Description

Summary Thesis

Olympus Corp. (TSE: 7733) is a leading global medical device company with significant potential for operational and financial improvement. Specifically, Olympus has the potential to expand its Operating Margins from ~10% last year to upwards of ~20% over the next 3-5 years. San Francisco-based activist investor ValueAct Capital Management owns ~5% of the company. As outlined below, the company has recently agreed to appoint a ValueAct Partner and two additional non-Japanese med tech executives to its Board of Directors. We believe these Board appointments and other structural changes associated with the recently announced “Transform Olympus” plan represent an inflection point in the company’s history and clear evidence that management is prepared to execute on the company’s significant margin opportunity. At ~¥4,915 per share, Olympus has a market cap of ¥1.8tn (~$15bn USD), de minimis Net Debt and trades ~$60mm USD per day.

Company Overview
Olympus has three segments as described below and shown in Exhibits 1 and 2:

• Medical (~80% of revenue and ~92% of Operating Income):
  • Gastrointestinal (“GI”) Endoscopes business line represents ~54% of Medical segment revenue. GI Endoscopes are high-tech flexible tubes with a camera on the end. They are used for colonoscopies, stomach cancer screening, and similar procedures. In this key end market, Olympus has ~75% global market share, a massive installed base with high recurring revenue and extremely sticky doctor relationships
  • Endotherapy Devices business line represents ~13% of Medical segment revenue. Endotherapy Devices are single-use tools used in conjunction with Olympus’ GI Endoscopes. Surgical Devices represent ~33% of Medical segment revenue
  • Surgical Devices business line includes a variety of tools and services used during general surgery, gynecological surgery, urological surgery, ENT surgery, etc.
• Scientific Solutions (~13% of revenue and ~8% of Operating Income): Olympus’ Scientific Solutions segment is made up of high-tech microscopes and test & measurement equipment used in a variety of scientific and industrial end markets
• Imaging (~8% of revenue and no Operating Income contribution): Olympus was historically a major player in the personal and professional digital camera business so its Imaging segment is a legacy of its past. Today this segment is small, non-core and has operated at roughly breakeven margins in the past few years

Exhibit 1: FY Mar-2018 Revenue by Segment

Exhibit 2: FY Mar-2018 Operating Income by Segment (Excl. Imaging and Corporate)

Olympus Margin Opportunity

GI Endoscopes and Olympus’ other medical devices are mission critical, high cost of failure products which typically generate ~50% to 80% Gross Margins. However, due to Olympus’ historically undisciplined SG&A spending and unfocused R&D, Operating Margins dramatically trail both Japanese and US med tech peers. Specifically, Olympus delivered ~12% margins in its Medical segment last year vs. peers in the low 20% to low 30% range. See Exhibit 3. Olympus’ lower margins can largely be explained by the company’s excessive SG&A spending. Olympus’ SG&A (including R&D) was ~54% of revenue last year vs. closest Japanese and US peers in the range of ~35% to ~45%. See Exhibit 4. Given Olympus’ low consolidated Operating Margins, the company has the potential for tremendous earnings growth even if they only modestly normalize the cost structure relative to industry peers. Note that Terumo, the most comparable Japanese Medical Device peer, has SG&A equivalent to ~36% of sales relative to Olympus at ~54%.

Exhibit 3: Olympus Margin Benchmarking vs. Peers

Note: FY Mar-2018 shown for Olympus and Terumo. FY Dec-2018 shown for Boston Scientific MedSurg Segment and Stryker MedSurg Segment. Olympus Medical shown net of all corporate and other costs.

Exhibit 4: Peer Cost Benchmarking

Note: FY Mar-2018 shown for Olympus and Terumo. FY Dec-2018 shown for Boston Scientific (BSX) and Stryker (SYK).

What’s Changed at Olympus?

On January 11, 2019 the company announced “Transform Olympus,” which is a set of initiatives designed to improve the company’s profitability and governance. We believe that Transform Olympus represents an inflection point whereby Olympus has now made it clear that they are focused on increasing shareholder value. Highlights of the Transform Olympus plan include:

