Patterson Companies Inc

NASDAQ:PDCO

Earnings Call Transcript 2022-Q2

[Operator]

Ladies and gentlemen, thank you for standing by. Good morning. My name is Brent and I will be your conference operator today. At this time, I would like to welcome everyone to the Patterson Companies Fiscal Year ‘22 Second Quarter Earnings Call. [Operator Instructions] Thank you. It is now my pleasure to turn the call over to Mr. John Wright, Vice President of Investor Relations. Please go ahead.

[John Wright, Vice President, Investor Relations]

Thank you, operator. Good morning, everyone and thank you for participating in Patterson Companies fiscal 2022 second quarter conference call. Joining me today are Patterson’s President and Chief Executive Officer, Mark Walchirk and Patterson’s Chief Financial Officer, Don Zurbay. After a review of the fiscal 2022 second quarter results and outlook by management, we will open 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 1, 2021. 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 2022. The reconciliation table in our press release is provided to adjust reported GAAP measures, namely operating income, other income expense net, income before taxes, income tax expense, net income, net income attributable to Patterson Companies, Inc. and diluted earnings per share attributable to Patterson Companies, Inc. for the impact of gains on investments, inventory donation charges, deal amortization, legal reserves and integration and business restructuring expenses, along with the related tax effects of these items.

We will also discuss free cash flow as defined in our earnings release, which is a non-GAAP measure and use the term internal sales to represent net sales adjusted to exclude the impact of foreign currency, changes in product selling relationships, contributions from recent acquisitions and the extra week of selling results in the first quarter of fiscal 2022. These non-GAAP measures are not intended to be a substitute for our GAAP results. This call is being recorded and will be available for replay starting today at 11:00 a.m. Central Time for a period of 1 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 2022 second quarter conference call. First off, I hope you and your families all had a very happy and safe Thanksgiving holiday. Patterson delivered another strong performance in the second quarter of fiscal ‘22, which ended on October 30, 2021. Our top and bottom line results demonstrate that our value proposition continues to resonate with our customers and business partners and that our Patterson team continues to show up everyday with great passion and focus to deliver on our promise of trusted expertise and unrivaled support.

Patterson is there to help our customers face business and market challenges, which have certainly become more acute since early 2020. The environment has magnified the importance of Patterson’s ability to support our customers with our comprehensive product, technology, software and service offerings. That value proposition, combined with our world class Patterson team, has been the formula for our success. It’s reflected in the trust our customers place in us as well as our continued business momentum and strong financial performance. I want to thank our entire Patterson team of more than 7,500 across the organization for their commitment to living our purpose, vision and values everyday and for delivering the services and solutions our customers need to help them succeed.

So with that as our backdrop, let me start with some of the highlights of our fiscal 2022 second quarter. First, on a year-over-year basis, internal sales grew 8%. While internal sales in our Dental segment decreased 2% year-over-year, our Dental sales exceeded our internal expectations for the quarter and posted a 10% increase compared to the pre-pandemic period of 2 years ago. Internal sales in our Animal Health segment increased 16% year-over-year and were up 24% compared to the pre-pandemic period 2 years ago. Through the first 6 months of fiscal ‘22, our free cash flow has improved by $60 million over the prior year period. We delivered adjusted earnings of $0.58 per diluted share. And finally, given our momentum and confidence in the business, we are raising our adjusted EPS guidance range for fiscal ‘22 to $2 to $2.10 per diluted share.

With that overview, I will now dive a bit deeper into the performance drivers in each of our segments during the second quarter, starting with Dental. Across our Dental segment, our field sales, service and support teams continued to deliver value for our customers and business partners and drive strong operational excellence. Now before we get into the specifics, I want to provide some additional context around our results this quarter. The year ago period, the second quarter of fiscal ‘21 covered the months of August, September and October of calendar 2020. As you may recall during this time period a year ago, the dental market experienced an accelerated recovery as patients gained comfort with the new safety protocols and were returning to the dentist even faster than the industry anticipated.

As a result of the rapidly improving market from a year ago, coupled with the great execution by our team, Patterson delivered internal sales growth of 12% in the second quarter of fiscal ‘21, including strong performance in our consumables category driven partially by the spike in demand and pricing for infection control products. Given these dynamics in the year ago period, we believe it’s helpful to refer to some 2-year comparisons back to the pre-pandemic period of the second quarter of fiscal ‘20 to provide additional perspective regarding the underlying strength of Patterson’s financial performance.

During the second quarter of fiscal ‘22, internal sales of dental consumables were down less than 1% compared to the prior year, yet increased 17% compared to the pre-pandemic period of the second quarter of fiscal 2020. As expected, sales of infection control products declined 13% compared to the prior year as we lapped a period of unprecedented demand in this category and have also seen prices moderate considerably compared to 1 year ago. We plan for this impact when forecasting fiscal ‘22 as we anticipated unit volumes and pricing of infection control products to normalize over the course of our fiscal year. However, we believe that sales of infection control products will remain at elevated levels from the pre-pandemic timeframe and we expect steady demand for these products to continue over the long-term.

