Stock Analysis ProjectGroup Project Part #7

Universal Analysis GroupAlyssa Hofstetter

Noran Naghi

Travis Taylor

Stock Information:

Company Patterson Companies

Ticker PDCO

Recommendation Buy?

Date 11/12/2014

Valuation and Return: Comp Avg. PDCO

Forward P/E

ROA 7.2%

ROE 14.3%

P/B for utilities

Comparables:

Henry Schein Inc. (HSIC), MWI Veterinary Supply Inc. (MWIV), Zimmer Holdings Inc. (ZMH),

VCA Inc. (WOOF)

Investment SummaryWe recommend … For these reasons:

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Business DescriptionPatterson Companies Incorporated is headquartered in St. Paul, Minnesota, and specializes in

a broad range of dental, veterinary, and medical products and services. The company was

founded in 1877 when the Patterson brothers opened a small drugstore in Milwaukee,

Wisconsin. The drugstore began selling dental equipment and quickly became known as the

M.F. Patterson Dental Supply Company, led by its first president, John F. Patterson. Over time,

the company acquired a broader product line, and expanded their customer base with the

purchase of D.L. Saslow Co., providing them with a strong position in the dental supply market.1

Today, Patterson Companies Incorporated sells dental, veterinary, and rehabilitation supply

1Patterson Companies, Inc. Company Overview." Patterson Companies, Inc. Web. 07 Sept. 2014. <http://www.pattersoncompanies.com/CompanyOverview>.

Current Price $45.125

Target Price

Shares Outstanding 104,259,810

Market Capitalization 4,704,723,926

products and services primarily in the US and Canada. Patterson has expanded its veterinary

supplies and services operations to the United Kingdom through the acquisition of National

Veterinary Services in August 2013.

The largest portion of the company’s revenue, 58%, comes from its dental products and

services, including consumables and dental imaging systems, used by dental practitioners.

Patterson provides supplies to 33% of North America’s dental services market. The veterinary

services division accounts for approximately 30% of total revenues, and distributes veterinary

hardware and consumables to veterinary clinics in the US, Canada, and the UK. The remaining

12% of revenues are created by Patterson’s medical division, which focuses largely on physical

therapy products and equipment.2

Industry AnalysisPatterson Company distributes products in three main industry categories: Dental, Veterinary,

and Medical. Each of these categories is comprised of its own set of competitors and dynamics.

Patterson’s competitive position in each of these industries varies. Below we will discuss the

intricacies within the industries that Patterson competes in as well as our overall industry

expectations and advice.

The Industries: Dental, Rehabilitation, and Veterinary

Patterson sells products in three primary industries: dental supply, rehabilitation supply, and

veterinary supply. However, the competitors that they face have various industries within

themselves as well. The complex list boils down to competitors in a broad dental/medical supply

segment, and the veterinary segment. Bloomberg lists many businesses as Patterson’s peers,

but based on the business descriptions of each, we found Henry Schein (HSIC), Owens and

Minor (OMI), Cardinal Health (CAH) and McKesson (MCK) as the primary competitors in

Patterson’s Medical/Dental Supply industry. There were no veterinary businesses listed as

peers in Bloomberg, however veterinary industry reports list Patterson as a competitor in that

industry.

2"Patterson Companies: Investor Relations Annual Report 2014." Page 2. Web. 1 Oct. 2014. <http://files.shareholder.com/downloads/AMDA-1HGAMJ/3419642901x0x780182/C0C4C4B2-57EC-463C-9BD5-9D12459B9EF3/2014_Annual_Report_-_FINAL.pdf>.

The top three competitors in the veterinary supply industry are MWI Veterinary Supply, Inc

(MWIV), Henry Schein (HSIC), and Patterson (PDCO). Patterson and Henry Schein are both

distributors in the medical industry as well as Veterinary. A smaller competitor in this industry is

VCA Inc. (WOOF) a veterinary producer, specializing in diagnostic technology. New products

such as more effective flea and tick medications have been introduced into the veterinary supply

market.3 These new products could potentially allow distributors more opportunities to create

strategic partnerships with suppliers providing competitive advantages by offering the latest

products.

