Overview

The Company's fiscal 2009 financial information is summarized in this Management's Discussion and Analysis, the Consolidated Financial Statements, and the related Notes. The following background is essential to more fully understand the Company's financial information.

Patterson operates a distribution business in three complementary markets:
dental supply, veterinary supply and rehabilitation supply. Historically the Company's strategy for growth focused on internal growth and the acquisition of smaller distributors and businesses offering related products and services to the dental market. In fiscal 2002, the Company expanded its strategy to take advantage of a parallel growth opportunity in the veterinary supply market by acquiring the assets of J. A. Webster, Inc. on July 9, 2001. The Company added a third component to its business platform in fiscal 2004 when it entered the rehabilitation supply market with the acquisition of AbilityOne Products Corp. ("AbilityOne") on September 12, 2003. AbilityOne is now known as Patterson Medical.

Operating margins of the veterinary business are considerably lower than the dental and rehabilitation supply businesses. While operating expenses run at a lower rate in the veterinary business, its gross margin is substantially lower. Over the past two years, the veterinary business has grown at a faster rate than the other two businesses, resulting in dilution of the consolidated operating margin.

There are several important aspects of the Company's business that are useful in analyzing the Company, including: (1) market growth in the various markets it operates; (2) internal growth; (3) growth through acquisition; and (4) continued focus on controlling costs and enhancing efficiency. Management defines "internal growth" as the increase in net sales from period to period, excluding the impact of changes in currency exchange rates, and excluding the net sales, for a period of twelve months following the transaction date, of businesses that it has acquired.

During fiscal 2008, the Company executed a series of transactions that effectively changed our capital structure, lowering our weighted average cost of capital by almost 100 basis points, and positioned the Company to increase returns to our shareholders. First, the Company repurchased approximately 18 million shares of its common stock on the open market and through an accelerated share repurchase agreement for approximately $636 million. A portion of the funding for the share repurchases came from debt issued in the fourth quarter of fiscal 2008, consisting of fixed-rate private placement notes totaling $450 million and a variable-rate term loan of $75 million.

Results of Operations

The following table summarizes the consolidated results of operations over the past three fiscal years as a percent of sales:

                                        2009       2008       2007
                  Net sales             100.0 %    100.0 %    100.0 %
                  Cost of sales          66.3 %     65.6 %     65.4 %

                  Gross margin           33.7 %     34.4 %     34.6 %
                  Operating expenses     22.5 %     22.4 %     22.6 %

                  Operating income       11.2 %     12.0 %     12.0 %
                  Other income, net       0.1 %      0.3 %      0.3 %
                  Interest expense        1.0 %      0.4 %      0.5 %

                  Income before taxes    10.3 %     11.9 %     11.8 %
                  Income taxes            3.9 %      4.4 %      4.3 %

                  Net income              6.5 %      7.5 %      7.5 %

Fiscal 2009 Compared to Fiscal 2008

Net Sales. Fiscal 2009 consolidated sales were $3,094.2 million, an increase of 3.2% compared to $2,998.7 million in fiscal 2008. Acquisitions contributed 3.8% to sales growth, resulting primarily from an acquisition by the veterinary unit. Fluctuations in foreign currency translation rates reduced sales by 1.1%. During fiscal 2009, sales at each of our business units were adversely affected by the economic recession. The Company believes the weakness in the general economy will continue to affect our performance in fiscal 2010.

Sales of our consolidated dental supply unit totaled $2,174.4 million, a decrease of 0.3% from $2,181.3 million in fiscal 2008. Acquisitions had a positive impact on sales of 0.9%, while fluctuations in foreign currency rates related to our dental operations in Canada reduced sales by 1.0%. Sales of dental consumable supplies of $1,217.2 million were virtually unchanged from fiscal 2008. In the first half of fiscal 2009, an economy-related trend of patients deferring higher-level and discretionary services began and continued throughout the year.

Dental equipment sales declined 1.7% in fiscal 2009, including a 2.0% decrease in basic equipment. Sales of CERECŪ 3D dental restorative systems were 0.7% lower in fiscal 2009, but did grow 5.7% in the second half of fiscal 2009 as compared to the second half of fiscal 2008. CEREC system sales in the second half of the year benefitted from promotional financing arrangements that were made available to qualified customers, as well as the January 2009 introduction of a new digital image acquisition unit by the manufacturer, Sirona Dental Systems, which provides significantly greater ease of use and imaging precision.

