Wednesday, December 18, 2013

Sirona Dental Systems Equity Research

One of the hardest puzzles in investing is to know what to do when a long-term growth story experiences a slower year. This is exactly the issue facing investors in dental CAD/CAM equipment maker Sirona Dental Systems. After three years of reporting constant currency growth of 16.4%, 12.6% and 11.7% respectively, Sirona's forecast of 4%-6% constant currency growth to Oct. 2014 looks disappointing. It's time to look more closely at the factors influencing its growth.

Four key questions for Sirona Dental
A quick look at its segmental gross profits illustrates that its CAD/CAM systems and imaging instruments are its core profit centers.

Source: Company presentations.

In particular, its CEREC CAD/CAM systems are the key to growth. The systems are distributed exclusively by Patterson Companies  in the U.S., and by Henry Schein  in Europe. Essentially, the systems gives dentists the opportunity to offer same day teeth restorations. Focusing on CEREC, there are three key questions that investors need to ask themselves.

Sirona Dental's gross margin
The first question is what will happen to Sirona's gross margins in 2014?

Sirona faces some challenges and opportunities with margins. Management indicated that next year's gross margins would be flat, but its CAD/CAM segment gross margins could decline by 50 to 100 basis points. One key issue is that its customers continue to trade up to Omnicam CEREC from its older CEREC Bluecam system. The main differences in performance are outlined in this video. Omnicam has a higher ticket price so it generates higher revenue, but its gross margin is lower. Ultimately, both products generate similar gross profits, so investors should expect lower margins as trade up occurs. Indeed, in the fourth quarter CAD/CAM gross margins fell to 64.5% from 68.9% last year, even as revenue grew 35.2%.

The other margin issue to look out for is that, Sirona's management nudged the market toward expecting emerging markets to contribute more growth next year.

Our geographic diversification continues to be an asset for Sirona. Our non-European international markets accounts for 35% of sales. We expect them to be a key driver of growth in fiscal 2014.

If you assume that emerging markets will tend to want to buy lower-priced products than this could imply a lowering of margins in 2014.

Sirona's CEREC penetration rates
The second question is can Sirona increase its penetration rates with its CEREC system?

This is the key to its long-term growth. The CEREC chair-side milling system is now in 15% of dental offices in Germany and 14% in the U.S. Penetration rates are significantly lower outside of these markets. These figures imply that long-term growth can take place in these core markets, and help -- at least in the U.S. -- could come from an unlikely source. Henry Schein has recently agreed a deal to distribute E4D Technologies CAD CAM system in the U.S. Although this is a rival system, Henry Schein's distribution of this product in the U.S. will surely increase awareness of the need for CAD/CAM systems. In other words, it could spur "me too" purchases of Sirona's systems.

Sirona's geographical growth
What will Sirona's geographical growth look like?

Germany and the U.S. make up 50% of Sirona's sales, and they grew 20% in 2013. The U.S. benefited from some pull-forward in sales due to the medical device tax, and from Omnicam trade ups. Germany was described as being "very difficult to grow" in 2014. In other words, growth is going to be a lot tougher in its core markets.

One issue is that Bluecam was only launched in 2009 , and many dentists may feel reticent to upgrade a system only purchased a few years ago.

Another issue that could possibly impact Sirona was mentioned on its U.S. distributor, Patterson Companies, conference call.

one of the issues we did run into in the quarter was the process of installing... ...Omnicams to our Bluecam customers. That process took longer than we had anticipated... ...our salespeople ended up taking more time in terms of the change management process.

Obviously, this is more of an issue for Patterson Companies, but if it causes an inventory build up, then Patterson may decide to slow the growth of orders from Sirona.

And finally, the cost of a CEREC system to its non-core emerging markets may prove prohibitive.

Where next for Sirona?
All told, it's likely to be a year of slower growth for the company, but not all growth stories are linear. The stock may well sell off in response to some disappointing guidance, but Foolish investors should watch closely and look out for an entry point of it does so.

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