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

Okay. Great. Good afternoon, everyone. My name is Nathan Rich, and I cover the dental space here at Goldman Sachs. Thanks, everyone, for joining for this session with Henry Schein, a leading distributor of products, technology and services to both dental and medical practitioners. I'm joined for this session by Stanley Bergman, the company's Chairman and CEO; as well as Steve Paladino, the company's CFO. Steve, I believe you wanted to start with a disclosure statement first, and then we'll pass it over to Stanley to share some opening remarks. I'd also just like to remind everyone -- I think you know the drill by now. [Operator Instructions] So with that, Steve, why don't I turn it over to you?

Okay. Thank you, Nathan. I'd just like to note that certain comments made during this call may include information that's forward-looking. And as people know, the risks and uncertainties involved in the company's business may affect the matters referred to in those forward-looking statements. As a result, the company's performance may differ from those expressed in or indicated by such forward-looking statements. And all of these forward-looking statements are qualified in their entirety by the cautionary statements contained in Henry Schein's SEC filings. So with that, I'd like to turn the call over to Stanley, who will make some brief introductory remarks.

Thank you, Steven. Nate, thank you for hosting us. I'll try and leave as much time as possible for questions. So just very briefly, Henry Schein is the largest provider of products and related services to office-based dentists and physicians. Our business is global. We have a dental distribution business, the largest of its kind in the world; a medical distribution business focused on office space practitioners, ASCs, ambulatory surgical centers, urgicenters, renal, cancer type centers. We have a value-added services business, which is -- a significant part of that is our Henry Schein practice management and electronic medical record business, also, I believe, the largest of its kind in the world. And then we have a specialty business focused on oral surgeons, implants and bone regeneration products, endodontics and orthodontics, both traditional orthodontics as well as an aligner offering. It seems like the traffic in dental offices is coming closer to what it was in 2019. In the U.S., a reference point could be the ADA survey, but that's a few -- several weeks ago, over a month ago, I believe. And the sense we're getting is it's coming closer to the 100%. There's still a couple of parts of dentistry that are not fully back to 2019, hygienist, for example, although it's getting closer. On the medical side, basically, visits are back to normal, except for vaccines. It's a little bit behind where it was in '19. And then the ASC, the ambulatory surgical center, electives procedure part is a little bit behind as well. Our business in dental has been good across the world. We indicated in our call, our last investor call in April, Nate, that our back order -- the backlog for equipment was quite strong going into the quarter. Our strength is our complete offering of products and related services that really puts a moat around our customers, gets them -- there's a lot of stickiness there because of the complete array of products and services that we offer. What's of recent interest is that we were awarded a part of the strategic national stockpile contract for PP&E storage. The technology and value-added services is an area we continue to invest in. We've had 2 announcements recently. One is the investment in Jarvis, which is a data analytics business; and most recently, eAssist, which we announced this morning, which is a business that helps practitioners in their collection of billings. It doesn't sound very exciting, but it's one of the biggest challenges practitioners had. They bill 100 cents, and they don't get anywhere close to that number. So this service helps. So Nate, happy to answer any questions you may have, or the audience, of course Steven as well. We're both ready to answer questions.

Okay. Thanks for the introduction. I guess maybe going back to your comments on the dental volumes in the U.S. being back to normal, I think based on your first quarter results, obviously, you saw a very steep improvement in the first quarter. It seems like it maybe continued to get a little bit better. What is the shape of sort of the recovery, if you want to call it that, look like now that we're kind of back to 2019 volumes? Is there a potential that we could run above 100% for a period of time? I'd just be curious to kind of get how you're thinking about that.

Yes. I was referring more to dental visits, which is what I think the ADA covers, not necessarily the volumes. I think the billing by dentists is getting closer, but it's not 100% there either. I expect that it will continue to grow over the balance of the year. And I would say in the medium term, the dental profession, we'll see further acceptance of the importance of oral care. There's a lot of studies that have come out showing a direct correlation between good oral care and good health care. I think insurance companies and employers are understanding that dental care is important. So I think the 2019 number starts being -- from a billings point of view, will start getting closer to that and then will slowly continue the growth that we've experienced over the years.

