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New Survey! Dental Stress Tests & Covenant Checks

By Jeff D. Johnson, O.D., CFA

Republished. Original Source: Baird Equity Research
March 24, 2020

On March 19, we surveyed 91 of 137 dentists who first responded to our March 12-13 survey, and not surprisingly plans to reduce office hours and close offices outright have significantly increased. In turn, this is pulling 2020 patient volume/dental equipment purchase expectations lower, and after stress testing our dental models with these updated views, we believe company-specific revenue/earnings could fall 10-50%+ this year. We review implications of these declines over following pages and believe it remains too early to stepin across the entire dental group.

On March 19, we fielded a modified version of our quarterly dental survey to 91 of 137  dentists who first replied to this same survey on March 12-13. Not surprisingly, plans to reduce office hours and close offices outright have increased significantly, in turn pulling 2020 patient volume/dental equipment purchase expectations lower:

  • 76% of respondents now expect to reduce office hours and 60% expect to close their office for at least a week, up vs. 5% and 4% of respondents, respectively, vs. just a week prior.
  • Nearly 15% of respondents have seen patient volumes contract by 20% or more in recent days, up vs. only ~2% of respondents who noted such declines in the week prior. Closer to 30% of respondents on the West Coast are seeing 20%+ patient volume declines.
  • Equipment spending on a per capita basis is now expected to fall by $14,000 this year vs. roughly -$7,000 in expected spending a week prior. While an oversimplification, this $7,000 larger expected decline in this survey vs. our last translates to roughly a $1.4B incremental potential headwind to the $2.5B annual domestic dental equipment market.

With these significant changes now expected across the domestic (and global) dental markets this year, we stress tested each of our dental models, and while visibility is extremely low and our conclusions very well could change several times over coming weeks/months, we now believe revenues could fall by roughly 15-30% and earnings could fall by 40-60% in the most pessimistic of scenarios across our dental names this year.

Thinking through bigger-picture implications of these potential earnings declines, we believe NVST could trip a debt covenant come mid/late 2020, although our broader industry checks suggest covenant waivers and/or re-financings could be made increasingly available for companies such as NVST being impacted by these unprecedented issues.

Outside this issue, we’ve also updated our views on dental group valuations, and if we assume 2021 earnings can rebound to at least 2019 levels, we believe most, if not all, of our dental stocks look compelling if investors are willing to take an intermediate- to longer-term view. Even so, our gut is that, as a group, dental stocks remain at relative risk of continued pressure in the near-term as the market still likely needs to digest mounting job losses and growing pressures on near/intermediate-term discretionary spending trends over coming weeks, things that have historically weighed on these stocks.

Survey Overview:  In just the past week, it’s become increasingly clear COVID-19 avoidance and mitigation efforts are likely to persist longer, and the macroeconomic impact of these efforts are likely to be deeper and longer-lasting, than we even could have imagined when we fielded our prior survey March 12-13.  As such, we re-surveyed nearly 100 of the same dentists from that March 12-13 survey just one week later, on March 19, and not surprisingly found further evidence of slowing demand trends across the domestic dental market.

We review updated results from our new, somewhat modified, survey over the following pages, with key highlights including a further fall-off in y/y patient volumes to -4.3%.  In all fairness, however, we assume even this 4.3% decline in patient volumes likely under-represents what is truly happening across most dental offices as potential volume responses we’ve historically offered in our survey dating back 10+ years have always stopped at “down 20% or more” at the extreme and we didn’t even think to update or broaden those decline options out until reviewing these survey results in recent days.  We will broaden those options out in future surveys, however, especially as nearly 15% of all respondents to our survey last week pointed to these 20% or greater volume declines (with nearly 30% of Pacific region dentists pointing to 20%+ y/y declines in patient volumes).

We also found that 67% all dentists across the U.S. now expect to reduce their office hours in response to COVID-19 issues, with 60% expecting to close their practices for at least a week due to these same issues.  These percentages are up vs. 5% and 4%, respectively, in our March 12-13 survey, and frankly we’d be surprised if they don’t increase further over coming weeks.  Dental equipment spending expectations for 2020 also fell further in this survey, with respondents expecting to spend $14,000 less on equipment this year vs. last, a bigger year-on-year decline in expected equipment spending than the $7,000 y/y decline in equipment spending these same dentists predicted for 2020 in our March 12-13 survey.

While we caution investors that the math is way oversimplified, we note that with roughly 200,000 dentists in the U.S., an incremental $7,000 in reduced spending this year on equipment vs. last would represent roughly a $1.4 billion incremental headwind to equipment spending this year vs. last.  That would effectively wipe out close to half of what we estimate is just over $2.5 billion in spending on dental equipment in North America each year.

