Hill-Rom Holdings, Inc.

    • Hill-Rom (“HRC” or “the Company”) is a low-quality medical equipment roll-up which is rapidly approaching the end of its current growth cycle. HRC is a jumble of hospital furniture and medical device businesses assembled in part through $3.5B-worth of hasty acquisitions executed throughout the 2010s. Its atrocious record of M&A has left management to divest of a graveyard-full of failed acquisitions – many of them now a fraction of their initial sizes, and some exited at nearly complete losses. Analysts nonetheless give management credit for diversifying outside of capital goods, growing “core sales,” and expanding margins, largely through M&A (despite its failures) and recent product releases. However, Spruce Point finds that sequential new product growth has plateaued for three straight quarters, and is set to translate into depressed annual growth as the plateau rolls into Q4. Excluding the incremental contribution of these product releases, HRC’s organic “core growth” has been flat at best – a fact which has until now been hidden by new products and management’s discretionary and suspiciously fluid definition of “core growth.” Spruce Point also finds that nearly all margin expansion can be attributed to recent divestitures of low-margin businesses and acquisitions of higher-margin targets, leaving HRC with seemingly no route to higher profitability without continued M&A – an avenue which will be limited to it as it nears self-imposed leverage limits. Meanwhile, key executives have dumped stock and fled the Company at a break-neck pace through the past two years, perhaps in anticipation of its growth reverting to stagnant levels just as management prepares to release renewed long-term guidance.
    • A History Of Value-Destructive M&A : In an attempt to make up for slow top-line growth driven by low demand for low-tech hospital furniture, management has spent ~$3.5B on M&A since FY09 on businesses across numerous sub-sectors and geographies. However, it has subsequently exited or divested of many of these businesses, usually at a loss after experiencing material top-line contraction. The sell side has cheered both Hill-Rom’s acquisitions and its divestitures, interpreting the former as an avenue to sources of more recurring sales and the latter as part of an initiative to exit low-growth and low-margin business lines. Spruce Point, however, sees them for what they are: evidence of management treading water as it burns cash to acquire businesses which it subsequently drives into the ground under a corporate culture which, per formers, prioritizes hitting numbers above all else.
    • Failure To Fully Write Down Assets: HRC has taken impairments of varying sizes in conjunction with a number of its divestitures of failing business lines. However, we identify two such exits for which management appears to have taken either no impairment or only an insufficient one. We believe that just over $500M of goodwill and other intangibles must be written off of Hill-Rom’s balance sheet, representing approximately 11% of Hill-Rom’s total assets.
    • Non-Stop M&A And Confusing Math Masks A Slow-Growing Business: As management exits failing acquisitions, it instructs analysts to evaluate growth using its proprietary “core growth” metric, which adjusts growth for the negative impact of planned divestitures even before they occur. Management conveniently “re-bases” core growth every few quarters by adding new slow-growth business lines to non-core revenue, supporting consistent mid-single-digit core growth even as these ring-fenced verticals drag on total sales. Why should investors give Hill-Rom credit for achieving higher growth when this growth is achieved by exiting businesses (typically at a loss) which it acquired and killed over the course of just several years? Why does management exclude divestitures from “core growth,” but include the inorganic sales contributions of new acquisitions? Management has been able to present top-line growth of almost 300 bps greater than total growth in some quarters by selectively adjusting the many puts and takes which make up “core growth.”
    • Free Cash Flow Inflated From Chronic Mis-Forecasting of Capex And Low R&D: HRC has consistently misguided investors about capex requirements almost every year since FY10, and has underspent on capex against pre-year guidance by 20-30% since FY16. With most of its fixed asset base having a 10 year stated life, we expect years of capital neglect to weigh on future cash flow growth. HRC suggests that new product releases are a key driver of growth, but how will it continue to generate new product sales as it shrinks its capex and R&D spend even as core sales increase? Spruce Point has found that companies which mismanage capex often subsequently disappoint investors with material margin contraction (e.g. Caesarstone, A.O. Smith, and Gentex).
