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

I think we can go in with our next presenter. We have Henry Schein. Very happy to have them participating in our conference this year. Ron Smith (sic) [ Ron South ] Chief Financial Officer; and Graham Stanley, who heads up the Investor Relations area.

I think just as I've started many of these off, I'm going to ask if you guys would just take a look at the year. We're almost 11 months in. What have been some of the wins and highlights from your perspective year-to-date, and to the extent there's been any areas of challenge you'd want to highlight?

Certainly. Thank you, A.J. I think that for those of you who aren't familiar with Henry Schein, we are the leading provider of products directly to the office space practitioner primarily in the dental space as well as in the office space practitioner physician space. The year has been a challenge, as it has been for many. I think we're very proud with how well we've endured those challenges thus far. We've been able to hold to the midpoint of our guidance. We firmed up our guidance with our -- with the release of our third quarter earnings last Tuesday and narrowed that guidance but maintained that same midpoint. And that's in spite of some pretty significant headwinds during the year. A relatively large product category for us is personal protective equipment or what we all know very well now as PP&E. And there has been some challenges during the year within the market as the prices of gloves has -- those prices have been coming down over the course of the year. But margins are -- we're able to hold the margins as those prices come down, and we are seeing a little bit of pressure in gross profit. But nevertheless, we feel like at some point, over the course of the next, we hope kind of 12 to 18 months, we'll see kind of a balancing of those sales. But as we endure the -- that decline in PP&E, which has been about a 30% decline is what we're projecting will be the decline this year versus the prior year as well as in COVID test kits, which is more of a volume issue than it is a pricing issue, in spite of that kind of 30% decline in what is a couple of very important product categories for us, we've been able to, for example, this past quarter, we were able to increase our EPS on a non-GAAP basis from $1.10 last year to $1.15 this year. And that was with a $260 million headwind in revenue in the combination of PP&E and COVID test kits. So to us, it shows that the health of the core business continues to be quite robust, and we feel very optimistic for the balance of this year. And we will be providing guidance on 2023 when we release our Q4 earnings in February.

That's great, that's great. I might take a minute and just sort of walk through the different businesses and what you're seeing there and any updated comments you have. I know in the dental equipment area, some of those purchases are financed. We've had a rising interest rate environment, but that doesn't seem to have impacted the business. Maybe just give us your perspective on that. It is interesting to me that despite rising interest rates, are you seeing less financing or how has that played out?

Yes. So our equipment sales, about 2/3 of our equipment sales are in what we call traditional equipment. So it's the chairs, units and lights. You go to the dentist and it's the conventional chair you're sitting in, the lights that are in your eyes. The -- and then the other 1/3 would be more around high-tech equipment, intraoral scanners, 3D imaging, 3D printers, so it's kind of a 2:1 mix. Especially on the traditional side, a lot of that equipment, I would say a vast majority of that equipment is financed. We facilitate that financing. We don't actually take the paper on it but we facilitate that financing on behalf of our customer. I think right now, the interest rates have not -- at least as a parent has not hit a tipping point to really pull back on that just yet. We look at the interest rates as high right now, but I think historically, interest rates are still at a fairly reasonable level. And so I think that it hasn't really diminished that demand for equipment. Our North American equipment growth in the third quarter was 12.8%, which we see as a very optimistic indicator of growth going forward. It means that the dentist is very optimistic about the growth of their practice. They're investing in that practice. And so we feel pretty good about that.

And as you break down that equipment between the more technology-oriented stuff and the more traditional stuff, are you seeing that same strength in both pockets or does it tend to skew on one direction or the other?

I think we've seen better growth in the traditional equipment. And I think part of that is because some of the high-tech equipment has experienced price declines. Like anything else that's high tech, you kind of start off at a price and then the price begins to move its way down a little bit as new technology begins to come out. We see that being made up with volumes on the high tech because I think the price point becomes more attractive on things such as intraoral scanners for the practitioner to buy.

Interesting on the -- and on the strength -- one other thing, and I think you maybe mentioned in the call, was it a preference to maybe upgrade your office, as a dentist, more frequently or maybe consumer preferences and so forth? I don't know if that's something you can even track. But are you seeing people say, hey, I used to be able to wait 15 years before I upgraded on the basic equipment. And maybe that cycle is accelerating a little bit.

