Description

I believe the U.S. dental distributors are an attractive short right now. I believe this theme can be played with a short of either HSIC or PDCO, its primary competitor. While this write-up has some overlap with gman’s PDCO write-up on May 10th that called out the Amazon threat, this write-up will be a little broader, touching on customer consolidation, the (temporary) sentiment-driven reasons for near-peak valuations, and most importantly, a massive class action antitrust lawsuit that threatens to upend the cozy industry structure in the U.S.

Industry Overview:

The U.S. dental distribution market is quite concentrated, with 3 players (HSIC, PDCO, and Benco (private)) accounting for 80-90% of the market. The remainder is made up of a variety of a few small regional distributors as well as some online competitors. The business is relatively simple – these companies serve as middlemen between dental suppliers (e.g. Dentsply Sirona, 3M, Danaher) and the ~200,000 dentists, orthodontists, and dental labs around the country. They provide a necessary service as the nature of these customers (fragmented, limited ability to hold inventory) makes direct procurement from dental suppliers inefficient if not impossible – distributors also take on the servicing function for most of the equipment they sell.

While both PDCO and HSIC have other lines of business, the U.S. dental business is the dominant driver of their profits given the relatively high margins compared to their other lines of business (~low double-digit EBITDA margins vs. low single-digits for other businesses). I estimate the U.S. dental distribution business makes up ~60% of HSIC’s and 65-70% of PDCO’s EBIT. Dental sales are split between consumables (~2/3) and equipment (~1/3).

The dental distribution business overall is mature – it is tied to dental spend which is a ~GDP grower. While it is not exposed to meaningful regulatory uncertainty, as a private pay-focused healthcare industry with a meaningful discretionary element (47% of spend is from private insurance & 40% is out-of-pocket), end-market demand is cyclical (less employment = less coverage and less discretionary income) and the equipment distribution side is even more-so (long-lived capital equipment is dependent on dentist sentiment on future demand.)

Thesis:

1. Increasing consolidation of customers should pressure margins for the distributors

2. Amazon is an increasingly relevant competitor and has the potential to make inroads

3. The presence of a massive class action lawsuit threatens to upend the cozy industry structure

4. Near-peak valuations are temporary, driven by this being one of the few “investible” industries in the healthcare sector given regulatory uncertainty

5. Risk/reward is very attractive given limited upside levers to pull and meaningful downside from multiple or margin compression

1. Increasing consolidation of customers should pressure margins for the distributors

The significant market power that the dental distributors have is exacerbated by the relatively small size of their customers (small dental practices). However, there has been an increasing trend in customer concentration, due in part to the emergence of Dental Support Organizations (“DSOs”) which provide non-clinical support to independent dental practices (including group buying). I’ve seen different estimates for the proportion of dentists represented by DSOs but it’s somewhere in the 10-20% range, and growing.

This is important because DSOs exert downward pressure on distributor margins. While HSIC/PDCO will tell you that the lower cost to serve these clients (less frequent sales rep visits, less handholding, greater use of e-commerce) makes up for the lower margins available, I would question this assumption, particularly given PDCO’s recent “win” of a contract with Heartland, a major DSO. The consensus amongst others in the industry is that PDCO “bought” this contract and are earning no margin on the deal. Up until recently, PDCO couldn’t effectively serve this customer segment due to an inferior e-commerce solution, but with a recent ERP integration they are on par with HSIC and are explicitly aiming to get their market share in DSOs up from ~15% currently to the ~30-40% share they have in the broader dentist community – aggressive bidding for these contracts will take business away from HSIC and will depress margins industry-wide.

