Description

Dentsply Sirona (“Dentsply”) is a high quality business in an attractive market with a stock down (-47% from its 52 week high) for numerous reasons I believe are mostly temporary (e.g., temporary poor performance, changes in management, potential accounting adjustments), and negative sentiment caused by recent news bad enough that it might make people ask you “How could you buy Dentsply Sirona?  Haven’t you read the news?”

Dentsply is the leading global manufacturer of dental equipment and supplies, and its dental consumable products, dental equipment, healthcare consumable products and dental technologies are distributed in over 120 countries under some of the most well established brand names in the industry.  The dental business is benefitting from the aging population in developed markets and an increased incidence of dental care in emerging markets.

The company operates in two business segments: Technologies & Equipment and Consumables.  The Technologies & Equipment segment includes dental implants, laboratory dental products, CAD/CAM systems, imaging systems, treatment centers, and consumable medical device products.  The Consumables segment includes preventive, restorative, instruments, endodontic, and orthodontic dental products. The equipment business is a lumpier business than consumables, and is therefore more difficult to forecast reliably.  The broad consumables portfolio offers recurring revenue and is more predictable. Technologies & Equipment represented ~55% of 2017 revenue, and Consumables represented ~45%.

In Feb 2016, Dentsply International (market leader in dental consumables) and Sirona Dental Systems (a market leader in dental technology and equipment) completed a large “merger of equals,” which broadened the scope of Dentsply’s business, adding things like in-office milling equipment, imaging, and chairs to Dentsply’s traditional strength in areas such as implants, endodontic supplies and restoratives.  However, the integration and expected synergies have been slow to develop.

News that has caused investor concern:

â–ª Q3’18 results missed expectations for revenue and earnings, and Dentsply announced a restructuring (anticipated to achieve $200-$225m in annual cost savings through streamlining the organization and consolidating functions by 2021), and lowered guidance.

â–ª Year-over-year comparisons for reported sales growth, inventories, and distributor inventories continue to be impacted by the transition in distribution strategy with Patterson Dental and Henry Schein (discussed in more detail below).

â–ª Growth in the global dental market has been anemic recently in both consumables and equipment.

â–ª The Sirona merger was expected to be accretive to adjusted EPS within the first year, and to result in annual pre-tax synergies of $125+ million (cost and revenue synergies from a broadened product offering, expanded customer base, and scalable infrastructure) by the third year following completion, but the acquisition has not delivered the expected synergies, and the company has taken large impairment charges against the carrying value of deal-related intangible assets.

â–ª An ongoing SEC Division of Enforcement investigation “relating to transactions with a significant distributor of the Company,” initially disclosed in the 10-Q filed on August 9, 2017 (discussed in more detail below).

â–ª The company announced in Oct 2017 the simultaneous resignations of the CEO, the President / COO, and the Executive Chairman, which may have been related to the SEC Division of Enforcement investigation, but was generally reported to be related to the slow realization of merger synergies.

â–ª Dentsply is under IRS audit for fiscal years 2012 and 2013. On August 31, 2018, the IRS issued a Notice of Proposed Adjustment relating to the Company’s worthless stock deduction taken in 2013 of $546 million, which IRS proposes to disallow under alternative theories. Dentsply recorded the tax benefit associated with the worthless stock deduction in the Company’s 2013 and 2014 tax years. The IRS additionally proposes to impose penalties that range from $38 - $74 million.  Dentsply believes the IRS position is without merit.

â–ª Henry Schein (HSIC) and Patterson Dental (PDCO) have long been leading franchises in dental-product distribution and are Dentsply Sirona’s two largest distributors, but Amazon is driving a structural shift—price competition and market share—in the market.  As a result, Dentsply has had to increase its internal sales efforts to service dentists who do not have the depth of relationship with Amazon that they had with the two incumbents, which has modestly increased Dentsply’s operating costs, but a larger issue has been that the competition has led to inventory destocking at HSIC and PDCO, which has materially reduced Dentsply’s 2018 revenue.

Positive attributes that have been overshadowed by the recent negative news:

â–ª High quality business, both in terms of profitability and durability.  The business is diversified by products, technologies and geographies.

â–ª High ROIC business with a platform that provides additional high ROIC reinvestment opportunities.

â–ª Largest global manufacturer of professional dental products and technologies, with leading positions and some of the most well-established brands across consumables, equipment, technology, and specialty products for dental professionals, specialists, and dental labs.  They have the #1 or #2 brands in multiple consumable categories that provide a reliable and stable source of growth, and leading platforms in equipment and technology with comprehensive end-to-end solutions.

