Envista Holdings Looks Worth A Flyer Here

This post was originally published on this site

On its face, the decline in dental supplier Envista Holdings (NVST) seems like far too much. NVST stock has declined 43% from January highs, and sits roughly one-third below levels that held after its spin-off last year from Danaher (DHR).

There’s certainly an argument that NVST should have seen some level of pressure. As detailed in this month’s first quarter report, business fell off a cliff in March. Closed offices and cautious patients suggest a significant impact in Q2 as well. Macro concerns and lower employment can cause lingering effects in the second half and beyond.

Amplify those short- to mid-term pressures with a balance sheet that was ~3x leveraged coming into the year (based on initial, and since withdrawn, guidance for 2020) and it’s difficult to argue that NVST should be back at December levels around $28, let alone January highs at $33.

Meanwhile, there’s another factor to consider: the possibility that NVST was overvalued after the spin. The exchange offer was oversubscribed. But, as several commenters argued after my piece on the stock in December, there was a case that Danaher was spinning the business not to let it stand on its own two feet, but to get Envista’s underperformance off its books.

The concerns are all valid, and combined suggest that perhaps the sell-off makes some sense. But I don’t see the situation quite so negatively. There’s still a lot to like here. From a mid-term perspective, there should be some level of defensiveness to the business. Envista has levers to pull to mitigate near-term effects. Liquidity shouldn’t be an issue, particularly with a $450 million convertible bond issue that priced last week.

It has been a mistake to focus on price over quality both during the bull market and even in many cases during the bounce of the last few recent weeks. From a broad standpoint, that is the biggest risk to NVST here. But at this point in the market bounce from March lows, both price and quality look good enough, even if neither is quite perfect.

The Risks Before COVID-19

Fundamentally, the risk to NVST is that the business wasn’t heading in the right direction even before the coronavirus hit. Core sales growth was basically zero between 2016 and 2019, while margins weakened. Initial guidance for 2020, issued on January 30, suggested adjusted EPS of $1.63-$1.73 against $1.79 in 2019, and $2.01 the year before under carve-out financials. That outlook didn’t contemplate any impact from COVID-19, even in China where Envista has a reasonably large (~8% of revenue, per figures from the 10-K) and growing business.

There have been a few sources of pressure. Most notably, distributors have cut down on their inventory, which pressured not only Envista but fellow supplier Dentsply Sirona (XRAY). On the Q4 call, management attributed disappointing revenue (-3.5% core) to disruption around organizational changes and a consolidation of brands on the value side of the dental implant business. Investors didn’t quite buy that explanation: NVST fell 8% over the two sessions following earnings.

And the worry even in January was that there would be more quarters ahead like Q4, in which revenue growth was negative and adjusted operating income declined 10%. The implant business is facing lower-cost competition that threatens to commoditize a business that provides higher margins than the rest of the portfolio.

CEO Amir Aghdaei said on the Q4 call that “we do not think our premium implant business is impacted by competitive products,” arguing that its NobelActive implant remained a market leader. Xeal and TiUltra, newly developed surfaces used in the implant process, are expected to help the company fend off rivals. And the N1 implant should launch later this year in Europe and in 2021 in North America.

But companies that get disrupted often believe their products have such quality that competitors won’t make inroads. And implants aren’t the only worry in the Specialty Products & Technologies business that drives over two-thirds of profit. The Ormco operating unit has historically focused on brackets and wires used in traditional orthodontic applications. It’s now facing competition from Align Technology (ALGN) and SmileDirectClub (SDC), and in response is launching its own Spark clear aligner.

Of course, those upstart rivals have a significant head start. And even if Ormco can recapture some lost brackets and wires revenue from Spark, the net effect still is negative on revenue and profits.

One big impediment to the bull case in May is that NVST stock in January didn’t necessarily look that attractive. Again, multi-year performance was soft. Valuation (~14x guided Adjusted EBITDA for 2020) hardly seemed compelling. Secular pressures were evident. And the second issue is that the profile of NVST has been a particularly dangerous one for probably close to a decade now. With only a few exceptions, owning a leveraged, low-growth business because it’s “too cheap” has been a bull case that even in a best-case scenario has led an investor to underperform. In a worst-case scenario (and I’m thinking even of large-caps like Walgreens Boots Alliance (WBA) or Anheuser-Busch InBev (BUD)), it’s proved disastrous.

