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

Great. Thanks, everyone, for joining us. My name is Nathan Rich, I cover the dental space here for Goldman Sachs. Very happy to have Henry Schein with us. Ron South, SVP and CFO. Thanks a lot for your time this morning. I appreciate you being here.

Maybe starting with just some high-level questions on the dental end market. You talked about a softer start to the year than some improvement in the Dental Consumables business in March and April. I guess can you maybe take us through kind of kind of how you -- what you feel like drove that improvement? Was it end market driven? Obviously, you're kind of coming kind of off of the cybersecurity incident, it still seeing some sales recovery there. How did you kind of see the first quarter play out? And as you think about the balance of the year, how do you kind of feel at a high level about the end market overall?

Certainly, yes. So the first quarter really kind of had a mixed bag effect, right? You had early in the quarter in January. We were still kind of coming off of -- from a specific company perspective, still kind of coming off some customer recovery process that we were going through following the cyber incident. But there was also kind of complicating factors in the early part of the quarter where there was some significant kind of adverse weather within the U.S. that can often kind of dampen demand for dental services as well as a higher-than-normal flu infection rate that we saw that will typically increase cancellations in dental offices. So January started off pretty soft for us, quite frankly. And I think most of the industry saw it that way as well. We began to see that recovery in February. How much of that is coming off of normalization of weather, normalization of flu infection? It's kind of difficult to assess, but we were just happy to see some recovery in February. And that recovery sequentially continued into March. We saw some stabilization in April and then the early part of May, that stabilization continued. But we still think there's opportunity for us as the year goes on to continue to regain market share and to also try to increase share of wallet with our existing distribution customers. But right now, the dental merchandise market is very much confined by what's happening in patient traffic, which is stable but we need it to be, I think, growing a little bit more in order to see meaningful merchandise growth going forward.

So I guess, maybe just on that point, just made. So stable patient traffic, I think you kind of talked about like not -- they're really not being much there from a pricing standpoint this year. Is that sort of like kind of March, April, flattish from a Dental Consumables?

That's probably fair. That would be a fair assessment. And it's also -- we believe our practices, our customers are very busy. Even anecdotally, when you talk to people, if they've had to deal with a -- if they've had to cancel a dental appointment it's often months before you can get back in to see your dentist. . So we -- the President of our North American distribution group was telling me, he would assess that his estimate is about 90% of our customers are operating at capacity, which is a very good number. And there's probably about 50% of the general population out there that should be seeing a dentist that's not seeing a dentist. So there's great opportunity for growth there, but if all your practices are operating at capacity, it kind of confines that opportunity for growth. So as we see more and more dental schools opening, which is a positive, we do think there's going to be opportunity in the next couple of years to see a little more market expansion on the dental side.

I want to come back to that point because I think it's an important one just in terms of like practice throughput and what that can do for the long-term growth of the market. I guess as you think about kind of getting back to this growth in patient traffic and consumables volumes, there's a lot of focus right now on [ precious ] facing the consumer is sort of the reason why the industry is kind of growing below what its target rate has been. I guess, from your point of view, what do you think are the key variables? Is it -- you have jobs? Is it inflation continuing to come down? Is the access to financing a hurdle right now for patients doing procedures? I just would love to get prospective on that.

Yes. Probably the one most important macro metric that we track is unemployment. And this is a -- it's a very U.S.-centric kind of comment, but within the U.S. looking at unemployment. Because if people are remaining employed and where I think we just did -- now hit 4% was the last I heard, but still not a bad number, then they still have access to care. And our business is largely driven by ultimately the public's access to care. If they have access to dental care, and they are generating that consistent churn of consumable merchandise in a practitioner's office, that's better for our business. So a lot of people are getting their dental insurance through their employer. And as long as those unemployment rates are staying as low as they are, that's a macro metric for us. You mentioned interest rates. We can address interest rates in a couple of different ways. Interest rates will impact some of the financing decisions that our customers might make on high-dollar equipment. What we can do, for example, with individual practitioners is that we can -- we will typically co-promote attractive financing rates to them with the manufacturer of the equipment. So if interest rates are ticking up higher than where our customers are happy with it, we can -- for example, we recently did a 5.99% equipment financing promotion for customers. And we shared in that spread, that interest rate spread with the manufacturer. So we will co-promote with that. The other way interest rates can't influence the market a little bit gets to some of the high dollar procedures that you referenced to. Things such as, for example, a full large implant can be very, very costly, and it's typically or can be typically financed by the patient. And if interest rates are a little higher, you can see some pullback in the demand for those procedures. Quite frankly, that's an area that we have -- it's a very small part of our implant business. Our implant business is focused more on the individual implant as opposed to the full arch implant. So that hasn't had -- I think has adverse an effect on us as perhaps others in the industry.

