2023-10-13 09:55:44 ET
Summary
- Henry Schein's stock price continues to decline, reflecting lower expectations for the company.
- The market's implied expectations for Henry Schein include modest earnings and sales growth.
- The company's profitability and capital allocation strategies are not economically valuable, and market technicals do not support a bullish view.
Investment briefing
The market's repricing of Henry Schein, Inc.'s ( HSIC ) equity value continues to push to the downside, extending the downtrend observed across the bulk of 2023 (Figure 1). Since my July publication where I recommended a Hold, the company's stock price has continued to sell lower, in a series of tighter closes and a more convincing trend channel.
The extended downsides imply the market's expectations are also revising lower for the company as well. The company's Q2 '23 numbers did little to change the expectations in my opinion, evidenced in (i) HSIC's economic performance, and (ii) the post-earnings announcement drift.
HSIC's post-COVID story has left plenty to be desired. It hasn't managed to recycle the excessive cash flows generated throughout the 'pandemic era' into value-creating investments. This was the central point to the revised thesis in July. Q2 revenues amounted to $3.1Bn, a marginal sales decrease of ~20bps. However, if PPE product and COVID-19 test kit sales are excluded, sales grew by 3.3% YoY. In fact, sales of PPE products were booked at $138mm, representing a 28% YoY decrease. Additionally, the company sold $26mm worth of COVID-19 test kits, marking a YoY decrease of about 62%. It is more than likely these trends will continue.
This report will unpack the latest investment updates and compare/contrast this to the price-implied expectations baked into HSIC's current market value. Net-net, I continue to rate HSIC a hold.
Figure 1. HSIC 3-year price evolution, with 2023 downtrend continuing. HSIC now trades back in range with 2021 levels.
Critical facts pattern underneath reiterated hold rating
1. Price implied expectations
In all markets, company stock prices are a discounted set of forward expectations. Gauging what's priced in is a thoughtful exercise to see if they are warranted or not, to potentially capture a change in said expectations.
Based on the estimations presented here, the market's implied expectations are the following in my view:
- An average 5.3% growth in earnings in the next 3 years, and pre-tax income growth of 0.34%.
- Sales of ~$12.91Bn, or 2% growth, behind management's forecasts of $12.77–$13Bn at 1—3% YoY growth.
- Implied ROIC expectations of 5.9%, plus an expected reinvestment rate of ~91% bottom-line earnings.
- A required rate of return of 2–11%, depending on various stipulations outlined later.
- Earnings and sales expectations
HSIC sells at 13.93x forward earnings as I write and is priced at ~14.5x forward EBIT. At its current market value of $9.6Bn and EV of $12.78Bn, this implies the market expects $5.27/share in earnings and $881mm in pre-tax income (12,780/14.5 =881). This equates to a 2% decline in FY'23 earnings and 0.34% in pre-tax income. At consensus estimates out to FY'24 and FY'25, the market expects 8% and 9.4% annual earnings growth, respectively. This brings the avg. growth estimate to around 5% across FY'23 to FY'25 (Figure 2(a)). Using the same reasoning the market expects $12.91Bn or 2% growth in sales (12,780/0.99 = 12,910). HSIC management's forecasts for FY'23 are observed below.
Source: BIG Insights, Company filings
- Expectations on returns on capital and capital deployment
HSIC is also priced at 2x EV/invested capital, meaning investors have priced its investments at a 1x premium. This is a flat market return on invested capital. Moreover, comparing its business returns (outlined later) of ~11–12% to our 12% threshold margin (hurdle rate used here), the economic value of HSIC's investments comes to 0.98—1x.
Comparing the market returns on capital to its business returns—the latter as a no growth multiple—the firm's earnings power looks well captured at its current market cap. The expected market return on capital (1/(EV/IC)xROIC) looks to be 5.9% at the time of writing (1/(2x11.7%) = 5.9%). The expected reinvestment rate is obtained by looking at implied ROIC and growth rates (RI = g/ROIC). Given the growth rates outlined earlier, this implies the market views HSIC to reinvest ~91% of pre-tax earnings over the coming 12 months, otherwise $797mm.
BIG Insights
- Required rate of return
The average expected earnings growth rate over the coming 3 years is 5.3%, as mentioned earlier, with FY'23 expectations of $5.27/share (using consensus EPS forecasts). These are reasonable estimates to bring out to FY'28 in my view. Thereafter, I've capitalized the continuing value at our 12% hurdle rate. The market's required rate of return is the discount rate needed to match the projected earnings back to the current stock price (the present value), amounting to 2.1% here, ranging from 0.8% to 11% under various scenarios shown in Figure 2(a).
Two things are obvious from this:
(i). The expected risk in investing in HSIC is perceivably low (given the low required rate of return to compensate for the risk and predictability of cash flows),
(ii). The expected growth rates for HSIC are relatively low and match up with estimates from earlier.
