profit growth from our value-added services.

In our Animal Health segment, we delivered solid growth in our companion animal business as we continue to enhance our value proposition for our customers.

Animal Health segment profitability and overall performance was consistent with the first quarter, reflecting our ongoing focus on mix and expense management, which offset certain expected macroeconomic headwinds in the beef and dairy categories of our production animal business.

We also made significant progress towards the resolution of important legal matters facing the company and recorded a reserve related to our agreement in principle with the U.S. Attorney's Office for the Western District of Virginia.

Overall, we delivered adjusted earnings per share of $0.39 in the quarter. And as a result of the progress we've made in the first half of the year, we are raising our adjusted earnings guidance range to $1.36 to $1.46 for fiscal 2020.

With that broader context, I'll now walk through some more specifics of our quarter, starting with our progress on the topline. Patterson's internal sales growth of approximately 2% underscores the impact of our enhanced sales execution, continued improvement in core operations, and the value of our investment in our ERP system, all of which have improved our overall customer experience.

Our topline was driven by growth in both of our segments and benefited from a particularly strong quarter in our Dental segment, which I will touch on more in a moment.

Driving earnings growth also depends on our ability to expand our margins, which remains an important focus and ongoing initiative. As I noted a moment ago, the 40 basis points of year-over-year operating margin improvement is due to our continued focus on improving our operations and effective mix management.

For example, our operation teams have driven continuous improvements in our supply chain using our ERP system, leveraging better visibility and more accurate system reporting to reduce the expense of customer returns and lower the frequency and impact of inventory adjustments.

From a mix perspective, our margin benefited from strong performance in our higher-margin Dental segment as well as total company private label growth that continued to outpace our overall internal consumables sales growth.

We will continue to invest in expanding our private label offering to provide high-quality products to our Dental and Animal Health customers at more attractive margins.

Overall, our continued focus on growing the business on the top and bottom line resulted in adjusted earnings per share performance of $0.39. It's also worth noting that our adjusted EPS performance in the second quarter of last year included a one-time investment gain of $0.04. Excluding this one-time gain, we increased adjusted EPS by 11% year-over-year.

Now, I'll turn to each of our business segments, starting with Dental. Dental segment internal sales increased 4.2% and we delivered Dental segment adjusted operating margins of 9.8%.

Our performance was fueled by strong growth in equipment sales, continued improving trends in consumables, and solid demand for our value-added services.

Let me now touch briefly on each of these areas. Our team in the field delivered 12% growth in overall equipment sales, primarily from sales in the CAD/CAM category. Our performance in CAD/CAM was due in part to our ability to take strategic advantage of continued manufacturer innovation, which Patterson promoted and executed effectively.

We also saw strong performance in core equipment sales, which grew over 8% year-over-year in the second quarter and indicates that dentists are continuing to invest in their practices.

As we've said before, when you look at our equipment category overall, the timing of promotional activity and other factors will impact our equipment business quarter-to-quarter, and that's exactly what we experienced in the second quarter as the strong equipment results we previously anticipated in the second half of the fiscal year shifted in part to be earlier in the fiscal year.

While there may be changes from quarter-to-quarter, we continue to expect equipment to grow over the long term. And if you look over the past four quarters overall, our equipment sales grew 4.8% compared to the prior four-quarter period.

Our equipment performance this quarter speaks not only to our strong execution, but also to the added value Patterson provides to dental practices when they purchase advanced technology.

Our value-added services business continued to grow in the second quarter, highlighting the unique benefit we bring to our customers, from financing to training to service and repairs throughout the lifecycle of the equipment purchase. In addition to providing value to our customers, these services improve our mix and help drive improved profitability.

Through Patterson's ability to provide responsive local service with our team of highly experienced service technicians as well as our comprehensive national support through our Patterson Technology Center, we are able to deliver a truly differentiated value proposition for our customers.

On the consumables side, our trend continues to show improvement. We came in essentially flat for the quarter, but notably the consumables business in our U.S. Dental segment grew on a year-over-year basis. This progress in our consumables business gives us confidence that our strategy of rebuilding the size of our sales force and investing in sales productivity tools has delivered steady and measured improvement.

We believe the positive impact these tools have had on our entire sales force has increased their ability to win new business in their respective territories and is reflected in our positive consumables trends.

Finally, we're pleased with the progress and performance of our teams' focus to pursue relationships with our DSO customers that will allow us to capitalize on our full value proposition.

Overall, we remain confident that Patterson serves a strong and stable dental end market. We're very pleased with our performance in all three categories of our Dental business – equipment, consumables, and value-added services. Our effective mix management in our Dental segment and continued focus on sales execution and the customer experience helped drive Patterson's strong performance in the quarter.

Turning now to Animal Health. In the second quarter, our Animal Health business generated internal sales growth of approximately 1%, driven by global companion animal internal sales growth of 3.5%.

We also maintained our profitability in the segment on a year-over-year basis as the Animal Health team continued to manage through the expected macro challenges in the production animal beef, and dairy markets to deliver adjusted operating margins of 3.5% for the segment overall.

Our ability to deliver consistent margins despite a softer topline shows the impact of our ongoing focus on margin enhancing initiatives and cost management.