Got it. Okay. That makes sense. And I guess, maybe how would you characterize kind of demand in Europe and some of the other larger markets like that you're in like Australia relative to the U.S. at this point, I guess, especially Germany. Because it seems like there's been a lot of focus that obviously being a key dental market and the weakness there.

Yes. Germany is one of the larger international markets for us. I would say, kind of Germany has been -- you see a little bit -- so depending on what part of the market you're talking about. But what we've seen in Germany is we're still doing well in implants there. We had kind of mid-single-digit growth with our implant business there, which we were quite pleased with. We felt that, that was an indication that we were getting market share. What we saw like in the standard business was it's relatively flat, but we actually got a little bit of growth driven by equipment servicing, which is interesting because it's an area that we have emphasized a little more. We're trying to market it a little more because we do see it as an area that our customers really kind of appreciate the service and they find value in the service. What we don't know is, is that growth driven by that marketing, or is that growth an indication of our customers holding onto their equipment a little bit longer what's happening? We'll be able to kind of see how that trends out over the next several quarters. But -- so that's been good for us in Germany as well. There's other aspects of the business in Germany that are, I would say, are a little more flat, but we haven't seen the same kind of headwinds perhaps as others who are more narrowly focused in that market, right? Outside of Germany, you mentioned Australia, important international market for us. Australia had some very good kind of post-pandemic incentives that the government put out there that have since expired. So that's creating a little bit of a headwind for us there. Also, a country like Australia, Spain is another where a high percentage of the population has a variable rate mortgage. And as interest rates go up, their mortgage payments go up. So it does kind of squeeze a little bit the disposable income. And you do see a little bit of impact of that in some markets, Australia probably being the most significant of that.

Okay. I wanted to go back to what you had just talked about with equipment because I think that's an area of the market where you've seen some pressure kind of across the industry. And I think there is a -- seem to be a fairly strong replacement cycle kind of right coming off of the pandemic. I guess to the point you made about the servicing plans, where do you kind of think we are in that like replacement cycle for the market? And do you think demand was pulled forward kind of coming off the post pandemic, I think very strong recovery in the market? And then I want to ask on the service plans in particular because I feel like many dental practices kind of outsourced out with third party. Now that's maybe a service that you can provide for them. So maybe how you're going to market there? And what's the margin implications as you grow that line of business?

So -- and we're really -- when we're talking about equipment in this context, we're really talking about what I'll call standard equipment, meaning the treatment center, the chair that the patient is in with the lights, et cetera, right? And yes, I do think there was some volatility, some what I'll call, kind of positive volatility in standard equipment in the last couple of years. . Some of that was coming out of the pandemic. You had perhaps a little bit of pent-up demand associated with those who perhaps deferred some equipment purchases during -- at the peak of the pandemic, say, in 2020. You also had a lot of end market churn of customers or patients who changed the business and created opportunities for some practices to expand their practices. [Technical Difficulty] You also had some who saw the pandemic as being something short term, that we're going to take the roles and opportunities... [Technical Difficulty] is less disruptive to their practice. So we were getting double in multiple quarters over, say, in '21, '22 that began to level off a little bit in '23. We do think that we go back and kind of look at the 2019 level of standard equipment demand versus where we are now. It's a nice, consistent CAGR. We're seeing it kind of level off a little bit now. But I think kind of going forward, as we go -- we should get back to something that would be more normal kind of in that mid-single-digit growth on standard equipment. In terms of where are we on the replacement cycle, kind of hard to say. It is a -- it is -- you have to look at kind of the individual practitioners versus the DSOs, lot of DSOs out there, that equipment growth comes from de novo practices as they build out new practices. Some DSOs are focusing a little more on how do we optimize the capacity of our existing practices versus adding -- continuing to add on de novos. So that will -- that has dampened -- perhaps that standard equipment demand a little bit, but not a great deal. So where are we in the replacement cycle, it's very hard to say. But this goes back to, if we can continue to get more dentists into the market because I do think the demand for dentistry services exceeds the existing supply that would prompt greater investment going forward in standard equipment as well because it's functional. It's just something if you're going to have more patients, you need more chairs. And so I just think that it just will follow that trend. On the service side, it is an area that we are starting to market more and more. We've developed a product that is much like an Uber style of an app that our customers can use that can pull a technician -- and quite quickly. Especially in the larger metropolitan areas, we can typically have a service rep in a practice in 2 hours or less, which is important to our customers. It's a -- if that chair is empty, you're not getting revenue from that chair. And so if we can get a service rep in quickly, not even -- it's a good margin but it's also -- it builds customer strength, right? It makes it stickier because the customer feels like you've given them good service. So it is an area of importance. And one that we are starting to invest in a little more, like I said in these types of tools, that can make it more efficient. Can we increase the number of visits that a technician can do in a day? That all just kind of falls out to the bottom line we can.

