Patterson Companies is a Safe Haven

One of things that all financial bloggers learn quite quickly is that all stocks are equal, but some stocks are more equal than others. In other words certain stocks and certain industries attract a huge amount of attention and others do not. For example, the world and his wife has an opinion on Apple’s stock price and prospects but very few would be attracted to investing in, say, the dental or veterinary supply industry. So guess what this article is going to be about?

Patterson Companies: Let Me Count the Ways

Okay a little bit over the top, but I’ve got a lot more buying interest in stocks like Patterson Companies (NASDAQ: PDCO) and Henry Schein (NASDAQ: HSIC) than I do in hot stocks that are being bid up just because they are in industries that the media likes to endlessly cover. In order to try to redress this imbalance, I’m going to make a few bullet points on why Patterson is attractive:

• Dental and veterinary products distribution is highly fragmented in the US and there is the need and potential for consolidation, which could improve margins down the line.
• Demographics (an aging population) favor increased dental provision and expansion in the numbers of companion animals.
• Social trends (singles, single parent families) increase the attractiveness of companion animals.
• Technological advancements from companies like Sirona Dental Systems (NASDAQ: SIRO) and Idexx Labs (NASDAQ: IDXX) will drive growth in spending. Both are key partners of Patterson.
• End demand is slightly cyclical but holds up well in downturns.
• Highly cash generative: Patterson has generated over 25% of its current enterprise value in free cash flow over the last five (recession affected) years.
• GDP+ type growth

Patterson has many of the qualities that investors might look for in order to provide balance to a portfolio. The downside appears to be relatively limited, but it appears to have some upside drivers coming from structural and strategic developments.

With that said, investors need to appreciate that end demand is somewhat dependent upon cyclical factors. A breakdown of its constituent segments demonstrates its resilience but also its partial reliance on the economy.

The impressive performance of its veterinary operations (formerly Webster but now branded as Patterson) is in line with the industry. I can't help but think there are some M&A opportunities here. Henry Schein also has a substantive veterinary operations, and MWI Veterinary Supply has been generating double digit revenue growth in the last few years; more of the same is expected in the future. Moreover, Idexx Labs (a partner of both HSIC and PDCO) is expected to accelerate consumables sales in the future. I’ve discussed Idexx in more length in an article linked here. The key point to understand here is that Idexx is in a phase of pushing system sales in order to increase consumables sales in the future. This will benefit Idexx and its distributors.

As for the dental side, it has expanded its key relationship with Sirona following some product unavailability in the last quarter. I discussed this matter in a previous article on PDCO. The good news is that this issue has been rectified, and PDCO's management affirmed that there is strong pent up demand for Sirona’s proprietary technology. This is good news at a time of ongoing sluggishness in core equipment sales to dentists. The consumables market may be stable for Patterson, but demand for things like chairs, lighting, cabinets etc remains weak. I think part of this is due to macroeconomic concerns (dentists reluctant to spend) and a tendency for them to want to allocate spending dollars to solutions like Sirona’s CAD/CAM system. More discussion on Sirona linked here.

One interesting aspect about Patterson’s commentary was that it did not see any ‘pull-forward’ effect from customers in Q4 due to fears over possible tax incentive changes to section 179. Henry Schein noted this and suggested there would be some backwash in the next quarter as a consequence. I guess we will find out who is right in a couple of months.

Where Next for Patterson Companies?

On a current EV/EBITDA evaluation of 10x I wouldn’t argue that the stock is particularly cheap. Since the economic recovery began in 2009 the stock has traded within a price band of 1-1.25x revenues. Based on April 2013 revenue estimates of $3.65 billion, this equates to a current share price of between $34 and $40, where the current price is around the mid-point of $37.

Analysts have GDP type top line growth penciled in for the next few years and double digit earnings growth for next year. There is upside potential to this given a stronger economy, and for the reasons articulated above I think longer term prospects are good with the potential for some kicker from M&A activity. It’s not the sexiest of stocks, but these stocks serve a purpose and I think it’s worth a look.