Description

Summary

I am recommending a long position in Bio-Rad Laboratories (BIO). I believe the company is worth at least $208 two years from now, or ~45% upside to the current stock price. BIO has a market capitalization of $4.2 billion and enterprise value of $3.9 billion. This valuation accounts for BIO’s $1.2 billion ownership stake in Sartorius, a German pharma and lab equipment supplier. 

BIO manufactures and supplies products and systems used to separate the components of complex chemical and biological materials, analyze specific chemical and biological compounds, and standardize instrumentation and processes in clinical and research laboratories. The company operates through two segments: (i) life science and (ii) clinical diagnostics. Life sciences segment, which generates ~33% of sales, manufactures and provides wide range of laboratory instruments, apparatus, consumables and reagents used for research. Clinical diagnostics, which generates ~67% of sales, sells and supports a large portfolio of products for medical (IVD) screening and diagnostics. BIO sells through direct distribution in 35 countries, and leverages distributors in certain international markets. 

At 16.2x 2016 Adj. FCF (ex-Sartorius equity stake & net cash), BIO seems to be attractively valued. To put it in perspective, I’m assuming a ~10% EBIT margin for 2016, while management is targeting achieving “mid-teens” margins by 2018-end, post the full ERP roll-out (discussed below). That 16.2x multiple quickly becomes even more attractive if you believe that management can achieve the mid-teens EBIT margins, thus my enthusiasm. As a reference, if I assigned 15% margin on 2016 numbers then the multiple decreases to 11.8x. Meanwhile, comps (with much better margins) are trading at 18.5x 2016 PE and 18.0x 2016 FCF. So it’s easy to get excited about BIO, if one believes the margin expansion story, and (in the upside case) hopes for multiple re-rating once margins get in line with peers.

The thesis here is that BIO should expand its margins to mid-teens range through 2018-end, driven by the ERP roll-out and other company specific initiatives, thereby growing adjusted free cash flow per share to $8.98 by 2018-end. 

As a way of background, this is family run business that outgrew its internal financial controls and systems. I suspect that this “family-run” management style has resulted in (i) material weakness in internal financial controls (during 2012-2013 period) highlighted in auditor’s review, and has likely contributed to (ii) the violation of US government’s Foreign Corrupt Practices Act (due to lack of oversight). Both of these issues have been resolved, but are likely the drivers for management’s decision to develop/upgrade/implement ERP system.

The ERP roll-out will be staged in phases: BIO rolled-out 2nd phase of ERP implementation in the US and Canada in July 2015, and expects to start preparing for the ERP rollout in Europe by the end of this year / early 2016, which is expected to be very complex and should last through 2018-end. During this period, BIO expects to streamline its business and expand margins from 9% (ex-currency) in 2015 to mid-teens by 2018-end. ERP implementation should be the biggest contributor to this margin expansion story along with other initiatives that are described in more detail below. As a reference, BIO already achieved ~15% margin in 2010, so it’s not unreasonable to assume that BIO can recover the lost margin. In fact, if you add back $30M of non-recurring ERP costs that are expensed through the P&L now and $45M of EBIT drag coming from recent acquisitions, the EBIT margins would expand by 3.7% without accounting for any other cost savings. 

When valuing BIO, I focus on FCF per share since the D&A is ahead of maintenance capex (which I adjust for ERP capex). I expect BIO to generate $8.98 of adjusted FCF per share by 2018-end, driven by 3.5% topline growth and EBIT margin expansion to 14%. Assuming 17x NTM PE exit, which is at a discount to where comps are trading today, I arrive at $153 per share ex-Sartorius equity stake (post-tax) & net cash. Once I add the 2017-end net cash balance $22 per share and Sartorius equity stake value of $33 per share (which assumes no appreciation and is post tax, so overly conservative), then the resulting value per share would be $208 or 46% upside to the current share price of $143 per share. This results in high teens IRR (~17%) through 2017-end, which I consider to be attractive in light of additional optionality that BIO offers. Namely, BIO could deploy net cash into acquisitions and/or share buybacks. Further, I’m modeling the 2018 EBIT margin at the lower end of BIO’s goal of mid-teens (14-16%). Also, management expects to enjoy more favorable tax rate post ERP roll-out as it will be able to re-direct its profits through more favorable tax regimes (similar to its competitors), which should lower the corporate tax rate to mid-20s range from 33% today that I’m keeping flat through 2018-end. All three of these initiatives would drive earnings and FCF growth in excess of my current projections. Lastly, at exit I assume no appreciation for Sartorius equity stake and I’m actually adding post-tax value of it, which is conservative. The Sartorius equity stake, which accounts for ~23% of today’s BIO equity value, should be meaningful value driver and thus an attractive upside option. 

