Henry Schein, Inc. (HSIC) Earnings Call Transcript & Summary

Good morning, everyone, and welcome. We're very pleased to have Henry Schein presenting today at the conference. My name is Michael Minchak, and I'm a member of the health care services equity research team here. For those of you who may not know, Henry Schein is one of the leading distributors in the dental and the medical products area as well as with technology and value-added services. So today, with us, we have CEO, Stanley Bergman; and CFO, Steve Paladino, to tell us more about the story. We're going to do a little bit of a different format here today with a fireside chat. And following the session, we'll have breakout questions in -- across the hall in the Georgian Room. But before we begin with that, I'm going to hand it over to Stanley to make some introductory comments, and then we'll get into the Q&A.

Thank you, Mike. Thank you all for being here. I'll be very brief because I'd rather have more Q&A to find out what's on your mind. But essentially, Henry Schein is the largest provider in the world of dental products and products to office space practitioners. Our dental business, of course, has a leading distribution platform. It's more or less in all developed countries but also growingly now in the developing world, parts of Africa, quite active in Brazil, China, Thailand. At the same time, we are the leading provider of practice management software, have a joint venture with Internet Brands, a KKR company, where we've not only taken our platform, our practice management software, but we've added to that electronic medical records and all sorts of other kinds of demand-generation software and patient financing-type applications. At the same time, we've advanced our position in specialty products -- dental specialty products, which is also an area that is doing well. So the goal has been to have a greater part of our gross profit coming from fast-growing areas in dentistry, namely equipment, value-added services and specialty-only products. Complementing our platform is -- on dental is our business on the medical side, which focuses on the alternate care market, providing products to physicians, surgery centers. Procedures are moving out of the hospital into the alternate care setting, and this is another area that has grown significantly for us in the years to come. The goal is, again, in the aggregate, to grow our top line organically somewhere around 4% to 5%, we've got a pretty good track record of doing that; increasing our operating margin and driving efficiency in our SG&A; driving positive EPS growth, which includes a little bit of buyback of stock. And we've done this quite well for the last 25 years and believe we have a very good strategy to continue to do this in the years to come. Mike, I don't know if you want anything more generally speaking or anything on the numbers, but...

No, we could start with the Q&A.

Then let's -- why don't we just go into Q&A.

Great. So maybe just to start off, big picture. Just looking to get a sense for sort of end market demand in the dental business. We see the CMS data that shows that dental service spending is increasing 4% per year, and it's forecasted to grow at roughly that same rate over the next 10 years. Can we sort of focus on the broader trends that you're seeing in the dental consumables business, I mean, we do have some positive economic indicators that -- but yet, the consumables market remains a little bit more subdued, stable but subdued. Can you talk about -- do you think we're going to see a reacceleration of the growth rate there? I mean if we look back 10 years, growth was sort of in the mid-single-digit range. We're less than that now. But do you think there's a path to get back to that? Or do you think you see any catalyst that could drive that acceleration?

So on general consumer spending with dentists, the data you're getting from CMS, could it be a little bit higher, could it be a little bit lower, I think generally, my sense and there's no hard data to prove it either way, it's more or less in the right ballpark. I think what we found is that in the U.S. GP market, the growth in the number of procedures has been modest, but also, there have been some challenges in selling branded products. I think the private brand has increased a little bit, but overall, the spend on GP national brand products has not grown significantly. Having said that, specialty products are growing. Equipment is definitely growing, and the spend on software practice management and related technology is also growing significantly.

Okay. It's a good segue into a couple of the other topics that I'd like to visit. So maybe just starting off with dental equipment. We do hear a lot about the digitization of the dental office. Can you talk about where we are in sort of the innovation cycle, how you see that driving dentist demand for equipment? Given some of the recent new product launches, do you see -- do you think that's going to accelerate growth in the near term?

