ICU Medical Not In Critical Condition, But There's Still Rehab Work To Do

Summary

• ICU Medical spent far more time, energy, and resources than expected in 2022 on fixing Smiths Medical, but the heavy lifting seems largely done for most of the businesses.
• Allowing that current results don't reflect the full impact of the improvements management has made, underlying sequential performance in the core business was still lackluster in Q4.
• Results should continue to improve through 2023 as the 2022 fixes play out, but the "new normal" and real synergies aren't likely to emerge until 2024 and beyond.
• I can argue for a share price closer to $200, but the issues at Smith Medical have cost the company a year or so of leverage and improvement.

Portra

I don’t think I could say it better than ICU Medical (NASDAQ:ICUI) CEO Vivek Jain did on the fourth quarter call when he said, “We could not be happier that 2022 is over.”

While the acquisition of Smiths Medical may very well still produce meaningful long-term value for the company, clearly Smiths Group (OTCPK:SMGZY) sold them a business that was in rougher shape than they disclosed, and management has spent a lot of time fixing numerous issues ranging from quality control to production, supply chain, and fulfillment. At the same time, I wouldn’t exactly call the underlying core performance of the business “robust”, as sales were noticeably weaker on a sequential basis.

Assuming the opening indications prove accurate, ICU Medical shares are up about 5% since my last update, good enough to outperform the broader med-tech space, but certainly lagging similarly-sized Merit Medical (MMSI) over that time (a company I’d argue has similar procedure volume and consumables exposure). I do think that a lot of the heavy lifting has been done to fix Smiths and that ICU Medical is on a path to 20%-plus EBITDA margins in the coming years. That can support a fair value in the $195 to $205 range, but there could still be some noise in the quarterly results for a little while longer.

Results Continue To Carry The Weight Of Significant Restructuring Efforts

By no means do I think that ICU Medical’s reported fourth quarter results reflect the likely profitability of the business on a long-term going forward basis, but it’s also certainly true that the company has had to devote significantly more resources (financial and otherwise) to fixing the Smith Medical operations.

Revenue was up 70% year over year as reported, but down 3% sequentially. Although a supply issue with product supplied by Pfizer (PFE) for the IV Solutions business explains some of the weakness, the reality is that underlying sequential performance was pretty close to flat or worse for much of the business - down a bit in Infusion Consumables, up a bit in Infusion Systems, down 12% in IV Solutions, up 2% in Smiths Infusion, down 21% in Smiths Vascular Access, and up 11% in Smiths Vital Care. Relative to the underlying performance seen at other companies with comparable businesses (Becton, Dickinson (BDX), Merit, et al), I’d say this was a lackluster performance on balance.

Gross margin continues to reflect the challenges of input cost inflation as well as amelioration of the Smiths business, including high airfreight costs to deal with fulfillment issues. Reported gross margin declined more than seven points from the year-ago level and about one point sequentially (to 30.3%), while an adjusted metric that backs out costs including remediation showed a 350bp yoy decline and 90bp qoq improvement to 35.7%.

ICU Medical is modestly profitable on a reported basis (an operating margin of 1.5% in Q4’22, down slightly from 1.6% in Q3’22), while adjusted operating margin came in at 12.7% (versus 12.5% in Q3’22). Although I’m normally pretty harsh towards companies that try to jigger the numbers to make results look better, I think it’s worth looking at both in this case - there are most definitely real near-term costs to the remediation of the Smiths Medical business, but it’s also important to keep in mind what the business will look like on the other side of those efforts.

The Heavy Lifting Is Likely Done, But 2023 Results Still Won’t Be Fully Representative

If I’m interpreting ICU Medical management’s commentary correctly, it sounds as though much of the heavy lifting with fixing Smiths Medical has been done. The necessary changes are in place and now it simply takes time for those changes to work themselves through. Sourcing and manufacturing should be more efficient in 2023 and fulfillment issues should be less pressing, though I can’t imagine the business is really where management wants it yet in terms of inventory and so on.

What this all should mean for reported financials is that the heavy spending headwinds should abate in 2023 and revenue pressures from operating problems should ease, though there’s still work to do in the Vascular Access business and work still to do in terms of quality control and FDA compliance. Quarterly adjusted EBITDA improved from the second quarter of 2022 onward, and I’d expect to see ongoing improvement in margins through 2023, but business really won’t be operating at normal levels until 2024.

Underlying Opportunities Are Still Worthwhile

The original point of the Smiths Medical deal is still valid, which is to round out ICU Medical’s offerings in infusion care (adding ambulatory infusion and syringe infusion products), expand areas like oncology care, vascular, and hemodynamics, and add complementary scale through expansion into markets like safety, patient warming, and respiratory/anesthesia.

Scale is a significant factor in ICU Medical’s chosen businesses, and past deals to add scale and expand the company’s portfolio have helped the business grow, although often at a cost of meaningful disruption and integration challenges in the near term. Beyond portfolio scale, Smiths also gives the company an opportunity to more effectively access markets outside the U.S., as Smiths has meaningful ex-US business.

The core of what ICU Medical will be about once Smiths Medical is fixed revolves around scale and efficiency. It is possible to differentiate in areas like infusion pumps and connectors through product development and features, but the reality is that the business revolves around volumes and operating efficiency (selling large numbers of low-priced disposables) as opposed to innovative therapeutic devices - this is less an R&D-driven business than a manufacturing, sales, and distribution-driven business, which makes the operational issues at Smith Medical all the more irritating.

The Outlook

While my numbers for 2023 and 2024 are lower, that’s more of a product of lower starting point produced by the challenges encountered in 2022. My longer-term outlook hasn’t really changed, as I still expect around 4% long-term core revenue growth and free cash flow margins in the low-to-mid-teens.

If management can really execute on the portfolio and customer synergy opportunities (cross-selling ICUI products to established Smiths customers, and vice versa), as well as lift Smiths Medical up to ICUI’s core operating efficiency, there is certainly long-range upside potential.

ICU Medical shares aren’t that cheap on discounted cash flow, but that’s not too surprising given that weaker near-term cash flows factor more heavily into the end result. Using my growth and margin-based EV/revenue approach, I do think there’s an argument that ICU Medical shares still offer some upside. If I split the difference between the EBITDA margins I expect for FY’23 and FY’24 (giving the business some credit for the core profitability on the other side of the remediation process), I get a forward multiple of 2.6x, which supports a fair value of about $195; if I go with the multiple appropriate to my FY’24 EBITDA margin estimate, that 2.7x forward multiple pushes the fair value to $205.

The Bottom Line

I do think that ICU Medical can and will be better than it is today. Management has had to roll up their sleeves and do a lot more work than initially expected, but they seem to have risen to the task. I still believe 20%-plus EBITDA margins are possible a little further down the road and that further rerating is possible. I’d like a wider margin of safety between the price and my estimate of fair value, though, so for now this is still more of a “neutral” idea for me.

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