Facing the Competition

In their Annual 2014 report, Patterson reported an “estimated 33% market share of the $7-billion

North American dental market”.4In the dental industry, Patterson holds a competitive edge

primarily in the sale of high-tech CAD/CAM dental imaging instruments supplied by Sirona

Dental Systems Inc. The only two customers listed in Bloomberg for this company are Patterson

and Henry Schein. Because these two peers are the only suppliers of this exclusive product, we

believe that there is high potential for sales growth due to these new products. We believe that

Patterson’s competitive edge in the veterinary industry lies heavily in their position in the U.K.

market following the NVS acquisition. By having international market spread, Patterson has

competitive edge over their competitors in any industry. The profitability in this market is

especially high because NVS already held a vast majority of the U.K. market for veterinary

supplies.

Market Changes

A threat to medical distribution companies is a decision by manufacturers of bypassing the

distribution channel and selling directly to the end users. Technology developments make

ordering products directly from a manufacturer much simpler for customers. Specifically,

Patterson is seeing this problem in its veterinary segment. The July 25, 2014 William Blair

Article5 discusses Idexx (IDXX), a large veterinary diagnostic products manufacturer that

3New Vet Products. “PiperJaffray”. (Page 1) Rep. 19 Feb. 2014. Web. 01 Oct. 2014. <https://ucmo.blackboard.com/webapps/blackboard/execute/content/file?cmd=view&content_id=_3092535_1&course_id=_105732_1>.4 "Patterson Companies: Investor Relations Annual Report 2014." (Page 2) Web. 01 Oct. 2014. <http://files.shareholder.com/downloads/AMDA-1HGAMJ/3419642901x0x780182/C0C4C4B2-57EC-463C-9BD5-9D12459B9EF3/2014_Annual_Report_-_FINAL.pdf>.5Veterinary Industry Update. Rep. William Blair & Company, L.L.C., 25 July 2014. Web. 8 Oct. 2014. <https://ucmo.blackboard.com/bbcswebdav/pid-3092533-dt-content-rid-8618432_1/courses/201510FIN389110926/Veterinary Industry Update William Blair 20140725.pdf>.

recently decided to bypass all distribution channels. Patterson was one of their distributors, and

this information caused a slight decline in equity prices in the industry until investors realized the

minimized effect. However, the article states that distributors generally only see 5%-10% of their

revenues coming from sales in the diagnostic product market.

On October 1, 2014 Patterson announced their strategic partnership with Abaxis.6 Under

Weaknesses and Threats we discuss the downside to relying on third party manufacturers. With

this Abaxis partnership, Patterson is effectively eliminating that threat. They have signed an

agreement with Abaxis where they will sell Abaxis’s full line of state of the art medical, research,

and veterinary products. This partnership is profitable for both businesses, and we believe that

this may offset the loss incurred by Idexx’s decision to skip distribution partners and sell directly

to end users.

Company AnalysisPatterson has expanded their product line, boosted sales and strengthened customer

relationships through acquisitions starting in the 1980s. In 2013,Patterson bought National

Veterinary Services Limited (NVS), which expanded their veterinary division to the United

Kingdom. Subsequently, they renamed their entire veterinary division, including NVS, Patterson

Veterinary to strengthen their brand. Patterson has been a financially stable company since its

foundation in 1877. Despite the numerous recessions in American industrial history since 1877,

Patterson has survived and flourished. The slow recovery from the 08-09 recession thus far

shows that Patterson has the capability of overcoming economic downturns. The industries in

which Patterson competes are all fairly economically stable. Over half of the US population

currently holds dental insurance, providing steady demand for Patterson’s largest division:

dental supplies. Rehabilitation in the medical field is generally very important to consumers, and

insurance can help to cover costs to those with unstable financial standing. The veterinary

market is currently growing rapidly, studies show that in 2013 pet spending increased by

4.5%.7By diversifying their product segments, Patterson ensures stability. In having three

completely separate industries, if one segment incurs losses, there are two more to make up for

it through growth.

