Results for the third quarter of fiscal year 9/2022 highlighted strong order growth, stable margins and a business exhibiting both defensive characteristics and long-term secular growth. Equities have corrected 40% since the start of the year, but we see no major downside risk and believe this activity keep composing. We price stocks as a buy.
Carl Zeiss Meditec (OTCPK: CZMWF) is a German technology and medical device company specializing in ophthalmology (eye disorders and diseases) and microsurgery, the former accounting for nearly 80% of total revenue. Its main competitive product is intraocular lenses (or IOLs) in the premium category used to treat patients with cataracts, with a global market share of 12% (page 12). It also manufactures LASIK laser vision correction machines. The main geographical area is Asia-Pacific, which accounts for 50% of total sales, with China being the largest market. It is 59.1% owned by unlisted parent company Carl Zeiss Group.
Key financial data, including consensus forecasts
A look at the year-to-date share price performance of lens/ophthalmology-related companies shows that Carl Zeiss Meditec has underperformed its peer group, although Olympus (OTCPK: OCPNY) is a major player in gastrointestinal endoscopy and other firms are more diversified such as FUJIFILM (OTCPK: FUJIY) active in pharmaceuticals and Hoya (OTCPK: HOCPY) in semiconductor mask blanks.
Carl Zeiss Meditec appears to us as a company that is sustainably increasing its profits as it expands overseas and benefits from aging demographic trends and increasing myopia cases globally. In this article, we want to assess whether equities present an upside risk given the recent trading and earnings outlook.
High order visibility
Results for the third quarter of FY9/2022 highlighted strong underlying demand for its two key business segments, with orders growing 36% year-on-year, setting an all-time quarterly record. Geographically, the main demand driver was Asia-Pacific, followed by the United States. The lengthening of delivery times to more than six months for the delivery of microsurgical products raises some concerns. However, it would appear that overall the company is managing to grow despite difficult conditions due to continued lockdowns in China, the Russian invasion of Ukraine and supply chain issues.
Currency-adjusted Q3 FY9/2022 sales grew an attractive 9.8% year-on-year, and EBIT margins remained at 20.7%, compared to 23.9% for the prior year, but were due to proactive marketing and R&D spending, as opposed to cost inflation or price discounts. Gross margins increased to 58.9% from 58.4% in the prior year due to an improved sales mix.
There have been a few challenges that are evident in cash flow. Operating cash flow was significantly reduced year over year as the company built up inventory related to safety stock for key components in light of limited supply. This will negatively impact free cash flow generation, but we believe management is taking the right course to meet visible customer demand.
The longer-term positive themes are still in place. Demand for cataract procedures is expected to grow from 25 million annual procedures to over 35 million by CY2027 (approximately 6% CAGR), and demand for the company’s higher-end offering is expected to increase as the need increases for higher value lenses such as bifocals (page 12). There is an age-old theme in the rise in global cases of nearsightedness (myopia) that will drive demand for more LASIK and other refractive procedures, given the high adoption of smartphones by young people and the heavy use of laptops and computers at work (page 13).
Stable margins ahead
The company has steadily increased its operating margins from teens to over 20% over the past 5 years, and in the medium term plans to continue investing in the business to grow. However, management believes it can maintain margins above 20% while doing so. Is this a realistic prospect?
The sales mix continues to improve, generating what the company calls “recurring revenue” in the form of consumables, implants and services. While there is no disclosure on the contribution of these revenues, management said demand appears to be “mostly sustainable” and should be able to offset any increases in operating costs such as R&D and marketing as the company aims to expand.
With the current macroeconomic environment, investors are weary of cost inflation. Here, the company appears to be a price maker for its products with strong underlying demand. Therefore, there do not appear to be any immediate and major external influences that will negatively affect profitability.
While we do not anticipate an increase in operating margins towards 30%, maintaining around 20% seems both realistic and achievable under current conditions.
Consensus forecasts have the shares trading at a FY9/2023 P/E of 36.6x and a free cash flow yield of 2.6%. These are not cheap valuations, but it can be explained by 1) the defensive and high yielding nature of the company which places a premium, and 2) the company benefits from strong secular growth themes which are very visible and understood by the market.
Upside risk stems from trading significantly ahead of FY9/2022 guidance, increasing profitability as recurring revenue grows. The company is cash-rich, with approximately €746 million/$746 million of net cash available for mergers and acquisitions, as well as potential increased returns for shareholders.
Downside risk comes from political risk, with China being a key earnings driver for the company, as well as potential fluctuations in orders given continued lockdowns. An appreciation of the euro against the US dollar will have a negative impact on translation.
Carl Zeiss Meditec is performing well, driving demand from key geographic markets for its two business activities. Valuations are not hugely discounted, but we view the year-to-date correction in equities as an opportunity to invest. The company is not a high-growth MedTech, but a decent, stable franchise business with strong market leadership and high earnings visibility.