Description

ICU Medical

Investment Summary:

ICU Medical is a great business available at a reasonable price. It is our largest position today as we believe that the underlying value of the company is not evident to the casual observer but soon will be. We feel confident that the company’s turnaround under the watch of a new and motivated CEO will be successful, and that buying shares today will generate satisfactory returns over the next three to five years. The following are the reasons that bolster our belief:

• High margin business with sticky and recurring revenues.

• Macro factors are providing tailwinds for sustainable international growth.

• The company’s state-of-the-art manufacturing unit is hard for competition to duplicate.

• The investment phase in the company’s manufacturing capex and excess R&D cost is winding down, and the harvest phase should begin in the no-so-distant future.

• Executive management reset. The founder/CEO, Dr. George Lopez, has retired and has now been replaced by a motivated CEO, Vivek Jain. We believe the new management is steering the company in the right direction to enhance the shareholder value.

Business:

ICU Medical (ICU) is the leader in the development, manufacture, and sale of innovative medical devices in the following applications: Infusion Therapy, Critical Care, and Oncology. The company markets its products in US and several other countries through direct sales or OEM relationships. The company’s products improve patient outcomes by minimizing bloodstream infection risks and also protect nurses from exposure to infectious diseases or hazardous drugs. For a detailed discussion, we refer the reader to ICU’s 10K filed with the SEC and the investor presentation on the company’s website.

Investment Case:

Dr. George “Doc” Lopez founded ICU in 1984 and served as its CEO for 30 years ending Feb 2014. Also, the average tenure of the executive team excluding Dr. Lopez was over 17 years before Vivek entered the scene. One can imagine the inefficiencies that are likely to creep in when there are no fresh eyes to look at the business. As an example, pasted below is the statement by ICU’s research-and-design tooling engineer in April 2008:

“Doc doesn't care how we use our time, as long as we're available to work when he has a new idea and needs us"

Wonder what they did when “Doc” had no new idea or did not need them. Clearly the company was not run professionally to maximize the returns to the shareholders. Fortunately, they had a high margin, secure business from Hospira to fund the hobbies; therefore, the ROI of R&D projects probably were not a high priority. Also, expanding manufacturing to excess capacity years ahead of booking sales exemplifies inefficient capital allocation strategies followed by prior management.

The company put itself up for sale in 2013 but was unable to attract adequate interest. CareFusion, Vivek’s employer at that time, was rumored to be one of the bidders. Vivek may have had an inside look at the company, and that may have helped when the company initiated a CEO search a few months later upon the retirement of Dr. Lopez. He evidently noticed an opportunity big enough to leave his comfortable position at CareFusion as President of one of the two operating divisions. The following developments subsequent to Vivek’s hire are the reasons we are confident about the future prospects of the company:

1. The prolonged transition period induced uncertainty among the ICU’s employees and its distributors. The new CEO bought the focus back to the company, taking a closer look and instituting performance based incentives, rationalizing costs, and consolidating where necessary. For example, the company ended 2013 with about six separate salesforces. In just six months, the business functioned with just two.

2. The company neglected to focus on areas of growth, resulting in a poor capital allocation strategy. The company is a clear leader in oncology, producing innovative devices in the field. Unfortunately, sub-optimal emphasis on this business unit did not help it reach its full potential. Also, OUS sales could have used an additional impetus to deliver additional growth. The company also deployed disproportionate dollars on R&D and manufacturing capex. Operational improvements and cost cutting will reduce SG&A spending in FY2015. We should see an additional $10MM in the cash flows, a significant FCF improvement.

3. ICU has been Hospira’s OEM supplier since 1995 and will remain so, at least until 2018. Every needle-free connector or product which Hospira sells, is an ICU product. As shown in the table, the company has maintained significant customer concentration throughout the past decade. Due to new GPO relationships, the metric has trended down and is projected to constitute a third of worldwide sales. Growing international sales is a major initiative of the new management. We believe growth in international sales will further minimize the concentration risk while increasing the topline.

