Analyst Note | Updated Nov 06, 2020
We are restarting coverage of Sweden-based medical device and sterilization company Getinge with a SEK 180 fair value estimate and narrow economic moat and stable moat trend ratings. We believe the shares are fairly valued and think the market has appropriately priced in upside related to short-term tailwinds associated with the COVID-19 pandemic (near doubling of ventilator sales) and the firm’s turnaround from past quality-control and regulatory difficulties.
We expect Getinge will maintain strong market positioning in key markets--such as life science sterilization, advanced ventilators, and operating room capital--and will slowly improve margin through a focus on U.S. market expansion and cost restructuring. We also expect Getinge will increasingly prioritize sterilization and biopharmaceutical workflows as it attempts to challenge wide-moat Sartorius and narrow-moat Steris. With restructuring and regulatory costs winding down, we think Getinge is on the right track to becoming a more stable and profitable business.
We award Getinge a narrow economic moat rating from switching costs, and we see particular strength in sterilization (about 25% of revenue) from the consumables and service revenue generated on sterilizers, washers, and sterile transfer systems, which can have lifecycles approaching 10 years. While we think sterilization drives Getinge’s moat, we do not think other parts of the business are value-destructive, and certain subsegments, such as life support and advanced ventilation, also have traces of an economic moat. For a company primarily known for providing hospital equipment, such as sterilizers and surgical tables and lights, Getinge has built a moatworthy razor/razor blade business, in our view, with 60% of total revenue from recurring consumables and service.
Business Strategy and Outlook | Updated Nov 05, 2020
Sweden-based medical device and sterilization company Getinge has managed through several years of operational and reputational challenges, and with the darkest days behind it, the company is focused on improving operating efficiency and building back trust with customers. To accomplish this turnaround, Getinge has committed nearly SEK 2 billion to remediation and restructuring related to the 2015 consent decree imposed by the U.S. Food and Drug Administration and about SEK 1.8 billion in provisions for surgical mesh liability costs. It has also divested its entire extended-care business. Although additional regulatory challenges remain a risk, we think Getinge is set to maintain strong positioning in key markets (such as life science sterilization, advanced ventilators, and surgical capital equipment) and slowly improve margin through a focus on U.S. market expansion and cost restructuring.
We anticipate Getinge will pursue several small to medium-size acquisitions over the coming years; it is likely to seek out companies that can further expand the sterilization portfolio to enhance contract bundling. We expect Getinge to increasingly prioritize sterilization and biopharmaceutical workflows to compete with companies such as Sartorius and Steris, and less moaty product areas such surgical tables and vascular devices will be less of a focus because of high competition and lower margins.
In general, Getinge’s outlook is generally positive, with restructuring and regulatory costs winding down, and business results indicate the company is benefiting from early success with margin-improvement efforts. Comparative results are difficult because of the distortion from the pandemic. Even still, we are convinced Getinge is on the right track to achieving a more stable and profitable business, and we think selling and general costs will decrease (as a percentage of sales) in the coming years as Getinge continues to disentangle its operations from the 2017 divestment of its extended-care business and the tail-end of its major restructuring programs.
Economic Moat | Nov 05, 2020
Getinge has a narrow economic moat supported primarily by high customer switching costs in sterilization, which we consider to be the most moatworthy of the business units.
The firm’s sterilization business, which includes hospital sterilization, biopharmaceutical sterilization, and sterile transfer, has high switching costs in our view, with sterilizers requiring closed-loop sterilization consumables during their full lifecycle, which can range up to seven or eight years. The sterilization business is about 25% of total revenue, by our estimate, and includes the full life sciences segment and approximately one half of surgical workflows. When we consider the additional switching costs of the closed-loop extracorporeal membrane oxygenation life support system, and traces of intangible assets in ventilation and anesthesia, we see enough product lines and business units with moats to justify a narrow moat rating. While less than half of revenue can be specifically tied to moatworthy product lines, we think Getinge’s moaty segments contribute a greater share of operating income, and the remainder of the business is not destroying shareholder capital, which allows us to be confident in returns exceeding cost of capital over the next 10 years.