And in terms of... [Technical Difficulty] I feel like one of the other things that... [Technical Difficulty] the last couple of years as you may be seeing a bit of a pullback in terms of private formation. Do you see that changing at any point over the next couple of years? Is that a fair characterization?

When you say practice formation just in terms of de novo [indiscernible].

Yes. That's right.

Yes. Well, I think this goes back to, are there enough dentists, right? And as you get more and more dentists coming out of dental school -- a lot of dentists coming out of dentist school these days, we'll actually go to work for... [Technical Difficulty] they're coming out some fair amount of debt, and they don't really have perhaps the funding to invest in their practice. So I think that will prompt perhaps a little more growth out of the DSOs and de novo practices. But like I said, we believe the demand is there for the supply of dental services to grow. And if that's the case, then that provides opportunity across the board, whether it be merchandise or equipment.

Stanley has talked a lot about the need for digital integration and that's sort of being one of the areas that you're focused on helping dental practices. I would imagine that could potentially from a capacity standpoint too, if you improve profits workflow. I guess can you maybe just talk about sort of what the specific solutions are there. And -- because I feel like it's something that we've heard about for a long period of time. I guess, maybe how that is sort of implemented in practice and a clinic would be kind of helpful context.

Yes, very much so. So we have a digital clinical workflow product called Nemotec that allows, we kind of call it, 3-click dentistry, right? And it allows a practitioner who has an intraoral scanner to take a scan of a patient with one click, update the patient records and then be able to then send that image directly to their 3D printer or their chairside mill or to a lab. And then also process a much more accurate claim with the insurance company along the way. and it really increases the efficiency of the practice. It starts with that scanner though. We've talked a lot about some of the disruption in scanner pricing the last year or so, that has stabilized. But it really has to start with that scanner. It's an area that we really think that as scanners have become more affordable to practices, we're seeing probably about a 50% penetration rate which sounds low. But there are a lot of practices out there, so hope we align impression material. If they don't have a scanner, none of the other things can happen, right? You're not going to buy a 3D printer without a scanner. So what we do expect to see is greater growth in this digitalization because it does provide an opportunity for the practice to see more patients in a day. It can actually increase their number of -- in addition to increasing the number of patients, they can increase the revenue per patient with this type of procedure and this type of efficiency and ultimately reduce their costs in terms of the accuracy of the claims that are going to the insurance companies and having to kind of reprocess claims. All of that are right now existing pain points for our customers for the practices that we think can be addressed through digitalization. .

And on the high-tech equipment piece, kind of the scanner being the cornerstone. I feel like you've seen good growth -- good volume growth there. ASP is starting to stabilize. Does that sort of mean that the high-tech piece of the equipment portfolio kind of gets back to growth this year?

That's our expectation. In our first quarter earnings release, we did say that we expect modest equipment growth this year, but that would be driven by relatively flat standard equipment growth, so those chairs, units and lights. But with some modest growth in kind of more CAD/CAM style equipment, that being standard, 3D printers, chairside mills. Imaging is still seeing some headwinds on pricing. But right now, we think that the CAD/CAM piece can more than offset that headwind on the imaging side.

