By Michael Waterhouse
We have upgraded Henry Schein (HSIC) and Patterson Companies (PDCO) to wide-moat companies thanks to their strong competitive advantages in the dental and veterinary distribution markets. As critical intermediaries between a highly fragmented base of customers and suppliers that depend on their scale and customer services, Schein and Patterson possess competitive advantages that support a long time frame of attractive returns on capital, in our view. We also think the high out-of-pocket dental and vet markets will sustain consistent midsingle-digit growth over the long term. Both stocks are trading close to our fair value estimates of $99 and $39 for Schein and Patterson, respectively, and while valuations don't currently suggest attractive entry points for either firm, we think investors should keep these names on their watch lists.
Schein and Patterson are both major players in the dental, animal health, and medical distribution markets.
For the most part, Schein and Patterson are extremely similar, particularly in their dental and animal health distribution segments. As distributors, these companies are key middlemen between customers and suppliers, guaranteeing timely delivery of consumable products, equipment, and services. Typical products handled by these firms include lab products, pharmaceuticals, vaccines, surgical tools, diagnostic tests, infection control items, vitamins, dentist chairs, and X-ray machines. Customer services include software products, IT networking and support, training and education courses, consulting and brokerage services, and equipment installation, maintenance, and repair. Each company also possesses smaller medical distribution segments. Schein's medical business distributes vaccines, pharmaceuticals, surgical products, and other consumables and equipment to physicians' offices and ambulatory surgery centers. Patterson's medical distribution segment specializes in equipment and suppliers for rehabilitation clinics. Dental, animal health, and medical revenue make up approximately 55%, 27%, and 17% for Schein, and 65%, 21%, and 15% for Patterson, respectively.
A few differences do exist between the two companies, including equipment offerings, geographic footprints, and capital allocation strategies. Each company also participates in different medical distribution markets. For example, Schein has international operations, a greater exposure to large group customers like corporations and universities, and a more aggressive acquisition strategy. Patterson operates only in the U.S., focuses only on small independent customers, and makes less frequent acquisitions.
Dental and animal health markets support stable growth opportunities.
Unlike most other segments of the health-care industry, the dental and animal health markets possess higher out-of-pocket payments. Out-of-pocket spending makes up approximately 50% of U.S. dental market expenditure and essentially all U.S. pet spending. While these markets are therefore more exposed to discretionary spending and economic cycles, we think both segments can sustain relatively stable midsingle-digit growth over the long term. An aging population, the growing importance of cosmetic dentistry, rising discretionary spending on pet care, and the greater adoption of technology among practitioners maintain growth opportunities for the distributors. Growth has slowed since the recession, but we expect it will recover as the economy gains steam, unemployment improves, and consumer spending rises.
We derive Schein's and Patterson's wide moats from four key characteristics.
The following table summarizes our moat framework for Schein and Patterson along four key and interrelated factors -- customer and supplier fragmentation, distributor market share concentration, distribution network scale, and switching costs from value-add services. Following the table is a brief discussion of each item's contribution to Schein and Patterson's competitive advantages that should sustain economic profits over the long term.
Customer and supplier fragmentation: Schein and Patterson are critical intermediaries between a highly fragmented base of customers and suppliers, which we think contributes to greater pricing power for the distributors. The U.S. dental and vet markets include a customer base of nearly 186,000 dentists and 63,000 veterinarians, the majority of which are sole practitioners. Schein and Patterson face more consolidated customers in their smaller medical segments, but both companies attempt to focus on more fragmented areas of the market. Schein focuses on clinics and physician groups with limited exposure to hospitals or pharmacies. Patterson's medical segment is solely focused on rehabilitation clinics.
Schein and Patterson also face an industry of fragmented suppliers. While their supplier base is not nearly as fragmented as the dental and vet customers, we nonetheless think the distributors hold a reasonable amount of leverage over dental consumable and equipment manufacturers. No supplier contributes to more than 8% of either company's total revenue, by our estimate. Manufacturers in dental equipment appear more consolidated, but fragmented competition exists in dental consumables, which makes up nearly 80% of the total dental market. We estimate that the top eight dental consumable suppliers, both in the general practitioner and specialty segments of the dental market, contribute to just over 50% of the market.
Much of the animal health supplier segment is also fragmented. Market share in the animal health pharmaceuticals market is fairly well dispersed among Big Pharma companies and numerous smaller players. We estimate that the remainder of the animal health market, such as nutrition, equipment and surgical supplies, and diagnostics, is even more fragmented. For example, reference labs Idexx Laboratories (IDXX) and VCA Antech (WOOF) each holds approximately 8% and 7% market share, respectively, in the pet diagnostics market, by our estimate. In each distributor's medical segments, we estimate supplier concentration is also relatively fragmented.
Large distributor market share: We think concentrated distributor market share combined with fragmented customer and supplier market share helps ensure additional pricing power for Schein and Patterson. These companies are the only two national distributors in the dental distribution market with over 70% domestic market share followed by about 15 regional and numerous local players. In the companion animal health segment, Schein and Patterson also contend with MWI Veterinary supply, all three companies accounting for approximately 90% of the domestic market, by our estimate. The following table shows our market share estimates by company and geography.
Source: Company filings, Morningstar.
