Description

Summary:  Halyard Health is worth roughly half of its current trading price, and has imminent catalysts.

Business Description

Halyard Health (HYH) is the recently spun-off former healthcare division of Kimberly-Clark (KMB).  Its Surgical & Infection Protection (S&IP) segment has leading market positions in surgical drapes and gowns, medical exam gloves, sterilization wraps, facial protection and protective apparel.  Its higher-margin Medical Devices segment includes surgical pain management, respiratory health, digestive health and interventional (or chronic) pain management products.  In 2013, total revenues were $1.7 billion with 72% generated in North America, 15% in Europe, Middle East and Africa, and 13% Asia Pacific and Latin America.

HYH's long-term strategy is to increase Medical Devices' contribution to revenues through acquisitions and greater R&D investment. 

Key Points

1.  S&IP is a modestly declining, commodity business facing intense competition and price-conscious hospital customers 

Making up 69% of revenues and 61% of operating profits, the S&IP segment was described by management as HYH’s cash cow, as revenues are expected to flat-line.  This was true in 2012 when revenues fell by just 0.2%, but in 2013, revenues declined 2.7%, and fell another 2.3% in the first 9 months of 2014.

This segment’s products are largely sold through group purchasing organizations (GPOs) in the U.S.  A GPO creates deep competition among hospital suppliers to extract the best prices, taking a 1-3% cut (called an “administration fee”) of suppliers’ sales volumes.  This cut is seen as a sales commission, but it acts as a further price reduction to the supplier.  We spoke to three GPOs all of whom said hospitals have become very price conscious in the current reimbursement environment and are looking to their suppliers to share in the pain.

HYH faces intense competition in this segment.  Sempermed, a medical exam glove competitor (we estimate gloves make up 20% of S&IP revenues), has more modern facilities than HYH and can produce at a lower cost.  Sempermed is in the midst of expanding its glove capacity from 12 billion gloves to 23 billion this year.  HYH management admitted that the capacity coming on is more efficient and they’d have to incur substantial costs to raise their efficiency to competitors’ levels.  Instead, HYH is shutting its Thailand facility by the end of this year and will outsource its capacity.  HYH has communicated this outsourcing move as a positive, as it will save the company $10 million pre-tax annually, however we see a long-term detriment.  HYH is no longer cost-competitive and as it outsources its volumes, its competitors gain greater economies of scale, allowing them to underprice HYH in the branded business. 

One GPO we spoke with explained that a lot more competition has come into the medical exam glove space in the last 10 years, and highlighted Cardinal Health (CAH) and Medline Industries, both of which offer private label products, as having greatly contributed to the reduction in glove prices over the years.  

HYH (then Kimberly-Clark Healthcare) got into the medical exam glove business by acquiring Safeskin Corporation in 1999.  In the prior year, Safeskin had $232 million in revenues, which were up 27% (it was a growth company).  We believe HYH’s medical exam glove business does roughly $220 million in revenues today.  Safeskin’s gross margin was 52% in 1998, and we believe the gross margin of HYH’s medical exam glove business today is far below its 34% overall gross margin.  We estimate this business is near break-even, compared to the $39 million in normalized net income Safeskin earned in 1998.  Considering KMB paid 3.7x revenues and 22x normalized earnings for Safeskin, a DCF analysis, with the benefit of hindsight, would suggest a fair value of less than half of Safeskin’s $850 million purchase price.   

The seller usually knows more than the buyer.     

Throughout our field research, we heard that Medline Industries is HYH’s most aggressive competitor.  HYH itself referred to Medline as “a formidable competitor.”  The company, which competes in virtually all of HYH’s S&IP products, is private and our calls were not returned, but one GPO told us Medline owns all of its properties and vehicles, has no debt, is owned by two gentlemen who are very frugal and they go after categories aggressively. 

Putting all of the above into the context of Porter’s five forces, the S&IP business is in a weak strategic position as the bargaining power of customers is very strong (GPOs play suppliers off each other and price is the only determinant on equivalent products), the threat of new entrants is high (it’s already happened) and the competitive rivalry is intense (private label competition, and aggressive private companies with lower return hurdles). 