As I mentioned earlier, our private label business has been and remains a strong part of our margin story. In the second quarter, Patterson Animal Health drove strong internal sales growth in our Animal Health private label business, and we are continuing to invest to expand that offering and enhance our ability to deliver a strong array of products to our customers.

On the companion animal side, our solid top line performance in the second quarter was a function of our continued ability to deliver a compelling value proposition to our customers. We are pleased with the top line growth in both our U.S. and international companion animal businesses.

Speaking of our value proposition, we are seeing continued progress on our mission to provide a comprehensive software solution that meets the evolving demands of our veterinary customers.

Our NaVetor practice management software is an innovative technology solution that is easy to implement and helps veterinarians manage their practice. In the second quarter, we continued to enhance the platform with new features and improvements, including integrating a tool called Reputation Builder, which is designed to help veterinarians manage their online reputation and ratings and automate the distribution of customer surveys to deepen their relationships and act quickly on feedback to improve their practices. This is just one example of our continued focus on driving innovation in the software and technology space.

In addition, we continued to benefit from our strategic relationship with Vetsource, a suite of software tools designed to improve compliance, enhance client relationships and increased revenue to thousands of veterinary practices across the country.

The Vetsource platform offers an integrated ecommerce and delivery solution that provides a tremendous benefit to veterinary customers. As a result of our relationships with NaVetor and Vetsource, 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, we saw the anticipated impact of continued softness in the beef and dairy markets. Notably, however, the swine business remains strong.

Importantly, Patterson's production animal teams successfully managed through the more challenging macro market dynamics and delivered results that indicate we continue to gain market share.

We are well-positioned to capture enhanced incremental value as the macro level conditions in our production animal business become more favorable over time.

Looking ahead, Patterson Animal Health is continuing to focus on meeting the product and service needs of our customers and driving sales execution. Consistent with our updated guidance we remain confident that this business is tracking in line with our internal forecasts and puts us in position to deliver the topline and margin growth we expect in fiscal 2020.

Across both of our segments, Patterson is a trusted business partner for our customers. We are delivering more than products, by providing services, technology and solutions to help our customers run their practices and businesses more efficiently with greater confidence to invest in their practice and the tools to help them meet their goals.

As we continue our focus on enhancing our value proposition for our customers, we will continue investing in our business to expand our portfolio of products, services and solutions to capitalize on opportunities in both the animal health and dental markets.

Now, before I turn it over to Don, I'd like to provide an update on the significant progress we have made towards resolving two important legal matters over the past several months.

As a reminder, these matters relate in part to legacy issues. However, reaching resolution has taken considerable time and effort from our current team. With these legal matters now largely behind us, Patterson is in even stronger position to execute on our strategic goals.

First, Patterson announced this morning that we have reached an agreement in principle which we expect will resolve the previously disclosed investigation by the U.S. Attorney's Office for the Western District of Virginia into certain non-compliant Animal Health international sales of prescription animal health products as well as other non-compliant processes the company disclosed during the investigation.

The agreement in principle remains subject to further negotiation and final approvals, but under the terms, our subsidiary, Animal Health International, Inc., will pay a total fine and forfeiture of $52.8 million and plead guilty to a strict liability misdemeanor offense under the Federal Food, Drug and Cosmetic Act in connection with its failure to comply with federal law relating to the sales of prescription animal health products.

In addition, Patterson and Animal Health International will enter into a non-prosecution agreement. Once the agreement is final, Patterson intends to finance the settlement expense through existing liquidity without impact to our capital allocation strategy, including plans to continue to return capital to shareholders.

The agreement in principle is part of ongoing close cooperation on our part with the U.S. Attorney's Office in connection with its investigation. In the course of that cooperation, we voluntarily shared with the government the findings of Patterson's own internal investigation across the enterprise into our licensing, dispensing, distribution and related sales practices.

Importantly, as a result of our own investigation, we have already made modifications to our licensing, dispensing, distribution and related sales processes that are designed to drive compliance with relevant regulations.

Secondly, in early November, Patterson announced that we were approached by the FTC and accepted its offer to settle a separate matter regarding an administrative complaint filed by the FTC concerning alleged conduct in 2013 related to the company's willingness to negotiate with buying groups.

While we categorically deny any wrongdoing, we determined that, for business reasons, a settlement was in our best interest. The agreement does not impose any monetary fine or require an outside monitor.

As a part of the settlement, Patterson agreed to continue to maintain our ongoing personnel training on anti-trust laws and to continue making independent decisions with regard to buying groups.

The significant progress toward the resolution of these legal matters builds upon the substantial enhancements we have made to our compliance program. I personally, and our entire management team, believe our compliance obligations are fundamental to our culture and operations. Patterson is committed to continuing to enhance all of our compliance and regulatory programs.

During this fiscal year alone, we have taken a number of important steps to put these words into actions, including creating a standalone compliance department which reports directly to me; investing in external subject matter expertise; hiring executives with extensive experience in the areas of compliance and regulatory affairs, including specifically both a Chief Compliance Officer and Vice President of Regulatory Operations; formalized our compliance program with substantive internal policies and procedures; and included compliance and regulatory as a key performance objective as part of our internal business scorecard.

