Description

Henry Schein is a global healthcare distributor operating in three areas - dental distribution, animal health distribution, and medical distribution.  Revenue is split 50/30/20 between the three, and EBITDA (my guess), is split roughly 60/20/20.  About 2/3 of revenue and 80% of EBITDA comes from North America.  The valuation here is not exceptional at just under 19x P/E on my 2017e, but this is a compounder that has rarely been cheap on near-term earnings and easily an above average business that goes in my Kirby-style 10-year lockbox.

Competitive strategy tells us that distribution businesses are best positioned when the distributors are consolidated and the suppliers and customers at the two ends of the funnel are highly fragmented.  In HSIC's core US dental franchise, it is the #1 operator with 40% share and the top 3 combined control 80%+ of the market (#2 PDCO is public and similar in size while #3 Benco is private and much smaller).  There are a few large suppliers, most notably XRAY (HSIC is ~4x the size of its consumables business) but the tail extends out to >300 providers.  The customer base is exceptionally fragmented with the vast majority of the 120k+ dental practices still having no more than a few practitioners.  This dynamic has enabled one of the highest margin/ROTC distributors I've looked at, with EBITDA margins in the low teens and returns on tangible capital nearing 50%.

The business is still quite attractive internationally and in animal/medical, just not as much as in core US dental.  In animal, the suppliers are less fragmented, but the customer set is a vet market that is nearly as fragmented as dentists v. competitors with large mix in the production animal market serving farms.  The medical business is similar to PSSI, which serves physician offices and stays away from low margin pharma products (PSSI was acquired by Merck in late 2012 and earned 8% EBITDA at the time of the deal).

HSIC's long-term return algorithm is basically 4-6% organic topline + 2-4% M&A + 3-4% buybacks, while keeping ND/EBITDA at ~1x.  All three of the company's categories are GDP+ growers, with dental spend driven by aging population + gentle but upward facing trend in like-for-like spend/coverage/adoption (dental cover is immature v. general health; even in the US it is ~40% cash pay).  The company has spent years investing in a global presence and accepting dilutive margins in markets like China and LatAm to build tomorrow's growth platforms - it is the only company doing this (eg. PDCO is still primarily US based), which makes it increasingly more important in the supply chain.  M&A is dilutive to returns v. organic growth, but on average I believe still generating attractive low-teens IRRs based on MSD+ EBITDA margins.

The company trades at a headline 24x P/E on 2016 consensus and 21x on 2017, but that figure includes amortization of intangibles which management does not back out in its adjusted earnings figures (competitor PDCO does adjust for amort which the street thus accounts for, making consensus EPS for the two not comparable).  I have the business at 21x 2016 and 18-19x 2017 on an ex-amort basis, which is practically in-line with the S&P for what seems like a better-than-S&P business.  The company does not currently pay a dividend, but due to continued FCF growth and not enough prospective acquisition targets of scale, this seems inevitable unless management decides to extend the scope of the business.

Concerns

Price war in US dental and/or recent legal complaints by SourceOne and general industry practices suggest we're at a peak in profitability.

International growth accelerates and dilutes consolidated metrics or fails.

Key man/succession risk with respect to Stan Bergman.

Capital allocation; company decides to go for a large transaction that blows up.

Catalyst

Time, natural compounding.

In the short term, acceleration in organic growth given stronger consumer, expansion of Sirona relationship.