2023-07-29 01:03:15 ET
Summary
- Following extensive review, I've pared back the rating on Henry Schein, Inc. to a hold.
- A raft of factors have impacted the company's economic characteristics and value proposition in my opinion.
- The company's economic profitability is negligible, and future value opportunities may be hindered unless a change in the facts emerges.
- Net-net, revise to hold.
Investment briefing
Following my February publication on Henry Schein, Inc. (HSIC) there have been multiple updates to the critical investment facts. Notably, these have impacted my viewpoint on the company and its inclusion in long-biased equity portfolios.
As a quick reminder, the investment tenets discussed on this channel-also used to identify selective investment opportunities-are relatively simple, and not too jazzy. Long-term positioning is the focus.
That involves:
- First, identifying high-quality businesses that are able to sustain high returns on capital employed.
- To ensure longevity and above-sector profitability, companies whose advantages are difficult to replicate are a plus.
- To that effect, a robust balance sheet, with low capital intensity is desirable, with leverage well contained also. There is also a case for companies impervious to the business and credit cycles.
Perhaps most importantly though, I want names that add a layer of certainty to their growth outlook-those who reinvest their free cash at high rates of return, and above the market return on capital. Valuation is therefore an ancillary benefit to these kinds of economic characteristics.
Consequently, as Keynes reportedly said: "As the facts change-I change my mind", and the investment facts have changed for HSIC, as mentioned. The dental and medical supplies giant doesn't present with the same economic rigour looking forward it has done in times gone by in my opinion. Back in FY'22, I advocated HSIC presented with a "resiliency premium", making it a standout amongst the list of names heavily sold off last year. This proved to be a defensive trade to help managers immunize the downside in the equity risk budget.
But markets are forward-looking. And, they are fairly accurate over the long-term, meaning HSIC's recent repricing says a lot [Figure 1]. My analysis is also forward-looking, and as you'll see in this report today, key findings suggest the risk-reward calculus is now balanced, versus a heavy weighting to the upside.
In that vein, I am paring back my rating on HSIC to a hold, for reasons discussed here in this report.
Figure 1. HSIC setting lower lows/lower highs [note: weekly bars]
Changes to critical investment facts
The major alternations to my thesis stem from fundamental, sentimental and valuation perspectives. Within the fundamental component, this relates explicitly to the changing economic characteristics of HSIC's business. My findings illustrate the company's value proposition is creating less value for shareholders than times gone by. Part of this is from base effects [due to the presence of Covid-related sales and turnover], but most is due to the raw economics of the company's operations.
1a. Fundamental factors
The company's last numbers , presented back in May, are quite telling. As a quick reminder, HSIC is set to post Q2 FY'23 earnings in August. Therefore, all numbers discussed here will be compared to those presented next month.
Most prominently, there's been a substantial reduction in absolute sales/earnings as Covid-19 sales wind off. You get a good sense of this calculus in action in Table 1, below. It shows the key YoY revenue drivers to April 30, 2023. Note, the 17% decrease in quarterly medical and healthcare distribution sales, keeping in mind that seasonality effects are accounted for (we are comparing Q1 vs. Q1 in different years). Critically, observe that:
- Covid-related declines accounted for an 8.8% reduction in quarterly turnover.
- Whilst it still grew sales by ~$3mm, this is far behind the top-line movement over the past 2-years.
- Adjusting for ex-Covid and FX headwinds in Q1 FY'21-'22, revenues were up 6.3% YoY.
Table 1. HSIC Q1 FY'23 revenue growth driver
Note: All dollar [$] figures show the change in booked revenues from Q1 FY'22-Q1 FY'23. These are shown as percentages in the subsequent column. Total Revenue Growth shows the same in both instances, and is not the absolute revenue booked for Q1. (Data: Author, HSIC SEC Filings)
HSIC will thus need appraisal without any attention to the segment-or term-of Covid-19 moving forward. No longer will base effects apply, even though it still clipped ~$150mm in Covid-sales in Q1 ($600mm annualized). This will likely roll off further and we'll get a more 'organic' picture of HSIC's operations moving forward. Why's this a talking point? Because management were adamant on Covid-sales clipping by ~40% this year, and now expect this to reduce by ~70%. This is still, after all, a source of income for the company.
What this says about the company's trajectory is telling. Ex-Covid revenues were all up YoY and I've got the company to do $13.8Bn at the top line by FY'24, stretching up to ~$14Bn in FY'25. You're looking at ~4-5% annual growth rates at these estimates, and I've got this pulling to ~8-9% in earnings growth over the same time. Good earnings leverage-each turn of revenue could produce 1.8 turns in earnings if this comes true-but as I'll show below, this may not create the kind of shareholder value one might expect on face value.
Figure 2. HSIC Covid-19 sales breakdown and declines
Data: HSIC Investor Presentation
1b. Economic characteristics
A firm creates additional value for its shareholders when it 1) recycles free cash flows back into the business, 2) invests this capital into new [or existing] growth opportunities at 3) high rates of investment return. The 'return' aspect is measured in additional profits and FCF.
