After we already analyzed thirteen new companies as part of my series, the fourteenth company will be one I already have written about before, but fits the criteria perfectly to be part of the series – the dental and health care distributor Henry Schein (NASDAQ:HSIC). The company is the largest global dental distributor and the second largest physician and alternate care distributor in the U.S. and is profiting from a real competitive advantage and high levels of defensibility against potential competitors.
As always, the article will follow the same structure and we start by describing the business model – especially after the spin-off which is getting Henry Schein out of the animal health business. We will look at the performance metrics of the last decade and describe the company’s wide moat – once again with a special focus on acquisitions as well as the spin-off. We will end the article by trying to determine an intrinsic value for the stock and search for a possible entry point.
Henry Schein believes the company is the world’s largest provider of health care products and services primarily to office-based dental and medical practitioners and has currently more than 1 million customers almost all over the world. When describing Henry Schein’s business model, we first of all have to talk about the recent spin-off that the company completed in February 2019. The completion of the spin-off of the animal health business – now trading as Covetrus (Nasdaq: CVET) – created a company that is quite different from the company Henry Schein was before.
Before February 2019, Henry Schein’s business was divided in four different segments – Dental, Medical, Tech/Value Added Services and Animal Health. After the spin-off, there are three segments left, but Henry Schein is only reporting in two segments – healthcare distribution (which includes dental as well as medical) and technology and value-added services.
(Source: Company Presentation)
The health care distribution segment includes the dental market and the medical market. This segment distributes consumable products, small and large equipment, laboratory and surgical products as well as equipment repair services. In the dental market, Henry Schein is number one in sales in North America, Europe, Brazil, and Australia. The dental group serves office-based dental practitioners, dental laboratories, schools and other institutions. The company also assumes that about 90% of U.S. dental practices and about 80% of dental labs in North America as well as 65% of dental practices in Europe are active customers of Henry Schein. Growth will come from global expansion as well as a potential further growth of the dental specialty market, in which Henry Schein is generating about $800 million in sales annually (10% market share). That market is not only offering higher margins, but is also growing faster than the core dental market. The second component within the health care distribution segment is the medical market. The global medical group serves office-based medical practitioners, ambulatory surgery centers, other alternate-care settings and other institutions.
The second reportable segment is the technology & value added services market. Henry Schein is providing practice management solutions and software systems, financial services, network and hardware services as well as education. Compared to the health care distribution segment that had an operating margin of 4.9% last year (still including the animal health business), the operating income from the Tech/Value Added Service segment was $134 million resulting in an operating margin of 26.2%.
Over the past decade, revenue, earnings per share and free cash flow all show a stable upward trend. Especially revenue is growing with a very steady pace and during the last decade the number increased every single year with an annual average growth rate of 8% (of course in 2019 revenue will be lower due to the spin-off). With one exception (2017 – due to higher income taxes and other expenses), earnings per share also increased every single year during the last decade and grew about 8% annually (share buybacks supported that number a little bit). Free cash flow increased “only” 6.2% and especially since 2013 free cash flow was more or less stable. This is the only weak spot among all the metrics we are looking at; however, FCF is an important metric. A reason for the missing growth during the last years are the increased capital expenditures – from $51 million in 2012 to $91 million last year. Additionally, net income couldn’t increase much during the last few years – earnings per share grew mostly due to share buybacks and, as a consequence, free cash flow stagnated a bit.
(Source: Own work based on numbers from Morningstar)
When looking at Henry Schein’s margins, we see a picture of great stability. The company might not be able to report extremely high margins like some other businesses, but when looking at the gross margin and operating margin during the last decade, we almost look at a straight line (the visualization of an extremely stable business). The gross margin was declining a little in the past few years, but the operating margin (which is more important) is solid. The reported operating income last year was 5.7% and leaving out the animal health business, the operating margin will increase about 7.5% (for the full year of 2018, it would have been 7.36%; for the fourth quarter, it would have been 7.79% - both non-GAAP numbers).
(Source: Own work based on numbers from Morningstar)
Return on invested capital declined a little during the last two years and was only about 10% (in 2017) and 12% (in 2018), but in the years before it was very constant at about 13-14% every single year. Return on invested capital doesn’t show the same extreme stability as the two margins, but the numbers are still very impressive.
At the end of December 2018, Henry Schein had about $950 million in bank credit lines and slightly above $1 billion in long-term debt. On the asset side, Henry Schein has only about $80 million in cash and cash equivalents, but as part of the spin-off, Henry Schein received about $1.1 billion which the company will use to pay down the debt. In the end, there would remain about $1 billion in debt on the balance sheet, which would lead to D/E ratio of 0.28. When comparing it to the “new” non-GAAP operating income (without animal health segment), it would take about one and a half years to repay the debt. These are both very acceptable numbers and point towards a healthy business. Even with $2.8 billion in goodwill – about 33% of total assets – and $584 million in intangible assets – about 7% of total assets – Henry Schein has a healthy balance sheet that should be no reason for concern.
When we look at the results without the animal health segment, the numbers become even more impressive. Leaving out the animal health segment, Henry Schein generated $9.4 billion in revenue last year (as $3.8 billion in revenue stem from the animal health segment). The total operating income last year was $753 million; without the animal health segment, the operating income was $694 million. While Henry Schein lost about 29% of revenue due to the spin-off, it only lost about 8% of operating income. Earnings per share before the spin-off were $3.49 for 2018 and without the animal health business, diluted EPS was $3.17 which reflects a decline of 9%.