6“Patterson Companies Announces Strategic Partnership with Abaxis” Patterson Companies: Press Releases. Web. 01 Oct. 2014. <http://investor.pattersoncompanies.com/releasedetail.cfm?ReleaseID=873989>.7PiperJaffray. “Favorable Pet Spending Trends”. Rep. Page 1. 9 Apr. 2014. Web. 1 Oct. 2014. <https://ucmo.blackboard.com/bbcswebdav/pid-3094720-dt-content-rid-8652418_1/courses/201510FIN389110926/Favorabel Pet Spending Trends Piper Jaffray 20140409.pdf>.

Future financial success lies foremost in their innovative products, services, and strategic

partnership. The company recently built the Patterson Technology Center, a customer oriented

base designed to give technical customer support, a huge necessity in today’s tech-forward

world. This is especially important to Patterson now that they have introduced several lines of

proprietary dental imaging products. Not only does Patterson have innovative products, they

also sell a huge number of consumable products that must be repurchased regularly. The

increase in the average population age ensures future sales in the medical/nursing home

segment. At the same time, active lifestyles are also becoming more prevalent, leading to

interest in rehab services. Patterson’s entrance into the international veterinary market has also

shown growth since the NVS acquisition, which will lead to future financial success as well.

Patterson’s innovative 3-D dental imaging product lines provide a competitive advantage in the

dental services industry. Overall, Patterson has strong brand recognition in each of their

industries. Additionally, Patterson has a reputation for reliability, innovation, and customer

appreciation. Each of these factors gives Patterson a strong competitive advantage.

Financial Analysis

The dental sector is Patterson’s largest revenue source, incurring $2.4B in sales for F2014. The

largest growth, however, is in the veterinary segment. Due to the NVS acquisition, total

veterinary segment sales had yr/yr growth in F2014 of 59%. Excluding sales in the U.K.

(primarily result of NVS), U.S. veterinary sales grew 4% in F2014 compared to 2% in F2013. 8

Patterson’s main expenses currently come from restructuring of the Medical unit, which we have

included in our forecasts.

Currently, Bloomberg reports Patterson’s P/E ratio as 19.4, and in F2014 it was reported as

19.76 which is the highest P/E since 2008.9 Bloomberg predicts the ratio to slowly fall for the

next five years. In trying to find an explanation for this downward trend, we found that

Bloomberg also expected PDCO dividends to increase slowly over the next few years. We

believe that this means that they expect earnings to increase with a relatively constant price,

thus, creating a smaller P/E multiplier. If this is true, it is not necessarily a bad sign for PDCO to

have a falling forward P/E ratio, because earnings are still increasing. However, if earnings and

8"Patterson Companies: Investor Relations Annual Report 2014." Page 3. Web. 1 Oct. 2014. <http://files.shareholder.com/downloads/AMDA-1HGAMJ/3419642901x0x780182/C0C4C4B2-57EC-463C-9BD5-9D12459B9EF3/2014_Annual_Report_-_FINAL.pdf>.9 Bloomberg

dividends are increasing but the share price does not reflect this increase in value, the stock

could currently be seen as undervalued.

There have been significant financial changes in the last two years including, the NVS

acquisition, the restructuring of the rehabilitation supply segment, and the refinancing of their

long-term debt. These changes Patterson currently has the capability to remain financially

stable given current debt loads. Because of this we do not expect any significant changes to

occur in the foreseeable future. We use this concept in our forecasting, as well as the details

described below.

Earnings Outlook

We began our forecasting for Patterson’s earnings by evaluating the overall conditions we

determined the economy to be in. We considered our predictions for inflation growth and

forecasted inflation to grow by 1.75% until the end of F2015, then for the next five years we

decided to forecast 2% inflation growth. These rates were determined by a consensus of each

of our analyst estimates. These rates were included in our forecasting model. Next we

determined what growth rates we would use for the segments that Patterson operates in. We

expect fixed growth in revenues for the dental segment to be between 1.5% and 4% for the

foreseeable future. We believe that Dental is in a mature stage with little expected changes to

propel the industry into any higher growth. We estimated revenues in the veterinary segment to

increase by a much larger amount. An increase of between 4% and 7% is expected after a

period of normalization following recent acquisitions Primarily, we see many increasing trends in

pet ownership due to cultural, demographic and economic changes. A survey relating to this is

quoted in the Piper Jaffray report.10 Rehabilitation supply segment is forecasted to have

negative growth for roughly the next 5 quarters, followed by slow growth thereafter. In this, we

factored in the restructuring of the segment.

