Why You Should Care About CareFusion

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While the IPO market has not produced an offering since the middle of August, a significant spin-off transaction will finally close early next week. Once again, the deal will come from the health-care sector, which has now produced three of the last four IPOs. Cardinal Health will spin off CareFusion, its medical products business, giving shareholders 0.5 shares of the new company for every share they hold. Morningstar equity analyst Matt Coffina is slightly concerned about a few short-term hurdles facing the company, and concludes the firm does not possess an advantage over competitors. At the same time, he thinks the company's problems are short-lived. He values CareFusion at $22 per share, and gives us his full take on the company's prospects in his thesis below:

"Despite near-term headwinds from constrained hospital capital spending, we think CareFusion will produce relatively stable, mid-single-digit growth over the long run as an increasing share of global gross domestic product is devoted to health-care expenditures. The spin-off from  Cardinal Health (CAH) could increase management's focus and better align its incentives, although we think any benefits will be offset by the increased costs of operating as a stand-alone company. We are doubtful that the company has a sustainable competitive advantage given its commodity-like products and low barriers to entry.

CareFusion chose an inopportune time to launch as an independent company. In the past year, the company has had to contend with an extremely challenging hospital capital spending environment, adverse currency movements, and recalls (and a shipping hold) on its Alaris infusion pumps, all of which contributed to very poor performance in the second half of fiscal 2009 (CareFusion's fiscal year end s in June). While CareFusion saw 10% revenue growth and 14% operating income growth in the fiscal first half compared to the prior year, second half revenue and operating income were down 12% and 40%, respectively, with the worst performance occurring in the fourth quarter.

We think CareFusion's problems are temporary. In response to the Alaris product defects, the company has increased its investments in quality control systems. Currency head winds are unlikely to persist indefinitely. Most importantly, as the economy improves, hospitals should see increased admissions of privately insured patients, lower bad debt expense and charity care, and improved access to financing, allowing for a rebound in hospital capital spending.

Long-run trends appear to be clearly in CareFusion's favor. A growing share of the economic pie is being directed to health care, and CareFusion also stands to benefit from an increased focus on patient safety, especially as managed care organizations and government payors attempt to institute reimbursement policies that reward quality of care and refuse to pay for the costs of preventable medical errors. Many of CareFusion's products are intended to enhance patient safety by automating health-care tasks.

On the other hand, we don't think CareFusion has a sustainable competitive advantage. Most of the company's products--such as medication dispensing cabinets, ventilators, and surgical instruments--appear to be easily copied by either established competitors or new entrants. Opportunities for innovation are limited, and customers are likely to become increasingly sensitive to costs over time as efforts are made to slow health-care spending growth. Although CareFusion may derive some advantages from the integration of its products with hospital information systems, from its established brand names, or from its customer relationships, we don't think these factors are enough to give the company an economic mo at."

Matt values CareFusion at $22 per share, a roughly 20% premium to the shares currently trading on a limited, when-issued basis at around $18.50. When-issued is essentially a conditional transaction where the shares involved have been authorized but not yet issued. He describes the reasoning behind his valuation below:

"We assume 7% compound annual revenue growth over the next five years, with a particularly strong year in fiscal 2011 when we expect hospital capital spending to rebound, and 6% long-run growth. Excluding restructuring charges, we expect operating margins to decline from 14% in fiscal 2009 to 11.5% in fiscal 2010 as the company incurs new administrative costs as an independent company and as CareFusion continues to struggle with a weak capital spending environment for hospitals. We expect the operating margin to average 12.6% over the next five years. We considered two scenarios in addition to our base case. In our bull case, we assum ed a stronger rebound in hospital capital spending in 2011, 8% long-run growth, and better cost control. Using 9% compound annual revenue growth and 13.5% average operating margins over the next five years would lead us to a fair value estimate of $26. In our bear case, we assumed another down year for revenue in 2010, no rebound in hospital capital spending in 2011, 4% long-run growth, and operating margins averaging 10.8% over the next five years. Those assumptions would give us a fair value estimate of $16. We estimate CareFusion's cost of equity at 11%."