February 2014
Robert W. Baird & Co.
In 2013, the RW Baird dental stock index modestly outperformed the S&P 500, gaining 35% compared to the S&P’s +30%. This was the third consecutive year—and fourth in the past five—in which dental has outperformed the broader market, with the group now up 71% and 183% over the past three and five years, respectively, compared to 47% and 105% for the S&P 500 over the same time periods. For clarity, we note that our dental stock index is calculated by taking market-cap weighted returns for the five dental stocks we currently cover from an equity research standpoint, including DENTSPLY, Henry Schein, Patterson Companies, Sirona Dental Systems, and Align Technologies, and excludes small-cap companies such as Biolase, companies that have dental exposure but are not pure-plays in the space (Danaher, 3M, Zimmer), and internationally traded companies such as dental implant leaders Nobel Biocare and Straumann.
For the year, we believe the North American dental consumables market grew ~3% (final C’4Q results expected over the next few weeks), roughly 100 basis points better than 2012, but some 150 to 200 basis points below the 4.5% to 5% growth we had projected at the start of the year. By our estimates, pricing was the key driver of improved 2013 growth relative to 2012, adding an incremental 100 to 150 basis points as most manufacturers attempted to pass through at least a portion of the 2.3% medical device tax that went into effect on January 1, 2013. That also means, however, that patient volumes or mix were stable to slightly lower in 2013 compared to 2012, which seems to make sense after considering the fact that average private consumption expenditure spending growth slowed to +3.1% last year compared to +4.1% in 2012, and employment gains were somewhat muted through the first half of the year.
For the North American dental equipment market, we believe growth was likely ~5% in 2013, slightly below what we estimated was ~6% to 8% market growth in 2012, and roughly in line with the low end of the 5% to 8% range we projected at the start of the year. With dental consumables market growth also finishing below our expectations in 2013 as noted above, and given the relationship that we believe exists between dental consumables and dental equipment market growth (dental equipment trends seem to lag consumables trends by around six months and reflect current dentist sentiment; that is, if dentists are feeling better about their business, equipment purchases tend to pick up a quarter or two later and vice versa), we’re not overly surprised in hindsight that dental equipment growth finished near the lower end of our expectations for the year.
As we think about potential market growth in 2014, we note that our industry conversations into the end of the year suggested North American dental consumables trends were very stable in the last quarter, with the market growing ~2.5% to 3% for the quarter. We believe that means end-market growth could slow a bit early in 2014, then, as above-normal medical technology tax-driven price increases from 2013 give way to more normalized pricing trends in 2014, taking ~100 to 150 basis points off market growth early this year. However, assuming improving jobs, consumer spending, and consumer sentiment factors begin to positively influence dental volumes and mix by mid-2014, we then believe North American dental consumables market growth could exit 2014 above 2013 full-year levels of +3%, with full-year growth (balanced by lower 1H and faster 2H growth) expected to trend very much in line with what we believe was ~3% market growth in 2013.
For equipment, we expect the North American market to grow slightly faster in 2014 than 2013 as stable patient volumes early in the year give way to improving volumes in the second half of 2014, potentially driving better confidence—and willingness to buy equipment—on the part of dentists. With 2013 market growth looking like it was likely ~5%, we therefore believe 6% to 7% growth for 2014 looks like a reasonable estimate to start with, with basic equipment demand likely growing low- to mid-single digits and high-tech equipment demand growing mid- to upper-single digits.
The bottom line is that while solid market outperformance for dental stocks over the past five years means the group enters 2014 trading at higher valuation levels than we’ve seen in recent years (including a 35% premium to the S&P 500 compared to five-year and 10-year average premiums of 26% and 34%, respectively), we believe these premiums can be justified by the stable to improving end-market trends we expect to see this year across both the consumables and equipment product categories, not just in the U.S. but also in a number of European markets. Add in dental’s lack of exposure to the regulatory and reimbursement risks that so many other medical technology names face today—especially as ACA-related issues in the U.S. and government-related nationalized health care budgetary issues in Europe put downward pressure on device pricing and procedure-specific reimbursement rates across many other parts of health care in coming years - and we consider group valuation not just rational at this point, but also see room for modest expansion in 2014.
