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

Good afternoon, everyone. Welcome to day 3 of our Morgan Stanley Global Healthcare Conference. My name is Edmund Tu, and I'm on the life science tools and diagnostics team here at Morgan Stanley. And I'm very excited to have Henry Schein with me this morning. Representing the company, I have Mr. Stanley Bergman, CEO; Mr. Steven Paladino, CFO; and Ms. Erin Sekula, Director of Investor Relations. Thank you guys for joining today.

Steve, you're on mute.

Okay. Hello, everyone. Thank you, Edmund. Before we begin, I just wanted to say that certain comments made during this call may include forward-looking information. As you know, risks and uncertainties involved in the company's business may affect those matters referred to in the forward-looking statements. As a result, the company's performance may differ from those expressed in or indicated by such forward-looking statements. And of course, 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'll turn the call over to Stan Bergman, who will give some brief introductory remarks.

Good afternoon here from New York. Good morning from California, I guess. Edmund, thank you for hosting us. Steven, thanks for those introductory remarks. I'll not say a lot at this stage, leaving more time for Q&A. In -- from a macro point of view, Henry Schein is the largest provider of products and related services to office space, dentists and physicians and similar kind of offices, including, for example, urgicenters, renal centers, cancer centers. We provide products to multiple locations where the kinds of medical services that are described are offered by local government and the federal government. And we're relatively global in all of the major developed countries. We have some developing business, I supposed, Brazil is a developing country and a few other markets as well. We have about 1 million customers. That's about 1.5 million practitioners. And we essentially offer all of the major products that office-based practitioners may need. Not all of the specialty products in medicine, for example, in orthopedics yet. But on the dental side, we have quite a nice offering and market position for dental implants and bone regeneration products, endodontic products and orthodontic, whether it's in the wires and brackets or in the aligner space. We also offer a comprehensive offering of related practice management services, including the leading offering of practice management software, electronic medical records, various kinds of e-commerce transactions such as electronic claims processing, credit card processing and the like. Our business is organized into a dental group, which includes consumables, pharmaceuticals, various kinds of medical or surgical disposables that are used by oral surgeons, for example, the software and dental specialty products as I described earlier on. On the medical side, also consumables. We have a pretty good position in pharmaceuticals, including injectables and vaccines and equipment and some software and other value-added services. The distribution business is a business that has grown for decades, internal growth in combination with acquisitions. And the goal there is to increase our operating income from that business over time. But there's another part of the business where we internally call our high-growth, high-margin businesses. These are the specialty businesses and the practice management software. So the goal is to increase the operating income from the high-margin, high-growth business over time. And in the decade or so that we've been in these high-growth, high-margin businesses, we have moved the operating income from these businesses as a percentage of the total up each year. So we operate through distribution centers throughout the world. We have about 3,500 what we call field sales consultants that develop a relationship with the customer on the basis of practice management advice and then offer as part of that an array of products and related services. And then we also have a quite powerful direct mail, which is now, to a large extent, converted to e-commerce business, social media and the like, which is all -- which is encompassed or included in our distribution businesses in general, but also our specialty businesses. And we have an effect of telesales operation that are still very important in the markets that we serve. So Edmund, with that in mind, let's chat.

Sure, sounds good. Stanley, thank you very much for that overview. And before we continue, I just want to amend to Steven's disclaimer statement earlier. And I just want to highlight to our audience, for additional disclaimers, please visit morganstanleyresearch/researchdisclosure.

And then with that, Stanley, if you could, I guess, kind of help us understand from a bigger picture view, what are some of the impacts of the current environment on sales performance and demand in global dental and medical markets? And if you were to take a second and step back and think, how do you see the role of the distributor evolving coming out of this pandemic? And where is it that you can really add differentiated value for your customers?

Right. So of course, our challenge specifically in 2020 related to the availability of PP&E products, rapid point-of-care tests, these issues are largely dealt with today. There are some dislocations in the supply chain as it relates to any business. Having said that, most of the products, if not all of the important products, we may not necessarily have every brand, but we have to have access to a product that can do the job. There's a slight challenge in the chairs, units and lights business. A manufacturer of ours left the market. And there's a void being filled by 2 manufacturers, but that is just a delay issue. And if a customer needs these chairs, units and lights urgently, we'll, of course, find a way to deal with that demand. The second question is related to where do we go from here, I guess, is the question. And for us, as I described in my opening remarks, we have 2 sides of the house. One is the distribution businesses, the medical and dental. And there is a steady demand for products. We're back to, we believe, 2019 numbers actually leaning more positive. And now the question is to drive that business through our infrastructure in a more efficient way, providing better customer service and so continue to gain market share. We are investing heavily, continuing to invest heavily in e-commerce and different kinds of systems to help drive customer satisfaction and efficiency. And on the other side of the house, it's the specialty products and the software businesses that we own. All of these are designed to help the office practitioner operate a more efficient practice so that they can provide better clinical care to their patients. On the specialty side, we are investing in R&D and have a pretty good offering from a quality of product from an innovation point of view. But our pricing has generally tended to be a little bit less than some of the leading brands. That's been the Henry Schein reputation but backed up by high quality.