The forecasts we used in our segments had direct correlation to many of the items in our

income statement, including operating income as well as net sales. Cost of sales was computed

to be the inverse of the gross margin, which was calculated as growing at a rate of 0.6%. We

saw this as appropriate for the future as well with no considerable changes. The operating

10Favorable Pet Spending Trends. “PiperJaffray”. Rep. 9 Apr. 2014. Web. 01 Oct. 2014. >."Investor Relations." Patterson Companies, Inc. Web. 07 Sept. 2014. <http://investor.pattersoncompanies.com/index.cfm>.

expenses include adjustments for the rehabilitation segments restructuring. The future tax rate

was estimated at 35.5%, as per management guidance. Next we used the management stock

repurchasing plan to estimate that they would repurchase 1.2M shares per year. This lead into

the EPS forecasts of considerable growth. Basic EPS for F2015 is expected to be $2.13 per

share, F2016 is $2.49 per share, and F2017 is $2.88 per share. These EPS estimates are

growing considerable due to the estimated growth rate for net income as well as the estimated

share buyback decreasing overall shares. Considering these components of EPS rising and

falling in opposite directions, we evaluated this as reasonable growth.

Recent PerformanceTwo major factors must be taken into account when evaluating PDCO’s recent performance.

The recent acquisition of NVS in the UK has grown the veterinary branch significantly, and the

divestiture of several product lines from PDCO’s medical branch should move the company

towards a more pro-growth strategy. Sales in the veterinary segment rose 77% year-over-year

in 4Q14, largely due to the acquisition of NVS. Adjusted for currency change and the divestiture

of several product lines, Patterson reported roughly flat sales in the medical division versus the

prior year period. Dental sales declined 1.5%, largely due to the negative impacts of weather in

several key market areas. Consolidated PDCO revenues rose approximately 14% over the prior

year period, mostly due to the acquisition of NVS.11

Dental sales improved slightly in 1Q15 year-over-year on a constant currency basis. PDCO

Veterinary sales rose 94% from the prior year period, owing partly to the acquisition of NVS, and

partly due to 7% organic growth. The medical division suffered a 4.5% decrease in revenues

over the prior year period. However, due to changes in product offerings, Patterson has showed

a 120bps improvement in operating margin for the medical segment. Excluding NVS, operating

profit and the operating profit margin decreased considerably over the previous year for all

divisions.12 Due to the large investing this year, PDCO expenses were relatively high, resulting

in lowered earnings.

Stock Valuation11"Patterson Companies 4Q14 Earnings Call Transcript." Page 22. May 2014. Web. 7 Sept. 2014. <http://files.shareholder.com/downloads/AMDA-1HGAMJ/3447670407x0x757839/f9c467d5-4143-4813-a6f6-7a7d7125d33f/Fourth Quarter Fiscal 2014 Earnings Transcript.pdf>.12"Patterson Companies 1Q15 Earnings Call Transcript." Page 21. Aug. 2014. Web. 7 Sept. 2014. <http://files.shareholder.com/downloads/AMDA-1HGAMJ/3447670407x0x778505/4f7f755d-3040-4e96-ac9d-135630e67012/1Q15 Earnings Call Transcript.pdf>.

Intro Paragraph including beta info

Dividend Discount Model

We calculated the current intrinsic value of PDCO equity using the Dividend Discount Model to

be $31.13. We did this by using expected dividends that are in line with historical growth. We

saw that every year dividends were increasing by $.08 every year for the last five years. We

continued this trend in our estimated dividends for fiscal years 2016-2019. We then calculated a

cost of equity of 9.04% using a normal risk free rate of 4%, a market premium of 6%, and the

beta reported by Yahoo of .84.13 We used these estimates to discount the dividends, summing

to a present value of $3.21, and to predict a terminal value of $27.92. In conclusion, we

estimated a price target of $31.13 for the end of F2015 using the Dividend Discount Model.