So what does this all mean for the many investors and dental industry contacts we assume are likely reading this survey today?  For our dental industry colleagues, we continue to send positive thoughts and wish you and your family good health and safety.  While we’re nowhere near a point we’d feel comfortable in trying to predict when industry demand might bottom, let alone begin to normalize, we remain committed to fielding these surveys every week or two (as frequently as it makes sense) in an effort to provide at least some insight into how dentists across the U.S. are feeling about their profession and what they might be seeing from a patient demand perspective in their offices.

For investors, we believe those same insights could prove useful when it comes to thinking about someday re-engaging with these dental stocks.  While we’d argue that all of our dental stocks at this point look compelling if investors are willing to take an intermediate- to longer-term (12-18+ month) view of the space, our gut is that, as a group, dental stocks remain at relative risk of continued pressure as the market still likely needs to digest the mounting job losses and growing pressures on near/intermediate-term discretionary spending trends that we expect to increasingly hear about over coming weeks.  Historically, job losses and moderating consumer spending trends haven’t been good for dental stocks, and while the group has already corrected more than broader medtech peers and the broader S&P 500 in just the past few weeks, we remind investors that dental continued to underperform both the broader medtech space and the S&P 500 during the Great Recession until all three groups reached a bottom at about the same time in March 2009.  At that point, the dental group enjoyed a steeper and quicker recovery than both medtech stocks and the more diversified stocks making up the S&P 500.

We believe that potentially provides a play book for how we could think about dental stocks rebounding again over coming months, but until we reach that bottom, which our gut says hasn’t yet been reached, we continue to see risk of relative underperformance across the entire dental group.

Stress testing dental models.  One of the questions we’ve continued to get from investors over the past week or two is “how bad can things get in dental” over the next few weeks, to months, or potentially even over the balance of 2020?  As it’s become increasingly clear COVID-19 avoidance and mitigation efforts are likely to persist longer, and the macroeconomic impact of these efforts are likely to be deeper and longer-lasting, we’ve started to accept that it’s unlikely we’ll see a v-shaped recovery in dental demand or a normalization of revenue and earnings growth for our dental companies in just the next few weeks or even by the end of 2Q.

As such, we looked long and hard at our dental models in recent days, and while we still aren’t yet updating estimates or price targets for our covered dental names yet (that is still needed and will get done eventually, but there’s only so many hand grenades we can jump on at one time…), we did build out what we believe are both optimistic and pessimistic scenarios for each of these names.  To be clear, even our optimistic scenarios may not look overly optimistic, as they assume roughly 10-15% revenue declines for most of our companies other than ALGN, and even bigger earnings declines for each of our covered companies in calendar 2020, including 15-50% revenue and even larger earnings declines just for calendar 2Q alone.  But with dental offices across the globe increasingly shutting down and governments suspending dental visits or asking dentists to forgo elective procedures to preserve PPE for front-line hospital workers, it’s hard not to believe such levels of declines might not truly be optimistic this year.

We provide a deeper review of the results of our stress tests for each company at the end of this report, but from a high level note the following:

  • First, our visibility regarding how the next few quarters might play out remains exceedingly low. So while some of our pessimistic estimates assume 50-70%+ revenue declines for some of our companies in 2Q and even into 3Q, those potential declines could quickly lessen if isolation efforts and “stay-at-home” orders lift within a couple months and life by this summer begins return to normal.
  • While some investors (and management teams) might view our 50-70% pessimistic revenue decline assumptions, at least in some parts of the world, as being too pessimistic, we remind investors that anecdotal feedback from China suggests demand for discretionary procedures in that market fell by 80-90% in February and early March. While we’re hearing that manufacturing efforts in China are slowly starting to normalize, it sounds like demand has been slower to rebound thus far.  As such, assuming similar types of fall-off in demand in some markets, and much less of a fall-off (but still some slowing) in other, less-impacted, markets leads us to believe that, at least in pessimistic scenarios, our 50-70% declines may not be crazy.
  • We taper both our optimistic and pessimistic declines throughout 3Q and into 4Q, which feels reasonable to us at this point (but could change as more information becomes available) as we believe even if global isolation efforts begin to fade by mid-summer, hesitancy to congregate in healthcare facilities such as a dental office could continue for months beyond, possibly until a COVID-19 vaccine is developed or time simply passes and memories/concerns that we’re all living with also begin to fade.
  • As a simplifying assumption, we are holding gross margin projections for each of our companies at levels we would have assumed this year in a world without COVID-19. While we know that won’t be true in the near-term (1Q, for example) as lower manufacturing overhead absorption impacts our manufacturers, we believe that could be closer to accurate over time if manufacturers temporarily reduce workforce in this area or possibly even keep lines running (and building inventory) in preparation for a return to normal.
  • For opex, we are assuming companies begin to cut costs over coming quarters, but likely at a rate less than what revenue declines in the near-term. In speaking with our companies, it is clear that T&E expenses are coming way down, as are commission costs (if products aren’t selling, 5-10% or even greater commissions on product sales aren’t being paid).  We’re also hearing that marketing and advertising costs will likely be reigned in fairly notably in coming weeks to months, while each of our manufacturers have also already begun to move training and CE courses online as training facilities and/or training events have largely been closed or cancelled.
  • Across dental consumables, equipment, and specialty products, we aren’t making significantly different assumptions in the near term, as we believe demand across all product categories will be impacted meaningfully in the near-term. We have assumed dental equipment demand is hit a bit harder, and remains modestly more depressed, than demand for general and specialty consumables, later this year, as we believe dentists’ willingness to spend on new equipment may remain depressed even as practice volumes begin to normalize as dentists work to repair practice and personal balance sheets in the near- to intermediate-term.