Got it. That's super helpful. And you've mentioned PPE availability and supply chain pressures. Is that still an issue persisting going forward? Or has that mostly resolved?

At this moment, there's adequate supply of the major PP&E products, whether it's masks or gloves, cleaning solutions, wipes, shields, gowns. There's adequate supply. The demand though is significantly up compared to 2019, but the prices are down from the peak of 2020. We've reached more or less a new plateau where the units have gone up and the pricing has stabilized. I think this new demand for PP&E, which is really now standard of use by practitioners, this new demand has stabilized and will continue to grow as more visits grow.

See, speaking of patient visits, the ADA has noted that patient traffic has increased to nearly 90% of pre-pandemic levels. And you said also that you've noted seeing customer levels returning to pre-pandemic levels. Can you kind of walk us through some of the trends you're seeing in the first couple of months of September and what your expectations are going forward?

Yes. The ADA data is interesting to a point. ADA does not report statistics on practices that are more than 100% of 2019. So they cut off at that point. They will be changing that, hopefully, in the next few months so that they will be able to provide actual visits. So right now, we believe that the ADA data is understated, perhaps by as much as 10% of 2019 pandemic's, the numbers. We base that assumption on our e-claims that we process. We are probably one of the largest, if not the largest, processor of electronic claims for dental offices. And there, we're seeing that we're in the 2019 range leaning a bit on the positive side. So there are some other studies out there. A lot of analysts are doing work in that area. But we're seeing that the market on dental in the U.S. has stabilized and moving towards the positive. Outside of the U.S., it's more or less similar. There was one market, Australia, where it was actually ahead, but now it's come down a bit because in certain cities, they periodically have lockdowns. But I think -- and it's not material to Henry Schein. That will be stable. China has had some issues as well. And the other small market is Thailand. But generally, from a dental point of view, we're back to '19, a little bit over. And on the medical side, it's similar. Vaccines for pediatric patients in the office space setting are not fully back to where they were, but it's not far from that. And the ASCs, the ambulatory surgical centers, are still running a little bit behind, but that's compensated by areas -- businesses such as the urgicenters, which are way ahead of where they were.

Got it. And then referring back to your comment on high-growth, high-margin businesses that you guys are looking into, 2 part of the question from the audience. Could you elaborate a little bit more on this? And the second part of the question was, where do you see the growth opportunities in your dental products and services?

Yes. So on the dental specialty side, we have a few leading brands in the implant and bone regeneration arena. We own Camlog, which in terms -- certainly in terms of units and maybe even in terms of euros is the leading brand in Germany, where we also own a company called Medentis Medical. And Medentis is a leader, may even be the leader in Germany of the high-value discounted area of dental implants. In the U.S., we own BioHorizons, which is a rapidly growing provider of dental implants as well. Both of these businesses also offer a wide variety of bone regeneration products. In other words, bovine, synthetic and human-based products. All of these are growing quite nicely. We also own a number of important brands on the endodontic side. Brasseler, which is a leading high-quality brand. And then Edge Endo we're involved with, and they are more of a generic provider of endodontic products. We have some other businesses in this field, and we have a relatively small but a growing orthodontic business, wires and brackets, Henry Schein Orthodontics and also technology in the U.S. And we have our own brand of aligners, where we offer a complete offering of, I would say, high-quality, transparent aligners. So these businesses are all growing and gaining market share, and we're quite comfortable that we can continue to grow the market share.

Got it. And then maybe passing one of these questions off to Steven from the audience. What is Henry Schein experiencing in terms of price inflation on product and wages? And what are your considerations baked into guidance? And what are you considering going forward?