Discounted Cash Flows

We calculated the current intrinsic value of PDCO equity using the Discounted Cash Flow Model

to be $91.17. We used estimated cash flows for years 2016 through 2019 by using a growth

rate of 3%. We believed that based on the current expected economic growth, 3% was an

appropriate estimate for the next four years. We calculated cost of equity in the same manner

as in the Dividend Discount Model, equaling 9.04%. With this, we discounted the cash flows,

summing to a present value of $1,164,834. Next, we used a terminal growth rate of 6% to

calculate a terminal cash flow of $7,927,925. By summing these present values and dividing by

the common shares outstanding we conclude with a price target of $91.17 for F2015, using the

Discounted Cash Flow Model.

P/E Valuation

Our estimate for the intrinsic value of PDCO using the P/E method is $46.95. We used the

current forward P/E estimate multiplied by one plus our expected negative growth rate of

approximately 2% for F2015. Our negative growth rate stems largely from restructuring made in

the medical segment and the adjustments to net income in regards to that fact. Without the

adjustments to F2014 net income, our estimate would have been $50.47 due to what would

then have been an expected year over year growth rate of approximately 5%.

Shortcomings of Valuation Models Used

We found that the Discount Dividend Model was fairly accurate in estimating the value of PDCO

equity. It was fairly low compared to the current trading price, but was not as varied as the value

estimated by the Discounted Cash Flow Model. The DCF Model gave us an estimated $91.17

value, which is more thandouble the current market price of the stock. I do not realistically see

13http://finance.yahoo.com/q?s=pdco&type=2button&fr=uh3_finance_web_gs_ctrl2&uhb=uhb2

the price of the stock rising all the way to $91.17 at the end of F2015. Clearly, PDCO is a

company that does not use cash flows as a realistic estimate of value. The dividends gave us a

much better estimate, but were still not factoring all the intrinsic value that investors are

currently seeing. The P/E valuation method is adversely effected in part due to the adjustments

made to net income due to restructuring. Overall, even with the restructuring effects, the

estimate of $46.95 is still within the bounds of what a reasonable person might believe possible

given the circumstances.

Price Target and Potential Return

The guidance we are setting for PDCO F2015 price target is $46.95. After deliberating all

possible options, it was determined that the P/E method of valuation offered the most realistic

estimate of Patterson’s value. The DCF method was considered to be so far outside the realm

of likelihood that it was discounted as a means of valuation, while the DDM method would

represent a significant decline in value for which we can find no realistic probability short of an

unforeseen financial catastrophe. We believe that our price target of $46.95 is reasonable given

the current expected economic outlook.

Investment RisksRisks for Patterson Companies are fairly typical for a company with cross-border operations,

stemming largely from exposure to currency exchange risk, which would primarily affect the

recently acquired NVS with a large market share in the U.K.As seen in the table below, today’s

current exchange rate for dollar to euro is 79%. The table then shows the dollar amounts you

would receive if you invested $1 in a European market, then the euro increased or decreased

before you exchanged it back to the dollar. This example shows how money invested in a

foreign market can lose value due to changes the exchange rate. If Patterson has large

amounts of sales and costs coming in/out through the U.K. location, they face losing substantial

amounts to exchange risk.

Values US Dollar EuroCurrent Values $1 $0.79*Increasing Euro Value $1.21 $0.96*Decreasing Euro Value $0.38 $0.30

*For illustrative purposes only, does not represent actual figures.

Patterson Companies estimates that the unmitigated impact of the Idexx move would be a

decline in EPS of$.04-$.05 per share.14The long term risk associated with this move is the

possibility of similar manufacturing companies deciding to follow in Idexx’s footsteps. Should

this occur, there is risk of running out of interested customers.

