By
Morningstar
:
By Alex Morozov, CFA
Thermo Fisher's (
TMO
) customer approach is compelling to its customers. The company
takes the mundane work of inventory management, procurement, and
other supply chain management processes out of its laboratory
customers' hands to allow them to focus on research, while
improving productivity and providing them with savings. This
approach has successfully worked with biopharma clients, as Thermo
Fisher's top pharma accounts have grown north of company averages
over the past few years. Now Thermo Fisher is applying the same
approach across other customer end markets. The company is
targeting industrial and academic clients with the same value
proposition, and considering the savings of the one-provider model
with global presence and robust product breadth, we believe it is a
good strategic partner for clients across the spectrum. We
appreciate the relative simplicity of the one-stop-shop approach,
which has been a key pillar to our moat assessment. The strength of
this model is particularly evident in Thermo Fisher's clinical
trials logistics segment, where the company is the leading provider
of trial service offerings. Thermo Fisher can support every step of
a clinical trial, from manufacturing of pharmaceuticals to storage
and transportation. This has resulted in virtually exclusive
relationships with firms such as Merck (
MRK
), Eli Lilly (
LLY
), Celgene (
CELG
), and others for trial support.
Product Portfolio Positioned for Continued
Growth
In addition to the unmatched distribution infrastructure, the
company has a strong analytical product portfolio that further
allows for client penetration and cross-selling opportunities.
Thermo Fisher has launched a number of successful products over the
past year, particularly in mass spectrometry. The Q Exactive mass
spectrometer launched this year has already exceeded both the
firm's and our initial expectations and is on track to deliver more
than $100 million in sales despite its hefty price tag and
challenging end market conditions. Thanks to the Dionex
acquisition, its new liquid chromatography offerings also have the
potential to improve Thermo Fisher's competitive standing. The
company points out that its research and development as a
percentage of total revenue has increased from 4.1% in 2009 to 4.7%
targeted for 2012 -- although we note that a big portion of this
increase is simply due to a shift in mix aided by acquisitions.
Bringing Dionex into the fold has been successful, with cost
synergies ($11 million) and market share gains due to cross-selling
opportunities ($14 million). The Phadia deal should also be
accretive to top-line growth and profitability over the long run,
although the firm is still in the early stages of bringing it into
the fold and delivering on its promise for return on invested
capital. The market opportunity is noteworthy, given the low
penetration rate of in vitro allergy testing and relatively minimal
competition in this area. Thermo Fisher highlighted its
Procalcitonin, ImmunoCAP, and uKnow Peanut Molecular Allergy tests
as products in areas of high-growth and low competition. However,
the overall molecular diagnostics field is getting more
concentrated and more competitive. Being largely a niche assay
provider, Thermo Fisher does risk eventually running into
competitors with more robust offerings (including instrumentation).
However, the company's commitment to R&D and virtually
unlimited appetite for acquisitions should allow it to maintain its
top-tier status across the board.
China a Model for Thermo Fisher's Emerging-Market
Strategy
Emerging markets are an integral piece of the firm's strategy to
increase its top line and gain market share. These geographies
currently account for 19% of total revenue, up from 10% in 2006.
Thermo Fisher targets 25% of total sales to come from emerging
markets in 2016, implying mid-teens organic growth in these
geographies. China has been driving overall top-line growth, and
the company now targets India, South Korea, Brazil, and Russia as
areas where it can successfully implement the Chinese model and
generate double-digit revenue growth. It is important to note that
China will still be a key component of emerging markets expansion,
particularly in the lipopolysaccharide and diagnostics segments.
Unlike government spending on infrastructure and housing, Chinese
investment in life sciences and health care is still scheduled to
grow at a double-digit clip, according to the latest five-year
plan, allowing companies already on the ground (particularly Thermo
Fisher) to capture the lion's share of this growth.
Thermo Fisher points out its still minimal consumable presence
in these geographies (limited to high-end reagents) compared with
legacy Thermo Electron products that have been in this marketplace
since the 1970s. A part of the problem, in our opinion, is the
fragmented and low-cost nature of the Chinese consumables market;
Thermo Fisher is addressing this by aggressively expanding the
local manufacturing infrastructure, such as the Suzhou facility
scheduled to open in 2012. A greater local presence should allow
the firm to more effectively compete with indigenous manufacturers.