Sure. We are seeing greater inflation on products than we've seen historically. That's a general statement. Of course, when it comes to PPE and COVID-related products, it's been very volatile to pricing. In early to mid-2020, PPE products went sky high. And now they're coming back down to more normal levels. So we're seeing a lot of price inflation that we haven't seen historically. With respect to wage inflation, we're also seeing that. But on that side, we're making sure that we're remaining competitive in the areas that we have people. As far as guidance, we really haven't given a detailed guidance on these measures other than to say, for the most part, we think that, unfortunately, these price increases will cause us some further price increases to the end user. We're probably not going to pass through 100% of the price increases, but we do need to pass some of it though.

Got it. And then staying with some of the financial questions. You guys saw significant gross margin improvements in the first half of 2021. What drove this improvement in gross margins? And how should we be thinking about the cadence of gross margin expansion going forward?

Sure. So we're optimistic that we'll see some modest improvement in gross margins for the balance of the year. That will be driven by probably 2 items. First is we don't anticipate any material inventory adjustments like we've had historically on PPE products, so we see that as something that we won't have going forward. We also think there'll be favorable sales mix towards higher-margin products that will help us. So we're optimistic that gross margins for the balance of the year, we'll see a slight improvement over what we saw in the first half.

Got it. And then in terms of your operating margins, how should we be thinking about the investments going forward?

Yes. Operating margins, we haven't given specific guidance on operating margin. Remember, in the second half of the year, we'll have some expenses come back that we hadn't fully bought back in the first half of the year, things like travel, that will be coming back. Also some investments in some IT projects. The most notable is what we call GEP, G-E-P, which is the global e-commerce platform that we're beginning to make investments in to improve our e-commerce platform. But overall, we've said publicly that we still believe there's opportunity for long-term operating margin expansion. Three drivers of that. One is shifting towards higher-margin products that we've talked about a fair amount already on this call, but also leveraging expenses on the core distribution business and continuing to take cost out through restructuring efforts. So those 3 items should help us deliver operating margin expansion going forward. We haven't said -- we haven't quantified how much the annual impact will be at this point, but we hope to do that in the not-too-distant future.

And in terms of your full year guidance provided in 2Q, you raised the floor of the revenue guidance, but you did not provide a top end range for your EPS guidance. Do you expect a drop in the EPS in the second half of the year? Or can you explain your thinking behind this a little bit?

Yes. We're not expecting a drop. People are looking at the floor. Some of them understand why we're doing it, but others haven't really understood it completely. But the genesis of that was that we still were uncomfortable giving traditional guidance. And we were getting back when we first initiated the floor concept. We're getting a fair amount of questions from investors and sell-side analysts saying, "Well, how do we have any idea on what you're predicting or what you're guiding to going forward when we suspended the guidance?" And the question that we were getting a lot was originally, "Are you at least going to be over 2019's reported results?" And so the initial guidance was to say, "Yes, we would be above that." We said the floor was to 2019. And now we've raised it even further. But there's still a fair amount of uncertainties in what's going on in the markets. So I'm hoping to get back to traditional guidance in the not-too-distant future, but we'll just have to wait and see. Yes. And one example of the volatility in some of our product lines is COVID test kits. We said at the end of Q2 that COVID test kits were down over Q1. But now what we said in -- at the end of Q2 was we saw an increase in COVID test kits primarily because of the Delta variant and more people getting tested because of that. So that's really difficult to predict what sort of happened with, and that's one of the reasons why we left it open-ended, the floor. But you should not assume that the floor is what we expect to achieve. We expect to be above the floor. It is a floor. We just haven't said how much above the floor we expect to be.

Got it. Steven, you mentioned the interesting point that's being asked by an audience right now, your COVID-19 testing revenue. I guess, this question could be either for you or Stanley. But how are you guys thinking about the testing revenue going forward? What are you seeing in terms of early orders for September? Are they actually going up a lot more because of the Delta variant? And how should we think about the contribution going forward?

Yes. As I said, we have seen an increase in COVID test kits. We said that on the Q2 conference call for early part of Q3. That's continuing. Again, very difficult to predict what's going to happen going forward, although at least my opinion is this elevated level of test kits will stay for a little while. Can't say what will happen in 2022. It's too early for that. But I think for the balance of 2021, they'll probably stay at elevated levels. Now we are also seeing a little bit of lower pricing in the test kits. So that's offsetting a little bit, but the bulk of it is coming from more unit demand.

Got it. And then in terms of COVID vaccine distributions, what do you guys have planned there?