â–ª The merger of Dentsply and Sirona brought together the largest provider of dental consumables (Dentsply) with one of, if not the most technologically advanced providers of dental equipment (Sirona), creating the industry’s largest global supplier, in a unique position to create and sell new value-added solutions in both equipment and consumables, and combinations thereof.  They are beginning to see some evidence of the power of combining differentiated products into one offering (e.g., a program where they offer digital impression with implants in a novel program to cross-sell both products, which not only improves the value proposition versus the competition, but is also driving new sales leads for both franchises).

â–ª Dentsply is well-positioned to benefit from the favorable demographics in the growing global dental market (i.e., demand for dental care should increase as the global population lives longer, and the aging population becomes increasingly larger and wealthier).

â–ª A new management team is in place and focused on better integrating Sirona, while favoring organic growth and share repurchases over big acquisitions. In Jan 2018, the Company announced that Don Casey was appointed CEO.  Casey has >30 years of global health care experience, most recently as CEO of the Medical segment of Cardinal Health.

â–ª Sirona’s flagship product is CEREC, a 3D dental restorative system that is the combination of an intra-oral scanner, CAD-CAM software, and a miniaturized mill that enables dentists to design and mill dental restorations in their offices during a single patient visit.  Dental restorations include inlays, onlays, veneers, crowns, bridges, copings, and bridge frameworks. CEREC has a number of advantages compared to the traditional out-of-mouth pre-shaped restoration method, as CEREC does not require a physical model, restorations can be created in the dentist’s office and the procedure can be completed in a single visit. The patient avoids spending several weeks with a temporary crown. Dentists love it, and patients love it.  In 2006, Patterson Dental paid a $100 million cash up front as a distribution fee to extend its existing exclusive North American distribution relationship with Sirona CEREC for at least a 10-year period beginning in 2007.

â–ª Products are used by hundreds of thousands of dentists globally each year, all of which represent a potential opportunity to cross sell other products.

â–ª One of the largest R&D platforms in the industry (over 600 experienced scientists and engineers, engaged in more than 50 clinical studies), with an unmatched technology portfolio that gives them a large amount of optionality, and can serve as an important foundation for leadership in the ongoing digital revolution in dentistry.  The Company releases >30 new products annually. 2017 R&D spend was >$150 million.

â–ª A world class sales and service infrastructure (>40 locations with sales in over 120 countries, ~5,000 global professionals, and ~5,000 dealers) well positioned to drive growth.

â–ª The broadest clinical education platform:  >350,000 professionals trained annually, >11,000 courses in 80 countries.

ValueAct Capital Potential Involvement

ValueAct Capital initiated a position in XRAY last quarter (Q3’18), and they own ~1% of the company.  That stake is consistent with ValueAct’s approach of making “farm-team” investments that Jeff Ubben described in this interview with Value Investor Insight:  “We like to live with smaller investments in a company for three to six months before making a full commitment. It gives us an opportunity to even better understand the company and its business while getting to know management and whether we’re all on the same page…Our goal is that by the time we’re ready to commit to taking a 10%-plus stake in a company we know the business cold and have bonded with management so that we’re really in it together.”

So it is possible ValueAct will continue to purchase additional stock, pursue a board seat, and get more actively involved.  They try to identify simple things that can be done with a business to create value independent of the market, and then take an active approach in working with management and the board.

Numerous other attributes mentioned in the interview that ValueAct seeks in an investment also apply to Dentsply:

â–ª Businesses that are so good that they are hard to screw up.

â–ª Industry structure: they favor relatively slowly evolving industries that are duopolies or have three primary players (in this case, some market segments are more oligopolistic than others, with Dentsply, Danaher, and 3M the leading players; overall, Dentsply, Danaher, 3M, and Align have 39% market share combined).

â–ª A company experiencing an accounting issue (e.g., revenue recognition) that does not impact cash flow (“Cash doesn’t lie. When people bail on a company because of an arcane accounting issue when the cash flow is there, we love it.”).  In this case, the SEC Division of Enforcement Investigation could potentially qualify.

â–ª For technology-based businesses, they look for industries that are mature, with recurring revenue making up a higher percentage of sales, and a company that has been around for a long time, has great intellectual capital, and a strong installed base.

â–ª “80% of the time” they invest around a management change initiated by the board on their own or at ValueAct urging. New management that can take advantage of the installed base, and focus on improving margins and cash flows.  In this case, Dentsply’s board made the changes on their own.

