Thursday, September 13, 2012

Sirona Dental Systems Equity Research

One of the things that we know we should be doing in equity investing is taking a long term view and, not getting seduced into looking at monthly or quarterly movements. I think this is an argument that should be applied to Sirona Dental Systems $SIRO. In summary, this is an attractive company with a technological edge in markets with very favorable long term demographics. In true Teutonic style –which belies its origins as a spin off from Siemens $SI - the company invests heavily in innovation and R & D because it knows it has a quality advantage that generates tangible return on investment (ROI) for dentists. The stock deserves a wider audience.

Before discussing the recent results, here is a brief primer on the company.

Sirona's Earnings Drivers

Sirona has two key profit drivers.

Firstly, the aging demographic. As people get older they require more dental maintenance. Furthermore, as older people tend to have more frequent tooth decay, dentists can expect more restoration work. Sirona should see more demand for its products due to aging. Secondly, its proprietary technology currently has low market share and, provides dentists with many cost and quality advantages. Whilst the demographic argument is well known in healthcare plays, it should carry more weight with Sirona because of a relative lack of insurance reimbursement issues with dentistry products and solutions. Indeed, the industry is shifting towards private from public pay and, much of what Sirona does is aimed at the high end of the private market.

Just like its former parent Siemens, Sirona doesn't skimp on R & D and spends around six to seven percent on it every year. Recent investments include $15m in setting up a major new innovation center in Germany. The balance sheet is solid, having seen the company engage in deleveraging the business over the last few years and it converts earnings into cash very well.

Who is Sirona Dental Systems?

Sirona is best known for its CAD/CAM system Cerec, which allows dentists to make a tooth restoration in a single client visit in 95% of cases. This is good because the patient gets an immediate treatment as opposed to a seven to ten day wait. The traditional system requiring a restoration created and then fitted in a second visit.

Among Sirona's distributors are companies like Patterson $PDCO  and Henry Schein $HSIC who have helped establish the Cerec system into low double digit penetration in developed markets. Although impressive, it does suggest that there is plenty of room for growth. In fact Sirona recently announced that it was extending its partnership with Patterson in the US to include all of Sirona’s products. Henry Schein remains its most important distributor in Europe. For those worried about moats, it is a proprietary system which is backed up by patents and Sirona's research leadership.

Both Henry Schein and Patterson should be buoyed by these results and I think other companies such as Align Technology $ALGN have demonstrated recently that the dental health care market is relatively recession resistant.

Regarding Cerec’s cost effectiveness in an age of austerity, clearly many dentists will balk at paying the sticker price of $100-120k for the system but it delivers a demonstrable return on investment. Sirona estimates that with 25 restorations a month, the cost savings of using the Cerec system should pay for itself within one year. Nevertheless, it is not hard to see that penetration has begun within the higher end practices. For less active practices, Sirona has Cerec Connect, which gives dentists the option to tap into the Cerec technology but at a lower initial cost. 

The second most important product line is Imaging Systems, and the company continues to see good underlying growth here as dentists shift to 3D from 2D imaging systems. Sirona has 40-45% penetration in this market place. Although this level seems high and therefore prohibitive to future growth, the 'penetration' actually refers to at least one sensor in the practice. Therefore, Sirona should have the opportunity to be able to sell more of them into this established base. Sirona tends to sell a few sensors into a given practice after establishing a presence.

Sirona's treatment centers are focused on the high end and have seen a resumption of growth as the economy recovers. Demand growth was stronger in Asia and Europe (Sirona is very strong in Germany) and I would expect this to continue as dental surgery for cosmetic reasons is something that the wealthy can afford. Another attractive feature of this segment is that it is focused on geographies (Germany, US, Asia) which are doing relatively better in the current economy.

The last (and smallest) product line is Instruments, which is also the lowest margin business. In fact, it only contributed 8% to gross profits in the quarter. This product line is the most challenging due to its not being able to offer any particular technological advantage.

What Happened with the Latest Results?

Sirona reported a strong set of results which were masked by unfavorable currency effects. No matter; the market ‘got it’ and sent the stock up sharply. Here is how currency movements affected results.




The negative contributions from currency mask some strong underlying growth.

In fact, Sirona raised its constant currency revenue guidance to growth of 8-10% from being at the ‘upper end’ of 6-8% previously. We can see just how good these results are with a longer term view of revenues.






Note that in Q3 2011 the company launched a new imaging product and saw outstanding sales at the International Dental Show (IDS). Ultimately, this meant that this quarter came up against a very tough comparable, but if you look at the sequential movement it is way ahead of the movement between Q2-Q3 in 2010.

The Bottom Line

I like the long term prospects here. CAD/CAM Cerec can expand penetration rates in the long term and imaging system sales should follow as the company sells into its installed base and benefits from the move to 3D. Treatment center revenues are favorably positioned in geographic regions and I would expect more growth to come. With this being an investment year, Sirona looks set to expand earnings and cash flow in the next few years. Indeed, analysts have forecasts for high single digit growth in revenues and low teens earnings growth. The company remains highly cash generative and could be set for appreciation once the market appreciates the long term story.