Key Assumptions

Since BIO is performing in line with its guidance for 1H2015, I’m assuming that 2015 ends up within the guidance range.

Below, I discuss the key drivers of my model for 2016 through 2018.

Revenue is expected to grow at 4%, 3.5% and 3% during 2016, 2017 and 2018, respectively. 2015 and 2016 will get the benefit of new product introductions (discussed in more detail during earnings calls) which are expected to drive above trend organic growth rate for that period. However, I’m assuming that 2017 and 2018 return to more normalized ~3% organic growth rate. 

EBIT margins (of 9%) are improving to 14.1% by 2018-end, driven by (i) elimination of non-recurring portion ERP costs that are currently flowing through the P&L, (ii) phase-out of the current $45 million drag arising from acquisitions (it was ~$70 million drag last year), (iii) gross margin expansion arising from improved procurement and (iv) decreased spending on SG&A as percentage of sales arising from global consolidation of back office functions. To be sure, all these drivers are arising from ERP roll-out and recent reorganization initiatives, which are discussed in more detail below. 

Tax rate is decreasing slightly to 32% from 33% today. As previously mentioned, this is more conservative than ~25% tax rate that management is expecting to achieve post ERP roll-out. 

I expect BIO to spend $125-135 million in Capex annually through 2018-end, which is above 2013 and 2014 levels and in line with management guidance. Note that this includes $30-40 million of ERP investments, which I consider to be non-recurring as ERP buildout should conclude by the 2018-end. Thus I adjust my FCF for the $30-40 million ERP Capex. 

FCF, post all earn-out payments, is assumed to accrue to the cash account on the balance sheet. Note that BIO has $425 million of 4.875% notes that I’m not paying off in my model. 

Investment Highlights

(i) Attractive valuation. As discussed, I think BIO is attractively valued especially if one believes in the margin expansion story. I’m focusing on adjusted FCF per share, as I think that’s the best way to value this business. EPS will be depressed by the inflated D&A coming from ERP investment, so D&A should be trending in excess of maintenance capex, which is capex excl. ERP investment in my model. 

(ii) Margin expansion story. For the first time in 5 years, BIO is starting to expand its margins. The biggest driver of margin expansion is the roll-out of the ERP system. As discussed, almost half of the margin expansion is achieved through the elimination of non-recurring ERP expenses (slightly offset by higher D&A) and EBIT drag arising from recent acquisitions, which should be flushed by 2018-end. The other half of margin expansion should come from (a) headcount reduction arising from back office consolidated on global basis, (b) procurement / increased purchasing power, (c) better NWC management, and (d) improved logistics. Currently BIO is half way through global ERP roll-out and expects to finish the project by 2018-end. As such, management expects to return to ~15% EBIT margins by the 2018-end (vs. ~9% today), with benefit of several years of additional 100bps of cost savings thereafter.

• Finished the 1st rollout in April 2013;

• Finished the 2st ERP rollout (to Canada and rest of the US, which represents ~35% of business) in July 2015.

• BIO will launch the 3rd phase of ERP buildout in late 2015 to cover the EU which is expected to be the most complex market yet, and will likely yield most attractive returns. Management noted in an earnings call: “And Europe, as we've talked about in the past, is extremely complex with 40 entities and more than 10 systems, et cetera. And so they'll be spending the better part of all of 2016 really working on that design and implementation. And barring any bumps in the road, we were hoping to start to go through a series of deployments in 2017 in Europe”

(iii) Organizational restructuring should accelerate the margin expansion. In 2014/2015YTD, BIO (a) globalized the supply chain, (b) globalized sales organization, (c) created a COO role, (d) is streamlining manufacturing footprint (closing manufacturing facilities), and (e) is shedding unprofitable products. All these initiatives are incremental to ERP deployment and should contribute to the ~15% margin goal. 

