Saturday, June 8, 2013

Patterson Companies Looks Like a Good Value Stock

Investors had a right to feel a bit cautious about what Patterson Companies (NASDAQ: PDCO) might say in its full year results, but in the end the results were quite good.

Its end market conditions are not ideal and its hard to see the stock recording rip roaring top line growth over the next few years. On the other hand, it offers investors a good value proposition coupled with decent earnings prospects and some upside from an improving economy. Moreover, its downside is somewhat protected by the core stability of its dental earnings.

In summary, Patterson is an attractive stock for cautious investors or those looking to balance the cyclical end of their portfolio.

Patterson Companies reassures investors

It might seem contradictory to refer to the need for Patterson to reassure investors while also mentioning its stability, but there were a few short term questions going into these results.  I’ve noted three of them below.

  •  Its rival Henry Schein (NASDAQ: HSIC) had spoken of a pull forward effect in Q4 caused by speculation over the potential loss of a tax benefit. Although Patterson had said in February that this wouldn’t have an effect on its numbers, the issue was likely to still be on investor’s minds.

  •  Its consumables and core equipment sales had been weak in the back half of the calendar year, and the fear was that this could extend into this year.

  • The overall economy hasn’t grown strongly, so the macro pressures on dentists were still likely to constrain spending.

All of these fears were pretty much allayed in Patterson’s results. The pull forward effect didn’t really occur for Patterson, and I’m wondering whether Henry Schein saw this because its sales force emphasized this in Q4.  Moreover, Henry Schein has a couple of major trade shows that should help it report good Q2 numbers. Like Patterson it is not the most exciting stock, but if you are looking for solid cash generator with limited downside and moderate upside Henry Schein could fit the bill. Analysts have it on near 10% earnings growth rates for the next couple of years. Nothing wrong with that!

For Patterson, consumables sales were up 2.4% and basic equipment (chairs, cabinets, lighting etc) sales rose ‘double digits’ in the quarter. While the latter appears bullish, its management was not keen to ‘call that out as a trend.’

Essentially dentist spending decisions will still be guided by their feelings about the economy, so we should expect it to continue to correlate with that. The good news is that dentistry spending is stable, and even in a downturn there will still be decent core demand for basic dental equipment.

Growth prospects?

Going forward I suspect it is more of the same from Patterson. The expansion of its distribution deal with Sirona Dental Systems (NASDAQ: SIRO) in order to sell its entire product line is a clear sign that it wants to migrate sales towards higher growth technology based sales. I’ve discussed Sirona at some length in this article. The key drivers of its growth are its market defining CEREC CAD/CAM system and its imaging systems, both of which Patterson distributes.

The CEREC system’s penetration rate is still in the low teens in the US, and multi-year growth looks assured. It can also generate growth in less developed markets thanks to its CEREC connect system (which allows a group of dentists to utilize the system) sales. Analysts have Sirona on double digit revenue growth for the next few years, and trade shows like the IDS in March are also likely to spur market take-up. In the longer term, an aging demographic (with more teeth per mouth) will ensure long term demand for teeth restorations--all of which speaks to good potential for Patterson.

The technology side of its dental operations is doing well, and it needs to be, because elsewhere Sirona is seeing some weakening. For 2014 it forecast low single digit growth in dental consumables, and the overall equipment market is forecast to grow in mid-single digits.

Meanwhile, it gave a mixed outlook for its other divisions. Its veterinary operations were predicted to grow at 3%-5% amidst talk of ‘headwinds’ and tougher comparisons, while its medical business was forecast to operate within an underlying market that was ‘flat to slightly down.’

Sirona's outlook pretty much mirrored what Henry Schein had said earlier. It had also spoken of stability in North American dental conditions and an overall animal health market growing 4%-5%. In addition, its commentary on competition from local players (versus large national distributors like Patterson and Henry Schein) was very interesting. It argued that the increasing share of dentistry spend on technology would make things harder for the smaller players. This is obviously good news for Patterson too, and suggests that there are consolidation opportunities within the fragmented dental distribution sector.

Where next for Patterson Companies?

In conclusion I think Patterson's attractive features remain in place. It is not the sexiest stock out there, but it is highly cash generative, with $277 million in free cash flow brought in for 2013 and a similar amount forecast for 2014. This represents 6.5% of its enterprise value of $4.25 billion, and given the relative stability of its growth prospects I think it is a decent value.

The question will always be over its growth prospects. Investors will have to look for sales of Sirona’s products to generate top line sales growth and hope for an improvement in overall economic conditions. In addition Patterson announced a $55-$65 million investment in information systems which should generate operational efficiencies (and margin expansion) down the line but will reduce EPS by around $0.06 next year.

It is a nice mix of modest upside potential with limited downside and on a decent evaluation. Well worth a look for a value investor.

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