In its 3Q14 10-Q, in reference to lower sales in S&IP, HYH mentioned price decreases on GPO contracts to secure renewals in North America, lower volumes in EMEA due to the company walking away from low margin business, lower prices in Australia due to increased competition and price reductions in Japan to retain business.  This is clearly not a high multiple business. 

Due to the intense competitive environment, S&IP focused on cost reduction, and did a good job on operating margins 

2011:                 12.6%

2012:                 13.1%

2013:                 13.1%

LTM 9/2014:     13.8% 

We believe HYH not only cut fat, it cut into muscle.  In late 2013, the company cut its North American sales and marketing staff.  With more sales going through GPOs there’s less need for sales people, but this puts future growth at risk as there are less “feet on the street.”  Finally, as part of KMB, HYH took part in the FORCE (Focused On Reducing Costs Everywhere) program, which saved $2.2 billion at KMB over the last 10 years.  We believe HYH is now very lean, possibly understaffed, and the opportunity for further margin expansion is largely gone.  Management confirmed that margin upside going forward will be tougher.           

2.  Medical Devices, HYH’s “growth segment,” is declining as well

At 31% of revenues and 39% of operating profits, Medical Devices was pitched as having mid-single-digit top-line growth.  This was true in 2012 when Medical Devices grew revenues by 5.6%, but growth slowed to 4.6% in 2013, and then 1.8% in the first 9 months of 2014, which benefitted from one-time strength. 

Q1:14 revenues were up 11.7% as HYH profited from a North American competitor’s exit from the surgical pain management business and supply chain issues at a competitor in EMEA.  Once these benefits ended, Q2:14 and Q3:14 revenues fell 2.6% and 2.9%, respectively.  Management attributed the decline to lower volumes in surgical pain management due to competition in the category.  We’ll address competition in a moment, but let’s look at the operating margin of this segment first: 

2011:                 17.0%

2012:                 18.6%

2013:                 17.2%

LTM 9/2014:     19.5%

The 230 bp jump in the LTM 9/2014 margin was due to significantly lower legal costs as HYH settled a patent infringement lawsuit that was running large expenses.  Since the gain was from non-operating items, we don’t see much opportunity for margin expansion in this segment as well.

Regarding competition, Pacira Pharmaceutical’s (PCRX) EXPAREL is like an automobile compared to HYH’s horse-and-buggy-like ON-Q pump.  Both products address surgical pain. 

Kimberly-Clark got into the surgical pain management business by acquiring I-Flow Corporation in 2009.  I-Flow’s ON-Q pump was a step ahead of morphine, which is typically given to relieve post-surgical pain.  A catheter, attached to a pump, is placed into the area where the surgery took place.  The ON-Q pump sends bupivacaine, a local anesthetic, into the area, relieving the patient of pain and eliminating the need for opioids, which can have side effects.  The patient goes home and holds the pump in hand (or wears a pouch which holds the pump strapped around their shoulder) for three days.  After that, oral pain medication is taken until the pain is completely gone. 

KMB paid 1.9x revenues and 35x EBITDA for I-Flow.  I-Flow had revenue growth of 9% in the first 9-mos of 2009 – an annualized rate of $145 million – after 14% revenue growth in 2008.  We estimate HYH’s surgical pain management business does $150 million in revenues today, for a revenue CAGR of 70 bps annually since the I-Flow deal.  Once again KMB paid a growth multiple for a no-growth business.  In addition, I-Flow disclosed in its 2008 10-K that it was a defendant in 63 lawsuits claiming ON-Q caused cartilage disintegration.  While I-Flow had product liability insurance at the time, such lawsuits have continued to plague ON-Q under KMB.  KMB will retain liability on existing claims, but HYH is on the hook for claims arising post spin.   

We believe the potential for cartilage damage and the inconvenience to the patient, who has to have a catheter in her and carry a pump around for 3 days, is why ON-Q, and its equivalents, only reached 10% market penetration.  Bupivacaine pumps were a step above morphine but, according to the market, not a very big step.  An orthopedic surgeon we spoke to said he never used a bupivacaine pump in his career due to the potential for cartilage damage.  Over a year ago, he started using EXPAREL.

