Description

Summary investment thesis

We are short Bio-Rad because we don’t believe the company will be able to deliver on its recently reiterated targets of hitting EBITDA margins above 20% by 2020. Trading on over 50x P/E, the stock is currently pricing an unrealistic assumption of long-term margin expansion which will be disappointed due to several headwinds, including pricing pressures in the US market and the launch of a competitive product in 2018. Management blamed a complicated and costly ERP implementation program as the root cause of Bio-Rad recent margin weakness which is, in our view, structural and irreversible.

Summary business description

IPO’d in 1966, Bio-Rad was founded in 1952 by David and Alice Schwartz, offering life science products and services to identify, separate, purify, and analyse chemical and biological materials. In 2003, the founder stepped down as CEO, being replaced by his son Norman, the company’s current President and CEO. Bio-Rad operates under 2 segments:

Life Science Segment – represents c. 36% of sales. The segment manufactures and markets a range of more than 5,000 reagents, apparatus and laboratory instruments that serve a global customer base which operates medical and pharmaceutical research or Biopharma laboratories. Bio-Rad focuses on selected segments of the life sciences market in proteomics (the study of proteins), genomics (the study of genes), biopharmaceutical production, cell biology and food safety. Life science customers include universities and medical schools, industrial research organizations, government agencies, pharmaceutical manufacturers, biotechnology researchers, food producers and food testing laboratories. The market grows at c. 3-4% per annum. The turnover generated is c. 50% coming from instruments / apparatus and c. 50% from consumables. The segment grew over 2010-2016 at c. 2% p.a. In 2017 it will grow c. 15% thanks to the acquisition of Raindance Technologies. Margins in this business are typically very low, averaging 4-5% between 2010-2017. We think part of the reason for structurally low margins in this segment is the absence of a large recurring revenue stream. While constituting over 1/3 of total revenues, this segment contributes to less than 10% of overall EBITDA. It’s therefore not a large shareholder return driver and we will therefore ignore this segment for the rest of the analysis.

Clinical Diagnostic Segment – represents c. 64% of sales. This segment serves more “commercial” customers requiring patients’ tissue, blood or urine tests. Bio-Rad serves over 3,000 different products that cover over 300 clinical diagnostic tests to the IVD test market. Revenue in this business is recurring as it’s derived primarily from consumables (reagents). It operates under a classic razor and blades business model whereby Bio-Rad sells the machine at cost, earning very low up-front margins, thereby increasing its installed base of diagnostic tests systems requiring Bio-Rad specific consumables. C. 75% of revenues comes from reagents and only 25% from instruments. Because of its recurring revenue stream, this segment has much higher margins. Management targets over 20% consolidated EBITDA margin by 2020 which imply segment’s margins in the low to mid-20s. Hospital Laboratories represent c. 61% of sales, Transfusion laboratories represent c. 18% and c. 21% of sales come from reference laboratories (like Quest Diagnostic and LabCorp). Bio-Rad is particularly exposed to blood virus testing, blood typing and diabetes monitoring. Competition is fierce and there are a lot of competitors but each one is active in different sub-segments of the IVD testing market. Bio-Rad typically enjoys market leadership in most of its segments. Key competitors include some of the largest medical equipment and testing companies (Abbott, Roche, Siemens, Danaher, Becton Dickinson) as well as more focused niche players (bioMerieux, Ortho Clinical Diagnostics, Immucor, DiaSorin, Quotient, Grifols)

The bull case

For a $7.5bn market cap company with c. 87% free float, Bio-Rad is surprisingly under-followed, with only 4 brokers covering it, all very bullish. Unsurprisingly, short interest is just over 2%. The bull case is very simple. Bio-Rad has the lowest margins in the industry and therefore the largest scope for margin upside. EBITDA margin declined for 7 years in a row but are about to inflect:

The bull case is predicated on the fact that Bio-Rad margins should revert to the industry mean:

The progress exhibited at Q3-17 with nearly 300bps of margin expansion was taken as a sign that the worst is over for Bio-Rad and margins will expand aggressively going forward:

Combined with its management’s bullish long-term margin targets, the reversal in the company’s margin outlook propelled the stock over 100% higher in the past 2 years.

The explanation for the historical weakness in Bio-Rad margins is, according to the bulls, linked to its ERP implementation program. The company made many different acquisitions globally in the last decade. These were not properly integrated and no synergies could be extracted because the business was running on several different ERP systems. In 2011, management decided to start a large ERP implementation program to move all its systems to a single SAP ERP platform. The move was supposed to be completed in 2016 but it’s now scheduled for completion in 2019. Bio-Rad claims that margin weakness was entirely ERP driven. Once the ERP implementation is over, not only expensive consultants will no longer be necessary but the company will finally be able to deliver on several costs cutting measures.