You're right. It is difficult for us to track. I don't think we have the actual statistics of how many units that we sell that are replacing existing units versus expanding an existing practice. Having said that, I mean, dentistry is a very competitive business. And the offices want to have that kind of new modern feel to it and want that patient to have a good experience. And I think that the chairs, units and lights aspect of that traditional equipment is something that enhances that. And then, of course, on the high-tech side, we do feel like a lot of the high-tech equipment we sell, there's actually -- there is an ROI on that, right? You can -- some of these high-tech equipment will allow the practitioner to see more patients over the course of a week. If you can fill that chair more frequently, you're going to make more money over the course of the week, and there's a return on that high-tech equipment. So I think it's a combination of those 2 things that we're seeing. But I think, Graham, you've had a view on that.

I would just add that I think the consolidation that's happening within the dental industry is helping with office fit-outs as well, whether it's DSOs that are investing in new offices or private practices that are growing their office space by -- from 1 to 2 to 3 to 4, that's the thing. And frankly, the private practice needs to complete in most markets against the DSO, which means their marketing efforts need to be sort of enhanced, and part of that is having a nice office that they can show the patient. So it's becoming a requirement for -- from the patient.

And one of the challenges on the equipment side has been supply chain. I'm sure we've heard that in a lot of segments but that's been an issue here. And just maybe for someone that hasn't followed Henry Schein closely and sort of getting up to speed today, where -- what's a normal supply chain turnaround? What did it get up to? And it sounds like at least in the last quarter, you're starting to see slight improvement there. Maybe some perspective on that?

So normally, you'd be able to order a chair now and get it installed before the end of the year. At the moment, probably sort of the lead time is out until around about March to April time with some suppliers. So it's still longer than usual but it's getting better.

And how was it at the worst, would you say, roughly?

We were out like 7 or 8 months, yes.

Okay, interesting. I think you guys just came off one of your big conferences, DS World. And it sounded like you were almost pleasantly surprised by the order flow out of that. Maybe just give us how that is as an indicator and just some takeaways from that experience.

Yes. So DS World was a nice event for us. Sort of like the dynamics with in-person shows is a little bit different now compared to where it was like 2 or 3 years ago pre pandemic. So yes, we were pleasantly surprised with the sort of the customer engagement and throughput. And the fact that in-person shows are still a good sales events for us. The sort of the sales that we took at the show were back in line with what we were seeing sort of like pre pandemic. So we should see a benefit for that in Q4 because the show took place, I think it's about a week or 2 weeks before the end of the quarter.

Yes, very late in the quarter.

So we'll take those sales and we'd recognize those in Q4.

Okay, okay. And then I think you also commented that an improved turnaround time could actually put a little pressure on your backlog. But it sounds like you ended the quarter with a little bit of a step-up. Is that right? And any comments you want to make along that to sort of wrap up on the equipment side?

Yes. I mean, the rate of growth -- so the backlog is growing. So the sales that we saw in Q3 was not at the expense of the backlog. There were true sales that we were realizing effectively in that quarter. The rate of growth of the backlog is moderating somewhat, so it's not growing at the same pace as it was like 2 or 3 quarters ago. But the fact that it's still growing means that we still got probably about 3 to 4 months with the supply of sales worth of equipment in our backlog that we'll realize in Q4, Q1 and into Q2.

Okay. Maybe pivoting over to dental consumables. That's sort of been a tale of 2 cities this year. You already mentioned it, Ron, about the PP&E and how that has trended and come down, and that's everyone that's involved in that area has seen that this year. Are we sort of normalized there at this point? And then I'm going to get you to talk about the more traditional or the rest of the dental consumables market. But give us a little bit of flavor on that.

Well, I think on PP&E, we're going to continue to see declines in prices of gloves. That's continuing into the fourth quarter and that's going to continue into '23. I think the slope, if you picture what happened with glove prices from -- at the beginning of the pandemic when costs went up significantly, and so the prices shot up with those costs. And now as we've kind of gone through 2021 and into 2022, we have seen that decline in pricing come down, and it's been a pretty steep decline. We do think that is kind of leveling off a little bit. It's not declining as rapidly as it has been. But it's still declining. We're seeing some stabilization but it's still declining. And right now, we're expecting those price declines to continue into 2023 but we're not quite sure how far and the timing of that. And that's one reason why we weren't comfortable providing guidance on 2023 until we got, I think, a little better intelligence on that. Kind of going over to the other consumables. I mean, volumes are fairly stable on other consumable merchandise. We are getting a little bit of a benefit on price increases. I would say a significant amount of the revenue growth we had in merchandise ex PP&E in the third quarter was the benefit of price increases more so than volume. We might have had a tick of benefit from buying, but it was primarily from price increases.

