2023-06-06 02:27:39 ET
Summary
- Patterson Companies appears undervalued, trading at a 40% P/E discount to peers.
- PDCO's earnings power and asset profitability, along with a potential mispricing on fundamental and valuation fronts, suggest the stock could be undervalued by 15-20%.
- The author reiterates PDCO as a buy, looking for a $3 billion market value or $31 per share, based on the company's growth initiatives and respectable dividend yield.
Investment Summary
As the current macro-milieu continues to evolve beneath our eyes, the window of selective investment opportunities continues to widen. The market's expectations have been sloshing around for the last 6-months, leading to many potential mispricings. In my last coverage of Patterson Companies, Inc. ( PDCO ) I argued that two critical factors underpinned the investment debate:
- The firm's generous returns on existing and incremental capital (fundamental factors);
- Valuation factors, with the stock trading at a 60% P/E discount to peers at the time in September 2022.
Back then, what was missing was the change in sentiment needed to drive the company's market valuation to new heights. Still, as the late singer Meatloaf screamed, "2 outta 3 ain't bad", and the company's Q3 numbers , coupled with the above-mentioned points, demonstrate to me there's a potential investment opportunity.
On factors or earnings power and asset productivity, PDCO appears undervalued in my view, and it appears investors aren't paying more than 12x forward earnings to buy the company today, still a 40% discount to the sector. PDCO is in a unique situation where its TTM revenues of $ 6.4Bn are greater than its current market cap of $2.64Bn as I write, meaning the firm has more in gross asset value ($2.94Bn) than its entire market valuation. Net-net, I am reiterating PDCO as a buy, looking for a $3Bn market value, or $31 per share.
Figure 1.
Before proceeding, investors must understand these key risks to the investment thesis:
- There is scope that PDCO will miss the stipulated projections made in this report. If so, there's scope for the market to react unfavourably to this.
- Continuation of the long-term downtrend in PDCO's market valuation, as a sharp reversal is required to change sentiment.
- Market-specific factors, including the current narrow breadth of the broad indices, weak market internals, and volatility, can cause prices to become disconnected from fundamentals.
- Macroeconomic factors that must be considered including tight money, the strain in credit markets, geopolitics, inflation and interest rates. These have shown to impact all market participants and cannot be overlooked in this sense.
- To that point, PDCO has ~$465mm in debt outstanding on the balance sheet, which could be sensitive to sharp changes in rates. It has been diligently paying this down each quarter, but the interest expense was $11mm last quarter, above the $1.2mm in Q3 FY'22.
These risks must be understood in full before proceeding with any investment decision.
Q4 earnings preview
PDCO is expected to report Q4 and FY'23 earnings on June 22nd. Management project to report earnings of $1.96-$2.06 in FY'23 and adj. earnings of $2.25-$2.35. Interestingly enough, this was above consensus estimates at the time of PDCO's Q2 numbers. However, there's been 2 sell-side analyst revisions to the upside during the last 3 months, despite 6 revisions down for turnover, and consensus now project $2.27 in earnings from PDCO this year. Management do not guide for revenue either. Still, looking at the YTD numbers, you're looking at total sales of $4.75Bn, $170mm in operating income, and $1.36 in earnings.
Taking these and applying these to management's estimates, you'd expect the firm to produce at least $0.60-$0.70 in Q4 earnings to get there. The Q4 gain is in-line with the firm's seasonality trends. Anything above that number would be very constructive in my view. Looking to my numbers, I've got PDCO to do $2.32 in FY'23 earnings, calling for quarterly EPS of $0.96, therefore above management's and consensus estimates. This adds to my bullish view, and even in a downside scenario, I'm getting to ~$2.10 in earnings, still above management's view. Getting me there are the strong returns on capital and economic earnings PDCO is set to produce rolling forward (discussed later). It is reasonable to believe that it can throw off these kind of earnings to shareholders whilst still maintaining its growth rates, given the profitability factors.
Table 1. FY'23-'27 projections
Q3 earnings dissection
Numbers were fair for PDCO last quarter with upsides marked throughout the P&L. It pulled in 30bps YoY growth in turnover to $1.6Bn (adjusting to 180bps with FX headwinds removed) , on OpEx decline of ~60bps and 13% YoY gain in quarterly earnings to $0.62.
The major takeout from Q3 in my view was the 30bps YoY increase to gross margin to 21.4%. A 10bps mark-to-market accounting adjustment on the equipment financing portfolio underscored this impact on the gross margin. Looking at this through a productivity lens, Figure 2 exemplifies PDCO's gross capital productivity on a rolling TTM basis since 2020. Here, the TTM gross profit is divided by the total operating assets each quarter to ascertain the gross profit produced per unit of total assets. You can see that as of Q3 FY'23, the company produces $0.45 on the dollar from its asset base, an increase above the c.$0.40 2-years ago. To me, this suggests that every $1 PDCO has invested, 45% of that comes back as gross each TTM period, to be then fed down the P&L.
Figure 2.
Looking to the segment highlights, in my opinion there were several takeouts from each division [Figure 3]. To name but a few:
- Dental
- Dental net sales pulled in 440bps lower YoY, driven by lower volumes and a high comps period last year.
- The bulk of this downside was driven from lower sales across the board, particularly in core dental equipment sales sliding from $241mm to $216mm.
- This is something to keep a close eye on in my view, because over the last 8 quarters, the dental segment has grown at an average 13%, therefore this could signal either a) the average growth rate is too high, or b) the growth rate could mean-revert back towards the 13% range.
- It pulled this to a $4mm YoY decrease in dental operating income to $60.3mm.