For HSIC and PDCO, we believe demand for medical (HSIC) and animal health (PDCO) products may not be nearly as impacted over coming months.

  • For HSIC, we expect demand for PPE and other medical products will likely accelerate near-term, although we do worry a bit about large group practices potentially looking to alternate sources (state governments, FEMA, etc.) for some of these products in the near-term and we also remind investors that HSIC does sell into some surgery centers, where cancellations of elective procedures will impact near- to intermediate-term. Even so, we’d expect declines in HSIC’s medical business to be smaller than what we’ll likely see in the company’s dental business.
  • For PDCO, we expect companion animal revenues (just over 30% of company-wide revenue) to be pressured over coming months as vet offices also close in some areas and pet owners likely look even more to on-line sources for necessary products in the near-term. We also remind investors that in past cycles, pet ownership has declined (and pet abandonment has increased) during periods of macroeconomic pressure.  That said, we are anecdotally hearing about an increase in pet ownership near-term (HERE), including by parents who have canceled spring break trips so instead are getting their kids a new pet to pass the time at home, and as such we’re assuming less of a decline for PDCO’s companion animal business relative to its dental business near term.    We’re also modeling flat revenue performance for PDCO’s production animal business over coming quarters due to easy comps and what we believe could well be a sustained rebound, at least in these times, for beef and dairy products as consumers fill freezers and refrigerators with such products.  We’ve seen beef and dairy futures both rebound a bit in recent days, and if we see a sustained move higher in cattle or dairy pricing, we could even imagine a scenario in which herd sizes begin to expand and PDCO’s production animal revenue benefits from the current COVID-19 uncertainties.  For now, flat production animal revenue feels more likely to us, but will watch beef/dairy futures going forward.  

In putting all the above together, we show below a summary of three scenarios we ran for each of our covered dental names, including estimates for 2020 if there had been no COVID-19 issues at all this year, and our optimistic and pessimistic scenarios with COVID-19 issues.  Again, a more detailed review of these findings are provided for each of our dental stocks at the end of this report, but as can be seen below, if the next few quarters play out even somewhere between our optimistic and pessimistic scenarios, investors will need to brace for potentially unprecedented y/y contraction in dental revenues and earnings:

With these scenario analyses, we also had to take a closer look at each of our dental company’s capital structures, as most of our dental stocks with debt (all but ALGN) have to maintain certain debt-to-EBITDA levels to remain in compliance with their debt covenants.  To that end, we show below even under our pessimistic scenario analyses, we believe each of our covered dental names would likely remain in compliance with respective covenants except for NVST, with our analysis suggesting that if our pessimistic views prove accurate, NVST could potentially trip its debt-toEBITDA covenant (calculated on a rolling ttm basis) somewhere in the second half of 2020.

While that likely explains at least part of the reason NVST shares have been under even greater pressure than most of our other dental stocks in recent weeks, we believe debt covenant issues in the near-term may not sound as scary or draconian as they might have in past cycles.  Specifically, we’ve clearly heard in our industry conversations even in recent days that, unlike the 2008-2009 credit crisis, banks are proactively calling companies today asking about potential capital requirements and voicing a willingness to provide such capital if need be.  We’ve also heard that if there’s any evidence in coming weeks that COVID-19 issues might truly prove to be fairly short-term in nature and that life could return to somewhat normalized levels even over the next 3-6 months, then there’s a good likelihood banks will be willing to grant short-term debt covenant waivers, as calling debt under these situations would simply extend the potential short-term financial pressures that are expected to emerge in the near-term.

