Saturday, August 4, 2012

Dental Health Care Stocks

It has been a mixed earnings season for the medical device sector and Sirona Dental Systems $SIRO certainly made the picture even more opaque with the results last week. For the other stocks in the sector, this report was quite positive as it indicated that discretionary spending was holding up quite well. However, the relative weakness of non-US & non-European growth versus the rest of the World should be noted. As should the underlying trend in dental spending.

In the sector Align Technology $ALGN gave a spectacular set of results recently with its Invisalign braces and 3D imaging solutions showing strong growth. Indeed, Align’s results certainly gave a lift to dentistry distributors Henry Schein and Patterson Companies. In addition, both these companies distribute for Sirona, so their investors will be interested to hear what Sirona has to say about market conditions.

Whilst Sirona is doing well outside of development markets, a company like Dentsply is doing particularly well in the US and Europe. With this confusing picture in mind, I think it is best to delve into the business of Sirona in more detail to see what is going on.

Incidentally, I have a more detailed write up on Sirona linked here which will serve as a good primer for those who do not know the company that well.

Sirona Dental Systems Q2 Results

Turning to the results
  • Q2 Revenue of $231.9m vs. estimates of $232.9m
  • Q2 Non-Gaap EPS of 64c vs. estimates of 69c
  • Full Year Revenue guidance of $968.7-987m vs. estimates of 970.7m
  • Full Year Operating Income plus amortization of $227-234m
It’s a miss on revenues and EPS so, it’s no surprise to see the market taking the stock down intially. However, upon delving into the results, there are a number of interesting trends here. Sirona is a company whose quarters do tend to vary quite a lot.

Currency had a significant affect. For example, on a constant currency basis, revenues were up to $238.4m vs. the actual number of $231.9m. This implies that underlying growth is strong, but there was no adjustment to the guidance of full year revenue growth at the high end of 6-8% which tells another story. In addition, management kept operating income guidance the same for the full year.
In a sense, this is positive because in Q1, they had talked about the previously mentioned ‘signs of caution’ abating in the US & Germany and this was confirmed with in the current guidance. Listening to the conference call, it is clear that this is going to be a year of investment in order to drive long term growth. Of which, Sirona is well placed.

For example, in Cad/Cam systems, the Cerec system has low market penetration, but its one-stop functionality for teeth restoration looks set to drive long term revenue growth in this division. Indeed, management feels that Cad/Cam system is a double digit long term growth opportunity.

Sirona Breakdown by Division

A breakdown of revenues by division is helpful to see how Sirona’s results are tracking.

Cad/Cam had a strong quarter with double digit top-line growth, although gross margins slipped 160bp to 70% due to current promotions. No matter, these are strong results and the long term potential for the Cerec ‘one-visit restoration’ system to capture the market share is growing. Demographics are also on Sirona’s side, as more elderly people with more teeth, will require more restorations.

Imaging growth looks weak at 3.5% reported (6% constant currency) but this is mainly because of tougher comparisons, due to strong growth last year caused by new product releases. Similarly, gross margins were down 170bp to 56.9% which is a lot weaker than management's stated belief that 60% margins are the realistic target.

The reasons for this were due to a less favorable product mix. Simply put, Sirona sold relatively more (lower margin) Orthophos panoramic units. However, Orthophos 2D and 3D imaging product lines sale were ‘robust’.

It’s easy to see how tough last year's Q3 comparison (particular in imaging) will be in this graph of revenue growth.

Note how strong Q3 was last year.

Longer term, this is cause for strong optimism, because Sirona is establishing an installed base. Sirona's 2D imaging systems sales remain strong, and the company is growing the installed base of customers that can be upgraded to 3D in the future. On thing that I found very interesting to hear was that current upgrading to 3D had not really been taking place so far, therefore there is ample room for future growth here.

Another positive aspect was the strong growth in treatment center revenue. Sirona claims to be taking market share, but nevertheless, these strong results suggest, that private expenditure on dental healthcare is holding up well, even in Europe.

In terms of geographic regions, US growth was at 4.9% whiilst non-US increased 9.2% with the real strength coming from non-Europe. This is a vindication of the management’s efforts to invest for growth in these regions.

Ma Ma Ma Ma My Sirona

Frankly, I’m not sure what to expect for Q3. Analysts have revenues to be flat and, Sirona’s management mentioned –a number of times- to be prepared for a tough quarter in comparison with last year’s stellar growth. No matter, I think these are mini bumps and troughs in a long term growth story that deserves a closer look from investors.

Once you have had a single visit restoration or seen 3D imaging at your local surgery you are unlikely to go back to the old system of the dentist sending an x-ray to a lab and asking you to come back in a week.

Cad/Cam systems have good prospects and the potential for imaging systems to generate future upgrade cycles from installed 2D to 3D systems is significant. Management has confirmed full year guidance and the company remains highly cash generative. Naturally, the threat of a slowdown in Europe is always a concern, but looking at the treatment center revenues, it looks like Sirona’s relatively high exposure to private pay (versus public reimbursement) is holding it in good stead.
The results were nowhere near as sexy as Align’s but they were perfectly good enough for a business with solid prospects driven by demographic realities.

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