Episode 1 - Dental Market

Sharpe Focus is a new podcast series featuring discussions with the Nuance Investment Team. We will be covering topics that we believe our partners will find insightful. Nuance is a boutique value manager that is 100% employee-owned.

The team focuses on buying leading business franchises with sustainable competitive positions that are trading at a discount to our internally derived fair value. We aim to outperform our primary and secondary benchmarks on an absolute and risk-adjusted basis, as measured by Sharpe ratio, over the long term.

In this episode, Paul Gillespie is joined by Portfolio Manager, Darren Schryer, CFA^®, CPA, to discuss our positioning within the dental market and why we believe it’s presenting a unique opportunity for our clients.

The views expressed are those of Nuance Investments as of the date of this podcast and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as investment advice. To view the most current and standardized performance figures available click here for Nuance Mid Cap Value and here for Nuance Concentrated Value. To view the most current top holdings click here for Nuance Mid Cap Value and here or Nuance Concentrated Value.

Investing involves risk, including the possible loss of principal. For more information or a copy of our disclosure brochure, please contact client.services@nuanceinvestments.com. Past performance is not a guarantee of future results.

Darren Schryer, CFA, CPA

Paul Gillespie

[00:00] Paul Gillespie

Hi everyone, it’s Paul Gillespie from Nuance Investments. I want to welcome you to our podcast Sharpe Focus with Nuance Investments. For those of you who are new to Nuance, I think you’ll notice our podcast name is spelled Sharpe with an E, which we think highlights our firm’s focus on risk-adjusted returns and Sharpe ratios.

For all of you who are existing clients, you probably won’t be surprised at all that we created a name which focuses on risk-adjusted returns since you’ve heard us talk so much about the importance of those over the years. This podcast is planned to be the first of what we hope is an exciting new way for us to communicate with our partners. We think creating this podcast will help our existing clients and prospective clients get to know our firm, team, and investment process in a more in-depth way.

For our clients who are regular readers to our Nuance Perspectives, you’ve heard us mention that a big portion of our overweight position within the healthcare sector is in the dental market. So today, we’re going to focus on what we believe is the unique opportunity within the dental market and how we’re positioned in that space. I’m excited to be joined by our portfolio manager, Darren Schryer, CFA, CPA today.

For those of you who aren’t familiar with Darren, he’s been with the firm now for almost 10 years. He started out as an investment analyst and now is a portfolio manager, which is the role he’s served in for the last several years. As with all members of our investment team, Darren has responsibility for specific sectors and Darren includes the healthcare sector.

So he is the primary analyst for all things dental. Darren, excited to have you on today and let’s get right into it. When we talk about the dental market and dental exposure, what does that mean?

[01:51] Darren Schryer

Sure, right, Paul. So we’re talking about healthcare related to teeth and oral health, everyone’s favorite activity, going to the dentist. Dental care is a niche within healthcare. It’s only around 5% of total healthcare-related expenditures, but it is an important category.

Poor dental health is very closely linked to a bunch of health issues and just about everyone is familiar with how much pain poor dental hygiene and poor dental care can cause. So in general, we’re talking about the companies that manufacture or distribute the clinical dental tools and supplies to dentists around the world.

[02:31] Paul Gillespie

And are these like consumables that they use and then throw away or is this like the equipment? What exactly is it that these companies are making or both?

[02:44] Darren Schryer

Oh yeah, it’s both and both are very important in dental care.

So when we think about the equipment side of the business, you’re talking digital x-ray machines to do things like identify cavities, the 3D x-ray machines, you know, the ones that kind of spin around your head and take the panoramic view of your teeth. Those are called code memes. Also intraoral scanners.

Intraoral scanners are the device that scans the topography of your teeth and it focuses on your bites rather than looking through the interior of your teeth. It’s critical for treatment planning. There’s also smaller equipment categories, you know, treatment centers, chairs, handpieces, milling equipment, 3D printers.

That covers most of the equipment market. On the consumable side, you’re talking endodontic tools and supplies used for root canals, supplies and tools used in implants for total tooth replacement, abutments, prosthetics, restorative supplies used to repair teeth, bonding agents, filling materials. We’re really focused on the more clinical types of supplies.