Other dental sales, consisting primarily of technical service parts and labor, software support services and artificial teeth, grew 3.2% in fiscal 2009.

Webster Veterinary fiscal 2009 sales of $550.6 million increased 23.3% from $446.4 million in fiscal 2008. Acquisitions, primarily the Columbus Serum Company ("Columbus") acquired in October 2008, contributed 19.7% of the sales growth. During the second half of the year, veterinary clinics were negatively affected by the contracted economy.

Sales declined 0.5% at Patterson Medical, including a negative impact of 2.9% related to foreign currency rates. The impact of currency on sales growth was partially offset by a contribution of 1.6% from acquisitions.

Gross Margin. Consolidated gross margin declined 70 basis points to 33.7% due to the Veterinary unit's sales representing a larger percentage of consolidated sales in fiscal 2009. Since Veterinary gross margins are lower than the other two business units, the increase in Veterinary's sales as a percentage of consolidated sales has a dilutive impact on the consolidated gross margin. In addition, the gross margin of Columbus is somewhat lower than the historical Webster Veterinary gross margin.

The Dental segment's gross margin was unchanged from fiscal 2008.

Gross margin of the Veterinary unit declined 110 basis points in fiscal 2009, due mostly to lower levels of vendor rebates earned and the lower Columbus gross margins. The negative impact of Columbus on gross margin is expected to moderate as the business becomes fully integrated.

Patterson Medical's gross margin improved 40 basis points, due mostly to better freight management and product pricing.

Operating Expenses. The consolidated operating expense ratio in fiscal 2009 was 22.5%, or 10 basis points higher than fiscal 2008. Beginning the third quarter of fiscal 2009, the Company began taking steps related to a range of cost control initiatives including a hiring freeze except in the area of sales representatives, a wage freeze and restrictions on travel.

Operating expenses as a percent of sales at the Dental unit increased 70 basis points, reflecting lost leverage on lower than planned sales. The Veterinary unit's operating expense ratio improved 30 basis points due

primarily to the Columbus business, which had a somewhat lower operating expense ratio as compared to that of the historical Veterinary unit's operations.

Patterson Medical's operating expense ratio was 50 basis points lower in fiscal 2009. In addition to the impact of expense control initiatives, the impact of added infrastructure expense at the branch locations added over the past three years has dissipated as the locations have become more established.

Operating Income. Operating income was $346.2 million in fiscal 2009, down $13.0 million, or 3.6%, from $359.2 million in fiscal 2008. Operating margin was 11.2% and 12.0% in fiscal years 2009 and 2008, respectively.

Interest Expense. Interest expense was $30.1 million compared to $12.8 million in fiscal 2008. In March 2008, the Company issued $525 million of long-term debt which resulted in the higher level of interest expense in fiscal 2009.

Other Income, net. Other income, net of other expenses, was $3.6 million compared to $11.0 million in fiscal 2008. Interest income decreased $4.3 million due primarily to a decline in interest rates on cash and cash equivalents.

Income Taxes. The effective income tax rate was 37.5% in fiscal 2009 as compared to 37.1% in fiscal 2008.

Net Income and Earnings Per Share. Net income declined 11.2% to $199.6 million due to a decrease in operating income and an increase in interest expense. Share repurchase activity in the second half of fiscal 2008 resulted in a decrease in shares outstanding in fiscal 2009. Earnings per diluted share and dilutive shares outstanding were $1.69 and 118.4 million, respectively, in fiscal 2009 and $1.69 and 132.9 million, respectively, in fiscal 2008.

Fiscal 2008 Compared to Fiscal 2007

Net Sales. Consolidated sales in fiscal 2008 totaled $2,998.7 million, an increase of 7.2% compared to $2,798.4 million in fiscal 2007. Foreign currency translation rates contributed one percentage point and acquisitions contributed 0.6% to the sales growth in fiscal 2008.

Sales of our dental supply unit increased 5.7% to $2,181.3 million. Sales of dental consumable supplies grew 5.5%. Dental equipment sales grew 4.2%, including basic equipment growth of 4.3%. Sales of CERECŪ 3D dental restorative systems rose 3.7%.

Other dental sales, consisting primarily of technical service parts and labor, software support services and artificial teeth, grew 11.7% in fiscal 2008.

