andreswd/E+ via Getty Images
andreswd/E+ via Getty Images
Following my coverage of Envista (NYSE:NVST), for which I recommended a buy rating as I believed that NVST could continue to penetrate the large and growing TAM of $27 billion given its extensive product catalog and international presence, this post is to provide an update on my thoughts on the business and stock. I am downgrading my buy rating to a hold rating as I lose confidence in NVST's ability to grow earnings as I expected previously. There are visible headwinds that led me to believe that near-term margin performance is going to stay weak. The macro environment also continues to put pressure on growth. To make it worse, the visible catalyst, Analyst Day, has been delayed until further notice.
NVST reported a 4Q23 core revenue decline of 2%, generating revenues of $646 million. By segment, S&T (Special Products & Technologies) grew 4.8% to $416 million, driven by 15% growth in orthopedics, while implants declined low-single-digits due to underperformance in North America. As for E&C (equipment and consumables), revenue declined 12.4% to $230 million due to double-digit declines in consumables driven by timing in North American distribution channels and high single-digit declines in equipment due to macro pressures. NVST also reported adj EBITDA of ~$101 million, below consensus estimate of $104 million, and notably, margin declined 530bps y/y to 15.6%, leading to adj EPS underperforming consensus expectations ($0.29 vs. $0.34). Relative to my expectations, revenue tracked alright, but earnings performance was very disappointing, especially in 4Q23, where net margin fell by nearly 430 bps sequentially to 7.7%.
With how NVST performed in 4Q23 and its outlook, I am downgrading my recommendation from buy to neutral as I lose confidence in the business's near-term ability to drive the earnings growth I expected. Management’s outlook for FY24 adj EBITDA margin saw a significant downgrade from the prior commentary that margin would expand in 2024 from 18.1% in 2023 to 16–17%, which reflects the magnitude of pressure that NVST is experiencing due to the macro weakness. On top of the macro weakness, the unfavorable product mix dynamics, new investments in its implant business, and the China VBP program make it harder for investors and markets to analyze the core business margin performance—and I meant this in a very bad way because it increases the level of uncertainty by a large extent. First of all, regarding product mix, I expect NVST to continue seeing pressure from weak consumer sales (that carry a higher margin vs. S&T) as the impacts (NVST has little visibility into sell-in/through dynamics, making it hard to conduct follow-up sales motion) from the Henry Schein cybersecurity incident linger for the near term. In addition, the NVST high-margin wire and bracket (W&B) business is unlikely to see any near-term recovery given that 1/3 of the business is in regions that are having geopolitical challenges (Russia and China), which also translates to more gross margin pressure. Secondly, touching on China’s VBP program, I see this as a structural erosion in the margin profile that is unlikely to recover given the government's intention to lower costs (note this is my opinion). Finally, management called out their intention to invest heavily in Spark, which could be a long-term growth driver (more below), but certainly a margin headwind in the near term.
And last but not least, this shift on the Spark. The higher, the faster that this grows, it is below average and it has a significant impact in our margin structure. 4Q23 earnings results call
Hence, my view is that the share price is going to be at best rangebound in the near term and possibly drift downward as investors start to price in near- and medium-term EBITDA uncertainties. There are also no visible catalysts to drive any positive sentiment in the stock. Even the analyst day, which should have been a catalyst to reset expectations and provide key updates (note that management has retracted their long-term targets), was delayed given the uncertain leadership changes as NVST waited for a new CFO appointment. While this seems like a prudent move as they can provide a more comprehensive update with a full leadership team, to me, this simply adds further uncertainty to the equity narrative.
All in all, what I am fairly certain of in the near term is that:
As such, I am holding off updating my valuation model as well, given my lack of confidence in making any key assumptions.
A key upside risk here is that the NVST valuation (16x forward PE) is cheap when compared to its historical average of 19x, which means the market is not embedding a lot of earnings growth at this point. If NVST manages to outperform expectations, either due to macro environmental recovery or the less-than-expected impact of the cybersecurity incident, valuation could see a mean reversion.
I am downgrading NVST from a buy to a hold rating due to evident headwinds affecting near-term earnings growth. Factors like macro weakness, unfavorable product mix, the China VBP program, and ramp-up investments in Spark are going to continue pressuring margins, make it challenging to foresee a robust recovery in margins (NVST exited FY23 with 4Q23 net margin of 7.7%). The delayed Analyst Day also effectively removed any near-term visible catalysts for positive sentiment. The potential upside risk lies in NVST's currently cheap valuation, presenting an opportunity for mean reversion if the company surpasses expectations.