You’re not going to see us investing in companies that are focused on, you know, gloves and paper trays.

[03:52] Paul Gillespie

And does that include when I go in and I have to get a crown put in? Are these the companies that are making that crown?

[04:04] Darren Schryer

Yeah, so something like a crown, the ceramic material that’s used to make the crown, the bonding agents, the tools used to place and secure the crown, that would potentially be made by all of these dental manufacturers that we’re talking about here today.

[04:24] Paul Gillespie

So this is really more highly engineered dental equipment for the most part that we’re talking about, which is kind of what fits our process.

[04:30] Darren Schryer

Yeah, oh, yeah, we’re talking about the more clinical, more differentiated, more advantaged types of products. And, you know, when you think about these types of products, you know, something like an implant, which is essentially, you know, a screw that’s going to be affixed to your jawbone, you know, that’s going to stay in your body for 10, 15, 20 years. There’s a big, you know, a big need for quality.

Dentists are staking their reputation on every procedure they do. They don’t want patients leaving with a poor experience or pain to go tell their friends not to go see Dr. Smith. So there’s a pretty high quality standard in addition to significant regulatory oversight, given the nature of the business.

[05:14] Paul Gillespie

And so that kind of leads me into how does dental in general fit into our competitive work and what we’re seeing? And you kind of alluded to that a little bit, but do you want to go into a little more detail about just overall how that space fits into what we’re doing just from a screening perspective and a competitive position perspective?

[05:36] Darren Schryer

Yeah, definitely. So, the industry backdrop here really fits what we’re looking for very well. There’s a long, long history of stable, growing demand for dental care.

There’s a nice tailwind to demand in international markets where, you know, even today there’s significant issues with access to care, unmet dental needs in many international geographies. There’s also a tailwind from an aging population. Older people tend to need much more dental care than younger people.

As I mentioned, barriers to entry are pretty high due to regulatory oversight and the quality focused nature of the customer base. And then from a screening perspective, you know, the primary thing we look for when we screen for any investment is high returns on capital relative to the sub-industry or their peers and stability of those returns. We found the metric that most often corresponds with the types of leading businesses we’re looking for is that sort of high returns on capital and stability of returns.

In Dentsply Sirona’s (XRAY) case, which is our largest dental holding, they’re at the very top of the healthcare supplies sub-industry. In Henry Schein’s (HSIC) case, which they’re another one of our holdings, they’re the leading distributor. They’re at the very top of the healthcare distributors sub-industry.

So in general, the space and the leaders fit what we’re looking for really well.

[06:52] Paul Gillespie

Broadly speaking, when you think about our investment process and what we’re doing, we’re obviously trying to identify companies with great competitive positions that are sustainable, and you talked about that. But we’re also trying to understand them in their normal operating environment when they’re over-earning due to maybe a positive transitory event, when they’re under-earning due to a negative transitory event.

So what’s causing, what do you see in the dental space today that is causing the under-earning and these companies within the dental market to under-earn their normal or our view of their normal returns on capital?

[07:28] Darren Schryer

Yeah, so we’re in a really interesting cycle here within dental. You know, which in most environments is a fairly stable industry. So when you think about what happened over the last five years or so, in 2020, during the start of COVID, no one was going to the dentist unless it was an emergency.

No one wanted to. And it was a pretty extreme under-earning opportunity for the dental manufacturers, and we were aggressively buying Dentsply Sirona (XRAY) for our own in 2020. In 2021 and 2022, everyone who had skipped a year’s worth of dental appointments started going back in, you know, they had pain, they had cavities, they had skipped a year worth of hygiene appointments.

Consumers were also spending stimulus dollars on cosmetic procedures like veneers and clear aligners. Dentists were investing in new equipment because their excited demand was increasing. They also took advantage of very low interest rates at that point in time.

So, earnings power throughout the industry improved dramatically from 2020 through 2021 and 2022. And, you know, at that time we were selling our Dentsply Sirona (XRAY) stock as a trade from the low $30 per share up to almost $70 per share. And today we’re on the other side of that reopening cycle.

