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

All right. Good afternoon. Thanks, everybody, for joining us. Welcome to the Jefferies 2022 Global Healthcare Conference. It's great to see everyone back in person. I'm Brandon Couillard. I cover the dental sector here at the firm. It's my great pleasure to have Henry Schein with us at the conference this year. And joining us from the company, new CFO, Ron South, who took over the role recently from Mr. Paladino after a long tenure. Ron, it's great to have you here and great to meet you in person, finally.

Thank you.

Thanks for being here. Maybe to kick off, it'd be helpful if you would kind of give us Henry Schein's state of the union right now as you look across your European and U.S. dental markets. A lot of noise in the macro environment, but like how are the dental markets holding up in Europe and U.S. right now?

The dental markets have proven to be, I think, fairly resilient. Our -- well, our Q1 results were -- I think, a great indicator from our Q1 results was the growth we experienced in equipment. Equipment, to me, is a great indicator of the confidence of the dental practices and making investments. And we saw something in the neighborhood of low double-digit growth in standard equipment as well as in high-tech equipment. So I think it was -- it's a very good barometer for us. And we said then that we remain bullish on equipment sales to the dentists both in the U.S. and in Europe. And we remain bullish. So I think the dental markets, a lot of questions we've been getting today and in past conferences, have been around how resilient to a recession might the dental industry be. And we feel like we are -- we can -- what you call recession-resistant, not recession-proof per se. Some of the specialty products, some of the -- such as implants into [ endodontistry ] input ancestry, we believe can work its way through a recession quite well. Orthodontics might be a little more exposed, but a very small part of our business. So I think that we feel like we're well positioned to kind of endure whatever the macroeconomic what's the throat is right now.

In terms of the equipment book, the growth in the first quarter has been strong. Were orders even stronger, have you built backlog? And kind of give us an update on sort of where things stand or some supply outages and how much that's maybe constraining growth in -- particularly imaging.

Yes. I mean as you can appreciate, I can only talk on to the first quarter right now, but I think that what we saw was that the backlog entering the quarter was consistent with the backlog exiting the quarter. So we felt like the activity that we recorded in the first quarter was really represented but representative of 3 months of activity, 3 months of actual demand. And so that's -- so we feel pretty good about that. That -- those backlogs are fairly extensive. And if, in fact, we can begin to compress those backlogs a little, it will even be more beneficial for us in the periods when that occurs. That's really more on the traditional equipment side. And by traditional equipment, we mean kind of chairs, units and lights, which those delays were primarily affected by often it's affected by construction delays of our customers. They're doing a build out, they're adding a couple of new chairs, taking out a wall, expanding their practice. And a lot of people -- if anybody in here has tried to use a contractor for something, you've experienced delays. And they're experiencing delays. We take the order, we take the chair, but we don't deliver it to them until they're ready for it. We record that revenue when we deliver it. On the high-tech side, the delays there, some of those delays were driven somewhat by the computer chip shortage, I think, we're all -- we've all heard about and are aware of, did create some delays. But I wouldn't say those were significant monumental delays that cause any kind of ultimate loss in revenue. It created maybe a little bit of loss in timing, but we feel like that's pretty well caught up at this point.

What does your guidance kind of assume for dental equipment growth over the balance of the year?

I don't think -- we haven't really given that specific of the -- within our guidance of what we think that equipment growth is. But it is built into our overall guidance of kind of 5% to 8% of revenue growth for the full year.

I'd like to maybe shift gears a little bit and maybe it'd be helpful if you could talk about the level of inflation that you are seeing from your supplier base. Are you able to pass through that entirely and maybe a little bit more? And is there any difference between the dental and medical businesses in terms of the pricing power right now?

