ICU Medical Stock: There Is Still Upside As Management Goes Big To Drive Value (ICUI)

Operating in a sub-sector of med-tech that has long rewarded scale, ICU Medical (NASDAQ:ICUI) has gone for scale in a big way. The acquisition of Smiths Medical from Smiths Group (OTCPK:SMGZY) was very nearly a “merger of equals”, at least in terms of revenue and so forth, and while the logic of the deal is sound, management is taking on some meaningful integration challenges and risks, including leveraging up the company.

There are a lot of things I like about this deal. Not only does Smiths Medical give ICU Medical more scale in its core infusion business, it adds complementary assets elsewhere in the business. Smiths will increase ICU’s international presence, and I see a lot of “blocking and tackling” opportunities to improve operational metrics.

Although these shares aren’t as cheap as I might like on cash flow, that’s not uncommon in med-tech, and I see fair value above $265 today.

A New Integration Challenge Lies Ahead

ICU Medical had some challenges integrating a large deal in the past, but I believe management has learned from those experiences. Initial reactions to the acquisition of the Hospira infusion business from Pfizer (PFE) back in 2017 were positive, but post-deal challenges (including serious issues in the commodity IV solutions business) ultimately hit the shares hard, leading to significant underperformance in the period between the close of the Hospira deal and the announcement of the Smiths deal.

Smiths Medical is more of an evolutionary, complementary deal for ICU versus the transformative acquisition of the Hospira infusion business, and Smiths doesn’t bring the same commodity business risk that Hospira brought. Moreover, ICU is a larger company today with more resources to tackle a large-scale integration.

Still, there are a lot of moving parts to this integration that ICU Medial will need to get right.

Cost / Margin Opportunities

Given that Smiths was positioning the medical business for a possible spin, it’s relatively self-contained, and attaining “back office” synergies should be relatively straightforward. Integrating sales forces is always a challenge, but both should benefit from having a more robust portfolio of complementary infusion assets to offer.

How ICU manages the manufacturing and R&D operations for the combined company will be key to the long-term success of the deal. ICU Medical has done well for itself outsourcing its manufacturing to low-cost countries, and I think there will be some opportunities to reduce production costs at Smiths and consolidate at least some operations. In the near term, though, ICU will have to invest significant resources into shoring up quality control at Smiths Medical, with the company receiving a warning letter from the FDA a couple of months after the deal was announced.

On the R&D side, Smiths Medical has a relatively poor track record of R&D productivity, and I believe this is an area where ICU is quite good, and likewise with the company’s go-to-market capabilities.

Smiths Medical enjoyed good margins coming into this deal, and I think if management can execute on these “blocking and tackling” opportunities in manufacturing, R&D, and marketing, there could be attractive longer-term upside to margins. It will take time, though, and a little finesse, as these are not changes that can be made quickly without significantly disrupting operations.

Revenue Synergies

I’m also eager to see to what extent Smiths can help ICU operate more effectively overseas. Prior to the deal, ICU generated about 70% of its revenue from the U.S., and I think there are meaningful opportunities to leverage Smiths’ more global footprint to improve market penetration outside the U.S.

There’s nothing particularly flashy about ICU’s product line-up of infusion pumps, infusion sets, specialty oncology products, and critical care, but those products needed in hospitals around the world. As seen at Merit Medical (MMSI), it’s possible for U.S. companies to compete effectively in markets like China with more “bread and butter” products, and I think this could be an under-appreciated opportunity for the company.

Can ICU Drive Share Gains In Its Core Business?

ICU’s near-term outlook is not bad. While I do believe orders are elevated as hospitals try to restock and insulate themselves from potential product shortages, I don’t expect a major tapering off of demand.

A bigger question is whether the company can opportunistically grab share from Becton, Dickinson (BDX). BD has been the leader in infusion pumps for quite a while (they bought it as a leading business and have maintained that status), but the company has seen multiple recalls for its lead Alaris pump system going back to 2019 related to both hardware and software and halted shipments. As part of the recall remediation, the FDA is requiring the company to go through its 510(k) approval process, and BD management does not expect approval in FY’22 (BD’s fiscal 2022 ends in September).

While BD has been allowed to sell some pumps on a medical necessity basis (recognizing the disruptions and medical need created by the pandemic), those sales are nowhere near “full strength” (around one-quarter of normal sales). Normally this would be a significant opportunity for ICU, but it takes time to retrain staff to use a new pump, and even with improved access to hospitals now that the pandemic has eased, staffing shortages and a large elective procedure backlog could argue against switching over when the BD pump should be available again within a year.

Longer term, though, while the Alaris recall may not create a compelling share-takeaway opportunity, I think the more robust portfolio of ICU+Smiths makes for a more compelling marketing case, and now ICU can compete more effectively with large bundling deals. It’s relatively common for large companies like BD to offer volume discounts on relatively expensive equipment like pumps by bundling in a wide range of products, and that’s not something ICU could compete as effectively against in the past. While BD still has a far larger array of offerings to hospital customers, Smiths does give them more leverage here than they’ve had before.

The Outlook

While ICU’s core markets generally offer low-single-digit growth, I believe the revenue synergy opportunities from the Smiths deal and market share gains can drive a long-term revenue growth rate closer to 4% or 4.5%.

I expect the inclusion of Smiths to drive ICU’s EBITDA margins from the 15% to 16% range immediately to around 20%, and I think post-deal synergies (including manufacturing, R&D, and marketing) can drive that to around 23% in 2025/26 and higher in the years beyond that. I expect that will then translate into FCF margins in the low double-digits that rise toward the mid-teens over the next 10 years, driving double-digit FCF growth.

The Bottom Line

ICU Medical does not look all that cheap on a discounted cash flow basis, but that’s fairly common in med-tech. Looking instead at the revenue growth rate and EBITDA margins I expect (which typically drive forward EV/revenue multiples in med-tech), I believe ICUI can trade at 3.35x to 3.5x revenue in FY’24; discounting that back gives me a fair value range today of around $265 to $275.

ICU Medical management cannot afford to fail with the integration of Smiths Medical, and I don’t think they will. Instead, I believe Smiths will take ICU to a new level and help drive increased market share, increased international sales, and better overall margins, and I think the shares do not fully reflect that today.