BDX Company Investment Highlights
- Strong growth ahead from merger of Carefusion products through Becton distribution in international markets
- High debt load will impede shareholder cash return for years
- Shares are fully-valued and significant risks to acquisition integration and debt lead to a hold recommendeation
Becton, Dickinson and Company (NYSE: BDX) is the world’s largest manufacturer and distributor of surgical products as well as a strong player in diagnostic instruments and imaging systems. International sales account for 60% of total revenue with nearly a quarter of sales booked in emerging markets.
The company closed its $12.2 billion acquisition of Carefusion in March which will make it a leader in medical systems like ventilators and pumps. The acquisition was priced at 28 times trailing earnings and a 26% premium on shares of Carefusion. Becton Dickinson has estimated that it can achieve $250 million in cost savings by 2018 by combining the two companies.
The combination of the two companies makes all the sense in the world on a strategic basis. Both companies are market leaders in many of their products so combining the two helps develop a brand for quality. Becton Dickinson has built a very strong international distribution system and has benefited from emerging market growth. Carefusion booked just 5% of its last fiscal year sales from emerging markets and the hope is that BDX can boost sales through its international reach.
Over the long-term, the acquisition looks like a strong one on synergies and general growth in medical instrument demand. I am more than a little worried on risks to the short-term though. Acquisitions in the medical instruments space have been on fire lately and the price paid for Carefusion was very high. BDX had to increase its debt load significantly and shareholders shouldn’t expect much cash return for at least a couple of years.
Becton Dickinson has historically steered clear of large acquisitions and may not have all the experience needed to integrate the two companies. Becton’s line of surgical products are in a commoditized business, meaning pricing power is fairly weak, though the company benefits from its enormous size and geographic reach. Carefusion’s products are more expensive and may not be as easy to sell to hospitals in emerging markets.
Sales growth has been weak over the last year though revenue has increased at a consistent pace over the last decade. The company has had trouble managing its operating costs over the past three years and operating income has not kept pace with sales. Selling, General & Administrative (SG&A) costs have increased roughly 16% over the period while sales have only increased 8% over the three years.
Cost savings from the integration will not be immediate and I expect the operating margin to continue weakening for at least a couple of quarters. The company posted a sizeable increase in receivables (from $1.0 billion to $1.57 billion) and in inventories (from $1.5 billion to $2.28 billion) in the last quarter. Some of this might be attributable to the merger but it still worries me that the company is not managing its working capital very well.
The biggest issue for me is the debt the company has had to issue for its acquisition of Carefusion. Becton issued $6.16 billion in debt this year and long-term debt is now 63% of the capital structure. Interest payments will be a drag on earnings and cash return to shareholders will be limited for at least a couple of years.
The change in working capital led to a steep drop in operational cash flow over the last year while higher investment spending exacerbated the decline in free cash flow. Capital spending increased to $677 million over the last twelve months from $588 million spent in 2013. The increase in investment spending does not worry me as much because it should help produce sales in the future but I wonder how much cash will be available over the near-term.
Dividend and Growth
The investment opportunity in Becton Dickinson has historically been in share price appreciation rather than dividend yield. The shares pay a dividend of 1.7%, slightly lower than the five-year average of 1.9% and well below other Dividend Aristocrats.
Dividends have grown at a respectable 10.2% annually over the last five years which should probably be considered a maximum rate for the next few years. The company is paying out 43% of its income, well above the five-year average payout ratio of 35% and I would expect this to limit dividend growth in the future.
The company does have a solid track record of shareholder cash returns with payments since 1926 and 43 consecutive years of increasing dividends per share. Until this year, the share repurchase program was a significant part of shareholder return. The $400 million annual buyback program has been suspended until the debt level is reduced, which I would expect to take at least two years.
Shares of Becton Dickinson trade for 22.0 times trailing earnings, well above the five-year average of 17.2 times earnings. This is in-line or even slightly lower than the price multiple in the medical instruments industry but the entire space may be overvalued on investor sentiment.
Becton Dickinson earnings are expected 13.3% higher to $7.08 per share in 2015 on a 22% increase in sales. Earnings growth for 2016 is expected to reach 20% to $8.47 per share on 24% sales growth to $12.8 billion. Most of this growth is a result of the combination with Carefusion and may be unrealistic unless the company can execute on the integration.
There are a lot of reasons to like the new Becton, Dickinson and Company. The opportunity of folding in Carefusion products into its international distribution system could make it an unstoppable supplier to hospitals around the world. That said, I think the downside risks outweigh the upside potential at this point.
Expectations are already high for growth and any hiccups in integration could mean a big selloff. While the company is not in danger of a cash shortage, the new debt level will be a burden for a few years and income investors are not likely to see much cash return. I would set a price target of around $125 per share, just under 18 times expectations for 2015 earnings, and wait for a better entry price. I see the majority of the risk around earnings releases as management updates the market on the integration process and provides sales guidance.