Denstply: Dental Dollars

07/30/2004 12:00 am EST

Focus:

Sam Stovall

Chief Investment Strategist, CFRA Research

While dentistry might not appear to be an exciting growth market, Sam Stovall highlights a variety of reasons-from demographics to technology-for investors to consider a leading stock in the dental sector. Here's his review of Dentsply from S&P's The Outlook.

"Denstply International (XRAY NASDAQ), founded in 1899, is the world's largest marketer of a broad range of dental products, with annual revenue three times that of its nearest competitor. We expect the outfit to continue to benefit from long-term demographic trends and generate increasing cash flows and improving return on invested capital through boosting internal growth, productivity gains through production rationalization, and beefing up profit margins through introduction of value-added products. Several factors, including some key demographic trends, bode well for Dentsply. The percentage of the US, European, and Japanese population over age 65 is expected to nearly double by the year 2030. In addition to having significant dental-care needs, the elderly are well positioned to pay for the required procedures since they control sizable amounts of discretionary income. Natural teeth are being retained longer. Individuals with natural teeth are much more likely to visit a dentist in a given year than those without any natural teeth.

"Dental practice in the US has been transformed from a profession primarily dealing with pain, infections, and tooth decay to one with increased emphasis on preventive care and cosmetic dentistry. We would also point to income trends in emerging markets. As per-capita and discretionary incomes continue to rise in the emerging nations of the Pacific Rim and Latin America, we believe that healthcare, including dental services, is a growing priority. Finally, the company should benefit from a fragmented dental-supply market. The dental products industry is experiencing substantial consolidation in both product manufacturing and distribution. However, it remains fragmented, creating numerous opportunities for Dentsply to acquire businesses to complement and broaden its existing product lines.

"We believe a rebound in orders for dental consumables should result in internal growth picking up. In 2003, the dental-consumables industry's organic growth (i.e., from existing operations) slowed to below historical levels of 4% to 6%, mainly because of weakness in the lab and equipment markets. As industry demand for lab products and consumables accelerates in the second half of 2004, we expect Dentsply's organic growth rate to stabilize and then accelerate toward 5% to 6%. Growth would be driven by the launch and ramping up of new products such as Oraqix, a new noninjectable anesthetic for periodontal applications, Acquasil Ultra impression material, Quickfill dental filling, Xeno III bonding agent, and the Duceragold advanced porcelain system.

"Dentsply has the leading market share in most of the products it focuses on, and this gives it significant advantages in areas like economies of scales in production and distribution, and research and development. In 2003, Dentsply invested $43.3 million in R&D. It operates research centers throughout the world and has 400 scientists, engineers, and technicians dedicated to research and development. In the past five years, over 50% of sales has come from new products. Dentsply plans to introduce 20 or more products per year.

"To drive internal sales growth, Dentsply focuses its marketing efforts on the dentists and dental hygienists, assistants, laboratories, and schools- the end users of its products. As part of this end-user "pull-through" marketing approach, it employs approximately 1,700 sales and technical staff to provide comprehensive marketing and service and to train laboratory technicians and dentists in the proper use of its products at its Educational Centers located in key international dental markets. Dentsply's strategy is to maintain ongoing relationships with various dental associations and recognized leaders in the field.

"We project Dentsply's 2005 revenue at $1.8 billion and expect the introduction of several new value-added products and productivity gains to incrementally boost gross margins. As Dentsply focuses on operational efficiencies such as inventory consolidation, we look for operating margins to widen from the 17.4% projected for 2004 to 18.3% in 2005. Earnings per share are projected to hit $2.36 in 2004 and $2.64 in 2005. We haven't included the effect of any potential acquisitions. Dentsply's earnings quality is good. Our Standard & Poor's Core Earnings estimates are $2.21 for 2004 and $2.49 for 2005, which fall 6.5% and 5.8% below our operating forecasts for these years. The difference reflects our projections of stock-option expense of 13 cents per share in both 2004 and 2005 and two cents of total pension costs in both 2004 and 2005.

"Dentsply's compounded annual growth rate of free cash flow was 29% over the last five years. In addition, over the last five years, the business has created shareholder value by generating return on invested capital above its cost of capital. We believe that a return to long-term organic growth of 4% to 6% and the introduction of new products should fatten operating margins and boost cash-flow generation and return on invested capital. Based on our discounted cash flow analysis, we have a 12-month target price of $60, which represents a potential gain of about 20% from current levels. Our DCF model assumes a compounded annual growth rate for free cash flows of 14% over the next five years, with a gradual slowing over the following ten years and a perpetual growth rate of 2%. Projected cash flows are discounted at a cost of capital of 7.6%. The stock's recent price-to-earnings multiple of 19, based on our 2005 EPS estimate, was in line with the level of the S&P Mid-Cap 400."

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