Henry Schein: Acquisition Strategy Has No Impact on the Economy (NASDAQ:HSIC)

Investment summary

Henry Schein, Inc. (NASDAQ:HSIC) is a company that I have gotten to know very well over the years, having owned it periodically through various market cycles since 2018. For example, I bought it for our portfolios during the 2022 market crash, as a defensive overlay to our equity exposures. However, my sentiments have remained unchanged since then, neutralized by the lack of economic value that HSIC’s management is providing to the company’s shareholders.

Figure 1.

In my last analysis in October 2023 – right when the broad indices started to rally – my assessment was that 1) the market had correctly valued HSIC and 2) there was little upside potential on offer at current multiples. Judging by the company’s latest data, little has changed in this view.

In this report, I will unpack the latest version of HSIC financial performance and link it to the broader economic picture so that investors can draw the best conclusions for the future. Net-net, I continue to rate HSIC as a Hold based on 1) valuation, 2) fundamentals and 3) sentiment.

Key results for the first quarter of FY24

HSIC recorded another flat growth period in the first quarter of fiscal 2024. Despite this, the CEO enthusiastically commented on the company’s BOLD+1 plan (discussed in detail in my latest analysis):

“We are very pleased with the progress we are making in executing our BOLD+1 strategic plan, as well as the contributions of our recent acquisitions. These acquisitions contributed to the profitability we achieved in the first quarter.”

Returning to quarterly statistics:

• During the quarter, HSIC did $3.2 billion in business, an increase of 460 basis points compared to last year’s first quarter.

• The growth was driven by revenues from acquisitions (2.8% revenue growth). Organic sales were up just 180 basis points year-over-year, but on closer inspection they were down in all segments except hardware and global technology, respectively.

• It saw its operating margin decline by approximately 100 basis points compared to the first quarter of 2023 and returned it to earnings of $0.72 per share, also down year-over-year (Figure 2).

Management has narrowed full-year guidance and now assumes sales growth of 8% to 10% in fiscal 2024 (200 basis points below prior). This will bring 2024 sales to approximately $13.5 billion by mid-year. Consensus is in line with this target, with earnings growth in this range of 12-13% to $5.07 per share, up another 10% to $5.60 per share in 2025.

Figure 2.

Capital allocation does not create value

The Management Board remains committed to its acquisition strategy of “buying” growth companies. As shown in Figure 3, taken from the company’s Q1 2024 investor presentation, the company has a wide range of acquisition opportunities from which it can benefit. It analyzes them in terms of revenue, as well as the strategic rationale for how each would engage with the current portfolio.

Figure 3.

To finance these acquisitions, HSIC can – and appears to be doing so – tap its balance sheet. For example, year-to-date, it has already committed about $20 million to acquisitions compared to $41 million in capital expenditures, and it has about $1.2 billion of liquidity available across its facilities. This equates to a debt-to-EBITDA ratio of 2.3x, as seen in Chart 4.

Figure 4.

A broader view of management’s capital allocation decisions is provided in Figure 5. It shows the amount of new invested capital needed to generate each dollar of new sales from 2020 to 2024 on a rolling 12-month basis. As expected, revenue growth remained flat at just 20 basis points in each period. HSIC is a high-volume, low-margin company, so it’s no surprise that its incremental pre-tax margin is 7.6%.

However, to show this poor revenue growth, management had to invest $7.36 to generate each $1.00 of additional revenue. Without acquisitions, this is still an investment of $2.46 per dollar of new revenue generated. As you can see, most of the investment went into acquisitions – $4.90 on the dollar. This is accompanied by changes in intangible assets (probably also as a result of acquisitions in my opinion).

The point is that HSIC has extensive capital requirements to maintain its competitive position. My estimate is that the company will invest approximately $55-60 million annually in its capital base going forward to maintain this position, and if it continues its acquisition pace, that amount will increase to $160 million. This is not inconsistent with the results of the last few years

Figure 5. HSIC, TTM 2020-2024 value factors

The result is relatively stable free cash flow production per share from which investors can benefit (Figure 6).

Paradoxically, in the case of HSIC the losses are twofold:

1. Does not pay cash dividends (only buys back shares),
2. There are not many reinvestment opportunities outside of acquisitions to grow – and in my opinion, these acquisitions do not increase their economic importance, as we will see below.

Figure 6.

Analysis of management’s investment decisions

From 2022, management generates a small rate of return on capital for shareholders, regardless of the acquisitions made. This is due to both 1) a growing capital base ($5.7 billion in September 2021 to $7.3 billion in the first quarter of this year) and 2) a decline in earnings of almost $300 million during this period (on a TTM).