And obviously, inflation has been a big theme all year. What are you seeing there in the consumables market? And is -- if you think about, I guess, you started to -- you have some impact early in the year, has that year-to-year impact sort of stabilized? Is it getting worse? Is it getting a little better? How would you comment on it?

Yes, it's a little erratic because typically, we would get kind of an annual price increase from our suppliers, and then you wouldn't see -- you really wouldn't see another one until the following year. But we have had some interim price increases over the course of the year. So that's creating a little bit of -- makes it a little more difficult to kind of gauge the, what I'll call, the annualization effect of those price increases, right? We did see some price increases come through -- additional price increases come through late in the second quarter. And that's what I was saying, provided a little bit of that revenue growth for us in the third quarter. So it's going to be interesting to see. I mean, we're kind of -- this is the time of the year that we start having more discussions with our suppliers around next -- 2023, what will prices be. It's going to be interesting to see just how far these prices can be pushed. I mean, we work closely with our customers. We have a price-sensitive customer. We do have a very broad portfolio of products. We will advocate on behalf of the customer. While we want to maintain that good relationship with the supplier, we will advocate on behalf of the customer. And if it's a price-sensitive customer, we'll make sure they're aware of alternative brands that might be more attractive to them or private label products that we can move them towards.

When you think about that customer base, you guys have used that phrase, price-sensitive customer, what percentage of the market is that price-sensitive customer, roughly?

I don't know. I don't think we really have that as a statistic. But we do know that our field sales consultants do know that it's -- we don't want to lose that sale. You don't want to lose the sale. They do know they can offer up alternative brands to these customers, right?

And what is -- I think you guys said, earlier in the year, talked about a 3% sort of inflation rate. What is it running at this point? Is it still the number?

Yes. I think the third quarter, we said, on consumable merchandise, excluding PP&E, we now think it's probably 3% to 4% of lift on the top line, on the consumable merchandise piece of the business. We haven't really -- equipment with the lag and everything, we haven't -- you haven't seen that effective information really come through too much. But on the merchandise, that churns much faster. We churn that inventory much faster so you do see that effect.

And putting aside some subset that you're calling price-sensitive, is it the vast majority are still -- we can pass that along? We're fine with it, would you say? Or is it starting to be something where people are being expressed and concerned generally?

I still think it's the vast majority are accepting the price increase. I think when you break down the cost base, and we'll use the dentist as an example, when you look at what their cost base is of running their practice, what they buy from us is less than 10% of their cost base, right, because their more significant costs are the wages to their administrative staff and their hygienist, insurance, their malpractice insurance, their occupancy. And those are all costs that they're managing as well. Not that we're trying to sneak in price increases on it. We're trying to be very transparent with them. But they understand we're getting increases from the suppliers and therefore, their prices are going to go up.

I think the challenge, A.J., is say, on the face of it, something like a 3% to 4% increase in the context of where we are in many industries is not significant. But the challenge for the dental industry is that reimbursement is not going up. So you're getting cost increases that the dentist is having to -- that they absorb and not being able to pass on to insurance.

Interesting. I should -- if you're getting a 3% to 4% increase and you're able to generally pass that on, inflation is a positive for Henry Schein there?

Well, I mean, I think the -- yes, I hate to put it, so was flu but we'll talk about that separately, right? I think that -- yes. I mean, I think it's a common fact that distribution businesses can benefit in an inflationary environment because you get the inflationary effect on your margin. And that's what we do.

On the consumables area, there seems to be a lot of focus on what's happening with the economic backdrop. Is that going to affect people's patterns? So whether they go to the dentist or not, whether they follow through on all the treatments that maybe the dentist is recommending, what are you seeing there? And maybe also in the context of that, I have a perception that things that may be the last downturn were more cosmetic or optional. Now they've sort of become part of the medical overall health of the patient. And do you agree with that, that things have changed in that direction? And so maybe a little comment on both of those.

Yes, I do agree with you on that, in that kind of we'll talk about our implant business for -- as an example. I think initially, people thought of dental implants as an aesthetic procedure when in fact, it is a standard of care that does allow for better oral health and that better oral health leads to better overall health. So while I do think in the event of an economic downturn, an area of our business that could be vulnerable would be implants because the patient does pay a fair amount of that out of pocket, there is still a standard of care element there that helps protect it from being, I think, overly hurt in an economic downturn. The one thing we do look at carefully and we monitor carefully are the unemployment rates. At least in the U.S., we know that as long as people are employed, they still have access to care. And they maintain their insurance. They're still going to go to their dentist. They're still going to go to their physician. And so you at least get that churn of routine stuff that continues to happen, and that's good for like, for example, for our merchandise sales, for our consumable merchandise sales. So in this particular economy, we're still looking at unemployment rates of under 4%. And so I think that while we do think that globally we may see a little bit of softness in, say, for example, oral reconstruction procedures, we're still seeing growth in that area. And in terms of everything else, we still feel like that the market has not been grossly affected by any kind of economic downturn.

