Published by Nick McCullum on February 15th, 2018
The past twelve months have been difficult for Owens & Minor shareholders. The company’s stock price has declined from nearly $35 a year ago to approximately $15 today.
Source: Finviz
While this type of performance has not been pleasing for the company’s continuing shareholders, we believe that there’s a lot to like about Owens & Minor right now.
First of all, the company is one of just 203 dividend-paying stocks in the healthcare sector. The healthcare industry stands out for having an excellent mix of recession resiliency, long-term growth prospects, and barriers to entry for prospective disruptors. Each of these factors strengthens the Owens & Minor investment thesis.
Second, Owens & Minor has an excellent combination of dividend yield and dividend safety for income-oriented investors. The company’s eye-popping 6.8% dividend makes it one of just 407 companies with 5%+ dividend yields in our investment universe.
As you can see, Owens & Minor has some unique characteristics, particularly for dividend investors. The company also just released its financial performance for fiscal 2017.
This article will analyze Owens & Minor’s fourth quarter earnings release to determine whether the company’s fundamental performance makes it a buy today, or whether it is a value trap and investors should avoid the stock moving forward.
Business Overview
Because of Owens & Minor’s relatively small size (a market capitalization of less than $1 billion), many dividend growth investors are likely unfamiliar with this company. Accordingly, an overview of the company’s business model is warranted before discussing its fourth quarter financial performance.
Owens & Minor is a healthcare logistics company that provides packaged healthcare products for hospitals and other medical centers. The company operates 22 facilities in 15 countries, and distributes ~220,000 different medical and surgical supplies to ~4,400 hospital systems worldwide. Owens & Minor was founded in 1882 and is currently headquartered in Richmond, Virginia.
On February 14th, the company released financial results for the fourth quarter and full year of fiscal 2017.
The next section of this article will discuss that earnings release in detail before moving on to discuss Owens & Minor’s valuation and expected total return profile.
Financial Performance Overview
Owens & Minor’s fourth-quarter financial performance beat consensus revenue estimates but disappointed on the bottom line by just a penny.
In the quarter, consolidated revenues of $2.39 billion increased modestly over the $2.37 billion reported in the fourth quarter of 2016. Adjusted net income of $21.0 million (or $0.35 per diluted share) fell noticeably from the $33.4 million (or $0.55 per diluted share) reported last year.
Importantly, Owens & Minor’s fourth-quarter revenue has marked a noticeably turnaround from the depressed revenue reported in the middle of 2017. This trend can be seen in the following slide from the company’s fourth quarter earnings deck:
Source: Owens & Minor Fourth Quarter Earnings Release
The company’s full-year financial performance was similarly poor. Owens & Minor reported consolidated revenues of $9.32 billion, which declined 4.1% over the $9.72 billion reported in the prior year.
Adjusted consolidated operating earnings of $180 million declined by 23.1% over the $234 million reported in fiscal 2016 while adjusted net income of $97.5 million fell by 27.2% from the comparable reporting period. On a per-share basis, Owens & Minor’s adjusted earnings-per-share of $1.61 fell by 25.8% when compared to the $2.17 reported in fiscal 2016.
Importantly, though, Owens & Minor’s 2017 adjusted earnings-per-share of $1.61 excludes a one-time benefit of $0.58 per share related to the recently-enacted tax reform legislation. If this is included in the company’s adjusted earnings-per-share figure, Owens & Minor’s adjusted earnings-per-share rise to $2.19 – a minor bump from the prior year’s figure.
So what caused the company’s poor financial performance?
In its earnings release, Owens & Minor provided the following details regarding its subpar financial performance:
“While the company focused on executing the transformation strategy it launched in 2017, a number of external factors and market forces continued to affect overall performance throughout the year. Revenue shortfalls, ongoing margin pressure in the domestic distribution business, and increased costs to support new business in Europe negatively affected operating earnings. Partially offsetting these factors were benefits derived from expense control and productivity initiatives, as well as positive contributions from Byram Healthcare, which the company acquired on August 1, 2017.”
In addition, here’s what Owens & Minor’s President & Chief Executive Officer, Cody Phipps, had to say about Owens & Minor’s performance in the quarter:
“2017 was a very challenging year for Owens & Minor. In order to deal with these challenges in 2018, we are taking aggressive steps to accelerate the transformation of our business toward a new future. We are reducing certain expenses while improving operational efficiency. At the same time, our teams are focused on serving our customers across our expanding geographic network. We are pleased with the contributions from our Byram Healthcare team, and we are all working intently to close the Halyard Health S&IP transaction. We believe that both of these transactions will strengthen and diversify our business model and will improve profitability.”
As the company’s CEO stated in the comments above, 2017 was a difficult year for Owens & Minor.