The COVID-19 Impact

Meanwhile, the response to the coronavirus will have a material, if not necessarily crippling, impact on valuation as well. In Q1, with what Aghdaei said in the Q1 release was a “significant adverse impact” only in the quarter’s last three weeks, adjusted net income declined nearly $50 million year-over-year. Q2 no doubt will be worse given worldwide shutdowns, and effects will linger into at least the second half as well. Even as Envista looks to furloughs and other efforts to offset the pressure, the short-term hit to earnings simply in 2020 could well be a few hundred million dollars. That’s a material sum against a mid-February market capitalization around $4.5 billion.

In developed markets, lower employment may lower mid-term demand. That’s particularly true in the U.S., which accounted for 44% of revenue in 2019. Meanwhile, developing markets were a key part of the post-spin bull case for NVST. Emerging markets, per the Q4 call, grew the top line mid-single digits in 2019 while driving nearly one-fourth of revenue. That included double-digit growth in China, a country that may see disruption not only from its coronavirus outbreak but trade tensions with the U.S.

And there will be a multi-year impact from higher interest costs. Envista drew down $250 million on its revolver in March. The aforementioned convertible offering adds $10.6 million in annual interest expense, while fees and the cost of hedging the convert total over $30 million. All of the prior debt (~$1.3 billion) needs to be addressed before a September 2022 maturity, and near-term pressure might add 100 bps or more to the refi rate, suggesting $13 million or more in incremental interest expense from that point on.

Again, there’s some material pressure to the business from the pandemic. It’s far too optimistic to suggest that even in a V-shaped recovery for the dental business, NVST stock necessarily follows the same trajectory.

The Case for NVST Stock

The risks need to be appreciated. At the same time, however, I’d consider three points in favor of NVST at the moment.

The first is relatively simple: at some point, and probably some point relatively soon, the dental business worldwide will get back to normal. That ‘normal’ might look a bit different. There may be some lingering second-order effects from macro and/or unemployment factors. Envista itself expects capital purchases to slow as new office development does the same. But over 70% of total revenue comes from consumables, and that includes all of the higher-margin Specialty Products & Technologies segment. For that side of the business, there should be a reasonably strong recovery.

The second is that while the short-term hit is material, it’s not nearly as material as price action suggests. NVST has lost over $1.5 billion in equity value from its close on Feb. 3 (two trading days after earnings). I’m far from convinced that interest expense and a short- or even mid-term hit to earnings justify that type of pressure. From here, it looks like the market overshot – which suggests some upside against a current market capitalization just above $2.5 billion.

Finally, Envista has some levers to pull to manage costs and to drive growth. There already was some cost coming out of the business: ~$60 million over three years, about 14% of 2019 Adjusted EBITDA. Envista now is targeting another $100 million-plus in permanent cuts, per the Q1 call. That includes savings on the equipment side, including the exit from Pelton & Crane, which focuses on dental office furniture and design.

Some of the drivers that were intact heading into 2020 remain as well. Spark still is receiving interest from clinicians, including a successful forum in February. N1’s launch remains on track. Envista is targeting the DSOs (dental service organizations) that are becoming ever more popular in the industry: revenue from the top ten DSOs grew double digits in full-year 2019 and “high-single digits” in Q1.

And there was some sign of growth before the crisis. The since-withdrawn guidance for 2020 adjusted EPS guidance looks disappointing, given the midpoint of the range suggested a 6% decline year-over-year. But as detailed on the Q4 call, that guidance included $0.12 in public company expenses and $0.06 in incremental interest expense, both direct results of the spin. Normalized for that expense, Envista was guiding for 4% growth. That’s not exactly torrid, but growing defensive businesses in that bull market, and even in the ‘new normal’, usually have received premium valuations. If Envista can get back to that trajectory, there’s upside from a valuation still at ~10x EV/EBITDA and less than 12x earnings (using the original guidance as a baseline).

And this still is a Danaher spin-off. Maybe the business model isn’t quite as attractive as that of the former parent, but Envista has its own version of the hugely successful Danaher Business System. The company has even made its first acquisition, picking up biomaterial manufacturer Matricel. That deal is expected to add “a few pennies” in EPS in a few years, and fits in nicely with the existing implant business.

This isn’t quite an “if you liked at $28, you should love it at $18” case. It’s perhaps more “if you liked at $28, you should like it a little more at $18.” But I thought NVST was intriguing at $28, and I like it a little more at $18. That might be enough.

Disclosure: I am/we are long NVST. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I have a small position in NVST, and may add to or exit that position in coming days or weeks depending on trading dynamics.

Add Comment