Solskin/DigitalVision via Getty Images
Solskin/DigitalVision via Getty Images
Baxter International (NYSE:BAX ) boasts a broad portfolio of medically necessary products and therapies, and its brand strength is a key advantage as the majority of its sales come from products with leading market positions. Some of its products include dialysis therapies, intravenous solutions, infusion systems and devices, parenteral nutrition therapies, advanced surgical equipment, smart beds, and respiratory health devices, among others. The company's products can be found in just about any healthcare facility from hospitals to nursing homes and beyond in over 100 countries.
In December 2021, Baxter acquired Hillrom through a deal worth ~$12.5 billion by enterprise value. Within three years of the deal closing, Baxter aims to generate ~$250 million in annualized pre-tax cost synergies due to the highly complementary nature of Hillrom’s portfolio. Going forward, Baxter is prioritizing deleveraging activities and the enlarged firm is expected to be a stellar free cash flow generator. We think shares of Baxter are starting to look attractive at ~$60 each, as our fair value estimate derived from our discounted cash flow process stands north of $80 per share. Shares yield ~1.9% at the time of this writing, though we note the firm's dividend isn't as strong as others on the basis of our Dividend Cushion analysis.
Dividend Cushion Ratio Evaluation (Image Source: Valuentum)
Dividend Cushion Ratio Evaluation (Image Source: Valuentum)
The Dividend Cushion Ratio Deconstruction, shown in the image above, reveals the numerator and denominator of the Dividend Cushion ratio. At the core, the larger the numerator, or the healthier a company's balance sheet and future free cash flow generation, relative to the denominator, or a company's cash dividend obligations, the more durable the dividend. In the context of the Dividend Cushion ratio, Baxter's numerator is smaller than its denominator suggesting weak dividend coverage in the future. The Dividend Cushion Ratio Deconstruction image puts sources of free cash in the context of financial obligations next to expected cash dividend payments over the next 5 years on a side-by-side comparison. Because the Dividend Cushion ratio and many of its components are forward-looking, our dividend evaluation may change upon subsequent updates as future forecasts are altered to reflect new information.
Baxter has a broad portfolio of essential renal and hospital products. Its global footprint helps it play a key role in expanding access to healthcare in emerging and developed countries alike. The majority of the firm's revenue is generated from products in market-leading positions. The company split via a tax-free distribution to shareholders in 2015.
Baxter's strong image and brand is augmented by an extensive global footprint and channel strength. The company continues to focus on growing international sales, which should be helped by its strong pipeline of new product launches.
In December 2021, Baxter acquired Hillrom through a deal worth ~$12.5 billion by enterprise value. Hillrom had a highly complementary portfolio in the medical technology space and within three years of the deal closing, Baxter aims to generate ~$250 million in annualized pre-tax cost synergies. Deleveraging activities are being prioritized in the medium-term.
Baxter’s net debt load swelled in the wake of its deal for Hillrom and its pro forma adjusted EBITDA to net debt ratio stood at ~4.2x immediately after the acquisition closed. Within two years of the deal closing, management aims to bring Baxter’s leverage ratio down to ~2.75x.
Baxter's dividend was reduced as a result of it splitting into two independent companies in 2015, but management has stepped up with some large payout hikes since then. Competing capital allocation options have the potential to impact the pace of dividend expansion moving forward.
Due to Baxter acquiring Hillrom in December 2021, management is prioritizing deleveraging efforts as Baxter’s net debt load swelled higher to fund the deal. Within two years of the deal closing, Baxter aims to reduce its net debt to adjusted EBITDA ratio down to ~2.75x, down sharply from ~4.2x on a pro forma basis immediately after the deal closed.
The best measure of a company's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Baxter Intl's 3-year historical return on invested capital (without goodwill) is 17.9%, which is above the estimate of its cost of capital of 8.7%.
As such, we assign the firm a ValueCreation rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate. Baxter is a strong economic-value generator.
We think Baxter is worth $81 per share with a fair value range of $63.00 - $99.00. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk rating, which is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them.
Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 8.4% during the next five years, a pace that is higher than the firm's 3- year historical compound annual growth rate of 4.8%.
Our valuation model reflects a 5-year projected average operating margin of 18.9%, which is above Baxter Intl's trailing 3- year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 4% for the next 15 years and 3% in perpetuity. For Baxter Intl, we use a 8.7% weighted average cost of capital to discount future free cash flows.
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $81 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
This is an important way to view the markets as an iterative function of future expectations. As future expectations change, so should the company's value and its stock price. Stock prices are not a function of fixed historical data but rather act in such a way to capture future expectations within the enterprise valuation construct. This is a key part of our book Value Trap: Theory of Universal Valuation.
Our ValueRisk rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Baxter. We think the firm is attractive below $63 per share (the green line), but quite expensive above $99 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Baxter is committed to generating strong cash flows and maintaining an investment grade credit rating. (Image Source: Baxter's second-quarter 2022 earnings presentation.)
Baxter is committed to generating strong cash flows and maintaining an investment grade credit rating. (Image Source: Baxter's second-quarter 2022 earnings presentation.)
The near term looks a bit rocky for Baxter as the company cut its 2022 reported revenue guidance to a high-teens growth rate from a prior range of 23%-24% when it reported second-quarter results July 28. The firm also cut its adjusted earnings per share guidance to the range of $3.60-$3.70 from a prior range of $4.12-$4.20 at that time. However, we expect the company to right the ship in relatively short order. Baxter has one of the best product line-ups across the healthcare arena, is a strong free cash flow generator, and generates tremendous economic value for shareholders. With its shares trading at a nice discount to our fair value estimate, they may be worth considering.
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Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Brian Nelson owns shares in SPY, SCHG, QQQ, DIA, VOT, BITO, and IWM. Valuentum owns SPY, SCHG, QQQ, VOO, and DIA. Brian Nelson's household owns shares in HON, DIS, HAS, NKE. Some of the other securities written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.