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Morningstar | Hill-Rom Meets Our Fiscal 2Q Expectations, but Shares Look Priced for Perfection

No-moat Hill-Rom reported fiscal second-quarter results that largely fell in line with our expectations. After sifting through the release, incorporating the firm's recently closed acquisition of privately held Voalte, and assessing management's updated guidance, we don't expect our $84 fair value estimate to change much.

While the firm's performance has accelerated in recent quarters, our valuation concerns are in the sustainability of its revenue growth. Updated guidance suggests core revenue growth should fall near the high end of management's prior 4%-5% range, but segment mix leaves us hesitant to project a mid-single-digit reported revenue growth figure over a multiyear period. Better-than-anticipated results year to date have relied on the patient support systems business in the United States, while the firm's front-line care and surgical solutions businesses are now expected to grow at the low end of the company's prior outlook, largely attributable to international weakness so far.

The PSS segment includes the bulk of Hill-Rom's capital equipment sales, characterized by inconsistent order patterns and reliance on hospital spending. Year to date, the segment's 9% core growth rate has benefited from favorable end markets while also annualizing the launch of the firm's new patient bed, Centrella. We expect this rate to decline through the rest of the year given the stellar revenue contribution from the product during the second half of 2018. Additionally, of the 6% core growth companywide in the quarter, nearly half is attributable to the firm's stable of new products, including at least 1% from Centrella alone, by our estimate. While these products are poised to meet or beat management's $400 million revenue target for the fiscal year, we think current valuation looks too favorably on the long-run growth potential of the remaining Hill-Rom franchise.

Finally, we feel compelled to better dissect management's "core growth" metric, as we believe it will become less useful for investors over time. It has been a helpful measure to understand underlying business performance as management worked to wind down and divest a handful of low-margin, low-growth businesses over the last few years. However, management intends to include revenue from the Voalte transaction in the measure for fiscal 2019, adding nearly 50 basis points to full-year guidance.

While not overly meaningful in this instance, including acquisitions while excluding divestitures (and anything management deems noncore) to a headline metric feels philosophically inconsistent and a little disingenuous. Management defended its position on definitional grounds; however, this is in stark contrast to the firm's treatment of "core growth" during the acquisition of Mortara Instrument in fiscal 2017. While this was admittedly a decision made by Hill-Rom's former management team, acquired Mortara revenue was explicitly excluded from the calculation of core growth for the first 12 months of its ownership. This is both a more consistent presentation of the non-GAAP calculation and provides more valuable information to investors looking to better understand the business, in our opinion.