Hill-Rom Holdings, Inc.
Q3 2018 Earnings Call Transcript

Published: 27 Jul 2018

[Operator:]

Good morning, and welcome to Hill-Rom's Fiscal Third Quarter 2018 Earnings Conference Call. (Operator Instructions) As a reminder, this call is being recorded by Hill-Rom and is copyrighted material. It cannot be recorded, rebroadcast or transmitted without Hill-Rom's written consent. If you have any objections, please disconnect at this time. I would now like to turn the call over to Ms. Mary Kay Ladone, Vice President, Investor Relations at Hill-Rom. Ms. Ladone, you may begin.

[Mary Ladone:]

Thanks, and good morning, everyone. Thanks for joining us for our fiscal third quarter 2018 earnings conference call. Joining me today are John Groetelaars, President and Chief Executive Officer of Hill-Rom; and Steve Strobel, Chief Financial Officer. Before we get started, I'd like to mention that in addition to the press release issued this morning, we have posted a supplemental presentation, which can be accessed on the Investor Relation's page of our website at hill-rom.com under Events and Presentations. So with that introduction, let me begin our prepared remarks this morning by reminding you that certain statements contained in this presentation are forward-looking statements and are subject to risks, uncertainties, assumptions and other factors that could cause actual results to differ materially from those described. Please refer to today's press release and our SEC filings for more detail concerning risk factors that could cause actual results to differ materially. In addition, on today's call, non-GAAP financial measures will be used. Reconciliations between GAAP and non-GAAP financial measures are included in our earnings release issued this morning. Now I'd like to turn the call over to John. John Groetelaars Thanks Mary Kay. Good morning, everyone, and thank you for joining us today. Since this is my first earnings call as President and CEO, I wanted to start by sharing some of my initial observations and why I'm so excited about Hill-Rom's future. Since joining Hill-Rom in May, I've immersed myself in the operations, visited several of our sites around the world and engaged with our employees, business leaders, customers and shareholders. This has provided helpful insights and a deeper understanding of our company, its markets and growth opportunities in the future in our pipeline. I have known and admired Hill-Rom for many years. I'm pleased to see that integrity, quality and a customer-first focus are a priority across all levels of the organization. I'm proud to be part of a company with such a strong track record of delivering innovative solutions that enhance clinical and economic outcomes for patients, caregivers and healthcare systems. I'm also proud to be part of a company that lives its values of results, responsiveness, respect and integrity, while having fun doing it. Hill-Rom has been on a transformational multiyear journey to diversify and strengthen its portfolio. Passion and capabilities of our leadership team and the strength of our culture are quite evident. We have a solid foundation, strong global brands and excellent growth prospects across the portfolio. There is a great opportunity to build on Hill-Rom's positive momentum and lead the company through the next phase of our transformation. I want to also thank our 10,000 associates around the world, who have welcomed me and embraced the next phase of our journey. Although it's only been 11 weeks, I know we are highly aligned on the mission ahead. Looking forward, my primary objective is to enhance our global category leadership and drive durable, sustainable top line growth. I believe our diversified portfolio will allow us to accomplish this objective. This will be supported by 3 strategic priorities. First, deploying a category leadership strategy to drive growth of differentiated new products. Second, increasing our focus on international growth, particularly, in emerging markets. And third, augmenting organic growth with strategic M&A. First, with respect to category leadership. We expect our organic R&D efforts to deliver innovative solutions that are impactful and deliver a clear value proposition for our customers. We will continue to focus on accelerating growth and improving margins from products we've recently launched. In addition, we have recently taken a rigorous look at our current R&D programs to ensure we are allocating resources to the biggest and most meaningful initiatives to drive sustained growth in the future periods. Our second objective is international expansion, particularly