And from your point of view, do you think anything has changed structurally for the industry overall? I guess either from the demand side and the consumers' willingness to spend on oral care or from the practitioner side saying that, "Hey, I've learned to be more efficient. I've learned to do a broader range of procedures, and so I can treat more," and that's going to lead to more durable demand for dental services over time.

Well, I think one thing that has significantly improved is the understanding that same-day dentistry is important, that the number of visits, if possible, can be reduced, and we've seen that, which leads to the whole world of scanners versus manual impressions. I think there is -- like with every industry in the world, there's a great appreciation of technology, of digitalization of the business, of dentistry. I think there's a greater demand now for cloud-based software, for example. So technology has taken a significant movement in a more positive direction, which is quite good for our business, so general efficiency in the practices there. Of course, there's been an elevated level in PP&E. I don't think the levels of 2020 are sustainable specifically because N95 masks, though in significant demand, are not the standard of care. But the number of units is going to be quite much -- quite a bit higher than in '19. And at the same time, the prices will be up from '19 but nowhere near the '20 number. So I think that's grown. And generally, I think the solo practitioners are viewing as important to go into 2-, 3-, 4-person practice. There's a growth in the mid-market DSO world. The very large groups are growing, but they're, in many respects, challenged with obtaining enough practitioners. They have the capital. But I think what we're seeing is the mid-market groups are growing quite nicely, and the very small solo practitioners are moving up. Steven, do you have any other further thoughts that perhaps you could add to this?

Well, I think you covered it partly, but the market, when it's fully back, we expect to be larger than the pre-COVID levels primarily because of PPE. The PPE level of usage will stay at these elevated levels. There will be a little bit of pricing decline, but still, it will be above. And we think, despite what you see with consumers -- and consumers right now, a lot of people are not wearing masks because the CDC has recommended that if you are vaccinated, you don't need to. But I think in the health care provider setting, masks, gloves, sterilization and all the things that they're doing will stay. I was recently at my dentist. He was wearing 2 masks and a face shield and, of course, gloves and everything else. Now I asked him, "Is that all needed?" He said, "Well, it gives me a little bit more security, but it also provides more confidence to patients. Patients like to see that you're doing all these procedures." So I think it's going to be the new standard of care.

Yes. I mean it's really been surprising if we kind of look across the health care continuum. It seems like dental definitely came back faster than many other areas. Obviously, the practices were quick to adjust their protocols and made it safe to go back to the dentist. I guess like when we look forward, do you kind of feel like this was sort of the get back to 2019 level here? And when we look out to 2022, we see growth that would be more indicative of what's considered kind of historically normal for the industry?

Yes. I think that's correct. But I also think there's this overriding understanding on the importance of oral care. 2020 was a dislocation year. It's some catch-up. I don't think it's huge. I think there's some, especially with some of the higher acuity procedures. But I think dentistry will continue to be a growing field, globally.

Yes. And I think most of the comments that we've had so far have been focused on the U.S. It'd be great to get an update on Europe and Asia Pac and just where you think those markets are relative to what we're seeing in the U.S. right now.

Yes. Let's start with Asia Pacific. Our presence on consolidated sales side is in China and Australia, New Zealand and Thailand. They're all doing okay. Thailand is not doing okay, but it's relatively small. It's still in lockdown. We have a business interest in the third largest distributor in Japan. We do not consolidate. Business is pretty good in Japan. Then you come to Europe, and the continent is okay. It's come back pretty nicely, never went down as much as the U.S. So it's -- I would say most of Europe is okay. Of course, Italy and Spain had big challenges during COVID, but that's long -- more or less long gone. U.K., there was a reimbursement challenge, the way in which the NIH funded. The reimbursement of dentistry was dentists were not incentivized to work. They've gotten closer to incentivizing in the normal way. It's coming back to where it was. Then you go into the rest of the world. Brazil, we have a very nice business there. I would say that's doing very well, although Brazil has still a big challenge with COVID. But our service is good, and we have a capital that's needed to fund our business, which our competitors are a bit challenged with. And then in North America, Canada was a little slower than the U.S., but it's moving close to 2019 levels, and we discussed the U.S. So the world here is moving closer to '19, maybe even more in -- outside the U.S.