All of these actions, among others, are focused on ensuring compliance across the entire organization. We are pleased with our progress toward resolving these legal matters along with the strengthened infrastructure in place to continually reinforce our commitment to compliance.

As I mentioned, although these matters relate in part to legacy issues, reaching resolution has taken considerable time and effort from our current team. As a result of the steps we have taken, these legal matters are largely behind us and Patterson is well-positioned to execute on our strategic priorities and focus on driving performance improvements and delivering value for our customers and shareholders.

Taking a step back, we are now in the second year of our three-year plan to drive improved performance. I'm pleased with our team's focus on execution and our progress in the first two quarters of fiscal 2020 puts us in position to accomplish our year-two goal to grow our business on the top and bottom line and deliver enhanced value for our customers and shareholders.

And with that, I'll turn the call now over to Don for a deeper dive into our financial results.

[Don Zurbay, Chief Financial Officer]

Thank you, Mark. And good morning, everyone. Consolidated reported sales for Patterson Companies in our fiscal 2020 second quarter were $1.42 billion, an increase of 1% versus the second quarter a year ago.

Internal sales, which are adjusted for the effects of currency translation and changes in product selling relationships, increased 1.9% versus the second quarter a year ago.

We're pleased to have continued our trend of positive year-over-year internal sales growth, which we believe reflects the positive impact of our initiatives to stabilize and grow the business.

Our second quarter adjusted gross margin was 21.5%, an improvement of 50 basis points from what we achieved in Q2 of fiscal 2019.

Adjusted operating expenses as a percentage of net sales for the second quarter were up 10 basis points on a year-over-year basis, primarily related to timing of certain expenses.

We continue to carefully manage our operating expenses within each of 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 second quarter, our consolidated adjusted operating margin was 4%, which represents a 40 basis point improvement over the same period in the prior year. Our consolidated adjusted operating margin has continued to improve, and in this continued momentum is the result of Patterson's efforts to drive operational improvements, effective mix management and expense discipline. Our ongoing execution on these priorities are contributing in tangible ways to our fiscal 2020 results.

On the bottom line, we experienced a GAAP loss attributable to Patterson Companies, Inc. for the second quarter of $33.1 million or $0.35 per diluted share. This loss on a reported basis is primarily attributable to the fact that, during the quarter, we recorded a reserve of $58.3 million related to the anticipated settlement with the U.S. Attorney's Office for the Western District of Virginia investigation into the sales of prescription animal health products.

While the agreement remains subject to further negotiation and final approvals, we expect, based on ongoing discussions with the government, that the recorded reserve will cover the total cost to resolve this matter.

As Mark mentioned, Patterson intends to finance the legal expense from existing liquidity. We do not expect legal expenses to result in any change to our capital allocation strategy, including plans to return capital to shareholders.

Adjusted net income attributable to Patterson Companies, Inc., which excludes deal amortization costs, integration and business restructuring expenses, legal reserve expenses and accelerated debt issuance costs, totaled $36.6 million for the second quarter of fiscal 2020.

Adjusted earnings per diluted share was $0.39 in the quarter. This represents a $0.04 or 11% operational improvement over the second quarter of 2019 when excluding the investment gain that we recorded in 2Q of last year.

Now, let's turn to our business segments. In our Dental business, internal sales increased 4.2% compared to the second quarter of fiscal 2019. On that same basis, Patterson sales of consumable dental supplies were essentially flat during the second quarter compared to a year-ago.

Consumable sales continued to improve sequentially as the customer experience and productivity of our most recent sales team hires improve and our talented sales force uses their new CRM tools and promotional programs to drive sales.

Internal sales of equipment in the quarter increased 12.3% versus the same period a year ago. As we have previously stated, the equipment market can fluctuate from quarter-to-quarter based on the timing of manufacturer-run promotions, the release schedules for new products and technology and other factors. Our job is to capitalize on these events as our sales team did in Q2, resulting in strong growth, aided by new innovation and promotional programs in the CAD/CAM and core equipment categories.

Adjusted operating margins in Dental were 9.8% in the quarter and reflect an approximately 140 basis point improvement compared to the prior year. This operating margin improvement was the result of continued sales execution on both consumables and equipment, an improved mix from increased sales of private label products and value-added services and disciplined expense management.

Now, let's move on to the Animal Health business. Internal sales for our Animal Health business increased 0.7% compared to the same period a year ago. This performance was driven by a nearly 4% sales increase in our companion animal business that was partially offset by slowing market growth and reduced producer profitability in the production animal business related to the dairy and beef cattle categories of the market and some improvement in the swine category. However, in both our companion animal and production animal businesses, we believe we're growing at or ahead of the overall market.

Adjusted operating margins in our Animal Health segment were 3.5% in Q2, an approximately 10 basis point decrease over the second quarter of the prior year.

Now, let's look at several cash flow and balance sheet items. We have continued taking actions to improve our overall working capital, increase Patterson's cash flow and strengthen our balance sheet, and we're pleased to see the impact of our results.