Importantly, internal sales of non-infection control consumables products increased 3% year-over-year and sales of non-infection control products increased 9% compared to the pre-pandemic period of 2 years ago. In addition, we drove increased demand for our private label portfolio of products. We continue adding new products to expand our private label offering and our sales team is highly engaged and motivated to drive sales growth in this more profitable category. We continue to perform well in our overall consumables category and believe we are growing faster than the market in the product categories in which we compete.

On the equipment side, internal sales declined 3% during the second quarter of fiscal ‘21 compared to the second quarter of last year, but increased 2% when compared to the pre-pandemic period of 2 years ago. As a reminder, our equipment performance can vary from quarter-to-quarter, particularly following or comparing to quarters where Patterson has successfully promoted and sold innovative new products.

During the second quarter, we attended the DS World program in-person where our team was highly engaged with our customers and once again delivered excellent performance. While a portion of the sales generated at this event were installed in our fiscal second quarter, we expect the majority will be reported in the remainder of this fiscal year. For over 20 years, our teams have worked to help build this chairside dentistry category in North America and we believe our knowledge base, sales experience, support and service have established Patterson as the clear partner of choice for customers who choose to invest in this digital technology. More broadly, our dental team does an outstanding job of selling, installing and servicing the latest digital technology for our customers throughout the year as we work with all of our manufacturer partners to launch their innovative new technologies.

Across the entire equipment market, we believe there is strong demand for new innovation to drive further improvements in productivity and oral healthcare that our dental customers are seeking to offer their patients. And given our large installed base, combined with unparalleled customer service and support infrastructure, we believe Patterson is best positioned to execute the continued digitization of dentistry that is taking place. We are pleased with our equipment results in the quarter, particularly compared to the strong quarter 1 year ago and given the recent supply chain challenges in the core equipment category that are currently impacting the industry. The demand for core equipment remains strong and we expect the delays we are currently seeing on product deliveries will build our backlog and be reflected in our sales volumes over the next several quarters.

As we look ahead at the dental market overall, we believe patient traffic has generally returned to pre-pandemic levels. We expect dentists will continue investing in the latest equipment, technologies and practice management software to build and modernize their practices and we believe the market will return to stable long-term growth. These trends and the momentum in our dental business give us confidence we can continue capitalizing on these market opportunities.

Turning now to our Animal Health segment, our Animal Health team continued their positive momentum and delivered a very strong second quarter, achieving fiscal ‘22 second quarter internal sales growth of 16% year-over-year and 24% growth compared to the second quarter of fiscal ‘20. The overall segment performance was led by internal sales growth in our fiscal ‘22 second quarter of 21% year-over-year in our companion animal business and 11% year-over-year internal sales growth in our production animal business.

Our Animal Health segment also delivered operating margin improvement in the quarter by working closely with our strategic vendor partners, growing equipment sales, exercising strong expense discipline and also expanding our private label portfolio. In fact, during the fiscal second quarter, our own private label brands of Pivotal in the companion space and Aspen in the production market both continued to perform well within each of their markets.

Within our companion animal business, we continue to benefit from the market tailwinds of increased pet adoptions during the pandemic and heightened levels of attention and spending by pet owners overall. However, beyond these strong market fundamentals, Patterson’s deep value proposition of our product and technology offerings, combined with our team’s expertise, service, training and support, continues to differentiate Patterson and propel our growth. And we believe our results demonstrate that our growth rates are outpacing the market.

As we have highlighted previously, the significant growth in demand for pet care has been a strong tailwind for our veterinarian customers over the past 18 months or so, but has also created some challenges. Not only are independent veterinarians responsible for responding to the increased demand from pet owners, they also face challenges in running their own small businesses, which have only been amplified by the recent pandemic.

As an indispensable partner, Patterson provides all of the products, services, equipment, training and software tools that vets need to do both aspects of their jobs and meet the needs of their growing customer base. For example, our companion animal customers use our Vet Hero offering to establish a constant connection throughout a pet owner’s journey to offer online appointment booking, to send text reminders in advance of an upcoming appointment, to provide convenient bill pay options and to solicit feedback with reviews. And our commercial relationship with VetSource allows the veterinarian to offer convenient home delivery of prescriptions and treatment products that can even be delivered on a regular single dose basis to the pet owner to achieve greater compliance.

In addition to the products we offer that promote engagement between the vet and their pet owner customers, we also provide helpful tools for the veterinarian to run their practice more productively. Our Market Hound platform enables veterinary practices to access all of their technology solutions in one place for an integrated, streamlined experience. Our vet success offering enables a veterinarian to automatically collect data and produce reports for key metrics within their practice. This management tool works across a number of practice management platforms to compare performance metrics between offices, provide the vet clinic with easy-to-read reports and helps identify opportunities to improve productivity, profitability and the overall customer experience.

Ultimately, our broad range of technology offerings and e-services help our busy companion animal customers save time, operate more efficiently and maintain healthy client relationships so they can focus on delivering the best possible care to the pets. Looking ahead, while the companion animal market growth rate is expected to moderate over the coming quarters, as we lap the extraordinary mid-pandemic growth in pet adoptions, we believe Patterson remains uniquely well-positioned to drive continued growth. We believe the increased attention and spending on pets, higher number of clinic visits by pet owners and additional new clinic openings will all serve as growth drivers in the companion animal market going forward. Our focus will remain on supporting our companion animal customers with the products they need to effectively meet the needs of pet owners and their pets everyday and providing the technology and services they need to manage and grow their practices.

