Henry Schein: Tailwinds And Headwinds From Covid-19; Near-Term Upside Only (NASDAQ:HSIC)


Investment Thesis

Henry Schein (NASDAQ:HSIC) has seen virus related disruption in its healthcare distribution and value-added services businesses this year. With near-term headwinds from Covid-19, wider industry complications and macroeconomic crosscurrents posing threats to the company, we believe that margin pressures will remain, and operating leverage will be affected over the coming periods. We see more dynamic competition in pricing activity from the above, also. HSIC’s fundamental outlook is impacted heavily by the volatility in consumables-led demand and patient volumes, which may also stretch margins in the coming periods.

Data Source: Author’s Bloomberg Terminal

Offsetting the above are the facts that HSIC has delivered sequential earnings growth amidst the pandemic. Plus, the company has large growth potential through M&A activity, targeting higher margin names, alongside expanding end-markets, all of which can bolster the fundamental picture. There are also potential Covid-19 related tailwinds via HSIC’s potential role in vaccine distribution, as reported by management. Although, shares trade at a premium to peers, and we believe that the majority of the drivers in the growth engine are well priced into the valuation also. Shares have also failed to make their recovery to pre-pandemic levels, down -4% YTD. Thus, in view of these points, we expect decent company performance, but have a balanced neutral view on the company from an investment perspective. Below we link our thesis to the overall picture, for the benefit of investors.

Catalysts for Near & Longer-Term Price Change

1). Near-Term Covid Catalysts

Covid-19 is an interesting force for HSIC. There are headwinds from patient and clinic disruption, which is balanced by exposure to Covid-related sales demand that have driven growth at the top this year. The company have in fact noted that the majority of Q3 revenue volumes were driven by PPE and Covid-related sales. However, HSIC are firm in their belief that they will play some part in the distribution of a Covid vaccine, perhaps increasing their role in testing too. HSIC does have a lengthy history in vaccine distribution, and holds several key manufacturing partnerships to support this viewpoint. Once commercial approval is granted for either or any Covid vaccine, then HSIC believes they will have a role in the commercial operations of the same, via distribution into clinics and perhaps even large workplaces. HSIC have also alluded to their role in private sector Covid testing, that has so far been contained to government. The company believe that they will receive a large allocation of testing authority, especially as the scale of testing begins to widen as testing itself becomes more privatised. These are certainly interesting viewpoints, and enable HSIC quite direct Covid-19 exposure, however we believe their claim on the testing side is a bit controversial. There are so many testing entities already designated, that competition will remain stiff to capture share of the testing market, private or not.

Covid-related labels within the product mix alongside PPE will remain important segments for HSIC, in light of the regulatory environment many workplaces are not likely to instil as businesses begin to reopen. This is especially true as mandatory Covid vaccination will be highly unlikely, thus, as a contingency, workplaces and other environments will heavily enforce PPE protocols. Many covid-related PPE units remain in short supply relative to demand, and the inelasticity in production has become evident this year, especially with face masks, face shields and sanitiser products. Thus, this segment will exhibit higher pricing phenomenon, with more dynamic competition forces as well. For HSIC, around 10% of international dental sales were fuelled by Covid-related products in the 3rd quarter, 11% in Q2. In medical sales, Covid products increased their contribution by 17% from Q2, and contributed ~24% of total sales in that segment. Dental sales seem to be an important growth driver, up ~130% YoY, with sequential growth of ~35% from Q2.

2). M&A Activity Remains Committed

Historically, acquisition activity has remained a key priority for HSIC, and the company has leveraged their M&A scale to consolidate assets in core markets, and support margins by targeting higher margin names that both complement and diversify core operations. To illustrate, HSIC has an annual marker of ~$200-$300 million in cash, that is allocated annually for acquisition purposes. They have averaged ~4 deals per year over the last 10 years, and in fact completed 4 transactions last year (2019). Recently, the company has spun off its animal health business, providing additional liquidity and capital for more M&A. We would anticipate the crux of the capital from this spinoff to be permeated towards the dental segment, which seems to be a large underlying driver across this year, especially with Covid-related tailwinds in the near-term. Nonetheless, further acquisition activity is imminent, especially targeting those higher-margin names and complementary lines to the current product mix. For instance, the company had acquired Medentis Medical in a strategic play to expand their “digital dentistry” capacity, especially for implants and the likes. Furthermore, they had acquired Lighthouse 360 as a complement to the Henry Schein One Platform, HSIC’s answer to patient management software. Therefore, we believe the company will continue on its average of ~4 transactions yearly, especially to ease pressures on operating margins, and continue the cadence of underlying growth post-pandemic.