During the first six months of fiscal 2020, we have used $14.7 million in cash from operating activities. We also collected deferred purchase price receivables of $212.3 million in the quarter, which is included in the investing activities section of the cash flow statement.

To fully appreciate our improved cash flow, the combined total of these two line items from our cash flow statement totals $197.7 million for the quarter.

When calculating adjusted free cash flow, which we have explained and calculated in our press release, cash has improved by $2.1 million during the first six months of fiscal 2020 compared to the first six months of the prior year.

We have also taken several actions to optimize our debt structure. During the second quarter, we paid off our term loan. Subsequent to quarter-end, we entered into agreements with various institutional purchasers of our privately placed debt to purchase and cancel $379 million of these notes on or about December 9.

To fund this debt retirement, we intend to draw on our revolving line of credit and a new committed term loan under our existing credit agreement.

Turning to capital allocation, we continued to execute on our strategy to return cash to our shareholders. In the second quarter of fiscal 2020, we returned $25 million to our shareholders in the form of dividends and, on a year-to-date basis, we have returned $51 million back to our shareholders as dividend payments.

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. We now expect GAAP earnings to be in the range of $0.42 to $0.52 per diluted share.

For our fiscal 2020 adjusted EPS, we're raising our adjusted earnings guidance range to $1.36 to $1.46 per diluted share compared to the prior range of $1.33 to $1.43 per diluted share.

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

[Mark Walchirk, President and Chief Executive Officer]

Thank you, Don. The end of our FY 2020 second quarter marked the halfway point in Patterson's three-year plan to drive performance improvement. Year one fiscal 2019 was focused on stabilizing our core business and our results show that we have successfully accomplished that goal.

In fiscal 2020, our focus is on continuing our momentum and driving top and bottom line growth. I'm pleased with our progress and believe we're right on track to continue to execute on our strategic priorities.

Over the longer-term, our strategic plan will focus on investing to expand our products, capabilities and service offerings.

Before we conclude, I want to thank our entire Patterson team for their passion, focus and dedication. The hard work of our strengthened Patterson team continues to show itself in our improving performance, and I have great confidence that we are aligned, energized and focused on bringing enhanced value to our customers, business partners and shareholders.

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

[Operator]

Thank you. [Operator Instructions]. Your first question comes from the line of John Kreger from William Blair. Your line is open.

[John Kreger, William Blair & Company]

Hi. Thanks very much. Mark, can you talk a little bit about how your corporate account business is doing across Dental and Animal Health? Curious if it's growing faster or slower than the rest of the business, and as we think about the coming calendar year, do you have any key renewals outstanding and also do you see other kind of jump all opportunities that you can go after? Thanks.

[Mark Walchirk, President and Chief Executive Officer]

Yeah. John, thanks for the question. We're certainly pleased with the continued focus on our corporate account business, obviously referred to as the DSO space in the Dental segment. I think as I've indicated previously, we've invested in field resources to continue to capitalize on the opportunity there, and we're really pleased with our results. And while, obviously, we don't report specifically on a specific customer segment, we certainly see our DSO business growing faster than our overall business. And so, we're really pleased with that and we also are really focused on working with the DSOs that see the real value in what Patterson can provide across our entire portfolio of products and services.

And the same would be the case in our Animal Health segment, continued investment that we're putting in field resources in this area, continued opportunities for us to grow in this area, and we view the corporate account space really across both Dental and Animal Health as a nice growth vehicle for us going forward.

[Don Zurbay, Chief Financial Officer]

John, this is Don. I would just add, we're also – with all that said, I think we're taking a pretty disciplined approach to the way we look at DSOs and make sure that they're a customer that fits our profitability profile and has the profit we need in order to take them on as a customer.

[John Kreger, William Blair & Company]

Great. Thanks. And maybe just one more question. It sounds like you're seeing some improved performance in the dental consumable business, particularly in the U.S. From your perspective, is that better market or just better productivity out of your sales force? Thanks.

[Mark Walchirk, President and Chief Executive Officer]

Yeah, thanks. I think, specifically, really continued execution and continued improvement in the productivity from our entire team. We talked about really improvements that we've made to the customer experience. We've talked about improvements we've made in building out our value proposition. And certainly, as we've invested heavily over the past couple of years in rebuilding our sales organization in the Dental business, we're really pleased with the productivity of our team, not only our less tenured reps, but certainly our tenured reps as well, who I think have a renewed energy and focus and certainly driving continued improvements in the consumables category is a key focus for us, and we're really pleased with the fact that our U.S. consumables business grew during the quarter.

[John Kreger, William Blair & Company]

Great. Thank you.

[Mark Walchirk, President and Chief Executive Officer]

Thanks, John.

[Operator]

Your next question comes from the line of Erin Wright from Credit Suisse. Your line is open.

[Erin Wilson Wright, Credit Suisse]

Great. Thanks so much. How should we be thinking about the quarterly progression of the dental equipment business with the timing of the DS World Show and some of the promotional activities? And can you speak to Dentsply Sirona's new promotional activity with the One-DS program and how the economics work for Patterson? Thanks.

