CZMWF - Carl Zeiss Meditec: Premiums Are Proven To Be Dicey In This Market

2023-10-24 03:32:23 ET

Summary

• Carl Zeiss Meditec has seen a decline in its stock price, along with other high-valued companies, due to the commoditization of premium stocks.
• The company has impressive products, high gross margins, and strong financial performance compared to its competitors in the Meditech and optic industry.
• While there are some uncertainties and challenges ahead, I believe that Carl Zeiss Meditec offers a compelling long-term investment opportunity with a potential triple-digit upside.

Dear readers/followers,

I've made a few mistakes in investing this year - but a common thread in the investment mistakes I have been making is the premiums accepted for typically expensive/premiumized companies. Many of these investments have unfortunately been declining at a non-trivial rate. Carl Zeiss Meditec ( CZMWF ) is, unfortunately again, one of those businesses. Since my last article , the company has declined double-digits at over 19% RoR in less than 3 months. This is not unique - many of the higher-valued companies have moved more downward - but this does not make things better.

I'm going to be updating my "BUY" thesis on the company here and show you why this company does deserve a premium, and why I have become more and more careful about investing in businesses with premiums, given both what is available on the market today, and what can be expected from these businesses during the next few years.

Carl Zeiss Meditec - A lot to like, but some things to be careful about as well.

Since I wrote about this company, we've seen a significant commoditization of premium stocks. Most things that trade at very high multiples have seen a decline, and some more than others. Carl Zeiss Meditech is a subsidiary of the massive Carl Zeiss AG. What it does, specifically, is to manufacture tools for the examination of eyes, as well as medical lasers, and solutions for neurosurgery, dentistry, gynecology, and oncology.

The company is one of the most impressive Meditec companies on earth based on its products, including market-leading Meditech patents and assets like the new CIRRUS 6000, laser systems, and other products used worldwide.

Segment-wise, Zeiss remains relatively simple to understand because it only has two segments, one of which makes up over 75% of company sales with Ophthalmic devices, and Microsurgery the remaining 20-25% of sales.

The company has one of the best gross margins in the entire industry - that's part of the sales argument here, of about 60%, with a 21%+ EBIT margin and net margins of above 15%. Anyone who analyzes or researches companies knows how solid a performance or fundamentals this is, as it implies an incredible degree of control from manufacturing to SG&A, to logistics, to other things impacting profitability.

The company is compared to other Meditech and optic firms. This includes Sartorius Stedim, West Pharmaceutical Services, ResMed, Gerresheimer AG, and others. There are many very solid companies in this segment - but I would argue that dividend yield notwithstanding, Zeiss is probably one of the best.

The company has a very stable growth history, and on a forward basis, the company is expected to continue growing. The yield isn't the lowest in the entire sector at over 1.2%, but it's not a good yield when you compare it to any sort of available investment on the market today.

Where Zeiss really outperforms, and why investors choose Zeiss as a business to "BUY", is the fundamental profitability and over-time performance. The company has a very, very high SE in relation to total assets. It has extremely low debt, and its ROIC and return metrics are some of the best you've likely ever seen in the sector.

We have the interim report for the company's 3Q period, or 9M23, with continued double-digit revenue growth. This growth contribution came from strong results not only in OPT but in MCS as well, this being the microsurgery segment. The company's order backlog despite this remains impressively high, and we have an EBIT of a quarter-million for this year on a 9M basis, which is lower than last year, and a slightly declining EBIT margin - more on the reasons for that in a bit.

Geographically speaking, all sectors actually saw good growth, despite the overall macro situation we're currently in. Even adjusted for currency, the main segments' results were up almost 12% on the top line. The decline in EBIT was not due to significant cost increases or inflation, but rather due to a less favorable mix in terms of sales products. This, in turn, was not due to lack of demand but continued long delivery times for refractive laser systems.

The company also pushed capital into SG&A investments and efficiencies, which coupled with the current SCM situation had a negative effect on EBIT. So while a 300 bps+ decline in company EBIT can be considered significant for certain, there are clear reasons, and I expect this to normalize on a forward basis.

As of the latest report, the company also clarified further some of its guidance. Company revenue is expected to come in just above €2B, which corresponds to a 10% year-over-year growth rate, and now expects a lower-end EBIT margin of 17% , which of course also means that the company's net margin is going to be below 15%. This is likely a part of the reason why the company's valuation is down 15-19% in a few months, aside from the risk-free rate changes and the overall market.

However, some company-specific considerations remain. Zeiss very strategically built up a large stockpile of inventory in China due to an expected demand in the face of renewed COVID-19 issues - and they expect this destocking to be largely completed in early 2023-2024, at the latest at 1H24. This is expected to amount to a ~€50M impact due to the effect of stock reduction. In the medium term, the company expects EBIT margin stabilization at the 20% level, but the duration for that recovery is currently unclear.