On the production animal side, as the market continued its recovery in the second quarter, our production animal team delivered outstanding results. The challenges that producers faced with processing plant shutdowns during the pandemic and through the demand variability of the market’s prolonged recovery have heightened Patterson’s ability to be a trusted, indispensable partner in such a dynamic environment. In the same way, we serve our veterinarians in the companion animal market, Patterson brings a depth and breadth of services and capabilities to producers that span products, equipment, technology, services and trusted expertise. Producers reward us with their business as we become an integral part of their team, helping them manage a sustainable and profitable operation and contributing to the health and safety of their animals. We continue to evolve our go-to-market strategy in the production animal market to meet the dynamic needs of each specific customer. Some customers have a large operation with an onsite veterinarian and we partnered closely with this veterinarian on their specific treatment plans and delivery solutions to serve their operation.

With other customers, we work more closely with the owner operator as they not only care for their animals, but depend on Patterson for operations and accounting software to more profitably manage their business. And finally, we stock retail locations with products where customers can purchase products at their convenience. This omnichannel presence in the production animal market demonstrates our team’s true customer focus by ensuring we are serving our customers in the manner they prefer with a broad set of capabilities to meet and exceed their expectations.

As we look ahead to the remainder of fiscal ‘22, the production market is expected to steadily improve. Currently, exports across all our production categories, cattle, swine and dairy, are running above the 5-year average, reflecting improving global trade. In the swine market, herd sizes have continued to replenish and grow and global demand remains strong. And finally, restaurants and schools have continued to drive demand for protein and dairy products. We will maintain our focus on supporting our producer customers as they navigate a dynamic market and help them drive growth in their business.

As I mentioned at the start of my comments, we are very pleased with the results of our second quarter and through the first half of fiscal ‘22 across both our segments and all three of our end markets and proud of the continued focus and dedication of our entire Patterson team.

And with that, I will now turn the call over to Don to share more details about our fiscal ‘22 second quarter performance. Don?

[Don Zurbay, Chief Financial Officer]

Thank you, Mark, and good morning, everyone. In my prepared remarks this morning, I will cover the financial results for our second quarter of fiscal 2022, which ended on October 30, 2021, and the outlook for the remainder of the year. As we did last quarter, due to the comparison dynamics to the market recovery from COVID-19 in the prior fiscal year, I will also refer to how our business is performing relative to the pre-pandemic period of the second quarter of fiscal 2020 as a more helpful way to understand our business performance as we have successfully managed through the pandemic within our respective markets.

Let’s begin by covering the results for our second quarter of fiscal 2022. Consolidated reported sales for Patterson Companies in our fiscal 2022 second quarter were $1.65 billion, an increase of 6.2% versus the second quarter 1 year ago. Internal sales for our fiscal 2022 second quarter increased 8.3% compared to the prior year. As a reminder, internal sales are adjusted for the effects of currency translation, changes in product selling relationships and contributions from recent acquisitions. Compared to the pre-pandemic second quarter of fiscal 2020, internal sales for our fiscal ‘22 second quarter increased 18.1%. We believe this improved financial performance in the second quarter of fiscal 2022 is the result of continued momentum and solid sales execution in both of our business segments.

Our second quarter fiscal 2022 adjusted gross margin was 19.8% down 80 basis points compared to the prior year. The 80 basis point decline this quarter was due to two factors. First, the impact of rising interest rates on our equipment portfolio reduced our gross margin by 20 basis points in the quarter. Importantly, this impact was completely offset by a gain on the associated hedging instrument, which is reflecting in our interest and other expense line item in the P&L.

The second factor is the impact of segment mix as our Animal Health segment grew faster than our Dental segment in the quarter. This had a negative 60 basis point impact on our overall gross margin. It is important to note that gross margin within our Dental business was flat year-over-year, while Animal Health gross margins improved slightly over the same period. Adjusted operating expenses as a percentage of net sales for the second quarter of fiscal 2022 were 15.3% and flat to the fiscal second quarter 1 year ago. For additional context, our operating expenses this quarter were 220 basis points lower than the pre-pandemic second quarter of fiscal 2020.

In the fiscal 2022 second quarter, our consolidated adjusted operating margin was 4.5% and down 80 basis points compared to the second quarter of last year. As we have previously mentioned, we continue to focus on driving operating margin improvement through our efforts on expense discipline, mix management within our segments and ongoing expense leveraging as we continue growing the top line. On a year-to-date basis, through the first half of the year, our operating margin was 4.0% down 60 basis points compared to the first half of last year. We expect operating margin expansion in the back half of the year, particularly in the fourth quarter, that will drive margin expansion in both of our business segments and for our total business for the full year fiscal 2022.

Our adjusted tax rate for the second quarter of fiscal 2022 was 25.0% compared to 23.7% in the same period 1 year ago representing an increase of 130 basis points and a $0.01 headwind compared to the prior year period. Reported net income attributable to Patterson Companies, Inc. for the second quarter of fiscal 2022 was $48.3 million or $0.49 per diluted share. This compares to reported net income in the second quarter of last year of $54.1 million or $0.56 per diluted share. Adjusted net income attributable to Patterson Companies, Inc. in the second quarter of fiscal 2022 was $57.1 million or $0.58 per diluted share. As a reminder, adjusted net income excludes deal amortization and integration and business restructuring expenses. This compares to $61.1 million or $0.63 per share in the second quarter of fiscal 2021.