Webster Veterinary sales grew 11.8% to $446.4 million from $399.4 million. In January 2007, Webster made a strategic decision to drop a line of products previously sold under an agency agreement, including flea/tick and heartworm products, and replaced them with fully distributed product offerings from several vendor partners. This transition progressed throughout the year as planned, although there was a modest negative impact to Webster's operating metrics during the first half of fiscal 2008.

Sales growth of 11.0% at Patterson Medical included the contribution of new branch offices that have been established by acquisition and greenfield expansion. As a part of its initiative to expand and strengthen its value-added model, the rehabilitation unit opened 12 branch offices in selected markets throughout the United States during fiscal 2008 and fiscal 2007. The November 2007 acquisition of PTOS software, a leading line of practice management software for physical therapists, enables Patterson Medical to create relationships with new customers and deepen relationships with existing customers.

Gross Margin. Consolidated gross margin of 34.4% was 20 basis points lower in fiscal 2008 due to declines at Patterson Medical and Webster Veterinary. In addition, the sales growth of Webster outpaced both the dental and rehabilitation segments, resulting in a dilutive impact to consolidated gross margin.

The Dental segment's gross margin was flat, despite approximately $2 million of expense related to a distribution agreement fee which began to be amortized in October 2007. In addition, local currency pricing in Canada was lowered in the third quarter of fiscal 2008 in response to the strengthening of the Canadian dollar compared to the United States dollar.

Gross margin decreased by 50 basis points in fiscal 2008 at the Veterinary unit. This was largely a result of the decision to terminate an agency relationship late in the third quarter of fiscal 2007, as replacement offerings for the products previously sold under the agency relationship are now being fully distributed.

Patterson Medical's gross margin declined 20 basis points, due mostly to higher freight costs in the early part of fiscal 2008. In the second half of the year, better freight management and product pricing mitigated much of the higher freight costs.

Operating Expenses. The consolidated operating expense ratio improved 20 basis points to 22.4%.

Operating expenses as a percent of sales at the Dental unit decreased 30 basis points, reflecting the leverage of infrastructure investments over the past two years and the elimination of duplicate costs from the distribution system. The operating expense ratio of the Veterinary unit declined 50 basis points due both to leverage on higher sales volume and distribution system realignment, including the closing of a stand-alone warehouse.

Patterson Medical's operating expense ratio was 100 basis points higher in fiscal 2008, resulting from the infrastructure expense of adding branch locations through both acquisition and internal startups.

Operating Income. Operating income was $359.2 million or 12.0% of net sales in fiscal 2008. This amount represents an increase of 7.0% from $335.7 million in fiscal 2007. Operating margin in fiscal 2007 was also 12.0%.

Interest Expense. Interest expense was $12.8 million compared to $14.2 million in fiscal 2007. The average debt balance carried for the majority of fiscal 2008 was lower than in fiscal 2007, resulting in the decrease in interest expense.

Other Income, net. Other income, net of other expenses, increased to $11.0 million from $8.1 million due to higher levels of interest income and foreign currency transaction gains.

Income Taxes. The effective income tax rate was 37.1% in fiscal 2008, slightly higher than a rate of 36.8% in the prior year.

Net Income and Earnings Per Share. Net income increased 7.9% to $224.9 million. Earnings per diluted share of $1.69 represents an increase of $0.18 or 11.9% from the $1.51 earnings per share reported in fiscal 2007. Approximately 18 million shares of common stock were repurchased in the second half of fiscal 2008.

Liquidity and Capital Resources

Patterson's operating cash flow has been the Company's principal source of liquidity in the last three fiscal years. The issuance of $525 million of debt in the March 2008 was used primarily to repurchase shares of the

Company's common stock. During fiscal 2009, the Company used its revolving credit facility periodically as a source of liquidity in addition to operating cash flow.

Operating activities generated cash of $124.0 million in fiscal 2009, compared with $265.4 million in fiscal 2008 and $243.5 million in fiscal 2007. In the second half of fiscal 2009, the Company invested in a financing program to support marketing efforts directed at the CEREC product line. This promotion, which ended at the close of fiscal 2009, generated approximately $98 million of finance contracts that the Company could not immediately sell to our funding sources due to certain requirements in those funding arrangements. The Company expects to fully liquidate these contracts in fiscal 2010, resulting in an incremental $98 million of cash flow in the year.

