BSX - Coloplast Offers A Fortress Business But At A Fort Knox Price

2023-10-12 05:03:31 ET

Summary

• Coloplast's shares have lagged behind other medical device companies on worries over margin pressure and aggressive moves to accelerate long-term growth.
• The company is expected to report organic revenue growth of around 8% for FQ4'23, but concerns remain about margin expectations as the company sees persistent cost inflation.
• Coloplast's recent acquisitions, Atos Medical and Kerecis, may boost growth but come with noticeable margin dilution in the near term and relatively low likely ROICs at Year 5 post-deal.
• Coloplast is a great business, but it's priced more than appropriately for its quality.

Businesses with strong recurrent revenue, high barriers to entry, and high margins deserve, and usually get, robust multiples in the market and still typically perform well over time. There's an implied bargain with these names, though - performance needs to be maintained at a high level or the multiple is in danger.

It's been quite a while since I've updated my thoughts on Denmark's Coloplast A/S ( CLPBF ) ( CLPBY ) (COLO-B.CO), but the shares have notably lagged the broader medical device space since that last article , not to mention other top-tier names like Boston Scientific ( BSX ) and Stryker (SYK), as the company has more or less come through as expected on revenue growth, but hasn't delivered the expected margin leverage. More recently, the company has made some aggressive moves that more explicitly trade near-term margin for longer-term growth potential and the market has not embraced this shift.

I love the core business at Coloplast and I'm really not that bothered by management taking near-term hits to margins to improve the long-term potential of the business. What bothers me more, though, is that I can't make the valuation work - even using my med-tech model that rewards exceptional growth and margins with premiums, I can't really carve a path toward a fair value that makes Coloplast look compelling today.

All Eyes On Margins

Coloplast won't report fiscal fourth quarter results for almost another month but did offer a last look at the guidance in late September with no real changes to the outlook. Management is still looking for organic revenue growth in the neighborhood of 8%, but with ongoing margin pressure from input and wage cost inflation, forex translation, and higher distribution expenses, as well as some dilutive impact from past acquisitions.

I have minimal concerns about the organic revenue growth numbers. One of the virtues of the Coloplast business model is that a substantial portion of revenue (around 75%) comes from products and devices used in chronic care situations like ostomy care and continence where there is reliable ongoing demand and where customers are typically reluctant to change providers once they're comfortable with a given product suite. I will be interested to see, though, whether Urology (Men's Health in particular) can drive some modest upside and whether the company can deliver a little more momentum in the Wound Care business.

On the margin side, I do have some concerns that expectations could be a little too high. I think the gross margin should improve into the mid-67%s (from 65.9% in FQ3'23), but I think opex could end up higher than expected, leading to an operating margin in the 28%s against a 29.25% sell-side target. Granted, that's not a large miss, but the Street is very sensitive on the subject of margins with this name today, so it could still drive an outsized reaction.

Paying Up To Reignite Growth

I am one of those investors who believe that if something isn't broken, management should be very careful about not breaking it... and so many management teams do exactly that when they try to boost a solid business into more of a growth story. Whether Coloplast is doing that is debatable, but they're clearly targeting more top-line growth.

To start with, it's not like the trailing growth rates here have been bad. Revenue has grown more than 7% annualized over the last 10 years and close to 7% since 2005, and that's without much large-scale M&A. The markets for products like ostomy and incontinence care may not be growth leaders, but they're hardly laggards and management has done a good job of maintaining share (though arguably has underperformed in gaining share in markets like the U.S.).

Still, the company executed its largest-ever deal in 2021 (Atos Medical) and then another large deal (Kerecis) in 2023 to further enhance the company's growth prospects. While I believe Coloplast acquired two quality businesses that can indeed boost the growth rate, they paid a lot for them and will see noticeable margin dilution as a result, not to mention likely no better than mid-single-digit returns on the capital deployed at the five-year marks post-deal.

With Atos, Coloplast acquired a leading player in maintenance/care products for stomas (post-laryngectomy or post-tracheostomy). While Atos has commanding share and the market is growing at a high single-digit rate (and there are opportunities to increase penetration/share in the U.S. and Japan), it's only about a $200M-$250M market and Coloplast paid $2.5B (or over 10x revenue) for the business.