With 60% of revenue coming from recurring revenue, which include consumables, equipment service, and equipment leasing, the company benefits from high switching costs, and the installed base of equipment generates high-margin consumable and service revenue for years in the future, beyond the initial capital purchase. Based on previous disclosures by management, we estimate service accounts for one third of this recurring revenue, or approximately 20% of total sales. These switching costs can be very strong, and consumables and service can account for 3-5 times the initial capital purchase price. Many of Getinge’s capital sales, such as ventilators, sterilizers and washers, generate guaranteed revenue far into the future, which can stretch into the eight to ten-year time horizon; this supports our narrow economic moat rating.
Getinge’s acute care therapies segment (55% of revenue, 70% of midcycle operating profit) can be subdivided into four product areas: critical care, vascular systems, cardiopulmonary, and cardiac systems. While not all products in these three segments have clear switching costs, the switching costs of the business combined with traces of intangible assets, particularly with the patented NAVA ventilator system, provide enough evidence, in our view, for the presence of an economic moat.
While standard ventilators are commoditized, with a well-established technological baseline, Getinge only competes in the advanced ventilator space; these types of ventilators have technology such as advanced monitoring and automated ventilation settings. We believe many customers choose Getinge ventilators for these features, despite the higher cost. Despite ventilators becoming an increasingly unpopular option for COVID-19 treatment, they will remain a crucial component of intensive care in a postpandemic environment, with about 30% of all ICU patients on ventilators at any given time. The importance of ventilators for critical care, the company’s existing installed base, and practitioner familiarity with Getinge ventilators lead us to conclude that ventilation is, at worst, a cost of capital business for Getinge and potentially also a source of moat.
Additionally, we have a positive view of Getinge’s innovative and patent-protected Neurally Adjusted Ventilatory Assist ventilator system, which eliminates the need for full sedation and uses the patient’s own breathing to regulate ventilation. This less intensive approach could become increasingly popular, as the systems can shorten the time of mechanical ventilation by about 35% for adult patients in intensive care. While NAVA ventilation is unlikely to become the gold standard for ventilation at least in the short term, because of the long ventilator lifecycle and NAVA’s higher cost compared with basic ventilators, Getinge’s innovation in the space provides additional support for a moat in critical care. The traces of intangible assets that we see here are also likely to cement switching costs because of the lack of similar alternatives provided by other ventilator companies.
We do not think Getinge has a moat in vascular systems. In our view, covered stents is not a market that is prone to moats because of the ease of switching to new surgical stents for operations when competitive innovation occurs. Still, we have a positive view of the firm’s patented Advanta V12 balloon covered stent, used for less invasive endovascular surgery to treat atherosclerosis (plaque buildup in the arteries). Evidence has shown that covered stents, which are stents with outer drug-based barriers, can provide additional patient protection from complications and can be safer than bare metal stents. While these statistics are relevant to compare the Advanta with inferior alternatives, such as open surgery and bare metal, a comparison with other covered stents is more apt. According to a recent article in the Journal of Vascular Surgery, the Advanta is the only stent with statistically significant long-term clinical data. Still, over time, we expect other covered stents will also get meaningful long-term data, and while the Advanta has an advantage in the short term, we believe this competitive advantage will be eroded over time.
In cardiopulmonary, Getinge’s Cardiohelp system, which is used for extracorporeal membrane oxygenation, otherwise known as life support, requires a single-use centrifugal pump, which Getinge refers to as an HLS set, and cannulas (a type of tubing) that connect the HLS set to the blood vessels. Both the set and cannulas are single-use, and therefore a constant supply is needed to operate the system on a regular basis. When the system debuted in 2012, it was the smallest system on the market. Getinge has maintained a top-three position in life support over the past decade. We see clear evidence for switching costs with this product, given the single-use component of system consumables.
And finally, in cardiac systems, Getinge’s main product line is related to intra-aortic balloon counterpulsation therapy (which helps the heart pump blood during hospitalization). Like the Cardiohelp device in cardiopulmonary, this segment benefits from switching costs because single-use intra-aortic balloons are required for each instance of operation with the Cardiosave system. However, Getinge has experienced recent regulatory issues with the Cardiosave system, so we hesitate to confidently state there is a moat in cardiac systems.