driving penetration in the emerging markets. I'm happy with the momentum in regions like Europe, Middle East and Africa, which will continue to be important contributors to our performance going forward. In other emerging markets, one of our first priorities is to conduct a robust assessment of the product categories with the highest growth potential. Once we've identified the appropriate product mix and the go-to-market model, we plan to invest in organizational capabilities and infrastructure to support meaningful growth acceleration. Lastly, M&A. It will continue to play an important part of our strategy going forward. We are successfully delevering the balance sheet, creating incremental capacity for larger transactions. We are actively looking for targets that support our category leadership positions through both tuck-in acquisitions and larger deals. Importantly, our M&A activities must be accretive to top line growth and provide attractive financial returns. To summarize, we have a compelling financial outlook over our LRP. This includes accelerated core revenue growth of 4% to 5%, and expanding margins and double-digit earnings and cash flow growth through 2020. I look forward to maintaining an active dialogue with the investment community as we shape our plans for fiscal 2019 and beyond. We are committed to delivering on our strategic and financial objectives, while creating enhanced value for customers, caregivers and our shareholders. So with that, let's turn to the key highlights for the quarter. Hill-Rom delivered another quarter of strong financial results, and we raised the low end of our adjusted EPS guidance by $0.02, to $4.62 to $4.65 per diluted share. Third quarter adjusted EPS of $1.15 per diluted share exceeded our guidance range and increased 26%. This is our 12th consecutive quarter of double-digit earnings growth. I'm very pleased to report core revenue growth was at the top end of our guidance range and accelerated to 4% compared to 2% growth in the first half of the fiscal year. The contribution from new products was the key driver. Strong U.S. performance was partially offset by a decline in international growth, primarily due to challenging comparisons in the Middle East and lower OEM revenue. Excluding these 2 items, international momentum continue to be positive, with core growth in mid-single digits. This is consistent with our international performance for the year even after absorbing headwinds in Asia-Pacific and Latin America. Today, these 2 regions account for only 7% of our total revenue. We continue to be in the early stages of reinvigorating our commercial operations in these 2 markets, which represents an encouraging future tailwind. Overall, core revenue growth accelerated. And combined with operational and mix improvements, we delivered 120 basis points of operating margin expansion and upside to our earnings guidance. As I mentioned earlier, innovation is our top priority. In 2017, new products contributed nearly $150 million in revenue. I'm very pleased to report that through the third quarter, our new product revenue is now already over $180 million. We are well on our way to exceeding an important milestone of more than $200 million in new product revenue for fiscal 2018. Let me just take a moment to elaborate on a few recent achievements. First, in Patient Support Systems, we have tremendous assets in our core business, including bed frames, Clinical Workflow Solutions and patient handling equipment. Late last year, we launched the new Centrella Smart+ bed system, and feedback from clinicians continues to be very positive. Customers are citing an improved patient experience, increased safety, features that reduce risk of falls and new technology that enhances patient and care team communications as key attributes differentiating our new product offering. Since the launch, Centrella has now surpassed $50 million in revenue, including several competitive conversions. Double-digit growth in med-surg orders and backlog are exceeding our expectations. Looking forward, with a stable hospital capital spending environment, we're confident in our ability to accelerate U.S. med-surg growth over a multiyear period. Along with the upcoming commercial release of WATCHCARE, our integrating incontinence detection device and EarlySense, a contact-free continuous heart rate and respiratory rate monitor, we have a unique opportunity to set a new standard of care and reduce costly complications in the acute care setting. For many years, Hill-Rom's Clinical Workflow Solutions business has been an innovator in communicating critical information in