Patterson Companies: A Positive Quarter Despite Headwinds (NASDAQ:PDCO)

dentist equipment over the clinic desk

izzetugutmen/iStock via Getty Images

Patterson Companies (NASDAQ:PDCO), a distributor of consumables and equipment to dentists and veterinarians, followed up a solid set of quarterly results with the reaffirmation of its fiscal year EPS guidance range. The outlook embeds some fairly conservative assumptions, though, including macro challenges related to inflation and interest rates, as well as a broader economic slowdown. This leaves ample room for more beat-and-raise quarters ahead, in my view. The mid-term PDCO earnings algorithm also remains intact, with management committing to modest organic revenue growth and margin expansion. Backed by a robust balance sheet, there remains ample capacity for accretive bolt-on acquisitions as well. At ~12x fwd earnings (four turns below peer Henry Schein (HSIC)), the undemanding valuation more than compensates for the risks of softening end markets and weaker pricing benefits going forward.

Chart
Data by YCharts

Recapping The Strong Q2 2023 Result

Having trailed internal expectations last quarter, PDCO made up for lost ground this time around, with a strong Q2 2023 performance moving H1 2023 in line with internal expectations. To recap, revenue was up slightly YoY to $1.6bn, with the gross margin performance emerging as the positive surprise at ~20% (+40bps YoY on a GAAP basis).

Q2 2023 Summary

Patterson Companies

Despite the challenging operating backdrop, the company’s pricing power remained intact, allowing it to pass through inflationary increases without sacrificing volumes. Plus, management cited a range of initiatives in the pipeline, many of which are beginning to be reflected in overall margins. Also, positive was that the margin improvement was consistent across both segments of the business (dental and animal health) as PDCO continues to gain share. All in all, the EPS result outpaced expectations at +12% YoY on a reported basis (+9% YoY on an adj basis), as the company also benefited from other income related to a gain from interest rate hedges for the quarter.

Puts And Takes By Segment

Impressively, the quarterly beat came despite weakness in the dental consumables segment. Excluding personal protective equipment, segmental revenue slowed to ~1% this quarter (down from 2% previously) but with price contribution intact at ~3%. This implies modestly weaker volumes this time around, though still higher than pre-COVID levels. In turn, pricing is now guided to decline at a moderate pace over the rest of the fiscal year (vs. the current 2-3% pricing and the 3-4% earlier this year), signaling lower segmental sales contribution going forward.

On the other hand, dental equipment was a bright spot, with internal growth of +11% (albeit against easier YoY comps) on resilient upgrade activity across dental practices. For context, key peer HSIC saw similarly strong North American dental equipment growth in the low-teens % internally. Expect more of the same in the coming quarters, as management sees the dental end-market demand strength sustaining into FY23 as well. This bodes well for more upward earnings revisions, given the mid-term guidance bar is only in the low-single-digit % growth range.

Q2 2023 Dental Segment Results

Patterson Companies

The outlook is less rosy for the animal health market, however. On the companion animals side, PDCO cited more staffing shortages at vet practices, while production animal demand will be pressured by challenging weather patterns. Compounding the challenges on the production side is the impact of pricing deflation from Draxxin going off-patent. The impact is already being felt in Q3, with livestock down YoY amid higher generic competition on Draxxin. While animal health sales were softer (albeit still up YoY), as a result, the solid growth on the companion animal side continues to provide sufficient offset.

Q2 2023 Animal Health Results

Patterson Companies

Guidance Reaffirmed Despite More Conservative Assumptions

Building on the strong margin performance this quarter, the company has maintained its outlook despite the macro-driven headwinds across its end markets. To recap, the FY23 adj EPS guidance stands at $2.25 -$2.35/share, while on a GAAP basis, the EPS guidance range is lower at $1.96 – $2.06/share due to the impact of deal amortization expenses. The contribution split between Q3 and Q4 should be in line with last year as well, so expect a QoQ step down in Q3 before a step-up in Q4. Also embedded in the company’s outlook are assumptions for continued inflationary trends and rising rates, driving a broader economic slowdown. Following the guidance reset, any easing on the macro front and, by extension, PDCO’s end-markets should thus result in more beat-and-raise quarters. Going forward, I would keep an eye out for monthly or quarter-to-date updates to gauge the shape of the underlying trends heading into Q3.

New President/CEO In Place

Heading into earnings, PDCO had announced the resignation of CEO Mark Walchirk due to an undisclosed misconduct finding. Importantly, the company stressed that this was unrelated to the company’s financials or operations. In his place, CFO Zurbay will be taking the helm as the new CEO, having been with the company since 2018. The current VP of Finance, Kevin Barry, will be appointed CFO on an interim basis. While this news is a negative surprise, I see no strategic implications given management consistency is maintained – for context, new CEO Zurbay had been a key driver of the company’s current mid to long-term strategic priorities. With management also reaffirming the FY23 guidance and showing no indications in the quarterly commentary of a strategic shift, I feel comfortable underwriting a status quo scenario from here.

A Positive Quarter Despite The Headwinds

PDCO’s strong quarter and reiterated FY23 EPS guidance of $2.25-$2.35 marks a positive new chapter for the company following the CEO transition in October. While the near-term outlook remains clouded by macro risks, management has accounted for most of these in its updated assumptions (e.g., continued inflation and an economic slowdown amid higher for longer interest rates). This makes the near-term setup quite compelling, in my view, paving the way for more beats and raises in the coming quarters.

Looking out to the mid to long term, PDCO’s ability to maintain its pricing through the down cycle bodes well for the achievability of its organic revenue growth and margin expansion path. Plus, cost discipline and acquisitions of higher-margin services to add to its distribution business present incremental upside to the mid-term earnings trajectory. Net, the current valuation at ~12x earnings seems very reasonable, given the quality of the PDCO franchise.

Be the first to comment

Leave a Reply

Your email address will not be published.


*