Convatec: An excellent buying opportunity?

The year since Convatec (CTEC) floated in London and joined the FTSE 100 index (UKX) has been nothing if not eventful. The £4 billion medical products and technologies firm has been up 50% and, more recently, down 50% following a grim profits warning to mark its one-year anniversary.

Third-quarter revenue grew by 6.8%, or 5.1% at constant exchange rates and 3.3% organically, and the product portfolio also continued to grow. However, new product sales failed to live up to expectations, and supply issues at both Advanced Wound and Ostomy Care divisions “severely impacted” the business.

Moving manufacturing lines from the US to the Dominican Republic might save a few bob, but there are risks involved, and failing to fix things quick enough lost the firm business. It’s why full-year organic revenue growth is now tipped to be just 1-2%.

And Convatec’s share price reflects market disappointment. From over 280p ahead of the warning, the price crashed as much as a third to a low of 182p. They had peaked at 349p in June, shortly after Nordic Capital and Avista increased a placing of shares from 200 million to 250 million shares at 322p, “due to strong investor demand”.

Writing was on the wall in August when higher than expected costs caused half-year profit to miss City forecasts.

Still, management expect supply issues to be sorted out by the end of the fourth quarter, after which it can start recovering some of that lost margin.

Non-executive chairman Sir Christopher Gent has been gobbling up shares in the aftermath, buying almost 39,000 at 213p, while new finance director Frank Schulkes celebrated taking up the role at the end of last month with the purchase of 100,000 shares at between 195p and 201p.

Insider buying did little to shore up the share price. However, after downgrading in August from ‘buy’ to ‘neutral’, and trimming its price target from 340p to 300p, Convatec’s joint corporate broker UBS has reinstated its ‘buy’ rating. The target slips again to 260p, though that still implies 37% potential upside.

“The stock is currently pricing in an overly bearish base case scenario in our view,” writes UBS analyst Ian Douglas-Pennant. “In order to see the stock valued at £1.90 we have to assume the Ostomy division will never return to market growth, that EBIT margins will stabilise at a level 450 basis points below those delivered in 2016, and that non-Ostomy divisions only grow 4%/ year.”

“Despite the company’s execution issues since IPO and recent investments at Coloplast none of these assumptions belong in a base case scenario in our view.”

But even the friendly broker admits that near-term uncertainty is high, which explains its “deliberately cautious stance”. Douglas-Pennant assumes it takes until late 2018 to fix manufacturing problems in Ostomy, so slashes earnings per share (EPS) estimates for next year by 21% to just 16 US cents. Consensus is for 18 cents.

On that basis, the shares currently trade on 15 times forecasts for 2018 earnings and 12.5 times enterprise value-to-cash profit, which “more than prices in expectations of further earnings disappointments and only limited scope for improvements in profitability in our view,” according to UBS.

Deliver its IPO thesis and the shares could one day be worth 340p, the broker argues. A structurally shrinking Ostomy business and declining margin – unlikely, says UBS given demand for Convatec’s products still exists – gives a bottom of about 150p.

Make no mistake, Convatec is full of risk right now, and much depends on management’s ability to fix problems at its new site. Even UBS doesn’t expect Ostomy to grow again until 2020. However, a swift resolution, and no impact on demand, would provide a shot in the arm for Convatec shares. Hopefully, we’ll get news before the next scheduled update in March 2018.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.