the patient care environment. With our market-leading platform, TWS revenue has increased by more than 15% this year. We are making competitive inroads in the $400 million U.S. Nurse Call market and generating significant demand from several large hospital systems. Market growth here is being fueled by an innovation-driven replacement cycle, provider consolidation and new construction. During the quarter, we further strengthened our mobile -- our workflow solutions with the clinical communications device entering the mobile communication market. With a limited release of Linq mobile, a smartphone application, we can securely connect members of the care team to each other, to patients and to patient information in real time. With the full commercial launch planned this year, the Linq mobile platform integrates Clinical Workflows with Nurse Call, clinical surveillance in monitoring systems to improve care team communication and efficiency. Just as smartphones have become a vital part of our daily lives, we believe Linq mobile will become an essential tool for caregivers around the world. This represents an incremental U.S. market opportunity of $200 million. Our leadership in hospital beds, bioscience measurement, patient monitoring and clinical communications uniquely positions Hill-Rom to enable the digital environment with a synchronized communication platform to improve patient outcomes across the care continuum. We continue to pursue investments in technology to assess and analyze critical information at the bedside. This will provide caregivers with actionable insights, help identifying predict risks, improve workflows, communications and reduce complications. I'm excited by a number of opportunities here to create a transformative, new growth vector for the company. Turning to Front Line Care, new products continue to be a key driver of growth. Leading the way is our higher-margin Respiratory Care business, which is growing double digits this year. With the introduction of the Monarch Airway Clearance System, patients with cystic fibrosis and other chronic respiratory conditions can be active and productive while receiving therapy. In Vision Care, we announced a new partnership with Siemens Healthineers, the market leader of A1C testing in the U.S. to provide comprehensive diabetes care in the primary care setting. The Welch Allyn RetinaVue imager will be included in a suite of diabetic instruments to provide proactive testing and treatment with a single visit. This will reduce costs, eliminating convenient follow-up visits and increase overall compliance. With our RetinaVue Network, we are making diabetic retinopathy screening simple and affordable for the primary care setting. The recurring revenue stream has been steadily accelerating with nearly 245,000 screens since the launch of this device in 2016. This represents an increase of nearly 40,000 screens since last quarter. With our new partnership investments to expand the dedicated sales team and upcoming enhancements to make the device easier to use, RetinaVue is one of our more exciting long-term growth drivers. Finally, Surgical Solutions is benefiting from a number of strategic partnerships. Integrated Table Motion placements continue to be very strong, up more than 30% this quarter as we sustain a very high attachment rate to the da Vinci XI robots. We continue to focus on increasing penetration not only in the U.S., but also select international markets like Japan. Overall, the key strategic focus in Surgical Solutions continues to be on hybrid operating rooms and robotics. An example of this is the launch of our new MRI neurosurgical table for the IMRIS Surgical Theater. This new table integrates a novel IMRIS MRI neurosurgical tabletop with our TruSystem 7500 operating room table, maximizing workflow efficiency and improving ergonomics. So in closing, we are in the early stages of strengthening the durability of our revenue growth trajectory. We have a broad and diverse product portfolio, strong global brands to drive our category leadership strategy. We will continue to innovate to meet challenges confronted by patients, caregivers and our customers with unique, differentiated solutions to reduce complications and costs. We are actively assessing new M&A opportunities that leverage and build upon our current position. We have a very solid foundation as we enter the next phase of our transformation. We look forward to keeping you updated on our progress as we complete our plans for fiscal 2019. And now let me turn it over to Steve for a review of our third quarter financial results and our guidance. Steve?