â–ª Valuation metrics they focus on:  “We’re looking for a free-cash-flow “coupon” of 10% – EBITDA minus real capital spending minus incremental working capital, divided by enterprise value – combined with a growth profile of 10%.  We look three years out at what we think the balance sheet looks like, what the cash flows look like and what type of multiple we should expect – out of that we want to see an annual 20% unlevered return.  The hardest piece to get is the growth. To get really high-quality businesses that have recurring revenue streams and industry structures that are stable, you tend to end up in industries that are very mature…We want a combination of the two that gives us a 20% return.”  Dentsply’s combination of valuation and growth exceed that hurdle.

â–ª “We don’t worry about headline risk – once we believe in an asset, we’re buying more on any dips because we’re focused on the end game three or four years out.”

SEC Division of Enforcement Investigation

An ongoing SEC investigation “relating to transactions with a significant distributor of the Company,” was initially disclosed in the 10-Q filed on August 9, 2017: “The SEC’s Division of Enforcement has asked the Company to provide documents and information concerning the Company’s accounting and disclosures, including its accounting and disclosures relating to transactions with a significant distributor of the Company. The Company is cooperating with the SEC’s investigation. The Company is unable to predict the ultimate outcome of this matter, or whether it will have a material adverse effect on the Company’s consolidated financial position, results of operations or cash flows.”  

The investigation is still mentioned as ongoing in the most recent 10-Q (Sept. ‘18) (“The Company is cooperating with the SEC’s investigation.”), so it remains a possible exposure. Given that the issue relates to transactions with a significant distributor, Dentsply may have engaged in channel stuffing and/or have issues with revenue recognition, and there is a risk of a restatement and/or future reported revenue shortfall as the issue gets unwound in future earnings reports and/or restated in past financial statements.  In response to numerous FOIA requests for information about the investigation, the SEC has denied access to records, and the SEC stated, “We have confirmed with staff that releasing the withheld information could reasonably be expected to interfere with on-going enforcement proceedings.”

Dentsply does not disclose sufficient information to thoroughly analyze and/or discount the magnitude or likelihood of the risk, and neither Patterson nor Henry Schein disclose in their 10-Ks an investigation by the SEC’s Division of Enforcement.  Dentsply filings do include some potentially relevant disclosures (included below), which suggest the potential exposure for a restatement could be ~$23-26 million (fines and potential class action lawsuit settlements could cause additional exposure):

â–ª 2017 10-K: “The Company had two exclusive distribution agreements with Patterson Companies, Inc. (“Patterson”) for the marketing and sales of certain legacy Sirona products and equipment in the United States and Canada. In order to maintain exclusivity, certain purchase targets had to be achieved. In the fourth quarter of 2016, Patterson’s decision not to extend the exclusivity beyond September 2017 was announced. Following that announcement, in May 2017, the Company entered into a new three-year agreement with Patterson whereby Patterson would continue to distribute the Company’s equipment lines in the United States on a non-exclusive basis. In the second quarter of 2017, the Company also entered into two separate multi-year agreements with Henry Schein, Inc. (“Henry Schein”) for the distribution of the Company’s equipment lines in the United States and Canada. While the agreement with Henry Schein with respect to the United States was effective September 1, 2017, the agreement relating to Canada was effective June 2017. The Company began shipping initial stocking orders for the equipment products to Henry Schein under the agreements in the second quarter of 2017 and continued through the balance of 2017. During the second quarter of 2017, the Company also modified its distribution agreement with Henry Schein with respect to the distribution of certain products in France. Based on the Company’s estimate, year-over-year changes in distributor inventories associated with these agreements positively impacted the Company’s reported sales for the full year of 2017 by approximately $23 million. Based on the Company’s estimate, distributor inventories increased during 2017 by approximately $26 million as compared to an increase of approximately $3 million during 2016. The increase in inventory levels was the result of the combination of lower equipment sales to end-users as well as higher than anticipated inventory levels held by distributors. The Company’s anticipated decrease in inventory levels held by distributors is projected to negatively impact the Company’s sales by approximately $40 million during 2018.”

â–ª 2017 10-K: “The Company’s business is subject to quarterly fluctuations of consolidated net sales and net income. Price increases, promotional activities as well as changes in inventory levels at distributors contribute to this fluctuation. The Company typically implements most of its price increases in October or January of a given year across most of its businesses. Distributor inventory levels tend to increase in the period leading up to a price increase and decline in the period following the implementation of a price increase. Required minimum purchase commitments under agreements with key distributors may increase inventory levels in excess of retail demand. These net inventory changes have impacted the Company’s consolidated net sales and net income in the past, and may continue to do so in the future, over a given period or multiple periods.”