[Don Zurbay, Chief Financial Officer]

Hey, Erin. This is Don. Maybe I'll take the first one. I think that, when we look back over the trailing 12 months, we see a 5% growth in our equipment business. I think, obviously, there's timing involved. You're all well aware of those kinds of things, but we would look at that mid-single digits as kind of the longer-term view on what we can do with equipment.

[Mark Walchirk, President and Chief Executive Officer]

Yeah. Just to add, Erin, I think, certainly, we really appreciate the great partnership we have with Dentsply Sirona and certainly as they're continuing to advance their business and introduce new and innovative products and continue to think about how they provide a total solution to our joint customer, that's good for Dentsply Sirona, that's good for Patterson. And we're really pleased with how our relationship there is continuing to evolve, and we're certainly pleased with the great performance our team delivered and working closely with them at the recent DS World, and we're just excited about the continued potential moving forward.

[Erin Wilson Wright, Credit Suisse]

Okay, thanks. And then I guess, could you speak to on the Animal Health side, speak to the underlying trends across breaking down both companion animal and production animal species segments, at least directionally kind of how those are trending, how we should think about the quarterly progression there? And are you taking share across the companion animal side? Thanks.

[Mark Walchirk, President and Chief Executive Officer]

Yeah, thanks. certainly, as we indicated, we do have some different dynamics in the two portions of our Animal Health business. I think we've spoken to some of the macro headwinds in the production animal space and we certainly have that built into our go-forward forecast. Certainly pleased with the continued growth in our companion animal business, up 3.5% in the quarter. We think that that's right in line with the market and probably at the higher end of the market that we believe is growing in the 2% to 4% range, and we continue to focus on really building out our value proposition in that area from a technology perspective, from an equipment perspective, from a value-added services perspective, and we believe really the vet continues to be at the center of the ecosystem. We believe we provide crucial value to the vet.

I would also say certainly in light of obviously, some challenging macro headwinds in our production animal business, really pleased with the overall performance of our Animal Health segment during the quarter, and as I indicated earlier, certainly, I expect continued performance from that team through the remainder of the year.

[Erin Wilson Wright, Credit Suisse]

Okay, great. Thank you.

[Operator]

Your next question comes from the line of Jeff Johnson from Baird. Your line is open.

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

Thank you. Good morning, guys. Mark, I wanted to go back to the equipment business. You did talk about pulling forward some business there. And to Erin's question, what do you think the next couple of quarters look like? And is there any way to quantify or maybe qualify for us how much of that initial upgrade push you might be through? You have the advantage of having a big installed CEREC base of customers. I think we're all assuming there's going to be a good amount of upgrades to Primescan from Omni and Bluecam. So, are we halfway through that? Or are we a quarter way through that initial pop? And when do we go to needing to execute on just kind of growing that overall market outside of upgrades?

[Mark Walchirk, President and Chief Executive Officer]

Yeah. Jeff, thanks. Well, look, certainly, we're very pleased obviously with our results in the quarter around equipment overall and, certainly, in the CAD/CAM category. But I would also just refer back to Don's comments and our comments during the prepared remarks. You look over the past 12 months, approximately 5% growth there. So, we believe we're gaining momentum in this area. We also are – believe we're a great partner for manufacturers that introduce innovation in the dental equipment category. We think we're the partner of choice. And frankly, we believe our team does a fantastic job of really the complete start-to-finish process around equipment and technology and can support our customers. And, frankly, we believe we get more than our fair share of that opportunity.

We're also excited about the pipelines that we speak to our manufacturers about in terms of future innovation. And certainly, as relates specifically to Primescan, we saw certainly a combination of both new users and upgrades.

Getting more specifically to your question, Jeff, in terms of the exact timing quarter-to-quarter, obviously, I'm not going to get into that, but we're pleased with our results in the quarter. We're certainly pleased with the pipeline that we have in our overall equipment and technology space. And I would tell you also, we're very pleased with all of the wraparound services that we provide that we think really differentiates us in the market in this area.

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

Got it. That's helpful. And on the consumables side, I think many of us are onboard with the move to private label as well, which has been a big area of opportunity for you guys over the years. How much, though? Is there any way to quantify or help us think how much that is creating a headwind on the topline, even though I know it's net neutral or maybe even beneficial to the flow-through to profitability? But just trying to understand kind of your core growth versus what might be some headwinds from that trade down to the private label products for some of your users.

And then, outside of that, maybe core pricing on general consumables. Are we still positive, neutral, slightly negative on apples-to-apples, like-for-like products? Or just how to think about pricing in the industry as well? Thank you.

[Mark Walchirk, President and Chief Executive Officer]

Yeah, thanks. I think, obviously, in consumables, you have a kind of a price volume mix scenario there. Obviously, different factors affecting the ultimate number. I would say the market is competitive. We're not seeing any undue pricing pressure. It's certainly a competitive market. Obviously, there is some reduction in the average sales price as we think about continuing to build out our private label portfolio. And we do see some unit growth. So, without getting into specifics, we certainly look at our consumables business in those three areas. And we're certainly pleased with the continued sequential trends on a quarterly basis that I think we've delivered here over the last number of quarters and also pleased with the fact that we did grow our consumables business in the U.S. in this quarter in light of the other factors with regard to private label, competitive pricing mix, et cetera.

