One of the big investing themes for 2023 is the potential for companies to expand margins as cost inflation eases due to higher interest rates and a slowly improving supply chain. But there are two types of companies in this environment. The first type is companies whose top lines are pressured by the same forces set to slow inflation, and the second type is those with growth prospects that will hold up in a slowdown. I think GE HealthCare Technologies(NASDAQ: GEHC) is a strong candidate to be in the latter camp, and that's what investors should be looking for in 2023.
GE HealthCare's 2022 will shape its 2023
To understand the company's trajectory this year, it's essential to appreciate just how badly the company was impacted by supply chain difficulties last year. Regular General Electric(NYSE: GE) followers will recall that the management team started the year expecting the healthcare segment (which ultimately became GE HealthCare Technologies) to post organic revenue growth in the low-single-digit to mid-single-digit range. In addition, margin expansion was supposed to lead to $3.1 billion to $3.3 billion in profit, and free cash flow (FCF) was supposed to be above the $2.7 billion generated in 2021.
None of these estimations proved accurate (GE's management tempered expectations for the segment through 2022). Margins declined meaningfully in the first quarter. Management lowered full-year profit expectations to $3 billion in the second quarter, and then to "at least $2.6 billion" in the third quarter, ultimately reporting $2.7 billion for the year. Meanwhile, full-year FCF came in at just $2.1 billion. Note that all the figures above are on a "GE basis" for ease of comparison. The GE HealthCare numbers, including $1.8 billion in FCF, include the impact of carve-out adjustments.
Turning to GE HealthCare's recently reported numbers, on a superficial basis they are somewhat disappointing. Only the ultrasound segment grew earnings before interest and taxation (EBIT) in 2022. So all of a sudden a business that GE's management team believed "is well-positioned to achieve high-teens to 20% margins over time" became a mid-teens-margin business. GE HealthCare's adjusted EBIT margin was just 15.6% in 2022.
EBIT Margin, 2022
Patient care solutions
The challenge is to increase sales and margin in 2023. Fortunately, there are three reasons to believe the company will do just that.
Growth opportunities for GE HealthCare
First, the extent of the margin decline in 2022 (adjusted EBIT margin was 15.6% in 2022, compared to 18% in 2021) creates a margin expansion opportunity for GE HealthCare as the supply chain issues hopefully dissipate through 2023. Of course, it won't happen overnight, but management believes it can improve its EBIT margin in 2023. Management expects pricing increases to flow through in 2023, and an increased ability to deliver product should lead to volume increases -- both of which will help margins.In addition, it's worth noting that adjusted EBIT margin was 17.1% in the fourth quarter compared to 15.3% in the third quarter, so it's improving.
Second, the company continues to grow sales through new product introduction (NPI). The share of orders coming from NPI was 35% in 2021, and management said it was near 30% in the fourth quarter of 2022.
Third, the company's services gross margin was around 49% in 2022, with product margins of about 34%. Given that services organic revenue rose 6% in 2022, but product revenue rose 8%, there was an unfavorable margin mix that could turn around in 2023, as full-year services orders were up 7%, compared to 3% for products. Of particular note, pharmaceutical diagnostics (markers and tracers used in diagnosis) revenue could improve significantly given a reopening in China and a consequent increase in procedures.
Is it time to buy GE HealthCare Technologies stock?
Management's plan for 5%-7% organic revenue growth, coupled with margin expansion from NPI sales, pricing improvements, volume growth, supply chain productivity, and ongoing growth investments (including $80 million to expand manufacturing capacity in pharmaceutical diagnostics) should give investors confidence in the company's top-line growth prospects. Meanwhile, the medium-term opportunity to get to 18% or more margin is a key earnings driver. All told, the stock remains attractive for investors.
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Lee Samaha has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.