SEMHF - VGI Partners - GE HealthCare: Under-Appreciated Opportunity As A Newly Independent Company

2023-08-17 11:00:00 ET

Summary

• GE Healthcare is a global leader in the medical technology industry, specializing in Imaging, Ultrasound, and Patient Monitoring.
• The company has a predictable and resilient business model, with recurring revenues and a focus on mission-critical imaging services.
• GE Healthcare has a margin opportunity as a newly independent company, with potential for cost optimization and the launch of higher-margin products.

The following segment was excerpted from this fund letter.

GE Healthcare

GE Healthcare ( GEHC ) is a global medical technology leader in the Imaging, Ultrasound and Patient Monitoring space. Having initiated a position shortly after it was spun out of parent company GE in late 2022, the stock has become one of our core holdings. Currently, it is our third largest position due to a combination of strong performance and growing the weight (we initiated a position when the company was spun off).

GEHC is a leader in Imaging and Ultrasound machines, which includes PET and CT scans, MRI, X-Ray and ultrasounds - these account for nearly three quarters of revenues. GEHC is a global business with revenues well spread between the US, Europe, China and emerging markets. The business model is both predictable and resilient in our view:

• Predictable because 50% of revenues are recurring in nature, coming from servicing the machines, selling spare parts and consumables - giving the business attractive razor & razorblade economics.
• Resilient because Imaging is a mission-critical category for GEHC's customers - it is the most important revenue driving category for hospitals and one that is prioritised irrespective of the economic environment.

We like the Imaging industry because it is effectively a three-player market between GEHC, Siemens Healthineers ( SEMHF ) and Philips ( PHG ), and the industry has continued to consolidate over the last 10 years. Scale gives the large players the ability to reinvest in R&D and to entrench their position through close relationships with hospitals.

Our GEHC investment thesis is based on an under-appreciated margin opportunity as a newly independent company. We often see this with spin-off situations:

1. A hidden asset with a renewed focus on capturing market share;
2. A bloated cost structure that can be better optimised; and
3. A newly independent and aligned management team.

All of these are in place at GEHC. For a long time, the company has been run within the larger GE conglomerate and milked for its cashflows, with GE's investment priority being its Aerospace business (prior to COVID, we were investors in GE so have followed the company closely for a long time). However now as a newly independent entity, GEHC can focus on its core business with a fully independent and aligned management team that we expect will act with more urgency.

The margin opportunity stands out when comparing GEHC to its closest peer Siemens Healthineers, whose Imaging business generates operating margins in the low 20s percentage compared to GEHC in the mid-teens. Our diligence suggests that there are no structural reasons for this margin differential - therefore, we think GEHC will close the margin gap over time by addressing the low-hanging fruit in the cost base while also launching new, higher-margin products (resulting from the recent step-up in R&D spend). We believe market expectations for GEHC's margins are too low and therefore see meaningful room to surprise to the upside - leading to high-teens earnings growth over the next few years.

Imaging Operating Margin Differential (GE HealthCare vs. Siemens Healthineers)

Another important tailwind for margins we expect will be the growing penetration of digital tools in Imaging, which GE has been investing behind. GEHC's large global install base of >4m machines gives them a strong advantage in terms of data collection, even more so today when data is extremely valuable and can be overlaid with software applications.

We have already started to see strong demand from hospitals for these software applications because they can meaningfully reduce costs - for example by allowing doctors to read and analyse imaging scans in much shorter time windows, addressing both staffing issues and costs. The adoption of digital services will support growth, better service attach rates and ultimately improve margins - and importantly we do not think we have to underwrite this to get upside to the current valuation.

We view GEHC's valuation as compelling at current levels, particularly with the meaningful improvement in free cashflow ((FCF)) generation we expect over the next 3 years. On current metrics, which we think still only reflect a depressed earnings base, the stock is trading at a discount to most medtech peers despite having a more attractive growth profile. On a more normalised basis, the stock is on a FCF yield of over 6%, which we think is very appealing. Being a newly independent company, there is still some scepticism with regards to management execution, but we think the market will start to become more comfortable as the company starts to deliver on its margin opportunity.

As a closing comment, the medtech industry is one we like and one where we have had some successful investments in recent years (Intuitive Surgical and Olympus). We expect to continue looking for opportunities in the sector.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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