TMO - GE HealthCare: Good Growth Prospects At A Reasonable Valuation

2023-07-27 18:04:31 ET

Summary

• GE HealthCare Technologies' revenue growth is expected to benefit from price increases, healthy end-market demand, and increasing digitization in healthcare.
• The company reported better-than-expected Q2 2023 earnings, with revenue increasing by 9.1% organically and adjusted EPS growing by 12.2%.
• GE HealthCare's revenue growth is supported by price increases, volume growth, backlog execution, and new product innovations. The company is well-positioned to capture opportunities in precision care and digitization in healthcare.

Investment Thesis

GE HealthCare Technologies' ( GEHC ) revenue growth should benefit from price increases, and good volume growth due to healthy end-market demand for procedures, and long-term secular demand trends arising from increasing digitization in healthcare. In addition, revenue growth should also benefit from healthy backlog levels and new product innovation.

On the margin front, GEHC should benefit from price increases, volume leverage, moderating inflation, productivity, and cost-saving initiatives, and improving product mix with high-margin innovations. The stock has good medium to long-term growth prospects and the recent spin-off as a standalone company should accelerate the growth prospects. Moreover, the company is trading at a discount to its peers. Hence, I continue to have a buy rating on the shares.

Q2 2023 Earnings

GE HealthCare reported better-than-expected results for the second quarter of 2023 earlier this week. The company's revenue increased by 9.1% organically or by 7.4% YoY on a reported basis to $4.81 billion, which exceeded the consensus estimate of $4.79 billion. Adjusted EPS grew by 12.2% YoY to $0.92 on a stand-alone basis and was higher than the consensus EPS estimate of $0.87. Stand-alone adjusted EBIT margin decreased by 10 bps YoY to 14.8%. The revenue growth was driven by volume and price increases, good demand, and a healthy backlog. Adjusted EBIT margin decreased due to planned investments and standalone company costs. Adjusted EPS increased due to volume leverage.

Revenue Analysis and Outlook

In my previous article on GE HealthCare, I discussed the company's good growth prospects given the good demand in its end markets and new product innovation. The company has reported its earnings for the second quarter of 2023 since then, and similar dynamics were seen there as well.

In the second quarter of 2023, the revenue growth momentum continued. The company's revenue growth benefited from price increases and good demand for imaging and surgical procedure. This led to good order growth which was up by 6% YoY. In addition, good backlog execution also contributed to revenue growth. All these factors led to a 7.4% YoY growth in revenue to $4.81 billion. Excluding ~2 percentage point headwind from foreign currency, organic revenue grew by 9.1% YoY.

Looking forward, I believe the company should continue to deliver revenue growth as it benefits from price increases, good volume growth due to healthy demand driven by secular trends toward digitization in medical procedures, and new product innovations.

The company, in order to protect its margins against inflationary input costs, has been increasing prices for its product and services. These price increases are also helping the company deliver organic sales growth. GEHC targets a 2%-3% benefit from price increases in 2023 and a benefit of 1%-2% beyond 2023. I expect the carryover impact of previous price increases and further price increases moving forward should help the company to continue to support its top-line growth momentum in the coming quarters.

In addition to price increases, I expect an increase in volume will also help organic growth. The company's volume should increase with the help of good demand for medical procedures post-COVID, and long-term secular trends from precision care as well as digitization in healthcare to improve diagnoses.

The end market demand for GEHC's imaging and ultrasound products should stay at a healthy level due to pent-up demand for medical procedures from the pandemic as there are a greater number of delayed procedures worldwide. Additionally, the aging population, especially those above 60 years is increasing at a fast pace. This should also drive further demand as the older population requires more procedures that necessitate imaging. So, the end-market demand for GEHC is expected to remain healthy and support revenue growth in the coming years.

Moreover, the secular demand trends for precision healthcare should also help the company deliver revenue growth in the medium to long term. Precision care is a healthcare service that involves a personalized approach to individual patient treatment based on their unique medical condition. The company has good expertise in delivering new products that are tailored to meet these needs of precision care. In the second quarter, the U.S. Food and Drug Association (FDA) approved new PET radiotracers and therapeutic approaches for high-prevalence diseases such as prostate cancer and Alzheimer's disease. Previously, the only option for Alzheimer's was to treat the symptoms fundamentally. As these new therapies become more widely available, GEHC should be well-positioned to meet the demand for precise, noninvasive imaging and digital Alzheimer's treatment solutions. Moreover, according to a research report , the precision healthcare market is expected to grow at a CAGR of 12.1% from 2023 to 2032 and reach a market size of $254 billion. So it's a long runway.