Great. And then from a market standpoint, I just kind of wanted to round out the discussion with equipment. Stanley, you mentioned the strong backlog in the fourth quarter. That's translated into stronger equipment sales in the first quarter. It sounds like you still feel good about where the backlog ended the first quarter in terms of -- as an indication of future demand on the equipment side. I guess do you feel like the -- anything has changed with the market longer term? Obviously, the importance of technology, like you said, has kind of been made very apparent with the pandemic. Do you think coming out of this, we see maybe wider adoption or faster adoption of a lot of the digital technologies that are out there than we did prior to the pandemic?

Yes. Digital dentistry has -- like with all technologies, has moved very fast during COVID. But also the idea that people don't want to go to the dentist 3x for a crown is something that is also playing into that way of doing dentistry. The whole idea of same-day dentistry, I think that's grown quite nicely. This -- we have a number of sources of product. You know who they are, and that's good. The traditional equipment is also growing, but I will also say that there is a slight challenge that -- especially on the chairs, units and lights side. The capacity is even back to where it was before the #2 player in the market closed, went out of business. So there is a slight challenge, not material for the whole of Schein. But the market right at this moment can't keep up with the demand.

The -- I wanted to ask about the Heartland contract. You won it back this year after about 3 years. I know you don't -- probably don't want to get into the specifics of the contract, but maybe at a high level, can you talk to the value that you think you brought to this new deal and that contributed to you winning back the contract?

Yes. Obviously, we can't get into margins. In fact, we try not to announce every time we win a contract. But generally, we've done very well in the DSO space, whether it's the very large DSOs, which are generally owned by private equity, and the midsize practices DSOs. What we bring them is the way we started the presentation, the widest variety of products, whether it's the branded products, our private brand, our more specialty products combined with the most unique value-added service offering, whether it's in the practice management software, electronic medical records, different kinds of e-commerce programs that we offer. And we have our financial services and our various kinds of consulting services. These are all of value to be offered to these practices, DSO operators. And yes, every now and again, we lose one. I'm pleased to say that very often, they come back because we do provide an outstanding level of service, which, of course, includes maintaining the equipment in the office, installing the equipment, designing the office, installing it, servicing it. It's a complete package to help the practitioner operate a more efficient practice so that they, in the end, can focus on clinical care. And it's what we've been doing for years. It's what we do well.

And it seems like based on your earlier comments, you've maybe seen more growth in that middle market segment of the DSO space. Could you maybe elaborate on that a little bit and talk about kind of your penetration in that middle market space relative to the larger DSO space?

Yes. I don't think we have -- it's a fluid market by definition. I can't tell you -- and as Steven -- I'm sure Steven has some more specific thoughts. But we don't have specific data on market share because how would you define that market? But generally, these midsize practices, 5 to 100 practices, have done well. I would say our market share is very good in that area. Look, we started servicing and focusing on the needs of these kinds of accounts in the mid-'90s, early '90s, before anybody even recognized there was a whole movement towards DSOs. So we've had an outsized market share in the DSOs, midsize and the large ones, for -- since the '90s. So they continue to grow and we grow with them. Steven, I don't know if there's more data that you have available or that we even share.

Yes. There's really not more data. But I think Stanley is right, we have, we believe, an oversized market position with the mid-market as well as the large DSOs. We're probably north of 70% of the large DSOs in market share. That's also a fluid number but something in that range. I don't have a good estimate on the mid-market, but it's greater than our overall market share, definitely.

And Steve, is it fair to think about the DSO contracts as being lower gross margin but lower cost of service? And so from an operating margin standpoint, sort of around the average, I think that that's kind of what you guys have said historically. Is that still the right way to think about it?

Yes. It is lower gross margin. It is lower cost to serve. But where it nets out is to a little bit lower overall average operating margin.

