Patterson Companies Inc.—A Distributional Powerhouse
Overview
Patterson Companies Inc. (PDCO) is a distributor of dental, veterinary, and medical supplies. Dental supplies represent PDCO's largest product line, accounting for about 65% of company revenues. PDCO sells dental equipment, software, and consumable dental products. It also provides office design, set-up and logistics solutions. Dental products are sold mainly to customers in North America. Veterinary supplies represent PDCO's second largest product line, accounting for about 20% of company revenues. PDCO's veterinary products include disposable medical tools, equipment, pharmaceuticals, diagnostics and laboratory equipment. Medical supplies represent PDCO's third largest product line, accounting for about 15% of company revenues. Medical products are specialised in the areas of rehabilitation and sports therapy and are sold all over the world.
Purchase Considerations
PDCO is North America's second largest supplier of veterinary products and has gained control of about 35% of the total dental supply market. Its biggest competitors are Dentsply and Henry Schein and the intensity of competition is medium-to-high. As one of the largest players and with exclusive distribution agreements on various products, PDCO has been able to retain some pricing power, though this has been in decline. We like seeing PDCO's dominance in the dental chair markets, restorative systems, and radiology graph systems.
We remain optimistic that growth in dental sales will pick-up eventually, as sales have lagged economic activity. Dental implants, basic cleanings, whitening services should improve as employment and income levels strengthen. Also, we continue to see greater cultural emphasis placed on the importance of “nice straight teeth,” which will bode well for sales. As the population ages, we expect to see an increased need for replacement crowns, dentures, and restoration treatments as well. PDCO's sales should receive some support from sales oversees as in many countries the dental care services industry is still in its infancy.
We are optimistic about the company's competitive position in the veterinary market. The company's success in this space will depend largely on family formation rates and per-capita income growth moving forward, both which have been on the rise. We also like seeing that management continues to reward shareholders--boosting its dividends and increasing share repurchase activities.
A summary of key purchase considerations follow:
- Recent and expected continued improvements in the U.S. economy will support sales.
- Esthetic dental work is growing in importance culturally across North America and Europe.
- Restorative treatments will rise with the aging population.
- European and Asian growth opportunities are largely untapped.
- The firm has a long history of securing exclusive distribution rights to new product lines.
- The firm has been relatively successful at expanding supply sales in veterinary and medical products.
- The firm is trading at reasonable multiples.
- Returns on invested capital remain strong.
- The firm carries a relatively low amount of debt.
- Capital expenditure requirements are minimal and cash returns are strong.
- Dividends are growing and share repurchase activities are strong.
Reasons for Caution
What we do not like about PDCO is the intensity of competition within the industry. Without the ability to win exclusive distribution agreements, the firm could be rendered largely a commodity-type business. PDCO will have to find further cost savings on the operating line to offset expected future margin compression. Another thing we do not like seeing is the trend across corporate America to reduce employee dental insurance coverage. If the number of firms offering dental insurance declines or if covered treatments are deemed "elective" and coverage withdrawn, PDCO's sales will suffer.
A summary of cautionary notes follow:
- A full recovery in dental supply sales is at least 2 years away.
- Margins continue to compress as the firm faces greater difficulties passing on the costs of inflation to consumers.
- Further declines in company sponsored dental insurance plans will hurt PDCO's sales moving forward.
- Receivables growth has outstripped revenue growth and should be treated as an earnings quality red-flag.
- PDCO is experiencing some inventory build-up; investors are well advised to continue to monitor PDCO's inventory position.
- The sustainability of the firm's competitive advantage remains highly dependent on its ability to win exclusive distribution agreements on new product lines.
- Revenue growth outstripping earnings growth and operating cash-flow growth remain a point of concern and could scare away share buyers.
Market-Based Price Multiple Valuation
As an initial step towards evaluating PDCO, we have assembled the 15-yr historical record of the company’s Price/Sales, Price/Earnings, Price/Free Cash-Flow and Price/Book Value ratios as shown below. After reviewing the distributional properties of the multipliers around their respective means, we are confident about using multiplier values of 1.15, 18.0, 18.5, and 13.0 respectively. Based on our experiences with the industry, we believe that free cash-flows and book value are particularly important predictors of company value. Consequently, instead of finding an equally weighted price average, we decided to apply the weights shown below for calculating a weighted average estimated price.
