Why This Healthcare Stock is Starting to Look Like Good Value
Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
In a recent article I discussed the issue of perspective and investment style and how it affects the decision to buy a stock or not. As a growth at reasonable price (GARP) investor, it’s hard for me to fall in love dentistry supply company Patterson Companies (NASDAQ: PDCO). The stock has had execution issues for a while, and revenue growth was anemic in the last quarter. Nevertheless value investors are likely to find a lot of interesting things about the company and I would suggest they take a closer look.
Harvester of Sorrow
The investment thesis is based on its attractive long term end market drivers and the idea that it will sort out its execution issues in time. The dental market is set to benefit from favorable demographics in future years. Higher numbers of older people with more teeth per mouth means more trips to the dentist and spending on dental provision. Long term, things look good, but it is the near to mid-term that looks problematic.
I’ve highlighted a few immediate considerations.
- The macro-economy is causing weak spending on core equipment in the US
- Austerity measures in Europe are hurting dental spending
- The company keeps harvesting sorrow by missing estimates with one segment weak, then another
- Although technology spending is good, it is hard to tell if this is being compensated with lower core equipment spending
Against these concerns, the company does have many positive points. Free cash flow remains very high and there are plausible reasons for the earnings misses in the last couple of quarters. As discussed at the time, Patterson missed last time thanks to the sales mix contribution from consumables. Last time around dental sales were good but consumables missed with a relative increase in sales from the lower margin consumables.
This time around dental equipment sales missed estimates with the weakness coming from things like core equipment (chairs, light, basic equipment). Meanwhile technology equipment spending did well in the quarter with the company talking of mid-single digit increases in technology spending in the quarter. As noted above, it is not clear if this is because surgeries are cutting back on spending on basic equipment because they were waiting to spend on technological upgrades.
Furthermore, gross margins were weaker than expected thanks to lower than anticipated Omnicam deliveries from Sirona Dental Systems (NASDAQ: SIRO) plus higher than expected upgrades from Redcam to Bluecam imaging products from Sirona. Upgrading to Redcam carries less margin than Omnicam and the lack of availability hurt the company. No matter, this is a good sign for future Omnicam sales and, although it will take over a quarter to sort out, it augers well for future sales.
Like I said, plausible reasons.
In defense of Patterson, it appears to be doing the right things. I’m a big fan of Sirona and discussed it recently here; Patterson’s extension of its exclusive distribution agreement with Sirona (which now covers its complete product line) is surely an attempt by Patterson to expand sales in the higher growth technological segment of dental.
Moreover, it is not just about dental. Patterson also has a strongly performing veterinary supplies business called Webster which recorded 13% internal growth in the quarter. Frankly, I think this is another good long term growth marketplace as companion pet spending has proved very resilient and is subject to favorable long term social trends. You can’t divorce your dog. Patterson is a distributor for Idexx Labs (NASDAQ: IDXX), a stock I like very much but am simply not willing to pay 30x its earnings for.
….And Health Care for All
In fact, if you add up the parts for Patterson, it is arguable that selling Webster (or the higher margin medical rehabilitation segment would realize significant value to shareholders. Indeed, something like MWI Veterinary Supply (NASDAQ: MWIV) is trading at a heady looking 26x earnings compared to Patterson on 15x earnings, even though Patterson’s overall business has double the operating margins. The difference is that MWI has growth and the market is willing to pay for it. Indeed, with Pfizer planning to spin off its animal health business, the industry is in a state of flux at the moment. With these sorts of developments, don’t be surprised if there is some industry consolidation to follow.
Nothing Else Matters
Patterson is doing the right things, but history suggests that when a company repeatedly disappoints, even for seemingly plausible reasons, it always takes longer to sort out than is expected. Full year guidance was lowered from $2.10-2.16 to $2-2.06 as a result of the Omnicam issue with Sirona and because management was cautious on the outlook, particularly in Europe.
With that said, it is generating a lot of cash flow with which it is engaging in buybacks, and on a sum-of-the-parts basis it looks relatively cheap to other companies. It is a tempting value play, but don’t be surprised if not all the moving parts work in sync every quarter.
SaintGermain has a position in Pfizer. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!