EUR 850.00 For Business Accounts Only

Morningstar | ConvaTec's Shares Swoon on Management Change and Inventory Issues, but Narrow Moat Intact

We're putting ConvaTec under review and plan to moderately lower our fair value estimate following CEO Paul Moraviec’s resignation and changes in inventory management at Medtronic--ConvaTec’s largest customer for infusion sets--that will materially lower infusion set sales in the fourth quarter. ConvaTec’s progress since its initial public offering could be characterized as one step forward, two steps back, in our opinion. Overall, we expect to further dial down our already-tempered projections for ConvaTec and hold steady on our conservative expectations for incremental improvement to profitability. We now anticipate significantly below-market growth through 2022 in advanced wound care, ostomy, continence and critical care, and infusion sets. However, we continue to stand behind our narrow economic moat rating, rooted in intangible assets and switching costs. As we’ve discussed before, end-user switching costs are strongest in the ostomy and continence businesses. We see little in the market to change our thinking on that. On the other hand, advanced wound care remains a less moaty business because the switching costs are lower for care providers. Additionally, we’ve seen aggressive tenders in Europe exacerbate this situation for other competitors.

We’ve consistently held a favorable view of ConvaTec’s underlying businesses, which reflect stable competitive dynamics that avoid outright price competition. We’ve also largely applauded management for its strategy of focusing on product innovation, rebuilding the pipeline of new patient discharges, and investing in patient-retention programs. We know this strategy works because competitor Coloplast has reaped impressive benefits from following the same playbook. Nevertheless, ConvaTec hasn’t been able to execute this strategy nearly as well. We think a new permanent CEO offers an opportunity to change that script, though we’re sticking with our measured estimates until we see consistent results.

We think the market has overreacted to the latest news and believe it is colored by the cumulative effects of stumbles over the past two years, including the recent product packaging recall in Europe, the rocky production transition from South Carolina to new facilities in the Dominican Republic (further hampered by the untimely death of ConvaTec’s executive vice president of operations), and a disconcerting level of management turnover that left key positions vacant. Now, we think investors are just waiting for the other shoe to drop. While we acknowledge there could be more dysfunction that has yet to manifest itself in further personnel departures or inventory issues, we also think the current share price gives no credit to ConvaTec for its existing businesses, which remain good ones to be in, from our perspective.

To reach the current share price, we’d have to completely eliminate ConvaTec’s advanced wound care and infusion set businesses in 2019 (thereby shrinking the firm’s revenue base by 48%) and assume the firm never reaches its goal of 300 basis points in operating margin improvement, with the operating margin instead declining an incremental 200 basis points. We think this doomsday scenario is highly unlikely. Instead, we plan to incorporate advanced wound care growth averaging 1.5% annually--significantly below 4%-5% market growth. We also anticipate growing ostomy and continence care at 1.5% and 4% through 2022, respectively, considerably below mid-single-digit market growth.

At this point, we think the firm’s prospects hinge on this opportunity for management change. We’ve seen ConvaTec take baby steps in the right direction, including the continued enrollment of new patient discharges in its ostomy patient-retention program, extension of its ostomy contract with group purchasing organization Vizient, acquisition of home health distributors in the United States, and the recent European approval of ConvaTec’s next-generation intermittent catheter for females (with approval of the male catheter anticipated in 2019). However, these moves have been overshadowed by missteps in execution. If new management can improve execution, we think there is upside to our valuation. However, we’re waiting to give the firm any credit for that until we see ConvaTec demonstrate progress in avoiding unforced errors.