Results for the third quarter of fiscal year 9/2022 highlighted strong order growth, stable margins and a business with defensive characteristics and long-term secular growth. Equities have corrected 40% year to date, but we do not see a material downside risk and believe this business continue composing. We rate the stock as a buy.
Carl Zeiss Meditec (OTCPK:CZMWF) is a German medical technology and device company specializing in ophthalmology (disorders and diseases of the eye) and microsurgery, with the former accounting for nearly 80% of total revenue. Its key competitive product is intraocular lenses (or IOLs) in the premium category used to treat cataract patients, with a global market share of 12% (page 12). It also manufactures LASIK laser vision correction machines. The core geography is Asia Pacific, which accounts for 50% of total revenue, with China being the largest single market. It is 59.1% owned by unlisted parent Carl Zeiss Group.
Key financial data, including consensus forecasts
A look at the YTD share price performance of lens/ophthalmology-related companies shows that Carl Zeiss Meditec has underperformed its peer group, even though Olympus (OTCPK:OCPNY) is arguably an endoscopy company gastrointestinal and other companies are more diversified, such as FUJIFILM (OTCPK:FUJIY) active in pharmaceuticals and Hoya (OTCPK:HOCPY) in semiconductor mask blanks.
Carl Zeiss Meditec strikes us as a composite business, with sustainably growing profits as it expands abroad and benefits from trends in aging demographics and rising myopia cases globally. In this article, we want to assess whether stocks are at risk to the upside given recent earnings and trading prospects.
Strong order visibility
FY9/2022 Q3 results highlighted strong underlying demand for its two key business segments, with orders growing 36% year-on-year and posting an all-time quarterly record. Geographically, the key driver of demand was Asia Pacific, followed by the US. There are some concerns about lengthening lead times beyond six months for delivery of microsurgery products. However, it appears that overall the company is managing to grow despite the challenging conditions of ongoing lockdowns in China, the Russian invasion of Ukraine, and supply chain issues.
FY9/2022 Q3 sales adjusted for FX were up 9.8% year-on-year, which is attractive, and EBIT margins stood at 20.7%, down from 23.9% of the last fiscal year, but it was due to proactive spending on marketing and research and development rather than cost inflation or price discounts. Gross margins reached 58.9% compared to 58.4% in the last fiscal year due to an improvement in the sales mix.
There have been some challenges that are evident in cash flow. Operating cash flow has fallen significantly year-on-year as the company built up safety-related inventory for key components given supply shortages. This will have a negative impact on free cash flow generation, but we believe management is taking the right course of action to meet visible customer demand.
Longer-term positive themes remain. Demand for cataract procedures is expected to increase from 25 million procedures annually to more than 35 million by FY2027 (about 6% CAGR), with demand for the company’s most premium offering expected to increase to as the need for more value-added lenses, such as bifocals, grows. (page 12). There is a secular theme in the rise of global cases of nearsightedness (nearsightedness) that will drive demand for more LASIK and other refractive procedures, given the high adoption of smartphones by youth and the heavy use of laptops and computers in the worked (page 13).
Stable margins to come
The company has steadily increased its operating margins from a minimum of 10% to more than 20% in the last 5 years, and in the medium term it has plans to continue investing in the business to expand. However, management believes that 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. Although there is no information on the contribution of such revenue, management has commented that demand appears to be “mainly sustainable” and should be able to offset any increases in operating costs, such as R&D and marketing, as the company looks to expand.
With the current macro environment, investors are tired of cost inflation. In this case, the company appears to be a price maker for its products with high underlying demand. Therefore, there do not appear to be any significant and immediate external influences negatively affecting profitability.
While we don’t expect operating margins to come anywhere near 30%, keeping it around 20% seems realistic and achievable under current conditions.
Based on consensus forecasts, the stock trades at 36.6x FY9/2023 P/E and a 2.6% free cash flow yield. These are not cheap valuations, but can be explained by 1) the defensive, high-yield nature of the business that places a premium, and 2) the company benefits from strong secular growth themes that are highly visible and understood by the market. .
Upside risk stems from trading strongly ahead of FY9/2022 guidance, increasing profitability as recurring revenue rises. The company is cash-rich, with approximately EUR746 million/USD746 million of net cash available for mergers and acquisitions for acquisitive growth, as well as potential increase in shareholder returns.
Downside risk comes from political risk, with China being a key profit driver for the business, as well as possible fluctuations in orders due to ongoing lockdowns. An appreciation of the euro against the US dollar will have a negative impact on the conversion.
Carl Zeiss Meditec is doing well, driving demand from key geographic markets for its two business activities. Valuations are not heavily discounted, but we see the YTD stock correction as an opportunity to invest. The business is not a high-growth MedTech, but a decent, stable quality franchise business with strong market leadership and high earnings visibility.