EXPAREL also uses bupivacaine to treat post-surgical pain, only EXPAREL is given as an injection and its slow release technology administers less of the drug, whereas ON-Q requires more anesthetic because it disperses in the body.

The orthopedic surgeon we spoke with said EXPAREL spread by word of mouth among his colleagues 1 – 1.5 year ago.  He didn’t know of one surgeon still using a bupivacaine pump, which he called “a nuisance” for the patient.  Pacira, in its 10-K, called ON-Q and similar products “clumsy, difficult to use and may introduce catheter-related issues, including infections. 

Pacira management identified surgeons using ON-Q as the “low hanging fruit” when it began marketing EXPAREL, and in just 10 quarters on the market, EXPAREL -- with $235 million in annualized revenues -- has already surpassed HYH’s $150 million surgical pain management business.

There are arguments in favor of ON-Q as well.  One is that an injection of EXPAREL does not relieve pain as long as ON-Q, which administers bupivacaine for 3 days.  In fact, Pacira received a warning letter from the FDA in September 2014 for overstating the efficacy of EXPAREL in its marketing materials, and Pacira had to remove its claim that EXPAREL is effective for “up to 72 hours.”  However, surgeons often prescribe oral pain medication for the patient to take when they feel pain, offsetting the reduced efficacy of EXPAREL.

In our view, the best expert on this matter is the free market.  EXPAREL sales were up 127% in 3Q14.   While HYH did not break out ON-Q’s volumes separately, it did say its sales were impacted by competition from EXPAREL. 

Finally, EXPAREL has not had cartilage damage issues thus far.  While it’s too early to tell, it’s quite possible that EXPAREL has obsoleted ON-Q, and that 40% of HYH’s Medical Device revenues are now in run-off. 

This 2-minute video shows how ON-Q is used:

https://www.youtube.com/watch?v=Z7FFn_Wx1Gg

At 35x EBITDA, KMB massively overpaid for I-Flow.  KMB’s Oct. 2009 press release stated the deal would be modestly dilutive to 2009 and 2010 EPS, and accretive beginning in 2011.  If a $145 million revenue acquisition was dilutive to KMB with $19 billion in revenues, imagine the dilution to its $1 billion in revenue (at the time) Healthcare segment.  We don’t believe this deal ever turned accretive and, as with Safeskin, estimate KMB paid more than double what I-Flow would prove to be worth.    

The seller usually knows more than the buyer.      

It comes as no surprise that I-Flow was KMB’s last sizeable healthcare acquisition.  Since then, KMB used Healthcare’s free cash flow to invest in its other businesses, and in Novermber 2013, announced it would spin off the segment.

3.  HYH’s growth strategy entails high risk

There are two reasons why a company would spinoff a segment: 1) to highlight the value of a great business, or 2) to get rid of a bad business.  Our guess is KMB got tired of Healthcare’s increased competition, falling margins and declining growth rates.  Since it had not distinguished itself in the M&A arena, there wasn’t much it could do to offset the trajectory of growth, plateau and, often, decay its acquisitions went through.  So, instead of having Healthcare drag down its growth, KMB took a $600 million distribution and spun it off. 

So what is Halyard’s growth strategy going forward?

Acquisitions.

The company plans to use the FCF of the S&IP segment to fund acquisitions in the higher margin Medical Device segment.  An acquisition-driven growth strategy entails high risk to begin with, but we see added risk at HYH for a couple of reasons. 

KMB chose Robert Abernathy, a +20-year senior executive at KMB, to run HYH over Joanne Bauer, who ran healthcare since 2004.  Abernathy ran healthcare from 1997 – 2004, and then held other roles within KMB.  We spoke to a former KMB Healthcare employee who knew both executives.  He had nothing but good things to say about Abernathy, and we don’t question his skills as a leader, but Abernathy has been away from day-to-day operation of the business for 10 years and the business has become far more competitive in that time.  In addition, the Safeskin acquisition happened on his watch.   

