July 1, 2007 (Vol. 27, No. 13)
How Have Companies Fared in Regard to Long-term Growth Potential?
Among the flurry of M&A activity of life sciences tools players over the past several years, some fundamental questions remain: What is the health of the overall life sciences tools industry? Are participating companies well-positioned for sustainable and profitable growth? Will these firms create long-term shareholder value? In this article, Scientia(www.scientiaadv.com) takes a look at the performance of leading life sciences tools players and attempts to answer these questions.
Our overall assessment is that while life sciences tools companies have underperformed the overall healthcare sector based on their operating performance, we are likely to see significant improvement over the next several years. However, competing players will have to fundamentally alter their existing operating and management styles and principles. While most of this industry has focused its efforts on achieving top-line growth over the past several years, the key to success will be based on achieving a careful balance between profitability and growth.
We have analyzed 30+ life sciences tools companies as well as other healthcare companies based on two metrics that are critical in driving long-term value: three-year returns on equity—ROE and three-year revenue growth rates. Our thesis is that companies that can consistently produce double-digit growth rates and generate returns on equity over their cost of equity are well positioned for sustained growth and long-term shareholder value creation.
The life sciences (LS) tools sector is a complex market with numerous segments that are at various stages of their growth cycle. While overall tools spending has been growing at a steady pace of 7–8%, each segment of this market is growing at a different rate and is at a different stage of its growth cycle. For example, the early to mid-90s saw the growth of genomics-oriented markets such as DNA sequencers, which resulted in the sequencing of the genome.
Then, the late 90s saw the emergence of early proteomics-oriented markets such as HPLC and mass spec. We are now seeing the growth of cellular/functional biology sectors, which are making a significant impact on basic cell biology research, stem cell research, as well as the pharmaceutical industry. Such spending shifts occur every five to eight years and alter the structure of the industry and the constituent players and make this a particularly challenging market in which to compete. Most established players have tried to keep up with such shifts through a flurry of M&A activity. However, as we will show, few life sciences tools companies have demonstrated their ability to create a profitable growth model over multiple product/technology cycles. In fact, our findings show that:
• Only half of the life sciences tools companies we analyzed have generated economic profits (i.e., generated return on equity over their cost of capital) over the past three years. While our analysis is over a finite timeframe, it provides a useful indicator of the overall direction of the industry.
• Darlings of the industry such as Invitrogen (www.invitrogen.com), while having fueled their growth through M&A activity, have depressed their ROE as they have acquired numerous players in the past with significant market premiums and have not been able to extract as many operating synergies as they had hoped.
• While industry ROE remains at around 11%, we think that there is significant room to increase ROE through operational improvements, re-formulating a business portfolio by divesting nonperforming assets and instituting a disciplined process to evaluate growth opportunities.
• Most established firms have been unable to foster a culture of innovation; most of the breakthrough products in LS tools over the last three years have been introduced by emerging firms. However, there are some notable exceptions:
1. Waters (www.waters.com) has consistently been able to generate high margins (25%+) and high cash flow, along with consistent growth.
2. Techne (www.techne-corp.com), which is also known as R&D Systems, has outstanding operating margins (55%+) and shown consistent double-digit growth. It has made just two small acquisitions over the past three years to broaden its diagnostics business.
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.
Arshad Ahmed is a partner at Scientia Advisors. Web: www.scientiaadv.com. E-mail: [email protected]