Given its size, scaling up existing capacity and/or operating efficiencies aren't always so easy to achieve. Acquisitions therefore become a talking point, to which HSIC has been quite active in recent periods. It recently acquired Regional Healthcare group to expand its Australia-New Zealand footprint. Last period, it also acquired S.I.N Implant System, a $60mm revenue company from Brazil.
Brazil, you might say? Quite an interesting market to expand into. The Brazil dental equipment market is forecast for 5.8% compounding growth into FY'28, with demand equally as high. The S.I.N acquisition will fold into its existing operations, providing direct access to this. Brazilian corner of the market. Finally, it opened a majority stake in Biotech Dental , a company that also offers dental implants, having done so for the last 35 years. HSIC posits these bolt-ons could provide an additional $100mm to its top line, based on FY'22 pro forma numbers. Both acquisitions are said to align with the company's "BOLD+1 Strategy". Per HSIC's 2021 annual report:
In short, our 2022-2024 BOLD+1 Strategic Plan positions our Company to BUILD ("B") complementary software, specialty, and services businesses for high growth; OPERATIONALIZE ("O") One Distribution to deliver exceptional customer experience, increased efficiency, and growth; LEVERAGE ("L") One Schein to broaden and deepen relationships with our customers; and DRIVE ("D") digital transformation for our customers and for Henry Schein....+1 = Pursuing Profits and Purpose - Stanley M. Bergman, HSIC Chairman [and CEO at the time].
With HSIC's capital budgeting strategy, a full appraisal of its propensity to create future value is required. With this, I've provided a full reconciliation of the shareholder capital tied up in the business through to its conversion to owner earnings below, and what this means for HSIC moving forward.
- Capital commitments
- The firm has leveraged up substantially over the last 2-3 years. It issued an additional $451mm in debt over the last 3 quarters alone, whilst retiring ~$7mm at the same time.
- The leverage effect, or equity multiplier, is quite pronounced, at 2.42x ( ROE /ROA = 5.58%/13.53% = 2.42x). Thus, the sector-beating 13.5% trailing ROE is less appealing, being driven by leverage effects.
- Moreover, it has retained $3.6Bn in earnings from shareholders over its lifetime. In total, HSIC has ~$4.4Bn investor capital tied up in the business [debt, equity].
- Of this amount, it has committed $5.9Bn-or 132% of the capital provided to the business. In other words, it has reinvested an additional 32% of cash flows to fund operating capital.
- Goodwill is included in all of this calculus given the firm's acquisition strategy.
Figure 3.
Data: Author, HSIC SEC Filings
- Gross productivity, post-tax earnings
- At the gross level, the firm sees ~$0.45 in gross income for every $1 held in its asset base. This has grown linearly from $0.35 in Q3 FY'20 [all figures are in TTM values].
- In my view, this needed to have crept up substantially in Q1, and has to in Q2 FY'23 as well. You can't expect to grow earnings ahead of the market when only <50% of operating capital recycles back to gross in my opinion. The economics simply don't add up.
- Balancing this fact, HSIC clipped $743mm in trailing post-tax earnings last period, another ~$160mm since 2020. Thus, it is pleasing to see the net effects of HSIC's Covid-19 sales over the last 2 years pull through to this level.
Figure 4.
Data: Author, HSIC SEC Filings
- Economic profitability
- What matters most in this appraisal is the net effects the above points have to HSIC's valuation and future prospects.
- You'll see it has increased owner earnings-defined here as post-tax income less new investments/divestments-quite substantially. It came to $812mm last period (TTM values). This as the result of a major reduction in capital density from FY'22.
- This stems from generating returns on capital employed of ~12% over this time frame. I benchmark the "market return on capital" here at 12%, given long-term market return averages of 10-12%. Thus, HSIC has failed to beat the market return on capital in this series.
- As a result, the economic profitability of the firm-its return on capital employed less the hurdle rate of 12%-is negligible, running at -1% to 0.5%.
Figure 5.
Data: Author, HSIC SEC Filings
This is absolutely critical to the debate. Firm's typically need to produce economic profits, not losses, in order to create value for their investors over the long-run. If not, then growth is actually detrimental to value. As has been the case for HSIC of late-earnings growth described earlier hasn't pulled through to the economic side of the business.
Moreover, a firm can compound its intrinsic value as a function of the returns on its investments, multiplied by the amount it actually invests to do so. Whilst the returns HSIC has pulled back from the capital it has put to work, it hasn't ploughed back free cash flows to size up additional profits across the line (no more than 20% of profits have been reinvested over the last 2-years). Instead, acquisitions have been the strategy. Cool-except that acquisitions typically create the least value for shareholders, and neither acquisition or organic operations have added anything to ROIC or owner earnings these past 3 years. Hence, it appears all the 'Covid-profits' haven't been recycled into value-creating opportunities as of yet, based on my examination.
