ICU Medical - Pfizer Deal Gets Cheaper For The Wrong Reason, Not Appealing Yet Amidst Elevated Uncertainty

| About: ICU Medical, (ICUI)

Summary

ICU Medical is getting a discount on the Pfizer deal, for the wrong reasons.

The discount, which not only reduces the price but allows ICU to avoid net debt as well, are mitigating factors.

A further retreat in the share price is necessary to leave enough potential return given the substantial integration risks out there.

ICU Medical (ICUI) offered both good and bad news for investors, yet the bad news overshadowed the good. ICU announced that the acquisition of Hospira´s Infusion Systems, which was announced in October of last year, is already falling short to expectations. This comes before the deal has even closed.

This is obviously not very good news, yet ICU has managed to reduce the final purchase price by anywhere between 10 and 32%, as incentive payments will only have to be paid later in time, providing time benefits as well. The changed structure of the deal and reduction in price allows ICU to operate with a net cash position and thereby avoid net leverage. This is welcome news as this year could post its challenges on the business.

Updating The Hospira Infusion Systems Deal

In October of last year, ICU Medical announced that it would acquire Pfizer´s (PFE) Hospira Infusion System business (NYSE:HIS). The company announced that it has obtained antitrust clearance, but more importantly that the deal terms have been changed in the light of the recent business performance.

The total deal price of a billion has been adjusted to ¨no more¨ than $900 million, implying at least a $100 million reduction from the previous price tag of a billion. Pfizer will obtain a $400 million equity stake in ICU. It will be issued 3.2 million shares which are appraised a valuation of $125 per share each, in line with the original announcement.

Furthermore, ICU was originally supposed to fork over $600 million in cash to Pfizer, but this cash payment has been cut to just $275 million. Instead ICU is potentially on the hook for $275 million in milestone payments, conditional on performance targets which should be met through 2019.

If all goes to plan, the deal should close in February. Of course Pfizer does not reduce the deal tag from a billion, towards $675-$900 million. The reason for the renegotiation is that the financial performance of the business is falling short of previous expectations, as will be discussed in the next paragraph. On the bright side, ICU will be able to avoid an anticipated net debt load of $175 million, now operating with a net cash position of $150 million going forward.

How Bad Is It?

The reduction in the $1 billion deal tag towards $675-$900 million is the result of a significant reduction in the anticipated performance of HIS. Between October and today, sales estimates for HIS in 2017 have fallen from $1.1 billion to a billion, as sales actually came in at $1.2 billion in 2015.

Worse, the deterioration in profitability is even larger. Adjusted EBITDA, which was previously seen at $75 million for 2017, is expected to fall to just $35-$40 million, with the poor profitability numbers resulting largely from sales deleveraging of course. Worse, the weakness is anticipated to last for a while. ICU cut the 2018 adjusted EBITDA outlook by $50 million towards $250 million.

Shares of ICU fell some 10%, or $15, in response to the news. With nearly 20 million shares outstanding, including the shares to be issued to Pfizer, the valuation of the company has come down by $300 million. This comes on top of a $100-$325 million reduction in the deal tag. As a result, the market is reducing the value of the company by $400 to $625 million on the back of a roughly $35-$40 million cutback in anticipated adjusted EBITDA.

It should be said that shares now trade at similar levels at which the stock traded before the deal has been announced. Investors initially reacted very positively to the deal as a result of the strategic and financial benefits, as shares hit a post-deal high of $155, only to now trade at $130 again.

Pro-Forma 2017 & 2018

In my October analysis, I believed that the deal looked attractive, yet did not jump onboard on the back of a favorable reaction displayed by the market already, strong multi-year momentum and real efforts which the company had to make.

At the time, I did mention that the original deal presentation contained a worrisome slide. IHS foresaw that adjusted EBITDA would fall from $158 million to $75 million. While part of that resulted from lower future sales assumptions, most of the fall was the result of costs incurred by IHS being allocated to the corporate account of Pfizer. Yet ICU has to reimburse Pfizer for these costs in the shortfall until it can build up its back-office solutions.

While ICU believed that the weaker momentum of IHS was temporary, that no longer seems to be the case. The 10% reduction in sales, and the fact that EBITDA has been cut in half, have some serious implications. With ICU itself generating $133 million in adjusted EBITDA, the pro-forma number now comes in at roughly $170 million instead of the projected >$200 million. Yet this $170 million number reveals that a lot of work is necessary to achieve the $250 million target for 2018, although realizing that could yield handsome results.

The good news is that the business is operating with a net cash position of $150 million. The 20.5 million shares trade around $130, for an equity valuation of $2.66 billion, or $2.51 billion on an enterprise valuation. GAAP earnings are seen at $70 million, based on the performance of ICU alone, a business which is seeing real momentum at this point in time.

It will be hard to estimate the profitability of IHS, yet given that D&A still has to be subtracted from the reduced EBITDA number, I estimate a flat earnings contribution. The $70 million in core earnings yields an earnings per share number of just $3.50 per share at the moment, which combined with net cash holdings of $7 per share yields a valuation at 35 times unleveraged earnings.

If the company can indeed deliver on the $250 million EBITDA number for 2018, up from $170 million seen today, the future arguably looks better. With GAAP earnings seen at $70 million this year, driven by ICU and zero profit contribution from the deal, accretion should come in at $80 million pre-tax in that scenario.

With a 25% tax rate, earnings could nearly double towards $130 million, boosting earnings per share to $6.50 per share. Including net cash balances, earnings multiples drop towards 20 times in that scenario, making it pretty attractive given the strong balance sheet.

Final Thoughts

ICU´s rather complex and large deal looked promising at the start, but included some warning signs, as I referred to at the time. The softer performance of the acquired business is of course disappointing, yet ICU has managed to reduce the purchase price by 10-32%, depending on milestone achievements to be paid out along the road.

The good news is that the company is being savvy in restructuring the deal, avoiding a net debt position - which is probably wise because of increased uncertainty. At the same time, a lot of upside is conserved for equity investors if the deal works out, supported by continued cash flows at ICU´s own business.

It is clear that the deal brings few benefits in the short run, yet I like the savvy dealmaking and restructuring of the deal. Despite the reduced outlook, the potential $250 million EBITDA number suggests a potential earnings number of $6.50 per share that year. As the company operates with a net cash position and has a lot of balance sheet capacity, while trading at 20 times earnings, one can argue that the company deserves a higher valuation based on the past, peer multiples and its strong track record.

On the other hand, the deal carries increased risks to the long term outlook in terms of margins, although balance sheet risks are largely avoided, as shares were not very really cheap from the outset. Using a 20 times multiple on $6.50 earnings by 2018, while adding net cash holdings of $10-$15 per share, yields a potential fair value of $140-$145 by the end of 2018.

Given the significant integration risks, as has become obvious by now, I require a significant 15-20% required return based on this scenario in order to see appeal. Discounting the $145 target at these percentages for two years suggests appeal in the $100-$110 region - levels last seen this summer - as a buying opportunity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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