Okay. Makes sense. I wanted to move over to medical. Maybe Stanley, if you could maybe elaborate on your introductory comments just around patient volumes. Have you seen any differences between like the sites of care that you serve? It sounds like we're maybe still below pre-pandemic levels, but just any more color there that you have on the kind of the base medical business.

Yes. The base medical business continues to grow across the board. We are -- we do well with large IDNs. The IDN movement has understood over the last few years that you can't go to a hospital provider to get your physician office needs satisfied. Look, we provide 6 tenable items in a box, vaccines. If a controlled drug is needed, it's one drug. It's not pallet loads delivered. It's a very different business. So we have gained a lot of credibility in that space in servicing the needs of a large provider like an IDN or a large group practice that has multiple locations under common management. So we've done well in that space. We've also done well in servicing the smaller practices. And there's not that many solo practices left. We do quite well in servicing. We have unique logistics reporting capability. Some of those are -- practices are still a little bit impulse buying. So we have promotions that are unique in that marketplace, flyers and catalogs and messages, et cetera. And we're also in a number of niche areas, kits. We service the urgicenter, the surgery center, all these different -- now there's a workplace area that is important. The government is becoming increasingly a purchaser of product. Government used to buy a lot of products direct from the manufacturers, but they realize that we can do a better job of controlling the inventory for them. They don't have to buy a lot and throw away expired product. So generally, our medical business is solid. It had a disproportionate growth, I think, in PP&E and some tests. But if you take that out, it's a pretty good business.

And I did want to ask on the COVID testing front, given some of the commentary that's been in the market about declining test volumes, obviously the vaccination rollout. The, I think, COVID testing revenue declined about $90 million sequentially from 4Q to 1Q to $180 million for the first quarter. I guess it seems like the pace of the decline has maybe accelerated in 2Q. I guess do you agree with that? And are there any differences between the test that you're selling and the sites of care that you're selling into maybe relative to the broader market just as we think about sort of the cadence of testing revenue this year?

Yes. Steven maybe can address the specifics.

Yes. So you're right on the volume. We did $270 million of test kits in Q4. It was down to $180 million in Q1. I know there's a lot of conversation on this because one of the manufacturers came out recently with a statement that volumes will be down. It's not new news for us, Nate. We expected that on our Q1 call. Obviously, as the vaccine starts to continue to get rolled out, there will be less need for test kits. And there's also new test kits that are coming out at lower ASPs, average selling prices, than the previous one. So for both of those reasons, we expect test kits to go down. But it's not again new news. That was contemplated in Q1 when we gave our guidance at that time.

And PPE...

I'm sorry, Nate.

Yes. I'm sorry.

On the contrary to that, in 2020, fourth quarter and 2021, we hardly sold any traditional flu tests, which is a big part of our business because obviously, there's no flu. So we expect that, that will go closer to normal in the fourth quarter and again in the first quarter next year, which will balance some of this.

I see. Yes. That's a good point. And I just wanted to clarify one of your previous comments on PPE. So it sounds like when you put it together, PPE volumes will remain above pre-COVID level's price, maybe a little bit more uncertainty on where that settles out, but maybe slightly above where it was in 2019. So kind of net-net, when we get to a new normal, offices will probably be buying more PPE than they did previously. And so that will be additive to your revenues relative to what you saw pre-pandemic.

Yes. And Steven, I don't know if you're giving any scale. I don't know what the guidance you've given.

No. We're not giving specifics on it, but your comments are right on, Nate. We think the pricing -- during 2020, pricing of certain PPE products went sky high. Some products were 2, 3, 4x what we were previously paying for the same product in 2019. A lot of that price increase has come down already now, but it's still got a little further to go, especially on gloves and specifically on nitrile gloves. But you're right in when you look at where it will be 2021 in long term, it will be at higher levels than pre-pandemic. So the market has expanded because of this new usage. I think it's going to stay at these high levels.

Okay. Great. And Steve, maybe sticking with you, I wanted to move over to margins. Can you maybe just start by reminding investors what the primary drivers of the step-up in gross margin was in the first quarter and kind of how you're thinking about gross margins over the balance of the year?