â–ª 2018 Q3 10-Q: “The Company continues to be impacted by the transition in distribution strategy with Patterson Companies, Inc. (“Patterson”) and Henry Schein, Inc. (“Henry Schein”). During 2017, the Company signed new distribution agreements with Patterson and Henry Schein for the Company’s equipment products. The Company shipped initial stocking orders for the equipment products to Henry Schein under the agreements primarily in the second and third quarters of 2017 which resulted in unfavorable year-over-year sales growth comparisons. Based on the Company’s estimate, year-over-year changes in distributor inventories associated with these agreements negatively impacted the Company’s reported sales growth in the first nine months of 2018 by approximately $75 million. Based on the Company’s estimate, distributor inventories increased during the first nine months of 2017 by approximately $6 million as compared to a decrease of approximately $69 million during the first nine months of 2018. At this time, the Company estimates that net changes in distributor inventories will unfavorably impact the Company’s sales by approximately $65 million to $70 million for the balance of 2018. Based on the Company’s estimate, year-over-year changes in distributor inventories associated with these agreements is projected to unfavorably impact the Company’s reported sales growth for the full year of 2018 by approximately $140 million to $145 million.”

â–ª Ongoing disclosure in 10-Qs and 10-Ks: “Purchase and Other Commitments From time to time, the Company enters into long-term inventory purchase commitments with minimum purchase requirements for raw materials and finished goods to ensure the availability of products for production and distribution. These commitments may have a significant impact on levels of inventory maintained by the Company.”

Distributors and Concentration

Dentsply’s primary distributors in the dental market are Henry Schein (HSIC), the Patterson Dental division of Patterson Companies (PDCO), and Benco Dental (private).  For the year ended Dec 31, 2017, Henry Schein accounted for ~15% of consolidated net sales. At Dec 31, 2017, Henry Schein and Patterson Dental accounted for ~14% and ~15%, respectively, of the consolidated accounts receivable balance. For the year ended Dec 31, 2016, Henry Schein and Patterson Dental each accounted for ~12% of consolidated net sales. At December 31, 2016, Patterson Dental accounted for 17% of the consolidated accounts receivable balance. For the year ended December 31, 2015, Henry Schein accounted for ~11% of consolidated net sales.

For many years, Sirona had an exclusive North American distribution relationship with Patterson Dental for its CEREC 3D dental restorative system.  Substantially all of Patterson’s relations relationships with hundreds of vendors are non-exclusive, and in November 2016, Patterson decided not to extend sales exclusivity for Sirona products (which ended in September 2017), to enable Patterson (in PDCO’s words) “to better serve the evolving needs of all of their customers and the full range of practice models, including the Dental Support Organizations (“DSOs”) that represent an increasing share of the dental market.”

Henry Schein and Patterson Dental have long been leading franchises in dental-product distribution, but Amazon has started to drive a structural shift in the market, and they have been experiencing greater than anticipated competitive pricing pressure at the point-of-sale and unplanned inventory adjustments, and have lost some market share to Amazon.  The traditional players are focusing on providing a complete value proposition for customers and trying to be more than a just supply partner, but also a business partner with a broad value proposition, including services, technical support, a broad equipment portfolio, and software technology. But they need to be competitive on price, and I expect Amazon to continue to gain market share in dental consumables as they bring more price transparency to the market.

Some Dentsply products are available at Amazon for direct delivery to dentists and physicians, some of which require an Amazon Business Account and a healthcare license:  https://www.amazon.com/l/3540011011.  Amazon has integrations to 50+ practice management systems, giving them a way into dental offices. Henry Schein and Patterson are at risk given their historically low price transparency, price increases, and relatively high margins for distribution businesses.  The competition presents downside for margins and multiples for Henry Schein and Patterson, but has less impact on Dentsply’s pricing.

As Amazon has taken share from Henry Schein and Patterson, Dentsply has had to increase its internal sales efforts to service dentists who do not have the depth of relationship with Amazon that they had with the two incumbents. That has modestly increased Dentsply’s operating costs, but a larger issue has been that the impact on inventory destocking at Henry Schein and Patterson, which in combination with the inventory destocking driven by the transition in distribution exclusivity, has reduced Dentsply’s 2018 revenue.

Market

The dental market is less volatile than the broader economy, and is less dependent on government reimbursement than the medical market because it has a has a large private pay component, so it is less exposed than other healthcare markets to reimbursement changes.  There is accelerating adoption of digital dental technologies, and increased patient awareness is driving demand growth for single visit and aesthetic dentistry. The market typically grows 1-2x the underlying GDP growth rate, and is fragmented: the top 10 competitors have only ~50% of market.  Customers for the dental supply market consist of a large number (hundreds of thousands globally, with ~198,000 dentists practicing in the U.S. alone (source: ADA)) of geographically dispersed, highly fragmented dental practices, ranging from sole practitioners to large group practices or dental service organizations.  The end-user customer generally has 1-3 dentists per office.