Bottom line, while potential for debt covenant issues for NVST (and to a lesser extent PDCO; none of our other dental companies seem likely to even come close to covenant issues) are something investors will need to keep an eye on, we don’t believe such issues will truly create going concerns for NVST longer term.  Additional details regarding our debt covenant analysis, however, can be found below:

Finally, from a valuation perspective, we show below that using our optimistic and pessimistic scenario analyses, each of our dental stocks is currently trading at much higher P/E and EBITDA multiples (using 2020 EPS and EBITDA assumptions) than suggested on Bloomberg, FactSet and other data aggregation sites as most sell-side models, including ours, haven’t yet updated to what reality for 2020 will eventually look like.  While that means the not-yet-updated valuation metrics on these sites are too low for 2020, we believe that’s also not a fair way, in our view, to think about true valuation levels for our covered dental stocks as we believe that even if we ultimately see a global recession over coming quarters, there will be a reasonably solid rebound in dental demand (and hence dental revenue and earnings for our dental companies) at some point over coming quarters.

Again, given low visibility, we believe there are a huge number of uncertainties even in our efforts above to predict 2020 financials for our covered companies, making any efforts to predict 2021 financials even more fraught with uncertainties.  What we do know, however, is that from 2008 to 2010, organic revenue for each of our covered dental names (plus stand-alone Sirona) grew, while EPS also increased over that two-year period for all but XRAY.  While we believe financial declines in 2020 could be much bigger for each of our covered dental companies than they were in 2008 or 2009, we also believe at least some level of recovery will come faster for each of these companies at some point later this year or early next as well.

As such, in an effort to be conservative (relative to the Great Recession), we show below that even if we assume revenue and earnings in 2021 for each of our covered dental names only return to 2019 levels, then each of these stocks is also trading some 30% or more below 5- and 10-year average NTM P/E levels and anywhere from at parity with five- and 10-year average FY+1 EBITDA levels (PDCO) to as big as 30-40%+ discounts to these same 5- and 10-year average FY+1 EBITDA levels.  Note for NVST, we are comparing the company’s current valuation to XRAY’s 5- and 10-year average valuation levels as we do not have more than a couple quarters worth of historical trading data for that stock and view XRAY as the company’s closest peer.  While that comparison suggests shares of NVST are currently trading at an even bigger discount to historical averages than the rest of our dental stocks, we believe the debt covenant issues discussed earlier partially explain.

Given the above, and as we alluded to earlier, we believe that given the sizable valuation discounts vs. historical ranges at which each of our dental stocks currently trade, each look poised to potentially move nicely higher over the intermediate- to longer-term once end-market demand begins to stabilize and potentially improve.  With ALGN trading at the biggest discount vs. historical ranges and given our belief that orthodontic cases are more likely being deferred not lost at this point, we believe that stock currently looks most attractive across our dental coverage, while we also continue to like the set-up on NVST given its lower absolute valuation levels vs. the rest of the group and potential for that company’s new product pipeline to drive a recovery in both revenue and earnings growth once dental end market demand begins to stabilize.  Again, that view on NVST also assumes the company won’t be overly impacted by potential debt covenant issues later this year, something we’ll continue to monitor and that we could have to worry more about if credit market pressures begin to build.

As for HSIC, PDCO, and XRAY, we believe all three of these stocks are also trading at valuation levels that will ultimately prove attractive from a longer-term perspective.  But with our view that dental stocks, as a whole, likely haven’t bottomed yet and with secular pressures on value-add dental dealers expected to remain elevated near-term, we don’t see a strong relative argument for upgrading any of these names at present.  That said, XRAY is the one name of the three we believe we could have a quicker trigger in potentially upgrading if we can gain some confidence that dental trends could begin to stabilize at some point in the near future as we believe even if Primescan and Primemill purchases are deferred in the near-term due to broader macro and dental end market uncertainties, demand for each product is still likely to exist over coming quarters.  While we’ve been questioning the extent of that demand in recent notes, if XRAY’s growth remains constrained near-term by COVID-19 related pressures, then a backlog of Primescan/Primemill demand could help the company’s revenue growth accelerate a bit sooner than we otherwise might have expected in a recovering macro environment, which could provide an additional potential reason to own this stock.

With that, we review our March 19 dental survey over the following pages and again wish each of you best of luck and good health over coming weeks….