Sure. So we saw a very nice step up in gross margins in Q1. It was related to primarily 2 items. One is the inventory adjustments that we were experiencing in Q4 and Q3 of 2020. Came down significantly. So that helped the gross margins. And also vendor rebates also increased not at 100% of pre-COVID levels but increased significantly over Q4. So what we said on the conference call is that we believe that gross margin that we achieved in Q1 will remain relatively consistent for the balance of the year. Obviously, we can't determine if there's any unusual things that happen in the marketplace. But assuming nothing crazy, we do believe that the gross margin will stay relatively consistent for the balance of the year. I'll just add to it, Nathan, that on the operating margin, we did say that it won't be at the same 8.4% for Q1 because there'll be some additional expenses that we want to invest in, in the balance of the year that were not in Q1 numbers.

And I guess on the inventory adjustments, it seems like the supply of PPE is better than it was in the back half of last year. Pricing has come down. And so should we think of that as kind of favorable to your gross margins? Obviously, maybe -- one, from an inventory adjustment standpoint; but also, two, just from the margin that you're making on PPE sales, it seems like the -- your costs are going down. You've, I think, tried to keep pricing stable to the customer through all of this. So as that -- this kind of plays out, is that actually a positive from a profit standpoint for your business that -- the deflation that we're seeing in PPE pricing?

Yes. It depends on what points you're looking at. But when the pricing went sky-high during 2020, we didn't pass on all of those price increases that we got to our customers. We did have to pass on some but not 100%. So now that the prices are coming down or have come down for the most part -- there's still a little bit more to go, we believe that the margin profile will stay at or maybe slightly above where it was in 2020 because we -- again, we didn't pass on all of the price increases in 2020.

Could I -- one last follow-up on the margin discussion. I think one of the other factors that you called out was the strength in equipment in terms of helping operating margins. Leveraging some of the fixed costs associated with the technicians and service centers, are those costs mainly in SG&A? Or does some of that fall into gross margin as we think about the different components?

Yes. Some are in cost of goods sold and some are in operating expenses. So the service technicians, there's a big chunk of the service technician expense that's in cost of goods sold for the installation piece. But the equipment centers is all in SG&A. So it's a little bit of a split there.

Got it. So the strong equipment helped both the gross margin and the overall operating margin?

Correct.

Makes sense. I wanted to talk about the dental specialties business. I think implants is kind of the largest piece of that, but also endo and ortho are important components, too. I think overall, specialties combined had about $700 million of sales in 2020. How do you go to market across these different 3 categories in terms of how do you kind of position the value proposition for these categories? And I think the business has grown mid- to high single digits over time. Is that the right type of growth that you think you can see? A lot of these markets are growing in line with that range. And so is the strategy to sort of provide value, kind of grow in line with the market or a little bit better and that's really what -- how we should think about this specialty business going forward?

Nate, we have a relatively small market share. We reported in the first quarter about $220 million of sales. It's spread out amongst 3 specialties: The oral surgeon, where we had an excellent range of premium implants, namely Camlog in Europe and a couple of other countries, which does very well. We believe Camlog is the leading provider of implants in Germany. And we have, in the United States, BioHorizons, which is -- has a decent market share. Both Camlog and BioHorizons are growing. And then we have the ACE brand of bone regeneration products. We have all 3. We have the bovine, we have the synthetic, and we have the human tissue product. We do very well with all those. These are all products that are either vertically integrated or packaged by ourselves. And we go to markets with these brands that I've mentioned. Plus, we also own an oral surgery, Medentis, line in Germany, which is the leading discount brand. So that's in the oral surgery side. On the endodontic side, we have the Brasseler line, which is also a premium line, which has done very well over the last years. And we have the Edge Endo, which is a discount generic line. And then in the -- and we go to margin also -- market in all of these areas with our own specialty sales force, own brands, and we do R&D in these areas. Likewise, on the oral -- orthodontics side, which is the smaller part of this business, we have a traditional wires and brackets business, which the Carriere line is the majority of that. It does quite well. There's a good following. And then we have, in the most recent years, the Reveal aligner product, which is a pretty good product, I think, from a product point of view. We're adding more software to that. But it's a pretty good product. We've done okay with some DSOs, et cetera. So that's the composition of that business, all having a little bit of R&D, actually pretty good R&D, and a physical sales consulting force in the marketplace the way the market generally operates, the way our competitors operate. And these businesses in aggregate and each individually have continued to grow market share now since we started out. The first was the implants about a dozen years ago.

