Why Baxter Is One Of My #1 2023 Bets For Healthcare/Medtech (NYSE:BAX)

Dear readers/followers,

I’ll revisit Baxter (NYSE:BAX) here, a small (currently) position in the healthcare portion of my portfolio. The company has been in a steady decline for months – the entire year of 2022 in fact – and I have been slowly buying and adding as the premium in the company has disappeared.

You might expect me to change or fundamentally adjust my price targets – that’s not going to happen. The company, as I see it, doesn’t face the sort of fundamental headwinds that would justify an adjustment of my initial financial modeling.

However, let’s still review recent results, and see what we have here – and why I’m unfazed with my “BUY”.

Baxter – Revisiting this upside

Baxter hasn’t been my most successful pick for 2022 to say the least. However, I believe that the case to be made for 2023 is a lot better for a number of reasons which I will present here.

Baxter International is a $10B+ revenue Medical equipment company founded back in 1931 in LA, and the company was an early producer of intravenous therapy solutions.

Today, its portfolio focuses on a broad selection of healthcare solutions and products, including but not limited to dialysis therapies, IV, infusion systems, inhaled systems, injectables, and hemostat/sealants. The company is a supplier to hospitals, dialysis centers, and nursing homes – basically, if you work with patients, you might be interested in calling your Baxter Sales rep and seeing what selection they have.

It’s a global business, with appeal in all markets, with a majority of sales in Americas, and about the remaining 40-45% in EMEA+APAC.

Each of the segments provides the company’s range of products for the specific geographical area. The company then further splits its operations into global business units which are made up of Renal Care, Medication Delivery, Pharmaceuticals, Clinical Nutrition, Advanced Surgery, and Acute Therapies.

The company’s major sales driver remains the legacy segment of medication delivery and renal care, with other segments either slightly or far smaller. The company operates an appealing sales model which mixes direct sales with independent distribution through wholesalers and specialty pharma providers.

Some company issues have seen the company’s previous A-grade credit decline to a BBB. Still investment grade, but not as great as it once was. However, at the same time, the yield which was once below 2%, is now at 2.28% – meaning I view it as comparatively solid.

In fact, the term, “comparatively solid” can be used to describe the company’s current situation to a T. Yes, we’ve seen structural declines in the company’s valuation and share price – but that has not been reflected or seen in the company’s corresponding financials, which gives us a fairly decent case for the company being cheaper than in a very long time indeed.

And you know me, I’m all about that “value”.

So, the recent results we have for Baxter are the 3Q22. The numbers there confirmed continued sales increases with a 17% YoY increase in sales, and 23% at constant currency. This is mostly a result of price increases and the Hillrom M&A, which contributed.

On the bottom line, Baxter saw less flattering results, including margin declines on a GAAP and adjusted level of between 10-300 bps, depending on where you look.

Adjusted EPS was down 20% YoY, reflecting the company’s current challenges related to supply chain constraints and negative overall FX, as well as the effects from interest rates, inflation, and the current overall geopolitical macro that we’re seeing.

The company is meeting these challenges with cost efficiencies and improved processes. it’s done a hiring freeze, reduced spending, and accelerated the Hillrom integration, trying to capture greater synergies overall. Of course, it’s also reviewing its portfolio for potential dispositions and making sure that everything is “needed”, as it were.

So, top-line results are great – but the way it flows down to the bottom line leaves something to be desired.

The same is true on a 9M22 basis. However, the company is still hitting its targets – meaning none of what we’re seeing here was really unexpected as such. In fact, some of the results were even better than the company expected overall.

Sales trends across the company are a mixed bag. Revenue growth could be seen above all in Advanced surgery and clinical nutrition, as well as the core segment of Renal Care, which is heartening given its the company’s largest segment with nearly a billion in sales.

Geographically speaking, Europe and NA were up at constant currency, while Asia was mostly flat overall.

The company’s current main problem comes down to the simple fact that they’re spending more dollars in relation to how much profit they get from each spent dollar. This comes in the form of SG&A expenses, which are up nearly 200 bps as a percentage of sales as well as the overall gross margins. R&D is not the issue, it’s actually improved from the YoY period – so it’s SG&A and margins most of all.

The continued logistical challenges during the crisis have had an impact on the company, especially from an international perspective. The company is also in a complex pricing action balance with its customers to try and retain its margins while shrugging off the inflationary impacts as well as other problems it’s currently facing. The fact is, the company hasn’t done as well as expected by the company itself, nor by the broader market.

This is not to say that Baxter has been close-mouthed on potential impacts. Back in 1Q22, the company already saw and guided for about $500M in incremental costs over a period of several years, including impacts from labor costs, material costs, freight costs, and other factors that are driving this significant uptick in overall cost inflation.