In surgical workflows (35% of revenue, 20% of midcycle operating profit), while we do not see evidence for an economic moat in the capital business, we do see an economic moat in sterilization within surgical workflows, which is about 40%-50% of segment sales (and likely over 50% of operating income). In recent years, Getinge has struggled to generate strong margin in this segment because of historical structural inefficiencies, ongoing costs related to the divestment of the Arjo extended-care unit, and difficulty improving profitability because of the high percentage of goods cost related to purchasing. Despite these challenges, we expect margin to improve over time due to reduced divestment-related costs, restructuring initiatives, and strength in sterilization. We see enough evidence of switching costs to award a moat to the segment as many surgical workflow product lines, such as sterilizers and endoscope reprocessors, generate much of their revenue from recurring consumables.
While surgical tables and lights are not particularly moatworthy on their own, given the low complexity of these products, Getinge provides 1 in 3 surgical tables worldwide and has meaningful share in the surgical lighting market. In our view, market share in these product areas is sticky because of Getinge’s negotiating power with the healthcare middlemen such as group purchasing organizations, and with Getinge’s broad portfolio in the surgical arena, hospitals have few alternatives for many crucial acute-care products, such as advanced ventilators, endovascular stents, mechanical circulatory support, and anesthesia.
Getinge also sells endoscope reprocessing systems, which generate consistent recurring revenue and have an average life cycle of about five to ten years. Additionally, Getinge’s strength in endoscope reprocessing is supported by its T-Doc endoscope management system, which supports switching costs by integrating Getinge technology into the healthcare workflow.
Getinge’s smallest business segment, life sciences (10% of revenue, 10% of midcycle operating profit), has an economic moat, in our view. This segment contains a similar product portfolio to surgical workflows, although the end market is different, with life science products and services primarily offered to pharmaceutical and biotechnology companies. Products in life sciences include sterilizers, isolators, and washer/dryers, which require high-margin consumables that support margin, despite lower margin on the initial capital. Getinge has a top market position in sterile transfer, which allows materials to be moved between sterile zones as part of pharmaceutical and biotechnology workflows, either with sterile bags or using portlike transfer systems. This aspect of the life sciences workflow is critical, and Getinge is established as a leader in the space. In some cases, the port transfer systems are built into the lab building walls, and with Getinge’s sterile transfer bags required for the transfers, these installations generate high switching costs. With life sciences relatively unaffected by the regulatory hurdles of the firm’s other segments, and with clear evidence of switching costs in the unit, we believe the segment earns an economic moat.
Fair Value and Profit Drivers | Nov 06, 2020
We are restarting our coverage of Getinge with a fair value estimate of SEK 180 per share, corresponding to a 2021 price/adjusted earnings multiple of 22 times and an equity value/ adjusted EBITDA multiple of 10 times.
We forecast operating margin ending 2020 at 14%, though we anticipate margin will decrease in 2021 from a combination of more-normal operating costs (hiring and travel) and reduced operating leverage due to lower pandemic-related demand for ventilators. We think operating margin will be 11.6% in 2021 and that expansion will average about 30 basis points over the following three years. We model gross margin expansion of 60 basis points over 2021-24, with increases related to newer product developments in ventilation and sterilization and a push into the higher-margin U.S. market. We anticipate five-year GAAP earnings per share compound growth of 19%.
Our expectation for business improvements in surgical workflows, the firm’s lowest-margin business unit, is offset in our model by slower top-line growth in the later years of our forecast period. We anticipate a normal level of growth in the 3%-3.5% range, and while Getinge’s recurring revenue base provides a buffer to unexpected macroeconomic distress, high competition in key markets limits upside potential for longer-term sales growth. On balance, we think Getinge will be moderately successful in its turnaround efforts, but recent underperformance will weigh on long-term business results, and Getinge will be challenged to achieve consistent earnings growth above the midsingle digits.
Our narrow moat rating, and the associated 10-year stage 2 in our model, accounts for SEK 12 of our SEK 180 fair value estimate. We estimate stage 2 EBI growth and return on new invested capital of 4.25% and 22.5%, respectively.
We use an 8.4% weighted cost of capital in our model, and we assume Getinge has an average level of systematic risk to equity and moderate credit risk.
Risk and Uncertainty | Nov 05, 2020
We have a high fair value uncertainty rating for Getinge.
We see a risk that Getinge will incur greater-than-expected costs to resolve surgical mesh product liability claims. While the firm has already provisioned SEK 1.8 billion, costs could eventually exceed this figure. We note that Getinge increased provisions related to consent decree remediation and restructuring in 2017 by about 33%, from SEK 1.5 billion to nearly SEK 2 billion. Beyond the consent decree and mesh litigation, additional quality-control problems have come to light in recent years, such as the 2019 intra-aortic balloon pump recall, and we think this could lead to greater scrutiny and slower approvals from regulatory bodies. Over time, these delays and associated scrutiny could compound, and Getinge may fall behind peers in key markets.