Yes. I would add one other thought. Our positioning in the marketplace is as follows: We go to our customers and say we believe our product is as good as anyone's. We believe our technical support is as good as anyone's. But we -- also, besides being comparable to any product on the market, we do have a pricing advantage. So that's one of the incentives to switch to our brand plus having a fuller relationship with Henry Schein, where you can buy your general dentistry, specialty products, your software, your technology, et cetera, et cetera. So we don't have the same brand recognition today as some of the larger companies, but again, we believe the product and support is just as good as anyone's, and we do have a pricing advantage.

Makes sense. I wanted to make sure we hit Henry Schein One, too. I think that makes up the vast majority of the technology value-added services segment. You continue to make acquisitions in that business. I guess where do you feel like the biggest opportunities are to kind of accelerate the growth of that asset? Because since you did the initial deal with KKR, you've kind of continued to build out the portfolio. Do you feel like you're at a point where you have kind of the breadth of services that dentists want, where we're kind of seeing maybe more adoption of that fuller suite of services?

Yes. The biggest opportunity, Nate, is to move our own customers to the cloud and add new customers to our cloud Ascend product. It's a really good product. I think it's the largest of its size, and so -- of its kind. So I think there's -- continues to be an opportunity, a good opportunity as we migrate to the cloud internally. Having said that, we're going to be adding additional value-added services to our offering. The synergies, the integration opportunities of a lot of these stand-alone businesses is quite good. So that and moving to a common platform amongst these various brands we own, these are the things we're busy with, which will increase sales, market share and, of course, profits.

Great. In the couple of minutes that we have left, Steve, maybe kind of trying to tie this together. Has your view of the long-term kind of growth algorithm for the business changed? And can you maybe just talk at a very high level how you're thinking about the 2 businesses -- or the businesses kind of coming together and how that translates to top line growth and margins over a longer period of time?

We haven't given specifics, but I can give you a general commentary on that. So one is with the technology and specialties that will enhance our overall top line growth rate because those markets are growing faster than the general dentistry markets. They also have higher margins. You can see the technology and value-added services margins. It's part of a separate segment that we showed. And we've said that our margins on the dental specialty side is comparable to the separate public companies that sell those product lines also. So you can do some math there. Overall, we still feel like the growth rate of the company, we have a lot of runway. We feel like there's opportunity to continue to expand margins. We'll do that in a few ways. One is because the higher-margin businesses will be growing faster, that will help margins. Two, we still feel that there's opportunity to be more efficient, take costs out of the system. And three, with additional sales growth in any product category, that will leverage the expense structure also to expand margins. Now what we haven't said is, okay, what's that going to translate to? What's the top line growth going to be? We haven't given that level of detail as of yet. And what's the margin expansion? We haven't also given that level of detail. But as things become less uncertain, we'll go back to giving more traditional guidance, but we do feel like there's good runway.

And you guys have done regular M&A over time. I mean, do you feel like you'll still take that balanced approach where we'll see some bolt-on deals, we'll see share buybacks and that's sort of the main uses of free cash flow at this point?

I think they'll stay the same. And the good news is we have ample financial wherewithal. The balance sheet, as you know, has very low leverage, less than 1x debt-to-EBITDA. Sometimes, we get a little bit of criticism on low leverage, but I kind of -- I'm proud of the low leverage and the strong cash flow generation that the company has. And if you look back in 2020, having a strong balance sheet was critical. It's critical during the pandemic. So we have the capacity to increase leverage a bit, but I still think we want to stay at or around investment-grade leverage for the company.

Great. Well, with that, why don't we wrap up. Stan and Steve, thanks so much for your time. We really appreciate it. Have a great rest of your day.

Thank you, Nate.

Thank you.