Capital expenditures were $32.3, $36.0 and $19.5 million in fiscal years 2009, 2008 and 2007, respectively. Fiscal 2009 and 2008 significant expenditures included the expansion of our general office building and the expansion of existing distribution facilities to accommodate multiple business units, in addition to continuing investments in information systems. At April 25, 2009, one distribution facility expansion in Florida remains in progress.

The Company expects to invest approximately $25 million in capital expenditures during fiscal 2009, including the completion of the distribution center project in progress as of April 25, 2009 and investments in information systems.

Cash used for acquisitions totaled $124.8 million in fiscal 2009. The acquisitions of the Columbus Serum Company and Dolphin Imaging Systems, LLC and Dolphin Practice Management, LLC accounted for the majority of the cash used.

Payments on long-term debt in fiscal 2009 were $130 million and related to a scheduled retirement of debt that had been issued in fiscal 2004. As of April 25, 2009, $22 million was outstanding under a revolving credit facility which expires in fiscal 2013. A maximum of $300 million is available under this facility.

As noted above in March 2008, the Company closed on $525 million of long-term debt financing which was comprised of $450 million of fixed-rate private notes with maturities of five, seven and 10 years in addition to a $75 million five-year term loan at a floating rate of interest through a group of banks. The Company used $250 million of the debt financing to repurchase shares under an accelerated share repurchase agreement ("ASR"). The remaining proceeds from the debt issuances were used to repay borrowings under the Company's revolving credit agreement and for general corporate purposes.

During the second half of fiscal 2008, the Company purchased shares of its common stock on the open market, under a 25 million share repurchase program authorized by the board of directors. In the fourth quarter of fiscal 2008, the Company entered into an ASR under which it paid $250 million and took an initial delivery of 6.3 million shares. In total, the Company repurchased approximately 18 million shares for $636.1 million during fiscal 2008. Under the terms of the ASR, the Company could have received additional shares, or could have been required to pay the counterparty in the form of either cash or shares. The final settlement of the ASR occurred in June 2008, with an additional 1.1 million shares delivered to the Company. As of April 25, 2009, 5.9 million shares can be repurchased under the current authorization by the board of directors, which expires on December 31, 2012. Going forward, in the absence of desirable acquisition opportunities, the Company would likely return excess cash to its shareholders through additional open market purchases of its common stock, or may consider initiating a dividend strategy.

Management expects funds generated from operations and existing cash to be sufficient to meet the Company's working capital needs for the next fiscal year. The Company expects to continue to obtain liquidity from the sale of its equipment finance contracts, including the $98 million of finance contracts generated during fiscal 2009. In addition, as of April 25, 2009, $278 million is available under a revolving credit facility. The

Company's existing debt facilities are believed to be adequate as a supplement to internally generated cash flows to fund anticipated expansion plans and strategic initiatives.

The Company sells a significant portion of its installment sale contracts to a commercial paper funded conduit managed by a third party bank, and as a result, commercial paper is indirectly an important source of liquidity for the Company. The Company is allowed to participate in the conduit due to the quality of its finance contracts and its financial strength. Cash flow could be impaired if the Company's financial strength diminished to a level that precluded the Company from taking part in this facility or other similar facilities. Also, market conditions outside of the Company's control could adversely affect the ability of the Company to sell the contracts.

Customer Financing Arrangements

The Company is a party to two arrangements under which it sells finance contracts it receives from its customers to outside financial institutions. These arrangements currently provide sources of liquidity for the Company that would have to be replaced should the current financial institutions be unable or unwilling to continue in the arrangements. The Company's financing business is described in further detail in Note 6 of the Notes to the Consolidated Financial Statements in Item 8 of this Form 10-K. Note 6, "Customer Financing", discusses the nature and business purpose of the arrangements and the activity under each arrangement during fiscal 2009, including the amount of finance contracts sold and residual interests held by the Company.

Contractual Obligations

A summary of the Company's contractual obligations as of April 25, 2009 follows
(in thousands):



                                                   Payment due by year
                                           Less than                              More than
 Contractual Obligations        Total       1 year       1-3 years    3-5 years    5 years
 Long-Term Debt               $ 547,000   $    22,000   $        -      125,000     400,000
 Interest on Long-Term Debt     168,232        25,880        51,045      46,576      44,731
 Operating Leases                50,688        14,599        21,442      11,473       3,174

As discussed in Note 11 of the Notes to the Consolidated Financial Statements, the Company adopted the provisions of FIN 48 at the beginning of fiscal 2008. The Company is unable to determine its contractual obligations by year related to this pronouncement, as the ultimate amount or timing of settlement of its reserves for income taxes cannot be reasonably estimated. The total liability for unrecognized tax benefits including interest and penalties as of April 25, 2009, is $20.7 million.