[Steven Strobel:]

Thanks, John, and good morning, everyone. As mentioned in the press release, we reported GAAP earnings of $0.67 per diluted share in the third quarter compared to $0.09 in the prior year. These results include after-tax special items related to recent tax reform legislation, intangible amortization, business optimization and other special charges. Adjusted earnings of $1.15 per diluted share increased 26%, exceeding our guidance range of $1.12 to $1.14 per diluted share. Now let me briefly walk through the P&L before turning to our 2018 financial outlook. Starting with revenue. For the fiscal third quarter, revenue of $709 million grew 3% on a constant currency basis. Revenue increased 1%. Core revenue increased 4% at the top end of our guidance range. As a reminder, core revenue growth adjusts for the impact of foreign currency, divestitures and nonstrategic assets we plan to exit. Domestic revenue on a core basis increased 7%, driven by strong performance in Patient Support Systems and Surgical Solutions. This growth was partially offset by lower OEM revenue and a challenging international comparison resulting from a large construction project in the Middle East last year. Excluding these factors, core international growth was 4%, continuing the trend of positive top line momentum with particular strength across Europe, which is growing in high single digits this year. Before moving on, keep in mind that as I discuss each business segment, I will address revenue growth on a constant currency basis only. Starting with Patient Support Systems. Revenue of $360 million was comparable to the prior year, while core revenue advanced 5%. Domestic core revenue accelerated to 8%, reflecting strong performance from all key capital product categories. As you may recall, we were encouraged last quarter with our building U.S. capital backlog and momentum materialized in the third quarter with growth of more than 20% in Med-Surg bed systems, Clinical Workflow Solutions and patient handling equipment. This quarter, Centrella accounted for nearly 50% of our total U.S. med-surg revenue and our orders and backlog continue to grow at an accelerated pace. Outside the U.S., core Patient Support Systems revenue declined 4%, but increased 4% excluding last year's Middle East order, primarily as a result of improved performance across Europe. Now moving to Front Line Care. Revenue increased 4% to $239 million. U.S. growth of 4% was driven by the contribution from new products, including the Monarch Mobile Vest and our Vision Care portfolio. Physical assessment tools, women's health products and thermometry also contributed to growth. International revenue increased 4%. Performance was solid across Europe, Canada and the Middle East as we continue to focus on increasing penetration with our Welch Allyn portfolio by leveraging Hill-Rom's geographic presence, brand and infrastructure. Lastly, Surgical Solutions revenue was flat to the prior year and totaled $110 million. U.S. growth of 8% was the strongest of the year, while international revenue declined as a result of lower OEM revenue in last year's Middle East order. Excluding these items, surgical revenue increased 6% on a global basis. Now turning to the rest of the P&L. Adjusted gross margin of 49.1% improved 80 basis points versus last year, reflecting the positive contribution from mix, primarily related to our portfolio optimization initiatives and new products as well as benefits from manufacturing productivity and our procurement efforts. R&D spending of $34 million declined 4% versus the prior year. This decline reflects the impact of elevated spending in the prior year period in preparation for the commercial launch of Centrella. Adjusted SG&A of $192 million increased 2%. Disciplined cost management partially offset other selling and marketing investments, supporting new products and initiatives to enhance our global commercial capabilities. Our adjusted operating margin in the third quarter was 17.3%, an improvement of 120 basis points compared to the prior year. And the adjusted tax rate of 21.7% included a $0.02 benefit from stock-based compensation and the favorable impact from U.S. tax reform. So again, bottom line, third quarter adjusted EPS advanced 26% to $1.15 per diluted share. On a year-to-date basis, adjusted EPS of $3.13 per diluted share increased 23%. And excluding the benefit of tax reform, adjusted EPS increased 15%. Turning to cash flow. Through the 9-month period, cash flow from operations of $250 million increased 4% versus the prior year. Growth in cash flow has been impacted by higher inventory levels to support our manufacturing consolidation initiatives and new product launches. We expect inventory levels to decline by the end of the fiscal year. Capital expenditures for the 9-month period were $72 million, $2 million lower than the prior year period. And as a result, year-to-date cash -- free cash flow of $178 million is 7% higher than 2017. In terms of the balance sheet and financial leverage, we have reduced debt levels this year by $138 million. And at the end of June, our debt-to-EBITDA ratio was 3.6. Now let me conclude this portion of the call by providing our fiscal fourth quarter and full year guidance. For the full year, we continue to expect reported revenue growth of 3% to 4% and constant currency growth of 2% to 3%. Core revenue, which is expected to increase approximately 3%, excludes foreign currency, divestitures, nonstrategic assets we plan to exit and Mortara prior to the anniversary date of the acquisition. As you may recall, collectively, divestitures and nonstrategic revenue in 2017 totaled approximately $100 million. With the divestiture of the third-party rental business in the third quarter, nonstrategic revenue is expected to contribute approximately $40 million in revenue in 2018. By business segment, there is no change to our prior guidance. We continue to expect Patient Support Systems revenue to decline in the low single digits. On a core basis, PSS revenue is expected to increase in low single digits. For Front Line Care, reported growth is expected to be in the high single digits, with core growth of low to mid-single digits. And lastly, we expect low to mid-single digit growth for Surgical Solutions. From a profitability standpoint, we now expect adjusted gross margin to expand 75 basis points and exceed 49%. We expect R&D spending of approximately 5% of sales and adjusted SG&A of 27% of sales, including further investment behind our growth initiatives. We continue to expect adjusted operating margin expansion of approximately 100 basis points. Other expense including interest of approximately $93 million and a tax rate of 21% to 22%, reflecting the ongoing benefit from stock-based compensation and U.S. tax reform legislation. Lastly, we expect a share count of approximately 68 million shares. So to summarize, this guidance translates into adjusted earnings of $4.62 to $4.65 per diluted share. We are raising the low end of our previous guidance range, which was $4.60 to $4.65 per diluted share by $0.02, while absorbing a modest headwind in the fourth quarter related to the implementation of new tariffs and the strengthening dollar. From a cash flow perspective, we continue to project operating cash flow of approximately $350 million. With capital expenditures now expected to be around $100 million, we now project free cash flow of $250 million for the full year. For the fourth quarter, we expect revenue growth of approximately 2% on both the reported and constant currency basis. We expect core revenue to increase 3% to 4%, and are providing guidance for the -- for adjusted earnings per diluted share of $1.50 to $1.53. So with that, we'll now open the call up for Q&A.