Now let’s turn to our business segments, starting with our Dental business. In the second quarter of fiscal ‘22, internal sales for our Dental business decreased 2.0% compared to the second quarter of fiscal ‘21. As we planned out our fiscal ‘22 year, we knew the fiscal second quarter would be a difficult comparison relative to the dental market recovery last year when we grew our Dental business by 12%. Additionally, we also planned for pricing on certain infection control products to decline on a year-over-year basis.

For some additional context in our Dental performance, it is helpful to look back 2 years ago to a comparable period before the impact of the global pandemic. On that basis, Dental internal sales for the second quarter of fiscal ‘22 are up 9.8% compared to the second quarter of fiscal 2020. Internal sales of Dental consumables declined 0.8% in the second quarter compared to 1 year ago. As we have discussed, the consumables category is undergoing a transition in the current environment as pricing on certain infection control products is considerably lower compared to the prior year. In our fiscal 2022 second quarter, sales of our infection control products decreased by 13% year-over-year. When excluding the sales impact from infection control products, our consumables sales grew 3% year-over-year.

Let’s also take a look at our Dental consumables performance compared to the pre-pandemic period of the second quarter of fiscal ‘20. On that basis, internal sales of Dental consumables in the second quarter of fiscal ‘22 have increased 16.7% compared to the second quarter of fiscal ‘20. And if you exclude the impact of infection control products, our non-infection control category in the second quarter of fiscal ‘22 increased 9% compared to the pre-pandemic period 2 years ago. Internal sales of Dental equipment and software decreased 3.0% compared to 1 year ago. Our performance in the equipment category in the quarter was impacted by the known supply chain challenges in the core equipment category. However, sales of CAD/CAM products increased double digits in the second quarter of fiscal ‘22.

As we have noted previously, the equipment category growth can vary by quarter, and it is worth noting that our average quarterly year-over-year growth for our equipment business over the past eight quarters is 7%. This notable performance is directly related to the work our dental team has done to establish Patterson as the partner of choice for equipment and technology for Dental customers. Adjusted operating margins in Dental were 9.4% in the fiscal second quarter and down from the second quarter of last year when we had a number of temporary spending reductions related to COVID-19. Again, we remain committed to driving operating margin improvement in our Dental business for fiscal 2022.

Now let’s move on to our Animal Health segment. In the second quarter of fiscal ‘22, internal sales for our Animal Health business increased 16.2% compared to the second quarter of fiscal ‘21. The Internal sales for our companion animal business increased 20.8% compared to the second quarter of last year, and internal sales in our production animal business grew 11.3% in the second quarter compared to the prior year.

For some additional context on this performance, we will look back 2 years ago to the comparable period before the impact of the global pandemic. Animal Health internal sales for the second quarter of fiscal ‘22 increased 24.3% compared to the second quarter of fiscal ‘20. Internal sales for our companion animal business in the second quarter of fiscal ‘22 increased 35.1% over the fiscal second quarter of ‘20. And for our production animal business, second quarter fiscal ‘22 internal sales increased 13.6% over the second quarter of fiscal ‘20.

Our Animal Health sales performance has been strong through the impact of the global pandemic, and these results demonstrate the high level of commitment and execution of our entire Animal Health team as they serve our Animal Health customers. Adjusted operating margins in our Animal Health segment were 3.4% in the fiscal second quarter, an increase of 50 basis points from the prior year. Our Animal Health team continues to successfully drive higher sales growth with vendor partners who reward us for our value-added approach to both our companion and production animal customers. And our team focused on expense discipline and also delivered improved product mix with stronger sales of product, private label products, equipment and software.

Moving on to free cash flow and capital allocation. Through the first 6 months of fiscal ‘22, our free cash flow is $31.3 million, an increase of $59.6 million over the first 6 months of the prior year. Please note that our free cash flow for the second quarter of fiscal ‘22 included the $36 million payment to settle our shareholder litigation. During the second quarter of fiscal ‘22, we declared a quarterly cash dividend of $0.26 per diluted share and returned $25.3 million to our shareholders. Through the first 6 months of fiscal ‘22, we have paid out $50.4 million in dividends. Our Board continues to view our dividend as an important component of our capital allocation strategy as we return cash to our shareholders.

Let me conclude with some comments on our outlook for fiscal 2022. Today, we are updating our GAAP earnings guidance from our prior guidance range of $1.64 to $1.74 per diluted share to a new GAAP guidance range of $1.69 to $1.79 per diluted share. We are also updating our adjusted earnings guidance from our prior guidance range of $1.95 to $2.05 per diluted share to an adjusted earnings guidance range for fiscal 2022 of $2 to $2.10 per diluted share.

At the halfway point of fiscal 2022, we are pleased with our performance to date and the continued momentum and trends we are seeing in our business and our respective end markets. For modeling purposes, given the comparisons to the prior year, you can assume that our EPS in the remaining two quarters of fiscal 2022 year will be more heavily weighted to the fourth quarter. Let me also add that our guidance assumes North American and international market conditions remain consistent with current market conditions and that there are no material adverse developments associated with the pandemic.