Network scale: The scale and efficiency of Schein and Patterson's distribution network support lower operating costs and greater salesforce efficiency than smaller peers, in our view, therefore making the scale and scope of their operations difficult for competitors to imitate. Patterson estimates that dentists source approximately 40% of their purchases through their top distributor, while veterinarians purchase approximately 80% of supplies through two distributors. Schein and Patterson ship a large portion of their products to a loyal practitioner base, but based on the market share numbers, we think these two companies interact with nearly every dentist or veterinarian in some capacity. Some regional competitors might hold concentrated market share in specific markets, but Schein and Patterson's national breadth are unmatched. Since most of Schein and Patterson's competition consists of private companies, accurate numbers are difficult to ascertain, but we doubt smaller competitors possess Schein and Patterson's salesforce productivity. Thanks to the scale of these companies' operations, we imagine Schein and Patterson post higher sales and operating profit per sales representative than smaller peers, which are therefore at a relative disadvantage of extracting value from their customer base. Consolidated warehousing and distribution operations also help maintain low overhead costs. Patterson distributes most of its segment products through shared warehouses, while Schein's vet distribution warehouses are mostly separate.
Switching costs: We believe Schein and Patterson's services, which include practice management software, network integration, and equipment installation, maintenance, and repair, retain high levels of customer loyalty. These services provide integral support for independent dental and veterinary business owners who lack the resources to handle more complex tasks, such as integrating various technology platforms or installing and servicing equipment. Schein and Patterson aim to become indispensable partners with their customers by providing critical back-office support. Combined with customer loyalty programs, few regional competitors or industry suppliers can match the level of Schein and Patterson's entrenched customer service relationships, in our opinion.
Moat trends are relatively stable in the vet and dental distribution markets.
We give both Schein and Patterson stable moat trends. Below we discuss the major influences on the competitive advantages for these firms.
Risk of customer concentration: Large group practices probably account for about 10% of the dental market, with limited potential for additional consolidation in the dental and vet markets, in our opinion. Unlike more complex and capital intensive hospitals, for example, we believe there are greater economic incentives for dentists and veterinarians to remain small business owners. The dental and vet markets are characterized by less complex procedures and simpler out-of-pocket payments, which reduces the advantage of consolidation. Unlike Patterson, Schein does carry a higher proportion of customers among large group practices and schools, which may pressure pricing somewhat. In comparison with the overall business, these more concentrated buyers still represent a significant minority to Schein's overall business, and the incremental margin on these higher-volume accounts likely remains attractive.
Risk of supplier concentration: We expect limited supplier concentration. While innovation in the dental and animal health markets is driven by a handful of industry leaders like Dentsply (XRAY), Danaher (DHR), and 3M (MMM), we imagine that barriers to entry in older and more commoditized products are low enough to allow a multitude of new entrants. While the dental industry shift to more complex digital equipment could potentially consolidate a greater portion of suppliers, such as Patterson's exclusive licensing agreement with Sirona, we still believe Schein and Patterson's large domestic sales and distribution networks give them the upper hand with suppliers. Furthermore, growing equipment complexity in these fields would probably place greater demand on distributor services, which could increase overall switching costs.
Sales channel disruptions: The growing shift of pet flea and tick health-care products through traditional retail channels is our primary concern for the vet distribution segment. Seasonal flea and tick parasiticides make up a limited portion of these company's operations, approximately 10% of vet segment sales, by our estimate. Most of the animal health market, such as vaccines and diagnostics, will not follow parasiticides into over-the-counter store shelves, and we also believe that a significant portion of flea and tick sales will remain in the vet sales channel. Schein and Patterson hope to significantly increase the importance of diagnostics, digital technology, equipment, and services in the veterinary market to expand segment profitability and help circumvent headwinds in the flea and tick market.
Competitor market share gains: From our perspective, we think Schein and Patterson are likely taking market share from their smaller competitors, and we don't see any significant threats to their market dominance. Acquisitions also remain a central focus of each company's growth strategy, which should continue to accrue market share. Schein ships approximately 120,000 packages per day, and these small but frequent consumable sales to fragmented customers help dissuade suppliers from circumventing the distributors with direct shipments. In equipment, supporting IT integration and repair services is a significant hurdle for suppliers as well. While other large-scale retailers, such as Amazon (AMZN), could enter certain commoditized dental consumables, we think Schein and Patterson's services, especially with marketing new products and handling equipment, are irreplaceable by online-only mass retailers. Thanks to thin operating margins in these distribution markets, price discounting for new entrants to gain market share seems like a relatively limited tactic, in our opinion.
Capital allocation in medical distribution segments: Schein and Patterson have carved out less of a moat in their medical segments, in our view. While returns in these segments seem healthy for now, greater customer concentration, lower distributor market share, and indirect exposure to reimbursement pressure could depress profitability. While we don't necessarily expect management to divest these less attractive operations, we're more skeptical of capital deployment in these segments.
Wide moats steer our free cash flow and return on capital projections.
Our fair value estimates for Schein and Patterson are $99 and $39, respectively, which imply forward price/earnings and enterprise values/EBITDA multiples of approximately 20 times and 11 times, respectively. Thanks to improving economic conditions, we forecast mid-single-digit internal growth in the U.S. bolstered slightly by additional market share gains and additional revenue from acquisitions. Faster growth in the lower-margin veterinary segment will remain a slight drag on margin expansion, but we predict Schein and Patterson can continue to gradually improve profitability, largely driven by greater operating leverage as top-line growth improves. We also imagine profitability in each company's vet segments will improve as diagnostics, equipment, and services become greater contributors to this segment's operations. For both companies, we believe mid-teen returns on capital are sustainable over the long term.