It should also support the company's push toward low-cost region
manufacturing to support its sales efforts, with the goal to
manufacture more than 50% of sales in China locally. Eventually, it
is possible that the company could move the bulk of its
manufacturing to emerging markets (it is also building out
facilities in India, Lithuania, and other countries), but given
logistical difficulties, low-cost region manufacturing will
primarily be used to serve local markets.
This does give the firm another lever to pull to improve its
operating margins, though. Nearly 11% of total manufacturing
revenue in 2011 was from low-cost regions, up from 5% in 2007, and
every $100 million of moved production saves the company $20
million. However, the magnitude of these savings from manufacturing
shifts is not likely to be fully reflected in Thermo's margins,
given the pricing dynamic in emerging markets. While the company
suggests that its margins in emerging markets are similar to
corporate averages, this can be explained by a greater percentage
of revenue in the form of high-margin instrumentation. As
low-margin consumables gain more traction, this will counter some
of these manufacturing-related margin gains. However, it does
benefit the overall cost structure, in addition to productivity
improvement measures.
On Track for Improving Margins, Double-Digit Near-Term
Growth
The company's record of margin improvement is stellar, averaging
70 basis points per year since 2006, and its forecast for 2012
calls for another 70-90 basis points of expansion (once again, some
of this is a simple mix shift benefit). While the company hasn't
offered an update to its 2012 forecast or provided 2013 guidance,
it did suggest that it should deliver double-digit earnings per
share growth in 2013, sequestration budget cuts or not. This should
soothe some investors who are worried about the impact of an
academic spending pullback on the company's earnings growth.
Several factors are likely to mitigate any sequestration-related
headwinds, from revenue as well as cost perspectives. First, the
company's total direct exposure to the National Institutes of
Health is about 5% of total sales. Second, while the indirect
exposure via academic spending is substantially higher (global
government and academic spending accounts for roughly one fourth of
total sales), the sequestration effect has more or less already
been factored into academia purchasing decisions. The NIH budget
for 2012 was 1% higher than the previous year, yet total spending
by academic and government end markets is down by mid-single
digits, suggesting that these customers aren't waiting for the
September decision on the 2013 NIH budget to adjust their budgets.
Thus, the proposed roughly 8% reduction isn't going to be as
punitive on suppliers as it appears. Thermo Fisher has felt the
effect since the third quarter of 2011 (the pullback actually
caught the firm by surprise and the stock has been punished
accordingly), so we anticipate the effect will be significantly
mitigated. Further, revenue growth is aided by the steadily
climbing presence of high-growth emerging markets in the mix.
Finally, a bulk of the company's total cost structure is variable
in nature, allowing Thermo Fisher to minimize the effect of a
revenue pullback on its margins and earnings. The latest example of
the levers the firm can pull is its 2009 performance, where
adjusted operating margins slipped only 100 basis points despite a
4% top-line decline.
The company's five-year guidance is admirable: mid-single-digit
top-line growth, 50-100 basis points of adjusted margin growth
(reaching 22%-23% by 2016), and earnings per share of $7.50-$8.75,
implying midteens growth per year. A sizable chunk of EPS growth is
due to some financial engineering, including buybacks, a product
shift mix to lower-tax locales, and a shrinking debt load. However,
Thermo Fisher's long-term adjusted operating margin improvement
targets are reasonable and just ahead of our expectation for a
40-basis-point improvement on average.
We do find Thermo Fisher's adjusted expectations for return on
invested capital (60-70 basis points of improvement per year) a bit
misleading, given that these targets don't incorporate any
acquisitions, which have been the company's modus operandi for more
than a decade. A capital allocation strategy heavily geared toward
acquisitions has resulted in suppressed ROICs, but the company is
finally in economic profit territory, having reached ROICs north of
9% (its cost of capital is roughly 9%, using the current leverage
level). We're still not convinced the company's acquisition
strategy is the most accretive use of capital to ROICs. We also
view acquisitions as the main company-specific factor contributing
to the lackluster stock performance over the past five years.
However, we think the company is likely to take a pause with
acquisitions over the next 12 months or so, small tuck-ins
notwithstanding. We think the company will probably spend the next
12 months de-leveraging its balance sheet. The recent dividend
initiation is yet another sign of the slight alteration of the
firm's capital allocation strategy, historically evenly split
between buybacks and acquisitions.
We think a less aggressive usage of capital over the past five
years would have been welcomed by investors. Nonetheless, we remain
bullish on the shares, as we think Thermo Fisher's long-term
earnings growth potential --driven by strengthening competitive
positioning and the growing penetration of higher-value-added
products and geographies -- is under-appreciated.
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See also
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on seekingalpha.com