And now I will turn the call back over to Mark for some additional comments.

[Mark Walchirk, President and Chief Executive Officer]

Thanks, Don. As we look ahead to the second half of our fiscal year and beyond, I wanted to highlight several key points that give us confidence about our strengthening position in each of our end markets and in Patterson’s long-term value creation potential. First, we have the right strategy in place to capitalize on positive end market fundamentals with the ability to stay nimble and manage through potential changes in market dynamics should they occur. Second, we have the right set of comprehensive products, services and technology to help our customers achieve their goals as we constantly aspire to be their indispensable partner.

Third, we have over 7,500 passionate, dedicated and focused team members who wake up every day energized to deliver on our promise of trusted expertise and unrivaled support. And finally, our capital allocation strategy remains focused on returning cash to shareholders through our attractive dividend and identifying strategic investments that will help accelerate our performance and create enhanced returns for our shareholders.

That concludes our prepared remarks. And now Don and I will be glad to take your questions. Operator, please open the line.

[Operator]

[Operator Instructions] Your first question comes from Nathan Rich with Goldman Sachs. Your line is open.

[Nathan Rich, Goldman Sachs]

Hi, good morning. Thanks for the questions. Mark, maybe starting with the companion animal business, I think it accelerated even on a 2-year basis. And I know you had kind of pointed to maybe trends moderated as you face tougher comparisons. But just curious kind of what’s driving the strength that you’re currently seeing and any kind of specific product categories that you would highlight there?

[Mark Walchirk, President and Chief Executive Officer]

Yes, Nathan, thanks. We’re really pleased with the performance of our companion animal business. The team is doing a great job. And as you noted, we’ve continued to see, I think, multiple quarters here, of very strong growth. And as we indicated, really, I think a couple of key reasons. First, obviously, the strong market tailwinds that we’re taking full advantage of, more pets in the system, more – pet parents like myself are paying more attention to our pets, going to veterinarian clinics more often. And we’re also seeing a higher spend per visit. So you have those really positive, I think, macro trends that are taking place. And then you couple that with, I just think the great work and execution of our team really being there from the start of the pandemic, helping our customers manage through some challenging periods, really supporting them with products, with technology, with services, with education to help our companion animal customers deal with the dynamics going on in the market and really help them manage their practices in a very productive manner. So I think the combination of those two factors has really been some of the fuel behind our strong performance in this area. And we think the team is well positioned to continue to grow. Like we said, we don’t expect these levels of growth going on continually. We do think, obviously, the growth rates will moderate. But certainly, we’re really pleased with our performance here and the fact that we believe our growth is definitely outpacing the market growth at this point.

[Nathan Rich, Goldman Sachs]

Great. Thanks. And if I could maybe jump over to Dental. Don, I think you highlighted the 2-year growth in Dental of about 10%. How should we think about that as we think about 3Q trends? I think if that kind of 10% 2-year growth held, that would imply revenues of around 690 for the segment. Is that in the right ballpark? I know there is maybe some moving pieces on the equipment side. So I would just be curious to get your thoughts on kind of cadence for the segment in 3Q.

[Don Zurbay, Chief Financial Officer]

Yes. Obviously, Nathan, we haven’t – we don’t normally give guidance like that. But I would say that maybe thinking about the way you just kind of characterize that is probably relatively in the ballpark.

[Nathan Rich, Goldman Sachs]

Okay, fair enough. Thank you.

[Operator]

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

[Michael Cherny, Bank of America]

Hi. Good morning and congratulations on the strong quarter. I want to drive a little bit into the operational side. Clearly, you’re dealing with a lot of macro uncertainties, positives and negatives. As you think about your ability to essentially flex – spending this flex cost, how much does that go into the typical cadence of the quarter? And especially with the potential pending uncertainty of the Omicron variant, what will that mean in terms of how you think forward for that expected margin expansion you think you’ll see in the back half of the fiscal year?

[Mark Walchirk, President and Chief Executive Officer]

Well, I’d say, first of all, Michael, thank you. I’d say make a comment or two. This is Mark, and Don can chime in as well. I think as we’ve indicated, we are seeing some pressure on the cost front, in particular, in the areas of transportation and labor. I think we’ve referenced that now for a couple of the last quarters. Our team is really doing a great job of mitigating those cost pressures. And really, as we see our top line continue to grow, we’re getting good leverage around our expense base there. In terms of Omicron, I think, look, it’s certainly too early to determine what impact, if any, the new variant will have on end market demand. Let’s – to be clear, at this point, we certainly don’t anticipate it will result in any type of broad industry shutdown that we experienced early last year. And I’d certainly also note that we’re in a much better position as an industry and I think society as a whole that we – to be prepared for these pandemic changes as they go forward. But the reality is no one really truly knows what the future will hold regarding the pandemic, and we’re going to continue to monitor it closely. But certainly, we don’t see – we don’t anticipate a significant impact from an end market demand standpoint.

[Don Zurbay, Chief Financial Officer]

Yes. I would just add that the cost pressures are really baked into the guidance and the thoughts that we have outlined today. I think in terms of the variant, to Mark’s point, we don’t expect a significant impact but our guidance really isn’t based on anything significant happening. If that were to come to pass, I think that would change the dynamics.

