Investors are right to be sceptical of ConvaTec — the medical devices specialist is an expert in false starts. Chronic underinvestment in research and development and supply chain mis-steps have added up to inconsistent sales growth during the group’s life as a public company.
That, in turn, has left the shares almost a fifth below the 2016 float price of 225p. The question now is whether a revised strategy focusing on product range and increasing operating efficiencies will be enough to lift the stock out of the doldrums. That’s no sure thing: the risks to profit progress aren’t reflected in a forward earnings multiple of 22, a touch above the average for the shares since Karim Bitar was appointed chief executive almost three years ago.
The FTSE 250 constituent was founded in 1978 as part of what later became Bristol-Myers Squibb, the American drugs group. It sells products ranging from advanced wound dressings to continence care.
Bitar introduced a fresh strategy to strip back the product focus to four categories — advanced wound care, continence care, infusion care and ostomy — and a dozen global markets, led by the United States and China. The company also has tried to cut costs by streamlining its back-office functions. Annual spending on R&D is set to double to about $100 million a year, or around 5 per cent of revenue. That spending will continue for at least the next couple of years. It has been investing, too, in improving manufacturing and in marketing. The company aims to generate annual organic revenue growth ahead of the market rate of 4 per cent and will launch seven new products in the next two and a half years.
Guidance for full-year organic revenue growth has been raised to the top of the range of 3.5 per cent to 5 per cent, yet sales progress has varied and has been obfuscated by the pandemic. A recovery in elective procedures meant that the advanced wound care division had the strongest growth in the first half, at 16 per cent, but increased vaccination and reduced intensive care rates meant that the need for critical care products eased. Meanwhile, the ostomy business, which suffered from the worst historical underinvestment, delivered below-par 3.7 per cent growth.
Now annual comparatives for advanced wound care are set to get tougher and critical care demand is easing further. Admittedly, infusion care has been a more consistent performer, helped by demand for diabetes infusion sets, but even that has eased as customers are now well stocked. Group organic growth slowed to 2.2 per cent during the third quarter.
Of bigger concern to investors is the outlook for the margin. The company downgraded its guidance for the adjusted operating margin this year to between 18 per cent and 19 per cent, from the 18 per cent to 19.5 per cent suggested four months earlier. The reason? Higher costs for raw materials and freight than had been anticipated and an acceleration in spending on R&D and sales and marketing.
ConvaTec believes last year, results for which have yet to be reported, should be the trough as far as operating margins are concerned. The risk is that inflationary pressures persist and it is forced to keep upping expenditure to keep up with the competition. RBC Capital reckons “selling expenses are likely to be higher than consensus for 2022, and that there is a risk operating margins decline for one more year”.
The markets that ConvaTec serves are attractive. Its products treat chronic conditions, so there is the potential for recurring revenue, but given the challenges to margins and the uncertain outlook for revenue growth, the case for buying its shares is unconvincing.
ADVICE Avoid
WHY The risk of further pressure on margins does not seem reflected in the shares’ current valuation
DFS
DFS Furniture has cash burning a hole in its pockets and some of it looks set to head into shareholders’ hands. Plans to make special capital returns, via a special dividend or share buybacks, will be announced at the release of the sofa seller’s interim results in March, after a post-lockdown rebound in sales.
Analysts had already inked-in an ordinary dividend of 12.87p a share for the financial year to June, which alone would equate to a dividend yield of 5 per cent at the present share price.
The company has had the wind at its back during lockdown periods thanks to a strong housing market and the high level of cash that people have available for discretionary spending. Even during the second half of last year, the split between purchases financed by interest-free credit compared with cash was 50/50, rather than the typical 75/25 division. Sales volumes over the 26 weeks to the end of December eased, by 2 per cent, from the exceptional boost given by pent-up demand last year, but they remained 10 per cent above the pre-pandemic level.
That doesn’t mean the group has been unaffected by the supply chain disruption wreaking havoc on companies in many industries. Constraints in suppliers’ manufacturing capacity and in logistics curbed sales volumes during the first quarter. DFS also was forced to cut off orders for Christmas delivery in mid-September, which caused a lull in business between October and December.
However, since Boxing Day order volumes have picked up, according to Tim Stacey, the chief executive. Lead times for deliveries are at between eleven and twelve weeks, above a norm of six to eight but down from a peak of fifteen to sixteen weeks.
Delays mean the order book is more than £200 million higher than the pre-pandemic level, which should provide a fillip to profits in 2023 as those orders unwind. Analysts at Peel Hunt have raised their pre-tax profit forecasts for that year to £95 million from £91 million,m and for 2024 to £100 million from £96 million. A forward earnings multiple of just under nine leaves the shares’ income potential underappreciated.
ADVICE Buy
WHY Good dividend yield at an appealing valuation
