|Shares Out. (in M):||162||P/E||17.1||16.9|
|Market Cap (in $M):||4,797||P/FCF||17.4||16.0|
|Net Debt (in $M):||1,119||EBIT||365||375|
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The former dental products segment of Danaher was spun-out via IPO on 9/18/19 at $22/share. Danaher distributed the remainder of its shares in an exchange offer that just closed 12/18/19. Envista, as it is now called, was built over fifteen years through the roll-up of twenty-five companies; they own some of the oldest brands trusted by dental professionals and hold the #2 position in the $23bn global market for dental supplies and equipment (behind XRAY). XRAY runs at 23% adjusted EBITDA margins, and Envista runs at 15%, by my rough estimate if they can get margins up to XRAY’s level the stock has 50%-60% upside. Given heavy participation from the analyst community on the Q&A portion of the company’s first earnings call in October, even signs of a definitive turn in margins may be enough to take the stock price upward. So, this is a high-quality franchise undergoing a margin turnaround.
The company serves over 1.0mm of the 1.8mm dentists in the world and generates about $330mm of free cash in a normal environment on $2.75bn of sales. Key public information may be found on pages 106-119 of their latest disclosure related to the exchange offer at https://bit.ly/399Bqp1. Note that the Street sees roughly $300mm next year and that a 1% change in margins (given historically high FCF conversion rates) can lead to an approximate 8%-10% change in FCF ($2.75bn * 1% * FCF conversion factor close to 1 = $27.5mm, and $27.5mm / $300mm = 9.2%).
A full 8% improvement in Adjusted EBITDA margins would translate to $2.75bn x 8% = $220mm of incremental Adj. EBITDA on say 12x (arguably 14x) would imply incremental equity value of $2.64bn and a share price ($2.64bn/162mm = +$16 share) in the mid-to-high $40s about 50% above today’s level (referenced earlier). Leverage is 2.7x Net Debt to EBITDA and management is targeting roughly ~3.0x. The CEO has observed in public statements that FCF has generally exceeded Net Income, so it seems reasonable to conclude that the company would be efficient at converting incremental EBITDA into free cash. For comparison, Envista has (again) $2.75bn of sales and employs 12,800 persons with a salesforce of 3,000; XRAY has $3.9bn of sales, 16,400 employees and a salesforce of 4,000.
Sales are divided 48%/52% between the (1) Specialty Products and Technologies segment and (2) the Equipment and Consumables segment. Constant currency revenue growth in Specialty Products and Technology was as follows: ‘17A 4.0%, ‘18A 3.5%, ‘19E 3.1% and EBIT Margins were ‘16A 19.0%, ‘17A 19.7%, ‘18A 18.4%, and ’19E 17.3%. The 1.7% approximate decline in margin over the past four years is obviously not great, but it’s not the prospective source of margin improvement that we’re trying to understand. Constant currency revenue growth in Equipment and Consumables was: ‘17A -3.5%, ‘18A -2.3%, ‘19E -1.8% and EBIT Margins were: ‘16A 14.6%, ‘17A 11.7%, ‘18A 9.1%, ’19E 6.9%. This is the problem. Margins in the segment have fallen by more than half while revenue has declined low single digits in each year.
Envista benefits from the secular trend toward an older, wealthier, global population that needs (and can increasingly afford) better dental care. Geographically, sales are 48% North America, 23% Western Europe, 23% “High Growth Markets” and 6% Rest of World. After the US (44%) China (7%) and Germany (6%) no one country represents more than 5% of sales.
Specialty Products and Technologies consists of Nobel Biocare Systems (dental implants) and Ormco (orthodontics). The Equipment and Consumables segment consists of fourteen different brands all related to dental equipment and supplies used in dental offices, including digital imaging systems, software and other visualization systems, handpieces and associated consumables, endodontic systems, restorative materials and instruments, rotary burs (i.e. drill bits), impression materials, bonding agents and infection prevention products. At a company-wide level, dental implants from Nobel are 40% of revenue and 33% of profit, the Ormco is 15% of revenue and 24% of profit, and consumable products (part of Equipment and Consumables) are roughly 25% of sales and 25% of profit.
To the company’s credit they have built a significant franchise in China (900 employees) that grew sales 44% from ’16-‘18 (‘16A $130.8mm, ‘17A $155.2mm, ‘18A $187.9mm). This is in contrast to Germany, for example where sales have flatlined (‘16A $167.6mm, ‘17A $166.1mm, ‘18A $164.7mm).
With respect to new products in the Specialty Products and Technologies Segment, in 2020 they are launching a product to compete with Invisalign, the Spark Aligners, as well as the N1 implant system. Spark is a little cheaper an a little clearer than Invisalign but may cannibalize some traditional orthodontic dental sales and works in about 65%-70% of cases vs Invisalign at 70-80%. It’s currently in use in Australia/New Zealand. The N1 implant system is their first new system of this type in about eight years and requires fewer drill holes in the jaw performed at slower speed. If you are interested to learn more about the products, go back to the link from above and see what the company’s 800 talented R&D professionals have generated. These new products may push growth in the segment from 3% to say 5%, all else equal. While important for the stability of both segment and company performance, it’s away from the key issue: sales and margins in the separate Equipment and Consumables segment.