So I'll start with the price increases. And -- yes, historically, we would get an annual price increase from our suppliers. We would then pass along that price increase to our customers. So what we're seeing now is some interim increases coming from the manufacturers, and we are continuing to pass along those price increases to our customers. Having said that, if, in fact, we believe we get to a point where those price increases are going to be -- create a problem for our customer or if we're going to lose the customers as a result of it, we feel like we're well positioned with alternative brands that we can offer to the customer that are at a lower cost, including, in some cases, our private label. So we will work with the customer to move them to a brand that they feel like they're comfortable with at a cost that they're comfortable with. And we will have that discussion with our manufacturers to let them know we understand you are increasing prices, but there could be some resistance in us being able to continue to sell at that price to some customers. And we will advocate on behalf of the customer and move them to another brand. So that's -- I mean, that's, I think, just kind of fundamental to what our role would be in that situation, right? So that was the first part of your question. What -- remind me again what the second half of your question was.

Well, I think you said in the first quarter that pricing was 300 basis points. Is that consistent in both dental and medical segments? In medical, you've got a lot of PPE. I want to leave that out of it. Just talk about kind of the base [indiscernible].

Yes. So the 3% we referenced in the first quarter was with reference to consumable merchandise in dental and medical, excluding PPE and COVID test kits, right? PPE, we're actually seeing some deflation, especially in gloves. And COVID test kits, pricing is kind of all over the place depending on what's happening with infection rates, et cetera, right? So -- yes, the 3% was in dental and medical consumable merchandise, ex those other items.

Is there a lag between when you pass through pricing and when it flows through inventory, such as there's perhaps a timing mismatch on our gross margins?

If there is, it's tiny.

Like [indiscernible].

Yes, it would be tiny. When we increase prices, we try to maintain the same margin. So there's a kind of a margin on the increase, right? But I think that -- we turn inventory about 5x a year, so there's not a lot of holding inventory waiting for a higher price to improve the margin. We're going to churn to that inventory. I don't see us kind of speculating on price and trying to hold more inventory and waiting for the price increases.

Got you. I want to touch on guidance for the year. And I have to say, you are being more open and transparent in terms of what's contemplated in your outlook, which is very helpful, I think, to The Street. One component of that is top line -- actual top line guidance, which you point to is 5% to 8% a year. First off, should we expect this to sort of remain a practice in terms of greater transparency, Number one, that as you're CFO. And number two, love to sort of peel back the components of that 5% to 8%, and in particular, the degree to which there may be more variability on the PPE pricing than kind of what's embedded. Like is that a moving target? Or do you feel pretty good at sort of the assumptions that's embedded?

Yes. I think in terms of the transparency, yes, I think we'll continue to try to provide what we feel like is appropriate -- an appropriate level of information that people understand the baseline assumptions that we're making and attempting to project our earnings so that we can talk more openly about it going forward and when discussing the business. I think that the components of that 5% to 8%, there's a couple of just kind of, what I'll call, math to it, right? I mean 1% of it is the extra week we have this year. We work off of fiscal years and about every 6 or 7 years, we need to add a 53rd week to keep us close to a calendar. So this year, we are in a 53-week year and that 53rd week, we've estimated, typically, is -- you can't prorate and say, "Well, that's 2% because it's the week between Christmas and New Years. So it tends to be a light week." So we said that's typically 1 percentage point of growth. We also think the acquisitions we did last year will give us about another 1% of growth on the top line. So now we're down to kind of 3% to 6%. There's probably going to be a couple of percentage points in there on the price increases. And then the balance is a net between what we have to try to gain in market share, gain in volumes, net of some of the resistance we get in the decreases in price on PPE, as you mentioned, specifically in gloves as well as a little bit of FX pressure and some decline in the COVID-19 test kit as well, in those revenues.

I think you said that PPE was $1 billion globally in '21, so the peak year. What was the base year pre-COVID? It was something like $200 million, $300 million?

In -- and I'm going to do this from memory, so hopefully, I get it right. If you go back to 2019, if you will -- let's first go back to 2020. 2020, we disclosed that we did about $1.3 billion in PPE and COVID-related products, right? And COVID-related products would include -- I'm not sure how much we did in COVID test kits in 2020, to be honest with you, off the top of my head. But it would include other related products such as thermometers, things that aren't necessarily PPE, but product that we didn't do a lot of sales in prior to the COVID pandemic. We said then that $1.3 billion was 208% increase over the prior year. So just using round numbers, $1.3 billion, call it 200%. That would put us at about $650 million in 2019. So that would be really the kind of the base here, if you were to do that math. That's just -- this is following the disclosed math in the MD&A in the 2020 10-K.

