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Morningstar | ConvaTec Makes Modest Progress on Turnaround; No Change to Our FVE

Slowly but surely, ConvaTec is making progress on its turnaround with another quarter that delivered slight improvements. Revenue growth in the first half of 2018 was largely consistent with our tempered expectations, and reported margins hit our estimates nearly on the nose. We’re leaving our fair value estimate unchanged. In terms of green shoots, we take the return of organic growth in ostomy care and 5.9% organic growth in continence care as positive signs. In particular, we think this growth underscores ConvaTec’s narrow economic moat, which we think stems from intangible assets and switching costs in these two categories. The global ostomy care market is highly consolidated, which should play to ConvaTec’s strength as a large existing competitor.

On the other hand, waning product cycles in advanced wound care hurt the firm in recent months, as older products including DuoDERM hydrocolloid dressing felt competitive pressure. These relatively quick share shifts are also consistent with our view that switching costs are low and competitors are plentiful in wound care, where it is more difficult to dig a moat.

We saw a little backsliding on adjusted operating margin, but we’re not overly concerned as this partially reflected the company’s efforts to restore inventory and address back orders. In our view, it is more important to fulfill product orders in the near term; rationalizing the cost structure can come later. Management indicated the earlier supply issues and back orders have been resolved. If this is true, we would expect to see steady albeit slow revenue growth from ostomy over the next few quarters. We were also pleased to see ConvaTec had hired a new leader for the ostomy business. However, we’re reserving judgment on Stephan Bonnelycke for now. His main experience in ostomy comes from his approximately 17 years at Hollister--a company that has always struck us as insular and behind the times.