Description

Overview: Hill-Rom manufacturers hospital beds, surgical consumables and patient monitoring devices. SI/Float = 2.4%, $7.1b market cap, $2.0b in net debt (levered 3.3x) pf for 3/11/19 deal. Stock has tripled from 2014 low of ~$35. Market perception: recent acquisitions diversified HRC away from cyclical capital goods manufacturer towards a stable, recurring revenue, consumable business with good growth prospects. Trades @ 15x adj FY 19 EBITDA and 21x adj FY 19 EPS. HRC has grown “core revenue” in the 3% range from FY 14-18 and grown adj EBITDA margins from 16% to 20% over the same time. HRC’s long range financial plan (through FY 20) calls for an increase in “core revenue” growth to 4-5% and another 100bps of margin improvement.

Management changes: In 2018 HRC replaced both its CEO and CFO. As CEO, John Groetelaars replaced John Greisch (2010-2018… announced retirement on 1/26/18 @ 62 years old). As CFO, Barbara Bodem (MNK) replaced Stev Strobel (2014-2018… announced retirement on 11/27/18 @ 60 years old). Strobel will remain an advisor through FY 19. *Strobel has been a NWL board member for more than 10 years and remains head of its audit committee. On 1/18/19, Charles Golden chair of HRC’s audit committee resigned from the HRC board.

Reported “core” revenue growth of 3-4% is closer to 1%: HRC guides/reports revenue growth in 3 ways… GAAP, constant currency (CC), and core. Think of core as constant currency less: 1) acquisitions revenue prior to 12 month anniversary; and 2) divested segment revenue. (To better understand HRC’s core revenue growth games, see our prior NWL write-ups and remember Strobel connection to that company.) Management goes to great effort to convince markets that core growth is organic growth and that HRC should be evaluated using core growth rates. HRC manipulates core revenue by: 1) spring-loading acquisition revenue; and 2) rebasing revenue with non-core revenue exclusions.

1. Spring-loading is the process of holding back revenue during the first 12 months of an acquisition, then catching up once or spring-loading revenue once it is classified as core (organic) growth. Lower the base year and you speed up growth in each subsequent year. Spring-loading evidence… consistent base year revenue reductions for newly acquired companies:

1. 2/13/12 $81m Volker acquisition: Volker (base year) FY 12 revenue was $111m or $6m lower than reported FY 11 revenue of $117m.

2. 7/23/12 $402m Aspen acquisition: Aspen (base year) FY 12 revenue was $115m or $3m lower than reported FY 11 revenue of $118m. Per HRC, Aspen was growing in the mid-single digits when it was acquired.

3. 8/1/14 $250m Trumpf acquisition: Trumpf (base year) FY 15 revenue was $214m or $43m lower (17%) than reported FY 14 revenue of $257m. Per HRC,  Trumpf was growing at 6% when it was acquired.

4. 9/8/15 $2.1b Welch Allyn acquisition: Welch (base year) FY 16 revenue was $718m or $28m lower than adjusted revenue should have been. This one is a little more complicated… Welch revenue: FY 14 = $684m; FY 15 = $688m; FY 16 = $718m (base year). Per HRC, Welch was growing at 3% when it was acquired at the very end of FY 15. Also, during Q3 FY 15 (5/5/15), 4 months prior to the HRC/Welch deal, Welch acquired Scale-Tronix for $40m (est. $20m in revenue). Assuming FY 14 revenue is correct (most likely), Welch (base year) FY 16 revenue was $28m lower than it should have been.

5. 2/24/17 $330m Mortara acquisition: Mortara (base year) revenue for the 12m ending 6/30/18 was $96m or $19m lower (17%) than it was for the 12m ending 12/31/16 ($115m). Per HRC, Mortara was growing at 4% annually when it was acquired.

2. Rebasing is the process of excluding non-core revenue from the core growth calculation. Excluding Chipotle revenue from McDonald’s when calculating MCD’s core revenue growth post-split makes sense – but that isn’t what HRC is doing. HRC’s non-core exclusions hide mal-investment, hide growth strategies gone wrong and are, most importantly, never ending. In a business where new products are constantly growing and old products dying, HRC is simply reaching into the cookie jar and selecting some dying  segment/product and saying hey – exclude this from our revenue and growth is great! (Please see FCF manipulation for a deeper explanation of each non-core exclusion.)

