A Look at the Veterinary Supply Segment
Veterinary segments may contain hidden value for both Patterson and Schein.
Patterson Companies' (PDCO) (FV: $36) Webster Veterinary, Henry Schein's (HSIC) (FV: $63) Butler Animal Health Supply, and pure play MWI Veterinary Supply together represent a 75% share of the addressable $3 billion veterinary supply market. Patterson's Webster unit has been a mainstay for the company over the years, contributing around 20% in revenue to total operations. Schein stepped up its commitment to its veterinary segment at the end of 2009, when it spent around $350 million to acquire a 50.1% stake in Butler, a significant purchase that took sales in the firm's animal health segment to $889 million in 2010 from $240 million in 2009, a 270% increase.
Patterson and Henry Schein have a significant and primary presence in dental supply, and we believe there are several similarities between their veterinary and dental businesses. Both markets are fairly fragmented, and customers typically use multiple suppliers and keep inventory on hand fairly low. One area where the two segments differ is with respect to the makeup of products in the sales channel. While the average dental distributor generates roughly 55%-60% of its sales in consumables and around one third from dental equipment, vet distribution sales are generated almost exclusively by consumables--roughly 95% for Webster in fiscal 2010.
According to data provided by Patterson, there are roughly 79,000 vets and 27,000 animal clinics currently, with roughly two thirds of vets working in private clinics with an immediate focus on companion pets. These practices typically generate nearly $800,000 in revenue and purchase on average around $100,000 in supplies each year. Clinics will typically use more than one supplier, but concentrate around 80% of total supply spending among the top two suppliers.
The addressable market sales channel has multiple components consisting of a pure distribution channel along with an agency relationship aspect. Roughly two thirds of the market is made up of the traditional distribution channels, where Webster or Butler would oversee the sales process from manufacturer to end customer. The remaining one third consists of an agency agreement business, where commissions play a role. This business is important in the sense that the vet actually controls the process and can order a particular product from his choice of distributors. In this scenario, the relationship and/or comfort factor with a particular rep is critical in determining the distributor a vet will use, and ultimately, whether the distributor receives the commission, which can range from 3%-10% of the sale. For example, Webster has an agency commission business with several of its larger pharmaceutical manufacturers. In this relationship, the firm receives commissions through the solicitation of orders from its sales force, but doesn't actually deal with either the product or customer payment. Webster's sales from this arrangement only accounted for less than 1% of revenue during the last year.
The strategies of both Butler and Webster looking forward appear to be fairly closely aligned in, our opinion. The focus on acquisitions has played a huge role for each of these units in the past. For example, over the last seven years, Webster has made a number of purchases, including Columbus Serum, a smaller distributor of companion-pet supplies in 2008, and several other small distributors spread over the U.S. that serve to bolster the firm's geographic presence. Furthermore, these smaller firms have cost synergies, and can be plugged into the distribution infrastructure at little incremental cost.
Animal Health Market Growth Remains Healthy
While there are certainly short-term factors that can constrain growth in the segment, we believe the animal health market has plenty of longer-term tailwinds that will drive favorable business for both Patterson's Webster and Schein's Butler over time. There has been significant growth in the number of households with companion animals along with average vet spending during the last 15-20 years. Overall, companion animal spending has increased almost three-fold during the past 15 years to reach almost $48 billion. The level of innovation in animal therapeutics has increased substantially, with the number of new products growing each year. It's important to note that the animal health space is an area where a product with only $50 million in sales is considered a blockbuster. However, there is much more revenue stability in animal health pharmaceuticals than in human pharmaceuticals, as the animal health business isn't exposed to the same imminent patent cliff. One product launch gaining some attention this year is Trifexis from Elanco, a chewable parasite protection product with a focus on fleas and heartworm disease.
Breaking Down the Value of Veterinarian Business Segments
The animal health business segments contribute roughly 20% of total revenue to both Henry Schein and Patterson. While the contribution of these segments to overall firm results is growing, dental ultimately remains the key driver with respect to earnings and quarter-by-quarter movements of Patterson and Schein's respective share prices. However, we feel that investors underappreciate the ultimate value of the vet businesses. Growth rates and margins tend to hover in the midsingle digits for vet supply segments--Webster's operating margin in 2010 was around 5%. Given that vet segment growth rates are actually higher than those of both dental and medical segments, it's arguable that the vet segments could be slightly undervalued relative to the other business units for both Patterson and Schein.
