Baxter International Inc. (BAX, Financial) is a health care company that offers a wide range of products and services such as dialysis treatments, IV solutions, infusion systems, parenteral nutrition therapies, inhaled anesthetics, generic injectable drugs and surgical products. As of its most recent annual report on Dec. 31, 2021, the company had manufacturing operations in more than 20 countries and sold its products in over 100 countries.
It completed the spinoff of its pharmaceutical business Baxalta in July 2015 and made acquisitions of Claris, a generic injectable products and services business, in July 2017 and Hillrom, a medtech company, in December 2021. The company has about 60,000 employees.
Baxter's stock has been battered this past year, down about 40% from highs, which is much worse than the S&P 500 and the SPDR S&P 500 Health Care Equipment ETF (XHE).
Quite frankly, I think this selloff is overdone. It looks like investors are being offered steak at hamburger prices; here's why I think so.
Recent earnings
Baxter's third quarter earnings results did not meet expectations due to higher operating costs, slowing growth in some core businesses and negative impacts from foreign exchange movements.
The company reported adjusted earnings of $0.82 per share on $3.77 billion in sales, missing estimates by $0.01 per share on earnings and about $130 million on sales. On a GAAP basis, Baxter reported a loss of $5.83 per share for the quarter, largely due to $3.1 billion in impairment charges related to the acquisition of Hillrom in December 2021.
Management lowered its full-year adjusted earnings outlook to $3.53 to $3.60 per share (down from the previous estimate of $3.60 to $3.70 per share) due to the greater impact of currency movements and supply constraints for electromechanical components. The company's performance has been impacted by inflation, foreign exchange challenges and supply chain issues, but it is expected to recover in 2023 with the help of contributions from the Hillrom businesses and a reduction in pressures on several fronts.
Following is a breakdown of Baxter's income statement from last year.
Baxter faces strong competition within the market, but it holds a leading position in various categories, and entering the market would be difficult due to regulatory and reimbursement hurdles.
Baxter's three largest units are detailed as follows:
- Renal Care: This unit includes sales of peritoneal dialysis and hemodialysis machines, as well as additional dialysis therapies and services.
- Medication Delivery: This unit includes sales of IV therapies, infusion pumps, administration sets and drug reconstitution devices.
- Pharmaceuticals: This unit includes sales of premixed and oncology drug platforms, inhaled anesthesia, critical care products and pharmacy compounding services.
Baxter forms deep relationships with its customers like clinics, hospital systems and governments and, once imbedded into its customers' systems, it is very difficult for a competitor to displace it.
Hillrom acqusition
The Hillrom acquistion was one of the largest medtech deals of 2021 and closed in December that year. Baxter bought Hillrom for 10.5 billion and also assumed Hillrom’s cash and outstanding debt, bringing the total value of the deal to $12.4 billion. The Hillrom acqusition has added basic equipment, including hospital beds, to the portfolio, although about half of Hillrom's 2021 revenue came from more digitally connected offerings like its smart beds and Voalte medical communications app.
Baxter said Hillrom was attractive because it would help it expand its digital capabilities and give it a broader array of medical products and services to offer patients and clinicians around the world. In addition, it said it expects the combination to accelerate the companies’ expansion into digital and connected care solutions that are increasingly providing patients with access to hospital-level care at home or in other non-hospital care settings.
When it acquired Hillrom in December 2021, Baxter assigned values of $6.8 billion to goodwill and $6 billion to other intangibles as part of the deal. Last quarter, alarmed by rising interest rates and declining equity valuations, as well as supply chain problems cutting into Hillrom’s sales forecasts, Baxter re-evaluated the unit and essentially admitted that those initial figures were too high given current economic conditions and it had overpaid. It took a $3.1 billion charge to write down the goodwill and reduce the carrying amounts of intangible assets related to trade names acquired from Hillrom. However, Baxter's total market cap has come down by over $18 billion dollars since the acquisition.
Baxter acquired Hillrom with debt, so it has become highly levered. Total debt is $16.43 billion, with $9.32 billion due in five years. However, the company has made deleveraging a priority and has begun to reduce long term debt. I expect that the company should be able to pay down about $1 billion a year. As of Dec. 31, 2021, Baxter's net debt to capital ratio was 54.6%, and its net debt to trailing 12-month Ebitda ratio was 4.9. This represents an increase from the previous year, attributed to the Hillrom acquisition.
In this time, it is likely to temper shareholder returns like dividend and share buybacks while it tackles deleveraging. Debt maturity is quite spread out, and the company has healthy cash flow and is somewhat recession resistant. While the debt is manageable, the company may struggle in the short to intermediate term with return on invested capital while it navigates the current high interest environment. Though Baxter has over payed for Hillrom, the saving grace was that it was able to lock in low interest rates for borrowed funds.
The following diagram shows the various components of Baxter's operating cash flow. I think the best metric to assess Baxter's performance is the core FCF (shown as the orange line). Core FCF is free cash flow without changes in working capital and with stock based compensation deducted. Core FCF has increased at the rate of 10% annually (and 14% through December 2021 prior to the current bear market and the Hillrom acquisition).
Valuation
The stock has lost 7% in value since August and about 40% year to date. However, I expect it to see strong price recovery over the next 18 months and the medium term (2025 to 2027) time frame.
Baxter's GuruFocus valuation panel is mixed:
While the GF Value and median price-sales value show excellent value, other metrics are poor. Because of continual acquisitions and divestitures over the years, Baxter's earnings and cash flow have fluctuated. The company does appear to be somewhat undervalued if we look at the Shiller price-earnings ratio (10-year average price-earnings ratio) of 15.83 and the forward price-earnings ratio of 13.81. The historical median price-earnings ratio for the company is 23, which would imply an undervaluation of about 15% to 60%.
Baxter pays a dividend yield of around 2.3%, which has grown at an impressive 16% clip over the last five years. The company has also bought back modest amount of stock but that will likely stop as it reduces debt.
Conclusion
Overall, my opinion is that investors currently have a value opportunity in this high quality medical devices and medical services company. Usually Baxter trades at a substantial premium, as shown by its median historical price-earnings ratio of 23 versus the forward price-earnings ratio of around 14. With aging demographics in most advanced countries, Baxter's products and services should continue to be in high demand. The management team appears to be on the ball and is shareholder friendly. The company appears to be well positioned to be a long term compounder, despite short term issues.
