TRUMF - Terumo Modestly Undervalued But Not Really Exciting

2023-09-08 07:25:58 ET

Summary

• Terumo's recent performance has been mixed, with operating income misses and lower guidance tied in large part to inflationary cost pressures.
• Management is looking to price hikes and operational efficiency efforts, including relocating manufacturing to cheaper geographies, to restore some margin leverage.
• Terumo has opportunities to leverage further growth in trans-radial procedures and pre-filled syringes, but the business largely doesn't pursue transformative growth or disruptive new technologies.
• Mid-single-digit revenue growth and mid-20%s EBITDA margins can support some upside from here, but I worry that Terumo could fall between the cracks given its growth and margin leverage outlooks.

When I last wrote about Japanese medical device company Terumo (TRUMY) (TRUMF) (4543.T), I thought the shares offered some upside on improving overseas opportunities tied to post-pandemic reopening and new product introductions, as well as operating leverage improvement. Since then, the results have been mixed - the local shares have outperformed the broader medical device space by more than 20% and have also outperformed other Japanese peers like Olympus (OLYMY) and Sysmex (SSMXY), but in dollar-denominated terms, the shares have lagged the U.S. medical device space by about 6% (down 23%).

At this point, I can't say my feelings on Terumo are more than lukewarm. I like the company's efforts to push through pricing to combat inflationary pressures, as well as moves to relocate manufacturing to cheaper countries. I also like the company's leverage to faster-growing markets outside of Japan. What I don't like, though, is a so-so legacy of innovative R&D and product launch efficiency, the latter highlighted by the company's challenges in rolling out its Rika plasma collection systems to CSL (CSLLY), as well as the modest scope for top-quartile growth or margins.

I can argue that Terumo is modestly undervalued today, but I can't say I find it an especially compelling name right now.

Mixed Results In Recent Quarters

It's worth noting that Japanese companies tend to report bigger quarterly beats and misses relative to sell-side expectations than U.S. and European companies. I attribute this largely to a greater focus on full-year results and not as much concern on quarter-to-quarter precision, but the fact remains that Terumo's recent performance has left something to be desired, with a 10% operating income miss in the last quarter (FQ1'24), a 20% miss in the quarter before that, and lowered guidance in the third quarter of fiscal 2023 on a small beat.

Revenue in the June quarter rose 5% in local currency terms, with the company enjoying stronger high-single-digit growth outside of Japan. Growth was led by the Blood and Cell Technologies (or BCT) business (up about 14%), while Cardiac & Vascular (C&V) grew about 7% and Medical Care shrank about 7%, hurt in part by a business divestiture.

Terumo has long enjoyed a strong position in vascular interventional devices and vascular grafts, and both performed well in the last quarter, with the former up about 12% and the latter up more than 25%. Blood center product sales improved more than 23% from the year-ago period, but the company is still not fully up and running with its contract with CSL (not a new issue).

Margins remain mixed as Terumo continues to try to offset inflationary pressures. Gross margin declined a half-point from the year-ago period (to 51%), while operating income declined about 1% in constant currency terms, with margin down 170bp to 13.8%. The BCT business did see better margins (up almost four points year over year to 14.3%) as it moves past elevated launch costs, but C&V margin declined more than three points to 20.6%, while Medical Care margin also shrank more than three points to 6.4%.

A Greater Focus On Operational Line Items Should Drive Better Margins

Terumo has been suffering from the impact of cost inflation for some time, and they're not alone in that regard as many med-tech companies have had to absorb higher prices for a range of materials, not to mention distribution and shipping costs.

While many U.S. companies have reported easing cost pressure, Terumo is still looking to push through more active policies to offset the pressure and improve margins. About three-quarters of the targeted improvement is tied to price increases across its businesses. While there are limits on what Terumo can do in markets like Japan and China due to government policies, Japan's policies tie allowable prices to global averages, so overall inflation does give the company some leverage here. Other markets like the U.S. have continued to grow in significance to the company (now about one-third of sales) and there is less pushback on pricing here.

The remainder of the margin improvement efforts is more focused on what I'd call basic "blocking and tackling", including reducing manufacturing costs. Terumo has a long track record of being willing to manufacture overseas (not traditionally as common among Japanese med-techs), and the company has recently shifted more manufacturing in C&V and BCT from the U.S. to Costa Rica.

I do think these efforts can help drive EBITDA margins back to the 24% to 26% range, an improvement from the sub-24% margin seen last fiscal year and a modest improvement relative to the average of the years leading into the pandemic (during the pandemic, margins were consistently in the 25%s).

There Are Growth Drivers, But They're Not Dramatic

One of my larger concerns about Terumo from an investment perspective is that I don't see the company as prioritizing needle-moving innovation in a way that will allow the company to stand out on revenue growth. That's not to say that there's no innovation and no growth potential, but the company certainly comes up short next to names like Boston Scientific (BSX) and is more on par with companies like Becton, Dickinson (BDX).

Terumo has long been a pioneer and advocate for radial access in interventional therapies (versus femoral access), and there is still room for growth in markets like the U.S. where adoption trails global averages (around 55% versus 70% in coronary procedures). There's also still growth potential in areas like peripheral procedures and oncology, with management sounding fairly confident that penetration rates can grow to 20% over the next five years. Terumo has long enjoyed more than one-third share in this overall area (access devices), and I don't see a lot of new competition in the space.

One growth driver arguably worth monitoring is in the pre-filled syringe space. This has historically been a very strong market for Becton Dickinson, but Terumo has been actively working to grow the business and recently announced a partnership with Eisai (ESAIY) to develop an auto-injector for the Alzheimer's drug Leqembi. Given the growing number of injectable therapies in the market (including GLP-1 drugs for diabetes and obesity), I do see an opportunity for Terumo to grow at above-market rates, but BDX is a huge presence in the market and Terumo will have its work cut out to score competitive takeaways (particularly given the regulatory hassles of shifting vendors).

The Outlook

Terumo is well-placed to continue leveraging growth in trans-radial procedures, as well as in areas like interventional neurology and oncology, as well as blood/plasma collection. I don't see a lot of game-changing innovation here, though, and while I do see better growth opportunities from the company's leverage to emerging markets, further government controls on pricing are a risk in several markets.

I'm expecting around 5% to 6% long-term revenue growth from Terumo, with growth driven by share gains in emerging markets and further share/procedure growth in areas like peripheral and coronary interventions. I do think that Terumo has the capacity to be more active in M&A, but Terumo has never been particularly active in acquiring emerging technologies (at least relative to companies like Abbott and Boston Scientific). I would also note that the company has been a little more active of late in returning capital to shareholders (a higher dividend and a buyback program), and I believe management will prioritize returning capital over growth-through-M&A.

On the margin side, I have my doubts that Terumo will be able to do much more than get EBITDA margins back to the 25% level, and I likewise think that free cash flow margin leverage will be relatively limited. While low-to-mid-teens FCF margins are possible down the road, Terumo's has long averaged FCF margins in the high single-digits and I'm reluctant to model or assume significant improvement in the future absent a more dramatic shift in the business plan.

Terumo isn't particularly cheap on a discounted free cash flow basis, but the shares do hold more appeal on a growth and margin-driven EV/revenue approach that I have found useful for med-tech companies. I believe Terumo should trade for around 4x forward revenue, but that only gets me to a fair value modestly above today's price.

The Bottom Line

I don't see why Terumo would meaningfully underperform the broader medical device space, but I also don't see many arguments for meaningful outperformance. The company has some appealing stability through its strong market shares in many of its addressed markets, but again this is not likely to be a standout on growth (revenue, EPS, or cash flow) nor on margin leverage. With that, I'd want a wider discount to fair value before getting really interested in owning the shares.

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