Sell ConvaTec as margins plummet

As is common for a private equity float, ConvaTec, which makes repeat-purchase medical products ranging from colostomy bags to catheters, came to the market with a lot of debt. The £1.5bn of new money raised at the IPO, plus a new $1.8bn credit facility was used to repay over $3.5bn of expensive debt last year. This resulted in a sharp drop in interest costs and an 84 per cent jump in underlying first-half pre-tax profit this year. But ConvaTec is still weighed down by debt. Broker Numis has forecast $1.45bn of year-end net debt, which equates to 106 per cent of total equity or 2.9 times adjusted cash profit forecasts – a long way off the two times target leverage that management set out at the IPO.

The trading outlook has also started to look less enticing. In the first half, the group disappointed the market by announcing higher than expected operating expenditure, which came in at 37 per cent of sales – outside the 34-35 per cent guidance – as general and administration costs rocketed. This forced broker Numis to cut its operating profit guidance from $472m to $463m.  

Top-line growth is also disappointing compared with peers. On an underlying basis, the group reported a 1.5 per cent increase in revenues in the first half, compared with 3 per cent growth from closest listed peer Smith & Nephew (SN.). The market is growing, but ConvaTec may have to increase its spending – putting further pressure on margins – to fight off increased competition. Many rivals have spent much more money on research and development (R&D) in recent years and therefore have a much stronger portfolio of products both on the shelves and in the later stages of development.

ConvaTech's second-half profit is also likely to be marred by a reversal of the currency benefit experienced in the first six months. ConvaTec sells its products globally (half of sales come from the Americas, 42 per cent from Europe, the Middle East and Asia, and the remainder from Africa and the Pacific regions), reports in dollars and incurs a lot of costs in Europe. This meant that the weakened sterling and euro boosted the bottom line in the first six months of the year. With those currencies strengthening against the dollar, reported profits are expected to take a hit in the second half.

Divisionally, the ostomy franchise (30 per cent of revenues) is ConvaTec’s saving grace, reporting 3.6 per cent underlying revenue growth in the second quarter and fighting off competition from US peer Coloplast. Meanwhile, the wound, critical care and infusion devices businesses have all been hurt by planned destocking, which management had hoped would help improve margins.