(Source: Company Presentation)
When looking at some metrics since the IPO, Henry Schein has reported very impressive numbers (these numbers reflect the development without the animal health segment). Net sales grew 13% annually since 1995, operating income grew 17% every single year for the last 23 years and diluted EPS increased 14% annually.
When looking at the impressive growth numbers of Henry Schein (leaving out the animal health segment and its low profitability) it makes sense to focus on the other two segments. These are also the segments where Henry Schein has a rather wide moat and have made a smart move by not only focusing on size (measured by revenue or market cap) but also putting the emphasis on those segments that can achieve high margins and have a competitive advantage. By spinning off the animal health business, Henry Schein focused on its core business, which is protected by high levels of defensibility against new competitors.
In addition to the spin-off, Henry Schein will probably continue to widen its moat by strategic acquisitions. In the last few years, Henry Schein made several small acquisitions to widen its moat. These acquisitions focused especially on the dental market and helped Henry Schein to expand into new markets all over the world – for example in Japan and Brazil and, very recently, also in China.
(Source: Company Presentation)
Among the three remaining segments, the dental segment is the most important as it is responsible for two thirds of revenue and the business segment with the strongest moat. Different reports see about 6% growth for the global dental market in the next 5 years with reasons being the growing ageing population or increasing demand for cosmetic dentistry. Despite continued growth, different analysts also see global dental sales being under pressure and continuing headwinds for the sector, which lead to price pressures. The highest growth is expected in the Asia-Pacific region, while North America and Europe are expected to grow moderately.
Price pressures are nothing we can deny, but I would like to point out that Henry Schein’s margins are still extremely stable which is a strong hint that the company is managing the pressure in contrast to Patterson Companies (NASDAQ:PDCO) quite well. For Patterson Companies, price pressures seem to be much more an issue as margins are declining constantly. Henry Schein’s gross margin is showing no sign of price pressure at all and operating margin declined only a little from 7.23% in 2015 to about 6.5% right now. In the last few quarters, it was very stable at 6.5% which is inspires confidence that Henry Schein is handing the price pressure quite well.
Henry Schein as distribution company is combining a very fragmented demand side with a very fragmented supply side. Henry Schein has more than 1 million customers worldwide and is offering more than 120,000 branded products (aside from company's private brand products) and more than 180,000 products that are available as special-order items. Of course, the supply side is less fragmented than the demand side as the largest supplier of Henry Schein accounts for 6% of all purchases and the top 10 suppliers account for 32%. Although Henry Schein (like other medical distributors) has rather low margins, the defensibility of the business is extremely high as it is difficult to cut out the middle man. Rebuilding the distribution network (with 30 strategically located distribution centers around the world) would also be a tough job for any competitor that is trying to enter the market and once that distribution system is in place, every additional customer Henry Schein is serving adds almost no additional expenses (as the distribution network is already in place), but increases profitability for Henry Schein.
Price pressures for the dental market may certainly remain, but I see Henry Schein’s competitive advantage and defensibility as very high and a guarantor for long-lasting success.
Intrinsic Value Calculation
But having a great company with high defensibility is not enough if the price we are paying is too high. To determine if Henry Schein is a good investment right now, we have to look at expected free cash flows in the years to come and calculate an intrinsic value.
According to its own guidance, Henry Schein expects a non-GAAP EPS growth of 8% for 2019 while the dental market will grow 5-6% in the next five years. I would assume that Henry Schein could also grow at least 5% annually despite price pressures and headwinds and due to the competitive advantage of its distribution network, 5% growth might also be a realistic growth rate till perpetuity.
Last year, free cash flow was $594 million, but due to the spin-off of the animal health business, the estimated FCF for 2019 will probably be lower. As operating income and earnings per share are about 10% lower without the animal health business, I would also subtract about 10% from the cash generated by operations. Due to the restructuring and spin-off, capital expenditures might be even higher in 2019 than in the previous years so therefore, I would start with $520 million as free cash flow. Using a 5% growth rate in perpetuity, 10% as a discount rate and $520 million as the free cash flow basis leads to an intrinsic value of $68.88 for Henry Schein.
In this case, I would include a bigger margin of safety (at least 25%) to reflect uncertainties about Henry Schein and the growth expectations in the dental market. But I am also a little puzzled by the huge stock drop after the spin-off. At that day, the stock dropped about 30% which is more or less reflecting the revenue Henry Schein lost due to the spin-off. But considering the low operating margin of the animal health segment and how little it contributed to the bottom line, the steep decline is irritating for me. According to its own guidance, Henry Schein expects a non-GAAP EPS between $3.38 and $3.46 for 2019 (compared to a GAAP EPS of $3.49 in 2018) and therefore suffered almost no decline as consequence of the spin-off. A few months ago, the company was trading at a P/E of almost 26 and is now down to about 18 (using the EPS of 2018 without animal health segment). In my opinion, Henry Schein will be similarly profitable in 2019 although it lost about 30% of its revenue and has become an even stronger business with a wider economic moat. The fact that the market obviously sees the company a little different could be a hint I am wrong or missing something and, as a consequence, I will add a margin of safety of 25% which leads to an entry point of $51.66.
Henry Schein already seems to be a bit undervalued, but I am not sure if it is a good buy yet. Aside from free cash flow (which hasn’t really grown in the recent past), all other metrics point toward a huge competitive advantage and high levels of defensibility for Henry Schein. But the spin-off and the headwinds in the dental segment are reason enough to be a little more cautious and include a bigger margin of safety to reflect potential risks and uncertainties. It certainly will be helpful to see the first 10-Q after the spin-off to get more information about the “new” company. However, at $50 Henry Schein could be a good long-term investment and a good entry point might have been reached.
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.