Our variant perspective on ERP

Our channel checks offered a different perspective on the whole ERP issue. It is certainly true that the ERP move to SAP was damaging to Bio-Rad but the key point that emerged is that it had long-lasting effects on Bio-Rad competitive position in the market. The single biggest market for Bio-Rad is the blood transfusion one where delays in the reagent delivery causes substantial supply chain issues to hospitals. The blood transfusion market is very conservative and reacts very negatively to any supply disruption. Blood for transfusions doesn’t have an infinite shelf life and inability to test for fresh blood due to lack of reagents can cause serious operational issues to large hospitals. Our understanding is that Bio-Rad market share decreased and its installed base lost a number of machines because of these ERP issues. Customers that switch away from Bio-Rad are very unlikely to come back. Furthermore, our understanding is that the full ERP rollout is yet to come in Europe and customers are already preparing themselves for supply chain interruptions with competing products.

Manufactured inflection point?

Bio-Rad share price jumped 20% on the back of Q3 results which pointed to a marked improvement in margins going forward. Our strong suspicion is that the company used some aggressive tactics to deliver the reported results. Inventory levels, especially of finished goods, reached an all-time high in Q3-17. DSOs also reached an historical all-time high, suggesting channel stuffing and loose payment terms to book revenues forward. We think these practices are not sustainable and could unwind in 2018. The free cash flow generation of the business is clearly in decline and it’s a truer representation of the underlying health of Bio-Rad:

US market challenges

We think the US testing market will face strong structural headwinds going forward. There are 2 drivers of this: PAMA and a consolidating laboratory testing market.

PAMA - or Protecting Access to Medicare Act of 2014, is a legislation that requires laboratories performing clinical diagnostic tests to report the amount paid by private insurers for laboratory tests. The reason for this is to push down Medicare costs. Medicare pays c. $7bn a year to Medicare-enrolled laboratories for more than 1,300 types of clinical tests. Medicare pays well in excess of private insurers and this measure was aimed at increase transparency. Based on the acquired private payers’ costs, the CMS (Centres for Medicare & Medicaid Services) came out with a new list of prices in November 2017 to be implemented from January 2018 onwards. We have a list of 1,360 test where the CMS applied a hefty discount for the period 2018-2020. On average, each test will be cut c. 20% over the period with a 10% reduction cap where applicable. Whilst the direct effect will only be for reference laboratories with exposure to Medicare and Medicaid, the indirect effect will be felt across the industry.

Consolidating US market – for years the US laboratory market has continued to consolidate and we think that the introduction of PAMA pricing will accelerate this trend as small laboratories will not be able to survive. In 2017 alone Quest and LabCorp completed over 10 acquisitions or partnerships with smaller independent labs. A more consolidated market means more efficient procurement and more transparent pricing. As a supplier, Bio-Rad will see increased pricing pressure.

Enter Mosaic

Our channel checks indicated that Bio-Rad’s highest margin business is the blood transfusion market where they have c. 35-40% market share. This market leadership is threatened by the entrance of Mosaic, a revolutionary machine that will be launched in 2018 in Europe by Quotient. Quotient is a small cap competitor based in the US with manufacturing in Switzerland that is about to launch a new transfusion diagnostic machine that could revolutionise the blood-testing market. Our channel checks confirmed this and confirmed Mosaic’s superiority to all other offers on the market. Through molecular diagnostic, this machine will be able to provide the same type of results that competitors offer at a fraction of the price and, most importantly, it’ll be 1 machine able to do all the tests. Mosaic will be able to do all Antibody Screen tests that Bio-Rad offers but also Molecular and Serological disease screening. It will be a no-brainer for laboratories to switch their different assays for one comprehensive solution. Timing is unclear but commercial launch should be imminent. This machine would disrupt Bio-Rad core market. Historical 3% organic growth would become unachievable for Bio-Rad.

Valuation considerations

Bio-Rad is a low-margin, worst in class testing company with a challenged outlook. Even in a bullish management scenario, the business is expected to grow organically the top line at c. 4% per annum. It is therefore not worthy of a premium valuation. Yet, it is trading on over 50x P/E with a free cash flow yield of less than 2%. The valuation is distorted though by the company’s stake in Sartorius, a publicly listed German equipment manufacturer with a market cap of c. $6bn. Bio-Rad made a small investment 15 years ago in the business which is now worth c. $2bn (combining the market value of Sartorius common as well as preferred shares held by Bio-Rad), or c. 25% of Bio-Rad market cap. Even though the investment is strategic and will not be sold any time soon, we will consider it as cash and adjust the Enterprise Value accordingly. This is a very generous assumption as the investment is highly illiquid and deserves a substantial holding discount. In order to adjust for the Sartorius stake, we value Bio-Rad based on EV / EBITDA multiples. Before the recent rally, the business historically traded on c. 10x EV / EBITDA adjusted for Sartorius, which we view as generous. Our 2020 EBITDA estimate is c. 20% below consensus. Applying a 10x EBITDA multiple to 2020 EBITDA and discounting the resulting share price 2 years at 8% discount rate, we get a fair share price today of c. $170, or c. 30% below current price. We note that at $170 the stock would still trade on 2018 P/E of over 30x, a premium to its peers, with a free cash flow yield of less than 3%. Other diagnostic equipment manufacturers trade on average at 25x P/E but they grow, on average, at 9% Vs. 3-4% for Bio-Rad and exhibit EBITDA margin of c. 30%, nearly double of Bio-Rad 2017 margins.

Catalyst

• Lower than expected 2018 guidance in February 2018
• Earning misses due to continued ERP issues
• Mosaic launch in H2 2018