Recent restructuring in Patterson Medical has refocused efforts on products with high growth

potential, including the high-tech dental and vet digital imaging CAD/CAM products. The risk

associated with acquiring new management in the medical branch is possible, since the new

management may not have the same techniques that have worked well for Patterson over the

years. There is also risk in the possibility that the realignment will not prove fruitful in the long

term.15

Finally, Patterson has long term debt that they recently refinanced that could pose as default

risk to investors. However, PDCO is stable enough to make payments on the $250M in debt that

matures in March 2015, thus eliminating default risk.16We believe they will be able to refinance

because they regularly have more than enough positive net income to cover interest payments

on debt.

14"Patterson Companies 1Q15 Earnings Call Transcript." Page 21. Aug. 2014. Web. 07 Sept. 2014. <http://files.shareholder.com/downloads/AMDA-1HGAMJ/3447670407x0x778505/4f7f755d-3040-4e96-ac9d-135630e67012/1Q15 Earnings Call Transcript.pdf>.15"Patterson Companies: Investor Relations Annual Report 2014." Web. 01 Oct. 2014. <http://files.shareholder.com/downloads/AMDA-1HGAMJ/3419642901x0x780182/C0C4C4B2-57EC-463C-9BD5-9D12459B9EF3/2014_Annual_Report_-_FINAL.pdf>.16"Patterson Companies 4Q14 Earnings Call Transcript." Page 22 May 2014. Web. 07 Sept. 2014. <http://files.shareholder.com/downloads/AMDA-1HGAMJ/3447670407x0x757839/f9c467d5-4143-4813-a6f6-7a7d7125d33f/Fourth Quarter Fiscal 2014 Earnings Transcript.pdf>.

Works Cited

Favorable Pet Spending Trends. “PiperJaffray”. Rep. 9 Apr. 2014. Web. 01 Oct. 2014. >.

"Investor Relations." Patterson Companies, Inc. Web. 07 Sept. 2014. >.

"Minnesota Business and Lien System, Office of the Minnesota Secretary of State." Business Filing

Details. Web. 07 Sept. 2014. <http://mblsportal.sos.state.mn.us/Business/SearchDetails?

filingGuid=9f861772-9ad4-e011-a886-001ec94ffe7f>.

New Vet Products. “PiperJaffray”. Rep. 19 Feb. 2014. Web. 01 Oct. 2014.

<https://ucmo.blackboard.com/webapps/blackboard/execute/content/file?

cmd=view&content_id=_3092535_1&course_id=_105732_1>.

"Patterson Companies 4Q14 Earnings Call Transcript." Page 22 May 2014. Web. 07 Sept. 2014.

<http://files.shareholder.com/downloads/AMDA-1HGAMJ/3447670407x0x757839/f9c467d5-

4143-4813-a6f6-7a7d7125d33f/Fourth Quarter Fiscal 2014 Earnings Transcript.pdf>.

"Patterson Companies 1Q15 Earnings Call Transcript." Page 21. Aug. 2014. Web. 07 Sept. 2014.

<http://files.shareholder.com/downloads/AMDA-1HGAMJ/3447670407x0x778505/4f7f755d-

3040-4e96-ac9d-135630e67012/1Q15 Earnings Call Transcript.pdf>.

“Patterson Companies Announces Strategic Partnership with Abaxis” Patterson Companies: Press

Releases. Web. 01 Oct. 2014. <http://investor.pattersoncompanies.com/releasedetail.cfm?

ReleaseID=873989>.

“Patterson Companies, Inc. Company Overview." Patterson Companies, Inc. Web. 07 Sept. 2014.

<http://www.pattersoncompanies.com/CompanyOverview>.

"Patterson Companies: Investor Relations Annual Report 2014."Web. 01 Oct. 2014.

<http://files.shareholder.com/downloads/AMDA-1HGAMJ/3419642901x0x780182/C0C4C4B2-

57EC-463C-9BD5-9D12459B9EF3/2014_Annual_Report_-_FINAL.pdf>.

Veterinary Industry Update. Rep. William Blair & Company, L.L.C., 25 July 2014. Web. 8 Oct. 2014.

<https://ucmo.blackboard.com/bbcswebdav/pid-3092533-dt-content-rid-8618432_1/courses/

201510FIN389110926/Veterinary Industry Update William Blair 20140725.pdf>.

Bloomberg Files: