TFX - Teleflex Shares Hit Hard As Growth Concerns Stack Up

2023-10-12 22:46:40 ET

Summary

• Teleflex shares have lagged a weak medical device market, with growing concerns about the company's internal growth capabilities and its need to turn to pricey M&A.
• Concerns about the impact of GLP-1 drugs on bariatric surgery may be contributing to the decline, but the ongoing weakness in UroLift growth and the expensive Palette deal loom larger.
• The expensive acquisition of Palette Life Sciences and the need for high-multiple deals to meet revenue growth targets raise concerns about Teleflex's future performance.
• Teleflex's valuation now reflects a lot of worries about growth and margin leverage, making this a name worth watching for more contrarian investors.

What do you do when a stock’s valuation starts looking rather interesting, but you just don’t like the company? That’s the dilemma I have with Teleflex ( TFX ) now, as the shares have fallen about 25% since my last update , lagging double-digit declines in the broader medical device space and likewise trailing other comparables like Becton, Dickinson (BDX), Boston Scientific (BSX), and PROCEPT BioRobotics (PRCT).

In truth, that opening question is largely rhetorical; while trading profits can be made almost anywhere, it’s not usually advisable to invest in companies you don’t like even if the valuation is appealing. To that end, Teleflex does indeed look undervalued today, but this is a company that has built a recent track record of over-promising and under-delivering and I think the Street needs more evidence of sustainable growth and execution before warming up to the name.

Another Target Of The GLP-1 Craze?

As I’ve written in other articles recently, GLP-1 drugs ( Lilly ’s ( LLY ) Mounjaro and Novo Nordisk ’s ( NVO ) Ozempic and Wegovy ) have caught fire not only in terms of prescriptions and revenue, but in the attention they’re getting from the mass media and sell-side analysts as people speculate on how impactful they’ll be to various industries.

I do think that perhaps some of the weakness in Teleflex since July could be tied to this growing concern that GLP-1 drugs will prove highly disruptive in various medical device markets – I would note here that most orthopedic stocks have sold off, with chatter about the potential results in the upcoming read-out of a Phase III study Novo Nordisk conducted to examine the impact of semaglutide ( Ozempic, Wegovy ) on knee pain in obese patients.

For Teleflex, the risk would be to its bariatric surgery business, and particularly the Titan powered stapler that it acquired for $300M (including earn-out) in August of 2022 and that address an annual market of around $250M-$300M (120K gastric sleeve gastrectomy procedures).

It certainly didn’t help that Teleflex then announced with second quarter results that it was cutting its near-term revenue expectations for Titan by half, though management attributed this to delays in getting hospital value analysis committees to sign off on the device. Still, I don’t think this should be a major driver of disappointment – while GLP-1 drugs are likely a good option for many people ( note: NOT medical advice ), I don’t believe they will necessarily lead to that much trouble in bariatric surgery, as these procedures are typically performed on patients with greater weight loss needs than GLP-1s have been shown to provide. I’d also note that the cost-benefit for a bariatric procedure versus a lifetime of GLP-1 usage favors surgery pretty strongly.

Flinging Paint At The Canvas – Palette Looks Like Pricey Growth

The bigger driver of Teleflex’s decline, I believe, is the late July acquisition of Palette Life Sciences and what it implies about what the company needs to do to maintain/reach prior growth targets.

Questions about Teleflex’s ability to meet management’s long-term target of 6% to 7% revenue growth have dogged the company since the May 2022 Investor Day when management put up that target. Since then, UroLift, a key growth driver that was supposed to generate mid-teens growth, has continued to disappoint, with management recently saying that they no longer expect growth from UroLift to be a meaningful contributor to that target.

Enter Palette.

Management announced on July 26 that it would acquire Palette Life Sciences for $600M in cash and a $50M earn-out. Teleflex agreed to pay almost 11x estimated 2023 revenue for a company focused on non-animal stabilized hyaluronic acid (or NASHA) spacers and tissue bulkers used in a range of urology, gynecology, colorectal, and radiation oncology procedures.

The key to the Palette deal is the Barrigel product, a NASHA spacer that is used to reduce radiation delivered to the rectum during radiation procedures targeting the prostate. Advances in imaging and software have been driving a shift toward the use of more intense radiation doses, and while those advances in imagine and software do reduce the risk to non-cancerous tissue, they cannot eliminate it entirely. That’s where the Barrigel spacer comes in, and products like this are now used in about 40% of cases.

There is competition here – Boston Scientific ’s ( BSX ) SpaceOar is the market leader with around $180M-$200M revenue, growing around 20% a year. This suggests Barrigel has around 20% share in a growing market, and there is clinical evidence supporting Barrigel as the superior option – it’s easier to use, more comfortable for patients, allows more time to create symmetrical spacing, offers less risk of rectal wall invasion, and produces faster benefits in toxicity compared to SpaceOar.

Still, almost 11x revenue (12.5x with the earn-out) is expensive, and the deal will be dilutive initially and likely won’t generate even mid-to-high single-digit ROIC in five years. Boston Scientific paid $600M (including earn-out) for SpaceOar’s company back in 2018 (when it was generating around $50M in sales), so there’s precedent that this isn’t unreasonable, but it does raise the question of whether Teleflex will have to continue to pursue expensive and margin-dilutive M&A to maintain top-line growth goals.

The Outlook

I still don’t think Teleflex is a bad business per se, and there are still worthwhile drivers here. I like the company’s portfolio of novel coated PICCs (which should take some share from Becton Dickinson) and opportunities in peripheral intravenous products. I also like its balloon pump business (for cardiac assist) and its leverage to bariatric surgery, and the MANTA closure products should also boost overall growth.

Still, this company is a bit of a hodgepodge and lacking in attractive core revenue drivers, and as I said in my recent Coloplast ( CLPBF ) article , med-tech managements are under a lot of pressure from the market to generate topline growth. With UroLift seemingly losing traction to Boston Scientific’s Rezum and Procept’s AquaBeam, I can see why management may feel the pressure to pay up through M&A to boost growth (even though I could argue that UroLift can still generate some decent growth from here against more realistic expectations).

With Palette in hand, I’m looking for revenue growth of a little more than 5% over the next three years and over the long term as well. Absent Palette my estimates would be lower relative to my last update, as the company has come in weaker than I’d previously expected on several of its main drivers.

On the margin side, the dilutive impact of Palette and the other challenges in the business lead me to lower operating income, EBITDA, and free cash flow margin assumptions. Where I previously thought the company could get to 30% operating margin in 2025, I’m pushing that to 2026/2027 and I likewise don’t expect 32% EBITDA margin until 2025 at best and possibly not even in 2027. The end result to FCF margin is a roughly 125bp decline in FY’27 margin to 22% and a 150bp decline to long-term FCF margin, though this is still enough to drive almost 10% long-term FCF growth.

Discounted back, the cash flows support a fair value over $240. I get a similar result with a margin/return (EBITDA margin, ROCE, et al) approach that suggests a fair forward revenue multiple of 4.5x and a fair value of close to $250.

The Bottom Line

I can understand the logic of the Palette deal, but I’m worried about repeated high-multiple deals (Palette, Standard Bariatrics) suggests more underlying challenges to meeting revenue growth goals. While it’s not unusual to pay up to boost growth rates (Boston Scientific and Stryker ( SYK ) have been doing it for decades), dilutive deals with low anticipated ROICs are nevertheless problematic. Teleflex’s valuation makes it worth closer watching now and it’s getting more interesting as a contrarian play, but it’s not quite there for me just yet.

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