March 19 Dental/COVID-19 Survey Results

Survey Profile

 Sample Size: 91 survey participants             

 Method:  Survey conducted via online survey tool on from March 19-20

 Survey Sample Profile – By Practice Focus/Size:

  • Practice Focus: 89% of respondents consider themselves general dentists and 11% are specialty dentists. In comparison, the ADA estimates roughly 80% of its members are generalists and 20% of its members are specialists, meaning our survey is biased towards general dentists. Given the generally slower growth we’ve been hearing about in general vs. specialty dental offices, we believe this means this bias could cause our survey to understate consolidated end market growth rates.
  • Practice Size: 55% of our respondents work in a single-doctor practice and 45% work in multi-doctor practices. This is generally in line with what the ADA estimates to be just over 60% of dentists operating as sole practitioners.
  • Practice Type/Ownership: ~86% of respondents work in a practice that has 1-3 offices owned by the dentist(s), with only ~4% of respondents working in non-dentist-owned corporate practices.  This ~4% of respondents working in corporate-backed settings is below the 8.8% of U.S. dentists affiliated with DSOs in 2017 per recent ADA reports (and what we assume was likely closer to 10% of U.S. dentists by 2019).  As such, and similar to our comments above regarding practice focus, we believe this bias towards smaller, privately owned vs. corporate-backed dental offices suggests our survey may not be perfectly representative of current dental end-market trends, with the largest potential risk for our survey then being that volume/procedural feedback may modestly underestimate true end market conditions as we know that in recent years (as DSOs have clearly been taking patient volume share away from private dental practices in recent years).

Survey Sample Profile – By Geography

  •  Geographic Distribution. Of the 91 dentists who responded to our survey, 41% were from the East Coast, 20% were from the West Coast/Mountain region, and 39% were from the Central states. Compared to BLS data, the most significant deviations were in the Middle Atlantic and East North Central regions, which were both overrepresented in our survey.

Dental Volumes/Consumables Trends

Q1. How would you characterize patient traffic flow through your office over the last 3-6 months as compared to the same period a year ago?

Results:  On average, respondents to our March 19 survey reported a 4.3% contraction in patient volumes over the past 3-6 months compared to the same 3-6 month period a year ago.  This was nearly a 400bp sequential fall-off in patient volumes vs. our survey just one week prior, and frankly we believe the sequential decline was likely even greater than this 400bp as nearly 15% of respondents reported a patient volume decrease of 20% “or more.”  We have been asking this exact same question, using the exact same phrasing and response grid, for more than 10 years, and until this past survey had never even considered that we might need to provide options in our survey answer key for patient volume declines greater than 20%.  We plan to include patient volume response options beyond “Down 20%+” in our future surveys, and suspect that including these additional categories, and the continued closings of dental offices across the U.S., will take patient declines in our future surveys beyond even the -4.3% found in this survey.

 We also show below that when breaking patient volume findings out by geographic regions, including (broadly speaking) west coast, east coast, and central U.S. trends, the biggest patient volume declines were again seen in this survey on the west coast, where respondents on a weighted average basis pointed to a 10% decline in patient volumes.  Similar to our commentary above, however, we wouldn’t be surprised if patient volumes on the west coast have fallen by even more than 10%, as nearly 30% of survey respondents in this region answered that their patient volumes have declined by 20% or more in recent weeks.  If we assume those declines are 30%, 50%, or even more for some of these respondents, then the true weighted average decline for patient volumes in this region is likely greater than 10%.  Again, we hope to get a better view on this point in our future surveys that will, going forward, include more granular details on patient volume declines beyond 20%.

Q2. On a scale of 1-10, with 1 being "the worst I've ever seen" and 10 being "great, have never been so busy," how would you rate the patient traffic flow in your office over the last several months?

Results/Our take: Similar to our March 12-13 survey, responses to this question suggest that patient volume trends in December through February were fairly consistent with 2018 and 2019 trends across the U.S. but fell off dramatically in March.  Because our survey respondent base on March 19 was consistent with our March 12-13 base (same dentists surveyed in both periods), we also find it interesting (but not surprising) that in just one week’s time, respondents went from qualifying their March results on a scale of 1-10 from 5.67 (March 12-13 survey) to 3.71.  Again, further evidence of the rapid fall-off in dental patient volumes we’ve seen across the U.S. in just one week’s time.

 

Q3. On a scale of 1-10, what have you seen in your practice over the last week or two with regards to the following? Please rate with:1 = significant decrease, 5 = no change, 10 = significant increase.