• Olympus announced plans to add 3 new Board members including a partner from ValueAct and two non-Japanese global medical device executives
• Made near term and longer term commitments to reduce cost and improve margins
  • In the near term, Olympus committed to freeze FY Mar-2020 SG&A expenses at FY Mar-2018 levels. As a result, FY Mar-2020e SG&A is expected to be ~¥10bn lower than FY Mar-2019e. ¥10bn of savings represents a ~1.2% Operating Margin improvement or an immediate ~10-15% increase vs. FY Mar-2019e Operating Income (excl. 1x items)
  • In the medium term, the company has committed to achieving ~15% consolidated Operating Margins within the next few years vs. ~10% in FY Mar-2018. The revised 15% margin target represents a modest ~100bps to 200bps upgrade vs. the company’s prior 13% to 14% Mar-2021 margin target that was provided in September 2018. Management has indicated that they will provide more detailed cost savings disclosures and timeline by fall 2019
  • Longer term, the company has indicated that they are targeting profitability in line with global medical device peers. As described above, our diligence suggests that Olympus’ most comparable peers have Operating Margins ranging from the low ~20% to low 30% range whereas Olympus’ Medical segment had ~12% Operating Margins last year
• Olympus CEO to step down on April 1, 2019 and will be replaced by current CFO
• Streamlined Medical segment organizational structure
  • Consolidated from five business units to two
  • One of these two business units will now be headquartered in the US and co-led by Nacho Abia, a non-Japanese leader who is currently CEO of Olympus’ Americas division
• Current Managing Director of Olympus Europe, Stefan Kaufmann, appointed as Olympus Chief Administrative Officer
  • Kaufman, who has spent his career outside Japan, will be responsible for global HR and talent
  • Kaufman is also one of the three incoming non-Japanese Olympus Corp Board members
  • Given labor savings represents a significant opportunity for Olympus, it is helpful that a non-Japanese executive will be both involved at the Board level and also responsible for implementing the global HR policies that the Board approves
• Olympus committed to review capital expenditure and working capital levels to sustainably improve free cash flow available for strategic M&A and shareholder returns
  • Note that Olympus currently has minimal Net Debt whereas most peers have Net Debt / EBITDA in the ~1x to 3x EBITDA range
    

Olympus’ Top-line Outlook and New Product Cycle

Over time, Olympus Medical has achieved MSD organic revenue growth driven by its exposure to attractive long term secular trends including an aging population and rising middle class globally. Additionally, Olympus has expanded its share in key product categories such as certain single-use products used alongside its GI endoscopes. As a baseline going forward, Olympus Medical segment revenue growth is expected to continue to benefit from these favorable tailwinds.

Additionally, Olympus is poised to benefit from a refreshed GI endoscopy product line that is expected to be launched in the near future. For context, Olympus has historically released a new GI product line every ~6 years. Due to the pent up demand that builds between product launches as well as premium capabilities that accompany the new products, Olympus has historically seen significant pricing and volume uplift in the years following a new product launch. As shown in Exhibit 5, Olympus Medical’s revenue growth accelerated by ~900 bps from low single digit to low double digit after its most recent GI new product launch in ~FY 2013. Although the company doesn’t provide precise expected product launch timing for competitive reasons, our diligence suggests that it will likely be within the next ~12 months. This product launch is a potential catalyst for the stock for two main reasons. Firstly, the product launch will provide an uplift to organic revenue growth, a key valuation driver for med-tech stocks. See Exhibit 6. Secondly, the accelerating revenue growth will provide a significant tailwind to operating margins given high contribution margins and high flow-through on price increases.

Exhibit 5: Olympus Medical Historical Organic Revenue Growth

Exhibit 6: Selected Med Tech Multiples vs. Organic Growth

Note: Peers include Terumo, BSX, SYK, BDX, MDT, STE, Hoya.

Valuation

From its current stock price, we believe that Olympus offers a compelling risk / reward given that it trades at a considerable discount to peers despite significant margin optionality. Exhibit 7 shows that Olympus trades at ~12x NTM EBITDA vs. closest peers in the 17x to 20x range.

Looking forward, if Olympus were to achieve ~18% consolidated margins, the shares would be worth ~¥7,800 to ~¥8,600, or up ~60% to 75% in just over two years. An 18% consolidated margin represents ~300bps expansion vs. the 15% target that the company has guided to thus far. However, our diligence suggests that 18% is achievable and still provides a margin of safety given that peer benchmarking, product level cost structure analysis and industry consultants all suggest that 20% margins are achievable over time. Additionally, the above valuation assumes an 18x to 20x PE multiple range which is a discount vs. Olympus’ medical device peers such as Terumo, BSX and SYK which currently trade at 29x, 26x and 23x NTM EPS, respectively. There would be considerable additional share price upside if the market were to ascribe a peer multiple to Olympus. See Exhibit 8 for an EPS and valuation sensitivity.

Exhibit 7: Olympus vs. Peer EBITDA Multiples

Exhibit 8: Olympus Valuation Sensitivity

Note: Assumes ~6% annual organic revenue growth from FY Mar-2018 to FY Mar-2022.

Risks

• Management execution

• Competition from single-use endoscopes in GI Endoscopes business line (e.g., Ambu)
• Competition from robotics in Surgical Devices business line (e.g., Intuitive Surgical)
• JPY strength: Olympus sells globally but manufactures mainly in Japan. JPY strength vs. USD / EUR would present a headwind to Olympus earnings
• Regulatory risks associated with legacy medical device litigation and issues

Catalyst

• Announcement of FY Mar-2020 guidance at FY Mar-2019 earnings release on May 10, 2019
• Election of 3 non-Japanese executives at June 2019 Annual Shareholders’ meeting
• New GI Endoscope product launch: expected next 12 months
• Revised medium term guidance and details on Transform Olympus margin improvement plan: expected at Fall 2019 analyst day
• Balance sheet utilization / portfolio optimization (share buyback announcement, strategic acquisitions, divestiture of non-core Imaging segment, etc.)