[Don Zurbay, Chief Financial Officer]

Jeff, this is Don. Just on the question of the impact of private label on our sales growth, I would say, overall for Patterson, it's relatively modest, less than a percent impact.

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

Got it. Thank you, guys.

[Operator]

Your next question comes from the line of Kevin Kedra from G.Research. Your line is open.

[Kevin Kedra, G.Research]

Thanks for taking the questions. Maybe first, just a quick housekeeping question. On the gross margin, the GAAP number, about 21.3%. You guys at 21.5%. The delta there looks like about $3 million. So, was that just the litigation tied to – the $3 million tied to one of your vendors? I just want to clear that up.

And then, secondly, I want to ask bit of a big picture question in the Animal Health landscape. We're seeing a lot of shift there between consolidation amongst some of the manufacturers, seeing them start to accept, if not outright embrace, alternate channels away from the vet. So, do you feel that the moves you're making in the technology aspect of that business are enough to evolve with the landscape as it appears to be shifting over the next several years? Or are there additional measures that you guys need to take to evolve that landscape?

[Don Zurbay, Chief Financial Officer]

Yeah, Kevin. This is Don. I'll take your first question. So, on the housekeeping item, you're exactly right. The difference there is the $3 million non-GAAP charge that we had. Without that, the gross margin was 21.5%, which was up 50 basis points year-over-year.

[Mark Walchirk, President and Chief Executive Officer]

Kevin, with regard to the general landscape around Animal Health, and specifically the companion area, look, certainly, the market continues to evolve as all the markets that we play in continue to do and we continue to think about how those markets will evolve over time. We believe we're very well-positioned. We compete in all channels. And certainly, our solid 3.5% growth in the companion animal business, I think, is a good example of our ability to continue to deliver great value for our veterinary customers. And we're certainly pleased with our growth there and also really continuing to build out our value-added services there.

And as I said earlier, look, I think the vet is still a crucial component to the ecosystem. We believe it will continue to be a crucial component. And certainly, as we think about continuing to expand our value proposition, working with our technology partners, building out our portfolio of value-added services and technology, certainly, we'd want to be very aware of how the market will continue to evolve, but we believe we're well-positioned. And our team is very focused on ensuring that we continue to stay ahead of some of the evolution that takes place.

[Operator]

Your next question comes from the line of Jon Block from Stifel. Your line is open.

[Jonathon Block, Stifel]

Thanks. Good morning, guys. Maybe first, just to start on the Dental side, the op margins were really solid and certainly big relative to our estimate. So, I know you alluded to the value-added services, the private label, but, Don, maybe anything more that you can share regarding the magnitude of these variables in terms of their respective contributions? And then, do we think about the sort of – I think it was 9.8% in the quarter as the new baseline as we think about further margin expansion going forward?

[Don Zurbay, Chief Financial Officer]

Yeah. Thanks for the question. Not trying to not be helpful, but, yeah, we're not really going to break out the pieces. I would say it's really just a really nice mix of all of that. And on top of that, good operating and expense discipline. The Dental folks did a great job this quarter with all of that. And so, I think when you put it all together, it gets you to the 9.8%. Yeah, I would look at that as – we think that we're making good progress and that this is kind of a new baseline for us as we move forward.

[Mark Walchirk, President and Chief Executive Officer]

Jon, it's Mark. I think I would just add, look, I think the results in the quarter and some of the improvements from a margin standpoint, it's just a reflection of the focus that our team is putting on really across the entire business and continued positive trends in consumables, obviously, strong growth in equipment, strong growth in our value-added services categories and really ensuring as we think about our overall Dental business, how can we drive topline growth, how can we continue to manage our mix more effectively, whether it's private label, whether it's value-added services and, frankly, pulling all those things together to drive continued top and bottom line growth. And I think that's been the focus and the team is executing well with that focus.

[Jonathon Block, Stifel]

Okay, great. That's very helpful. Thank you. And then, maybe to shift over to Animal Health, Mark, you've been calling out sort of the beef and dairy being weak for some time now. But just sort of that high level look at dairy pricing would seem to imply that it's been rebounding. So, just would love to get your thoughts. When you look out – I don't know – a quarter or two or more within the beef and dairy, do you see any stabilization or even strengthening of dairy in the horizon? Thanks, guys.

[Mark Walchirk, President and Chief Executive Officer]

Yeah. John, thanks. As you indicated, maybe a little bit of an improvement from a dairy pricing standpoint. I think at this point, we certainly believe that some of the continued macro trends, we expect them to continue at this point. And we've certainly built that into our forecast going forward. I wouldn't say – there may be some small signs, but I wouldn't say we're at a point now where we would expect any material shift in that here over the next couple of quarters.

[Operator]

Your next question comes from the line of Glen Santangelo from Guggenheim. Your line is open.

[Glen Santangelo, Guggenheim Partners]

Yeah. Thanks for taking my questions. Mark, just want to follow-up on some of the previous commentary around consumables. It kind of sounds like the investments you've made in the sales force are really starting to bear fruit, and that's kind of brought your consumables back into positive territory. But just sort of following up on that market growth question, do you feel like, one, your investments in the sales force are complete at this point? And if that's the case, and we look at kind of flattish performance in that segment, is the market actually contracting at this point or you're still ceding a little bit of share and there's a little bit of a gap you need to close?

