TMO - GE HealthCare Technologies: Good Growth Prospects And Potential For Valuation Multiple Re-Rating

Summary

• Revenue should benefit from a healthy backlog, good end-market demand, China's economic reopening, and new product innovations.
• Margins should benefit from price increases, volume leverage, and easing supply chain conditions.
• Valuation multiple can re-rate higher which coupled with good EPS growth prospects bodes well for the stock.

Investment Thesis

GE HealthCare Technologies Inc. (GEHC) looks poised for growth as a standalone company after its spin-off from General Electric Company (GE). The company's revenue growth is expected to benefit from a healthy backlog, strong end-market demand, China's economic reopening, and new product innovations. On the margin front, GEHC should see gains from price increases, improving supply chain challenges, volume leverage, and high-margin product innovations. However, despite these positive factors, the company's valuation remains at a discount to its peers. With good growth prospects and low valuations, I believe GEHC stock is a good investment opportunity.

Revenue Outlook

GE HealthCare experienced good revenue growth last year, driven by pent-up demand and volume recovery in elective procedures after Covid related lockdowns were eased and the economy reopened. In Q4 2022, this growth momentum continued, with reported product revenue increasing by 13% YoY due to good demand in Imaging, Ultrasound, and Patient Care Systems ((PCS)). Healthy backlog and price increases also contributed to sales growth, resulting in a 7.6% YoY revenue increase to $4.9 billion. This reflects approximately a 1% benefit from acquisitions and a 6% headwind from foreign currency. Excluding FX and acquisitions, organic sales increased by 12.5% YoY.

Looking ahead, I believe GE HealthCare is well positioned to deliver strong revenue growth in the coming years, supported by a healthy backlog, robust end-market demand, China's economic reopening, and new product innovations.

Exiting 2022, GEHC's backlog levels remained healthy, with $14.3 billion of remaining performance obligations (backlog) at the end of Q4 and a book-to-burn ratio of 1.07x. However, the backlog declined by 2% YoY due to some shifts in the timing of multi-year service contract renewals. The backlog should increase moving forward as end-market demand remains strong and these timing issues are resolved, supporting the company's revenue growth. Additionally, the company is seeing improvements in supply chain conditions, which should help to improve backlog to revenue conversion in 2023, further bolstering the top line.

In addition, China's economic reopening is expected to provide a tailwind for GEHC's revenue growth, with the company generating approximately 15% of its sales from China. While COVID-related closures have adversely impacted GEHC's revenue growth in the region over the past few years, the situation is normalizing now that the Chinese economy is reopening. As pent-up demand from postponed procedures over the last couple of years due to lockdowns starts to materialize, I anticipate a significant improvement in China's revenue growth as the year progresses. Furthermore, the company is experiencing rising demand for imaging equipment due to medical stimulus funds launched by the Chinese government, which should support revenue growth in the near term.

Moreover, new product innovations and R&D investments are key drivers of GEHC's long-term organic revenue growth. The company believes that the trend towards precision health, which involves a personalized approach to individual patient treatment based on their unique medical condition, will support its product and service growth in the future. GEHC's expertise in developing products equipped with artificial intelligence, easing the diagnosis procedure, and digital platforms, bringing the right data at the right time for the patient's care pathway, is expected to provide better outcomes for patients and productivity to its customers.

The company has made a cumulative investment of $2.7 billion in R&D from FY20-22 to continue developing new products and around 35% of its orders have come from new product innovations over the past 12 months. The company has a solid product pipeline and, according to management, there are 10-15 new products which have the potential to reach around $100 million each in sales and contribute significantly to revenue growth over the next few years. This demonstrates a good return on its R&D investments and should help the company gain market share and drive revenue growth in the medium to longer term.

Management has guided for mid-single-digit organic growth in 2023, which seems achievable given the healthy backlog, China's reopening, good demand, and new product launches. With exposure to high-growth areas like precision healthcare and new product launches, I believe the company has the potential to continue delivering mid-single-digit organic growth over the medium to long term. Furthermore, the company's leverage ratio of 2.5x should support possible bolt-on M&A activities to further boost revenue growth in 2023 and beyond. Overall, I am optimistic about the company's revenue growth prospects.

Margin Outlook

Since the beginning of 2022, the company's adjusted EBIT margin has been negatively impacted by inflation in raw materials and logistics costs. In the fourth quarter of 2022, GEHC's adjusted EBIT margin was also adversely impacted by higher material costs, FX headwinds, and planned R&D investments, partially offset by price and volume increases. As a result, the adjusted EBIT margin declined by 90 basis points to 17.1%. For the full year 2022, adjusted EBIT margins were 15.6% vs 18% in the prior year.

Looking ahead to FY 2023, GE HealthCare is expected to face an additional $200 million in corporate and other costs as it transitions to a standalone company. These costs were not factored into the last year's adjusted EBIT margins. So, for a like-by-like comparison, management has provided the company-level EBIT margin for FY22, which includes standalone corporate costs. Adjusting for these costs, the company's adjusted EBIT margin for FY22 was 14.5%.

The company should be able to achieve margin expansion in 2023 on a like-by-like basis as a standalone entity. The company's margin should benefit from price increases and volume leverage resulting from revenue growth. Another factor that should support this is the easing of supply chain challenges, which is expected to further improve with China's reopening. In addition, a favorable product mix through high-margin product innovation should help drive margin growth, despite increased R&D investments.

In terms of cadence, while the first half of the year may be impacted by high-cost inventory, margin improvement is expected to accelerate as the year progresses and the company begins to benefit from moderating raw material costs. Management has guided for an adjusted EBIT margin of 15-15.5% for the full year 2023, representing a 50 to 100 bps expansion from its 2022 standalone adjusted EBIT margin of 14.5%. This target seems achievable given the easy comparisons from the previous year.

Looking further ahead, management is targeting high teens to 20% operating margin in the long term. While the visibility around the long term targets is limited, I believe directionally there is a good chance for margins to continue improving as a more focused management team post-spin-off could drive significant productivity savings in the coming years.

Valuation and Conclusion

GE HealthCare is currently trading at a forward P/E of 20.52x FY23 consensus EPS estimate of $3.66 and a forward P/E of 18.05x FY24 consensus EPS estimate of $4.16. According to consensus estimates, the company is expected to achieve double-digit EPS growth over the next couple of years. Despite having a similar growth profile to its peers, the company is trading at a discount. The table below summarizes the company and its peers' forward P/E and EPS growth based on consensus estimates.

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

I believe that as management continues to execute, there is a good chance for the company's P/E multiple to re-rate higher and reach inline with its peers. This along with good EPS growth bodes well for the stock. Therefore, I recommend a buy rating on the stock.

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