Headwinds On The Horizon

The top-line results this year are undoubtedly driven by PPE and Covid demand. However, in Q3 management completed an inventory write down of PPE in the product mix, which saw a ~400bps YoY deficit in gross margin scores. This happened for 2 reasons. First, most of the PPE inventory was acquired from third parties, back when demand for this segment bumped pricing activity well north. Since, the correction in prices from more elastic supply and competitive pricing activity, has resulted in HSIC adjusting the balance sheet to reflect the true value of the inventory. Second, PPE products are a lower margin segment anyway, in relation to HSIC’s other categories, and have formed an overwhelming bolus of sales YTD. Both of these factors therefore drove margins down at the top.

Figure 1: Margins Remain Under Pressure

Data Source: Author’s Bloomberg Terminal

Furthermore, although it appears dental is the underlying segment winner, removing the Covid tailwind shows a flat performance in the core dental business YoY. The disruption from the pandemic on patient volumes and clinic operations is therefore apparent, and we believe HSIC has seen a weaker rebound in patient flow than peers. Ongoing volatility in patient volumes and uncertainty around clinic operations will continue to impact growth here. Additionally, once PPE sales related to Covid begin to diminish, the rebound in deferrals and patient volume may not be as strong as HSIC hopes, considering the relative recovery we’ve seen to date in the core business (outside of Covid).

Both of the above points highlight the pressure that remains on operating leverage over the coming periods. Firstly, the continued demand for PPE products will continue to drive the top-line, however, the lower margin nature of this segment coupled with the effect of inventory adjustments on the balance sheet, will certainly impact operating level margins. We would also highlight that nitrile exam gloves are now in shortage, which means that volatility in supply and therefore pricing will likely be experienced here as well. Thus, we may see additional inventory effects from this mix as well. In addition, the cadence of sequential growth quarter/quarter may not be sustainable compared to the transition from Q2 to Q3, as management have indicated that the majority of PPE sales are related clinic reopenings’, which removes the repeatability of these contributions. Operating margins were ~7% for the quarter, ~60bps decrease YoY, although operating profit increased ~450bps YoY, at ~$195 million. The disconnect in operating profits to operating leverage highlights the pressure that remains at this level, and we would postulate that additional inventory pressures on the balance sheet may also continue over the coming periods. Thus, we are more conservative on EBIT level margins vs management, estimating ~5.5% for FY2020, ~30bps lower than guidance. This represents a 184bps decrease YoY.

Financial Outlook

We’ve balanced the 3-statement model to reflect the run-down in Covid-related demand, in addition to the settling of Covid-related headwinds over the coming years. We believe it is not unreasonable to expect CAGR ~5.5% top-line growth for HSIC by 2025, with some recovery in gross margins over that period. Operating and EBITDA margins will likely remain under pressure for that period, but we see ~75bps in margin expansion at that level in years to come. Furthermore, we believe that free cash will likely convert at a rate of ~5-6% into 2025, especially given the historical acquisition pattern of HSIC.

On the credit side, the company has adequate coverage over interest expense at ~23x coverage, although, liquidity is certainly tight with only ~1.5x coverage on short-term obligations from liquid assets, and only 0.2x coverage from cash alone. Removing the value of inventory from the equation, thus simulating any further inventory write down, there is only 0.75x coverage, cash included. The debt ratio is ~18%, and has come down YoY, whilst total debt to total capital is ~25%, which has also decreased by ~300bps YoY. The company also has a $740 million available credit facility, which they have only drawn ~$10million down on to date. Net cash burn has been ~14% since Q1, although has slowed sharply quarter/quarter to net -80% burn on the Q2 cash balance.

Data Source: HSC SEC Filings; Author’s Calculations

Data Source: HSC SEC Filings; Author’s Calculations

Valuation

Given the imminent slow down in Covid-related demand and lower-margin PPE exposure in the product mix, these must be priced into the valuation. Shares are trading at 21.9x P/E, ~3x book value and only 0.95x top-line sales. Shares are also trading at ~19x free cash flow, on a FCF yield of 5.77%, on the higher side. We also see shares trading at 13.16x Q3 EBITDA, and we believe that these figures will come into correction amidst macroeconomic crosscurrents that will eventuate to the end markets for dental, value-added services and consumables-led growth. The above figures are using TTM values.

