EUR 850.00 For Business Accounts Only

Morningstar | Zeiss' 3Q Results Support Upside to Our FVE, but Market Expectations Look Aggressive

Third-quarter results for Carl Zeiss Meditec keep the company on track to meet our expectations for the full year. While management had announced strong revenue results and raised annual guidance in early July, our current forecasts fall at the high end of the company's new range. That said, we're modestly bumping up our longer-term projections as growth across Zeiss' business lines appears more durable than we had anticipated. We plan to raise our fair value estimate for this narrow-moat company to EUR 46 per share from EUR 42 to reflect these changes, which implies a valuation of 24.5 and 15.5 times our fiscal 2019 estimates for adjusted earnings and EBITDA, respectively. This contrasts with a current market price that implies roughly 38 and 24 times our forecasts--valuation levels that we think likely prohibit attractive long-term returns to current or prospective investors.

Zeiss delivered a characteristically solid quarter with consolidated year-to-date revenue growing 7.1% as reported or 11.7% excluding currency fluctuations. All regions have contributed to these results, with Europe, the Middle East, and Africa up 10%, the Americas growing 11.7%, and Asia-Pacific expanding nearly 13% year to date in constant currency. Growth appears broad-based, with particular strength globally in the refractive laser and intraocular lens businesses and in the United States with an impressive turnaround in the diagnostics category thanks to a handful of new product launches and renewed investment in the sales team.

Zeiss appears well positioned to meet our operating margin forecast near 15% for the full year, in line with management's 14%-16% target. However, this implies only modest improvement off 2017 levels. Our model calls for approximately 250 basis points of margin expansion through 2022, driven by subsiding product launch costs, improved consumables mix, and sustainable pricing power.

While results to date have been encouraging, it is difficult for us to justify the assumptions baked into current market expectations. Our back-of-the-envelope calculations suggest the market is valuing the company based on double-digit revenue growth in perpetuity, with terminal gross and operating margins near 60% and 20%, respectively. Given the company's limited ability to show sustainable margin expansion throughout history, these numbers strike us as optimistic as best. While we're giving management credit for modest improvements given higher-margin product introductions, a shift toward higher-margin consumables, and a greater emphasis on cash flow from a performance standpoint, our numbers fall closer to 56% and 18% on the gross and operating lines, respectively. Additionally, while our higher revenue forecasts call for nearly 8% compound annual growth through 2022, up a little over 50 basis points from our prior projections, we don’t believe this is a business that can sustain double-digit growth over the long run. Recent years have benefited from a new product platform launched in the microscope business and broader adoption of Zeiss' refractive laser as its proprietary small-incision lenticule extraction, or SMILE, procedure has gained regulatory approval globally. As these product cycles wax and wane in the ensuing years, we think a more normalized growth environment is supportive of a rate in the mid- to- high-single-digit range.

Market prices could also be pricing in sizable optionality tied to the firm's balance sheet that, as of this quarter, has accumulated nearly EUR 600 million in net cash. While we applaud management for being disciplined in its capital allocation, we think the fact that cash has been building for the better part of two years suggests complementary assets are scarce at the valuations management is willing to pay. We'll wait for an announcement to incorporate potential transactions into our valuation but would highlight that a transformative acquisition is the most likely upside risk from current levels, in our opinion.