[Michael Cherny, Bank of America]

Got it. And I guess when you think about the dental business as a whole and coming out of the New York Dental Show and with conferences slowly, but surely starting back up, how do you think about any changes that you would expect to see relative to the broader sales cycle? Now that we are almost 2 years into COVID, have your customers taken a different approach in terms of how they want to buy? Do they need that consultative approach that they had historically going forward? And how do you think that factors into the ongoing and I guess maybe new normal of conversion cycle tied to overall, in particular, equipment and high-tech equipment sales?

[Mark Walchirk, President and Chief Executive Officer]

Well, I think that consultative approach, Michael, is frankly now more important than ever. And I think we have really proved that, our team really proved that through the course of the pandemic. Obviously, the dental industry facing an unprecedented challenge as a result of the pandemic. And I think that consultative approach that our field teams, field sales and service and support teams implemented with our customers, I think has had a meaningful impact and has had a real impact in helping to build the momentum that we are seeing across our dental business. We believe the industry is generally back to pre-pandemic levels really across the board, again, to the point earlier, if there are changes to the pandemic, that could affect that, but we are not anticipating that at this point. Our customers are continuing to show a lot of confidence in their practices. They are investing in equipment and technology. We talked a little bit about some of the supply chain challenges that we are seeing on the core equipment side. Well, one of the key elements of that is just the strong demand that our customers are driving, again, due to I think the confidence in their practices and the confidence in the long-term growth prospects for the industry. So, I really think back to the – my early comments that, that consultative approach is more important than ever. I think our customers appreciate really the comprehensive set of products and services, technology support that Patterson provides. And I think that’s a key element to our success, both the momentum that we have been building and going forward.

[Michael Cherny, Bank of America]

Thank you.

[Mark Walchirk, President and Chief Executive Officer]

Thank you.

[Operator]

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

[Jeff Johnson, Baird]

Thank you. Good morning guys. Can you hear me out there?

[Mark Walchirk, President and Chief Executive Officer]

Yes. Hi Jeff.

[Jeff Johnson, Baird]

Hey guys. How are you? So, Mark, you have made some changes here in dental leadership. Eric is taking on more of a strategic role. I think you have been pretty clear on some recent calls. You are maybe increasing your focus on potential M&A. Two things I would like to understand on that. One, with where cash flow dynamics have been, what capacity would you have right now? Just kind of put us in a ballpark just so we could think about that? And then I think more importantly, strategically, are you thinking about scale in your current verticals? Could you vertically integrate from a manufacturing perspective? Is there a potential third leg to the stool? Again, I don’t expect you to name your targets, but just kind of how are you thinking conceptually about where that M&A could go, sorry? Thanks.

[Mark Walchirk, President and Chief Executive Officer]

Yes, Jeff, thank you. And Don can talk to the capacity question here in a second. Let me maybe cover the broader topic here. And certainly, we continue to focus on opportunities to accelerate our growth and profitability through accretive M&A. And you mentioned some of the leadership changes we have made. I am really pleased with the work the team has been doing over the past six months to nine months to identify potential opportunities and really to rebuild that muscle at Patterson. Prior to our recent acquisition of Miller Vet, it had been a number of years since Patterson had done any type of significant M&A. So, we have the opportunity to put our balance sheet to work. We intend to do so, but really only if the opportunities meet our strategic rationale, meet our financial hurdles and really that we find opportunities that would be a good fit culturally within Patterson. And again, really, the intent here is to drive greater value for our customers, strengthen our value proposition, build and expand our presence in margin-accretive product and service areas, potentially close gaps in our portfolio and as you mentioned, also looking to build scale in the core business. So, this process takes some time and continues to be a key focus for our executive team, and we will certainly be very selective about the opportunities that we pursue. But the good news is we have the capacity to make some of these types of investments looking forward, and it’s a key focus for us.

[Don Zurbay, Chief Financial Officer]

Yes. And Jeff, in terms of capacity, I think for the right transaction, in the right circumstances, we would certainly be willing to move our debt-to-EBITDA ratio north of 4x, between 4x and 5x temporarily. And given our cash flow dynamics, I think we would be comfortable with that and comfortable with the ability to pay that down relatively quickly. So, we have quite a bit of capacity. I think that shouldn’t be a constraint in terms of the things that Mark just outlined.

[Jeff Johnson, Baird]

Yes. Fair enough. And I guess, if I think about margins, I go back kind of post the rehab divest and the AHI deal, you were kind of sitting around 24%. Today, you slip below 20%. This past quarter, OpEx control has obviously been very strong here and more than offset that. But I guess when do we – how do we think about titrating that? One, do – gross margins mainly from mix or are there other issues there, does that continue to trend lower? And when does OpEx start to rise back up as you maybe attend some of these meetings, do more training, things like that? Just kind of help us titrate how to think about maybe the interplay between gross margin and OpEx spend over the next four quarters to six quarters to eight quarters? Thanks.

