Wednesday, February 27, 2013

Henry Schein Equity Research

I have had a difficult time investing over the last few weeks. It seems that all the defensive sectors like consumer staples and health care have been bid up inordinately while all the value seems to be congregating in the technology sector. This is a problem for me, as I like to balance the long side of my portfolio and can’t afford the risk of being overweight any one sector. With that in mind I decided to look around for a relatively stable defensive stock, with double digit growth prospects and sound fundamentals. If you share my desire for this then Henry Schein (NASDAQ: HSIC) could fit the bill for you too.

What Henry Schein Has to Offer

Okay I know what you are thinking, a boring dental and animal health distributor with GDP+ type growth etc. However that’s exactly the sort of thing that I want. The long term idea here is simple. An aging demographic in the Western world is leading to more dental care and companion pets per population. I also think that certain social trends like increases in divorce rates and marriage declines will cause more demand for pets and spending on them.

With that said, these industries are still somewhat cyclical. People tend to take their pets to the vet on fewer occasions and get their teeth looked at with less frequency when the economy is tough. This is something that investors will need to think about because HSIC does have ample exposure to some European markets (within International) that are struggling at the moment.

A breakdown of its sales shown here:

North America makes up 64% of sales and International makes up the rest.

Henry Schein Reports Confusing Numbers

Superficially its results were somewhat concerning. Indeed, when any company I look at reports that sales in its core global dental operations were down 2.4% I would immediately lose interest. However, there are mitigating circumstances here. Firstly, last year contained an extra sales week. Second, currency effects negatively impacted international sales and third, the huge IDS trade show in Europe in 2013 is likely to have held back European (particularly German) sales.

In order to adequately express the underlying trends I will display the ‘Local Internal Sales Growth’ figures as given by the company. This will account for the currency and extra week effects.

The underlying picture looks okay, and International Dental sales should do better after Q1 with the IDS trade show in March.  On a more negative note, HSIC did suggest that some US dental sales had been pulled forward into Q4 thanks to speculation around the loss of a tax benefit. In the end the benefit wasn’t lost (in fact it was increased), but the pull forward effect was likely to have had an effect nonetheless.

The exact impact of this pull forward is somewhat open to question though. I note that Patterson Companies (NASDAQ: PDCO) was also asked about this issue on its conference call but it didn’t seem to think it was a big issue. Perhaps the sales guys at HSIC were pitching on this and are convinced that it helped close deals while Patterson thought it was business as usual? Patterson largely blamed the economy for the weak trend of growth in its dental equipment sales, although it too did well in Animal Health.

Turning back to HSIC, analysts have mid single digit revenue growth forecasts penciled in for the next two years, and this is in line with the 5.1% consolidated local internal sales growth reported for 2012. As for Q1 analysts have 7.7% revenue growth penciled in but I think they will need to lower this target because of the issues discussed above. No matter, it is not a material effect on the long term growth prospects, and the company is set to grow earnings in double digits over the next two years.

More Confusing Numbers!

The animal health division recorded strong growth, but much of this was due to an accounting switch related to Novartis. Adjusting for this, HSIC argued that internal growth was closer to 6.5% and going forward it is seen as growing in the mid single digit range. By way of comparison MWI Veterinary Supply (NASDAQ: MWIV) is forecast to grow revenues averaging double digits over the next two years.  However, you will have to pay over 16x its EV/EBITDA multiple to get hold of this kind of growth. MWIV is just one of those stocks that gets hot and everyone wants to own it. I do too, but I won’t overpay for it, and something like HSIC or PDCO looks like a better way to get exposure to animal health.

Another area that needs explaining with HSIC’s latest numbers is the cash flow situation. The company is traditionally a good converter of income into cash flow but eagle eyed readers will note that 2012 saw a ‘disappointment.’

The simple reason for this is that HSIC brought forward around $150 million in inventory purchases in relation to potential pricing increases thanks to the medical device tax which came into effect in January this year. Adjusting for this would give an underlying free cash flow figure of $507 million or around 6.1% of its current enterprise value.

Where Next for Henry Schein?

Based on the calculations above, I think the stock is good value up to around $102 and presents one of the few value propositions in medical sector at the moment. I like the stock and evaluation and picked some up. It provides a good balance to the portfolio, and I’m confident it can outperform in any market correction. It’s not the sexiest stock around but these things serve a purpose. Revenue growth of around 5-6% is fine, and I think this stock can go higher from here.

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