[Operator:]

[Operator Instructions] Our first question comes from the line of David Lewis of Morgan Stanley.

[David Lewis:]

A couple of quick questions here this morning, John and Steve. So just thinking about the guidance and how you intend to, sort of, finish off the year. So you've got -- your pipeline is ahead of expectations. It will exceed $200 million. Comp gets a little easier, Steve, into the fourth quarter. You're sort of guiding business 3% to 4% in the fourth quarter similar to the third. So can you just kind of walk us through how you see the business kind of finishing off the year, easier comps, same growth, building momentum? And how that kind of looks U.S. versus OUS.

[John Groetelaars:]

Yes. David, thanks for the question. We feel confident with the guidance we're setting for the fourth quarter. We are -- our goal here is to set guidance and then deliver against that guidance. We do have some headwinds that we need to overcome in the fourth quarter that we've taken into account when we set this guidance. But we feel confident with where we are. It still represents a significant increase over the first half of the year, and our objective here is to deliver durable, sustainable growth levels at this rate as we end the year.

[David Lewis:]

Okay. That's helpful, John. And then, you gave some nice strategic overview of the business this morning. And I wonder, as you start thinking about what's in the core pipeline versus what would have to sort of be acquired? I mean, obviously, the goal here is to accelerate organic growth. How are you feeling about the opportunity of that core pipeline to get you, sort of, to mid-single-digit consistent growth? And have you had a chance to assess how active this company is going to need to be externally to deliver that kind of mid-single-digit growth?

[John Groetelaars:]

Yes. David, as I mentioned in the prepared comments, we recently done an internal R&D review of all of our projects across our 3 business units. And I would say, as evidenced by our new product performance in the third quarter and year-to-date, we do feel good about what our product pipeline is currently delivering. We feel equally good about what the future looks like and our ability to deliver on the LRP objective of $350 million. We're clearly at a pace that will get us there at this current moment. So I feel good about the organic opportunities to support category leadership in our 3 business units. We are actively assessing M&A opportunities that would further enhance and support that category leadership in each of our businesses. That pipeline is building, and we've recently increased our business development resources across each business unit by a significant amount, a multiple over what we have today. So we're putting incremental resources of our own people against business development to make sure we can build the pipeline and then execute against that pipeline across these 3 businesses. Operator Matthew Mishan of KeyBanc is on the line with a question.

[Matthew Mishan:]

I think -- first off, I think -- just following up on the previous question, I think you mentioned headwinds in the fourth quarter you're going to have to overcome. Can you elaborate a little bit?

[John Groetelaars:]

Yes. I'll let Steve comment on some of the specific headwinds in the fourth quarter as we enter the fourth quarter here.

[Steven Strobel:]

Yes. Matt, we're going to have balanced growth across both U.S. and OUS, but we are going to have a little headwind in Asia-Pacific and Latin America as we go -- as we had in the third quarter. Those are going to continue for us into the fourth quarter, and those are probably the biggest headwinds. We're going to deliver, like we said, 3% to 4% core growth, which is a step-up from where we were in the first half and a continuation of the trends in the third quarter. So we feel -- those are the major things that we've got -- that we have our eye on that the team -- Carlos and team are addressing as we go. So we feel good about in general, the momentum across the rest of the business and those are probably the biggest things that we've got in front of us.

[Mary Ladone:]

Yes. Matt, this is Mary Kay. Also just recalling the third quarter, we had the difficult comparison related to the Middle East large construction order that was just over $10 million. We really don't have a significant comp issue in the fourth quarter. I think David pointed out that we have a little bit easier comps. But we did -- here in the back half, we are exiting some of this lower-margin OEM business. That's going to impact us in the fourth quarter as well and that will be a headwind.

[Matthew Mishan:]

Okay. Great. And then on the long-term growth, especially in the long-range plan, the LRP implies you go from 3% this year to 4% to 5% over the next couple of years. How confident are you in that 4% to 5% growth now that you've conducted the initial portfolio deal?

[John Groetelaars:]

Yes. Matt, I feel -- we're very confident about that LRP outlook. We have a lot of work to do to execute against this. But I think the strength of our businesses, the strength of our leadership team, the diversity of our portfolio and the opportunity we have to continue to accelerate growth in our emerging markets and turn that into a tailwind. I think that's -- those are all reasons for us to feel confident about our ability to meet that LRP projection.