The whole equipment category remains robust. Basic traditional equipment is solid. The chairs, units and lights are okay. Over the last 3 or 4 years, we've done very well with the A-dec line, and we never carried the A-dec line before. And now generally, we are seeing our customers spend more money with perhaps better equipment, higher-end range. A-dec is the beneficiary. On the imaging side, units, I think, are okay, but the price has compressed a little bit, 2D, 3D. And then on the digital side, we've seen significant growth, whether it's in the scanner -- the DI scanner only or on the full chairside system. We, of course, have done well in that area, specifically with DI and, to some extent, historically, with the full chair system, but we didn't have the Sirona line until 2.5 years ago. That line has been introduced to Henry Schein and has done very well. Now I'm referring, of course, to the U.S. And so we've been able to capture some of the winds, the positive winds that are the direct result of practitioners investing in their practices. So overall, I would say the equipment category is doing well. Pricing is pretty stable except in the imaging area, where the price of these products has come down, but I think it's more or less stable right now. Hard to tell precisely, but I don't think the erosion that occurred in the last couple of years is continuing.

If we drill down a little further into that -- into the CAD/CAM area, which I think is your biggest category of equipment if we include sort of the full CAD/CAM as well as digital impressioning, where do you see current penetration? And where do you think you can go to and over what time frame?

Yes. Again, it's hard to have specific data, but if you compare penetration of CAD/CAM in the U.S. to where it is in Germany, where, of course, CEREC was launched 30-plus years ago, it is much lower. I would imagine that in the next decade, DI and even the full chairside system will become more standard of care. So if we're in 25%, 20% penetration on full chairside systems, it's not there, it's much less. We have a long way to go. So we remain pretty optimistic. And we also remain optimistic that new technology will be introduced, and anytime you have new technology, it's good for the business.

Maybe just to segue into the dental specialties area. You guys have talked about that as a big growth opportunity for you, so things like implants, bone regeneration, ortho and endo products. How big are those relative to the overall size of your dental business? And how fast is it growing? And sort of can you talk about the relative margins of those products?

It's about just over 10% of our dental business, and the margins are significantly greater. We, I think, in 2 particular areas are doing extremely well. One is in the implants and bone regeneration area, the oral surgery. We have 2 leading brands: CAMLOG, which is the leading premium brand in Europe sold at a discount, the leading player in Germany, for example. And in the U.S., we have BioHorizons, which is a leading brand, value -- leading premium brand sold at value pricing. The bone regeneration business is very good. Intellectual property resides at ACE Surgical, which is either #2 or #3 in that space, probably closer to #2. We're doing well growing our penetration in that area and more recently, introduced -- or acquired an interest in Medentis, which is Europe's, Germany in particular, leading provider of economy implants. So overall, our portfolio is very good in that area. The other area that our portfolio is very good is in the endodontics. We have a very good brand in the Brasseler brand, which is #2 in that field. It's a distant #2. But we also own an interest in Edge Endo, which is the leading value provider of endodontics. Of course, patents have matured in that space and Edge Endo is doing well. The orthodontics is relatively flat because we've invested significantly in the aligner area, and so that took our focus. But if we add all 3 of these together, we've had decent growth anywhere from mid-single digits to high single digits quarter-to-quarter.

Okay. So maybe to elaborate on the aligner products. So you've launched 2 different products in the last year, 1 to GPs and 1 to the ortho market. What do you see as the near and long-term opportunity in that market? Obviously, it's a competitive market. Can you talk about what you think differentiates your product and sort of what the reception in the market has been to this point?

So we have a competitive offering in the specialty area. It's a hybrid model using traditional and the aligner working together. Look, there's opinions -- we have KOLs that support us that tell us we have the best solution, but of course, it's a matter of opinion. We have a good solution there. I think the product itself is very good. It's very stable. The area we need to improve on, and we are doing that, is in the software that supports this product. And we expect that the software will integrate nicely with the Henry Schein line of products, so we believe we will have an advantage over time. And we're not talking about a long time, sometime in 2020. But the area where we see the real upside is with the Reveal line, which is a version of aligners that is very easy for GPs to use and is a very, very good tool for GPs to use as they compete with the direct-to-consumer product offerings. We want to be careful to introduce this in an orderly manner. We have capacity but want to be careful as to how we use that capacity. We have some DSOs that have signed up for this, 2 of them. We expect them to take up a lot of demand. These DSOs are doing important work in the pediatric and in the adult orthodontics space but have not had an aligner yet and so we gave them a good solution. So this whole area is an area we want to -- we're quite optimistic. But we want to make sure that we iron out all the bugs. I think the align -- the Reveal line is pretty stable today and is doing okay. But as we scale this up, we want to make sure that we can delight our customers because in this area, buying from Schein, they would expect Schein service, and we need to make sure we give them service that's commensurate to the brand.