Another incremental factor in favor of customer consolidation will be the implementation of MACRA. As HSIC indicates in their 10-K:

“MACRA may encourage physicians to move from smaller practices to larger physician groups or hospital employment, leading to a consolidation of a portion of our customer base. “

2. Amazon is an increasingly relevant competitor and has the potential to make inroads

As small businesses, dental offices are a natural market for Amazon to cater to. A prior write-up by gman goes into this element of the thesis, but essentially, Amazon sees:

• A set of customers who are already “Prime” owners and are often already ordering basic office supplies from them (i.e. this is an edge-out opportunity, not a brand new market to penetrate)

• Customers who value their ability to process small, frequent order sizes with quick delivery

• A set of competitors with high margins: “your margin is my opportunity”

Currently Amazon’s share and growth have been limited. HSIC/PDCO views them as “bargain basement suppliers” of low-end consumables with too limited of a product catalog to be a meaningful threat. However, what this view misses is that the only reason that Amazon has been relegated to this role is because of anti-competitive behavior from the existing distribution oligopoly (discussed below) limits their access to larger suppliers. To the extent that the lawsuit is resolved in an adverse manner this roadblock could be lifted with devastating results. I believe it is noteworthy that PDCO’s recent 10-K (filed June 28th) contains a brand-new risk factor:

We may experience competition from third-party online commerce sites.

Traditional distribution relationships are being challenged by online commerce solutions. Such competition will require us to cost-effectively adapt to changing technology, to continue to provide enhanced service offerings and to continue to differentiate our business (including with additional value-added services) to address demands of consumers and customers on a timely basis. The emergence of such competition and our inability to anticipate and effectively respond to changes on a timely basis could have a material adverse effect on our business.

3. The presence of a massive class action lawsuit threatens to upend the cozy industry structure

I believe this aspect of the thesis is potentially the most impactful, yet least appreciated by the market. While sell-side analysts are “aware” that there is a lawsuit out there, I have not yet seen it referenced in any form, in any conference call or research note since it was filed in January 2016. However, a number of things make me believe this could be a very big deal:

• The suit seeks to represent 142,000 dental practices in the U.S. – a material majority of HSIC/PDCO’s customer base

• When I asked HSIC/PDCO IR about relatively mundane aspects of the lawsuit (timing, how it arose, etc.), they immediately shut down and made it clear that their lawyers have told them they can’t say anything at all about it

• The plaintiffs have hired one of the, if not the, top trial lawyers in the U.S., who has experience winning very large class action & antitrust judgments (http://www.susmangodfrey.com/why-us/wins/) and who usually works on contingency (i.e. they only take cases they think they can win)

• HSIC included a brand new risk factor in its 10-K filed Feb 21st, which seems like quite the coincidence:
  
  

Antitrust:

The U.S. federal government, most U.S. states and many foreign countries have antitrust laws that prohibit certain types of conduct deemed to be anti-competitive.  Violations of antitrust laws can result in various sanctions, including criminal and civil penalties.  Private plaintiffs also could bring civil lawsuits against us in the United States for alleged antitrust law violations, including claims for treble damages.

The class action complaint is very detailed (filed Mar 11, 2016, Case 1:16-cv-00696 on PACER) and contains very specific descriptions of margin fixing, agreements not to poach customer lists, and threats to boycott suppliers who made their products available on Amazon or other third-party distributors – all classic (and seemingly brazen) anti-competitive behavior.

Here are some of my favorite passages (although you should really read the entire complaint):

For years, Henry Schein, Patterson, Benco, and Burkhart have agreed on the distribution fee or margin component they would charge customers. At least as far back as 2005, Henry Schein, Patterson, Benco, and Burkhart agreed to charge margins on dental supplies and equipment between 26-28%. They have, every year since 2005, raised these margins, and presently, the cartelized margins are 35% or higher.

… in June of 2008, reeling from the force of the Cartel Members’ group boycott … Archer & White and Dynamic Dental … met with Henry Schein’s Mark Lowery and Burkhart’s Jack Powers. In that meeting, [Archer & White] learned of the Cartel Members’ long-standing price fixing conspiracy. Messrs. Lowery and Bowers offered to end the group boycott of Archer & White if Archer &White and Dynamic Dental agreed to maintain margins on their sales of dental products between32 and 34%, the then-prevailing cartelized margin.

Mr. Lowery responded, “What—what we don’t want to do is come across [as] dictating the price to the end user. That will get us in a lawsuit. Guarantee it. But you know, a couple things. One is I think when everyone plays on the same field, it makes things a lot easier.”