To do this, each expected multiplier was multiplied by the corresponding variable for the company’s expected average 10-yr forward sales, earnings, free cash-flows, and book value per share. We then decided to overweight free cash-flows and book value and derived a fair value estimate for PDCO of $52.05, which is considerably higher than its current price.
Table: Historical Multipliers, Distributional Properties, Expected Multipliers, Multiplier Weights, and Average 10-Yr Forward Per Share Sales, Earnings, Free Cash-Flow and Book Value
| Fiscal Period | P/S | P/E | P/FCF | P/B |
| Apr00 | 1.55 | 25.33 | 30.85 | 4.91 |
| Apr01 | 1.80 | 27.17 | 29.52 | 5.07 |
| Apr02 | 2.22 | 32.93 | 39.74 | 6.07 |
| Apr03 | 1.66 | 22.95 | 36.51 | 4.31 |
| Apr04 | 2.58 | 34.10 | 28.55 | 6.28 |
| Apr05 | 2.90 | 38.30 | 39.80 | 6.84 |
| Apr06 | 1.73 | 22.78 | 296.18 | 3.64 |
| Apr07 | 1.78 | 23.88 | 22.12 | 3.65 |
| Apr08 | 1.52 | 20.24 | 19.77 | 4.40 |
| Apr09 | 0.78 | 12.11 | 26.57 | 2.10 |
| Apr10 | 1.18 | 17.96 | 16.14 | 2.74 |
| Apr11 | 1.21 | 18.37 | 18.27 | 2.69 |
| Apr12 | 1.07 | 17.76 | 12.96 | 2.73 |
| Apr13 | 1.08 | 18.69 | 13.18 | 2.87 |
| Apr14 | 1.02 | 20.66 | 21.09 | 2.87 |
| Mean | 1.61 | 23.55 | 43.42 | 4.08 |
| Variance | 0.36 | 49.98 | 4967.84 | 2.22 |
| Std. Dev. | 0.60 | 7.07 | 70.48 | 1.49 |
| Skewness | 0.82 | 0.72 | 3.77 | 0.56 |
| Kurtosis | 3.20 | 3.12 | 17.42 | 2.12 |
| Median | 1.55 | 22.78 | 26.57 | 3.65 |
| Mean Abs. Dev. | 0.46 | 5.39 | 33.70 | 1.24 |
| Mode | 1.77 | 19.10 | 19.71 | 2.83 |
| Minimum | 0.78 | 12.11 | 12.96 | 2.10 |
| Maximum | 2.90 | 38.30 | 296.18 | 6.84 |
| Range | 2.12 | 26.19 | 283.22 | 4.74 |
| Count | 15.00 | 15.00 | 15.00 | 15.00 |
| Sum | 24.08 | 353.21 | 651.26 | 61.17 |
| 1st Quartile | 1.08 | 18.37 | 18.27 | 2.74 |
| 3rd Quartile | 1.80 | 27.17 | 36.51 | 5.07 |
| Interquartile Range | 0.72 | 8.80 | 18.24 | 2.33 |
| Expected Multiplier | 1.15 | 18.00 | 18.50 | 3.00 |
| Multiplier Weights | 5% | 5% | 70% | 20% |
| Â | SPS | EPS | FCFPS | BVPS |
| Avg 10-Yr Forward | $51.08 | $2.53 | $2.74 | $18.98 |
Fair Value = $52.05
Conclusion
PDCO is a great company and a successful distributor of disposable and specialty dental, veterinary, and medical supplies. Our analysis of the company’s stock, based on a market-based price multiple valuation approach, suggest that PDCO is valued at $52.05, which is considerably higher than its current market price of $38.97 suggesting a margin of safety of 34%. The question that remains for investors is, given the risks inherent in the business, is a 34% margin of safety sufficient to qualify for investment.