The combined global dental equipment and consumables market was ~$34 billion in 2017 and is expected to grow to ~$50 billion by 2024.

~67% of the overall market is Dental Consumables, ~22% is Dental Equipment, and ~11% is Dental Implants.  North America and Europe represent the majority of the market, with lower penetration (and faster growth potential) in Asia Pacific and Rest of World.

Dentsply estimates they have ~17% market share, with opportunity to take additional share:

Many segments are led by Dentsply and divisions of 3M and Danaher, with market shares stable for many years, but there have also been incursions into the orthodontics market by Invisalign maker Align Technology.

Dentsply Leading Brands and Technologies

Key Competition by Segment

Barriers to Entry

â–ª Established brand names

â–ª Extensive patent portfolio

â–ª Strong relationships with dental schools and end-users

â–ª Broadest clinical education platform:  >350,000 professionals trained annually, >11,000 courses in 80 countries.

â–ª ~5,000 highly trained product-specific sales and technical staff

â–ª Complexity and global scale in manufacturing

Comparable Multiples

Although many of Dentsply’s competitors are not dental market pure plays (e.g., Danaher (although DHR has announced its intention to spin off its Dental segment in 2H 2019), 3M, Mitsui, etc.) or are privately owned (Planmeca, Ivoclar Vivadent, Carestream Dental—owned by Clayton, Dubilier, & Rice), there are several pure play comparables: Align Technology (ALGN), Integra LifeSciences (IART), Straumann AG (STMN.S), and Zimmer Biomet Holdings (ZBH), and XRAY is selling at a meaningful discount to its comparables:

If Dentsply hits its financial targets (below), by year end 2021, EBITDA – Cap Ex will have compounded at a 14% CAGR for 3.25 years.  At the current 14.9x EV / (LTM EBITDA – Cap Ex), the LTM FCF yield is 6.7%, and the FCF yield based on 2019 EBITDA – Cap Ex is 9.5%, which combined with the growth in FCF, both exceed ValueAct’s 20% target.

After Dentsply’s results have normalized following the transition in distribution strategy, if they execute the plan below, and its FCF multiple increases to just the low end of the comps above, the stock has the potential to increase ~2.5x.  If they achieve some, but not all of the targets below, a multiple more in line with the comps (a bit above the low end) would result in the same stock performance. The downside is far more limited given the recent results reflect the transition in distribution strategy (which should improve from here), and Dentsply’s multiples have already been penalized accordingly.

Financial Targets

Revenue Growth:  ~3-4%

â–ª Consumables growth steady at ~2-3%

â–ª Technology and Equipment returning to growth in 2019, and 4%+ thereafter

â–ª New product introductions

â–ª Investing in global scale and faster growing regions (e.g., China and Latin America, growing HSD)

â–ª Overall growth at or above dental market

EBIT Margin:  20% by the end of 2020; 22% by the end of 2022

â–ª Restructuring to save $200-225M by 2021

â–ª Portfolio shaping

â–ª Continuing plans for margin expansion after 2020

EPS Growth: Double Digit

â–ª Accelerated EPS growth in the near-term as cost savings are realized

Risks

â–ª Ongoing SEC investigation: there is a risk that the investigation finds that Dentsply engaged in channel stuffing and/or had issues with revenue recognition, which could lead to a restatement and/or future revenue shortfall as the issue gets unwound in future earnings reports and/or restated in past financial statements.  There is also risk of fines, potential securities fraud class action lawsuit settlements, etc. Dentsply does not disclose sufficient information to thoroughly analyze and/or discount the magnitude or likelihood of these risks.

â–ª Although Dentsply’s results will eventually adjust to the changes in the distribution strategy with Patterson Dental and Henry Schein as well as the Amazon impact, the disruption driven by inventory de-stocking could continue to be a headwind that weighs on some upcoming quarterly results.

â–ª The recent significant changes to the Company’s senior management team present execution risks, and the broad restructuring program poses additional material execution risks: re-shaping the internal supply chain and centralizing several areas of oversight and financial planning.

Catalyst

▪ Normalization of the y/y comparisons for reported sales growth, inventories, and distributor inventories skewed by the changes in distribution strategy as Dentsply fully acclimates to the changes, which could happen relatively quickly in upcoming quarters.

▪ Resolution of the SEC Division of Enforcement investigation, which will clarify the magnitude of the issue (separate from any class action lawsuits).

▪ Resolution of the IRS audit for 2012-2013.