The medical instruments industry is a group characterized in part by diversity, and as such, there are ideas of all shapes and sizes. Let’s dig into two overvalued companies in the space and what put them in their current positions.
By Alexander J. Poulos and Kris Rosemann
The medical instruments industry has something to offer investors of all strategies. From growth candidates to defensive plays to dividend growth ideas, the medical instruments industry has you covered. However, we’re not seeing much valuation opportunity in the medical instruments industry at this point in time. The market’s advance post the election of Donald Trump has stretched many companies’ valuation metrics past historical norms, and this note intends to highlight two of the most overvalued names in the space. The list is by no means comprehensive but includes two of the most aggressively priced, from our point of view.
Mettler-Toledo (MTD)
Mettler-Toledo is the world’s largest manufacturer of weighing devices; its products are used in laboratory, industrial, and food retailing applications. Mettler’s reach is widespread through a multitude of diverse industries from precision lab equipment used for the research of new therapeutic products to commercial scales used to weigh heavy-duty trucks, but the most common everyday use of Mettler’s scale products is found in grocery store checkout lines via their incorporation into POS systems.
Mettler’s share price gains over the past five years have been nothing short of impressive, but one of our primary concerns at this juncture is the lack of meaningful sales growth over the past five years, a statement that appears to contradict the recent share price action. Though there has been some volatility, Mettler’s revenue has advanced a mere 7% since 2012, good for a compound annual growth rate of only ~1.4%, hardly the kind of growth that warrants a price of nearly 28 times the midpoint of 2017 earnings guidance. The inability to meaningfully grow revenue may very well be a sign the end market for Mettler’s products is mature, and rapid revenue and profit growth are simply not available. It is our opinion that Mettler should be classified as a low growth company in a mature market, yet shares continue to trade well above the upper bound of our fair value range.
Fueling Mettler’s advance has been the company’s ability to expand margins. The expansion of margins–it set a quarterly gross margin record in the fourth quarter–coupled with Mettler’s share repurchase plan allowed the company to post a double-digit increase in earnings per share in 2016. The stellar increase in the share price not only limits management’s ability to continue retiring a similar number of shares, thus restricting the boost to earnings per share figures, but it also makes repurchasing shares an increasingly value-destroying proposition as share prices continue to march higher (any buybacks above our fair value estimate range, we think are value destroying). Mettler spent $500 million on share repurchases in 2016, nearly $60 million more than it was able to generate in cash flow from operations. Clearly, we’re not fond of such aggressive value-destroying activity, and the executive team plans to buyback another $500 million in shares in 2017.
Looking ahead to 2017, management is expecting local currency sales growth to be approximately 5.5% over 2016 levels and adjusted earnings per share growth to be 12%-13%. This earnings guidance assumes a $0.31 benefit (roughly 2% of 2016 adjusted earnings per share) from the new accounting standard associated with the tax impact of stock option deductions, but it also reveals expectations for the company’s bottom line growth to continue outpacing its sales growth. Mettler is targeting EBIT margin expansion of one percentage point in 2017, a goal that becomes more impressive after considering the recent margin performance the firm has put up. Despite our admiration for Mettler-Toledo’s ability to continue expanding margins, there are too many red flags to get us interested in shares at current price levels. Our fair value estimate for shares of Mettler-Toledo currently sits at $317, well below its lofty share price.
Align Technology (ALGN)
Align Technology is another example of a stock whose share have impressed over the past five years. The outperformance has garnered the attention of momentum players who have stretched the company’s valuation far above a reasonable, fair value, from our point of view. Align’s primary product is the Invisalign Orthodontic system used in place of traditional braces. The advantage of the system is discretion; the system uses near invisible trays to correctly align the patient’s teeth. Its target demographic is a teenager with concern placed on ‘looks,’ as a mouth with metal braces draws unwanted attention, not to mention the embarrassing potential for food to be caught in the braces.
The Invisalign system continues to drive robust revenue gains, more specifically an attractive double-digit annual rate. As revenues continue to push higher, we expect margins to expand thanks to efficiencies of scale, and Align has not disappointed in recent years as its operating margin has grown to just over 23% in 2016 from less than 19% in 2011, while net revenues have advanced more than 75%. However, operating margin peaked at more than 25% in 2014 as currency fluctuations have hurt Align’s reported financial performance in the past two years, a negative side effect of the company’s international growth efforts. We view currency headwinds as largely transient and their impact is not reflective of the fundamental strength of the business.
Align Technology continues to expect impressive revenue growth moving forward; its long-term operating model calls for annual growth between 15%-25%, which is expected to be driven largely by continued growth in the Invisalign system. Such a target may be in danger of a downward revision after the FDA recently cleared two directly competing products from Dentsply Sirona (XRAY) and 3M (MMM) in early 2017. Management is guiding for 2017 sales growth to be above the midpoint of its long-term operating model despite assuming average selling prices (ASP) to be flat to slightly up from 2016. Align is still the undeniable leader in the invisible braces market, but competition is coming, potentially bringing pricing pressure with it.
Similar to its ASP pricing guidance, operating margins for 2017 are expected to be flat to slightly up compared to 2016 results, and we’re not expecting a company that continues to expand as rapidly as Align to pursue considerable margin-expanding initiatives of the cost-cutting variety at this point in time. In fact, strong marketing spending trends can be expected to continue in the near term. The catalyst for shares continues to be overall company growth, but we also like the company’s balance sheet as it holds more than $640 million in cash, cash equivalents and marketable securities and no debt as of the end of 2016.
Despite management’s expectations for robust growth to continue throughout its business, we see little opportunity to generate alpha via a position in Align Technology. Shares are trading well above the upper bound of our fair value range and are changing hands at more than 33 times 2017 consensus earnings estimates as of this writing. The company offers no income generation via dividend payments, though it is buying back stock, a move we see as significantly value-destructive at this point in time (similar to Mettler-Toledo’s situation). Over $96 million was spent on share buybacks in 2016, and the firm has $300 million available under its 2016 repurchase plan that was announced in April.
Investors chomping at the bit for exposure to a unique orthodontic technology appear to have missed the boat on this idea. Management is going to have to continue executing flawlessly to grow into its current valuation, in our view, and we wouldn’t be surprised to see shares punished for even the slightest disappointment. Competition may still not yet be a real threat to Align’s growth trajectory, but we would like to see management acknowledge the presence of new market entrants some time in the near future, if only to reassure investors that no stone will go unturned in its quest to grow into its overheated valuation. Our fair value estimate for shares of Align Technology is $74, below its share price.
Medical Instruments: ALGN, BAX, BCR, BDX, BSX, COO, HRC, MTD, NUVA, RMD, SYK, TFX, TMO, WST, XRAY