As we’ll get into below, we believe HYH will face modestly declining revenues and EBITDA, putting pressure on Abernathy to offset the declines with acquisitions.  Any deal will be dilutive initially, and HYH has said as much, with a goal of accretion in the third year.  Is an executive 10 years out of the business really the best person to be sitting across from Goldman Sachs’ bankers, pitching him a deal, when he’s under the gun to boost growth?

Due to large one-time transition costs ($60 - $75 million in transition services from KMB, branding and supply chain transition costs through 2016, 80% expected in 2015) and royalty payments to KMB ($10.4 million annually for the use of intellectual property for the first two years) we estimate HYH will generate just $24 million in FCF through 1Q16, barely making a dent in its $600 million of net debt.  

Assuming all FCF goes toward debt paydown, HYH is actually more expensive on EV/LTM EBITDA at the end of 1Q16 (12.3x) than it is today (11.5x), as we estimate 1Q16 LTM EBITDA will be 6% lower, more than offsetting the $24 million in debt reduction. 

Medical device acquisitions are going for very high valuations today as private equity is competing on deals.  Given all of the above, we just don’t see where HYH gets any growth.    

The seller usually knows more than the buyer, and this time KMB is the seller.

4.  Outlook

As mentioned above, LTM revenues and EBITDA are inflated by one-time benefits in Medical Devices, and this inflated base will create tough comps going forward.      

For 4Q14, we’ve modeled revenues being sequentially down by 50 bps in both segments.  This results in revenues down yr/yr by 5% in S&IP and 8% in Medical Devices, for down 6% overall.  This will be a far greater decline rate than anything HYH has reported recently, and it will make for an ugly first earnings call.  Note that our assumptions mean volumes will be up sequentially, more than offset by the impact of the higher USD.

We’ve modeled revenues down 3% in 2015 and down 2% in 2015, due to lower pricing in S&IP, continued market share losses to EXPAREL and a substantially higher USD.  HYH will benefit somewhat from a decline in raw material costs.  About 20% of COGS is polypropylene and 10% is ABS.  These compounds are derived from crude oil, but they have their own supply/demand equations, and polypropylene supplies are tight.  We estimate HYH will gain a $15 million cumulative boost to EBITDA (on $239 million in 2014 EBITDA) over the next two quarters from lower raw material costs.  This benefit could increase if prices continue to fall, however, HYH won’t hold on to the higher margins for very long. 

64% of HYH's GPO contracts (25% of total revenues) come up for renewal this year and GPOs told us they will seek lower prices, since suppliers asked for price increases years ago when oil surged.  The remaining 36% of GPO contracts (14% of total revenues), expire by the end of 2017, but GPO contracts have 90-day cancelation clauses, so if a GPO felt they could get a materially lower price for their hospital customers (their entire value-add is to create deep competition and extract the best prices, otherwise they serve no purpose and hospitals could buy from suppliers directly) they’ll break the contract and re-bid the business.

In short, we see adjusted EBITDA falling 22% in 4Q14 as HYH comps its strongest quarter to date.  Then, we see EBITDA down 2% in 2015 (helped by lower input costs) and down 9% in 2016 as HYH increases R&D spend with no immediate benefit to revenues.  We did not forget to give HYH credit for its $10 million is savings in 2016 for its Thailand plant closure.  

5.  Valuation

HYH trades at 10.8x LTM EBITDA (ending 3Q14).  On 2014 EBITDA, when that strong 4Q13 quarter comes out of the base, HYH sells for 11.5x EBITDA, and as EBITDA continues to decline, it trades at 11.8x and 13.0x 2015 and 2016 EBITDA, respectively.

In some sort of strange deja vu, HYH appears as overpriced as what it paid for Safeskin and I-Flow: by a factor of 2x. 

We valued HYH using sum-of-the-parts, separating S&IP, surgical pain management and the rest of medical devices, as each face different competitive and growth profiles.