Okay. Yes, I'm going to ask about the digital M&A because it seems like that's been particularly negative, just like probably towards the top of the high-ticket pieces of equipment, practices can buy. What's -- within, like, I guess, high tech, what's the relative mix between like CAD/CAM and imaging?

Within high tech I mean, I would say it's probably roughly half and half. I mean that's a rough number for us. It could differ from other companies, but I think for us it's been -- and equipment in general, our standard equipment has typically been about 2/3 of our equipment revenue at being about 1/3. And then within that 1/3, it could be roughly half and half.

I wanted to spend some time on the specialty businesses because that, I think, particularly implants is for the company and an area where you guys have done incredibly well. I think that investors are having a tough time kind of thinking through the dynamics of the implant space. And specifically, you have a tough end market like we've talked about, especially towards the higher end of the endpoint procedures that are done. You have a lot of manufacturers, making it a focus to reaccelerate growth of their implant businesses. It's kind of -- at a high level how you see this playing out. It seems like in that type of environment, it could put pressure on pricing, which probably plays right into your portfolio and where it's positioned. So I'd just be curious to kind of get your perspective on how you think the dynamics of this market are going to [ deploy ]?

No, I think especially in terms of North America, where we have kind of positioned ourselves historically has been with a -- what we would consider to have kind of a premium implant product but at a sub premium price. So we've been able to be fairly price competitive in that premium market. If other premium players are bringing their price down, we haven't seen them bring the price down to our price, right? So we still feel like we are price competitive there, and it's allowed us to protect market share. Where we have had kind of a bit of a gap in North America was on the value implant side, where we think there's actually potential for very good growth on value implants. The acquisition we did last year of S.I.N. in Brazil gave us access to a value implant that was already... [Technical Difficulty] S.I.N. had this implant, they weren't selling it yet in the U.S. at any kind of level of scale because they didn't really have the infrastructure for it yet. But we are able to fold it into our product portfolio at BioHorizons, and now we are selling SIN's value implant in the U.S. That's an important product for our DSO customers whose GPs would like to do their own implants as opposed to referring it. Typically, if they're doing that, they're going to take on the more basic procedures in which case they can work with a value implant. So that's -- we feel like we have good demand for that. Equally, there's another product that we are awaiting FDA approval. We should have it very soon that will allow us to sell a more deeper connection bone implant that is really represents about 50% of the market out there that we were not able to sell into. And we have -- again, our DSO customers and other customers are -- have expressed an interest in this product, and we think that will help us on the back half of the year in terms of our revenue growth there. So we -- the Implant business in North America with these changes with the S.I.N. value implant, with the FDA approval of the more deeper connection bone implant has really allowed us to broaden the product portfolio and I think set us up for good growth going forward there.

So that's the first bone level implant you're going to be able to sell it?

We have a bone level implant in the U.S., but this is a much deeper one. It's a can't -- not to get into, what they call, a Deep Connection Conical Tapestry implant. So it's very similar to the technology we use for our implant. The CAM log sells in Europe. So it's proven technology. It just had -- didn't have FDA approval in the U.S. It's not the exact product that we're doing in Europe, but it's very similar. It's based on the same technology.

And you face a big competitor in that space. I mean, is this the strategy the same sort of you want to bring that premium type product at a value price?

Yes. I don't know if I would call it a value price as much as I would call it a sub-premium price. Yes.

Sub-premium price. Okay. Fair. And then on S.I.N., in value space, how do you feel like you can differentiate yourself. Because I think the sub-premium pricing on a premium-type product was -- that is a real compelling value proposition. The value space, I feel like is there the same type of opportunity to kind of price at a discount versus the other options that are on the market currently?

Yes, very much so. And I think that it is a -- like I said before, it is an area that our DSO customers have been asking us about how do we get a value implant from you. And now we've been able to address that with them. One of the advantages DSOs have perhaps is their access to education. They will sponsor a lot of kind of broadly based education program. So it gives our GPs the opportunity to learn implant procedures, get certified on implant procedures. And -- but they're typically going to at least start if not to stay with the more straightforward procedures that they can do with the value implant. More complicated procedures will likely still get reference to an oral surgeon. So they don't need a premium implant system to do the type of procedure that they would like to do. So the value implant is attractive to them.