Okay. And you mentioned -- I know it's more in your specialty design are the implants. One of the things you did a couple of years ago was by a German implant, and I know you said that, that implant manufacturer is positioned as sort of a lower-cost option in the implant market. Obviously, that might make sense if we do have some price sensitivity on the part of consumers. How does that pivot? And is there significant capacity there to take advantage of people needing a lower-cost alternative? Is that -- you drive that or how does that happen in practice?

Yes. I think it more follows the market. So I think you're right, we did invest in a company called Medentis. They are an implant manufacturer in Germany. It's not a real large subsidiary of ours but they do make a discount implant. And I think what -- the advantage is that if a practitioner believes they are starting to lose some procedures because the cost of the implant is getting too high for the patient, they can -- if they know they have an alternative implant, they can go to that perhaps is not as expensive. They think that starts to drive a little more demand their way. And we've actually -- they actually had a very good quarter for us. So it's a market trend that we're still trying to figure out a little bit. And it's restricted to Europe in this case. But it is something that we are taking a -- we're trying to get a little smarter about, what does this mean? And how can we kind of optimize this as an opportunity if in fact, that's the trend?

So is there any reason why you're not selling it in the U.S.?

Well, we have a U.S. manufacturer who already kind of sells an array of -- BioHorizons does sell an array of implant products.

I think it's still important to say, though, that the premium product still has an important role to play because it's not just selling the product to the patient. The sort of the -- it's a solution that you're selling to sort of the dental surgeon, whether it be clinical support or education and other services around it as well as the implant itself.

I want to pivot over to some of the other business areas as well. But maybe just a final thing. You've raised this issue a couple of times over the course of the year about dental hygienists and there being a tight market there. How much of a constraint do you think that is an ability to take patients and so forth? And are we seeing any easing of that dynamic at all?

We get it from -- we see the same survey data from the ADA and then also then anecdotally from our customers, right? It does create a bit of a disruption to the dental practice, obviously, and it can affect how many patients they're able to see over the course of a week. I think that it's interesting. We've actually heard that one of the national DSOs is considering starting a dental hygienist school to address the shortage, which the market will find a way of getting -- of fulfilling this gap, right? So we do our best to help our customers find dental hygienists when they need them. And I think that -- because it can be disruptive to the practice. So perhaps some of the -- I know there's been a lot of discussion around patient traffic. Are patient traffic levels back to the levels they were prior to the pandemic? Speculation is, it's probably off mid-single digits, a little from that. Some of that could be from the fact that there is some disruption to the practices from a lack of dental hygienists.

Okay. Just to spend a minute on the technology and value-added services business. I think the business is taking a step down in profitability since pre-COVID. Can you talk through why that's happening? And what do you think about the long-term opportunities? And I know you're making some investments there, too, and where are those targeted?

So it's a couple of things happening in that segment, right? So that segment consists of Henry Schein One, which is our practice management software business. But there's also some smaller value-added services businesses within that segment, such as Henry Schein Financial Services, which facilitates the leasing of equipment, and eAssist, which is a revenue cycle management business we invested in last year. So some of these other businesses and especially some of the ones that we've invested in more recently do have lower margins than Henry Schein One. So you kind of see a different dynamic as these new businesses come enter that segment. Within Henry Schein One, we're kind of managing this transition from selling Dentrix, which we continue to sell, and that's our on-premises practice management software, to Dentrix Ascend, which is our SaaS product, our in-the-cloud product that is subscription-based. So a lot of the development is now being geared towards Dentrix Ascend as we try to make it a more attractive product to start to transition customers to that, that the cost of executing that transition versus when you get the revenue from that transition is, I think, putting a little bit of strain in that profitability that you referenced, A.J.

Okay. Maybe pivoting over to the Medical side. People thinking about companies involved in medical distribution have heard a lot of different things, depending on where your target customer base is in medical, and there can be a lot of different groups you're servicing. Maybe just to level set everyone if there's some new people in the room looking at Henry Schein. What is the focus of your medical effort? And how has that progressed through the year?

