Summary
- The investment debate continues for Teleflex and recent weakness on the chart begs the question of relative value.
- With shares now trading at 12-month lows, valuations look far more appealing than in previous analysis.
- Return on capital remains a standout for the company and is a key feature to keep an eye on looking ahead.
- Net-net, we are more constructive on TFX but retain a hold rating with revised $240 valuation.
Investment Summary
We are more constructive on Teleflex Incorporated ( TFX ) following the sharp pullback in share price that's occurred over the past 12 months. Despite this, there's still a lack of upside to collect by my estimation. Although the market is somewhat more clear on the rates' story looking ahead, there is still a number of systematic factors that continue to override company fundamentals/catalysts, pricing in wider economic downturn instead. With that in mind, I've illustrated the deeper analysis we conducted into TFX's numbers to see what's driving its strong return on capital. Net-net, the case remains unchanged, and I've revised our valuation up to $240 [previously $235], ~22% return potential.
Recent catalysts heavily discounted
The two most recent updates to TFX's growth engine came in August. However, the market looks to have fully discounted any potential earnings upside from these events, considering the subsequent price action on the tape. Firstly, the company noted it signed a deal with Vizient , Inc. to supply central venous access products, effective August 1 2022. Vizient is a 'healthcare performance improvement company' and purportedly has access to more than 50% of the nation's acute care providers. The deal favours Vizient by enabling it to capture pricing advantages in venous access. The agreement includes each of the Arrowg+ard Blue Plus CVCs, and Arrow ErgoPack segments. It is not entirely understood the full economics the deal, nevertheless, investors were swift to price in the deal, with the longer-term downtrend remaining well in situ.
Following this TFX then acquired Standard Bariatrics, a weight loss surgery player on a $300mm valuation. It will pay $170mm in cash up front with another $130mm contingent on certain milestones. Standard Bariatrics has niche exposure to the sleeve gastrectomy segment. Its Titan SGS system offers surgeons and patients a more symmetrical sleeve pouch anatomy by lengthening the continuous cutline to 23cm. It is expected to book revenue of c.$15mm in FY22. TFX estimates a total market of 120,000 surgeries per year, and with an estimated cost per surgery of ~US$14,900, would result in a total addressable market of $1.788 billion per annum. Again, investors overlooked the news and have discounted the potential lift in cash flows should this convert. Question now becomes if TFX is approaching a bottom, or if it is ready to turn off these lows back to previous range.
Deeper look at TFX's fundamentals
In our previous analysis of TFX, we looked at the 'reflexivity' of the market in its ability to control near-term fundamentals, re-rating may stocks to the downside in doing so. We commented on profitability measures and these continue to be a standout for the company. It realizes a 10% TTM return on invested capital ("ROIC") from the last earnings print and this is well in line with historical averages, as seen on the chart below. There is now a divergence in the distribution of the TFX market cap and its ROIC. As mentioned the previous time, this continues an upswing in the capital budgeting cycle for TFX that started in mid-FY21.
Exhibit 1. Upswing in capital budgeting cycle well reflected in return on capital invested
However, I suggest to look a little deeper into the composition of the company's returns, to gauge exactly what's driving the profitability. Ideally, we're checking to see how organic it is, and what we need to focus on in terms of valuation. As seen in the table below, the over the 12 months to Q2 FY22, the company's quarterly ROIC lifted from 3.25%-3.68%. Breaking the economics of ROIC down into its subcomponents, we see that a $1.89mm lift in NOPAT and 0.03-point lift in Invested capital turnover correlate to a sizeable lift in actual investment return. This balances the risk/reward calculus. First, the company can sustain a quarterly growth rate at ~3.7% [15.6% annualized] and that it can do so above the WACC hurdle of ~9.3%. It is also adding a respectable spread above the cost of capital in economic value added. Hence, if the company can sustain this momentum, I argue it has the resiliency to withstand a large shift in macro-variables.
Exhibit 2.
Note: ROIC Breakdown performed using DuPont analysis of same. (Data: HB Insights )
I performed the same coverage on its ROE and found that the quarterly 2.74% [11.4% annualized] also benefitted from an uptick in organic profitability. As seen in Exhibit 3, net income margin lifted 4.5 percentage points to 15%, whereas asset turnover was flat, and leverage wound back to 1.74x. As a result, shareholder equity widened due to the c$30mm gain in retained earnings of the period. The fact the gain in ROE stemmed from earnings and not leverage is satisfying and should be factored into the investment debate. However, at a ROE of just ~11.5%, there are more appealing cash flows on offer out there, especially when paying nearly paying nearly 2.5x book value.
Exhibit 3. ROE growth a function of earnings growth versus use of leverage or large sales jump [DuPont].
Data: HB Insights
Question then becomes how does the near to mid-term future look to manifest for TFX. As seen in the chart below, we estimate the company to expand its quarterly total revenue at a CAGR 5.4% over the coming two-year period. We see meaningful growth at the top-line across the entire distribution of revenue, with upsides in vascular access and interventional two areas of focus. In terms of quarterly earnings growth, this we forecast to balance at CAGR 4.1% from FY22-FY24, in-line with company growth rates estimates calculated above at c.3.7%.
Exhibit 4. Quarterly operating trends set to lift from top-bottom line over coming 2-year period, in-line with growth rates shown above
Valuation and conclusion
Pending one's view on the matter, this provides interesting perspectives. First, is the fact that we project $13.10 in FY22 EPS, as seen in Appendix 1 [located at end of this article]. Should the company convert on these estimates, this creates a compelling case for valuation. TFX currently trades on a 5.4% TTM earnings yield, and applying this figure to obtaining a fair forward P/E, as observed below, advocates that TFX should trade at 18.4x forward earnings. On this multiple we value the stock at $240.92 per share, around 22% upside potential from the current market value. This is in-line with previous analysis of ours.
Exhibit 5. Fair value still looks to be priced to the upside - question is, how agreeable is the market?
Data: HB Insights Estimates
Net-net, the investment debate remains balanced for TFX looking ahead. This is unchanged from previous recommendations. However, there still looks to be medium-term upside in price action should the company continue its strength in return on capital trends. As seen in the fair valuation model below, we see upside potential of around 22% to $240.92. This return is driven primarily by the earnings upsides discussed above that result in a premium of ~545bps for taking on additional equity risk in tactical exposure to a position in TFX. Hence, the pullback in share price has opened up a window of opportunity to capture shares at a fair and reasonable valuation.
Appendix 1.
TFX Forward Earnings Estimates [FY22-FY24]; Quarterly, Annual.
For further details see:
Teleflex: More Constructive Following Recent Weakness, Valuations Noteworthy