"This is not a situation where investors should expect a quick return on their money, but patience over the next couple of years could be well rewarded."
As it turns out, I was half-right - the shares have risen almost 20% since then, with the market taking notice (I believe) of the opportunities in the recovering energy sector, the expanded opportunities in detection, and the prospect for significant portfolio adjustments.
That latter point is highlighted by the acknowledgement from Smiths that it is exploring the possibility of some sort of business combination with ICU Medical (ICUI) for its medical business. While it's very early in the process, I believe Smiths' interest in making a transaction of this sort with its medical business shows that it is serious about active portfolio management and focusing on those areas where it can generate real long-term value.
Time To Do "Something" With Medical?
Smiths Group's Medical segment has been a frustrating business for investors for some time. Although the business has good share in infusion, vascular access, and vital care, with a strong mix of single-use/disposable devices, the reality is that these product categories are highly competitive and often experience almost commodity-like pricing. To that end, organic growth over the past decade has been on the order of 3% or so, albeit with margins that even companies like Stryker (SYK) and Medtronic (MDT) would find more than satisfactory.
Part of the problem with the Medical business has been a lack of R&D productivity. While Smiths Group spends a respectable amount of sales on R&D for an industrial company, its R&D spending has been less impressive, and while high levels of R&D spending don't guarantee success in med-tech, not spending on R&D (or not spending effectively) does often relegate a company to slower long-term revenue growth.
In any case, new management has been making changes in the medical business. These changes have included an adjustment of R&D spending priorities and an improved go-to-market strategy. The net results are already starting to show up, with the company slated to close to a dozen new products in the second half of its fiscal 2018 and refresh half of its portfolio over the next five years.
Despite all of that, management has still faced a steady drumbeat of pressure from investors to "do something" about the Medical business, even though it is not a drag on overall company margins or cash flow. Now it seems those investors may get their wish.
An Infusion Of Options?
Smiths Group acknowledged a late May report that the company was in early-stage discussions with ICU Medical about a potential combination, and Goldman Sachs put the stock on its restricted list at that point. At this point there's no guarantee that any sort of deal can or will be reached, nor the structure of such a deal.
ICU Medical is a logical dance partner. ICU is a leader in medical infusion, having built its way up with needle-free connectors and customized tubing sets, acquiring Hospira's critical care business, and innovating into new markets like oncology safety. More recently, the company acquired the Hospira infusion pump business from Pfizer (PFE), giving it a much more complete array of infusion products.
That all sounds like a strong complement to Smiths' Medical business, which includes an infusion business built around products like syringe pumps, ambulatory pumps, and IV sets, as well as the vascular access and vital care businesses (which includes monitoring, airway management, and safety/infection control).
The two businesses are roughly the same size now in revenue terms, though Smiths Medical is much more profitable. ICU Medical has generated very strong operating margins in its past (mid-20%'s), but the acquisition of the operationally-challenged Hospira infusion business means it's going to take a while before margins get back to where they used to be (and it may well be the case that they never get back to the mid-20%'s).
There would be strong synergies between these two businesses. ICU Medical would offer more U.S. market exposure for Smiths, as well as low-cost manufacturing sites, while Smiths would expand ICU's European business and its product line-up. There would also be meaningful back-office synergy opportunities as well as some leverage in R&D.
But what sort of deal would work? Smiths Medical's low revenue growth rate would argue for a forward revenue multiple in the 2s, but that would still be more than double ICU Medical's shareholder equity. A mix of cash and stock could perhaps be possible, but I think it is more likely that a deal would either be structured as a sort of joint venture or as a merger of equals with ICU Medical management in charge and Smiths Group either spinning the shares to shareholders or selling them over time.
Both ICU Medical and Smiths Group have the luxury of not needing to do anything. Acquiring/merging with Smiths Medical would certainly create a lot of synergies for ICU Medical and give the company a much larger operating base, but the company is already digesting the Hospira deal. Smiths Group could arguably get better value through a merger of near-equals, but again I don't believe the Medical business really hurts the company as is, so I don't think they need to accept a bad deal just to do a deal.
The Bottom Line
Given all of the uncertainties about what a deal may look like (or if there will even be a deal), I'm not factoring in any changes to my basic model on Smiths Group. What I will say, though, is that I believe management has a lot more credibility now regarding its willingness to think big in terms of maximizing the value of its portfolio and divesting assets that may not fit with the company's long-term goals. Although I still like this company, and I like this potential tie-up with ICU Medical (at least on the conceptual level), the share price performance has soaked up a lot of the upside and this looks more like a respectable hold now at these levels.
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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