I expect continued uncertainty here due to this, with an unclear time period of share price recovery. This coupled with the current uncertain market situation, and the fact that 6-9% yield is very easy to find, makes the upside case for an investment like Zeiss somewhat uncertain - but I still do believe the company offers a long-term compelling investment case.

There is still plenty to like here, despite the market. I have no plans of divesting or in any way lowering my overall investment here. It made it clear in my last article that while Zeiss has never been my #1 focus, it's one of those companies where I slowly intend to build a position as the company shows its appeal like it is now.

Of course, that needs to be put into further context, because even after a near-20% decline in share price, the company can still be said to have a considerable premium.

Let's look at what the ups and downsides are here.

Carl Zeiss Valuation - Better, but still at a slight premium

Things have been down since my last article. We're now looking at Carl Zeiss trading at 25x normalized, which is very significantly below where many investors typically invest in the company. It could almost be said that the company is within what could be considered "cheap", at least on a 10-year basis. On a 10-year basis, we're looking at a 38.66x P/E, which compared to around 25-26x P/E today, would imply a long-term upside of 122% until 2026E if the company reverses this.

This might sound completely insane looking at the market today, but the company was there around a year ago, and above.

That being said, I don't expect this to materialize any time soon. Not in this market, and not with these interest rates, and the company's growth rate going into 2024E. Zeiss' growth is usually based on above-average earnings growth levels of at least double digits. That's unlikely, given destocking and inventory and investments, to be the case for 2024E. So there are two ways you could approach Zeiss Meditech.

Either you say that you don't believe the company to go down more than it has until now - to which I would say you might be a bit optimistic because I don't believe rate hikes are finished and the market has finished dropping yet given the macro we're in. Or, as I intend to do, I do believe the company constitutes a "BUY" here based on long-term trends, but I think given alternatives on the market, and there's not that big a downside to waiting here, see how the 4Q and 1Q24 turn out because the company itself has further guided for earnings decline.

If we were to estimate the company at a €120-€125 PT, which would be around 25-28x P/E, then this would be between 15-18% annualized RoR. That means that on a conservative forward estimate, we're now able to get market-beating returns on Zeiss. I'm lowering my PT slightly to account for the challenges, and now given the company a long-term price target of €120, down €5/share from my last one - but I'm still saying that you could, and perhaps should, consider the company as an alternative only if you can't find other, more attractive investment prospects - and I believe such prospects exist.

Zeiss trades under the native symbol AFX on the German stock market. Less than a year ago, the high-end target was over €200/share, and an average PT of €140/share. Now we're down to a high-end target of €140/share, a low-end of €87, and an average of €110/share. 11 analysts follow the company, and out of those, only 5 have the company at a "BUY" despite these targets, and despite no analyst believing it worth less than €87/share.

I see a potential upside of 50%+ in the long term for Carl Zeiss Meditec, but I do believe the market will either keep the company "down" here or go even lower, which means the following is my thesis for the company.

Thesis

• Carl Zeiss Meditech is an incredibly qualitative Medtech business originating out of Germany but with an international growth and sales profile. It does not offer a compelling yield, but what it does offer is a very compelling overall long-term upside. Even conservatively speaking if you accept some of the premiumization here, you have triple-digit upside potential
• However, this requires you, as mentioned, to accept one of the highest premiums I've ever seriously considered for this market. Provided it's essentially a market leader in extremely specialized areas, this might make sense to you as well - but I would size your position with extreme care.
• Nonetheless, I added my voice to the chorus of "BUY" with this company. A quality company has the right to cost quite a bit - and this is the highest I accept for a business like this. I say "BUY".
• My PT comes to a 28x forward P/E, which puts the company at around €120/share long-term, a lowering from my last price target.

Remember, I'm all about:

1. Buying undervalued - even if that undervaluation is slight, and not mind-numbingly massive - companies at a discount, allowing them to normalize over time and harvesting capital gains and dividends in the meantime.

2. If the company goes well beyond normalization and goes into overvaluation, I harvest gains and rotate my position into other undervalued stocks, repeating #1.

3. If the company doesn't go into overvaluation, but hovers within a fair value, or goes back down to undervaluation, I buy more as time allows.

4. I reinvest proceeds from dividends, savings from work, or other cash inflows as specified in #1.

Here are my criteria and how the company fulfills them ( italicized ).

• This company is overall qualitative.
• This company is fundamentally safe/conservative & well-run.
• This company pays a well-covered dividend.
• This company is currently cheap.
• This company has a realistic upside based on earnings growth or multiple expansion/reversion.

It's even possible for me here to call the company actually "Cheap" - and that is rare for this business.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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