The core dental business, patient traffic for things like hygiene appointments, basic restorations, that’s stable. But demand for your high-end elective procedures, your high-end cosmetic procedures, that’s below normal due to that pull forward of demand into that 2021-2022 time frame. Dentists who purchase new equipment in 2021-2022 also don’t need to repurchase that same equipment again here in 2023-2024.

Interest rates are higher today than they were a few years ago. Most new equipment is financed. Interest rates also impacts the rate of new practice formation.

Even your high-end elective procedures are often financed. So there’s a number of factors that’s causing demand for equipment, demand for elective procedures to be below normal levels today.

[09:34] Paul Gillespie

So you mentioned the word cycle a couple times, and you mentioned the cycle during COVID.

We’ve talked about as a group that typically the cycle within dental has to do with the recession. More people are out of work, so they don’t have dental insurance. They put off their visit to the dentist because they don’t have insurance.

It’s a degenerative condition. It gets a little worse. Those are the kind of cycles we’ve seen historically. Where does this period that we’re in today relate cycle-wise to what we’ve seen historically?

[10:08] Darren Schryer

Yeah, so it’s an interesting question because this is a very unique catalyst for a trough then peak then trough cycle within dental being COVID-19 and the related shutdowns followed by reopening as the catalyst versus your more sort of classic cyclical recession. So the last sort of poor end market within dental, as you might expect, was in 2009 following the global financial crisis. And in 2009, equipment sales were down.

It took about one to two years to recover. If that same sort of normalization pattern were to repeat, that would imply normalization sometime next year. But this is a unique cycle related to COVID.

[10:58] Paul Gillespie

We spent some time at the beginning talking about the competitive position of dental and why we like it so much. One question that seems to come up with clients when we’re out talking about dental is something called dental service organizations and DSOs is the term everybody uses. Can you talk about what that is and how that might impact dental and what we think about that?

[11:25] Darren Schryer

Yeah, definitely. So, DSOs are basically just groups of dental practices that have consolidated back office function. So the dental market used to be almost entirely your single office mom and pop type practice, one dentist or two dentists, one or two hygienists, an office manager. DSOs are larger.

They’re more sophisticated. So it could be anything from a handful of offices in a region like Kansas City, where a dentist has opened a few different offices, hired some younger dentists and has sort of consolidated it into a group, all the way up through a big private equity owned group of dental offices like a Heartland or an Aspen are two of the larger ones that are owned by private equity. You know, most estimates have maybe 15 or 20 percent of dentists being affiliated with a DSO today.

It is a growing presence, though. Younger dentists are tending to gravitate towards DSOs because it’s easier and cheaper to get started out of school. And there are puts and takes to the impact.

A DSO does have some economies of scale that you have some purchasing power, certainly relative to just a single mom and pop office, but it’s still a very fragmented market. I mean, even the largest DSOs are well less than one percent of the total market. And there are some real benefits to DSOs tend to be early adopters of technology.

Our businesses, being the leaders, generally benefit from that in terms of new, you know, new adoption of software, of the most modern imaging and treatment planning. They’re also more open to bundled purchasing, you know, which our businesses, Dentsply Sirona (XRAY) especially, being the largest and most broad manufacturer of dental products, are very well positioned for.

[13:19] Paul Gillespie

So if I’m thinking about it correctly, somebody who was playing devil’s advocate might say DSOs are going to be bad for this dental equipment because they’re going to have better pricing power because you’ve got now 10 dental offices coming together and buying equipment rather than the mom and pop historically. And the counter argument to that would be, well, that might be true and they might get some pricing power there, but generally speaking, we believe they’re going to be buying more higher end equipment. So longer term, any of the pricing power they might get is going to be offset by that higher end equipment. So we think when we think about margins, historically, we think margins are going to be pretty similar over time because of that. Is that a fair way to paraphrase it?

[14:07] Darren Schryer

Yeah, you know, for manufacturers, they have a long history of earning a fair return on capital. We have a really good, clean, long history in Dentsply Sirona (XRAY) in particular. And to the extent that they give some volume-based price discounts, that’s not uncommon throughout the medical equipment and supplies group of businesses.

You’re typically able to make up for it with, you know, capturing all the volume yourself by bundling and selling more premium products. You know, if you can deploy scanners at the entirety of a fleet of DSO offices, mom and pop dentists, it might take them a decade for that same number of offices to choose to invest in a scanner one at a time.