I wanted to ask you about DSOs because that's kind of been a core of your distribution business for a long period of time. You've talked about -- I think, I've made several references here about kind of selling more specialty products into DSOs. Have you seen sort of consolidation in sort of the vendors that they want to work with in terms of the scope of products that they're buying? And then can you also touch on the technology side as well? Have you been able to kind of sell in the Henry Schein One solution set to those customers?

Yes. I don't know if I would call it consolidation of vendors with our DSOs as much as, I'll call it -- some people don't like the word formulary when it comes to this thing -- this type of thing, but it's really kind of what formulary do they want to have. I think one of our customers likes to call it the marketplace because their practices don't like the idea of being restricted to a formulary. But it is -- we do try to keep them to that. Our supplier partners are welcome to participate in that. If it's a price competitive situation, it's up to us to negotiate a charge back from that -- from our supplier partner. A lot of our DSO customers are interested in private label from us as well. If it helps -- get helps to get to pricing that they find more attractive. So that becomes part of it. The technology piece very important part of it. A lot of -- many of our DSO customers want their practices to be on a common platform. And so we do -- for a lot of our larger DSO customers, we set up a conversion. You can't convert everybody on the same day, obviously. But as they acquire practices and build out practices, we have a schedule of getting them on to -- primarily on Dentrix Ascend. Most new customers are going on to Ascend, which is the cloud-based practice management system. And so we do have -- we schedule them out and get them on to Ascend. What that allows us to do as well, our DSO customers also like some of the business analytic tools that come with the Henry Schein One can offer because it does give them the opportunity to get kind of a snapshot of the financial metrics of all their practices and identify the outliers, both negative and positive that they can develop some best practices in terms of the profitability and what can they apply across all their practices.

And I guess one of the other kind of long-term opportunities was the Tech business has a pretty broad suite of solutions. I think kind of the upselling beyond just kind of the core Ascend product is potential for multiples of additional kind of spend from a customer relative to that baseline. I guess, maybe where are you in progress with that and sort of just the strategy around trying to drive that sell-in since that seems like a big incremental revenue opportunity?

Yes, I know that share of wallet opportunity is very important for us because from a practice management perspective, especially in the U.S., we're already at about a 50% market share. So the market share expansion opportunity is more limited. But what you can do is you can take a look at the suite of services that those customers are buying. And the -- if a customer were to purchase everything available to them, they'd be spending about $1,500 a month with us. I think average customer is spending about $500 a month with us. So there's that opportunity. So we've been really focusing on that share of wallet, whether it'd be patient experience, electronic claims and the latest that has gained some traction is Detect AI. Detect AI helps the practitioner with their diagnosis of cavities, specifically carries, which are kind of pre cavities and that may not be necessarily visible to the naked eye. And so it does give them that opportunity to sit down with the patient, show them where they should be anticipating an issue. And then is there a way to treat that in a way that's going to be much more palatable to the patient as opposed to having to have a cavity filled. And that's really gaining a lot of traction as well. So that's where we see the opportunity there is how do we continue to improve that share of wallet.

And I feel like what we've talked about with the specialty businesses and with tech, it seems to be having an impact on gross margin. It's kind of been one of the areas that have recently kind of consistently exceeded expectations. I guess, can you maybe talk about just like it's one and a high level, are we at this point where you guys have been talking for several years about getting the growth of these higher-margin businesses, driving gross margin and offsetting pressure in the core distribution business. And then over the balance of this year and into '25, maybe how you -- we should be thinking about modeling gross margin?

