Five year summary of PDCO stock price. From 2012 to 2018

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Noam Ganel is the Managing Director of Pen & Paper, a value-oriented stock research publication. Subscriptions are now available. He also serves as  Vice President in Capital Markets at Silvergate Bank and holds the Chartered Financial Analyst (CFA) credential.

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Patterson Companies

An Update

June 15, 2019

In investing one group cheers while the other fears. When Patterson Companies (PDCO on Nasdaq) was delisted from the S&P 500 index, in the course of 90 days, Patterson’s common stock price dropped by 42%, to $22 from $38. Shareholders were disappointed.  

The S&P 500 composers replaced Patterson with three companies. The first company was SVB Financial Group (SIVB on Nasdaq), a bank holding company. Take-Two Interactive (TTWO on Nasdaq), whose business is video games, was the second company. And Nektar Therapeutics (NKTR on Nasdaq), a pharmaceutical, was the third. Shareholders were pleased.    

It is unconventional to buy the stock of a delisted company - not only has the stock lost momentum, pundits argue, but also the delisting follows some deterioration in the business fundamentals. "The results we report today clearly do not meet our expectations," said Patterson's boss, Mark Walchirk, a year ago. "They fall short of what we know the business is capable of achieving."

The original investment thesis

I wrote about Patterson Companies in May 4, 2018. My original thesis was that while the company's operating performance was poor over the second quarter of 2018, if investors had saw the company's operations over the prior decade, a different view would emerge – that the company had materially improved both its market share and operating performance.

PDCO earnings over past decade
A 10-year outlook on PDCO's earnings

One of the reasons I bought Patterson was that employees are shareholders of the company. In the 2018 proxy statement, on page 23, management reported that employees of the company owned 11.7 million shares, about 12% of the outstanding stock.  

Another reason for buying Patterson were tailwinds of the two industries in which Patterson operates in - veterinary and dental products. Its website  summarized the bull case for the dental and animal industries: "95% of adults say they value keeping their mouth healthy. 68% of U.S. households own a pet. And 200 million tons of protein will need to be produced by 2050."

I estimated that management would restore the operating margins. The average pre-tax income to revenue ratio was over 10% between April 2004 and April 2012. It steadily declined over the following 7 years. The most recent ratio reported was a minuscule 4%. In addition, the pre-tax income on tangible assets over the past decade was greater than 10%, a reasonable ratio for a company in the distribution business.  

Last year

With no corporate restructures, major refinancing efforts or corporate shakeups, it is little surprise that Patterson's stock price has not moved since May 2018. Patterson is trading at the same price it traded hands a year ago, at about $22 per share. Over the past year, the stock climbed to $26 in November 2018 and dropped to $19 in December 2018.

PDCO Stock price over past year
PDCO's stock price over past year (Screenshot from Google)

Mark Walchirk has been the President and Chief Executive Officer since November 2017. Don Zurbay has been the Chief Financial Officer since June of last year, effectively when I began to buy the stock, and Kevin Pohlman has been running the animal health division since July 2017. The only new addition to the executive team is Eric Shirley who began to head the dental division 5 months ago.

In regard to financials: as of the third quarter of this year, Patterson reported on $1,472 million or $15.77 per share in equity compared to $1,461 million or $15.65 per share in 2018. Revenue is $4,137 million or $44.31 per share for the last 9 months ending in January 26, 2019 compared to $4,065 million or $43.56 the prior year. The main shortfall is that pre-tax income is down by $79 million because of an increase both in cost of sales and in expenses.  

In a year or two

Unless Patterson's stock trades hands at over $30 per share a year or two from today, I will sell the position. The reason for the $30 price tag is that over the past decade, investors paid between 15 to 20 times for one dollar of pre-tax income per share. At the time of this writing, given the lackluster operating performance, investors are paying less than 10 times one dollar of pre-tax income.  

Should Patterson's financial performance improve, so will its stock price. But when - and if - the increase will happen is unknown to me. Since my return objective is 15% to 25% each year, unless the stock appreciates to $30 in two or three years the position will be sold for "time is money" reasons.

***
In business, random, short-term driven decisions have a long-term impact. A friend of mine recently described his work environment as akin to a tank, in that senior management was reacting to obstacles along the way without any strategic thought. This was eroding the company's culture.

What appear to be random decisions also affect prices. The S&P 500 composers believed replacing Patterson with three companies would be a boon for the index over the long term.

Yet, collectively, the stock price of the three companies tumbled by 25% over the past year. SIVB traded for $320 a year ago and now trades for $213. NKTR traded for $53 a year ago and now trades for $37. TTWO fell from $120 to $109 over this period.

Judged by the rules of the stock market, that prices are paramount, replacing Patterson with a trifecta of a pharma company, a video game company and bank was a mistake. And owners of the S&P 500 index would be better off  had Patterson never was delisted. But then I would not cheer for the stock.