4. The majority of the company’s products end up at in-patient hospital settings, hemodialysis clinics, home infusions, surgery centers, etc. The manufacturing process is difficult and very complicated, supported by volumes of clinical data. That makes the company’s products very sticky and difficult to duplicate. The consistency in sales is a testament to this fact.

5. Throughout past decade, the company has spent a disproportionate amount of money in automating the manufacturing process, transforming itself into low-cost producer in the industry. New shareholders will enjoy the fruits of this spending, if the topline improves in the coming periods.

6. Over past three years, the company has spent extraordinary amounts on R&D, the first products of which will start rolling out in FY 2015. New oncology products and changed regulation requirements will provide nice tailwinds for the company to grow revenues in the current fiscal year and beyond.

7. Recently the company has revamped management, bringing in an experienced professional to head the underperforming Critical Care business. We believe the organizational change will contribute positively to the company’s bottom line.

8. Management’s incentives are based on performance and therefore in perfect alignment with shareholders. Furthermore, the new CEO made $1.7MM worth of open market stock purchases upon arrival.

To summarize, we believe the company is undergoing dramatic changes internally, benefits of which will be visible in the future financial statements. Below are the CFO’s remarks in the company’s recent earnings calls:

“Now before we open up for questions I would like to say that I have been CFO here now for six years and the changes over the last three months in how we are examining our cost infrastructure and how we are developing and executing on long-term plans has been the most activity that we have had in my tenure. Overall our team is very excited about the positive changes we are implementing throughout our organization.” – 2014 Q2

“Lastly, I believe it's important to know that the initiatives that we began implementing after Vivek arrived are beginning to take shape. And while there is still more to do, it's exciting to be part of the beginning of driving the company through greater earnings and growth opportunities.” – 2014 Q3

Valuation

ICU Medical is a predictable business that has performed in good times, as well as bad. Historically, ICU has been profitable and generated cash during recessions with minimal loss in the top line. The revenue growth of 13% and 22% for 2009 and 2010 demonstrates the resiliency of the business, even in the face of distressed market environments. In our view, the opportunity exists today because the market is underestimating the company’s earning potential, especially under the guidance of new management. The company trades at 10x estimated EV/EBITDA for the year 2016. The comparative businesses in medical devices are trading at 13x multiples, implying that the market has not fully valued the positive changes the company has made over the past three quarters. Also, we differ from the consensus view and believe that it can grow the international business, which the market seems to ignore. In our view, the fair value, if valued on par with other companies in the space, should be about $100 per share, and we see the PPS drifting higher in coming years.

Risks

We consider an investment in ICU Medical as a low-risk proposition. However, below are a few risk factors an investor should be aware of:

• Customer concentration is a significant risk consideration in our view. We are comfortable with this risk for the following reasons:

  • Hospira and ICU has had successful partnership for over two decades and current agreements extend to 2018,

  • the healthcare workers in large hospital settings do prefer reliable, high-quality products, especially when it involves bloodstream transfusions,

  • ICU is poised to reap the rewards after sinking cap ex into automating the manufacturing process.

• The FDA ordered recall of Hospira’s infusion pumps early last year. Since ICU’s products serve downstream to these pumps, the recall has had a material effect on ICU’s topline. If the situation worsens, ICU OEM revenues will decline further.

• Due to the restructuring that is underway, quarter-to-quarter financial information is somewhat unpredictable in the short term. Since we invest for the long-term, we are not too concerned.

• Regulatory/recall risk.

• Execution risk.

   

Catalyst

• At the end of 2014, we project the company to have about $350MM in cash and no debt. We trust management to make intermediate-term, accretive acquisitions at favorable multiples. We believe Vivek is waiting for an opportune time to put the cash to work and will make a move sometime in next few months.

• As the year progresses, the operational improvements will be visible in the financial statements, and ICU’s market value will re-rate accordingly.

• Our bet is that Vivek Jain will surprise the market with his execution and capital allocation skills and will enhance the intrinsic value of the company in the next few years.