[14:54] Paul Gillespie

So when we talk about, and we’ll get into specific names here in a second, but when we talk about risk, I think DSOs is the biggest thing that comes to mind when most people think about dental. What other risks do you see out there? We’re constantly talking about making sure the competitive position is sound today and to the best of our ability, making sure it’s sustainable over the next 5-10 years. So what other risks do you think about when you think about dental today that we might not have touched on?

[15:25] Darren Schryer

Yeah, so there’s not much secular or structural that I really am concerned about for the industry as a whole. Those trends are generally positive.

We talked about, you know, globalization, improving access to care in emerging markets, aging population. The thing I worry about for our position today is a little bit what we talked about before, which is that we’re in a unique cycle that’s related to COVID and unemployment still is pretty low, below 5% right now. And if we did get much higher unemployment, people would lose their dental coverage.

Could demand weaken even further from here? It probably could. But when I think about that scenario, dental is only somewhat cyclical. If you have a cavity, if you have pain, you’re still going to go in. There’s still a very large cash pay market. There are many, many, many, much more pro cyclical businesses than the dental businesses we are invested in. And so even if we did get that sort of economic cycle where you saw higher unemployment from this point where the companies are already under earning, I would expect at least on a relative basis, the dental stocks to hold up better than the broader market.

[16:45] Paul Gillespie

Yeah, I think that’s there, if we go into a recession, unemployment goes up. There could definitely be some downside to Dentsply Sirona (XRAY) here and some of our other dental names. But the downside to those dental names, in our opinion, is going to be much less than the downside to some of the more cyclical type names that we follow.

[17:09] Darren Schryer

Yes, especially since these dental businesses we’re invested in are trading at much cheaper valuation multiples than the broader market. So we’re getting compensated for any risk that’s there. Much more risk than taking an investment in a company that’s over earning at peak valuation. That could be facing even worse cyclical pressure than something like a recession.

[17:34] Paul Gillespie

Yeah, which we’ve got.

We’ve got some of those on our list, on our nuance universe. Let’s talk about specific names. Our largest position within dental is Dentsply Sirona, tickers XRAY, X-R-A-Y.

Why is that our largest position today?

[17:49] Darren Schryer

Yeah, so Dentsply Sirona (XRAY) is a longtime dental leader. They’ve been one of our favorites for a while. We’ve been invested in the company on and off when the opportunity presents itself for, gosh, more than a decade. So they have the best breadth of products within dental. They’re number one in endodontics. They’re number one in restoratives. They’re number one in general consumables. They’re a clear leader in imaging equipment, scanners, treatment planning software, chairs, instruments, implants for total tooth replacement. They’re gaining share in clear aligners.

They are the overall dental leader. And that’s really the primary reason they’re our largest position. But beyond that, it’s also the cheapest of the dental stocks that we see today, and we think it has the best risk-reward opportunity.

So they’re expected to earn around $2 a share this year, which is clearly below normal levels, we think. It’s well below what they were earning pre-COVID. We talked about the COVID cycle.

They were earning almost $2.50 in 2019. We think normal earnings power is at least $2.25. The stock has traded down from almost $70 a share during that reopening period in 2021 to, gosh, $25 today. It’s 11 times normalized earnings.

We’ve got a long history here where it’s traded at 20 times normalized earnings. Today, the value benchmarks are trading at over 20 times. The S&P 500 is trading at over 25 times. We’re getting Dentsply Sirona (XRAY) at 11 times. It’s really a significant discount. So we’re happy to take an 8% or 9% unlevered free cash flow yield after tax to invest in a year like this.

[19:35] Paul Gillespie

You talked about broadly what’s going on in dental that’s causing that to under-earn. Is there anything specific for Dentsply Sirona (XRAY) that they’re going through that the other dental companies that we own aren’t? Meaning from a negative, like one-off company-specific transitory event, or is most of the headwinds that dense supply is facing very similar to the other holdings within dental?

[19:59] Darren Schryer

Yeah, they’re all facing the same cyclical under-earning, and all the dental companies are under-earning that we own. In Dentsply Sirona (XRAY) case, the majority of it is that cyclical under-earning, but there are some company-specific items.

