TRUMF - Improved Revenue Growth Is Terumo's Next Major Target

2024-01-17 07:12:44 ET

Summary

• Terumo has benefited from improved sentiment in the med-tech sector, as well as its own margin-focused financial outperformance.
• The company absorbed some revenue headwinds from divestments and weaker glucose monitoring, but core cardiovascular and vascular procedure demand remains strong.
• The appointment of a new CEO is an opportunity to shift toward a greater focus on growth projects, including target market opportunities in cardiology and oncology.
• Valuation is only so-so; although Terumo isn't overvalued, I believe greater visibility on revenue growth and margin expansion may be needed to get further rerating.

Better sentiment around med-tech stock and good execution on margin improvement initiatives have been a welcome one-two punch for Terumo (TRUMF) (TRUMY) (4543.TO) since my last write-up on this leading Japanese medical device and medical technology company. Up almost 20%, the shares have roughly doubled the performance of the broader med-tech space and likewise outperformed the U.S. S&P 500 over that period by a healthy amount.

My main concern with Terumo has been that the company may "slip between the cracks" with not quite enough revenue growth or margin leverage to appeal to the growth or "quality growth" factions within the med-tech investment community. I do still see that as a meaningful risk, and I don't find the valuation particularly cheap, but I do also see the possibility that the transition to a new CEO and a move toward more directly fostering growth (versus margin improvement) could unlock more upside.

Underlying Core Trends Are Still Pretty Solid

It certainly didn't hurt sentiment when Terumo reported stronger than expected fiscal second quarter results in mid-November that saw the company reverse a 10% miss on operating income in the first quarter with a better-than-17% beat. This beat was largely driven by better execution on previously-identified targets - namely pricing actions and operational efficiency efforts.

On top of that, core growth outside of Japan remains healthy for much of the business, with 6% overall revenue growth driven by double-digit growth in the U.S. and multiple smaller growth markets. The Cardiac & Vascular business grew about 8% in constant currency (or 14% reported), with double-digit reported growth across the segments, including mid-20%'s growth in Vascular (helped by strong stent grafts), strong overall growth in access devices, and good growth in intravascular imaging.

Medical Care sales were less impressive, down slightly in constant currency, on a divestment and weaker sales in glucose monitoring, though the company's injector and pre-filled syringe businesses are doing well. The Blood & Cell Technologies business was up around 5%, with ongoing progress in improving capacity for its new Rika system for the U.S. market (where key customer CSL (CSLLY) has had to extend supply agreements with Haemonetics (HAE) to compensate for Terumo's issues).

Gross margin improved 70bp year over year to 51.8% largely on improved pricing and efficiency efforts, and management believes that easing input cost inflation should be a further tailwind in the second half of the fiscal year. The company did even better on controllable operating expenses, paving the way for 19% adjusted operating income growth (with margin up 120bp to 18%), or 15% growth in constant currency. I wouldn't expect similar levels of outperformance in the coming quarters, though running stronger pricing through a more efficient cost structure does still offer margin leverage opportunities.

Will A New CEO Unlock More Growth?

One of the biggest changes to Terumo since my last update was the mid-December announcement that Hikaru Samejima will become the CEO with the new fiscal year (April 1, 2024). Mr. Samejima has been with Terumo for over 20 years and has experience running two of the three major businesses at Terumo (Cardiac & Vascular and Medical Care).

So far not a lot has been said about major changes to the business with this change at the top, and frankly that's fairly typical for Japanese companies. What Samejima has said, though, does suggest a modest change in some of the high-level priorities for the company - moving away from a recent focus on operational efficiency improvements and toward more growth initiatives, including more collaboration between business units.

Although I'm skeptical about what cross-business collaboration can really do for the company (I do see some synergies in areas like access and stenting), I nevertheless see multiple potential growth drivers for the company that are worth monitoring.

Terumo has continued to invest in intravascular diagnostics (imaging systems like IVUS and functional measurement approaches like FFR) and a new dual sensor system that offers improved resolution should be a strong offering next to rivals like Philips (PHG). Moreover, while it has taken time for the market to develop, intravascular diagnostics is getting more and more attention in the U.S., with growth accelerating into the high single digits as system capabilities improve and data continue to accumulate on the benefits of the approach.

Terumo is also looking to grow its pre-filled syringe and auto-injector businesses. The company's auto-injector for Leqembi offers near-term upside, but I also see opportunities to gain some share from Becton, Dickinson (BDX) as the company looks to pursue more partnerships with drug companies, as well as expand its CDMO business.

Longer term, I also see opportunities for the company to benefit from a shift in focus toward conditions like heart failure and cancer. In the case of cancer, not only does the company currently sell products like radioactive beads (for inoperable liver cancer), the company's Cell Technologies systems are leveraged to ongoing growth in cell therapeutics, including CAR-T therapies where Terumo's systems can meaningfully reduce the cost and time required to produce these customized therapies.

The Outlook

In the near term I do still expect healthy underlying trends in the core C&V segment; I see ongoing opportunities to gain share via increased adoption of radial access (where Terumo has a significant lead in the market) versus traditional femoral access, as well as opportunities to gain share in intravascular diagnostics (and benefit from overall market growth) and stent grafts. Pricing actions taken earlier in 2023 should likewise continue to produce benefits in 2024.

On the negative side, the company is going to see some headwinds from volume-based procurement in China for access devices. The company will also be losing its DexCom (DXCM) continuous glucose monitoring distribution business in 2024 as DexCom goes direct; the "good news", such as it is, is that these agreements typically don't generate major profits for the distributor (I don't believe Terumo has ever quantified the contributions from this agreement).

Given the aforementioned drivers, and including positives like Terumo's leverage to improving/expanding care in markets like China, I think 5% to 6% long-term revenue growth is attainable. I do also see scope for improved profitability, though I question whether the company can get beyond mid-teens free cash flow margins on a sustained basis (which is not that impressive for a med-tech company).

Between discounted cash flow and growth/margin-driven EV/revenue, I don't think that Terumo is all that cheap now. About the best I can do is say that Terumo could be modestly undervalued (less than 5% relative to my fair value estimate), though if management can convince the Street that it can unlock more growth over the next three to five years, a further positive rerating in the multiple is possible.

The Bottom Line

Terumo's outperformance has swept up what undervaluation I did see before, and while I was impressed with the second quarter results (relative to expectations), I do think a higher bar in 2024 is a challenge. Terumo has a good base business but to continue to outperform from here I think the company needs to focus more on reinvestment and messaging to investors as to how it can sustain above-average growth, and particularly how it will target growth opportunities in areas like heart failure and structural heart issues.

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