Henry Schein is a good business at an average price. It is a good business, not a great one. However, it is a business I understand and with which I feel comfortable, so I find myself sticking around.
First, what does Henry Schein (“HSIC”) do.
“The Company believes that these investments, coupled with its broad product offerings, enable the Company to provide its customers with a single source of supply for substantially all their healthcare product needs and provide them with convenient ordering and rapid, accurate and complete order fulfillment. The Company estimates that approximately 99% of all orders in the United States and Canada received before 7:00 p.m. and 4:00 p.m., respectively, are shipped on the same day the order is received and approximately 90% of orders are received by the customer within two days of placing the order. In addition, the Company estimates that approximately 99% of all items ordered in the United States and Canada are shipped without back ordering.”
Not much has changed since the first 10-K in 1996.
[As a side note: this is a great example of an industry where change is slow and where HSIC has been doing the same thing for many years.]
Henry Schein has been doing the same thing for the past 30+ years (and even before that as a private company). HSIC distributes dental, veterinary and medical products to the point of care providers in those industries (dentist, vets, and physicians). Additionally, HSIC provides the following ancillary products: practice management software, repair and financial services.
HSIC is a plain vanilla distribution business. In its most simple form, a distribution business serves as a middleman between the supplier of the product and the end user. This middleman is necessary in a variety of situations; shipping logistics, middleman serves as single point of buying for broad product portfolio, inventory management, short-term financing, and a slew of other reasons. The inconvenience of going directly to the supplier is either too cumbersome for the end user or often the supplier will not do business with the individual end user due to the hassle factor of dealing with such small accounts.
In theory, the best distribution business is created when a distributor stands between many small suppliers and many end users, a state of affairs often called a “many to many distributor.” At the other end of the spectrum, the distributor who stands between a few large suppliers and a few large end users is not a great business. Henry Schein falls into the first category, buying and stocking a large amount SKUs (over 100,000) from a variety of suppliers, and then shipping these goods to a large base of end customers. Furthermore, if the distributor is able to gain a large enough scale where no other distributor can match its small spread pricing, convenience and service, it will gain a dominant market position. This is also something Schein has been able to do, growing to the number one market share provider in both the dental and veterinary markets.
It helps to dig into the details of the business and understand exactly what value HSIC provides to its customers.
There are a few main value-added services that HSIC provides to its customers. These main seem like small points of value, but every time I speak with or research why their customers use HSIC, these items are front and center.
First, inventory management. A dentist could buy a year’s worth of dental gloves every January, but where would they store all those gloves. It’s a simple process, but a dentist or vet can order supplies and receive them within two days. Thus, no need to buy in bulk. Second, one-stop shopping. Most vets and dentist run small back offices, essentially employing a few receptionist/family members to greet, schedule, bill patients and order supplies. Both of these industries are still characterized by entrepreneurial, hang-out a shingle-type providers (although the vet business is shifting to more corporate ownership). Without highly trained back-office members, these providers need a one-stop shop to order and re-order supplies in an efficient and most importantly easy manner. One dentist I talked to said he used a part-time high school student to do his billing and inventory management. Third, these providers use HSIC as a way to manage their payables. Operating like a short-term credit facility, HSIC extends payment terms between 30-60 days to their end customers, so that the working capital strain is borne by HSIC instead of the individual providers.
Each of these value-added items provides incremental reason for the customers to continue to use HSIC and most importantly for HSIC a reason for HSIC to earn a return on their invested capital.
Despite its market leading position, HSIC is not without its drawbacks. The largest drawback to HSIC is its inability to move backwards in the supply chain. Since a distributor is a spread business, the main way to earn more money is simply to grow your end users. However, some distributors have successfully integrated backwards to become their own supplier of certain products. Medline is a good example in the medical products industry. Check the box of gloves the next time you visit your kid’s pediatrician. Medline is the distributor selling its own branded products. Some other examples of this backward integration are in the grocery distribution business where Trader Joe’s and Costco have strong store-branded products (Kirkland at Costco). This backwards integration provides higher gross margins to the distributor and is a result of the trust the end customer has in the quality of the distributor.
This brings us to a discussion of how good a business HSIC is. Buffett’s 2007 letter is perhaps one of the best descriptions of the difference between good, great and terrible businesses. Here is a link to the letter.
Buffett describes three types of businesses. First, a See’s Candy type business that can grow its earnings without additional capital. The typical attribute central to this type of business is pricing power. This is the case with See’s Candy and also Moody’s. Buffett’s famous quip on pricing power is memorable:
“If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”
The second category is the company that can growth its earnings, but requires additional capital to do so.
“Typically, companies that increase their earnings from $5 million to $82 million require, say, $400 million or so of capital investment to finance their growth. That’s because growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.”
“A company that needs large increases in capital to engender its growth may well prove to be a satisfactory investment. There is, to follow through on our example, nothing shabby about earning $82 million pre-tax on $400 million of net tangible assets. But that equation for the owner is vastly different from the See’s situation. It’s far better to have an ever-increasing stream of earnings with virtually no major capital requirements.”
This second category is where HSIC lands, in my opinion. HSIC has been able to grow its earning power since 1996 quite dramatically, however, this increase in earning power has come with a corresponding increase in invested capital. Focusing on the last ten years, I have sketched out some rough figures regarding HSIC’s invested capital and their returns.
HSIC has been able to increase its earning power from $164m in 2006 to $479m in 2015, however, that process has required HSIC to retain over $2B of capital. The return on incremental capital, measured by the increase in earning power equates to approximately 14%. HSIC has retained approximately 67% of its net earnings in order to grow its capital base and distributed an additional $1.6B.
If we take a step back and think about the business, these numbers make sense. If you are serving 100 dental and vet practices, you may need $10m in inventory to adequately reach a 99% two-day delivery goal. However, if you are serving 1,000 offices, you are going to need a larger inventory base. Additionally, since HSIC is using its own balance sheet to provide short-term financing to its customers, its accounts receivable balance is going to grow in-line with its customer base. In other words, HSIC is a good business that can produce above average returns for an investor if you buy it at the right price. However, it does not, in my opinion, qualify as a great business.
What is the right price?
Some back of the envelope math might look like this.
|Return on Reinvestment at 14% and Reinvestment Rate at 65%||$312||$340||$371||$405||$442||$482|
For the above calculation, I assumed that HSIC would continue to earn around 15% return on its retained earnings, retain roughly 65% of its earnings going forward and earn a 14% return on this additional invested capital.
Using these figures, HSIC could be worth around $18B in 2020, assuming current valuation multiples. If you are looking for ideas that would provide 20% annual returns with this future valuation in mind, you would need to buy HSIC for around $9B or about $110 per share. Currently the stock price is around $150. In other words, HSIC isn’t cheap enough yet. Additionally, the future growth of HSIC is tied to international markets given HSIC’s dominance in the U.S. Acquisitions and incremental capital is being invested in areas where HSIC does not have a long track record. These investments could prove less fruitful than past investments in growing its U.S. business. If future growth becomes less clear, today’s valuation multiples may contract further, limiting your potential upside. These numbers are rough and scratch pad math, however, I am firmly in the camp of being approximately right instead of precisely wrong. The valuation or margin of safety on an investment should not force you to carry the math to three decimal places.
Sadly, HSIC is a good business that does not have a schizophrenic shareholder base. Rarely, if ever, does it trade outside a reasonable valuation.
Matt Brice is the portfolio manager of The Sova Group, LLC, an investment firm that manages separate accounts for clients. Matt can be reached at firstname.lastname@example.org.