[Mark Walchirk, President and Chief Executive Officer]

Look, I certainly believe that the market is growing in the low-single-digits overall in the dental space. And we're going to continue to invest in our field sales organization and continue to bring top quality sales reps on to the team, continue to invest in productivity tools to help them be successful and continue to frankly to invest in our overall value proposition for our dental customers, of which consumables is certainly one portion. So, we're really pleased with the continued progress there. We're pleased with the investments we're making in the specific customer segments, not only private practice, but certainly the DSO space as well. And we, obviously, are pleased with the fact that we showed some growth in the U.S. consumables business this quarter, the first time in a number of quarters, and we believe we're continuing to build momentum there.

[Glen Santangelo, Guggenheim Partners]

Maybe just two quick financial question for Don. Don, you were discussing the non-prosecution agreement. I just wanted to make sure I understand the significance of that. Does that mean this litigation is over for good? And I think you sort of flagged on the heels of that that there would be no change to your capital allocation strategy. I just want to make sure I understood the significance of that.

And then, secondly, on the cash flow side, could you maybe update us on the decision to maybe continue to sell the receivables? And do you think that will continue to be a part of the strategy going for the foreseeable future?

[Mark Walchirk, President and Chief Executive Officer]

Glen, it's Mark. I'll take the first part and then turn it over to Don for the second part. I think, obviously, as we mentioned in our prepared remarks, you can certainly read through our press release. We'll be completing our 10-Q later this afternoon. I would just suggest to read through that really for any more specifics you have. But really not going to comment any further on that at this time.

And then, with regard to your second question, I'll turn it over to Don.

[Don Zurbay, Chief Financial Officer]

Yeah. We don't expect the payment of the penalty to impact our capital allocation strategy at all. So, we remain committed to our dividend. And really, we'll make the payment out of our existing liquidity and be in a position to move on from there.

On the receivables sales, yeah, we definitely will continue to do that program. That's been a really good program for us. And we feel like that's something we want to continue.

[Glen Santangelo, Guggenheim Partners]

Okay, thank you.

[Operator]

Your next question comes from the line of Nathan Rich from Goldman Sachs. Your line is open.

[Nathan Rich, Goldman Sachs]

Thanks for the question. Just looking at the dental consumables business, following up on Glen's question, Mark, could you maybe talk about where the incremental growth that you're seeing is coming from? Are these customers that are new to Patterson? Are you doing a better job kind of growing your share of wallet with the existing customers?

And as we look forward, do you feel like you're on a path to kind of maintain that positive consumables growth in the U.S.?

[Mark Walchirk, President and Chief Executive Officer]

Yeah. Nathan, thanks. I think, really, the improved trends in our consumables is really coming from across all elements. Certainly, we believe we're going and winning back some of the confidence in our customers after going through a difficult time several years ago with the ERP implementation. We've launched programs to bring on new customers. As I mentioned earlier, we've invested in field resources, specifically focused on the DSO space and we're seeing some real positive trends there. So, really, it's, I think, across the board. I wouldn't want to characterize it in one specific area. We believe that we're continuing to make progress in this area. And as I mentioned, we expect to continue to build on that momentum.

[Nathan Rich, Goldman Sachs]

Great. And, Don, if I could just ask you a follow-up, you talked about the refinancing actions that you're taking. Can you talk about just what impact that's going to have on your interest expense going forward once those are completed?

[Don Zurbay, Chief Financial Officer]

So, we're moving essentially about $380 million from our private placement notes into a bank loan. And there's roughly about a 50 basis point interest expense savings on that move. So, a bit of a tailwind for us.

[Nathan Rich, Goldman Sachs]

Okay, great. Thank you.

[Operator]

Your next question comes from the line of Steven Valiquette from Barclays. Your line is open.

[Steven Valiquette, Barclays Investment Bank]

Great, thanks. Good morning, guys. Just in relation to dental buying groups, or GPOs, that might represent more of the individual or smaller group practitioners, separate from any legal discussion around alleged behaviors from 2013, et cetera, I'm just curious, are you able to talk about just the evolution and prevalence of dental buying groups overall in the marketplace over the past five years or so. Obviously, there has been some acceleration, but I guess I'm just curious at a high-level today, roughly, what percent of the individual dental practitioners do you think are part of a GPO? And also, you probably don't want to say what percent of your reps are tied to that. Just trying to get a sense for how much Patterson's embraced GPOs over the past five years, if it's become a bigger part of the market. Thanks.

[Mark Walchirk, President and Chief Executive Officer]

Steven, thanks. Look, the dental market obviously has different segments. And we focus on customers across all segments. And we're certainly focused on identifying opportunities, whether it's in the private practice space, DSO space, the buying group space, the GPO space, where we can work with customers that fit well with our value proposition, that see the value that we bring across the entire portfolio of products and services and technology, equipment, et cetera. And so, we're not – we focus on the entire market. And again, we look for opportunities in the buying group space that are a good fit with our value proposition. And certainly, it's a competitive market and we're competing to win in the marketplace across all customer segments.