They’re taking market share and clear aligners, but that’s not yet up to a normal scale, which means margins are below normal levels as they fill up the capacity that they’ve invested in over the last few years. So that would be sort of unique to them, and not necessarily industry-specific.

[20:39] Paul Gillespie

Okay, one other thing that I would ask you about Dentsply Sirona (XRAY) is, you had mentioned the kind of tailwind that dental is taking as more underdeveloped markets, dental care is becoming more important.

International adoption. What does XRAY’s global footprint look like in dental? Is it purely a U.S. company, or do they have a lot of exposure outside of the U.S. too?

[21:03] Darren Schryer

Oh, no, yeah, absolutely not. It’s a global company. 60% of their sales come from outside the U.S., so they’re in many, many geographies, including emerging markets. They have a large presence in Europe as well, so it’s a global business, and they have plenty of exposure to those emerging markets-type opportunities that should be a long-term tailwind.

[21:30] Paul Gillespie

And those emerging markets, we would argue, as you mentioned earlier, are underserved at this point.

[21:35] Darren Schryer

Oh, dramatically so. Dramatically so. I mean, there are many areas around the globe where there is simply not plentiful access to dental care. There’s no preventative care. There’s very little sort of run-of-the-mill care. You’re talking about going to the hospital to get to be pulled is like the only option you have for dental care in some markets.

[21:54] Paul Gillespie

Wow. What other dental names? We have two other larger positions in the portfolio today that are related to dental. Those would be Envista (NVST) and Henry Schein (HSIC).

Do you want to talk about those for a second and kind of differentiate those two versus XRAY or compare them to XRAY?

[22:16] Darren Schryer

Yeah, definitely. Henry Schein (HSIC), they’re the leading global dental distributor. They’re the only distributor with global scale.

Dental distribution is a value-add service for a couple of reasons. It’s not just putting products in boxes and shipping them to the dental offices. Schein is doing all of the equipment installation, repair, and maintenance. That’s a critical function. If you lose your X-ray machine or something like that, you’re kind of dead in the water, and that’s costing you dentists money. That’s a critical service they’re providing.

They’re also providing consultation. They provide the practice management software. Distribution is more value-add than most distribution businesses you might think of. That’s reflected, and I mentioned before, Henry Schein (HSIC) is at the top of the healthcare distributors sub-industry tracker, which includes distributors of all different kinds throughout healthcare. Like Dentsply (XRAY), they’re under-earning today. They’re going to earn less than $5 per share in earnings.

We think normal earnings power is more like $5.40 or $5.50. They’re trading at only 13 times normalized earnings. Again, much cheaper than the market, much cheaper than their own history. Envista (NVST) is another leading manufacturer.

They have a bit of a different product mix versus Dentsply (XRAY). They have larger exposure specifically to implants and orthodontics. Still a very strong competitive position. They’re trading at 14 to 15 times normalized earnings. We also think there’s some capital deployment upside for Envista(NVST). Envista’s (NVST) balance sheet is very strong at under two times net debt to normal EBITDA leverage. They don’t pay a dividend. They don’t repurchase shares. We think they should be doing both, and we actually think both are likely.

They just recently hired a new CEO and CFO, and that could be a positive catalyst for the stock as well.

[24:15] Paul Gillespie

That’s great. Anything else that you’d want to mention on Dental that you think is important for our clients to know or understand? I think we’ve gone through why it fits our competitive process, what we like about it, why there’s under-earning today, and that under-earning is in turn causing it to be one of our most attractive risk rewards today, which is why you see the three positions that we talked about close to top 10 positions.

Anything else that you would leave us with today, Darren?

[24:46] Darren Schryer

No, I think we covered the majority of it. It’s a really exciting opportunity to invest in some great businesses that are under-earning and are much cheaper than the broader market.

[25:58] Paul Gillespie

Darren, thanks again for your time today and for your insightful discussion related to the dental market and the opportunities we are seeing there.

We’d love to hear from any of our listeners with any feedback or follow-up they might have on today’s episode and we look forward to seeing you all next time on our Sharpe Focus with Nuance Investments podcast.

Thanks, everybody.