Monday, October 8, 2012

Dental Health Care Stocks

Apologies for the attention seeking title but I'm frequently amazed at how little interest there is in solid well run companies in boring industries (you know, the ones that make money), as opposed to the frenzied interest to invest in anything that the financial services industry are hyping right now. Forget social networking, and lets look at teeth and pets!

I don't know what Peter Lynch would think, but the market didn’t like Patterson's $PDCO recent results very much. However, that is not good cause to ignore them. I think the stock and the sector are both interesting, and investors would do well to look at some of the key takeaways from the results. There are plenty of "read across" opportunities to the prospects of other companies. In summary, Patterson missed earnings estimates but beat on revenues, mainly due to sales mix, but the underlying long term story is intact.

A Demographical Favorable Stock but Pre-Tax Margins are Falling

Dental, veterinary and rehabilitation. I doubt you will find three better ways to play current demographic trends, and Patterson’s business is to distribute to all three markets.

Dental (Patterson Dental) is attractive because the population is getting older and is keeping more teeth, which means more dental work per capita. Regarding veterinary (Webster), older people tend to have more pets, and don’t forget that declining birth rates, increasing divorce rates, and larger numbers of single people and single parent families are all encouraging the supplanting the emotional attachment of partner or child with a pet. Rehabiliation (Patterson Medical) is another obvious beneficiary of an ageing demographic.

 Share of revenues by division.

So if Patterson is exposed to all these positive trends, then what is going wrong?

Actually, nothing is going wrong. The long term trends remain intact, and Patterson has recently expanded its exclusive marketing agreement with Sirona Dental Systems $SIRO in order to sell its complete product line. I’m a bit of a fan of Sirona and will come back to it in a moment. Patterson also reaffirmed its exclusive relationship with Idexx Labs $IDXX, which is a specialist in companion animal pharmaceuticals and diagnostics.

The issue with these results is that operating expenses and 'other' expenses are increasing more than gross profits, so net income actually fell 2.2%. The issue is mainly due to a change in the sales mix. Overall, consumables and printed products now make up 66% of total sales as opposed to 67.8% in Q1 last year, and they tend to be higher margin. Moreover, within consumables the products that are growing the fastest are the lower margin products. The result is that while gross profit increased, gross margins fell. Net income did fall but the EPS increase was due to a reduced share count.

By division, Dental sales were up 6.4% but consumables sales were below forecasted levels and I suspect Patterson is feeling the heat of competition here. I also note that Sirona’s instrument sales division has been growing weakly too.

Veterinary sales increased 6.4%, and the strength here augurs well for Idexx. By way of contrast, veterinary consumables sales were pretty good. On the subject, PetSmart $PETM recently gave pretty good results and confirmed that all is well with consumer expenditure on pets. In my opinion discretionary spending on pets is aligned with veterinary visits so they are worth watching together.

Rehabilitation Supply sales were down 2.7% and the management argued that this was temporary weakness due to Government cutbacks particularly in the UK. As a Brit that invests a lot in the medical sector I can confirm that a whole host of other companies are saying the same thing.

On a brighter note, full year EPS targets were maintained, and Patterson remains a prodigious generator of cash. A good thing, because  management were talking up the opportunity for some mergers & acquisitions activity on the conference call. We shall see.

Where Next For Patterson?

As a Sirona stockholder, I was particularly intrigued by how bullish Patterson was with regarding its Sirona’s CEREC system sales opportunity. I have covered Sirona in detail in an article linked here, and I note the stock was up nicely on the day after these results. Patterson regards the CEREC CAD/CAM system penetration rate in the US at being close to 10% so there is plenty of scope for sales expansion in future, particularly with the release of a powder free camera and a high resolution sensor. I agree and think Patterson is onto a winner here.

Incidentally, whilst Patterson handles the US, Henry Schein $HSIC is Sirona’s key distributor in Europe and elsewhere. The tricky bit is that sales growth from Sirona’s hardware could end up margin dilutive. No matter, Patterson can hope to make it up with volume.

In conclusion, the stock doesn’t look expensive but no one likes to see pre-tax margins going down. Sirona & Idexx are exciting partners to have and I think will spur top line growth in future. These results are a net positive for them. The near to mid-term challenge for Patterson is to overcome the issue of the margin mix in dental consumables and demonstrate that it can get back to growing earnings quicker than revenues. Longer term, the outlook is very good this may prove a decent buying opportunity.