Okay. So is that a fair sort of baseline level to perhaps think about it in an endemic environment? We wash all this out, in, let's say, '23, that, that might be [indiscernible].

It's hard to say actually. It's hard to say. It's a baseline. It's a -- how fair is it -- could it just reopen the debate? Because it is a baseline. And the use of PPE is different now than it was in 2019. So I would think that there would be -- there's a little greater awareness, perhaps there's going to be a slightly greater demand. Pricing seems to still be a little more volatile. We're not quite sure where that glove -- glove pricing is coming down, but it's still above what we sold gloves at prior to the pandemic. We're not quite sure where that's going to level off at. So it's hard to say. If you want to start with that as a baseline, you can, but then you have to make your own assumptions in terms of what kind of adjustments you would make to that.

Got you. Just for modeling purposes, that $650 million, ballpark, that's split evenly between dental and medical? Hate to torture you here.

My recollection of 2019 PPE sales in dental and medical. It would be pretty fair to say it's close. Yes. It would be fair to say it's close.

Okay. Maybe shifting gears back over to the dental segment, specifically within specialties. I'd say another area of expanded disclosure that's very helpful on a consistent basis. What is Schein's right to win in specialty markets? Or how would you just sort of describe the go-to-market strategy in the portfolio? And where are you strongest, which franchises?

Okay. So when we talk about our specialty products, we're really talking about 3 product categories. In an order of importance, those 3 product categories are implants, endodontic products and orthodontic products. I would say I really want to focus most on implants because I think that's by far the most relevant of those 3, and where we're actually seeing some -- experiencing some very good growth. I think our strategy to market on that is we're not the cheapest implant, but we're not the most expensive either. I've kind of referred to it as sub-premium pricing. You got your premium product, and then we come in just probably about 10% below that at a kind of a sub-premium level. So we can provide a high-quality reputable product at a slightly more attractive price point and that has been a very good strategy for us. And I think that's what's driving a lot of that growth.

The business itself is very high margins. I want to say, 20%.

That's a fair estimate, yes.

Is there room for that to move higher let's say, on -- if we assume the portfolio is growing high-single digits, similar to the end markets, is there margin leverage on that? Or should we sort of think about that as stable and you reinvest that back into R&D and maybe sales?

Yes. I would -- let's put it this way, I mean, I'd be disappointed if we didn't get some improvement in the operating margin as we grow those businesses more, just out of the scalability of them. But it could be a little lumpier because to your point, these are the types of businesses that we need to make sure we're making appropriate investment in those businesses, whether it be R&D or otherwise. So you could -- that could create a little bit of inconsistency in that margin. But I would hope over a long term, we would see improvements in operating line.

Part of that business does play in orthodontics the number of, I'd say, mixed data points in the orthodontic space, whether we're talking about clear aligners or wires and brackets. In the first quarter, what are you seeing in your ortho business? And how is your own clear aligner launch progressing?

So I would like for us to get better traction on the clear aligner business. Having said that, we've made some, I think, meaningful improvements in the software that supports the -- our product, and we're beginning to see some favorable reaction from the market to that. So we are, I think, a little more optimistic going forward with our orthodontic products, with our clear aligner products. We still do well in the -- what I call, the old-fashioned, wired braces. They still sell and that's -- and we sold those at a nice margin. So those are out there. But we know the future, I think, in that is going to be in that clear aligner side.

When was that software update rolled out?

During the first quarter.

First quarter?

Yes.

Okay. Good. Got you. Does that business have a license for M&A? Are you prioritizing those types of markets? And are there any available assets to put in that portfolio?

There's always something available, right? I mean some things are just more available than others. But I think that -- yes, we're open to let's put it this way, our M&A priorities are really in what we view as the high-growth, high-market products that we operate with. So we're talking about dental specialty products, and we're talking about our technology product line, right? That's where we really want to focus our M&A going forward. And if that includes finding something that helps us expand our orthodontic line and we feel like we can get it at a fair price, yes, that would be in play.