1. In FY 17, $25m of Architectural Products and $10m of WatchChild revenue declines was classified as non-core.

2. In FY 17 and 18, $10m and $30m of Volker related revenue declines was classified as non-core.

3. In FY 17, 18 and 19, $10m, $30m and $40m of 3rd party rental and service revenue declines was classified as non-core.

4. In FY 19 and 20, $10m and $50m of International Surgical OEM revenue declines will be classified as non-core… possibly more.

3. Other notes about HRC revenue:

1. HRC revised financials to comply with ASC606 starting in FY 19. HRC expects revenue for FY 19 will be $14m below what it would have been under ASC605… but does not disclose what FY 18 would have been under ASC606. Recurring theme… GAAP revenue unchanged, but reduce base year revenue and presto… core organic growth!

2. FY 19 revenue guidance: GAAP = 1.5%; CC = 2.5%; Core = 4.5% implies a 1% FX drag. Core growth excludes: 1) ~$25m in incremental spring-loaded Mortara revenue; 2) $10m in Surgical Solutions revenue decline and $50m in PSS revenue decline mostly from UHS related wind-down.

3. Another little trick HRC uses to boost perceived topline growth is to call out “new” product revenue/growth. This practice started in earnest during Q4 17 – the quarter before CEO Greisch announced his resignation. Rather than going into details, suffice it to say that when they call out the Accella or Centrella bed or the Monarch Vest or any of the other products in this category, they fail to mention sales declines of related legacy products.

Reported adj numbers (EPS/EBITDA/FCF) significantly overstate profitability and incremental improvement: HRC guides/reports adj EPS and FCF but  does not guide or report EBITDA. HRC uses a number of tactics to make the company appear more profitable than it is:

1. Adj FY 19 EPS guidance of ~$5.00 is overstated by ~$2.00:

1. HRC backs out recurring special charges, settlements, integration costs, etc to the tune of about $0.80 a year… consistently over the last 5 years ($0.83 in FY 18).

2. HRC under-reserves for ARs, warranties, inventories and severance to the tune of about $0.12c a year… consistently over the last 5 years ($0.07 in FY 18).

3. 96% of HRC’s ~$3.2b in acquisitions over the last 7 years has been allocated to goodwill and intangibles which are excluded from adj EPS… impacting EPS by $1.00+.

4. In FY 17, 18 and 19 HRC’s tax rate was materially reduced by the significant appreciation of stock options issued in prior years to the retiring management team. The tax impact increased EPS by $0.13, $0.24 and an estimated $0.10 in FY 17, 18 and 19.

2. FY 18 EBITDA of $580m (20.3%) and FY 19 EBITDA of ~$600m (20.8%) are overstated and impacted by accounting tactics outlined below. Almost all “real” EBITDA growth is due to acquisitions – not organic improvements.

1. See recurring special charges/reserves (1a & 1b above)

2. Since FY 2012, HRC has spent $100m acquiring 4 vendors (Liko, Virtus, Triden, and “asset acquisition”) – often at E/O/Y or B/O/Y – effectively capitalizing ongoing expenses into goodwill. With the exact yearly impact on EBITDA impossible to calculate, adjustments are estimates. Do consider though, $60m of the $100m in acquisitions has occurred in the last 24m. Also consider:

1. All of HRC’s margin improvement has been in the hospital bed segment – where 3 of the 4 vendor acquisitions have occurred. Operating margins – which are reported on a segment basis – for the hospital bed segment have improved from 14% in FY 14 to 20% in FY 18.

2. It’s most recent vendor acquisition (the “asset acquisition”) was done in the Front Line segment and on the first day of FY 19. Front Line has struggled with margins for the last few years, so watch for improved results in q1 19! Spring-loaded Mortara revenue starts in the Front Line segment in q1 19 too.

3. Margin growth has been aided by lower margin divestitures (Volker, Surgical OEM, etc) and higher margin acquisition (Welch Allyn), not organic improvement. Front Line operating margins – which is largely Welch Allyn – are 600-800bps higher than the PSS segment.

4. Until its FY 18 10K, HRC grouped amortization of debt discount with amortization of intangibles, effectively facilitating an improper add back of ~$8m in below the line amortization into EBITDA.

3. FY 18 FCF of ~$300m and FY 19 FCF guidance of $330m are overstated and impacted by accounting tactics outlined below. Incremental improvement is once again largely due to acquisitions.

1. See capitalizing ongoing expenses into goodwill through vendor acquisitions (2b above), and also consider the potential for inter-company working capital balances to be manipulated. With the exact yearly impact on FCF impossible to calculate (each acquisition impacts FCF in more than the year it is made), adjustments are based on cash outlays for vendors to simplify.