The Kerecis deal saw Coloplast pay $1.3B (including an earn-out) for about $73M in trailing revenue (close to 18x) for an advanced wound care company with a proprietary FDA-approved process for converting the skin of North Atlantic cod into a wound care product. Fish skin has many attractive properties, including its similarity to human skin and because there are no known transmissible viruses between cod and humans, the tissue needs less processing and more of its original structure and lipid composition is maintained.

Those aspects do lead to real-world benefits - Kerecis has multiple trials in hand that have shown that its products achieve faster and better healing rates compared to commonly used alternatives in applications like diabetic foot ulcers and burns. The business is heavily skewed to the U.S., where Coloplast has a modest presence, and the advanced wound care biologics market could be worth close to $3B in five years (growing at a mid-to-high single-digit rate), and Kerecis could easily generate double-digit growth by building on its roughly 5% share today (management is targeting 30% compound growth).

Still, the deal dilutes margins in the near term. While the gross margins are good (90%-plus), the business is sub-scale and there won't be many synergies with Coloplast. Management is targeting an operating margin of 20% in three years, but that's still about 900bp below current margins, and there are no guarantees that management will be able to leverage this deal to grow its very modest presence in the U.S. wound care market with its other products.

The Outlook

Paying up for growth can work - Boston Scientific and Stryker have done it repeatedly over the years - but I have to wonder whether these deals really suit Coloplast and its investor base. I realize other companies, including close comparable ConvaTec (CNVVY) (CNVVF) are trying to branch out and boost their long-term growth rates, but it's not as if Coloplast's growth rate or prospects were poor and it remains to be seen whether these deals generate real value over time (Coloplast long-term history with M&A hasn't been great).

Coloplast is also looking to harness internal R&D to drive more growth. R&D spending is actually quite low here for a med-tech at around 4%, but the company has recently launched the Heylo digital ostomy platform (which can detect leaks and alert users), as well as the new Luja intermittent catheter (Continence Care), and management is taking a hard line with Luja - with clinical trials demonstrating the superiority of the product, the company won't launch/sell it where they can't get the premium pricing they believe it deserves.

All told, management is targeting 6% to 7% organic revenue growth, and I think that's an attainable target. Were the company to revisit its go-to-market strategy in developed markets outside Europe (the U.S. and Japan, mainly) I think there could be upside, as the company punches far below its weight in these markets. I do also see Kerecis as a legitimate growth driver, but the long-term margins are debatable and it's worth remembering that there has been a lot of price pressure in wound care that has limited the uptake of more advanced solutions (despite strong clinical evidence backing their use/adoption).

Over the last eight years, Coloplast's revenue actually developed very much as I expected - FY'22 revenue was within 1% of the estimates I made back in 2015, and summing all those years together, I was only off by about 5%. There was a much bigger difference on the margin and cash flow side, though. While I'd expected meaningful margin leverage, there hasn't been much progress and EBITDA margins have bounced around from the low-30%s to the mid-30%s, and free cash flow margins stalled out in the low 20%s (I expected progress toward the mid-20%s).

I expect EBITDA margins to head back toward the mid-30%s over the next two to three years, and I'm cautiously bullish that EBIT margin can get to 30% in FY'26, still coming in below management's prior targets. With that, I'm still expecting FCF margins to get to the mid-20%s over time, driving double-digit FCF growth.

The problem is that none of this really supports a robust fair value. It's not uncommon for quality med-techs to look pricey on discounted cash flow, but the expected return here is lower than that for Boston Scientific despite roughly similar revenue growth outlooks and long-term FCF margins.

Likewise with a multiples-based approach. The 7.5% growth I expect over the next three years should be enough to earn a premium multiple, as should the low-to-mid-30%s EBITDA margins, but even at a 6.5x multiple of FY'24 revenue (equivalent to Boston Scientific which offers a little better growth but less margin), I can't get to today's price, let alone an attractive fair value.

The Bottom Line

I can understand a lot of the appeal of Coloplast - it's a durable growth franchise with high margins and high barriers to industry. It also has growth upside if the Atos and Kerecis deals really pan out. Still, even with my willingness to pay up for quality med-tech, I think today's valuation already reflects the positives of Coloplast and doesn't leave much, if any, margin for disappointment.

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