Investors often have to choose between three different types of stocks—value, growth, or dividend stocks. Sometimes, a stock will exhibit one of these characteristics. For example, certain asset classes such as Real Estate Investment Trusts or Master Limited Partnerships have very high dividend yields of 5%+. However, these companies typically lack growth potential.
In other cases, investors can buy growth stocks like technology companies, but many of these stocks have bloated valuations and do not pay dividends. In rare instances, investors can find stocks that offer a combination of all three qualities.
Owens & Minor (OMI) is a dividend stock with a high yield of 6%. It also has growth potential, due to the changing demographics of the healthcare industry. And, the stock is significantly undervalued, which makes Owens & Minor a hidden gem dividend stock.
How Undervalued Is Owens & Minor?
There are many ways to value stocks. Discounted cash flow analysis is often the standard measure for judging a stock’s fair value. For dividend stocks specifically, investors can also utilize the Dividend Discount Model, or DDM. The DDM uses a companies’ current dividend payments and projections for future dividend payments, and discounts all those dividend payments back to the present, to derive a fair value estimate for the share price.
Owens & Minor could increase dividends by approximately 3.5% per year over the next five years, which is a fairly conservative estimate of dividend growth. Along with the stock’s Beta value of 1.24, an expected market return of 7%, and a risk-free rate of 2%, a fair discount rate for Owens & Minor is 8.25%. With these inputs, the DDM implies a fair value for Owens & Minor shares of $23, which is approximately 35% higher than the current share price of $17.
It’s not surprising to see that Owens & Minor is significantly undervalued according to the DDM. On a price-to-earnings basis, a widely-used metric for valuation, the stock looks cheap as well. Owens & Minor shares trade for a price-to-earnings ratio of 11.8. By contrast, the stock held an average price-to-earnings ratio of 18 in the past 10 years. This is a more reasonable estimate of fair valuation for the company. An expanding valuation multiple would result in annual returns of 8.8%. Undervaluation has also led to a remarkably high dividend yield, which will add to shareholder returns, as will the company’s future earnings growth.
Investor Confidence is Waning
Owens & Minor is a healthcare distribution, transportation, and data analytics company. It provides healthcare products, mainly pharmaceuticals, for hospitals and other medical centers. In all, Owens & Minor distributes approximately 220,000 medical and surgical supplies to roughly 4,400 hospitals. Its other clients include group purchasing organizations, product manufacturers, the federal government, and at-home healthcare patients.
Source: Investor Presentation, page 8
However, this is a challenging period for Owens & Minor. Healthcare distribution is under pressure from falling drug prices, which has eroded profit margins in an already low-margin business. In addition, the persistent threat of Amazon entering the healthcare industry has caused investor sentiment to deteriorate.
Owens & Minor’s most recent earnings report did not help restore investor confidence. The company grew revenue by 8.5% last quarter. Contributors to this strong revenue growth include $128 million from the acquisition of Byram Healthcare and two months of revenue contribution from Halyard Health’s Surgical & Infection Prevention (S&IP) business. But while falling drug prices helped distributors like Owens & Minor ship more products, it came at a steep cost to profitability. Earnings-per-share declined by 26% from the same quarter a year ago.
Making matters worse, Owens & Minor significantly reduced its earnings guidance for the remainder of the year. The company now expects to generate adjusted earnings-per-share between $1.40 and $1.50. This is well below prior estimates of $2.00 per share. Due to the poor second-quarter results and weak full-year forecast, investors have rushed for the exits. This is why Owens & Minor stock has declined nearly 40% in the past 12 months.
Despite these issues, Owens & Minor still has a long runway of growth up ahead.
An Unappreciated Growth Story
We continue to believe in Owens & Minor’s long-term growth potential, for a very simple fact. The U.S. is an aging population, and healthcare demand in the U.S. is only going to grow in the years ahead. Owens & Minor has made major acquisitions to capitalize on the growth opportunities presented by these demographic changes. For example, last year the company acquired Byram Healthcare and Halyard Health’s surgical & infection prevention (S&IP) business. These acquisitions will help the company enter new, high-growth product markets.
Source: Investor Presentation, page 14
The $380 million acquisition of Byram Healthcare should be immediately accretive to Owens & Minor’s earnings. Byram Healthcare generated $450 million in annual sales and should allow for significant cost synergies after the two companies are integrated. Separately, the $710 million acquisition of Halyard Health’s S&IP business was the largest acquisition in Owens & Minor’s history. The S&IP deal expanded Owens & Minor’s portfolio, to include new medical supplies like sterilization wraps, surgical drapes and gowns, facial protection, protective apparel, and medical exam gloves. Owens & Minor’s earnings should rebound next year as these two acquisitions begin to impact the company’s financial results.
Price deflation in the pharmaceutical industry is a concern, but Owens & Minor can withstand the industry challenges. If prices stabilize, Owens & Minor should be able to achieve an average earnings growth rate of 8% per year over the next five years, thanks to its acquisitions and organic growth.
Owens & Minor’s competitive advantage comes from its entrenched position within the healthcare distribution industry and its strong relationships with customers. Owens & Minor is also very recession-resistant. The company increased its adjusted earnings-per-share each year during the 2007-2009 financial crisis.
The combination of 8% annual earnings growth, 8.8% annual returns from an expanding valuation, and the 6% current dividend yield result in total expected returns of 22.8% per year. This makes Owens & Minor a significantly undervalued dividend stock.
Disclosure: I (Ben Reynolds) am long Owens & Minor (OMI)