NVST - Envista: Weakness In 1Q23 Should Be Done And Dusted

2023-06-07 05:30:03 ET

Summary

• I maintain a buy rating for NVST stock despite lower 1Q23 results, as management reiterate FY23 guidance and expectations for low single-digit core growth in 2Q23.
• NVST's presence in China offers growth opportunities despite political and regulatory risks, with the impact of VBP policies expected to lessen and future sequential comps likely to be easier.
• The weakness in the Equipment & Consumables segment is attributed to market conditions and strategic initiatives aimed at focusing on more profitable products, which I believe is overlooked by the market.

Overview

My initial long thesis for Envista ( NVST ) is based on the growth potential of the global dental industry, which has a total addressable market of $27 billion (refer to previous post) and is expected to expand at a CAGR of mid-single digits. NVST's extensive product catalog and international presence allow the company to cater to the requirements of dentists everywhere. Despite the lower results in 1Q23, I am maintaining my buy rating for NVST because I believe the weakness in 1Q23 is over. Management has reiterated its FY23 guidance and indicated low single-digit core growth for 2Q23 (reversing the -2.4% Q1 core revenue decline). Margins are also expected to improve sequentially from the 18.2% in 1Q23 to more than 20% . Overall, despite the dismal quarter, I think attention has shifted to the next few months to see if NVST can live up to expectations. I reiterate my buy rating and would look for opportunity to size up my position if NVST delivers as promised.

China

Looking at the big picture, it's remarkable that NVST has established a foothold in China and secured implant and ortho contracts. Given the large market size in China, it is definitely positive from a growth and TAM perspective. However, in my opinion, political and regulatory risk is the main problem with doing business in China. NVST was not spared from this as it got impacted by the VBP policies. While these policies only impact the public sector, I believe the spillover to private sector is an eventual thing due to the increased price difference. Management has indicated that the Implant division has felt the full effects of spillover thus far, while the Ortho division has only been exposed to these risks to the tune of 10%. As far as I can tell, the worst of it is over; and we'll likely only see a $20 million impact in FY23 (as management indicated), and the future looks bright thanks to easier sequential comps. In my opinion, the private sector (NVST in this case) will begin to see volume flow again as prices return to similar levels (after adjustment for VBP), which could be an upside surprise for FY23 guidance. Management also pointed out that 1Q23 results in China were impacted by COVID-related disruptions, so this allows for an easier sequential comps for the coming quarters vs 1Q.

Equipment & Consumables weakness

One possible explanation for the stock's poor performance is that investors failed to properly assess the situation with E&C. In my opinion, there are two parts to the weakness in this segment. The first is the general malaise in the market that has led to de novo delays and increased spending constraint as a result of the current macro environment and rising interest rates. In addition, the weak macro environment also highlighted NVST the weakness in imaging as the product becomes more and more commoditized, reducing NVST pricing power. In good times, customers might be willing to pay more for better branding and what not, but in bad times, expensive commoditized products will simply get switched out of. Second, there are NVST's strategic initiatives. Since 2Q22, management has been working to rationalize the equipment portfolio by exiting markets and discontinuing sales of less attractive products in order to place greater emphasis on those in which the company has a competitive advantage. As a result, this has impacted equipment sales and the E&C industry as a whole.

The second is, in my opinion, what the market has been missing out on. If rationalizing the portfolio means less commoditization and more pricing power for NVST overall (through a concentration on more profitable products), then I am all for it. Obviously, in the course of this, revenue will be impacted as number of SKUs drops, but the lasting impact is better margin profile and market position. The good thing is that the headwind from this rationalization has ended in 1Q23 and the segment should start seeing like-for-like growth next quarter onwards.

Valuation

As the share price falls further and valuations fall to lower levels, the upside becomes more appealing. I revised my model to reflect management's long-term core sales growth in the high single digits while improving margins. In comparison to my previous model, this is a lower growth forecast as I remain cautious about China's volume recovery potential - an upside surprise that I am hoping for. I continue to believe that the NVST valuation multiple will gradually return to its historical norm as the company's growth profile and margins improve.

Conclusion

Despite the lower results in 1Q23, I maintain my buy rating for NVST as I believe the weakness is over. Management's reiteration of FY23 guidance and expectations for low single-digit core growth in 2Q23, along with improving margins, are positive indicators. NVST's foothold in China, despite political and regulatory risks, presents growth opportunities in a large market. The impact of VBP policies is expected to lessen, and future sequential comps are likely to be easier. The weakness in the Equipment & Consumables segment can be attributed to market conditions and strategic initiatives aimed at concentrating on more profitable products, of which the latter is likely overlooked by the market.

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