[Don Zurbay, Chief Financial Officer]

Yes. Well, I think the thing – the gross margin issue is really a segment mix issue entirely. I think I had outlined, we don’t normally give gross margin by segment, but I did mention that, in the dental business, our gross margin in the quarter was flat quarter-over-quarter, and then the Animal Health segment was up slightly. So, we are really just experiencing the segment mix impact. I think as – obviously, we will see where the animal health growth rates take us, and that will be – we expect that to be a bit of a headwind we continue to battle. But we also think that we have good opportunity on the expense side. I think you saw, in the quarter, 15.3% of our sales and OpEx that is a good number for us. I think we expect that to go up slightly as things kind of come back online in certain ways. But I think, overall, we think we have the expense controls to really keep mitigating that margin – the gross margin impact.

[Jeff Johnson, Baird]

Got it. Thanks guys. I appreciate the color.

[Mark Walchirk, President and Chief Executive Officer]

Thanks Jeff.

[Operator]

Your next question comes from the line of Jason Bednar from Piper Sandler. Your line is open.

[Jason Bednar, Piper Sandler]

Hi guys. Thanks for taking the questions. Congrats on this quarter here. Mark, I wanted to start asking on some of the pricing dynamics out there, a bit of a hotter topic in the current environment. Some price increases are being pushed through as we have all seen, but many manufacturers take these price increases at the turn of the year. We are just a month out from looking to ‘22. So, it would be just great if you could talk about what you are hearing from your dental and animal health manufacturing partners with respect to planned price increases going forward. How much higher than normal are these price increases? And have you experienced any pushback from your dental or animal health customers?

[Mark Walchirk, President and Chief Executive Officer]

Yes. Jason thanks. Good question. Certainly, we are seeing, as you noted some higher levels of cost inflation from some of our manufacturers, some so far in the kind of calendar Q4 and, certainly, as we move into ‘22. Really across both business segments, we typically see average cost increases in the 2% to 3% range, and we are seeing some of those manufacturer cost increases moderately higher so far. A little bit more pronounced and wide spread in Dental than in the Animal Health segment, but we are seeing some increased levels in the Animal Health segment as well. Our pricing – our customer pricing methodology is built to really help ensure that these manufacturers specific cost increases get passed on to the marketplace. And again while the level of increases are slightly higher this year, our same market pricing methodology is in place. I will say, at the same time, we are working closely with our manufacturers to really work to mitigate the impact of these inflationary trends and try to identify other ways take costs out of supply chain all with really the joint approach from both the manufacturers and us to try to minimize the ultimate impact to the customer. So, certainly something that we continue to watch closely, our teams are working daily with the manufacturers to make sure we clearly understand what changes will be made. And again I think the key here is our pricing methodology is really built to help ensure that these cost increases do get passed on to the market.

[Jason Bednar, Piper Sandler]

Great. That’s helpful. Thanks Mark. And then on the gross margins side, the segments, the commentary was helpful Don. I know we don’t have gross margin guidance. But I guess following up a bit on Jeff’s question, is there anything we should have in mind that would shift these segment gross margins higher or lower when we think forward over the coming quarters? I guess aside from company business mix, any other factors we should be considering here for gross margin, again, back half of this year and then we start thinking about fiscal ‘23 as well?

[Don Zurbay, Chief Financial Officer]

No, I think the way that we have – kind of the cadence of margin here so far this year is really as we expected. I don’t have anything specific I would highlight for you as a significant or one-time type situation that would impact margins in the back half.

[Mark Walchirk, President and Chief Executive Officer]

Yes. The only thing that I would add is just the continued focus across both of our businesses really to try to drive and improve our mix. So, whether that’s through private label products, software and technology, equipment, for example, in particular, in the animal health space, those would be some key elements to helping to improve our mix and really selling and further penetrating our improving customer revenue numbers with some of our higher-margin products. So, that’s the key focus for us as well.

[Jason Bednar, Piper Sandler]

Alright. Thanks so much guys.

[Mark Walchirk, President and Chief Executive Officer]

Thank you.

[Operator]

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

[Jon Block, Stifel]

Thanks guys. Good morning. Mark, maybe I will just start with consolidation. There is ongoing talk of accelerated rate of dental consolidation coming out of the pandemic among the DSOs. Are you seeing that, has it occurred in companion animal as well? Maybe just talk to what that does or doesn’t mean for Patterson based on your positioning within those corporate accounts? And then I have got a follow-up.

[Mark Walchirk, President and Chief Executive Officer]

Okay. Sure. Yes. Jon, thanks. First of all, in the dental space, the DSO segment has been growing rapidly here for the last several years, and we are certainly seeing that continue. I think as we have shared, we have made significant investments over the last several years to build out our team and our capabilities to support the DSO and really the regional DSO or our DSO segment as well. And we are pleased with the continued focus of our team there and frankly, the business performance that we are seeing. And obviously, that’s going to be an important growth vehicle for us going forward. And I think also we have mentioned we are really focused on working with those groups and those customers, both at the regional and national level that really see the value proposition that Patterson can help bring to their operation and making sure that we are partnering with the right DSOs and our DSOs where we can jointly certainly benefit from that. So, definitely a focus from us and we are not seeing necessarily an acceleration, to your question. But I think the growth of the DSOs has been going on, and we expect that to continue. I think shifting over to the animal health side and the Companion Animal segment in particular we are seeing some strong growth there. Like we have in dental, we have built out our strategic accounts team in the Companion Animal segment. We are winning in that space. We are showing up more frequently maybe than we have in the past. And we certainly think that – we know that that’s an element that’s helping to fuel some of our growth in the Companion segment as well. So, very important portions of the business in both dental and companion, and we are certainly focused on continuing to grow there and making sure we grow with the right customers.