2. Comparison to economic drivers
Critical insights are gained from the way in which HSIC is creating (or destroying) economic value for its owners. The key insights include the following:
(1). HSIC had employed $48.80/share towards capital required to run the business by Q2 '23. It produced $5.73/share of trailing NOPAT on this, 11.7% return on existing capital. This is down on prior periods. We employ a 12% required rate of return on capital across all current + potential holdings. Hence, we're not at rates above this threshold margin at this time.
(2). Comparatively, from 2020–date, it had deployed an extra $12.50/share of investment to growing the business, producing an additional $1.88/share in post-tax income, or 15% return on incremental capital. Note in Figure 3 that earnings after tax have been flat since 2021.
(3). The company assumes an acquisition strategy to growth. Its capital allocations have been to M&A over the last 3 years. As seen in Figure 4, a 2.2% growth rate in sales produced avg. operating margins of 7.6%. But each new $1 in sales came with $0.05 in NWC, $0.04 in fixed capital, and $0.335 in acquisitions, totaling $0.49 on the dollar of investment for each dollar in sales growth.
(4). Critically, the economics of HSIC's profitability aren't attractive in my view. This is a low-margin, relatively low capital turnover business. Post-tax margins hover ~6%, whereas the ratio of sales to capital is ~2–2.1x, not enough to overcome the margin pressures.
Consequently, we have a situation where the profits produced on HSIC's investments are not economically valuable (when considering a 12% hurdle rate). As a result, it would appear the company's acquisition strategy is not compounding its intrinsic value, potentially eroding shareholder value instead.
BIG Insights
3. Market-generated data
Market technicals are equally as unsupportive based on the data presented in Figures 6 to 9.
One, money flows into HSIC's equity have been weak in the back end of FY'23, as seen below. These follow heavy outflows in the first half, where capital flows bled the company's market value and relative strength vs. the U.S. benchmark ( VOO ).
Figure 6. Money flows into/out of HSIC from 2022—date. Flows in the back end of '23 have been soft.
Data: Updata
Two, trend positioning doesn't support a bullish view either, as seen in Figures 7 and 8. On the daily cloud chart, both price and lagging lines are beneath the cloud, calling for a reversal above the $76 mark to see a more constructive trend. On the weekly chart in Figure 8, both price and lagging lines tested and failed at the cloud base, and have tracked lower since this point in time. Here I'd be looking to a move closer to $80 by Jan/Feb next year to form a bullish view.
Figure 7. HSIC Daily Cloud Chart, looking to the coming weeks.
Figure 8. HSIC Weekly Cloud Chart, looking out to the coming months.
Unsurprisingly, we have downside targets extending as low as $64 and $55 based on the prevailing trend action. These objective targets are critical to gauging price visibility in the near term, and it would appear HSIC is primed to continue its descent, unless there is a sharp reversal spurred on by either a key catalyst or broad market rally.
Figure 9. Downside targets to $64 then $55. A break lower would certainly activate these targets.
Data: Updata
4. Confirmation/Derivation from market expectations and valuation
The value drivers shown in Figure 5 are reasonable expectations to carry forward in my view. Management explicitly stated the desire to continue acquisitions, and sales are tipped to grow at 2-3%. Figure 10 outlines what this would look like moving forward with a conservative view, keeping sound economic principles. In my view, with the wind-back in COVID-19 sales, HSIC could throw off ~$490–$560mm in TTM FCF, keeping 11–12% ROIC and compound its intrinsic value at ~2% each period. This might require $265—$413mm in quarterly investment, on capital turnover of ~2x.
Note that:
- The projected sales are in line with consensus and management estimates, so no major divergence there.
- Investment requirements to hit these levels are actually ahead of implied expectations, which could crimp the present value of FCFs below what's already priced in.
Based on this, the evidence for differing from the market's view is negligible in my opinion.
BIG Insights
The stock also sells at 13.9x forward earnings and ~14.5x forward EBIT, as mentioned. Extending the above estimates out to FY'28, then discounting at the 12% hurdle rate, provides an implied value of $81–$82, ~11% value gap. Not a wide margin of safety. This is supported by the market's pricing of HSIC when compounding its intrinsic value at the function of its ROIC and reinvestment rate, as seen in Figure 12. This corroborates a neutral view.
Discussion summary
Based on the data presented here, there is lack of conviction to suggest the market has mispriced HSIC incorrectly in my view. Instead, the culmination of economic factors continues to suggest it has been an accurate judge of HSIC's intrinsic value. Most critically, the combination of:
- Low margin, relatively low capital turnover business model,
- Acquisition-heavy growth schedule with the bulk of capital allocated to M&A,
- Flat performance on existing and new investments,
continues to indicate a flat equity performance moving forward. HSIC must do a better job at demonstrating its propensity to create value past the pandemic-era, and illustrate to us how its acquisition strategy is set to create value above the cash value of each transaction. So far, I'm not eyeing evidence of the same. These things considered, I reiterate HSIC as a hold.
For further details see:
Henry Schein: Economic Value Matches Market-Implied Expectations, Reiterate Hold