[Steven Valiquette, Barclays Investment Bank]

Maybe just a quick follow-up would be, again, as far as just evolution of buying groups, do you think we're above the halfway point as far as just representation or are we still the lowest? So, there's just a little bit more evolution of that. Just trying to figure out what percent are – what inning we're in just from your own perspective as far as the evolution of that across your customer base?

[Mark Walchirk, President and Chief Executive Officer]

Yes. I think that's hard to really give you a specific inning that we're in. Look, I think the Dental – I would think about it not – just the context of buying groups, but in the overall evolution of the dental market and the continued segmentation. And as I said, we're focused on all customer segments, including buying groups. I really wouldn't have a comment with regard to where that part of the market is from an evolution standpoint. So, that would be our position there.

[Steven Valiquette, Barclays Investment Bank]

Okay, all right. Appreciate the color. Thanks.

[Operator]

Your next question comes from the line of Elizabeth Anderson from Evercore ISI. Your line is open.

[Elizabeth Anderson, Evercore ISI]

Hi. Good morning, guys. Thank you for the question. Where do you think we are in intra-oral scanner penetration? And sort of as a corollary, what are the factors that you would see that would drive the number potentially incrementally higher from here?

[Mark Walchirk, President and Chief Executive Officer]

Well, Elizabeth, thank you. We try not to get into specifics around some of the micro segments within each of the various equipment technology categories. Certainly, I would say the penetration is high in the intraoral area. And we also see continued innovation in this area. And as I mentioned earlier, we believe we provide a fantastic resource to manufacturers with innovation across the various elements of the technology category. So, I wouldn't want to comment specifically on that micro component of the marketplace. But, certainly, we believe we continue to be a great partner and a great choice for manufacturers with innovation across all of the categories to help deliver really great value to our customers

[Elizabeth Anderson, Evercore ISI]

Okay, thanks. And then, just switching to Animal Health. Is there anything you think that would be good to call out in terms of any magnitude from any like agency sales shifts in the back half of the year?

[Don Zurbay, Chief Financial Officer]

No, we don't think so.

[Elizabeth Anderson, Evercore ISI]

Okay, perfect. Thank you.

[Operator]

Your next question comes from the line of Michael Cherny from Bank of America. Your line is open.

[Allen Lutz, Bank of America Merrill Lynch]

Hey. This is Allen in for Mike. Can you provide any commentary on how quickly private label for dental is growing? I know that it's a small number at this point, but is growth accelerating?

[Mark Walchirk, President and Chief Executive Officer]

Our private label business is certainly growing faster than our overall consumables business. So, we're pleased with that. And that's been a trend that we've seen now for quite a number of quarters. That growth is coming from both further penetration of our existing product categories as well as new launches that we're continuing to bring to the market to expand our portfolio. We're seeing growth across our Dental business as well as across both companion and our production business. And so, we're really pleased with the continued overall growth of private label and certainly believe that there's some runway going forward as well.

[Allen Lutz, Bank of America Merrill Lynch]

Great. And then, regarding the prior headcount reductions and SG&A, is this an area of the business that you think you can grow more slowly than revenue into the back half of the year?

[Don Zurbay, Chief Financial Officer]

Sorry. Can you repeat the question?

[Allen Lutz, Bank of America Merrill Lynch]

Yeah. Basically, last quarter, you talked about some headcount reductions. And as that relates to SG&A, is it a part of the business you think can scale over the next two quarters?

[Don Zurbay, Chief Financial Officer]

Yeah. I think it will scale over time. There's, obviously, timing that can affect this on a quarter-to-quarter basis. I am not going to give that kind of specific guidance as we get into the second half, but I think we feel like that's an opportunity for us over time.

[Mark Walchirk, President and Chief Executive Officer]

I think we have time for one more question.

[Operator]

Your final question comes from the line of Kevin Caliendo from UBS. Your line is open.

[Brett Gasaway, UBS]

Hey, guys. This is Brett on for Kevin. I appreciate you squeezing me in. Going back to the production animal market dynamics, could you comment just a bit more specifically on some of the macro drivers that are driving the weakness? And then, with that, are you seeing any material impact from the growth of plant-based meat on beef market production?

[Mark Walchirk, President and Chief Executive Officer]

Yeah, thank you. I think as we mentioned, certainly, there's just been some general softness in the dairy market, I think, which has certainly been there over time. I think the beef market, just continuing dynamics with regard to the profitability structure of the different elements of the supply chain there. And we have not seen, to this point, any material, measurable impact with regard to other products. And we certainly believe the long-term fundamentals of the production animal business are strong and we're just seeing some existing macro headwinds in those two categories. I would say our swine category is growing. We believe we continue to do very well there and continue to grow our market share position in that category.

[Brett Gasaway, UBS]

Great, thank you.

[Operator]

That concludes today's question-and-answer session. I'll turn the call back over to the presenters.

[Mark Walchirk, President and Chief Executive Officer]

Yeah. Thank you so much. And thanks, everyone, for joining us this morning. And we look forward to connecting with you again at the end of our third quarter. Thank you.

[Operator]

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