Assigning a 17.1x P/E estimate to our 2021 EPS estimate of $3.79, then we see a price target of $65:

  • 2021 12 month P/E estimate – 17.1x
  • 2021 EPS estimate – $3.79
  • 2021 Price target = 17.1×3.79 = $64.80

Assigning the 12 month P/E estimate to our 2022 EPS estimate, we see a price target of $71:

  • 2021 12-month P/E – 17.1x
  • 2022 EPS estimate – $4.16
  • 2022 Price target = 17.1×4.16 = $71

We would note to investors that the 2021 P/E estimate on our end is well below the 20x multiple that HSIC has held on average for the previous 10-year period. However, we believe this accurately reflects the risks that must be priced in from the factors mentioned above. In this vein, we are encouraged by HSIC’s ROIC scores of 11.57% for the quarter, which has grown from 9.35% YoY, and is well above the cost of capital of 7.6%. Thus, we believe that the [small] valuation premium we have assigned is justified, with the risk included. If the company failed on ROIC vs WACC comparisons, then we’d be more hesitant to attach the premium in valuation for HSIC shares.

HSIC also has ~$1.80 in free cash per share, ~$3.75 in cash per share, and a whopping ~$20 in revenue per share. Thus, whilst shares are trading at a premium to peers, much of the premium is a reflection of the per-share measures and sequential sales growth the company has exhibited this year.

Data Source: Author’s Bloomberg Terminal; Author’s Calculations

Investors can see the potentials in pricing outcomes should shares continue at the current level of support, on the chart below. This is crucial information for long-term investors seeking to understand entry and exit points over the coming few quarters. Thus, we would encourage investors to view the below chart to make the most informed reasoning possible.

Data Source: Author’s Bloomberg Terminal

Further Considerations

On the charts, shares have trended in a wide ascending channel since the selloff back in March. The level of support has been quite defined, and shares have been tested and bounced away from support 7 times over this period. We can see the regression channel via the red line, on the chart below, which indicates the mean in pricing returns from March. Since the dispersion in prices has been quite wide around this level YTD, there has been a reasonable level of volatility and downside exposure on the charts. However, shares have reverted to the mean around 6 times across the regression period, and are currently away from the line on the downside, indicating that a near-term uptick may be within the scope of the next moves. Shares have failed to break the upper level of resistance earlier this year, and are currently quite contained in the upward movement since September. Investors can view the pricing activity YTD, on the chart below.

Data Source: Author’s Bloomberg Terminal

We can see reasonable autocorrelation in multifactor exposure to RSI and momentum ranges YTD, on the chart below. The regression analysis in pricing returns to momentum in particular has been significant, and RSI ranges have shown a causal relationship to prices 4 times this year across our testing period. On board volume has begun to snake higher since May and then again in September, indicating the bullish longer-term trend. Thus, we firmly believe that the current investor sentiment is bullish, and believe further upside is likely in the near-term, based on the charts. However, in view of the foreseeable headwinds over the longer-term, the neutral view is balanced on longer-term share movement. Investors can see these causal relationships on the chart below, with onboard volume in the bottom window.

Data Source: Author’s Bloomberg Terminal

In Short

HSIC has had a year of sequential growth driven by Covid-related demand. Whilst investors have rewarded these outcomes YTD, there are several longer-term headwinds that must be priced into the valuation and future outcomes. We do see a slight disconnect in valuation and current trading, that is fuelled by near-term Covid-related demand by our estimation. The company is also adamant they will play a role in the distribution of a Covid vaccine, and participate in greater testing allocation as tests become more privatised. However, basically all of Q3 revenue volume was driven by PPE and other covid-products, especially in the outperforming dental segment. Take the covid-tailwinds out of that segment’s performance, then growth was flat YoY in the core dental business, which highlights the exposure and therefore concentration risk there.

Additionally, management are not confident the cadence of PPE scale is sustainable, and neither are we. We also see pressure on operating margins over the coming periods, as product shortages may cause pricing disadvantages and the carry through to inventory effects on the balance sheet will be recognised in operating leverage. Investors should keep an ear out for further acquisition activity, that will strengthen the balance sheet, should the company target higher margin names or more complementary product/service lines. We also view macroeconomic crosscurrents that may continue to impact patient volume volatility, and the state of the economy as a whole. Of course, any surprises from the company and/or the economy here will offset this thesis. However, we believe these factors must be priced into the valuation, and although we believe that near-term upside is likely, we hold a neutral stance as an investment considering the ex pandemic uncertainties. Thus, we set a price target of $65 in the near term, which points to the fact that most of the near-term revenue upside is already priced into the valuation. We look forward to providing additional coverage.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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