Okay. We talked about your equipment business earlier. But as we think about some of your software and technology offerings, we're now 18 months since the close of the transaction with Internet Brands to form the Henry Schein One JV. How has that JV tracked relative to your expectations with respect to growth and cross-selling opportunities, synergies? Has there been any surprises, positive or negative? And taking a step back, can we talk a little bit more about the offering and what's some of the unique products you have that are sort of driving growth? And any opportunities around the rollout of new products?

Everything takes longer and is more difficult but we're very pleased with the progress. I think you saw some good progress in the third quarter. We're very optimistic about that business short term, medium term, long term. And quite frankly, we're not in any way changed in that view. So from the positive side, we have seen significant interest in demand-generation software that enables patients to make appointments directly with the practitioner. Perhaps on the negative side, we were challenged with the integration on some of these products, Internet Brands to Henry Schein's core business -- Henry Schein One's core business. A lot of that is already behind us. It just took longer. It's a little slower. But we are very, very optimistic about this business and think we're going to create huge value both in -- we already are, but both in terms of operating income but also stickiness with our other businesses, whether it's our core distribution businesses, from a consumable point of view, equipment point of view or our specialty businesses, where there's huge opportunity to connect with the specialty businesses. We now have very good software for all specialties in the oral surgeon and orthodontics. And we're very optimistic about the U.S. platform expanding further into Canada and our international platform.

Okay. One of the areas that gets a lot of attention on your quarterly earnings call is around margins. Historically, you've targeted 10 to 20 basis points of operating margin expansion. Obviously, there's some unique factors that may impact that growth in 2020, stranded costs, investments in the business. Maybe can you talk about some of those key factors that's going to drive the margin expansion going forward? Is it gross margin? Or is it...

So now you're asking a factual question. Steven should answer that.

Thank you. So we still feel confident that we can continue to expand our operating margins, and our goal is still to get about 20 basis points per year. 2020 will be below that because we have a couple of headwinds. We still have to eliminate some stranded costs with the animal health spin-off but that will take a little bit of time to achieve, and we're also stepping up some IT investments for some technology that we think will pay good dividends. The way we expect to get there is -- I think if you look at the total gross margin, the total gross margin will be relatively flat year-to-year. Now the components of that, there might be a little bit of margin compression on the core general practitioner products, but also we'll see expansion of the margin because we'll shift more of our business to higher-margin product categories. And the 2 specific areas there are continued growth in dental specialties as well as continued growth in technology and value-added services, both of which are much higher margins than the core business. And so gross margin should stay relatively consistent, and we expect to get leverage on the SG&A line. And some of those specialties and technology products do carry significantly higher operating margins also. So we still feel comfortable that we can get that operating margin expansion, but 2020 will be a bit less than that because of the 2 headwinds that I've just mentioned.

Okay. Maybe just to shift gears a little bit. In addition to the dental business, you're also a leading player in the medical distribution market, which I think sometimes gets overlooked. Your growth in that business has been very impressive. I think you've exceeded the market growth rate by 2 to 3x over a pretty extended period of time. If you can talk about the drivers there. I know you've talked in the past about focus on large customer accounts, big large group practices. Is your growth coming mainly from winning new practices or sort of expansion within existing practices as their footprint grows?