Burkhart’s Jack Bowers told Henry Schein’s Mark Lowery and Dynamic Dental’s Skip Pettus in 2008 that they “have to be very careful, if a customer doesn’t like us, they could have us all up on price fixing. . . . Price fixing or—or somebody complaining about getting together as a group and saying: Okay, well, we’re going to hold to a certain margin.”

In approximately 2009 … Scican Dental—a manufacturer of dental instruments—terminated its relationship with Archer & White, citing a threat from Henry Schein and Patterson that Scican Dental would be cut off from those distributors’ critical distribution channels if Scican kept doing business with Archer & White.

Benco, Henry Schein, and Patterson, acting in concert, agreed to boycott dentists that purchased supplies from SourceOne by withholding service and repair for installed equipment at those dental practices, or to provide service and repair at higher prices or with significant delays.

In a February 14, 2014 email, Henry Schein described the competitive threat posed by Amazon.com: “Amazon is a freight train that will drive down margins and within 18-24 months, at the most, Team Schein will have to adapt or huge layoffs will occur.”

… in 2015, soon after a large dental supply and equipment distributor conference held in Chicago that Defendants’ representatives attended, Defendants informed many of the large dental supplies manufacturers in attendance, including 3M—a major dental supply manufacturer—that if they sold to Amazon, all of the Defendants would cut them off. Many major manufacturers acquiesced to the threats and refused to sell to Amazon.

4. Near-peak valuations are temporary, driven by this being one of the few “investible” industries in the healthcare sector given regulatory uncertainty

Both HSIC and PDCO trade at near-record multiples. On a forward EV/EBITDA basis, HSIC trades at 15.2x, versus a 10-year average of 11.2x, a 5-year average of 13.0x, and a peak multiple (sustained for 1Q) of 15.3x. On the same basis, PDCO trades at 13.0x, versus a 10-year average of 10.3x, a 5-year average of 11.1x and a peak multiple of 13.1x.

I believe that the reason for this multiple inflation is that the dental distributors are seen as one of the few “investible” industries in the healthcare sector. In particular, this is driven by their high exposure to private pay (employer-provided insurance + out-of-pocket) and therefore lower exposure to Medicare & Medicaid. As a result, it is one of the few industries that a healthcare investor can put money in without having a view on the myriad possibilities for ACA reform – I believe this has caused HSIC/PDCO to be a beneficiary of flows post the election. Notably, any increase in regulatory clarity in the coming months (in either direction) should make the rest of the healthcare space more investible and pull flows away from "safe" industries like the dental distributors.

5. Risk/reward is very attractive given limited upside levers to pull and meaningful downside from multiple or margin compression

Finally, I believe the risk/reward is very attractive given the asymmetry involved.

Upside here is very limited from an industry-wide perspective. While there are some idiosyncratic items that can shift the balance of power from HSIC to PDCO or vice versa (e.g. ability of PDCO to compete for DSO deals; loss of PDCO’s XRAY exclusivity), the dental distribution industry as a whole is essentially just tied to the GDP-like growth of the broader dental industry. When I pushed both IR teams as to what a “plausible best case” scenario might be for their respective industries, they talked about a bunch of incremental stuff and potentially faster overall dental growth (from 2% to 3-4%) driving EPS growth of HSD/LDD – yawn. Essentially, if you don’t believe there will be multiple expansion (as I don’t – see item #4 above), in a bull case these shorts merely accrete against you at a ~10% p.a. rate.

As a base case, going back to 5-year average multiples would be ~20% downside to each of HSIC/PDCO.

In a bear case scenario where the lawsuit ends unfavorably for PDCO/HSIC and Amazon has a greater impact, the impact could be very significant. Remember that dental distribution EBITDA margins are in the low double-digits while basically every other medical distributor is in the low single digits – there is room for these margins to halve or even worse. Add in the impact of moderate leverage and multiple compression and 50%+ downside does not seem crazy at all.

Bottom line: do I know that the lawsuit is going to be successful and that Amazon is going to take over? No. But am I willing to pay a moderate amount per year for a reasonably high likelihood of meaningful multiple or margin compression and a possible 50% decline? Definitely.

Catalyst

Increased competition from Amazon or DSOs showing up in margins
Movement on the class action lawsuit
Clarity on healthcare reform