[Matthew Mishan:]

That's helpful. And then last question. Can you talk a little bit about the cadence of the wind down of the noncore businesses now? And how we should be looking at that through next year? And it seems like surgical OEM is another potential area you should be winding down. How we should be thinking about that?

[Steven Strobel:]

Yes. I think the -- Matt, this is Steve. Those -- the businesses that we have been winding down -- we're out of the third-party rental business, we'll be out of third-party surfaces business by the end of this year. So the $40 million or so of revenue that we had in this year's results for those businesses that we're getting out of will basically be nothing next year.

[Operator:]

Rick Wise of Stifel is on the line with a question.

[Rick Wise:]

Let me turn back to M&A, John, if I could for a second. Your comments couldn't have been clearer. You're actively looking, you're actively assessing. A couple of things around that. When you talk about -- you're looking at smaller and larger. May be defined larger for us? Is it -- is larger mean Welch Allyn kind of size or is it bigger than that? And just given you're a new leader here, obviously. How do we think about your tolerance or willingness to take on dilution? I mean, just maybe give us a sense of what we should expect whenever that press release comes across?

[John Groetelaars:]

Yes. Thanks for the questions. And I think -- look, our primary objective here is to continue to allocate capital to pay down our debt, but keep that in balance with our -- the opportunity to do M&A that's strategic and financially attractive. We're very pleased with our progress on paying down the debt and reducing our leverage. We expect to be approaching 3.2x leverage by the end of this year. And that continue -- that allows us a little more capacity to consider larger transactions. I think the key theme here though is really about driving growth and driving -- enhancing our category leadership strategy. That's really the key opportunity that we have. And then once we look at those categories that we're in today and how to support staying at a #1 or #2 position or getting us into that position of being #1 or #2. We actually see a pretty rich environment of M&A opportunities that spans the scale. I won't be specific in terms of what size deal we would look at, but we do have increasing flexibility financially. And if the right strategic deal that fit our profile of financial returns and accretion were to come along that were across that spectrum of tuck-in to a larger scale, we feel ready to do it.

[Rick Wise:]

Go ahead.

[John Groetelaars:]

No, it's good.

[Rick Wise:]

Okay. Turning to Centrella, John. You highlighted the success so far in competitive accounts. Maybe just a little more color on the opportunity. Where are we in the launch? Does adoption -- since you're having success in competitive accounts, does growth or uptake of Centrella accelerate from here? How should we think about it? And in another setting, a month or 2 ago, you indicated -- I think I'm quoting you directly that you were seeing pull through from the Centrella success across other parts of Hill-Rom. Anymore color on that front?

[John Groetelaars:]

Yes. A couple of good questions there, Rick. So Centrella -- we feel Centrella is still in the earlier phases of its launch cycle. We are seeing double-digit growth in back orders and backlog, and we've recorded record revenues in the quarter. It's almost representing half of our med-surg revenue in Q3. And the average order size is significantly larger than what we would normally see in this business, 2x larger as a matter of fact. So the combination of higher ASPs, higher order sizes and double-digit growth in our back orders and backlog make us feel very confident around the opportunity in front of us for Centrella and the med-surg category in general. Is it accelerating the replacement cycle? We actually believe it is, given the metrics I just gave you and the fact that we're seeing larger than normal order sizes by 2x. In terms of the question on pull through, I would -- I guess, I would have to point you to our growth in CWS, which really as an integrated smart bed system, the combination of a smart bed and the ability for it to connect and communicate to our CWS franchise, really demonstrates that pull through. CWS grew last year 13%, is growing year-to-date so far at 15%. Again, our backlog and orders -- our backlog continues to grow at double digits. So we're excited about that opportunity and entering the new mobile segment with Linq only helps enhance that product offering.

[Operator:]

Larry Keusch of Raymond James is on the line with a question.

[Larry Keusch:]

John, I recognize that the emerging market strategy is in its early stages and you're sort of assessing things at this point, but just at a high level it sounds like this will be important to growth over time, at least from your perspective. So what -- kind of what perhaps countries that you're kind of interested in? Or as you at a high level look at product portfolio, where do you think you could move with some of this stuff to get into those markets?