- Animal Health
- Net sales increased by 4.6% YoY, underscored by growth in the companion animal business of 7.4%. Meanwhile, the production animal business reported flat growth of 1.4%.
- Both sub-divisions were influenced by competition forces. Essentially, an essential branded product came off patent, thereby creating more generic competition in the segment. Excluding this impact, organic animal sales increased 240bps YoY.
- This pulled to a 29% YoY gain in operating income for the segment to $30.2mm.
- Corporate Division
- The firm's corporate sales didn't share in the same good fortune as its other two segments. Despite an enormous increase in turnover to $9.7mm, it still booked a $14.5mm operating loss.
- This is a marked improvement on the $26.7mm operating loss last year, however I'd like to see it hit the black in its corporate division sometime soon to unlock future value.
In total, the firm booked $75.9mm in operating income from its 3 major divisions, a $15mm or c.25% YoY increase in pre-tax earnings. This is a steady number and evidences the tremendous operating leverage on show here, with the 30bps YoY gain in revenue corresponding to a 25% gain in operating income, otherwise 8.3 turns operating leverage.
Figure 3. Segment Performance [Revenue, Operating income]
Additional critical factors
A further analysis of PDCO's ability to create value down the line is warranted. The firm embarked on a number of growth initiatives in Q3, including capital investment to its sustainable warehouse in the U.K., its loyalty program [Patterson Advantage], and so on.
The long-term investment and corresponding profits PDCO has made since 2020 are observed in Figure 4. The total capital provided to the firm (equity, debt) is shown alongside the capital PDCO has put to work as operating assets ("capital at risk"). It is shown that PDCO has ramped up its capital base from $1.3Bn at risk to $1.35Bn at risk over the last 2-3 years. This represents ~86% of the total capital provided, sparing room for the firm's $1.04/share dividend (45% payout).
Figure 4.
Putting this data into context, note the following points regarding PDCO's incremental profitability [Also observed in Figure 5]:
- Since 2020, operating Expenditures have increased 11% from $970mm to $1.08Bn in the TTM, behind the 18% cumulative gain in turnover.
- The firm has produced an additional $62mm in pre-tax earnings on an incremental basis over this time.
- PDCO is also increasing the amount of cash thrown off to shareholders, with free cash flow available to owners up from $164mm to $202mm (TTM figures).
- Alas, the return on PDCO's existing capital remains well above the 12% hurdle rate (long-term market average).
To me this suggests a couple of very important things. First, the economic earnings ( those profits earned above the cost of capital ) PDCO is producing are creating value for PDCO shareholders in my view. I want my companies investing their own capital at rates higher than what I can achieve elsewhere, in order to unlock value down the line. PDCO is in fact doing this, with the average economic profit (ROIC - hurdle rate) covering 4-7% over this testing period [Figure 6]. Second, it tells me of the company's earnings power, in that it is actually high, where it converts free cash flow to shareholders at 103% of the TTM net income as of Q3 FY'23.
For a firm to create future value for its shareholders, it should be generating a return on its invested capital above the hurdle rate. Since I observe PDCO achieving this for its shareholders, but the market trading it near 52-week lows, this tells me of a potential mispricing on the fundamental and valuation fronts. These two factors may also instil a change in sentiment once recognized, very important to seeing PDCO rate higher in my view.
Figure 5.
Figure 6.
Valuation and conclusion
On factors of earnings power and asset profitability PDCO appears undervalued at a 40% discount to the sector , or ~12x forward earnings. This, coupled with 0.84x PEG ratio implying the company's projected earnings growth may not yet be accurately priced in. Looking further, we've got PDCO at 10x forward EBIT and 2x book value, each evidence of either value disconnect or value added, respectively.
Consider the following:
- At the current market cap of $2.64Bn, and a 12% discount rate, the market expects $317mm in pre-tax income from the company (317/0.12 = $2,641).
- With these same stipulations, and the TTM EBIT of $252mm, this tells me the market is expecting 4.6% geometric growth in pre-tax earnings from PDCO over the coming 5-years getting you to the $2.64Bn, more than achievable in my view ((253x(1+0.46)^5/0.12) = $2,639).
My numbers call for PDCO to do $6.4Bn of business in FY'23 and $6.5Bn next year, calling for $301mm and $371mm in pre-tax earnings, respectively [see: Table 1]. The market's estimates call for 4.6% YoY growth to $264mm in pre-tax income for PDCO, hence, I am above the market's consensus and believe this creates a mispricing opportunity. On my numbers, I've got PDCO at $3Bn market cap or $31/share in FY'24 and to me this suggests the company could be undervalued in the range of 15-20%, a respectful margin of safety and potential for valuation re-rating. This also corresponds to 13.7x consensus FY'23 EPS.
As much is supported by objective findings in the quant grading system [Figure 7]. This supports a buy thesis.
Figure 7. PDCO Quant Ratings
At the present valuation of c.12x forward earnings, ~8x operating leverage and PDCO throwing off ~$200mm in trailing cash to shareholders, it appears that investors aren't paying attention to PDCO's prospects to unlock future value. The market has PDCO discounted a value that expects fairly benign earnings growth of 4.6% p.a. over the coming 5-years, a figure PDCO can surely outpace in my view what with growth initiatives discussed in this report and the respectable 3.86% forward dividend yield that isn't discussed here. My numbers value the company at $3Bn market cap or $31 per share. This in mind, I am reiterating PDCO as a buy on fundamental and valuation grounds, in the belief these two factors may pull through to sentiment into the mid-term.
For further details see:
Patterson Companies: Earnings Power, Asset Factors Suggest Mispricing