In addition, the Company is contractually committed to approximately $6 million of capital expenditures relating to a distribution facility construction project that is in-process as of April 25, 2009. For a more complete description of our contractual obligations, see Notes 7 and 10 to the Consolidated Financial Statements in Item 8 of this Form 10-K.

Outlook

Over the last 10 years, the Company has been able to grow revenue and earnings through its strategy of emphasizing its value-added, full-service capabilities, using technology to enhance customer service, continuing to improve operating efficiencies, and growing through internal expansion and acquisitions. While we believe that the weakness in the general economy that existed throughout much of fiscal 2009 will continue to affect our performance for at least several more quarters, the Company's strategy will continue to focus on these key elements. With strong operating cash flow and available credit capacity, the Company is confident that it will be able to financially support its future growth. The strategic initiatives that the Company has implemented in the

past several years, as well as those that will be implemented in fiscal 2010 and beyond, will strengthen the Company's operational platform and contribute to future growth. Given these factors, the Company considers itself well positioned to capitalize upon the growth opportunities in the dental supply, companion-pet veterinary supply and the worldwide rehabilitation supply markets.

Asset Management

The following table summarizes the Company's days sales outstanding (DSO) and
inventory turnover the past three fiscal years:



                                                2009   2008   2007
                   Days sales outstanding (1)     56     43     44
                   Inventory turnover (2)        6.8    6.8    7.2

(1) Receivables as of April 25, 2009 include approximately $98 million of finance contracts received from customers related to a financing promotion. The Company expects to sell these contracts to outside institutions under existing agreements during fiscal 2010. If these finance contracts are excluded from the calculation of DSO, the pro forma DSO would be 44.

(2) The inventory values used in this calculation are the LIFO inventory values for all inventories except for manufactured inventories and foreign inventories, which are valued using FIFO inventory methods.

Foreign Operations

Foreign sales are derived primarily from Patterson Dental and Patterson Medical operations in Canada and from Patterson Medical's operations in the U.K. and France. Fluctuations in currency exchange rates have not significantly impacted earnings. However, changes in exchange rates adversely affected net sales in fiscal 2009 and enhanced net sales in fiscal 2008 and 2007. Without foreign currency effects, net sales would have been $33.4 million higher, $27.0 million lower and $12.3 million lower in fiscal years 2009, 2008 and 2007, respectively. Changes in currency exchange rates are a risk accompanying foreign operations, but this risk is not considered material with respect to the consolidated operations of the Company.

Critical Accounting Policies and Estimates

The Company has adopted various accounting policies to prepare its consolidated financial statements in accordance with accounting principles generally accepted in the United States. Management believes that the Company's policies are conservative and its philosophy is to adopt accounting policies that minimize the risk of adverse events having a material impact on recorded assets and liabilities. However, the preparation of financial statements requires the use of estimates and judgments regarding the realization of assets and the settlement of liabilities based on the information available to management at the time. Changes subsequent to the preparation of the financial statements in economic, technological and competitive conditions may materially impact the recorded values of the Company's assets and liabilities. Therefore, the users of the financial statements should read all the notes to the Consolidated Financial Statements and be aware that conditions currently unknown to management may develop in the future. This may require a material adjustment to a recorded asset or liability to consistently apply the Company's significant accounting principles and policies that are discussed in Note 1 to the Consolidated Financial Statements. The financial performance and condition of the Company may also be materially impacted by transactions and events that the Company has not previously experienced and for which the Company has not been required to establish an accounting policy or adopt a generally accepted accounting principle.

Revenue Recognition-Our revenue recognition processes involve establishing estimates for returns, damaged goods, rebates and other revenue allowances. These estimates are based on historical experience and the

facts known at the date of the preparation of the financial statements, but future events could cause actual results to vary from our estimates.

Inventory and Reserves-Inventory consists primarily of merchandise held for sale and is stated at the lower of cost or market. Cost is determined using the last-in, first-out (LIFO) method for all inventories, except for foreign inventories and manufactured inventories, which are valued using the first-in, first-out (FIFO) method. The Company continually assesses the valuation of our . . .