ICU Medical Stock: Hit Hard As Smiths Medical Needs TLC (NASDAQ:CUI)

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ICU Medical‘s (NASDAQ:ICUI) transformative acquisition of Smiths Medical from Smiths Group (OTCPK:SMGZY) is off to a rough start, as ICUI management has encountered more operational challenges in the new-to-them business than they’d counted on in these first quarters of ownership. Add in sector-wide margin pressures from input costs and a rerating across the med-tech space, and the stock has taken a beating.

Down about 25% since my last update against a roughly 10% decline for the medical device sector, it’s going to take time, money, and management attention to get Smiths Medical into proper shape. Wall Street is not a particularly patient place in the best of times, and the significant hit to FY’22 and FY’23 margin assumptions is a tough headwind to overcome. I do still think that the logic of the deal is sound and that better, more profitable, days lie ahead of ICU Medical, but investors will have to exercise some patience before those benefits are reflected in the shares.

An Ugly Quarter, As Smiths Isn’t Quite What Management Expected

ICUI management had indicated that there were some challenges with the Smiths acquisition that would need to be dealt with, but the results from the second quarter speak to even more issues than the Street expected. With that, earnings were well shy of expectations as the company took a hit to gross margins and to invest more operating dollars in quickly addressing some of the more serious challenges.

Revenue rose 74% as reported, with core organic ICU Medical revenue up 6% in the quarter. Unfortunately, management didn’t provide any year-ago information about Smiths, and the sequential comparisons are of less use given the operational issues at Smiths and a modest difference in sales days between the two quarters (the deal closed on January 6, excluding a couple of sales days from the first quarter.

The 10-Q filing did indicate that sales were lower year-over-year due to supply chain and fulfilment issues, but didn’t quantify the difference. Looking at Smiths’ year-ago reports and factoring in exchange rates, it would seems as though sales may have been down as much as 25% year-over-year for Smiths Medical in the first half of 2022, but I want to strongly emphasize that that’s an estimate based on pieced-together information (and non-overlapping time periods) as follows:

Smiths reported fiscal year ’21 revenue (ended July 31, 2021) of GBP 849M and first half revenue (ended January 31, 2021) of GBP 427M from Smiths Medical, leaving GBP 422M of revenue for the February-July six-month period. At average exchange rates, that works out to $586M of revenue versus the $438M reported by ICU Medical in the first half of 2022.

Gross margin declined 850bp as reported (to 29.9%), with adjusted gross margin down almost four points just over 36%. Management blamed about 200bp of that on supply chain issues tied to Smiths, with another 300bp from an overall increase in material and freight costs for the company. While adjusted EBITDA rose 27% as reported, margin fell 570bp (to 15.1%), and adjusted operating income fell to a loss.

More Work To Do

Management was clear that they had to spend “at a very high rate” in the second quarter to improve service levels at Smiths, as there were issues in IT, product availability, and operations. Management characterized production levels as “acceptable” at the time of the earnings call, and noted progress with fulfillment challenges, but there’s still work to do across the board, and the CEO noted that the “situation is harder than we expected”.

Although I’m surprised by the magnitude of the issues, I’m not surprised that ICU Medical has found some challenges here. The company had been struggling for some time under Smiths, and I think there were reasons that Smiths tried multiple avenues to monetize the business and couldn’t find a valuation to their liking before eventually agreeing to the ICUI offer.

To be clear, I think the underlying assets that ICU Medical has bought are worthwhile and that the deal still makes strategic sense. Smiths Medical brings in highly complementary ambulatory and infusion pump products, as well as vascular, safety, and critical care products, and there should be significant cross-selling opportunities with Smiths’ larger ex-US sales footprint. On top of this, there are clearly abundant opportunities for ICU Medical to improve Smiths’ core manufacturing and fulfillment/distribution operations, as well as its R&D productivity.

Clearly the initial work to integrate the businesses and get Smiths running at an acceptable level is going to be more difficult and expensive than anticipated. Management had initially guided for $450M to $500M in adjusted EBITDA for FY’22, with legacy ICU Medical contributing $275M and Smiths contributing around $175M to $225M (with an initial pre-synergy EBITDA contribution estimate of around $190M). With guidance now at $350M-$370M and not that much underperformance in the core ICUI operations, clearly Smiths is only about half as profitable in this first year as initially hoped.

The Outlook

Based on the commentary with second quarter earnings, I would expect Smiths Infusion to performance better in the second half of the year (and likely better in Q4 than Q3), and I would likewise expect improvement in Vascular Access later in the year as that will be the next area of immediate triage. For the core ICUI operations, infusion consumables are tracking well given recovering procedure counts, but the comps get tougher in Q3. For infusion systems, management is expecting better installs in the second half as hospital operations (and spending priorities) continue to normalize.

It’s amply clear that there is a lot of work to do at Smiths, including resolving the Class I recall of Smiths syringe pumps, improving manufacturing/fulfillment, and eventually driving the operational and strategic synergies that motivated the deal. I still believe that ICUI will get there and will realize those synergies, but it’s going to take longer.

I’ve cut my FY’22 and FY’23 revenue estimates by about 7% and 4%, respectively, and likewise have cut my near-term EBITDA margin assumptions by about four points and 350bp, respectively. Long term, I still expect organic revenue growth of around 4% to 5%, adjusted EBITDA margins in the low-to-mid 20%’s, and FCF margins in the low-to-mid-teens.

The Bottom Line

Given the sharp reduction in near-term FCF prospects and a higher discount rate (to reflect increased integration risk), the DCF-based fair value for ICUI shares is not tremendously compelling now, though I do see a high single-digit prospective annualized return, and there should be room to outperform my assumptions.

A multiples-based approach is also challenging now – not only because this is now a “special situation”, but also because there has been a sharp derating and only partial rerating in the med-tech space. Nevertheless, I think my FY’23 adjusted EBITDA margin assumption (17.5%) can support a 2.65x forward revenue multiple and a fair value close to $200.

It’s true that you can often find the best long-term values by buying into ugly-looking situations, but it’s also true that M&A transactions can prove to be value-destroying mistakes that permanently hamstring a company. I believe Smiths will eventually be a value-added move for ICU Medical, but investors considering the shares today certainly need patience while management works to get the acquired operations up to scratch.

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