Results/Our take: This question, and the next two, are new to our dental survey over the past two weeks, so we only have two data points for historical context.  But even with just two weeks of data, it is clear that appointment cancellations have risen and patient exam numbers have fallen over the past week, with purchasing trends for both dental consumables and equipment also softening over the past week.  While it’s hard to translate these responses into specific patient volume or dental consumables/equipment revenue estimates, we believe the biggest value in these new questions will be monitoring for a bottoming of – and eventually a recovery in — these patient volume and dental supply purchase intent findings.

Q4. On a scale of 1-10, what is the likelihood that you do any of the following over the next couple/few weeks due to coronavirus/COVID-19 concerns? Please rate with: 1 being very low likelihood and 10 being very high likelihood.

Results/Our take: Again, we’ve only asked this and the question just prior and just after in each of our past two surveys, so our historical context is limited.  That said, there has been a big increase in just the past week in the number of respondents who now expect to reduce their office hours or close their offices completely over coming weeks.  For example, 5% of respondents expected to reduce their office hours due to COVID-19 issues in our March 12-13 survey, while 4% of respondents expected to close their office completely for a week or more due to these same issues in that March 12-13 survey.  By our March 19 survey, however, which included responses from 91 of the same dentists included in our March 12-13 survey, the number of offices expecting to reduce hours or close for a week or longer had increased to 67% and 60%, respectively.

Q5. Have you been notified of any shortage of product availability in regard to infection control/hygiene products in recent weeks? If so, what kind of products?

Results/Our take: Again, this question and the prior two are new to our dental survey, so we only have two weeks of data for historical context, but even over these two surveys it is clear that shortages for PPE-related products have increased from two weeks ago to last week.  As dental offices close in the near term, we believe this question might lose relevance or importance, especially relative to the two questions above, but we’ll continue to monitor this issue in future surveys as well.  

Q6. Considering both the current state of your business (patient volumes and practice revenues) and your expectations for the next 3-6 months (again, focusing on both patient volumes and practice revenues), please rate your sentiment for each. Please rate with 1 = awful, 10 = great, never been better.

Results/Baird Take:  Sentiment in this survey decreased notably, even relative to the prior week’s survey, and is now well below multi-survey averages and at all-time lows dating back to when we first started asking this question in 2012.  Similar to our comments earlier, we believe the real value with this question will be in monitoring for a rebound in sentiment over time, with our expectations being that until life in the U.S. begins to return to normal, sentiment will likely remain depressed.

Dental Equipment Spending Outlook

Q7. On a scale of 1-10 and given recent patient volume and practice revenue trends, what best describes your expectations for dental equipment spending over the next 6-12 months? Relative to the past 6-12 months, I expect equipment spending to be...

Q8. Regarding dental equipment, how much did you spend over the past 12 months and how much do you expect to spend over the next 12 months on dental equipment purchases?

Q9. Along the same lines but asking in percentage terms, how much more or less do you plan to spend on dental equipment over the next 12 months relative to what you spent over the past 12 months for each of the categories below?

Results:  Question No. 7 above asks qualitatively about dental equipment spending plans over the next 6-12 months (“on a scale of 1-10, will you be spending more or less over the coming year”), while Questions No. 8-9 are more quantitative in nature (“how much did you spend over the past year and how much do you plan on spending over the coming year?”).  On both fronts dental equipment spending expectations in this survey declined notably relative to recent surveys, including the survey from just one week prior.

Specifically, respondents to our March 19 survey expect to spend somewhere between “modestly” less and “much” less on equipment this year vs. last, while even just one week prior these same respondents has been expecting to spend somewhere between similar amounts to last year and only slightly less than last year.  On a quantitative basis, respondents to our March 19 survey now expect to spend $14,000 less on equipment this year vs. last, with these same respondents in our March 12-13 survey suggesting they would spend ~$6,800 less this year than last.  And while it was a different respondent base in our December 2019 survey, respondents in that December survey noted that they expected to spend ~$6,700 less on dental equipment in 2020 vs. 2019.

Bottom-line, dentists are reigning in their dental equipment spending expectations for 2020, something that is not surprising as offices throughout the U.S. close and uncertainties about when patients might return to the dental office grow.  On our list, exposure to dental equipment sales on a global basis (as a percentage of ww revenue) is greatest for XRAY at ~30% of global revenue, vs. ~20% for NVST, ~17% for HSIC, ~15% for PDCO, and ~10% for ALGN, all by our math.  To be fair, however, we believe other types of dental revenue (consumables, specialty, software/services, etc.) will also be heavily impacted in the near-term, although as we showed earlier in this report, in the 2008-2009 cycle dental equipment sales (at least in North America, where we have the most data) recovered on a lagging basis, with specialty revenue recovering fastest, followed by consumables, and eventually equipment revenue.

