Mixed Operating Performance
LS tools companies have shown a wide variety of performance results over the past three years. Approximately half of them have posted an ROE that has exceeded their cost of equity. This implies that a sizable portion of the LS tools firms, including perceived leaders such as Invitrogen and Serologicals (now part of Millipore; www.millipore.com) have not yielded economic profits. While we do see high performers such as Waters and Sigma-Aldrich (www.sigmaaldrich.com) that have shown their ability to generate profits effectively while growing, they have been more the exception than the rule.
Among the high growth players in LS tools, companies such as Invitrogen, MDS Analytical Technologies (encompassing Molecular Devices; www.moleculardevices.com), and Serologicals have shown consistent growth, albeit through M&A activity, but, as a result, have depressed their ROE. However, high performers such as Waters and Sigma-Aldrich have been selective about their M&A activity and instead have focused on organic growth.
Waters is an excellent case-in-point. The last significant acquisition for Waters was Micromass in the late 90s; this has been a successful acquisition for the firm. We draw several key lessons from such dynamics:
1. LS tools firms that are generating ROE below the cost of equity need to focus on restoring profitability and extracting synergies from past acquisitions rather than growth
2. LS tools firms in general need to make capital allocation decisions that are based on careful monitoring of profitability (such as ROE) and top-line growth; firms need to ensure that growth capital is optimized particularly for M&A decisions and monitored on an on-going basis to ensure value-creation.
3. LS tools firms need to conduct a thorough review of their existing portfolio of assets (business units and product lines) to understand what to focus on and how to rationalize past investments. Emphasis needs to be put on divesting underperforming assets and temporarily shrinking the asset base and, possibly, the revenue base of the company.
While the performance of the pharma/biotech sector has been mixed, the medical devices sector as well as the diagnostics sector have produced many examples of high performers. For example, companies such as Saint Jude(www.sjm.com), Medtronic (www.medtronic.com), and Cytyc (ww.cytyc.com) have shown their ability to sustain growth with high economic profits and thus demonstrated their long-term growth potential.
Despite lower operating performance relative to other health care sectors, LS tools firms have produced relatively high shareholder value (Figure). For example, average total shareholder returns for leading LS tools firms over the past three years has been around 18%, whereas the average appears to be around 12%. There is a fundamental reason behind this trend.
Due to the relative immaturity and perceived risk of the industry, the capital markets have rewarded LS tools companies based on top-line growth. However, as the tools industry matures and its investor profile evolves, the companies in this sector will have to place much higher emphasis on sustained growth along with profitability (returns on their invested capital). Not surprisingly, many of the tools firms that have been highly acquisitive have underperformed in the capital markets relative to non-acquisitive firms. For example, Invitrogen and Millipore (highly acquisitive firms) have experienced considerable volatility in their stock prices over the past year and have not created as much shareholder value as Waters and Sigma have, which are both highly selective in acquisitions and have consistent operating performance.
Overall, the health of the LS tools industry will increasingly depend on how players respond not only to emerging competitive threats, customer needs, and technological changes but also the evolving investors who will increasingly pressure such firms to generate not only growth but also returns that exceed their cost of capital.
Our view is that the LS tools industry will continue to grow at a steady pace over the next several years. While academic research spending appears to be slowing due to NIH cuts, the pharma and biotech sectors are likely to continue spending on new technologies that address critical bottlenecks in drug discovery. Moreover, the convergence of discovery and diagnostics will create new markets for LS tools in the clinical markets (e.g., the use of tools in the diagnostic setting—theranostics and molecular diagnostics).
However, LS tools companies will have to increasingly focus on drawing a careful balance between profitability and growth. As the industry matures and attracts a more mature investor base, we will see a much higher level of discipline instituted by management teams on operational efficiency, profitability, and organic innovation. This also means that these firms need to constantly review their portfolio of assets and institute a proactive approach to managing growth. The difference between the next generation of winners and losers in this industry will depend on management’s ability to adapt to this changing environment.