We also think there are uncertainties regarding Getinge’s business fundamentals and management execution. Notwithstanding a profitable 2020 generated by COVID-19-related demand for ventilators, Getinge’s management team, in place since 2017, has yet to show consistent, long-term performance, and restructuring and divestments have obscured the financials of the core business. Margin expansion remains highly uncertain, and with management reticent to provide concrete margin goals, we think there is a risk that Getinge is chronically underperforming its medical device and sterilization peers in profit generation. Although we believe it will be difficult for Getinge to regain its former stature, we think the firm’s brands and competitive advantages have not been permanently impaired and that the firm maintains moatworthy switching costs.
Additionally, intangible assets account for over half of the firm’s asset base, and while intangible write-downs have diminished each year since the SEK 270 million reported in 2017, future write-downs could call into question the firm’s capacity to leverage existing competitive strengths into longer-term shareholder value.
Stewardship | Nov 06, 2020
Getinge earns a Standard capital stewardship rating.
CEO Mattias Perjos has led the company since 2017. He was previously CEO from 2012 to 2017 at Coesia Industrial Process Solutions, an industrial and packaging solutions company. Perjos took over Getinge's leadership following the departure of Alex Myers, who held the CEO role for just 18 months before leaving due to an undisclosed difference of opinion with the board. Although we have some concern about Perjos’ lack of healthcare experience, we also think an outside perspective might provide be beneficial to Getinge; it could allow the firm to make material, business-changing decisions that would be more difficult under tenured management.
Minority shareholders should be aware that Carl Bennet, Getinge’s largest shareholder and a member of the board, has majority control of the company with 50.1% of the voting rights. Though Bennet owns 20% of the firm’s capital, the voting control is due to his holdings of 18.2 million Class A shares, which have additional voting power. While Bennet’s incentives are aligned with long-term shareholders due to his equity stake, insider control does pose some risks, such as giving minority stockholders limited power to change the firm’s strategic direction.
The board of directors comprises 14 members, 4 of whom are independent. The board’s composition additionally includes 4 employees and 3 major shareholders: Dan Frohm, Bennet and Johan Stern. We think the inclusion of employees on the board, which follows the codetermination model common in Europe, helps to incorporate different stakeholder views into board decisions, although we would typically like to see more board independence. In our view, while having two former CEOs on the board (Bennet and Johan Malmquist) could benefit the firm because of better continuity and shared experience, it may also be difficult to fully incorporate fresh perspectives, particularly because of Bennet’s majority voting power.
We think Getinge’s management has effectively managed the balance sheet, and leverage and interest coverage ratios have steadily improved over the last few years. While interest coverage (and associated balance sheet health) fell in 2017 due to business difficulties related to the firm’s regulatory and quality-control problems, we believe this was due to poor execution of previous management teams, and we would be hard-pressed to assign blame for these past issues to current management. Additionally, Getinge’s largest problems occurred at Atrium, which was acquired in 2011, and therefore it is unlikely, in our view, that the issues that arose in 2013-16 were related to longstanding structural quality-control issues.
While Getinge has not repurchased shares, it aims to pay out 30% of net income to shareholders in the form of dividends. We have some qualms with the firm’s historical dividend policy, as we believe Getinge should have utilized all available capital to improve quality-control issues when concerns were first brought to light by the regulatory bodies in 2013, which could have prevented the years-long restructuring expenses that continue to this day. Still, with Getinge’s operations improving and growth steadying, we think the current dividend policy makes sense.
On balance, we think the firm’s healthy balance sheet, divestment of the struggling extended-care business (which reduced leverage) and path to shareholder value creation makes a Standard stewardship rating most appropriate. However, Malmquist and Bennet, who led the firm as CEO and chairman during the difficult 2012-16 period, still hold significant power as the current chairman and vice chairman, and we see some uncertainty on whether newer management, with Perjos as CEO, will be given carte blanche to make necessary business improvements. We would not hesitate to downgrade Getinge’s stewardship if it becomes clear that current management has been unwilling or unable to make the appropriate investments to improve the business. We think success, or lack thereof, in this area will be borne out by growth and profitability metrics over the next few years.