Yes. So our -- first of all, we're incredibly pleased with the success of our medical business this year. They -- in the third quarter, excluding PP&E and COVID test kits, we had growth of, I think it was 9.3% in that business. And so that's -- we think that's a great accomplishment. In the first 2 quarters, I think they were in double digits both quarters. So we're experiencing very good growth in that portion of our business. Our medical business is really -- our strategy has always been to kind of follow the patient. Years ago, and I started at Henry Schein in 2008 and it was before I started at Henry Schein, we kind of got out of the hospital business, right? Because we saw the hospitals taking on fewer of the patient procedures than historically had been done. And we're starting to shift towards the ambulatory surgical setting or even more and more things being done in the physician setting. So our medical business is really geared towards the ASCs and the physician office and not to the hospital. And as we begin to see more and more patient procedures being -- or patients being cared for at home, we're looking for opportunities there as well. So last year, we bought an interest in a business that provides product to home health care businesses and they're specializing in wound care products. We're looking at opportunities, perhaps on the orthopedic side or on the diabetes-related product side and see, is there an opportunity for us there as well in medical? So that's kind of where we see the growth of that. In the meantime, we have great relationships with the IDNs. A lot of our growth is really kind of achieving greater depth of sales with our existing customer base but also expanding some of those sales to the independent physicians as well. And then there's also a commercial aspect to our medical business that sells into sports teams, government contracts, other kind of like larger kind of commercial-type transactions as opposed to directly to a physician. And we've had some good traction this year in that area as well. So that's really kind of the onward focus of that business.

And the strength you've seen, has that been more oriented toward ASC? Has it been more oriented toward the physician side?

I would say both. I think early in the year, we probably got a little bit of benefit from people going in for elective procedures that they had put off for a while because of the pandemic. And I think that created a lot of traffic into the ASCs. And we benefited from that. But we've seen -- from a product perspective, we've seen good growth, especially in point-of-care diagnostics, so flu diagnostic kits, strep diagnostic kits. And of course, we also had the COVID diagnostic kits which aren't doing as well this year as last year. But flu diagnostic kits are in high demand right now. And so that has also been a good kind of stimulus to the business.

Yes. I was going to ask you about that. We haven't had a normal flu season in a couple of years. Is what you're seeing, and this has been brought up several times before, is what you're seeing more of a normal flu season returning? Or is it something more significant than that? And I don't know how big a flu season can be for you all but maybe any perspective on that?

Well, in terms of flu-related products for us, we do sell flu vaccines to the physician. Most of our flu vaccines are sold before we buy them, like they're preordered by the physician. We buy from the manufacturer and then ship to them. But we always do buy a surplus amount and then we can sell those on the spot market. And so the fourth quarter, we'll see more spot market sales of flu vaccine than what the third quarter did. And then there's also the flu diagnostic kits, which, like I said, has had significant demand. Our expectations are, and I think everything that we've all read is that this will -- could be a pretty heavy flu season just based on what happened in the -- the Southern Hemisphere is really the precursor to it. We were just talking in the last breakout session that we had, the CDC has a kind of a heat map. You can go and take a look at the map of the country and so where flu is prevalent and where is it moving to. And all indications are right now is that it's going to be a relatively heavy flu season. So I'm not applauding a heavy flu season, but from a business perspective, it's something we had to be prepared for.

And maybe I'll just -- as we're winding down on time, a quick comment on capital deployment. I look at your share repurchase activity and seems like to me, your authorization, you may run through that pretty quickly? Or is that still going to be part of the capital deployment story? And then you've done a couple of deals recently. I don't know if that's part of your ongoing thing as well. What does the pipeline look like?

Yes. So I think that from a capital perspective, historically, we have spent $300 million to $400 million in M&A over the course of the year. But last year, it was over $550 million, I think it was around $570 million. This year, it's a little light of that -- of the kind of $300 million to $400 million normal run rate. But it's just really timing of things in the pipeline. But the pipeline is robust. I think from a share repurchase perspective, yes, our Board has always been very supportive of share repurchases. And my personal expectations are when we use up what's been authorized for share repurchases, if we go back to them, I'd be surprised if they didn't give us that authorization. So we've got a very healthy balance sheet. Our debt ratio to EBITDA is about 0.7. We've got a lot of headroom if we want to do more transactions if the right opportunities come to us. So we like having that flexibility, and we're -- but like I said, the M&A pipeline is -- there's a lot going on out there, but we're careful. We'll deliberate. We want to make sure we make the right transactions.

No, that's great. Well, I think that's a good note to wrap up on. I really appreciate Henry Schein participating in the conference this year. Ron and Graham, thanks for being part of it. And next up in this room, we have Apollo Medical.

Very good. Thank you, A.J.

Thanks, A.J.