[Jon Block, Stifel]

Got it. Very helpful. And Don, I am going to push you on gross margins a little bit. A lot of helpful color on the GMs down 80 bps year-over-year, and the mix, the financing, I get it. But last quarter, you thought it was going to be up gross margin throughout the balance of the year. The remainder of the year was down 60 bps sequentially. And I don’t think it’s all mix because you said actually dental was better than your internal goals for fiscal 2Q. So, getting away from year-over-year and leaning on mix, if we just isolate last quarter, you thought it was going to be up, what happened, call it, sequentially, if that makes sense, that occurred – that made gross margins to decline 60 bps Q-over-Q? Were there any other pressure points to call out other than mix? Thanks.

[Don Zurbay, Chief Financial Officer]

Well, it was down – as I mentioned in the script, it was down 80 basis points, and 60 basis points of that is just pure mix. I think that in that context, the animal health performance was better than we expected, better than our internal forecast. Dental was probably slightly lower in some areas. And so that had an impact. The other 20 basis points of the 80 basis points is really the effect of rising interest rates on our equipment financing portfolio, and we are required to mark that to market. That goes into the margin as a negative. But however, it’s fully hedged. And so below the line, you saw the offsetting impact of that and there is really zero impact on EPS. But we do get that cost in our gross margin that’s then offset down below the line. That was a 20 basis point impact.

[Jon Block, Stifel]

Yes. Okay. I think I got a lot. Fair enough, I will follow-up offline. Thanks guys.

[Mark Walchirk, President and Chief Executive Officer]

Thanks Jon.

[Operator]

Your next question comes from the line of John Kreger with William Blair. Your line is open.

[John Kreger, William Blair]

Hey guys. Don, I wanted to follow-up on your comment, I think a couple of times that growth would be a little bit more weighted towards the fiscal fourth quarter. Can you just expand upon why that would be? I would think, with the dental optimism that we might see a surge of equipment buying around the calendar year-end.

[Don Zurbay, Chief Financial Officer]

Yes. I think what we are talking about is really the more just the EPS impact. And that’s really less about sales and some – more about the cadence of expenses and some of the timing of other elements of our margin. I was really – so I was talking about that in the context of guidance and how to model the back half on an EPS basis.

[John Kreger, William Blair]

Okay. Great. Thank you. That’s helpful. And maybe just as a follow-up to that, can you talk about supply chain issues causing any stock-outs and delayed equipment? I think you said some core equipment categories have been challenged within dental. Can you talk about when that might improve? And are you seeing that impacting any other categories?

[Mark Walchirk, President and Chief Executive Officer]

Yes, John, thanks. This is Mark. As we indicated in the prepared remarks, we are seeing extended lead times from our manufacturers, in particular, in the core equipment category. I think this is an industry issue that is widely known. And I think there is a number of factors that are impacting that, certainly supply chain elements, but really very strong demand from our customers. So, we are really pleased with the backlog that we have. But as I indicated, we are experiencing longer lead times than normal in this category in particular, and that certainly affected our overall equipment results in the quarter. But again, the good news here is our customers are investing in their practices. We have a strong funnel, and we certainly believe this is a near-term issue. And we work – we are constantly working with our manufacturer partners to minimize the disruption and to work with our customers to let them know the status of their orders, but we do anticipate this issue to continue over the next quarter or so and really then moderate and really get back to normal, probably mid next – early to mid next year.

[John Kreger, William Blair]

Great. Thanks. And maybe, Mark, one last quick one, the 11% livestock growth was really impressive. Can you talk about – is that just an easy comparison, or is there something else going on that’s allowing you to do so much better than what I would consider to be a longer term market trend in the low-single digits there? Thanks.

[Mark Walchirk, President and Chief Executive Officer]

Yes, thanks. I mean I think bottom line, we saw a really nice recovery in some of the market trends and again, coupled I think with the great execution and focus of our team in the production animal business. And I think really, that’s been a formula for success for us, not just in production, but really across the business overall. And so again, our production animal team, they have been there every day with our customers in this space since the pandemic started and supporting our customers, managing through some very challenging periods. And now that demand for dairy and protein products is really coming up and really driving some of those good tailwinds. Again, our team is there to support our customers. And I think again, our growth here is outpacing the market. So, we did have a tougher comp than first quarter, but we are really, really pleased with the results of our production animal business in Q2 and really through the first half. And the team is doing a great job in executing and taking care of our customers and really bringing the value that our customers expect.

[John Kreger, William Blair]

Great. Thank you.

[Operator]

There are no further questions at this time. I will now turn the call over to Mr. Mark Walchirk for closing remarks.

[Mark Walchirk, President and Chief Executive Officer]

Well, great. Well, thanks, everyone. Really appreciate all your time today and your continued interest in Patterson. Wishing all of you and your families a very happy and healthy holiday and look forward to speaking with you again soon. Thanks very much.

[Operator]

Ladies and gentlemen, thank you for your participation. This concludes today’s conference call. You may now disconnect.