Moreover, as Figure 7 shows, marginal return and invested capital – that is, the returns earned on incremental investments – were also negative on an ongoing basis.

An after-tax operating margin of approximately 5 to 6% is expected in this industry, however, capital turnover of less than 2x will not be enough to raise HSIC’s business profits to a more attractive level. When I say attractive, I mean a yield of 12%, roughly in line with long-term market averages.

If the company can submit its internal valuation based on its ROIC and the amount reinvested at these interest rates, it can be seen that HSI C has not met its expectations in this regard. The point is that, in my opinion, the continued commitment of resources from HSIC’s management does not add additional economic value to shareholders. The market agreed to this.

Figure 7.

No economic added value

This can best be quantified in Figure 8, which shows the opportunity cost of purchasing HSIC compared to a hypothetical company earning a 12% return on invested capital. All figures are in 12-month format. For example, in 2024, to achieve a 12% return on equity of $7.3 billion, HSIC needed to generate a profit of $877 million. It ended up throwing away $635 million in after-tax profits. This is an economic loss of approximately $242 million (877-635 = 242), which equates to approximately 2.6% of the company’s current market capitalization as I write this.

Therefore, despite generating stable, strong free cash flow every quarter, the fact that it has no additional use for this purpose beyond acquisitions means that HSIC does not generate a high return on invested capital. Investors may have better opportunities elsewhere. This forms the basis of my neutral view on HSIC.

The number 8.

To better illustrate this point, I have constructed two hypothetical portfolios, calculated from the market sell-off so far in 2021/22. I chose this period because I was in favor of HSIC at the time, given the “resilience premium” at the time. Here I compared it to a conventional 60/40 portfolio of stocks and bonds respectively. In the charts below, it is listed as “Portfolio 1” respectively.

As you can see, Portfolio 1 performed exceptionally well in 2021/22, outperforming the diversified option. This trend looked set to continue in volatile markets in 2022. However, the opportunity cost of holding HSIC is now abundantly clear, and as of January 2024, there has been a wide performance gap between Portfolio 1 and the benchmark index. In my opinion, this is due to the factors discussed above.

Figure 9. (includes next 3 images)

Projections and valuations

Following the company’s latest 2 earnings results, I have updated my modeling estimates and forecasts as shown below.

If things continue in a similar fashion, my estimates are for capital investments of $53 million per year to generate $12.5 billion in sales by 2025 – excluding acquisitions. It’s not unreasonable to see the company losing around $600-$700 million in free cash flow after these capital investments. However, in my opinion, these funds are likely to be converted to additional acquisitions given the lack of alternative options.

For context, if the company continued to allocate capital at its current pace, required investment would increase to approximately $160 million per year, or approximately 22% of projected annual net operating profit after tax. This would reduce FCF to $440-540 million.

Figure 10.

Projecting these cash flows at the growth and reinvestment rates presented above for 10 years, at a 12% discount, I arrive at a valuation of $80.96 (Figure 11).

I also looked at what the company’s market value might consist of by comparing the expected return on invested capital and the reinvestment rate and discounting the same 12%. Here I arrive at a valuation of $55.55 per share. Combining both estimates 50/50 gives a valuation of $68 per share.

I would support this valuation given that the company does not create economic value beyond what investors could reasonably expect elsewhere. An 8% return on equity leaves a lot of costs on the table.

Figure 11.

Figure 12.

The company is also trading at a multiple of 2.6 times book value. The final rate of return on capital management generated in Q1FY24 is 9.8%. So, if you pay a 2.6x multiple, investors’ return on equity will drop to 3.8%.

On the earnings side, the company is trading at a final P/E of 16.6x. This is directly in line with the five-year average.

Figure 13.

The consensus estimate is for the company’s earnings to grow 12.7% this year, when converted to GAAP net income of $4.36 per share. If the P/E multiple remains unchanged, the company could command a valuation of $81.50, consistent with the target I outlined earlier. That’s not enough meat to put on a skeleton, which confirms my neutral view.

In short

HSIC continues to grow and management is committing large amounts of capital through an acquisition plan to grow it. This is a strategy for creating “value” for the coming 5-10 years. In my opinion, these acquisitions do not have much of an economic impact, as evidenced by the diminishing returns that HSIC earns on its invested capital. With each new investment there is no corresponding increase in profits. My analysis shows that the company is worth between $68 and $81 per share, depending on the valuation method used. Net-net, hold again.