TFX | Recovery in Surgery Volume Sets Up Med Tech Long
Background
Teleflex Incorporated (TFX) is a large cap, medical technology company that provides a catalog of surgical products to hospitals, ASC's, and OEM's. The company's product sales are heavily tied to the recovery in surgery volumes both in the US and abroad. Utilizing our Quad-Factor screen, we identified TFX as a high probability long based where TFX ranks in terms of factor ranges that have historically outperformed in Quad 4: estimate momentum, enterprise value, margins, short interest, and multiples. Along with other Hedgeye Health Care Best Idea Longs (BDX, BAX, and HCA), TFX is poised to benefit from the release of incremental pent-up demand and has been pinned down by the Delta and Omicron Variants from 2H21 through 1Q22.
Teleflex’s share price has underperformed compared to the XHE index in the past year [1yr absolute performance: -$135.76 (-34.31%)], but slightly outperformed the index in the past 6 months [6mo absolute performance: -$60.82 (-18.96%)]. Over that same time period, consensus estimates have revised negatively, largely tied to supply chain disruptions and investments which they will soon begin to benefit from. While we do believe the Macro Quad 4 environment will continue to weigh on the market broadly, we expect that med tech is best poised for upside given the current state of the US Medical Economy.
Thesis
Although Healthcare historically performs well in Macro Quad 4, we prefer med tech due to its positive fundamental set-up into 2Q22 earnings and guidance for 2H22. The Delta and Omicron variants prolonged the “return to normal” from the peak impact of COVID-19. Following the rollover in cases in January 2022, the BA.2 variant has not resulted in a similar level of hospitalizations relative to previous waves. In response, non- COVID hospital occupancy, including surgical case volume, has continued to improve and looks as if it will continue to break to new highs as we get into the easier COVID compares in the second half of the year.
Apart from the favorable set-up for med tech patient volume, we specifically like TFX for the unique opportunity the company has to benefit from incremental growth in the US medical economy due to their portfolio of products. By maintaining a roughly 60% mix of durable core products, which has historically outperformed inpatient non-COVID occupancy growth since the beginning of the pandemic, the company has a built- in backstop for the recovery going forward. In addition to that backstop, Teleflex has acquired a portfolio of high growth products including UroLift, the family of Arrow products, and Manta. We have developed trackers for the number of UroLift trained, active physicians, as well as a highly- correlated Google trend result for the device as a search term.
While UroLift is currently the sole product in TFX’s interventional urology segment, the remaining high growth portfolio products tend to move directionally with it. Based on the evidence we’ve compiled, we believe we can defend the company’s comments made at their Investor Day last month that they “were ahead of expectations for UroLift in 2Q22." Furthermore, we believe we have developed a set of trackers to monitor growth going forward and are currently searching for subsequent resources to better map and measure the remaining facets of the high growth portfolio. Lastly, it is worth noting that the upside scenario is based on the recovery in surgery volume to pre- COVID levels and would be further boosted by the release of incremental pent- up demand.
Aside from the potential for outperformance from the top- line growth opportunities, Teleflex began making the significant investments necessary to improve their end-to-end to supply chain long before the pandemic. These cost improvement programs (CIPs) have already proven their ability to outpace inflation and will be instrumental in continuing the positive trend in adjusted gross margin which has improved from 54.9% in FY19 to 59.4% in FY21. TFX expects to close FY22 between 59.75%- 60.25%.
Despite management’s guidance of an additional $48MM investment to build TFX's current supply chain resilience and develop a global command center to track inventory by product line, we are re-assured that Teleflex has adequately addressed and quantified the margin impact in their guide. The company’s proactive approach to continually improve margins and insignificant dependence on chips (only two products) will serve as an additional tailwind in their outperformance during the recovery in surgery volumes.
Valuation
During the contraction, the company’s Price-to-NTM-Earnings multiple has fallen from its pandemic/all- time high of 29.9x in April 2021 to 18.6x today, bellow the bottom of its pre-COVID, historical range of roughly 19x-24x. Relative to the peer group we defined, the multiple looks to have moved on a directional basis almost in parallel with the other med tech names over the past year, but significantly more negative than the mega caps on a percentage basis.
Based on our estimates and utilizing TFX’s historical P/E range, we expect an upside scenario of 5%-35% from the current price. Despite the Macro Quad 4 landscape, med tech looks to be “set up” in the back half alongside the recovery of surgery volume and steady unleashing of pent- up demand. We are adding TFX to the Long Bench as we monitor our basket of highly correlated macro series for an inflection above consensus.
Catalysts
We expect timing for the long to improve the closer we get to the earnings release for 2Q22. We expect an in- line quarter and positive guidance for 3Q22 and 2H22 as comparisons ease. For 2Q22, TFX and the US Medical Economy have tough comparisons on patient volumes. For providers, wage inflation should peak in 2Q22 and ease into 2H22. With non-COVID volume accelerating against easing compares, TFX should have a positive set up to guide against.
Risks
Despite the aforementioned thesis and catalyst path, we have outlined the following risks to our thesis:
- Wage Inflation and Labor Scarcity Breaks Trend | From what we have seen in our data and heard anecdotally, staffing shortages and wage spikes within the US Medical Economy appear to be easing. While we do consider labor to be the most important theme within our space, it is a positive sign for surgery volume that these headwinds are beginning to fade. Staffing surgical case volume is less prone to the spikes in labor rates during the COVID peaks.
- Further Supply Chain Disruptions | During the company's investor day , management dedicated an entire segment to their outlook on the current supply chain and measures taken to proactively manage through them. Included in these remarks was management's $48MM investment to build TFX's current supply chain resilience and develop a global command center to track inventory by product line. The company has taken the necessary steps to withstand these headwinds, and has only two products which are dependent on chips.
- Surgery Volumes Remain Soft | We track not only US COVID volume, but also the mix of COVID versus non- COVID hospitalizations daily. Based on the Omicron wave, we do not expect subsequent variants to have nearly the effect of Delta in terms of hospitalization or media frenzy. Nonetheless, a variant breakout has occurred roughly every 4 months dating back to the initial lockdowns in 2020. Subsequent waves will further prolong the release of pent- up demand and sustain patience reluctance to return to care.
- Impact of Stagflation on the US Economy | Historically, medical utilization is insulated from economic downturns, although the current growth and inflation back drop is unlike anything we've seen in the modern US Medical Economy. Consumers will typically accelerate medical spending into a Quad 4 slowdown, but the inflationary pressure may discourage routine visits to a provider. In our claims data we've seen a pattern that suggests this may be happening, with higher acuity imaging volumes accelerating compared to patient visits to a doctor.
Key Slides
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