As a result, HSIC hasn't compounded its intrinsic valuation at above-market rates, nor have investors priced it as such in the marketplace. Note the periodic change in market value from December FY'21 to date (keeping in mind the bear market last year) in Table 2. Still, whilst all S&P 500 sectors are now above their 200DMA's, HSIC has languished. Remember-markets are forward-looking, so the divergence is telling.
Table 2. You can see the intrinsic value growth rate not keeping up with market values
Note: Market return on investment is calculated by the change in market capitalization each period divided by the company's invested capital on a rolling basis. (Data: Author, Refinitiv Eikon)
2. Sentimental factors
We can see the change in sentiment in HSIC's equity stock via two ways.
First, Wall Street analysts have made 13 downward revisions to HSIC's earnings growth outlook over the last three months. This, in combination with 7 reductions in revenue outlook. It's not all bad-there's been 7 revisions to the upside for sales growth as well. Hence, this supports a neutral view, but does not support a bullish outlook.
Two, options-generated data tells me that investors are hedging a downside move in HSIC via the large open interest in September puts at strike $80. This demand is not shared on the calls ladder, with investors loading up on calls of the same strike depth in the chain. Complex options strategies also allow investors to profit in sideways markets, and this could be evidence of the same. Without the motives of investors to go by, however, this is just my opinion.
Collectively, these points support a paring back to a neutral viewpoint.
3. Valuation factors
You might find that investors selling HSIC at 15x forward earnings is quite attractive, being a 26% discount to the sector. This, and 11x forward EBITDA-also 14% discount. However, consider what you're getting in paying these multiples.
One, factor in growth projections. Sure, 15x forward is an attractive number right now on face value. When factoring in a growth variable, the picture is less colourful. Don't forget, if you presume no forward earnings growth, your payback period is 15 years at a 15x multiple. We can ascertain the adjustments for growth in two ways. First, my numbers project HSIC's earnings growth of 8% in FY'23 and 9% in FY'24. As you'll note below, folding this into the valuation calculus, 15x forward does not appear to be attractive. You'd be paying $15 for every $1 in future earnings, only for this to lag substantially. In fact, my estimates suggest HSIC would need to nearly double its bottom-line fundamentals to ~16% earnings growth in order to justify paying the 15x today.
Figure 6.
Data: Author
Two, based on a function of the return on capital employed and the cash flows HSIC is deploying at these rates, the company appears fairly valued at its current market values. Compounding the firm's valuation at the "intrinsic value growth rate" shown in Figure 5, you'll see my numbers don't deviate too far off the market's view, to date anyway. These estimates look at the potential cash flows HSIC could produce over the forecast period, the investments it could make, and the profitability of these investments moving forward.
Figure 7.
Note: Implied market value is comprised with an initial taking of the firm's market value, then compounding this at the "intrinsic value growth rate" of [ROIC x Reinvestment rate]. All figures are TTM in the calculations. Market values above the line by more than 1 standard deviation are considered "overvalued". Those 1 standard deviation below are considered "undervalued". Within this range is fairly valued. (Data: Author, Refinitiv Eikon)
Extending this out over my forward estimates to FY'25 (rolling TTM basis), I've got HSIC at an $11.9Bn market valuation, or 15% upside potential over this forecast period. This isn't an exciting number to position against, and there's no dividend income to support the total return of holding HSIC long in this instance. Moreover, $11.9Bn in market value gets me to $90/share, 15% upside, as mentioned, but not enough to get me over the line. Discounting this at 12% (the hurdle rate used in this report) to the present gets me to $80, around about the current market value, thus supporting a neutral view further.
Figure 8.
Note: Same points as in Figure 7 apply. (Data: Author)
Discussion
Based on the valuation symmetry derived from this HSIC analysis I believe the firm is fairly valued at present. Markets are forward-looking, discounting the company's future expectations into an equilibrium price point. Given the similarities in my forward estimates to the market's pricing of HSIC, I would presume expectations are as neutral as my own. At the end of the day I get to $90 share by FY'25 in the company's intrinsic value, ~$80 discounted to the present. I'd expect a present value much higher than this in order to reiterate a buy rating. Keep in mind, findings here are based on:
- Projected future cash flows and investing activities by the company;
- Returns on capital employed (trailing and projected);
- The relationship between both points (1) and (2).
Consequently, based on the economic characteristics of the business (both trailing and projected), my outlook on the company as an investment grade holding have weakened. I thus pare back my rating on HSIC to a hold, always ready to re-capitalize and enter long if the critical facts turn in HSIC's favour again. Until then, I believe ~$80 is fair for the company at this point in time. Look out for its Q2 earnings in the next month or so, laying careful weight to this analysis to observe any convergence or divergence from the forward estimates. Net-net, reiterate hold at $80 valuation.
For further details see:
Henry Schein: Not Shining At 15x Earnings And No Intrinsic Growth (Rating Downgrade)