Edmund, we are a significant distributor of vaccines to office-based practitioners. Over 60% of all vaccines, closer to 2/3, and actually a much higher number for pediatric vaccines are administered in the office space setting. The situation for the COVID vaccine is that the government is the purchaser of, on an exclusive basis, of all COVID vaccines from 3 manufacturers that have the right to sell the product in the United States. Furthermore, the government has engaged a firm to handle the logistics, not the traditional distribution, but simply the third-party logistics. And it is organized on a state-by-state basis. Every state has slightly different regulations for the distribution of those vaccines and determining who can receive those vaccines or not. And actually, there are another dozen or so jurisdictions. Like New York City has a different requirement to, for example, New York State. The traditional vaccine distribution is done by region, not by state geography. And it is our hope and certainly anticipation that at some point, the government will exit the distribution of these vaccines and turn it over to the private sector, again. At which point we will be able to help our customers who, right now, are having a very difficult time acquiring these vaccines because there are certain minimum requirements and quite complex regulations. Some states make it easy, other states make it difficult. So this COVID vaccine, we are hopeful, will be distributed under the same distribution regime as, for example, the traditional flu or any of the dozens of other vaccines that we sell. The manufacturers would like to work with us. But at the moment, the government is still the exclusive purchaser, and we're anticipating that the government will get out of the vaccine business in the not-too-distant future.

Got it. Super helpful. And Stanley, I know you talked about the supply chain constraints a little bit earlier in a lot of detail, but I have a question from the audience asking specifically, hearing about some supply chain disruptions at A-dec and DCI, how do you think this will impact Henry Schein?

I wouldn't call them a disruption. In fact, both of those companies are doing a remarkable job in satisfying the needs of the marketplace. What happened is a major manufacturer of chairs, units and lights, and the companies you mentioned [ have got ] business in chairs, units and lights, it gave us 90 days' notice and exited the market last October, I believe. So we had -- and we were, by far, the biggest customer of that manufacturer. So we had to find alternative supplies. We are a big customer of A-dec, and DCI is also a significant customer. They have increased their manufacturing capacity and, I believe, are servicing us to the best they can. We're very important customers of theirs. And I would just say that -- and they have great products, both of them. And relationships are good, not only in the U.S., but we work with them globally. And I would say we'll be out of this within a few quarters. But I would furthermore say, if a customer needs something urgently, we will get the products to them.

Got it. Super helpful.

I'll just confirm, it's chairs, units and lights. It's not all the other equipment. It's nothing to do with imaging. It's nothing to do with compressors or for that matter, digital, and it's kind of limited to the U.S. It's not as bad in Canada, and it's certainly non-issue in Europe, for example.

Got it. Super helpful. And then you guys have recently announced changes to your field sales consultants' commission plans. Has this caused any sort of turnover that you guys are seeing?

Right. I'm glad you asked that question, Edmund, because it is so much written, and the answer is no. There is, of course, turnover in our sales force, and it's relatively modest. Actually, it's a bit lower than in previous years. And the people that left us didn't leave us because of a change in compensation. They left for other reasons, maybe opportunity, et cetera. And there's been a lot written about people that have gone to a particular competitor of ours. I would say it's kind of breakeven. They hired a few from us. We hired a few from them, but it's a really minimal handful of numbers, and that's not an issue, certainly not the issue that a couple of analysts have been writing about. It makes for good reading, I have to say.

Yes. Definitely. Thank you for the clarification. That's very helpful. And being considerate of the time left, do you think there's anything that we haven't covered today and you would like to highlight? Or have there been any specific points of pushbacks from investors that you would like to clarify? The last...

Well, I will ask Steve Paladino, who is in direct contact with our investors every day. Steven, one of the big questions that we've not answered. Or even if there's some that we've answered, maybe you have better answer.

Yes. I think we covered a lot of stuff. The questions that we have been getting has been on guidance which we talked about, has been on market conditions which we've talked about, on operating margin opportunities which we also talked about. I would say, Edmund, those are probably the top 3 questions that we've been getting most recently, and we did cover them in this session. So I can't think of anything really critical that we missed on.

Okay. Great.

I would just stress, Edmund, that we have our distribution businesses that have a lot of tonnage, a little bit lower margin. And then we have our high-growth, high-margin specialty and software businesses, high margin in rapidly growing markets. And we are doing well, gaining market share actually on both sides of the house, but we are driving our operating income towards more from the high-margin -- high-growth, high-margin businesses than the distribution businesses. Together, the tide will rise, and I'm quite optimistic that we'll continue to grow organically, inorganically, our EPS, our cash flow as we have for the 26 years we've been public.

Got it. Thank you very much, Stanley and Steven and Erin. And with that, I would like to thank everyone who joined us today, and please enjoy the rest of our Global Healthcare Conference. Thank you.

Thank you.