2. Accounting for non-core divestitures/wind-downs artificially boosted CFO in FY 17, 18 and will again in FY 19/20. These are the same non-core assets which boost core revenue growth… two benefits for the price of none! While disclosure around non-core divestitures/wind-downs (be it total proceeds, retained working capital) is limited, there are some adjustments we can make. To begin… below is a chart which shows disclosed cash outflows associated with acquisitions and disclosed cash inflows associated with divestitures.

1. In FY 16, HRC sold WatchChild (perinatal business) to PeriGen for $11m. And in FY 17, HRC sold its Architectural Products business to Wittrock Woodworking for $5m. No accounting adjustment was made for these transactions – proceeds from the sale flowed through CFI and valuations seem somewhat reasonable.

2. In FY 12, HRC bought Volker for $81m – at that time Volker was doing ~$120m in revenue. Five years later, in FY 17, HRC sold Volker – or more likely a portion of Volker – that was doing $40m in revenue. (IR is tight-lipped about details). Before selling the company, HRC took a $28m impairment charge against long-lived assets and working capital. Upon sale it recognized a ~$1m CFI inflow. Did HRC receive only $1m for Volker??? More likely it generated ~$25m in CFO by reversing the write down.

3. In January 2015, UHS brought suit against HRC for anti-competitive practices relating to bundling rental/service contracts with bed sales. HRC had gotten into anti-trust trouble twice before for bundling contracts (settling a suit for $250m in 2002 and one for $337m in 2006)… and did again for effectively bundling underpriced rental/service contracts with overpriced bed sales (leveraging its ~70% market share). UHS/HRC settled the case confidentially on 5/1/18. As a result, HRC both conveyed rental equipment (~$23m in net PP&E - $90m gross?) to UHS and surreptitiously decided to wind-down certain of its rental/services business. Regarding growth strategies gone wrong (from rebasing revenue section): HRC told the market in FY 15: “the rental business is a very attractive to us financially; but more importantly, it’s a very attractive business to us from an overall value proposition that we have with our customers.”

1. The decision to not settle in cash and fully write down the PP&E before conveyance effectively turned a ~$25m CFO outflow in FY 18 into an unobservable CFI outflow… a gift of PP&E that never impacted cash.

2. The decision to wind down of the 3rd party services business (& part of the rental business?) likely resulted in the run-down of associated working capital from the businesses. This run-down is estimated to have boosted CFO by ~$10m in FY 18 & 19.

4. At the beginning of FY 19, HRC called out its International Surgical OEM assets as a non-core revenue component. This business was part of the $250M Trumpf acquisition and apparently some customers plan on insourcing their production capabilities. Presumably HRC will wind down the business and artificially boost CFO through working capital wind-down later in FY 19/20. Regarding mal-investment (from rebasing revenue section): Surgical OEM non-core revenue of $60m is 25% (!) of Trumpf reported revenue. Ie HRC is winding-down 25% of the Trumpf business 4 years after acquiring it.

1. HRC’s tax rate was reduced in FY 17, 18 and will be in FY 19 due to large, option value differences that grew from grant date to exercise date.

Cycle: US Healthcare expenditures @ $3.5T (~20% of GDP) are outgrowing US GDP by ~200bps per annum. Hospital cap ex (the best proxy for capital spending) account for 1/3 of the total spend and are growing at the same rate as aggregate expenditures. Hospital beds (<800K) have been ~flat/down a little over the last 20 years. Domestic population growth has been offset by: 1) continued outpatient/inpatient mix deterioration; 2) declining length of stay; and 3) higher utilization/hospital consolidation. On average, 60k beds (7.5%) are replaced annually in the US. Hospital clients are generally bulk/lower margin – larger hospital networks often have internal service teams. Long term care part of the business is faster growing, higher margin with good service contracts… but need larger sales teams.

Where are we in the cycle? Above mid-cycle, probably not peak but maybe close to it. Hospital profitability key driver… long cycle time means any concerns/uncertainty will likely delay purchase managers decisions about beds. Could that be 2020 elections? Maybe.

As for competition… Stryker and ARJOB SS are expanding their product lineups and likely taking some share from HRC.

Also… on 3/11 HRC acquired this https://www.youtube.com/watch?v=DVmTd69BPj0 for ~$200m @ ~5x sales

Catalyst

leverage, cycle