Also, fundamentals really aren’t an issue long-term for this business. The company has $1.6B of cash and equivalents with access to another $2.7B – and with regards to reducing and carving away that Hillrom debt, almost a billion has already been put to work YTD at October 2022. The company has never been the highest yield, and you really need to be aware when you “BUY” the shares here – but there’s a lot to like about Baxter at this valuation.

The Baxter Valuation

One of my biggest flaws as an investor is at times going in to a company far too early. The indication I’ve found when I’ve put this into data points is that I tend to be somewhat backward-looking – I put perhaps too strong a focus on historical trends and results, and not enough discount on what the future might bring. At least, that’s the case with 3 key investments I’ve looked at and done in 2022 – and this is something I’m currently working on with regard to my strategy.

However, it’s equally important to point out that at times I’ve not gone in early enough, instead missing the opportunity of undervaluation that presented itself. The market is fickle, and it’s hard sometimes to know how deep or how serious it might view a company when facing something like this – and how deeply it wants to discount it.

When it comes to Baxter, I believe the flaw was disregarding too much the depth of the valuation drop we can see on a 20-year period.

As you can see, Baxter spent almost 7 years in what was at the time not viewed as a valuation slump where it traded below 15x P/E. My mistake here was not discounting the company with regard to that and entering too early. Thankfully, it was a small position – and I’ve been adding to it, reducing my overall cost basis again and again, albeit slowly.

My current stance is that we might be in for another slump in valuation. As you can see, the slump did not occur because the company’s earnings did not grow. They did. The same is more or less true here – earnings are stable and they’re expected to increase going forward. Current forecasts see EPS coming in around $3.57, which is down about 1.1%, with the next few years seeing the Hillrom integration and efficiencies reversing this trend.

That low 6% EPS growth on average would be a problem combined with the low DGR if the company was trading at 20x+ P/E. But it’s not. It’s now priced under 15x, which is a price we’ve not seen for Baxter for some time.

Even on the basis of a 15x forward P/E, the outperformance potential for Baxter relative to the market is around 12.11% per year, or 40.95% until 2025E – and that’s at 15x P/E. Any sort of long-term reversion to a premium could easily break that into triple-digits, at above 100% total RoR.

How long might that take? That’s difficult to ascertain here – but I know one thing – that I believe Baxter is being overly pressured here. The latest bearish article on the company focuses mostly on technicals and how Baxter has been trading at an excessive premium for years – and this is an easy “agree” for me – they have.

There also isn’t much else in terms of negatives focus on except sector-wide GAAP multiples, which to me is a bit thin of an argument when you look at a company like this. Fundamentals are superb, and the company has a good history of making turnarounds into earnings growth.

Overall, I believe the combined upside of fundamentals, a decent yield, and a stock trading at the lowest valuation we’ve seen in 5+ years makes this company attractive – and I am far from the only analyst to think this.

Street targets for Baxter from S&P Global come in at a range of $51 on the low side to $85 on the high side, with an average of $63. That’s an upside of 23.3% for the bulls, and I believe it is valid. Out of 16 analysts, 10 are currently giving the company positive ratings, implying “BUY”.

I am shifting my PT for BAX here – but not as much as you might expect. I believe the $63 is on the low end, I do allow for a long-term Premium for Baxter based on its market position, and lower than $82/share is not a level I’m willing to go here.

Hence, this is my thesis for the common.

Thesis for Baxter’s common shares.

My thesis for Baxter is as follows:

• The company is a solid healthcare company with interesting segments that both suffer and gain tailwinds from the current situation. I continue to estimate the net effect of a pandemic unwinding to be about 1:1 for Baxter, which means that overall longer-term growth potential is intact. The current negative also doesn’t reflect the underlying EPS trends, as I see it.
• At current valuations of below 15X P/E, I consider the company a buy to a forward 17-19X P/E range.
• BAX is a “BUY” here. A price target that I would consider attractive for investment based on my goals would be around $82/share.

This company also fulfills every last one of my investment criteria (italicized):

• This company is overall qualitative.
• This company is fundamentally safe/conservative & well-run.
• This company pays a well-covered dividend.
• This company is currently cheap.
• This company has a realistic upside based on earnings growth or multiple expansion/reversion.

The company currently fulfills all of my criteria, making it a “BUY” here.

The Options case for Baxter

However, one of the more interesting potentials here might be options. Its share price means that capital exposed here for a contract isn’t massively significant compared to other businesses. Also, when a company is moving as Baxter is, with violent ups (or downs), in this case, you’re sometimes better off trying for the options.

So, here’s a PUT based on current closed-market data (the last data from Friday). I’ve used data from options that actually had volume at the time.

I view this as a “Decent” put option, given the price difference and the relative annualized yield.

This is an option I might do at the market opening.