Additionally, the trends toward precision care also call for the need for digitization in healthcare procedures through Artificial Intelligence ((AI)) and Machine Learning ((ML)) in order to improve the treatment and diagnosis in line with providing precision care. The post-COVID labor shortages have also necessitated automation across many industries, in order to improve productivity. The healthcare industry was also not immune to these labor issues and hence having AI & ML-led digitization of procedures is also an emerging need for healthcare providers to improve their own productivity along with providing precise care to the patients. So, there is good demand for AI and ML in healthcare services. The integration of AI can greatly assist healthcare providers in efficiently managing patient data, leading to reduced medical errors and improved patient outcomes. Additionally, AI implementation can also help address labor challenges, optimize resource allocation, and enhance overall healthcare delivery. According to a research report , the market size of the global Artificial Intelligence in healthcare market is expected to grow at a CAGR of 30.6% between 2023 to 2032 and reach $280 billion by the end of the forecasted period.

GEHC is well-positioned to capture these growing opportunities and secular trends through new product innovation. In the second quarter of 2023, the company launched two new product innovations, backed by deep learning ((DL)) AI technologies, Precision DL and Sonic DL. The Precision DL is a deep learning-based image processing software and is available on GEHC's Omni Legend PET/CT scanning machine. Precision DL is developed to enable faster scan times and smaller lesion detectability. Similarly, the Sonic DL leverages capabilities from the company's Air Recon DL MRI platform and acquires high-quality MR images up to 12x faster than conventional methods. So, these new product innovations demonstrate that the company is advancing healthcare through the adoption of AI and ML technologies. I expect GEHC's investments in new product innovations and long-term secular demand tailwinds for digitization in healthcare should help the company's revenue growth moving forward.

Hence, I am optimistic about the company's revenue growth prospects both in the near term and long term. Management has also updated its guidance, given the strength of the company's backlog (remaining performance obligations of ~$14.3 billion exiting Q2 2023), good end-market demand for medical procedures globally, and price increases. Organic growth is now expected to increase by 6-8% for the full year 2023, up from the previous guidance of 5-7%. I believe the guidance is achievable and the company should continue its revenue growth journey moving forward.

Margin Analysis and Outlook

In the second quarter of 2023, the company's margins were adversely impacted by planned investments in R&D and new product launches, along with standalone company costs (incremental cost of ~$200 for the full year 2023). These headwinds were partially offset by price increases, productivity improvements, and volume leverage.

This resulted in an adjusted EBIT margin decline of 120 bps YoY to 14.8%. However, the standalone adjusted EBIT margin on a like-by-like basis (includes standalone company costs that were not factored in the previous year), which I believed is a better metric for margins, decreased by 10 bps YoY to 14.8% as compared to the standalone adjusted EBIT margin of 14.9% in the prior year's quarter.

Looking forward, while planned investments and incremental stand-alone company costs are still a headwind for the company's margin growth in the second half of 2023, the company should be able to partially offset them with the help of price increases and volume leverage. On a standalone like-by-like basis, price increases and volume leverage from good revenue growth should help the company grow standalone adjusted EBIT margins in the coming quarters. Moreover, inflation is also moderating as logistics costs have come off their peak levels. Management is also experiencing the impact of inflationary costs lessening in the second half, especially for its imaging segment. So, a more favorable cost environment should also help margin growth moving forward.

Further, as mentioned in the revenue analysis, the company is focused on capturing end-market demand by innovating new products that are equipped with AI and ML. Digitization in new products helps the company improve its mix as they are of high margins. So AI and ML-backed new products should also help margin growth by improving product mix. In addition, the company is also focused on improving productivity through operational efficiencies and cost savings. In the second quarter of 2023, the company worked on reducing its SKUs to simplify the product portfolio and centered it around higher-margin products. The company plans to take further G&A cost-saving initiatives by reducing its real estate footprint. GEHC believes that the benefit of these initiatives to be accelerated in 2024 and beyond. So, these initiatives should increase productivity and help margin expansion beyond 2023.

Lastly, the company is incurring ~$200 million of stand-alone costs for the full year 2023. These costs equate to roughly 100 bps of margin headwind for each segment. From FY24, as these standalone cost anniversary, the comps should ease and margin expansion should accelerate. Hence, I am optimistic about the margin growth prospects ahead.

Valuation and Conclusion

GEHC is currently trading at a 20.39x FY23 consensus EPS estimate of $3.80 and an 18.03x FY24 consensus EPS estimate of $4.29. The current valuation of the stock is lower than that of its peers who have similar growth prospects (see table below).

Table: Relative Valuation of GEHC versus peers

Source: Consensus Estimates (*Note: GE FY23 EPS growth is versus FY22 standalone EPS of $3.38 provided by management)

The company's growth prospects remain encouraging. I believe that the company has good near-term, as well as medium to long-term revenue and margin growth prospects. This coupled with a reasonable valuation makes it a good buy.

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