It Pays to Be in the Middle

Hot Financial Stocks To Own Right Now

In the health care sector, investors can tap into the full range of the risk spectrum. They can swing for the fences with bets on emerging biotechnology companies set to deliver groundbreaking new drugs, or they can make lower risk plays on “Big Pharma,” hoping these giant drug makers can stay ahead of their patent expiration curve.

Among the lowest risk plays of all in the sector are distribution companies that produce steady growth and returns on trends as simple as increasing utilization.

Henry Schein (NSDQ: HSIC) is a global distributor of health care products, including medical, dental and animal health care supplies with about 35 percent of sales outside of the US. It also offers software systems used to manage finances, educational requirements and other office functions as well as value-added services such as practice design.

Since the company went public in 1995, its sales have grown at an annual compound rate of 17 percent, rising from $616.2 million to $8.9 billion last year. Earnings per share (EPS) have experienced similar growth, up from $0.34 in 1995 to $4.44 in 2012.

Henry Schein’s original focus was primarily on dental supplies, which accounted for nearly 70 percent of sales when the company went public. However, the company has successfully diversified its business lines, with dental now accounting for only about half of sales. Veterinary supplies account for about 26 percent of revenue, medical is at 18 percent and value-added and technical services are at 3 percent.

Schein’s growth and diversification is impressive given the fact that the company has faced stiff competition. A number of middlemen operate in all of Schein’s markets, such as McKesson Corp (NYSE: MCK), MWI Veterinary Supplies (NSDQ: MWIV) and Den! tSply (NSDQ: XRAY).

But Schein has set itself apart by becoming the largest supplier of dental veterinary products in the world, allowing it to leverage impressive economies of scale that most of its competitors lack. Schein has also stayed ahead of its demand, with 75 percent – 80 percent utilization rates, which allow it to quickly adapt to growing volumes.

The company has also emphasized strong customer service over the years, offering its “Privileges” preferred client loyalty program that currently serves more than 28,000 US dentists and 24,000 US medical members, as well as more than 7,000 international members. The program gives customers preferred access to sales representatives, sales discounts, extended warranties on medical equipment and guaranteed response times in the event of equipment failure.

As a result of that “VIP” treatment, the company’s Privileges customers face higher than average switching costs given the benefits they realize as Schein customers.

Henry Schein also benefits from the fact that its market, competition and supplier base are extremely fragmented. Some suppliers are able to effectively compete with Schein on a limited regional basis, but given Schein’s large distribution network and volume advantage, few can successfully undercut its prices on a long-term basis. At the same time, Schein can fairly easily acquire many of its smaller competitors when and if it is so inclined and poach competitors’ customers, because Schein can generally under-price them while offering rapid delivery times.

Schein is increasing its offerings of value-added services, especially in the areas of financing, credit card processing and e-claim filing. It is also pursuing exclusive and semi-exclusive distribution agreements with a number of suppliers, making the operating environment increasingly difficult for its competitors.

Another attractive feature of the company is the fact that it has been diversifyi! ng away f! rom its almost sole focus on medical supplies.

While the Patient Protection and Affordable Care Act will create a rising tide for most health care companies through its aim of extending near-universal insurance coverage, as part of the law reimbursement rates for a number of goods and services have come under pressure. But less than half of all Americans have dental insurance and it is virtually unheard of in many other parts of the world, meaning there’s almost no reimbursement pressure.

As a result, dentists are generally able to order the supplies they need with relatively few worries about how much they will ultimately be reimbursed. Veterinarians are even less susceptible to reimbursement worries, even as many people in the developed world are spending an ever-growing sum on pet care.

Henry Schein is expected to grow earnings by nearly 12 percent over the next five years, compared to a forecast of 9.8 percent for the broad S&P 500. Schein’s management expects diluted EPS to come in between $4.86 and $4.91 this year (the median Wall Street forecast is $4.91), while its forecast for 2014 is between $5.31 and $5.47 (Wall Street looks for EPS of $5.46).

At the moment, the company’s shares are fairly valued, commanding a trailing 12-month price-to-earnings (P/E) ratio of 24 and a forward P/E of 20. But it is undervalued compared to its industry as a whole, which currently has a trailing P/E of 31.3 and a forward P/E just shy of 25.

With attractive industry beating returns on assets (8.1 percent compared to 3.5 percent for the industry) and equity (15.9 percent compared to 13.9 percent) and strong growth prospects, this company should be a steady performer in the medical distribution space.

With almost no debt and steady growth, for an industry beating performance Henry Schein is a great buy up to 130.