    • Slowing Revenue Growth From New Products Sets Hill-Rom Up To Disappoint: New product releases such as its Centrella “smart” bed have prevented Hill-Rom from showing dramatic core sales contraction over the last two years: these new products have grown from generating zero revenue prior to 2017 to over $400M in FY19 (expected). Management claims that it has accelerated the hospital bed repurchasing cycle by transforming the bed from a mere piece of furniture into a vital piece of hospital room technology. However, former employees and industry experts suggest that new product revenue will quickly normalize after a brief initial period of sales uptake. After adjusting for M&A and incremental sales contributed by new products, Spruce Point believes that Hill-Rom’s underlying sales growth has been effectively flat at best, versus management’s reported “core growth” of 2%-6% through the past two years. As the recent plateau in sequential growth from new products is set to become visible in annual growth starting this quarter, we believe that Hill-Rom may be set up to post disappointing growth in Q4 and in subsequent years as Company growth reverts closer to its ex-new product sales growth rate of ~0%. Heightened Company leverage close to its stated maximum of 4.5x will limit the extent to which management can keep core growth afloat through ongoing M&A, and could represent significant tail risk should the hospital purchasing environment weigh more heavily on growth.
    • Few Avenues To Margin Expansion: Almost all EBITDA margin expansion since FY16 can be attributed to divestitures of lower-margin business and acquisitions of higher-margin businesses. Price increases, endless restructuring, and supposed post-acquisition synergies appear to have had almost no positive impact on profitability. The sell side continues to see room for close to 250 bps of margin expansion through FY21, but, with divestitures set to cease next year and with limited capacity for further M&A, Hill-Rom will likely achieve less than half the sell-side’s expected level of margin expansion.
    • Aggressive Accounting Practices Under CFOs Tied To Roll-Up Train Wrecks Flatter Earnings: Management appears to have under-allocated for numerous reserve accounts consistently through the past four years. Spruce Point believes that management’s practice of under-reserving could have contributed a cumulative ~$55M to Hill-Rom earnings over this period. Hill-Rom would have to take a one-year hit of ~16% to earnings to bring its reserves back to prior levels. Management is also liberal in defining earnings adjustments, which together account for ~50% of non-GAAP income. Included in these adjustments are acquisition-related expenses and restructuring charges, despite the fact that Hill-Rom conducts frequent M&A, and that it has engaged in restructuring every year since it split from Hillenbrand in 2008. Growth via sloppy acquisition rather than internal reinvestment has shifted spending out of capex and into M&A, which, alongside frequent downward capex guidance revisions, has allowed management to hit implied FCF targets. Worryingly, these practices have taken place under recently-departed CFO Steven Strobel – Audit Chair of Newell Brands, a levered roll-up whose stock collapsed amidst allegations of mismanaged inventory channel build-up – and his replacement, Barbara Bodem, a recent alum of scandal-tainted pharma roll-up Mallinckrodt.
    • Accelerated Executive Exits Harbinger Of Disappointing Long-Term Guidance?: Over the past two years, HRC has lost its CEO, CFO, CIO, and two of its three division heads. It is currently on its fifth CFO since 2010. Executives frequently leave after having spent just one or two years (or fewer) at the Company. Employees report that management is increasingly focused on hitting financial targets to satisfy Wall Street, which has taken a toll on morale. We believe that HRC may be preparing to re-set expectations for the worse when it releases its new Long-Range Plan in Q4: rather than set unrealistic and unhittable long-term targets, it may be in the new management team’s interest to lower sales growth targets and impair zombie goodwill sooner rather than later.
    • Slowing Growth And Earnings Adjustments Leave HRC Shares Overvalued: Spruce Point believes that the Street overestimates Hill-Rom’s forward sales growth due to its focus on the “core growth” metric and its lack of appreciation for slowing new product sales. We believe that investors will be disappointed by slower-than-expected sales growth and stagnating margins as the recent round of divestments is set to end. We also believe that investors should not give management credit for earnings growth achieved through dubious adjustments and reserve reductions, which have boosted earnings materially through the past four years. Spruce Point sees 25-55% downside in HRC shares when each of these factors is taken into account.
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