[John Groetelaars:]

Yes. Thank for the question, Larry. Let me first point to an area of strength. In the Middle East and Africa, we do very well -- disproportionately well, I would say, for a company of our size. So it gives me confident. It gives our whole organization confidence that we know how to execute in an emerging market opportunity, and we can repeat that in the Middle East and Africa. We actually are having exceptional performance out of Europe. Our One Hill-Rom approach and our ability to focus on the portfolio, focus on the right go-to-market strategy and the right organizational structure to untap international growth in both developed and emerging markets. We know we can do it. We've demonstrated we can do it. We need to get ourselves into a regular cadence of performance in Latin America and Asia-Pacific. So those will be the 2 areas of priority, specifically, Latin America and Asia-Pac. We have significant opportunities there. Those 2 regions only account for 7% of our total revenue. As a -- from a benchmarking point of view, that's disproportionately low. These -- we believe these are regions that can deliver high double-digit growth rate for us in the future. But we have to get our plans in place, we have to understand what our opportunities are, we have to make the investments. So we're not indicating that today, but that opportunity should be there for us, and we're busy -- very busy about assessing the opportunity and preparing those investment plans, which we hope to share with you a little more in the months going forward.

[Larry Keusch:]

Perfect. I have 1 additional question about -- 1 more just on emerging markets. How central is China to the strategy?

[John Groetelaars:]

Well, China is the big 50,000-pound gorilla, when it comes to emerging markets. So that's -- it's #1 on our list to make sure we understand what the opportunity is there and how we unpack it and tap into it.

[Larry Keusch:]

Okay. Perfect. And then second question perhaps for you John as well as Steve. Look, I know you're not providing 2019 guidance today, but can you help us think a little bit about perhaps some of the dynamics that as we comp up against '18 that we should be at least considering as we think through the numbers?

[John Groetelaars:]

Yes. That's a great question. And one of the pieces of feedback that I've heard from investors, we ourselves don't like the lumpiness, so to speak, in our business in the past. We're making every effort to eliminate and reduce that kind of up and down quarter-to-quarter discussions that we've had in the past. So as we look at 2018 and think about our baseline as a launching pad for 2019, we feel very good about where we are. That we have a nice even distribution of activity over the course of this year. There's no single large event that stands out to us as we look at the year-to-date performance. So we think it provides us a stable backdrop to have a more consistent, durable top line performance into the future.

[Steven Strobel:]

I guess, I'd add a little bit of color on that one, Larry. And that we think about some of the tailwinds we're going to have, we're going to continue to see benefit from our new products. And we'll continue to drive those not only ones that are in market now, but continue to invest behind ones that are going to generate revenue in 2019 as well. So that should be a tailwind for us. The headwinds are some of the things that you see in the news today. The tariff situation is going to have an impact on our cost structure. Still determining what that is, but I think that could be somewhat of a tailwind for us. The -- we've enjoyed stock-based comp benefit in our tax rate this year. I don't know as if we'll have that level in 2019. And so those are some of the things that are on our radar screen as we sit and are in the process of preparing our plans for 2019 as we speak now. But we've got a lot of -- we feel good about the momentum we have, like John said, and developed here in the second half of the year carrying into 2019.

[Larry Keusch:]

Though it sounds like the message is on the core growth side, you guys are feeling quite good as you kind of end up '18 and you head into '19.

[John Groetelaars:]

Yes. We expect to deliver what we outlined.

[Operator:]

Isaac Ro of Goldman Sachs is on the line with a question.

[Isaac Ro:]

So John, just curious as you review the financial structure of the company, wondering if you see any new opportunities for improvement either in terms of margins or cash flow? Obviously, that was something that was in progress before you showed up, but perhaps with a fresh look there's something new to talk about that might be worth [indiscernible]

[John Groetelaars:]

Yes. Isaac, thanks for the question. I think in terms of what we've outlined from margin expansion and cash flow, I feel very confident about where we are. Really liked what I've seen as we've uncovered our opportunity for improved mix, improved cost of goods, supply chain efficiencies, plant consolidations. All of those things at a gross margin level feel good. Obviously, getting top line growth moving is going to help drive improved mix and also improved operating margin. And our business optimization efforts continue to be underway. We are putting -- I'd say we're a little bit past the halfway point of putting our plans together. We would expect to be able to communicate something more specific around that in the future, but we're very serious about the business optimization effort we identified before. We feel it's going to free up additional resources for us to deploy against significant investments that could really help us in achieving our objectives of driving more durable, sustainable top line growth and driving the initiatives I outlined earlier around category leadership and M&A.

