Description

At its current valuation (free cash flow yield of approximately 9%), an investment in Carefusion  (“the Company” or CFN) provides a compelling risk/reward proposition with the potential to generate double-digit returns with limited downside.  While the management team is relatively unproven at this point and some initial spinoff investors have become frustrated by the Company’s lack of progress, delays in filing its 10-K (due to the accounting treatment of some sales-type leases; it has a June 30^th fiscal year-end), and resultant languishing stock price, we believe that Carefusion nonetheless is an attractive opportunity based on the Company’s quality business, margin expansion opportunities, solid balance sheet and attractive valuation

Company Description

Carefusion is a global provider of medical technology and products with annual revenues of $3.6bn, 15,000 employees, and 25,000 customers located in 130 countries around the world.  Its offerings include established brands that are considered the gold standard in hospitals around the world.  Its stated mission is “to provide clinically and economically differentiated products and services, globally improving the safety and cost of providing healthcare.”

By way of background, Carefusion was formed in January 2009 for the purpose of holding Cardinal Health Inc’s clinical and medical products businesses, and was spunoff from Cardinal Health on August 31, 2009.   As of September 15, 2010, Cardinal had sold all of its remaining shares.

The company is organized into two global operating segments: Medical Systemts (Approx. 70% of revenues)  and Procedural Solutions (30%).  This organization is a result of a reorganization and change from its prior two reporting segments, Critical Care Technologies, and Medical Technologies and Services, which took place in September 2011.

The Medical Systems Segment is aligned around the Company’s capital equipment business, and consists of Dispensing Technologies, Infusion Systems, Respiratory Technologies, and “Other”.  The Dispensing Technologies business line includes equipment and related services for medication and supply dispensing, and houses the Company’s flagship  Pyxis medication dispensing system, which accounts for 29% of the Company’s overall sales. The Infusion Systems business line includes infusion pumps and dedicated disposable infusion sets and accessories, with its chief product being the Alaris infusion pump and disposables/accessories.  The Respiratory Technologies business line includes respiratory ventilators and dedicated disposable ventilator circuits and accessories. The Company also includes its data mining surveillance service business within the Medical Systems segment, which it reports as "Other." Revenues for the segment increased 11% during FY 2012 to $2.32 bn, while segment profit increased 28% to $502m on an adjusted basis. 

The Procedural Solutions Segment is focused on the Company’s disposable products business, and consists of Infection Prevention, Medical Specialties, Specialty Disposables, and “Other”. The Infection Prevention business line includes single-use skin antiseptic and other patient-preparation products and non-dedicated disposable infusion administration sets and accessories, including its flagship Chloraprep (16% of the Company’s overall sales), a single-use skin antiseptic product used to prepare a patient’s skin for surgery.  The Medical Specialties business line includes interventional specialty products used for biopsy, drainage and other procedures, as well as reusable surgical instruments. The Specialty Disposables business line includes non-dedicated disposable ventilator circuits and oxygen masks used in respiratory therapy. The Company also includes its respiratory diagnostics business within the Procedural Solutions segment, which it reports as "Other."  Revenues for this segment declined 3% during FY 2012 with a significant decline in operating margin to 11% due to sales pressures and realignment.

Snapshot financials:

Investment Thesis

For a company that was spun-off just a little over three years ago, Carefusion has seen its fair share of turmoil and change, including: 

• The delay in filing its fiscal year 2012 10-K.  On Aug. 30 2012,  CFN announced a delay in filing its10K  due to the company’s is consultation with the SEC about its accounting policy for sales-type leases in its Pyxis® medication and supply dispensing
• Management changes at both the C-level as well as throughout the organization.  Kieran Gallahue was named CEO in Feb 2011 to replace Dave Schlotterbeck, who retired at the end of 2010 after  the spin-off.  Gallahue has eliminated certain positions while also promoting high performers from within and adding talent from the outside.
• Product recalls:  Like most medical technology/products companies, Carefusion has seen its share of product recalls over the last few years, including a version of its Alaris pump, and certain ventilators.

While these issues should certainly not be dismissed – and indeed, some, like the management changes are a positive -- we believe they mask the underlying attractiveness of the investment opportunity:

Quality Business with margin expansion opportunities

Carefusion possesses leading franchises in several of their products including medical infusion pumps (Alaris), medication dispensing systems (Pyxis) and infection prevention (Chloraprep).  In fact, these three flagship products comprise over 70% of the Company’s overall revenues, and are each attractive for different reasons – Alaris due to its razor/razor-blade model predictability and high margin disposable business, Pyxis due to its recurring revenues model and tremendous market share (of approx. 70%), and Chloraprep due to its high margin and growth/market penetration opportunities.

Carefusion also has visible and quantifiable margin expansion opportunities, with the potential to increase its overall OM from its current 17% to the low 20’s over the next 2 years.  In fact, the Company has guided to such, and has taken actions to effectuate this, including a post-spin restructuring of its business, a realignment of its sales force, and continued focus on SG&A opportunities.  Margin expansion can also come from a positive mix shift as revenues grow, due to the high margins of its highest growth potential products.

Strong balance sheet and capital allocation opportunities

With $1.5bn in cash (though a large percentage would have to be repatriated), a net cash position of $300m, and over $1.5bn in gross lease receivables, the Company has a solid balance sheet that we believe gives it several options including the return of capital to shareholders and consideration of strategic alternatives.   In that vein, in February 2012, the Board of Directors approved a share repurchase program authorizing the repurchase of $500 million (the Company purchased a total of 3.9m shares for $100m during FY 2012), and the Company has announced plans for approximately $1bn in share repurchases over the next three years.

Valuation and Multiple expansion opportunities

At its current valuation of approximately 12.8x FY 2013e EPS(adjusted), and 6.6x EV/EBITDA, the Company trades at a 10-20% discount to its peers (normalizing for calendar years).  We believe that as the Company executes, this multiple will narrow very quickly and in conjunction with continued earnings growth and prudent capital allocation, create a 15-20% IRR over the next few years with limited downside.

Catalyst