The company attributes margin pressure in Equipment and Consumables to distributor “inventory destocking,” “unfavorable mix, and “pricing headwinds.” From 2016 to present, North American distributors of dental equipment and supplies have cut inventory about 30% in response to M&A and the rising aggregation of previously independent customers into DSOs (dental support organizations). DSOs run the non-clinical side of a dental office and will hire new dentists or acquire existing practices – in some cases with the help of PE funds. On the M&A side, Patterson, one of the top three US distributors of dental equipment and supplies, lost an exclusive relationship with a major manufacturer called Sirona, as a result of the Dentsply/Sirona deal that formed XRAY.
In the long run, Envista actually likes these DSOs because some are building their own receiving centers and could buy direct. Recall that Envista can meet 90% of a dentist’s needs because of the breath of their product portfolio. In the short run, however, DSOs represent less pricing power for Envista.
In 2015, Benco, Henry Schein (HSIC) and Patterson (PDCO) distributed roughly 85% of all the dental supplies and equipment in the $10bn US market. All three were sued that year by the FTC for discriminating against so called GPO’s (Group Purchasing Organizations). The following year increasing numbers of dentists began to join GPOs to gain the advantages of collective purchasing power. Today, a dentist who does not want to join a DSO might instead join a GPO for better equipment and supply pricing, and remain in independent practice. As an aside, Henry Schein was not convicted but the other two players were found guilty and as of November of this year both declined to appeal.
The filings are sparse on detail about GPOs and make limited reference to DPOs. Note the following anecdote from a dental trade magazine on GPOs.
“We began by compiling the data from our dental office as well as my uncle’s office. We have two separate practices operating out of the same building. Everything about our practices are separate except the building and three front office staff which we share. We were both purchasing supplies and capital equipment from the same distributor, same sales rep, same ship-to and very similar yearly spend. Upon examination of the data we learned that the two practices had different pricing on 95% of exact same items. Needless to say, we were shocked, but also extremely interested and motivated to learn what can we do about it.
Throughout the past two years my team members and I have spoken with upwards of 2000 dentists on supply chain, various models and our own model. Over time, we began to notice several trends. It was and continues to be extremely common for a dentist to say either during the presentation or after, “I’ve been with the same people for a very long time and I know I’m getting a good deal and being treated fairly.” How do they know? The truth is they have no idea. What I’ve seen is that the blind follower is often taken advantage of more than anyone else. There is no risk of this dentist leaving. There is no contracted pricing. The dentist is complacent, trusting and naive. It creates a perfect storm, or in the eyes of traditional dental supply chain models, a perfect customer.
The transparency that data can provide is of the utmost importance. If you never see your pricing stacked up against your colleagues how can you possibly know how you’re being treated. The dentists that had these sentiments and allowed us to show them the data comparing their practice’s pricing compared to their colleagues and/or IndepenDENT Dental Solutions pricing were often the most shocked to learn they were paying 18-33% more than their colleagues. How could they not know? The reason is the lack of transparency and the strategies implemented to keep them complacent and trusting.”
We know that 90% of Equipment and Consumables are sold through distributors and that DSOs and GPOs are in this bucket. Envista discloses only that Henry Schein, a traditional distributor, represents 14% of company sales and is the largest single customer. So, 90% of sales to distributors x 52% of total company sales in Equipment and Consumables – 14% for Henry Schein = 32.8% of the mix attributable to the two other main distributors (Benco and Patterson), DSOs and GPOs. What’s concerning here is that GPOs (and arguably DSOs) have developed over the same period margins have declined, and we don’t know what percentage of the mix they represent. That said, even if we did know, we’d still be in the same place, waiting for the company to report evidence of margin improvement.
The global dental products industry generated approximately $23bn in sales last year (as mentioned above), and Envista accounts for roughly 12% of that figure. The space is fragmented such that 38% of the market consists of sub 1% players; XRAY, the number one player, has 16% share. Although Envista already offers 90% of the products a dentist needs, a large number of companies inside the 38% cover the remaining 10% of products (i.e. roll-up targets). So, with ~$300-$330mm/year of free cash to spend, the roll-up strategy may be a helpful offset if Equipment and Consumables continue to lag.
Tracking the Turnaround
Core sales growth in Equipment and Consumables was down -3.0% in 3Q19A versus a decline of -5.0% in 3Q18A. On a sequential basis the -3.0% decline was a worse that the -1.0% in 2Q19A. 2Q18A, growth was actually +0.5%. The business exhibits some seasonality with equipment purchases more prominent in the back half of the year. Though based on guidance, in 4Q19E sales would be down -7.0% in this and up +3.0% in Specialty Products and Technologies.
3Q19A Equipment and Consumables margins were 9.1% up sequentially from 8.4% in 2Q19A but down from 10.9% in 3Q18A. Notably 3Q18A margins had sequentially declined from 11.7% whereas 3Q19A, margins slightly improved. So, the margin story, while in the early innings, appears to be getting slightly better. 4Q18A margins were 14.2% and 4Q19E guidance implied margins are 12.0% (and 16.4% in Specialty Products and Technologies where 4Q18A margins were 17.0%).
Envista is a heavily followed spin-off with depressed margins and a #2 market share position in a sub-segment of the med-tech space with highly attractive secular characteristics. A 30% drop in industry inventory over three years, combined with the rise of DSOs and GPOs, have shocked the Equipment and Consumables segment. But the company is telling us the worst is over. If they are right, and demonstrate margin improvement, the stock has around 50% upside. If they are wrong, then the segment continues to stagnate until eventually their other businesses lines overtake it. In the meantime, tune out the noise and keep an eye on incremental margins in Equipment and Consumables.
The company reports 4Q19E in January - watch for quarterly core sales growth in Equipment and Consumables of better than -7% and operating margins in better than 12%.
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