Patterson Companies: Seems Destined To Stay Stuck

| About: Patterson Companies (PDCO)
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Summary

Patterson Companies has seen its shares go nowhere over the past several years, despite being a supplier in attractive end markets.

Whenever things look to turn favorable, something pops up. Most recently, the non-renewal of the exclusive distribution agreement with Sirona.

Animal Health International acquisition integration could be going better as well.

After a dismal earnings report, look to see if results improve before jumping in with both feet.

Long-term shareholders of Patterson Companies (NASDAQ:PDCO) are likely a cranky bunch. The company has been a chronic underperformer, but worse yet, the two end markets that the business serves - dental and animal health - have seen a number of companies post standout investment returns over the past several years, with more than a few commanding hefty buyout premiums as consolidation sweeps both industries.

Watching that happen from the sidelines has to have been a frustrating experience. The recent loss of exclusive distribution rights with Sirona Dental, likely caused by new management review after the recent merger with Dentsply (NASDAQ:XRAY), has caused some short-term pain, and the company's shift to a new enterprise resource planning ("ERP") system to better manage inventory and demand has built up some sizeable initial costs.

Investors and the Board of Directors have had enough, and it is likely the recent announcement that long-time CEO Scott Anderson is stepping down has a lot, or everything, to do with recent performance. In the interim, former CEO James Wiltz will take the helm, a man who has worked at the company since 1969. For a company that is seemingly always "in transition," is now finally the beginning of operational improvement? Or is Patterson Companies doomed for more years of just treading water?

Company Overview, Corporate Moves

Patterson Companies is a value-add distributor, serving the U.S. and Canadian dental supply markets, as well as those same geographies within the animal health business. I love the concept of the structure, but it came at a cost to acquire. During calendar year 2015, Patterson Companies announced the acquisition of Animal Health International ("AHI") for $1,100M, a move that doubled the size of Patterson's veterinary business (previous focus on commercial enterprises).

While there is very little overlap or revenue synergies to be had between the companion and commercial animal businesses besides logistics and scale, the acquisition broadened and diversified the product suite. However, the price was steep: On the low end of synergy estimates, the valuation multiple came in at 12.5x EV/EBITDA. While this is a growing business, most products shipped (97%) are low margin consumables, and historical operating margins at AHI are less than 3.5%; any way you cut it, this was premium price.

Further, this really levered up the company's balance sheet to an area that management really did not feel especially comfortable at (near historical highs at 3.5x net debt/EBITDA), so Patterson made the decision to jettison its medical supply business to Madison Dearborn Partners, a private equity firm based out of Chicago.

This business had similar EBITDA earnings to the acquired Animal Health International business pre-synergy estimate (~$70M ttm EBITDA), but Patterson only managed to squeeze $715M in proceeds from the sale. The net result was a set of transactions slightly dilutive to company earnings, but at the benefit of creating a company with two clear identities in dental and animal care.

Today, the businesses are fairly evenly split by revenue (47% Dental, 53% Animal Health), with the company having commanding market shares across its end markets (25-40% share). The company has an excellent physical logistics network, with nearly one hundred facilities in operation throughout the service area. More than 43,000 packages are shipped out daily to customers, with the vast majority of that (96%) via one-day ground.

Still, the company thinks it has plenty of opportunity for improvement when it comes to adaptive sales and inventory management, and has been investing in a new Enterprise Resource Planning ("ERP") system to save costs. The pilot program has already been launched, with more than a dozen locations now operational. Thus far, management says that there has been a 25% increase in order filling productivity, with shorter times reducing packing time and shipping costs.

Most importantly, this is all about big data, giving improved visibility into customer ordering habits, which should allow for some working capital improvement. Expect the balance sheet to improve measurably (inventory turn, overall inventory levels). The system should be fully implemented by the end of fiscal 2018 (Summer 2018). The company has guided there will be a repeat of the $25M in pretax step-up expense in fiscal 2018, as well as an incremental $5M as the company scales up deployment, along with additional depreciation expense. Efficiencies are expected to begin realization during fiscal 2019.

Dentsply/Sirona Merger

In a game-changing move, Patterson Companies recently announced the end of a twenty-year exclusive distribution relationship with Sirona for its CEREC technology. While the decision was portrayed as Patterson's choice not to renew, I think there is a little more to that story, and I suspect the merger between DENTSPLY and Sirona in some way prompted this move. For perspective, late in 2015, Dentsply and Sirona announced a planned merger of equals, the combination of which combined two pure-play, highly complementary dental operations.

While this was portrayed as a merger of equals, Dentsply was the slightly larger entity (shareholders control 52% of the combined entity), and Dentsply retained a more significant executive presence (prior CEO Bret Wise as Executive Chairman, Christopher Clark and James Mosch as COOs of both segments). I suspect Dentsply-Sirona pushed for better terms in order to help meet aggressive deal synergy targets given their new-found size, and Patterson balked and simply decided to walk from the negotiating table.

The Sirona contract was responsible for a large portion of technology and equipment sales; unlike Animal sales, only a little over half of sales are consumables (versus nearly the entirety of volumes there). While the drop of the contract does open up distribution to new SKUs from outside parties, the sales staff will need time to adjust. As a result, the initial impact from the loss of this deal was heavy. Dental segment sales were down 16% in Q4, and management has guided comps down double digits y/y again in fiscal Q1 2018.

It isn't all rain clouds on the horizon; current guidance is for substantial improvement in the back half as the company adjusts around the exclusivity loss, back to low single-digit growth. The question facing any investor is whether returning to normal growth is a reasonable expectation. As far as I'm concerned, this is the single biggest concern heading into this upcoming year. While revenue split is nearly even between two businesses, more than two thirds of pro forma operating income for the company is going to come from the Dental segment (double the operating margin). Paterson Companies cannot afford poor execution here.

Animal Health Businesses Under Pressure As Well

In the fourth fiscal quarter, companion animal sales rose 3.5%, with revenue from production animals up 4%. This was well below growth rates last year and disappointing, with the blame largely due to considerable foreign currency pressure (British Pound). Investors can take solace in strong U.S. growth, particularly within U.S. companion animal sales, which saw sales rise double digits (up 10.6% y/y).

There are some cracks in the story surrounding the acquired Animal Health International businesses, however: despite "good" execution on synergy capture and cost control, gross margin came under pressure, pushing operating margin down 70bps. Management is actively working on better marketing, improving product sales mix, developing stronger partnership with vendors, and further integration work to move this the other direction.

With some pressure within the Animal Health segment, earnings growth will come under pressure for the full year. Fiscal 2018 guidance is for $2.33/share in adjusted earnings per share, relatively flat versus prior year earnings ($2.34/share, which was down from the year prior as well). Management five-year financial objective targets remain at managing 8-10% EPS growth, primarily based off margin expansion (3-5% expectations on organic revenue growth annually). I can see that possibility, but only if ERP implementation goes according to plan and the Sirona issue is sorted - without that, Patterson will have some problems.

Given that the company has historically traded at 20x earnings, to me it seems like Patterson Companies is doomed to another year of range-bound trading in the $40-50/share range. In my opinion, the risk leans more to the downside if they cannot execute the turnaround in Dental sales that they expect, but investors should get a better grasp of that as the company begins reporting fiscal 2018 earnings. Watch carefully.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.