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Morningstar | Pressure Mounts as Patterson Struggles to Cope With Significant Dental Market Headwinds

The secular shift in the dental market has pressured the operations of Patterson, and the company is searching for an answer to this negative dynamic. While the new management team is in the midst of revamping the firm’s entire operating structure to deal with these headwinds, we are not overly optimistic that it can institute enough change over its short tenure to offset the industry's current issues. We believe Patterson will ultimately need to re-evaluate its core client-servicing apparatus as dedicated regional service staffing may be too cumbersome and costly, given new market dynamics. Accordingly, we believe Patterson should explore alternative strategies, including a partial or total sale. Despite the continuing issues, we are holding our $28 fair value estimate and narrow moat rating steady, as we have anticipated many of the issues Patterson is currently facing.

There has been increased competition from online-based wholesale players that can source dental consumables from the cheapest suppliers nationwide. Given this dynamic, Patterson reported a significant deterioration in pricing for this segment in its fiscal first quarter, which pressured profits. We don’t expect this trend will dissipate anytime soon, and we believe this has forced Patterson to adjust its sales and pricing strategies. This dynamic was reflected in firm’s sales and profit performance for the quarter as dental consumable revenue declined 5% and overall operating margins compressed 402 basis points to 0.34%. Offsetting this development was solid performance from the animal health segment, which reported revenue growth of 6% and operating margin expansion of 16 basis points to 2.31%. We believe Patterson should strongly consider following its main rival, Henry Schein, and either spin out or sell this segment in order to unlock material value that is currently buried under the underperforming dental business.

We acknowledge recently appointed CEO Mark Walchirk is taking significant steps to try to turn around Patterson, and we believe the centerpiece of any strategy will need to deal with a weaker pricing and lower profit environment. Recognizing this dynamic, management said it will seek to build and push its own line of private-label consumable products, with the intention that it will encompass a growing percentage of overall sales mix. While this strategy has the potential to help preserve profits, we ultimately believe management will have a tough time competing with vendors that price most dental consumables products at points that are multiple times lower than what Patterson and its peers currently are able to offer. Given the poor pricing dynamics in the dental consumable industry, we believe the company will need to streamline its cumbersome regional service staff. Thus, we would not be surprised to see Patterson take part or all of the firm into the private market.