2015 EBITDA = $234 million, split:

S&IP = 142

Surgical Pain = 28

Medical Devices, rest = 64

EBITDA multiples:

S&IP = 6x

Surgical Pain = 5x

Medical Devices, rest = 10x

Blended multiple for HYH = 7x

Fair Value = $22

Downside = 52%

We believe 6x is fair for the commodity S&IP segment which faces pricing pressure and intense competition.  We believe it’s prudent to value surgical pain management as a run-off business at 5x, given the market’s rapid adoption of EXPAREL, and the infection and inconvenience issues of ON-Q.  The rest of HYH’s Medical Device segment is comprised of good businesses with less competition and better margins than S&IP.  Management thinks these businesses have mid-single-digit top-line growth and we believe 10x EBITDA reflects that. 

At HYH’s current share price, the implied segment multiples are as follows: 11x for S&IP, 10.5x for surgical pain management and 14x for the rest of medical devices.  Clearly, Mr. Market thinks he’s valuing a different business than Halyard Health.

6.  How we got here and how it ends  

The froth started percolating on HYH’s first day of regular-way trading in November 2014 when Jim Cramer had CEO Robert Abernathy on his Mad Money show.  Cramer compared HYH’s prospects to Carefusion, which was spun off in 2009 at $20, and got acquired for $58 in 2014.  Ebola was making headlines at the time and Cramer saw HYH as an Ebola play.  In response to Cramer’s question, “when did it [HYH] become a burden for Kimberly-Clark?” Abernathy denied the characterization saying, “this has been a very, very strong business for Kimberly-Clark.”  At the end of the show, Cramer postulated that HYH could by another Mallinckrodt (spun off from Covidien in 2013 at $45, today trading at $117). 

Here’s the link to the show. 

http://finance.yahoo.com/video/halyard-health-ceo-innovation-drives-234000289.html

On the same day, with the stock trading around $38, Morgan Stanley initiated coverage with a $33 price target.  The market ignored the report. 

Then, a spinoff-focused research shop that highlights 2-3 “great” ideas a year, recommended HYH and placed a $48 price target on it, valuing it at +11x its 2015 EBITDA estimate, which assumed growth.  This news makes it into Barron’s in early December. 

In late December, with the stock around $42, another sell-side shop initiated coverage with a $50 price target.  Although the analyst’s model was not robust enough to estimate the impact of lower raw material costs, a chart of the historic price of WTI crude and KMB Healthcare’s operating margin showed that in 2008-2009 when oil plunged from $145 to the $30’s, Healthcare’s operating margin jumped from a depressed 7.3% to a high of 22.2% before stabilizing around 15%.  In addition, the report looked at eight prior healthcare spinoffs and found they, on average, outperformed the market by 4,180 bps in their first year.  HYH had performed in line with the market to that point and it seems the promise of another highflying healthcare spinoff drove HYH to outperform the market by 1,600 bps in the next nine trading days.

The market seems focused on the performance of prior healthcare spins, the high valuations of HYH’s comps -- which are hardly comps since no public company has commodity businesses like HYH’s S&IP segment, and HYH’s margins are the lowest in the group -- lower oil prices, an Ebola play; anything but fundamentals.  And what’s presently in Mr. Market’s blind spot -- ie, fundamentals -- is precisely what will take the stock down to fair value.   

Risks to our thesis

The biggest risk we see is continued declines in polypropylene and ABS.  HYH values the vast majority of its inventories using LIFO, meaning lower raw materials prices will benefit the P&L with a 1-2 month lag.  While GPOs and competitive dynamics will mean-revert excess margins, this will take time and HYH could appear, for a time, to be a margin improvement story.  However, one industry expert sees polypropylene as being in tight supply and expects prices to rise in the near-term. 

Catalyst

- 4Q14 revenues down mid-single digits, driven by tough comps and a higher USD.  4Q14 EBITDA down +20%.

- S&IP continues to face pricing pressure, and ON-Q continues to lose share to EXPAREL.

- HYH's first acquisition is dilutive in years 1 and 2.

- Priced for growth, growth is nowhere to be found.