Wednesday, November 27, 2013

Time To Buy Patterson Companies

Sometimes investing is about buying go-go growth stocks that are lovingly discussed by the general public, and sometimes it's about buying boring medical supply stocks like Patterson Companies  . Patterson's end markets of dental, veterinary, and medical rehabilitation aren't growing very fast, but the company has taken a number of initiatives to generate growth. Moreover, the underlying business is highly cash generative. It's worth taking a Foolish look.

Patterson beefs up its veterinary supply business
The company reports in three segments, with dental being its largest revenue generator.

Source: Company presentations.

In each of these segments, Patterson has been taking measures in order to generate earnings long-term earnings growth.

Eagle-eyed readers will note that the veterinary division has seen a jump in revenue this year, which is largely due to the $117.7 million contribution from the acquisition of U.K.-based veterinary distributor NVS, from its former parent Dechra Pharmaceuticals. The deal is particularly interesting because unlike its rival Henry Schein    Patterson didn't have substantive international veterinary operations before the acquisition took place.

In recent years, NVS has tended to be a low-growth but highly cash generative business. Dechra's focus has been on expanding sales of its growing veterinary pharma business, and its 87.5 million pound sale of NVS looks like a good deal for both companies. Dechra reduced its debt with the cash while renewing its focus on pharma. Meanwhile, Patterson bought the leading player in the U.K. vet supply market for just 10.4 times its underlying profit. That's an attractive valuation considering that Patterson currently trades on a P/E of 19.3 times forward earnings.

NVS generated 333.2 million pounds (around $539 million) in revenue in its year to June 2013 with 5.5% revenue growth, but has wafer-thin operating margins of 3.3%. It's entirely possible that Patterson can use its distribution expertise and scale in order to generate some margin improvement in the future. Indeed, Patterson is expecting the acquisition to be earnings accretive by $0.03-$0.04 in 2014 alone. More to follow?

Patterson's mixed earnings from dental
In theory, the dental market should provide strong long-term growth for Patterson. An aging U.S. demographic and better dental care (which implies more teeth per mouth to service) should mean increased demand in the future. Unfortunately, dentists don't see it that way at the moment and are reluctant to spend on core equipment. According to Patterson's management on its conference call:

While dental consumable sales were up year-over-year, consumable growth remained sluggish... ...On a macro level, since the economic downturn, dentists have remained cautious about expanding and upgrading their basic practice infrastructure, which includes chairs, units and cabinetry. 

Patterson's dental supply sales were up just 2.5% in the third quarter, with consumables only up 1.7%.  Equipment and software sales were up a more impressive 4.3%, and this is where the immediate growth prospects lie.

Indeed, Patterson has taken measures to accelerate dental growth by expanding its relationship with dental dental CAD/CAM company Sirona Dental Systems . Sirona's CEREC system allows for same-day teeth restorations, and the technology looks set to benefit from strong growth in future years. Indeed, Sirona just gave its full-year results and reported 18% revenue growth with its CAD/CAM and imaging solutions. Its growth is always likely to be lumpy (it's somewhat contingent on the timing of new product releases), but Sirona (and Patterson) should receive a boost from an unlikely source.

Henry Schein recently signed a deal with Sirona's rival E4D Technologies in order to roll out E4D's CAD/CAM technology to various dental practices in the U.S. This could be good news for Patterson and Sirona, because Henry Schein's move (it already distributes Sirona's products in Europe) will help create awareness of the benefits of this class of technology. Ultimately, this could spur adoption of Sirona's CEREC system.

Medical disposals and IT investment
Patterson's medical rehabilitation business is in a tough market as austerity measures impinge on its growth opportunities. Its sales declined 5% in the third quarter, but this is partly due to measures taken to drive long-term earnings growth. In response, Patterson has been disposing of some of its non-core medical assets in a bid to cut costs. Management forecasts that savings equivalent to $0.01 in EPS will be generated by these measures starting in 2015.

And finally, Patterson is investing between $55 million and $65 million in IT over the next five years in order to ensure future productivity gains.

Where next for Patterson?
After excluding the $0.12 restructuring charge taken for its medical business, its internal guidance is for $2.13-$2.24 in EPS for the year to April 2014. This puts the stock on a P/E ratio of 19 times forward earnings. This may seem expensive but recall that Patterson has generated an average of $264 million in free-cash flow over the last three years. This equates to around 5.8% of its enterprise value as I write.

In conclusion, Patterson has been busy engaging in "blocking and tackling" initiatives to improve its productivity in medical. Veterinary has seen the acquisition of NVS, and its dental segment has expanded its relationship with Sirona. All three measures are set to increase its long-term potential, and Foolish investors should look favorably on the stock.

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