[Steven Strobel:]

Isaac, and that's -- obviously, there's a P&L flavor to what we've talked about in the optimization. But in terms of reducing complexity and simplifying across the company, we expect that there's going to be opportunity for us on the working capital side as well. And so that we're working on both ends of the aisle, if you will, on the P&L as well as the balance sheet to generate -- continue to generate strong cash flow in the company.

[Isaac Ro:]

Okay. And then just a follow-up on the tariff comment you made earlier. It will be helpful if you could put a little more precision around how that affects your business. Maybe not specific numbers, but just directionally some of the moving parts that are important for us to watch, just so we're prepared for -- once there's more clarity, what it means for you guys?

[Steven Strobel:]

Yes. Isaac, the -- our cost structure has and our products have steel and aluminum in them. Our Patient Support Systems, whether they be lifts or beds have steel and aluminum. So the impact of the tariffs on market prices has had an impact on our cost structure. Here we're going to see some of that a little bit in the fourth quarter. We alluded to that as part of a little bit of the headwind that we will experience in the fourth quarter, and right now based on the lay of the land, would expect continuing into 2019. There's also imports from China. So to the extent that we would have, for instance, printed circuit boards and other types of things that are in many of our products -- our connected products, we'll -- we are in the process of assessing what tariff codes are going to be containing the products and the raw materials that we use. So those could be -- those are probably 3 areas in particular as we think about 2019 that we're watching closely and trying to estimate the impact.

[John Groetelaars:]

As far as Q4 goes, Isaac, we fully contemplated what that is. We got it covered in our guidance, and we're confident that we'll be able to overcome the modest headwinds on increased costs there.

[Mary Ladone:]

Matthew, I think we have time for 1 more question.

[Operator:]

Mike Matson with Needham & Company is on the line with a question.

[Unidentified Analyst:]

This is David Saxon for Mike. Just one more on the -- your M&A strategy. Is the idea to continue to diversify away from capital equipment? And you mentioned you're at 3.6x, aiming for 3.2x by year-end. But if the right deal came along, how high would you be willing to go?

[John Groetelaars:]

Yes. Thanks, David, for the question. Again, the -- not prepared to talk about how high we'd go with leverage. I think you can historically see where we've gone. For the right opportunity, we would certainly contemplate that, but it would need to be -- provide the right returns and provide the right strategic fit for us to do that. Our primary objective at this point is, we're in multiple different product categories. We see really nice clear opportunities for us to enhance that leadership position. And we know from doing that we're going to get a tremendous amount of financial leverage by pursuing those kinds of deals. So we can -- and we can move the needle on top line growth with significant small to medium-sized transactions with a company of our size. So that's going to be an active area for us to look at. We always look at larger transactions, and it's just harder at times to determine if they're actionable, determine if the right financial conditions exist to pursue those larger scale deals. So it's all in place. You've seen from our historical leverage point what we've been comfortable with in the past, but we do see a nice rich set of opportunities here to go after.

[Unidentified Analyst:]

Okay. Appreciate the color. And then just in terms of new product contribution, are you still comfortable with achieving $350 million by 2020? And then just with this significant increase year-to-date, why hasn't that driven more significant revenue growth acceleration?

[John Groetelaars:]

Yes. Great. Good question, and good follow -- I guess, final question. Look, the new products are not just 1 product. I want to make that point clear. It is well over a dozen products that contribute to new product growth. There is a diverse set of products that are driving this performance. We feel confident about our ability to build that momentum as we've seen in the first 3 quarters here. It is driving a significant amount of incremental growth. 270 basis points of growth out of the 4% core growth is from new products. So it is the engine that's driving our top line growth, combined with the diversity of our portfolio and our regional presence around the world. So thanks for the question, and appreciate your attention today.

[Mary Ladone:]

Yes. David, the only other thing I would add is that not all these products are driving -- are incremental to our base growth, probably half of them are cannibalizing existing revenue. So -- just so you have that in mind when you're think about our overall growth and the contribution from the new products.

[John Groetelaars:]

Yes. A little less than half have some cannibalization associated with it. Well, thanks very much for the call, everybody. I appreciate the questions and look forward to our next call with you.

[Operator:]

Ladies and gentlemen, this concludes today's conference call with Hill-Rom Holdings, Inc. Thank you for joining.+