2020 Stress Test,
Debt Covenant Review by Company

Price Target Justification and Risks

ALGN. Our $325 price target continues to represent a 35x EBITDA multiple applied to our $890M EBITDA projection for 2021, discounting this number back by 25% to account for an expected return on this stock next year, and giving ALGN credit for ~ $15 in cash per share we expect them to have on the balance sheet one year from now. We’re building our valuation off 2021 instead of 2020 EBITDA as we believe 2021 EBITDA will be normalized vs. the depressed EBITDA expectations we have for ALGN in 2020 due to COVID-19 issues that are clearly impacting in China so far this year. Note we are also adding back stock comp into our 2021 EBITDA estimates when valuing this company even though management has decided to begin providing non-GAAP margin and earnings results beginning in 2020 that will exclude both non-recurring items and stock-based comp. We’re doing that, at least for now, as we’ve long valued this company including stock comp and believe our valuation shouldn’t be artificially inflated today simply as management is now choosing to exclude stock comp in how it communicates margins and earnings to the Street. As for the 35x EBITDA multiple we’re using to value this name, we believe such a multiple is warranted by the 25-30% EBITDA growth we expect for ALGN over the next few years, with this 35x EBITDA multiple largely in line with the average multiple at which this stock has traded in recent years. Risks to our Outperform rating on ALGN include: (1) highly competitive industry, (2) growing new market entrants in the comprehensive part of the market following treatment planning IP for ALGN that expired in late 2017, (3) risk of shifting consumer purchasing behavior for clear aligners as DTC providers such as SDC, Candid, and others continue to spend aggressively, (4) risk that shifting mix to lower acuity cases in DSOs and other offices and/or growing doctor retention costs continue to pressure ASPs and drive revenue/earnings growth below case shipment growth over the longer term, and (5) general macroeconomic risk, especially in the near-term from China, which is ALGN’s second largest market after the U.S. and where GDP growth has recently slowed to multi-year lows, and (6) risk that the coronavirus headwinds that are expected to impact ALGN significantly in 2020 may not resolve as quickly as we currently expect heading into 2021.

 HSIC. Our $68 price target applies a multiple of just under 17.5x to our forward year NTM (2021) EPS projection of $3.92. While uncertainties around HSIC’s NA dental business and overall margin performance remain, medtech multiples also continue to rise, meaning that the 17.5x multiple we continue to use when valuing this name is now a slightly bigger 4-6 point discount (~20-25%) to the 22-24x valuation range at which HSIC’s broader medtech peers currently trade. With the greater secular uncertainties we believe HSIC is currently facing and the more limited margin expansion and EPS growth we expect from HSIC in the near/intermediate-term vs. medtech peers, we believe this discount vs. peers we’re using to value this stock remains warranted. Risks to our Neutral rating on HSIC include potential that dental end-market growth rebounds back toward historical 4-6% levels over time, HSIC’s medical business continues to grow well above the mid-single digits (closer to the upper-single-/low-double-digit range it did in 2015-2017), potential that planned restructuring efforts over coming quarters drive more than 5-10bp per year of annual OM% expansion, and potential that management considers a more aggressive recapitalization of its balance sheet with net debt-to-ebitda levels currently ~1x following the spin-off of the company’s animal health distribution business in early 2019.

 NVST. Our $33 price target applies an 18x multiple to our 2021 EPS projection of $1.81. From an EBITDA perspective, this $33 price target assumes ~16.5x our 2020 EBITDA projection of $421M. Relative to smid-cap medtech peers that we estimate are currently trading at median NTM P/E and EV/ttm EBITDA multiples of ~26x and 19x, respectively, these 18x forward year NTM P/E and 16.5x NTM EBITDA multiples we’re using to value NVST represent discounts of ~15-30%. We believe such discounts for NVST vs. peers are currently appropriate given the ongoing secular growth challenges facing the broader dental market overall, as well as NVST’s own company-specific growth challenges near term. If, however, NVST is able to deliver the sequentially improving revenue and earnings growth we currently project into late 2020 and 2021, we believe the valuation gap at which NVST currently trades relative to these peers could narrow, while the size of the valuation discount we’re currently using to value NVST over the coming year could also moderate, suggesting potential upside for this stock even beyond our current $33 price target over the coming year. Risks to our Outperform rating include: 1) a slower macro environment in the U.S. or globally translates to weaker-thanexpected dental patient volumes, 2) increased secular headwinds from factors such as DSOs and payer reimbursement, 3) highly competitive markets, particularly in the clear aligner and dental implant categories that NVST is launching new products near term, 4) financial and integration risk associated with potential future M&A activity, and 5) any change in relationships with dental dealers as 50% of company-wide revenue is tied to products sold through dental distributors.

