We’re fans of consistent dividend payers with strong free-cash-flow coverage and solid balance sheets, but we remain very skeptical of companies with a dividend that seems “too good to be true” as the eye-popping dividend is often a byproduct of an egregious drop in the price of the stock. We believe Owens & Minor is an example of an overleveraged, slow-growth entity that may have trouble maintaining its dividend in coming years. We value shares at $20 each, however, so the market may be overreacting a bit on the downside.
By Alexander J. Poulos
Key Takeaways
Business disruption has taken its toll on Owens & Minor’s margins and underlying profitability.
From where we stand, there is little in the way of proprietary offerings by Owens, which opens the company up for potential disruption by more well-established players such as Cardinal Health or Amazon that can steal crucial market share.
We feel the acquisitions made to offset the decline in margins are “more of the same;” hence, cash is declining while return on invested capital continues to decline.
We’re skeptical about the resilience of the dividend, but shares are not expensive.
Overview
Owens & Minor (OMI) remains a pioneer in the medical distribution business as the company traces its origins back to 1882. The medical distribution business has evolved dramatically since the founding of Owens with the company managing to stay one step ahead of the changes in the industry. Owens’ main customers originate in the acute care and hospital settings versus the retail drug setting, which compromises far-better capitalized entities such as Cardinal Health (CAH). While Owens has dutifully expanded its niche, the recent competitive entry of Cardinal Health has caused a great deal of heartburn for the executive team at Owens.
Medical Distribution Facing Competitive Headwinds
The deflationary forces that continue to wreak havoc in the retail drug distribution segment, as recently highlighted in a recent piece titled “Generic Drug Deflation Continue to Hamper Cardinal Health and Amerisource,” are evident to a certain degree in the hospital sector, too, as an extremely competitive environment has led to severe margin compression at Owens–as Cardinal seeks additional verticals to offset the decline in its core drug distribution sector. Cardinal views Owens’ niche as a fertile whitespace for additional expansion, in our view, with more attractive margins than in its core business, hence its willingness to compete on price.
We view this development as a significant impediment for the prospects of Owens. We feel the pricing environment will remain challenging, bordering on irrational, as Cardinal seeks to wrest greater share from the now poorly-capitalized Owens. Speaking of the retail drug distribution sector, the three main competitors are similarly capitalized, hence a rational oligopoly exists which has tended to lead to stable pricing. We fear, however, that Cardinal aspires to become an aggressive competitor, as it may be able to easily fund a price war. A price war with its peers in the drug distribution space could lead to significant profit pressure.
A large degree of the headwinds plaguing the industry is the lack of differentiation in the core products sold by the companies as they continue to compete in an increasingly commoditized sector. For example, from where we stand, there is little to distinguish between the hospital gowns or surgical gloves sold by either entity. Hence the easiest way to garner business in a largely-commoditized space is to compete on price. We think it is a largely commoditized industry with very little in the way of pricing power, making cost-containment paramount.
Owens Minor on the Acquisition Trail?
We’re generally fine with companies making complementary bolt-on businesses, as the move tends to help top-line sales, and sometimes profitability, if the purchase is made on favorable terms in a business line that is growing. Owens’ purchase of Halyard Health’s Surgical and Infection Prevention (S&IP) business fails in this regard, however, as the business remains challenged, even though the S&IP business further augments Owens’ position in surgical gowns and exam gloves, an area which is becoming increasingly commoditized.
We do not share the view the patent estate portfolio is a key differentiator, as Halyard’s S&IP unit struggles mightily in 2017, even though volumes rose as net selling prices contracted, a clear sign to us that end users are demanding severe price concessions to purchase the products. We applaud Halyard’s decision to jettison the unit to focus on its core medical device units as the margins in this business line are more robust (mid 20% range) versus the single digit levels in the S&IP division. The decision on the part of Owens to purchase Halyard’s S&IP division will further augment current offerings, but it does very little to address the challenges posed to the underlying business.
Owens remained on the hunt for new lines of business in 2017 with the move to acquire Medical Action Industries for Byram Healthcare for $380 million in cash. The acquisition will broaden Owens reach in the direct-to-consumer healthcare market as Bayram distributes a wide range of products such as ostomy supplies. We view the move as incremental at best as the pivot into this vertical does little in the way of differentiating Owen’s product suite. We believe the pivot opens Owens to further disruption this time in the form of Amazon (AMZN), the internet powerhouse with a commanding lead in the online shopping. We see little to prevent Amazon from offering similar products to its vaunted Prime members as the products travel well and do not need special handling, hence they can easily be included with other household essential items.
Balance Sheet
The acquisition spree of 2017 has taken its toll on the balance sheet of Owens as the management team has steadily drained the vast majority of cash accrued by the underlying business. Cash stood at ~$87.6 million at the end of the first quarter of 2018. We are very concerned by the current debt carried on the books (~$900 million) coupled with the steady decline in operating performance, as the trend hasn’t been great. Net revenue has fallen to $9.3 billion in 2017 from $9.7 billion in 2015, while adjusted EBITDA of $257 million in 2017 was the lowest since at least 2013. Free cash flow has also fallen to $206 million in 2017 from $269 million in 2015 trends. The acquisition spree, in our view, does little to arrest the steady decline.
Adding additional fuel to the fire that Owens may have become become, the CFO recently decided to abruptly resign, and while we can never be sure, we hardly view the occurrence as pre-planned. Our read of this event is that conditions for the core underlying business have continued to deteriorate, but we’re hesitant to make such a proclamation so early into 2018.
Valuentum Ratings
We view Owens’ dividend in poor shape with little in the way to give us confidence that the next CFO may not cut the overly generous dividend rate. We think Owens will have a tough time preserving the payout, and if it does cut the dividend, it may lead to a new leg down in the price of the equity, as business conditions continue to deteriorate. Our Dividend Cushion ratio captures the challenges at Owens with a poor -0.8 ratio (anything less than 0 suggests elevated payout risk), which coupled with our Dividend Safety rating of very poor, gives readers a quick guide to the inherent troubles we forecast with the dividend.
Concluding Thoughts
We don’t think Owens & Minor’s troubles are over, and the risk of a cut in the dividend might serve to drive income investors away from the investment. We value shares at $20 each, so downside from a valuation standpoint may be largely limited, assuming performance doesn’t deviate too much from our current expectations.
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Independent Healthcare Contributor Alexander Poulos is long Amazon. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.