(iv) Good business. BIO enjoys (a) predictable top line trajectory, (b) strong market leadership, (c) diversified revenue mix and (d) recurring revenue base.

• BIO has grown for each of last 10 years, even during the financial crisis.

• >80% of revenues comes from areas where BIO holds top 3 position (vs. 3 years ago when it was 60%).

• Overall portfolio essentially comprised of several $100M product franchises which mitigates competitive pressure for any specific area. Also, no single customer accounts from more than 3% of sales

• The diagnostics segment, which accounts for 66% of sales, is a high recurring revenue business. An install base of diagnostic test systems typically creates an ongoing source of revenue through a sale of test kits for each sample analyzed on an installed system.

(v) Possible take out target. On a revenue multiple this business is trading at significant discount to peers – the obvious reason for this are lower margins. If the acquirer can bring margins up / eliminate costs, this could be a very accretive transaction. When comparing BIO’s cost structure to its peers, one could make a strong argument that the acquisition of BIO (by one of its peers) could result in meaningful cost synergies – the biggest disconnect arises at SG&A and R&D, both of which could be largely eliminated through a transaction.

• BIO’s COGS as % of sales is 45% vs. competitors: BIM ~50%, TMO ~54%, DHR ~47%, BDX ~49%, PKI ~55%.

• BIO’s SG&A as % of sales is 36% vs. competitors: BIM ~25%, TMO ~28%, DHR ~28%, BDX ~25%, PKI ~29%.

• BIO’s R&D as % of sales is 10% vs. competitors: BIM ~12%, TMO ~4%, DHR ~7%, BDX ~6%, PKI ~6%.

• BIO is trading at ~1.8x 2016 sales vs. peer group of ~3.0x. If Sartorius equity stake is treated as cash and backed out of EV calculation, then the BIO sales multiple decreases even further.

Investment Concerns / Risks

(i) Exposure to 3rd party payors (government health care programs, commercial insurance and managed healthcare organization), which are increasingly reducing reimbursements for certain medical products and services. Government and academic customers account for majority of BIOs revenues. Reimbursement reforms are putting pressure on the growth in developed markets (grants and research are under pressure). However, most of the growth in coming years is expected to come from emerging markets which have less exposure to 3rd party payor issues. 

(ii) Customer consolidation pressure. Customer consolidation in France is putting pressure on volumes and pricing, but management argues that this consolidation is in late innings. However, same / similar market dynamics could repeat themselves in other markets.

(iii) Poor M&A track record. BIO absorbed 4 dilutive acquisitions since 2011, which are estimated to be a $45M drag to EBIT margins. BIO typically acquires pre-profit businesses, but recent acquisitions have not performed as planned. 

(iv) Control owner. The ownership structure makes it difficult to acquire this business, as the family owner has voting and board control. The Schwartz family collectively held approximately 15% of our Class A Common Stock and 94% of our Class B Common Stock. As a result, the Schwartz family has the control. 

(v) FX exposure. ~68% of sales come from international markets while 35-40% of expenses are from international markets. 

(vi) Trapped valued of Sartorius equity stake. BIO has increased its Sartorius stake over last 20 years and views it as strategically important. In fact, management would like to acquire Sartorius once the Sartorius family trust decides to liquidate its position, which won’t happen for another 15 years or so (because of how the trust is structured). Therefore Sartorius equity could remain a trapped value and not get the full credit by the market. 

No reliance, no update and use of information. You may not rely on the information set forth in the above write­-up as the basis upon which you make an investment decision. To the extent that you rely on such information, you do so at your own risk. The write­-up does not purport to be complete on the topic addressed, and we do not intend to update the information contained therein, even in the event that the information becomes materially inaccurate. Certain information contained in the write­-up includes calculations or projections that been prepared internally; use of a different method for preparing such calculations or projections may lead to different results and such differences may be material. We now own the security discussed above, and may decide to buy or sell such securities at any time of our choosing without providing an update.

Catalyst

BIO significantly surpassed consensus estimates for the 4Q2014 and 1Q2015, due to higher than expected profitability. Similarly, phase 2 of ERP rollout should hit the P&L and start expanding margins in 4Q2015 / 1Q2016, which should provide more excitement around margin expansion thesis and/or phase 3 of the ERP roll-out. 

Additionally, management may announce a share buyback or institute a dividend as the cash continues to build on the balance sheet.