|Shares Out. (in M):||341||P/E||21.1||15.2|
|Market Cap (in $M):||15,100||P/FCF||0||0|
|Net Debt (in $M):||500||EBIT||0||0|
Olympus Corp. (TSE: 7733) is a leading global medical device company with significant potential for operational and financial improvement. Specifically, Olympus has the potential to expand its Operating Margins from ~10% last year to upwards of ~20% over the next 3-5 years. San Francisco-based activist investor ValueAct Capital Management owns ~5% of the company. As outlined below, the company has recently agreed to appoint a ValueAct Partner and two additional non-Japanese med tech executives to its Board of Directors. We believe these Board appointments and other structural changes associated with the recently announced “Transform Olympus” plan represent an inflection point in the company’s history and clear evidence that management is prepared to execute on the company’s significant margin opportunity. At ~¥4,915 per share, Olympus has a market cap of ¥1.8tn (~$15bn USD), de minimis Net Debt and trades ~$60mm USD per day.
Olympus has three segments as described below and shown in Exhibits 1 and 2:
Exhibit 1: FY Mar-2018 Revenue by Segment
Exhibit 2: FY Mar-2018 Operating Income by Segment (Excl. Imaging and Corporate)
Olympus Margin Opportunity
GI Endoscopes and Olympus’ other medical devices are mission critical, high cost of failure products which typically generate ~50% to 80% Gross Margins. However, due to Olympus’ historically undisciplined SG&A spending and unfocused R&D, Operating Margins dramatically trail both Japanese and US med tech peers. Specifically, Olympus delivered ~12% margins in its Medical segment last year vs. peers in the low 20% to low 30% range. See Exhibit 3. Olympus’ lower margins can largely be explained by the company’s excessive SG&A spending. Olympus’ SG&A (including R&D) was ~54% of revenue last year vs. closest Japanese and US peers in the range of ~35% to ~45%. See Exhibit 4. Given Olympus’ low consolidated Operating Margins, the company has the potential for tremendous earnings growth even if they only modestly normalize the cost structure relative to industry peers. Note that Terumo, the most comparable Japanese Medical Device peer, has SG&A equivalent to ~36% of sales relative to Olympus at ~54%.
Exhibit 3: Olympus Margin Benchmarking vs. Peers
Note: FY Mar-2018 shown for Olympus and Terumo. FY Dec-2018 shown for Boston Scientific MedSurg Segment and Stryker MedSurg Segment. Olympus Medical shown net of all corporate and other costs.
Exhibit 4: Peer Cost Benchmarking
Note: FY Mar-2018 shown for Olympus and Terumo. FY Dec-2018 shown for Boston Scientific (BSX) and Stryker (SYK).
What’s Changed at Olympus?
On January 11, 2019 the company announced “Transform Olympus,” which is a set of initiatives designed to improve the company’s profitability and governance. We believe that Transform Olympus represents an inflection point whereby Olympus has now made it clear that they are focused on increasing shareholder value. Highlights of the Transform Olympus plan include:
Olympus’ Top-line Outlook and New Product Cycle
Over time, Olympus Medical has achieved MSD organic revenue growth driven by its exposure to attractive long term secular trends including an aging population and rising middle class globally. Additionally, Olympus has expanded its share in key product categories such as certain single-use products used alongside its GI endoscopes. As a baseline going forward, Olympus Medical segment revenue growth is expected to continue to benefit from these favorable tailwinds.
Additionally, Olympus is poised to benefit from a refreshed GI endoscopy product line that is expected to be launched in the near future. For context, Olympus has historically released a new GI product line every ~6 years. Due to the pent up demand that builds between product launches as well as premium capabilities that accompany the new products, Olympus has historically seen significant pricing and volume uplift in the years following a new product launch. As shown in Exhibit 5, Olympus Medical’s revenue growth accelerated by ~900 bps from low single digit to low double digit after its most recent GI new product launch in ~FY 2013. Although the company doesn’t provide precise expected product launch timing for competitive reasons, our diligence suggests that it will likely be within the next ~12 months. This product launch is a potential catalyst for the stock for two main reasons. Firstly, the product launch will provide an uplift to organic revenue growth, a key valuation driver for med-tech stocks. See Exhibit 6. Secondly, the accelerating revenue growth will provide a significant tailwind to operating margins given high contribution margins and high flow-through on price increases.
Exhibit 5: Olympus Medical Historical Organic Revenue Growth
Exhibit 6: Selected Med Tech Multiples vs. Organic Growth
Note: Peers include Terumo, BSX, SYK, BDX, MDT, STE, Hoya.
From its current stock price, we believe that Olympus offers a compelling risk / reward given that it trades at a considerable discount to peers despite significant margin optionality. Exhibit 7 shows that Olympus trades at ~12x NTM EBITDA vs. closest peers in the 17x to 20x range.
Looking forward, if Olympus were to achieve ~18% consolidated margins, the shares would be worth ~¥7,800 to ~¥8,600, or up ~60% to 75% in just over two years. An 18% consolidated margin represents ~300bps expansion vs. the 15% target that the company has guided to thus far. However, our diligence suggests that 18% is achievable and still provides a margin of safety given that peer benchmarking, product level cost structure analysis and industry consultants all suggest that 20% margins are achievable over time. Additionally, the above valuation assumes an 18x to 20x PE multiple range which is a discount vs. Olympus’ medical device peers such as Terumo, BSX and SYK which currently trade at 29x, 26x and 23x NTM EPS, respectively. There would be considerable additional share price upside if the market were to ascribe a peer multiple to Olympus. See Exhibit 8 for an EPS and valuation sensitivity.
Exhibit 7: Olympus vs. Peer EBITDA Multiples
Exhibit 8: Olympus Valuation Sensitivity
Note: Assumes ~6% annual organic revenue growth from FY Mar-2018 to FY Mar-2022.