We've used sales and EBITDA multiples to approach the valuation of vet supply segments at Patterson and Schein. Looking at pure-play competitor MWI, the firm currently trades at 0.72 times sales and around 15 times EBITDA. Henry Schein's acquisition of a 50.1% stake in Butler in late 2009 from Oak Hill Capital Partners and Ashkin Family Group for around $351 million in total consideration gives us additional insight into current values in this space. Butler had $649.2 million in revenue in 2010, and if Henry Schein had bought the entire company, we can assume they would have paid close to $700 million in total, a multiple of slightly over 1 times revenue.
Webster reported $643 million in revenue in fiscal 2010 and generated EBITDA of roughly $39 million. If we value Webster using an EBITDA multiple, we think it would be worth around $585 million on the high end, using a 15 times multiple. Given that Patterson itself is worth around 11 times EBITDA currently, we would value Webster at around $429 million on the low end. Taking into account sales multiples from MWI (0.72 times) and Butler (1.07 times), we can assume a value range of roughly $688 million on the high end and $463 million on the low end. The midpoint of these sales-multiple valuations actually corresponds nicely with a 15 times EBITDA multiple, or around $585 million. Given Patterson's current enterprise value of $4.5 billion, this would imply that Webster comprised 13% of the firm's total value.
By comparison, Webster contributed only 8.9% of Patterson's total operating income in 2010. However, we think that the vet supply segment's faster growth rate justifies the difference between EBIT contribution and total value. For example, in fiscal 2010, Patterson had an organic growth rate that was essentially flat, while Webster posted internal growth of around 5.4% during the same period. Given that the unit has demonstrated annual growth rates consistently higher than those of both the dental and medical business segments during the past three years, we believe the difference in operating income contribution and value contribution to the entire firm is justified.
Economic Moats in the Veterinarian Supply Business
We've assigned narrow moats to both Henry Schein and Patterson on the strength of their dental businesses, which have created a de facto oligopoly and dominate the supply chain on both ends. Due to the commoditized nature of many dental products, manufacturers don't have much bargaining power with distributors, limiting price increases. In addition, dental practices are a fragmented group that doesn't typically participate in Group Purchasing Organizations (GPOs), leaving them with little ability to push back on pricing and qualifying them as price takers.
We have long thought that the vet supply business had the potential to slowly emulate the dental chain and form a narrow moat over time. However, while vet distributors can control vet offices (also price takers, in our opinion), they don't seem to have as much control over manufacturers at first glance. Only six firms control two thirds of the market for animal health products, which would seem to make it harder for the vet distributors to have the same level of bargaining power as they see on the dental side. However, with far fewer blockbusters, higher commoditization, and lower product differentiation in the vet space compared with the human pharmaceutical arena, we think the dynamic is actually more similar to dental than it appears.
The numbers also support the case for vet segment moats. As we mentioned previously, MWI, Butler, and Webster control roughly 75% of the distribution market. As a public, pure-play distributor, MWI has posted returns on invested capital in each of the past two years of around 12%, and the firm has also generated strong returns on assets and equity of 8.7% and 15.8%, respectively, in 2010. Given our cost of equity and weighted average cost of capital assumption for Henry Schein and Patterson of 10%, and assuming a similar metric for MWI, we believe the company has earned a return above its cost of capital and will continue to do so over the next 15 years, giving it a narrow economic moat.
While Henry Schein does not break out operating earnings and assets for its animal health business, we can use Patterson's Webster as a proxy. The unit generated a return on assets of around 10%, higher than that of MWI. Webster's return on equity is therefore at least 10%, and is likely more in line with MWI's midteens return on equity, assuming Webster has any debt.
Based on this analysis, the three largest vet supply players each appear to hold a narrow moat, forming an oligopoly similar to the dental distributor space. However, there are industry trends that have the potential to disrupt these moats or remove the slight advantage vet distributors have over manufacturers. One prominent issue arising recently is the notion of manufacturers selling directly to the end market, bypassing distributors altogether. Patterson lamented this trend during its second-quarter and third-quarter earnings calls last year; due to various mergers in the pharma space, certain products are now sold directly rather than through the distribution channel.
We see this as a minor development for a few reasons. First, distributors have developed a strong knowledge base around animal health products, and ultimately perform a valuable service in working with vets to decide which products are appropriate or desirable for the practice. Second, vets don't have the time to deal with multiple pharma or manufacturer reps; distributors act as aggregators of both products and information, which we think ultimately saves time and money. Finally, given the fragmented nature of vet offices in the U.S., we think it behooves the typical manufacturer to take advantage of the distributor infrastructure to get its products into as many clinics as possible. Their vast network and reach (Webster has 12 distribution centers across the U.S.) is difficult to duplicate.
Bill Buhr does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.