In terms of -- at the corporate level, you've guided to 20 to 25 basis points of margin expansion this year which is actually consistent with your longer-term sort of target model. Bigger picture, I guess, is there a consistent margin expansion story here which has been somewhat mixed last few years, perhaps for different reasons, that maybe investors don't appreciate?

Yes. And it kind of goes back to the reference I just made to the high-growth, high-margin product lines that we have. We feel like if we can take a greater focus in those areas, again, those being the specialty products and the technology business. That gives us a greater gross margin, allows us to make some investment back into the business and still achieve that operating margin expansion that we'd like to have.

So should we think about the 20% to 25%, it's mostly on the gross margin line this year?

I think this year, the way we get there is through gross margin -- a little improvement in the gross margin, net of some investment back into the business to get there. But I think for us to have achieved meaningful growth in the dental specialty side and in the technology business. I'm conscious of not underinvesting in those businesses. I want to be sure that as they generate more gross profit for us that we're also maintaining a steady line of investment in those businesses so we can maintain that growth.

Is the decline that we're seeing this year in PPE, is that dilutive or accretive to margins for the year? Like, does it have an impact? Or is it a wash?

I think if you look at our margin percentage, it's fairly consistent, right? It's really -- you're seeing decline in prices, but we're also seeing decline in costs. So those are kind of moving in tandem. And that margin percentage, that's contributed by PPE, is fairly consistent.

So gloves, you would capture the same type of operating margin for that type of...

On a...

PPE product as you look for a dental consumable product?

Yes, on a percentage basis, yes. Yes.

Yes. Okay. Maybe as part of a tangent of the margin story, describe for us what exactly Schein's One Distribution initiative is, which is a more recent program. And is that part of the margin expansion story?

Yes. We -- the One Distribution is a -- and this is really a U.S.-centric program, right? Because medical outside the U.S. is a very, very small part of our business. So -- 97% of our medical business is U.S.-based. So when we talk about One Distribution, we're talking about One Distribution in the U.S. And there were certain operating characteristics that were already very shared. They share the same warehouses, et cetera. But this is really bringing some of the top-level management under -- bringing it under one level of top level management. So Brad Connett, is leading this up. He was previously in charge of our medical business, and he's now -- he has the U.S. dental business as well. We just hired a Chief Commercial Officer, Dirk Benson, who is a former Medline executive to also help us on both sides of that business, right? So that we can begin to treat it more as a one approach to the customer on both the medical and the dental side.

So what are the synergies or the benefits of leadership running both divisions now?

I think it's really just kind of getting these -- a common practices and common management practices and even things like common KPIs under the businesses that we can begin -- where the businesses can learn from each other a little better, the specific businesses can learn from each other a little better. But I think, too, even when -- as you get out, dental procedures are becoming -- in some cases, are becoming almost more medical-type procedures in nature. And you're beginning to kind of see some synergies of the products. I mean we already have a lot of SKUs that are obviously common SKUs across those. But I think there's some learnings that can be made in terms of how we approach the customer on both sides of that.

Got you. Lastly, in terms of capital allocation, you didn't buy back any stock in the first quarter. I think there's maybe $30 million left, it's kind of on the buyback. How do we think about M&A? You did a small tuck-in deal last week but pretty small in the scheme of things. Should we expect the majority of free cash flow to continue to flow into the repurchase?

Yes. So we had -- we didn't do any share repurchases in Q1, but we did resume -- we instituted a new plan and resume repurchases in Q2. As of the end of Q1, we had $200 million available for share repurchases. We do about $800 million a year in free cash flow. In a typical year, we'll do $300 million to $400 million in share repurchases. We'll do $300 million to $400 million in M&A. And the balance is reinvested in the business. Right now, we're kind of sticking to that formula until we see an opportunity that we believe we need to change that mix and we'll change that mix.

We're good. Unfortunately, we're out of time, so we'll leave it there. Thanks for being here, Ron.

Very good. Thank you.

Appreciate it.