With that said, we believe the company’s valuation more than compensates investors for the underlying business risk. As the next section of this article discussed, Owens & Minor appears to be positioned to deliver market-beating returns over the next several years.
Valuation & Expected Total Returns
Our investment thesis for Owens & Minor is very compelling and is grounded in conservative assumptions about the company’s future dividends, valuation changes, and business growth. We discuss each in detail in the following paragraphs.
First, Owens & Minor’s dividend payments. At the company’s current stock price of $15.33, Owens & Minor’s quarterly dividend payment of $0.26 per share yields an eye-popping 6.8%. This will be an important contributor to the company’s future total returns if its current dividend payment can be sustained.
Fortunately, we believe that Owens & Minor’s dividend is very reliable despite the company’s exceptionally high yield. The company reported adjusted earnings-per-share of $1.61 in its recently-completed fiscal 2017, implying a payout ratio of just 65% given its current quarterly dividend payment of $0.26 per share.
Perhaps most impressively, 2017 was a significant down year for Owens & Minor’s bottom line. Value Line expects Owens & Minor’s adjusted earnings-per-share to rebound to the $2/share level in fiscal 2018 (which has already begun), which implies an even safer dividend payout ratio of 52%.
In any case, Owens & Minor’s current dividend is safe, and dividend growth is likely moving forward. The company has increased its dividend at an annualized rate of 11.5% per year over the past decade, and has a demonstrated consistency in its schedule of dividend hikes.
More specifically, Owens & Minor is a member of the exclusive Dividend Achievers List, which is composed of stocks with 10+ years of consecutive dividend increases. The company’s payout ratio and dividend history suggest that further dividend growth is likely for this healthcare distribution company.
Moving on, the next component of Owens & Minor’s total return profile is changes to the company’s current valuation. This is – by far – the most interesting component of our investment thesis.
Owens & Minor reported adjusted earnings-per-share of $1.61 in its recently-completed fiscal 2017 while shares currently trade hands for just $15.33. This implies a price-to-earnings ratio of just 9.5x.
An earnings multiple of 9.5 is low for essentially any company. With that said, it’s always important to compare a stock’s current valuation to its normal trading range. The following diagram compares Owens & Minor’s current valuation to its long-term historical average:
Source: Value Line
Since 2002, Owens & Minor’s average price-to-earnings ratio has been 17.7 and its median price-to-earnings ratio has been 17.5. A price-to-earnings ratio of 17 or 18 seems to be the “right” value to assign to Owens & Minor in a normal investing environment.
With that said, there is an above-average level of uncertainty in the healthcare distribution industry right now. Increasing competition and cost-consciousness in the sector combined with fears of Amazon (AMZN) entering the market are weighing heavily on health care distributors.
In addition to these industry issues, investors must also admit that Owens & Minor has recently printed some rather poor financial performance. This has certainly contributed to the low valuation currently being assigned to the company by investors.
With all this in mind, a return to an earnings multiple of 17 may be overly optimistic for Owens & Minor’s investor in the medium term. Still, the company’s current valuation provides a considerable margin of safety for today’s buyers. We believe that there is a very good chance the Owens & Minor will return to an earnings multiple of at least 13x over the next several years.
If Owens & Minor’s valuation can expand to 13x earnings over the next 6 years, this will add a little over 5% per year to the company’s expected total returns. Keep in mind that this is a conservative estimate, as this is still below the company’s long-term average valuation multiple and it very well may take less than 6 years for this mean reversion to occur.
The last component of Owens & Minor’s expected total returns is the underlying growth in the company’s per-share intrinsic value. The company’s long-term growth trajectory is shown below.
Source: Value Line
Between 2002 and 2017, Owens & Minor’s adjusted earnings-per-share grew from $0.87 to $1.61 which implies a cumulative annualized growth rate (CAGR) of 4.2% per year.
Note that this includes 2017’s figure for adjusted earnings-per-share, which is noticeably depressed. If we exclude 2017’s figure, the math becomes more attractive: Owens & Minor compounded its adjusted earnings-per-share at 5.5% per year between 2002 and 2016.
Looking ahead, we believe that 4%-6% growth for Owens & Minor is a very conservative expectation that has a very high probability of being achieved.
This concludes the company’s (very attractive) total return profile, which includes:
- 6.8% dividend yield
- ~5% annualized returns from valuation expansion, assuming a 13x earnings multiple is achieved in 6 years
- 4%-6% adjusted earnings-per-share growth
For expected total returns of 15.8%-17.8% per year.
Final Thoughts
We are usually very hesitant in issuing a buy recommendation on a stock with the expectation of 15%+ total returns.
With that said, each of the assumptions in the expected total return calculations shown above are quite conservative. Owens & Minor’s future total returns will be driven by its eye-popping dividend yield, profoundly undervalued stock price, and continued growth in earnings-per-share.
For the reasons stated in this article, Owens & Minor is a buy.