Well, about a decade ago, we were known as a good provider of products to small physician practices. Just over 11 years ago, we formed a group focused on large group practices and IDNs. Today, there's not a bid that goes out of any size where we're not a contender, and often, we win these bids. So 2 things are happening in that market. One is there's a movement of procedures from the acute care setting to the alternate care setting, just an organic growth in the market, and that is expected to grow significantly as the sophistication of technology improves. And for example, orthopedic procedures that had to take place in a hospital will now start being more focused on in the alternate care setting. But the second is that we have an excellent product offering, both in terms of logistics and in terms of the support we provide, including the software for procurement and supply chain, and we offer several hundred value-added services to customers in that space. That has been understood. 3, 4 years ago, in these markets, the IDNs thought that they could get much better pricing from the big hospital suppliers so they gave these awards out to the hospital suppliers who really couldn't satisfy the needs of a stockless inventory system for physicians. Slowly but surely, the procurement offices in these big IDNs are starting to realize that you need to go to a company like Henry Schein that can put 6 med-surg products in a box together with a vial of an injection and a tablet and a capsule that's needed for a procedure the next day. So I think our brand awareness has become more important. People recognize that we provide this outstanding service, all within the context of a rapidly growing market. So the dynamics are in a good place.

Okay. Maybe a question for Steve. One of the key positives with respect to the Henry Schein story is your strong cash flow and balance sheet. Your current leverage ratio is around 1x. What do you see as the target leverage ratio? If you don't have a specific target, is the focus to remain investment-grade? When you think about capital allocation, you've generally deployed capital through a mix of share repurchase and acquisitions, sort of tuck-in M&A. What areas do you see a lot of interest or opportunities in? And would you be willing to do sort of a larger, more transformative deal if it made strategic sense?

Sure. So first, we're not embarrassed that we have a very strong balance sheet. We actually think it's a competitive advantage. I think that the business can handle more debt, although I'd like to be still in investment-grade land if we did increase debt. The capital allocation will continue to be strategic acquisitions and stock buyback. And people that have followed us have seen that most of our acquisitions are smaller compared to the size of Henry Schein. But when you string 10 or 12 of them together in a year, they actually become meaningful for the year. There are a few larger ones. We would be certainly open to doing a larger acquisition if it met our strategic and financial hurdles. I do think the cash generation also -- just to talk about that. There is opportunity to improve our cash flow. Specifically, we think that we can improve our inventory turns over the next couple of years. We're targeting at least 0.5 turn improvement over that 2-year period. We think that's still a good opportunity. So strong cash flow generation. I think one of our strengths has been our capital allocation and really being prudent in how we deploy capital. We do have internal metrics like return on investment and accretion and others that we focus on. And if it doesn't hit that hurdle, we're probably not going to do the acquisition. Remember we report acquisitions on a GAAP basis and our EPS on a GAAP basis, and I know a lot of people have moved to cash EPS. Cash EPS -- to me, it would be impossible at almost any price for us to do a dilutive deal on the cash EPS. So I think that the way we're looking at it, which is looking at all costs, is the preferred way, although I know there's a lot of debate about that. But in any case, it does make sense to make sure that we're targeting the right returns on investment, which we do. So we can increase leverage a lot. But unless there's a significant acquisition, we're going to generate close to $600 million of operating cash flow, and that should be growing similar to earnings growth. So there's a lot of free cash flow that we can continue to use to invest in the business.

Okay. I think we have just about a minute left. So just maybe wrap up with sort of a big-picture question that we've been asking all of the companies. As we sort of sit here, if we look ahead to 2021, what is it that you think investors will better understand about your story that they might not appreciate right now?

I think the big area of miss is to understand the businesses other than the business that sells branded consumable products in the U.S. It's a global business in the dental distribution field. We're selling equipment. Our private brand is growing. There's the specialty areas. There's Henry Schein One, and there's the medical business. So as the latter all become a greater percent of our gross profit and we become more efficient in running the business, we generate the profits. Of course, we have to overcome the hurdle of the spin-off of Covetrus, which we're dealing with, and that's a year or 2. And also, we want to invest significantly in software. So taking all of that into account, I think you'll continue to see a very good projection in terms of bottom line and, in particular, cash flow because our goal has always been to turn our profits into cash. So I'm not sure if that full story, each one of those components is really fully understood.

Okay. Well, thank you. We're going to take questions across the hall in the Georgian Room.

Thank you, Mike.

Thank you.