GE Healthcare Technologies (GEHC 0.34%) will never be a high-growth business. Still, it doesn't have to be to generate significant returns for investors. A combination of incremental revenue-growth improvement and margin expansion coupled with maintaining free-cash-flow conversion is a recipe for a significant lift in the share price.
And the good news is: There's evidence that GE Healthcare could get there. Here's the how and why.
GE Healthcare's medium-term plans
Management laid out its medium-term plans in its investor day presentation in December, and they are simple:
- Improve revenue from a 3% compound annual growth rate (CAGR) in 2019-2021 to a mid-single-digit annual rate.
- Improve its adjusted earnings before interest (adjusted EBIT) margin from a range of 15% to 18% in 2019-2021, and improve stand-alone margin for EBIT (earnings before interest and taxes) from 14.5% -- including the costs of separating from GE -- to an initial range of 15% to 15.5% in 2023, and then to the high teens to 20% over the medium term. For those unfamiliar, the adjusted version of EBIT excludes onetime and other expenses not truly affecting the business in the long run, and so, is higher than standalone EBIT.
- Maintaining its free-cash-flow (FCF) conversion from net income at a rate of 85% so FCF grows with earnings.
To put some back-of-the-envelope figures onto this, a move from a 15% EBIT margin (management's guidance is for 15% to 15.5% in 2023) to 18% (a conservative estimate for "high teens" margin) in five years accompanied by a 5% revenue CAGR implies a 53% increase in EBIT and FCF over the period.
GE Healthcare margin plans
There's good reason to believe GE Healthcare can hit its targets.
At the heart of the strategy lies the opportunity afforded to management by the separation from GE earlier in the year. As an independent company, it can drive revenue growth and margin expansion through investing for growth, cutting costs, and improving productivity.
Moreover, it's important to note that these actions involve GE Healthcare taking an initial hit to its profit margin that, if all goes to plan, will be more than recovered in the future.
Near-term pain
For an example of near-term pain, consider that the company is suffering "$200 million of recurring stand-alone costs annually that are now impacting our segment EBIT margin rates," according to chief financial officer James Saccaro on the earnings call. By "stand alone," he's referring to the extra costs the company is subject to after it split from GE earlier this year.
Another area where GE Healthcare is seeing near-term margin pressure is from management's decision to increase research & development (R&D) spending to drive growth.
As you can see below, there's a slight uptick in R&D expenses on an absolute level and as a share of revenue.
Data by YCharts.
Long-term gain
That said, the events causing the near-term margin negatives are likely to help GE Healthcare achieve its growth and long-term margin expansion plans, and there's tentative evidence that it's starting to work.
For example, management increased its full-year organic growth estimate to a range of 6% to 8% from a prior range of 5% to 7%, partly due to a pickup in orders in the second quarter (see the chart below) and 9% year-over-year organic revenue growth in the quarter.
Moreover, as a stand-alone company, it can take a more focused approach to its product portfolio and pricing. Saccaro said the company was targeting price increases of 2% to 3% this year, and 1% to 2% in the future.
Data source: GE Healthcare Technologies presentations.
New products, AI, and Alzheimer's disease
CEO Peter Arduini said that the growth in revenue and orders was "driven by strong demand" for its new product introductions (NPIs). The company had 40 NPIs in 2022, a sign of its growth. Its NPIs tend to carry higher margins, another way GE Healthcare can ramp up margins.
Among its NPIs, the company has artificial-intelligence (AI) powered products that carry higher margins, and Arduini said GE Healthcare had 42 AI-integrated applications approved by the Food and Drug Administration (FDA) that it was selling into its installed base of devices.
AI is highly complementary to healthcare in that the vast amounts of data generated by the industry (including that created by GE Healthcare's imaging and scanning equipment) can be better analyzed to produce insights that lead to better patient outcomes.
Image source: Getty Images.
The company's ambitions in precision healthcare and theranostics (the use of diagnostic agents to precisely deliver drugs to affected areas) received a boost recently with the FDA approval of Eisai and Biogen's Leqembi for some people with Alzheimer's. Leqembi has proved effective in reducing amyloid beta plaques in patients and is the sort of therapy that creates opportunities for GE Healthcare's imaging and pharmaceutical diagnostics to assess, treat, and monitor patients.
A stock to buy
All told, the healthcare company's top-line growth and margin expansion opportunities are real, and the numbers for this year don't reflect that long-term earnings potential. It will take a while to come to fruition, but GE Healthcare remains an excellent choice for investors in the healthcare devices industry.