 PDCO. Our $28 price target applies a 15.5x multiple to our forward-year NTM earnings projection. We believe this multiple is warranted given the company’s improved operating performance in recent quarters (three consecutive quarters of OM % expansion, narrowing of dental consumables market share losses) and increased confidence we have in management’s ability to execute to its near-term financial targets. Relative to PDCO’s historical trading range, this 15.5x multiple is below the 16.4x average NTM P/E multiple at which these shares have traded over the past five years, a discount that we believe is warranted by secular end market pressures in both of PDCO’s dental and animal health segments, as well as profitability metrics that remain below five-year average levels. This 15.5x multiple is also below the 17.5 multiple we’re currently using to value PDCO’s closest dental peer HSIC, although we remind investors that on an apples-to-apples basis, we’re really only using a multiple closer to 15.5x to value HSIC on a cash EPS basis (after adjusting for deal-related amortization that HSIC does not exclude when calculating its EPS the way PDCO and many other company’s current do). While we’ve historically argued for a multiple premium for HSIC vs. PDCO given HSIC’s stronger execution history and the faster growth HSIC has historically delivered relative to PDCO for much of the past decade, we believe PDCO is likely positioned to grow its dental business faster than HSIC over coming quarters given the PDS win for PDCO/loss for HSIC and as Primescan (and possibly Primemill) upgrade tailwinds should ultimately prove more impactful for PDCO vs. HSIC over coming quarters given PDCO’s bigger installed base of CEREC users and smaller overall dental equipment revenue base. Risks to our Neutral rating on PDCO include: (1) risk that company-specific dental and/or vet execution begins to improve sooner or to a greater extent than we currently expect, (2) risk that dental end markets strengthen and begin to grow faster than the 2-4% we’re currently assuming in our dental models over the next couple years, (3) risk that PDCO’s new management team can move the company into adjacencies or other areas of dental or vet that might carry greater growth and/or margin expansion opportunities over time, and (4) risk that PDCO’s struggles and recently depressed valuation attract either activist, strategic, or financial interest from outsiders.

XRAY. Our $57 price target applies a 19x multiple to our forward-year NTM EPS projection of $3.00. We believe this multiple is warranted as the median multiple at which XRAY’s midcap medtech peers currently trade has fallen recently to 21x vs. 23x a few weeks ago, and we continue to believe XRAY deserves a couple point discount to these peers given continued uncertainties regarding both the broader dental market’s secular outlook and XRAY’s competitive positioning across a number of product lines (implants, orthodontics, digital imaging, etc.). Risk to our Neutral rating on XRAY include potential that dental end market growth rebounds back toward historical 4-6% levels over time, that new products drive revenue growth above mid-single-digits near term, recent restructuring and headcount reduction efforts drive the company’s operating margin back into the upper teens/low 20% (vs. ~15.5% in 2018) sooner than we currently anticipate, and potential that management considers a more aggressive use of its balance sheet for share buybacks and/or acquisitions once restructuring-related expenditures fall away beyond 2019.

Appendix - Important Disclosures and Analyst Certification

Approved on 22 March 2020 22:39EDT/ Published on 23 March 2020 01:05EDT.

Covered Companies Mentioned
All stock prices below are the 3/20/2020 closing price.

Align Technology, Inc. (ALGN – $144.82 – Outperform)
DENTSPLY Sirona, Inc. (XRAY – $32.82 – Neutral)
Envista Holdings Corporation (NVST – $11.94 – Outperform)
Henry Schein, Inc. (HSIC – $45.01 – Neutral)
Patterson Companies, Inc. (PDCO – $16.31 – Neutral)
( See recent research reports for more information )

10  Robert W. Baird & Co. Incorporated and/or its affiliates have been compensated by Henry Schein, Inc. and DENTSPLY Sirona, Inc. for non-investment banking-securities related services in the past 12 months.

  • Robert W. Baird & Co. Incorporated and/or its affiliates managed or co-managed a public offering of securities of Envista Holdings Corporation in the past 12 months.
  • Robert W. Baird & Co. Incorporated and/or its affiliates have received investment banking compensation from Envista Holdings Corporation in the past 12 months.

Appendix – Important Disclosures and Analyst Certification

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