Certainly. So I think as we mentioned in the Q1 release, we do see the gross margin for Q1 being relatively representative of what we expect the gross margin to be going forward for the year. You could get some pluses or minuses coming out of that, depending on what happens with some of the products. If, in fact, we get greater growth, for example, in distribution than we expect right now, that might put a little bit of pressure on the gross margin, but that likely will help us on gross profit dollars. So that's not a problem I'm going to dodge from correct, right? But yes, I mean, as we see the growth of our high -- what we term are high-growth, high-margin businesses exceed that of the distribution business, is going to continue to provide a little more profitability, a little bit of leverage in the P&L. I think one of the internal measures and something we've talked about externally as well and one of our internal goals was by the end of this year, we wanted our specialty businesses, so that being implants, endodontic products and orthodontic products, all of which we self-manufacture. Plus, if you take our Henry Schein One, our technology products and other value-added services products that we provide to our customers. If you took that portfolio of business, which right now consists of something a little north of 15% of our revenues, our goal was by the end of this year that, that 15%, 16% of revenues would actually constitute at least 40% of our operating income. And we actually hit that goal in Q1 when it was nearly 41%. So while it's a small part of the top line for us, it's a much bigger piece of the operating income pie for us. If you take that number and kind of tag on some of the private label we're doing in distribution, that is another about 10% of our operating income. If you add that in, that means roughly 50% of our operating income is being generated by brands that we wholly control, whether it be through the self-manufactured specialty products through the technology products, the value-added services for the private label. So that will obviously never get to 100%, but we do think we can continue to get some growth on that going forward as well.

Yes. So 50% of operating income from those products that you kind of manufacture or -- yes.

Brands that we own. So we're not reliant on a third-party partner on those brands.

We've also gotten some questions around SG&A and just how to think about that. I think it's been maybe especially challenging this year just with all the acquisitions that you did last year. Any kind of guidance on how investors should think about modeling SG&A over the balance of the year?

No. I mean I acknowledge it is challenging. We did $1 billion in acquisitions last year. The SG&A profile of the business is different than what it was, say, 5 years ago. We have more and more businesses that are self-manufacturing product, which means while we get that manufacturer's margin, we also have higher R&D expenses, for example. As we continue to push for more growth in Henry Schein One, we're going to incur more software development costs on the SG&A side. So there is -- the SG&A used to be relatively predictable. It's a little less predictable than it was, I think, for -- at least from an external view as people look at it than it was, say, 5, 6 years ago. But there are areas, we've had some programs in place to reduce our occupancy costs. We've had some programs in place to kind of [ corral ] and headcount a little bit. We had a voluntary retirement program a couple of years ago. These are all things that have helped with SG&A, but we're constantly having to look at given the transactions we're doing, you're constantly kind of going back and looking for redundancies, opportunities for integration, what can we do to reduce that cost base, and we'll continue to do so.

And I guess maybe what's sort of the near-ish kind of 1- to 2-year kind of view on M&A? Because you're obviously digesting a lot of deals that you've recently done. Should we, I guess, expect a bit of a slower pace over the next couple of years while that happens? And how do you feel sort of just about the pipeline of opportunities that you're looking at?

Certainly, certainly. So yes, we did do approximately $1 billion in acquisitions last year, which is by far the most we've ever done. We had room on the balance sheet to do that. We had been -- our leverage ratio was about 0.7 more or less. It's now closer to a 1.7, but -- so it's still a reasonable leverage. And part of it was, we wanted to keep the balance sheet clean so that if a year came along like we had last year where we saw some great opportunities that really fit into the execution of our strategic plan, we'd be able to do it. . So that was an exciting year for us. I don't expect to do $1 billion this year. I don't think we have the management capacity to do $1 billion of acquisitions this year, let alone put that much more pressure on the balance sheet, I'd rather not do that. So it's important that we integrate the businesses that we acquired last year and really execute on that integration and drive all the initiatives we have to accelerate the growth in those particular companies. An area that we are taking a look at this year that where we see some opportunities would be more along investing, increasing our investment in businesses which we already control. If you look at our first quarter statement of cash flows, it will indicate that we spent $20 million in acquisitions, I'm using round numbers, right? That's in the investing section. You look down to the financing section, you'll see that we spent $90 million in shares that we acquired of minority interest in businesses that we already control. This is a good year for us to execute on this type of strategy because what it allows us to do is, for example, one of the transactions we did in the first quarter where we bought out a minority partner was in our Endodontic business. And it now allows us -- we can more easily sell some of those endodontic products using our U.S. dental sales team. We don't have a minority partner who we have to kind of work out that profit sharing with, et cetera, right? And we're taking a look at other businesses around the world where we can do something similar. So it's -- you know they really do a lot of due diligence. You already have control of the business and it increases your leverage opportunity going forward. And this is kind of the right year for us to be looking at those opportunities.

Interesting. Great. Well, with that, we're out of time. So Ron, thanks very much. Appreciate your time this morning.

Thank you.