At the risk of sounding a bit mean, CareFusion (NYSE:CFN) doesn’t get all that much attention in the market. The company has a solid business between its operations in pharmaceutical dispensing, infusion, respiratory care, and procedural disposables, but it never really seems to get much attention unless/until there’s another round of news about infusion pumps – a business where rivals like Baxter (NYSE:BAX) and Hospira (NYSE:HSP) have seen recalls that benefited CareFusion.
That has changed very recently, though, as CareFusion seems to be a key potential acquirer for at least 2 medical device businesses known to be on the block – ICU Medical (NSDQ:ICUI) and Smiths Group‘s (LON:SMIN) Smith Medical. CareFusion has long been an active acquirer and recently not only reaffirmed its commitment to future deals, but a willingness to do larger deals than before. While both ICU Medical and Smiths Medical make solid sense for CareFusion, both deals have certain drawbacks as well.
ICU Medical – smaller and synergistic, but with a big catch
Disposables (connectors and custom tubing sets) for various types of infusions make up more than ⅔ of ICU Medical’s business, so the potential synergies with CareFusion are pretty significant right off the bat. Add in ICU’s growing oncology business (which is similar in many respects to infusion), and nearly 80% of the business at ICU Medical is very familiar to CareFusion.
ICU Medical also runs a pretty tight ship with a history of strong economic returns. Although the gross margins of the 2 companies are pretty similar, ICU Medical has produced higher operating margins than CareFusion and over a decade of double-digit returns on equity, despite a relatively limited global presence.
All told, while the critical care business of ICU Medical would be new and challenging for CareFusion (and it hasn’t been doing so well against the likes of Edwards Lifesciences (NYSE:EW)), this is a business that would integrate quite naturally with what CareFusion already does.
But there are at least 2 significant downsides that I see. First, ICU Medical generated 38% of its last quarter’s revenue from Hospira – one of CareFusion’s biggest rivals – and there are supply agreements that tie the 2 companies together through 2018. While ICU Medical management has never publicly addressed it, I got the impression when I covered the company as a sell-side analyst that there’s little love lost between ICU Medical and Hospira, and I cannot see why Hospira would cooperate in any way with a CareFusion transaction. So while CareFusion could definitely expand the distribution of ICU Medical’s products and reap real operating leverage, dealing so closely with a major rival could be an insurmountable issue.
Second, and perhaps less appreciated, is the nature of ICU Medical’s business. I have argued before that management has significantly under-invested in R&D (management disagrees, arguing that they pursue a very focused product development strategy that results in very few new product failures). That not only reduces some of the low-hanging fruit for post-deal expense reductions, but also means ICU Medical is largely a “what you see is what you get” sort of situation. With rivals like Baxter and Becton Dickinson & Co. (NYSE:BDX) having launched their own safety products in attractive markets like oncology, CareFusion may actually have to invest more in an ICU purchase.
Smiths Medical – more opportunity, but less growth and more cost
A deal for Smiths Medical would likewise offer many potential synergies for CareFusion. Smiths’ operations in medication delivery (infusion pumps), vascular access, and respiratory care/monitoring would appear to fit pretty well into what CareFusion already does.
Accordingly this deal would be more about adding scale to the business, leveraging more of the cost-savings potential, and expanding CareFusion’s field of operations. The latter could be particularly valuable, as Smiths Medical generates about half of its revenue in Europe, the Mideast, Africa, and Asia and enjoys a pretty solid footprint in China. On the cost-cutting side, the similarity of the 2 businesses could mean that CareFusion could strip anywhere from 20% to maybe 35% of the costs out of Smiths Medical over time.
This looks like a pretty attractive target, then, particularly as this deal could add momentum to all of CareFusion’s operations (from the international exposure) and significantly better scale and efficiency in pumps, respiratory care, and procedural solutions. But there’s a catch, and that catch is the size of the deal.
Smiths rejected a $3.9 billion bid for Smiths Medical back in 2011 and while the business hasn’t done remarkably well since then (roughly flat on a revenue growth perspective), Smiths isn’t going to sell cheaply. What’s more, given that Smiths has a sizable pension shortfall, any deal could trigger/force a sizable payment that would dilute the deal value further. Last and not least, the sheer size of this deal would be a new challenge for CareFusion management, and one that would meaningful increase the execution risks.
Why not do both?
I believe that CareFusion would likely have to pay a price in the low $80s for ICU Medical. At that price (a market cap of about $1.2 billion or an enterprise value of about $1 billion), CareFusion would be paying a traditionally reasonable 3x EV/sales multiple and about 12.5x times trailing EBITDA. The deal would also bring plants in Mexico and Slovakia that could be beneficial to CareFusion’s long-range gross margin. Leaving aside the possibilities of cost synergies and an improved growth rate (ICU Medical is expected to grow its revenue at roughly twice the rate of CareFusion), it wouldn’t be hard for CareFusion to raise the capital to do the deal.
A deal for Smiths would be more demanding. CareFusion would probably have to go north of $4 billion to get a deal done, and maybe as high as $4.5 billion – or a multiple of 3.5x sales and 14 times EBTIDA. I don’t think that CareFusion would have much (if any) trouble raising the funds needed (CareFusion has nearly $1.4 billion in net cash and investments and could likely borrow $3 billion on reasonable terms), but it would likely limit the company’s deal-making flexibility for at least a couple of years.
But what about buying both? Would an extra $1 billion make that much difference? CareFusion could likely support the extra debt (it would bring the long-term debt-to-equity ratio up to about 80%), but it would definitely up the execution risk for the company – as Boston Scientific (NYSE: BSX) learned the hard way with its debt-fueled acquisition of Guidant many years ago. Both deals would likely throw off strong cash flows almost immediately, but the challenges of integrating 2 businesses, particularly when the ICU Medical – Hospira relationship would require a lot of management time and energy, make this an unlikely scenario.
The bottom line
One way or another, almost everybody involved in this article is going to get what they want. ICU Medical is almost certain to find a buyer, whether it’s CareFusion, Becton Dickinson, or private buyers like B. Braun or Medline Industries. Likewise, assuming Smiths Group is reasonable about the valuation they want for Smiths Medical, that business will get sold without too much fuss. CareFusion, too, is going to come out of this just fine – there is no shortage of potential acquisition targets for the company, particularly if the objective is to add scale to existing businesses and/or expand into new international markets.
What it all comes down to is price and terms. While I do think ICU Medical and CareFusion would make sense together, that relationship with Hospira very well may be an unmovable fly in the ointment. Accordingly, I think Smiths Medical is quite possibly the deal that CareFusion wants to do, particularly given the international exposure Smiths would offer, but time will tell if the parties can hammer out a mutually agreeable deal structure.
Stephen Simpson CFA is a former sell-side and buy-side analyst who focuses most of his professional attention on financial and investment writing. In addition to a decade of work as an analyst, Mr. Simpson has worked as a wet-bench biomedical researcher and a consultant in the med-tech industry, as well as writing on a freelance basis for over 10 years. He can be reached via email at firstname.lastname@example.org.